A commercial bank largely depends on its profit. The more profit it earns, the better business it can do. However, with the increase in loan failures, the share of non-Performing advances goes up. It adversely affects profitability.
Research has been done to examine a bank through bank-specific and macroeconomic predictors of profitability. And the research has clearly shown a correlation between NPA and the rate of profit.
With stringent procedures to give loans, and a better NPA account settlement process, a bank can improve its profitability ratio. It has to be done to reduce the NPA and operating cost, and thereby increase the profitability.
How does NPA affect profitability?
NPA in India has become a big problem. As banks face more cases of non-performing advances, they get worried about their financial health.
Not only an NPA makes an asset non-productive, but it results in the non-recovery of the principal capital as well.
Loss of interest puts a dent in the income. Loss of capital erodes the capital base. Both can potentially affect a bank and its stability.
When do we call an asset non-productive? According to the definition given by the RBI, an asset for which the principal or interest payment remains overdue for a period of 90 days, it is called NPA. There are three sub-categories of it: Substandard asset, Doubtful asset, and Loss Assets.
When an NPA remains in the same category for a period less than or equal to one year, it is called a substandard asset.
When it becomes NPA for more than 12 months, then it goes into the category of Doubtful Asset.
A Loss Asset is an NPA for which, the loss has been identified and the amount is not written off.
The total NPA of a financial institution is the combination of these three subcategories.
Due to the increase in the operating cost and drop in the interest amount, profitability goes down. The bank has to do provisioning out of their operating profit. It causes a dent in its profit margin.
Apart from generic aspects, every bank has some bank-specific determinants of profitability. They should be considered while deciding the NPA account settlement procedure.
Total bank assets, total deposits in the bank, the proportion of non-interest income are a few examples.
Looking at the higher impact of NPA in India on profitability, it is mandatory to keep it under control. It is the only way of recovery.