Early Warning Signals (including Sma And Rfa ): Puneeta Chugh Mcom 2 5817

EARLY WARNING SIGNALS (INCLUDING SMA and RFA ) PUNEETA CHUGH MCOM 2 5817

INTRODUCTION • MEANING - A non performing asset (NPA) refers to a classification for loans on the books of financial institutions that are in default or are in arrears on scheduled payments of principal or interest. In most cases, debt is classified as nonperforming when loan payments have not been made for a period of 90 days. • No loans turn NPA overnight. It is generally a prolonged affair. The failure of the banks to notice the warning signals lead to repayment problems or potential cases of NPA. • The early warning signals are those which clearly indicates or show some signs of credit deterioration in the loan account. They indicate the potential problems involved in the accounts so that remedial action can be initiated immediately.

CLASSIFICATION OF EARLY WARNING SIGNALS

EARLY WARNING SIGNALS

FINANCIAL

OPERATIONAL

BANKING

MANAGERIAL

EXTERNAL

OTHERS

FINANCIAL WARNING SIGNALS • • • • • • • • •

Default in repayment. Continuous irregularity in the account. Devolvement of LC or invocation of guarantees. Deterioration in working capital position or in liquidity. Declining sales compared to previous period Substantial increase in long term debts. Raising sales but falling profits. Incurring operating losses or net losses. Raising level of bad debt losses.

OPERATIONAL WARNING SIGNALS • • • •

Underutilisation of plant capacity Non payments of electricity, wages etc Frequent labour problems Poor diversification and frequent changes in plan for expansion or diversification or modernization. • Delayed or missed employee payrolls. • Evidence of overstocking and aged inventory. • Loss of important customers

MANAGERIAL WARNING SIGNALS • Diversion of funds and poor financial controls. • Lack of cooperation from key personnel. • Change in ,management or ownership pattern or key personnel. • Undertaking of undue risks. • Fudging of financial statements.

BANKING WARNING SIGNALS • Frequent request for further loans • Delays in servicing of interest • Reduction of operations in the account or reduction in bank balances. • Breaching the limit of operating loans; for example, a sudden overdraft without any business logic. • Opening of accounts with other banks. • Dishonour of cheques or return of bills sent for collection • Not routing sales transactions through the account. • Delays in submitting stock statements and other data or non submission of periodical statement. • Frequent excesses in the account.

EXTERNAL WARNING SIGNALS • Economic recession. • Introduction of new technology • Changes in government policies • Emergence of new competition. • Natural calamities. • Weakening of industry characterstics.

OTHER INDICATORS

OTHER INDICATORS BEHAVIOUR

GEOGRAPHIC

INDUSTRY

PERCEPTION

BEHAVIOURAL INDICATORS

• Any attempt at deception / misrepresentation of facts. • Regular and consistent attempts at delaying financial reporting requirements; unwillingness to respond to various communications. • Avoiding direct and complete responses to specific questions; bluffing by answering a question with a question. • Evading requests or providing irrelevant information to a request; excessive delays in responding to a request for no valid reason. • Creating fake or shell entities for the purpose of misappropriating goods and services. • Transferring assets without any concrete business reason to back up the decision; disposing of the asset at less than the fair value.

GEOGRAPHIC INDICATORS • Exchange rate devaluation. • Continuous decline in economic growth in the region • Steady growth in money laundering. Country risks due to unfavorable political environment

INDUSTRY INDICATORS • Increase in adverse industry regulations, such as a ban on exports. • Inability to control increasing costs and rising input prices. • Changing customer behavior with respect to the business segment.

PERCEPTION INDICATORS • A decrease in awareness of the client’s brand and/or logo. • Less positive media exposure. • Deteriorating relationships. • Negative price perception in the eyes of end customers

FRAMEWORK FOR DEALING WITH LOAN FRAUDS • Objective of the framework • Objective of this framework is to direct the focus of banks on the aspects relating to prevention, early detection, prompt reporting to the RBI (for system level aggregation, monitoring & dissemination) and the investigative agencies (for instituting criminal proceedings against the fraudulent borrowers) and timely initiation of the staff accountability proceedings (for determining negligence or connivance, if any) while ensuring that the normal conduct of business of the banks and their risk taking ability is not adversely impacted and no new and onerous responsibilities are placed on the banks.

Early Warning Signals (EWS) and Red Flagged Accounts (RFA) • • •

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A RFA is one where a suspicion of fraudulent activity is thrown up by the presence of one or more Early Warning Signals (EWS). These signals in a loan account should immediately put the bank on alert regarding a weakness or wrong doing which may ultimately turn out to be fraudulent. All accounts beyond Rs.500 million classified as RFA or ‘Frauds’ must also be reported on the CRILC( Central repository of information on large credits) data platform together with the dates on which the accounts were classified as such. The CRILC data platform is being enhanced to provide this capability by June 1, 2015. The modalities for monitoring of loan frauds below Rs.500 million threshold is left to the discretion of banks. However, banks may continue to report all identified accounts to CFMC( central fraud monitoring cell), RBI as per the existing cut-offs. The tracking of EWS in loan accounts should not be seen as an additional task but must be integrated with the credit monitoring process in the bank so that it becomes a continuous activity.

Some Early Warning signals which should alert the bank officials about some wrongdoings in the loan accounts which may turn out to be fraudulent (APPENDIX I) • • • • • • • • • • • • • • •

Default in payment to the banks/ sundry debtors and other statutory bodies, etc., bouncing of the high value cheques Raid by Income tax /sales tax/ central excise duty officials Frequent change in the scope of the project to be undertaken by the borrower Under insured or over insured inventory Invoices devoid of TAN ( Tax Deduction and Collection Account Number) and other details Dispute on title of the collateral securities Costing of the project which is in wide variance with standard cost of installation of the project Funds coming from other banks to liquidate the outstanding loan amount Foreign bills remaining outstanding for a long time and tendency for bills to remain overdue Onerous clause in issue of BG/LC/standby letters of credit In merchanting trade, import leg not revealed to the bank Request received from the borrower to postpone the inspection of the godown for flimsy reasons Delay observed in payment of outstanding dues Financing the unit far away from the branch Claims not acknowledged as debt high

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Frequent invocation of BGs and devolvement of LCs Funding of the interest by sanctioning additional facilities Same collateral charged to a number of lenders Concealment of certain vital documents like master agreement, insurance coverage Floating front / associate companies by investing borrowed money Reduction in the stake of promoter / director Resignation of the key personnel and frequent changes in the management Substantial increase in unbilled revenue year after year. Large number of transactions with inter-connected companies and large outstanding from such companies. Significant movements in inventory, disproportionately higher than the growth in turnover. Significant movements in receivables, disproportionately higher than the growth in turnover and/or increase in ageing of the receivables. Disproportionate increase in other current assets. Significant increase in working capital borrowing as percentage of turnover. Critical issues highlighted in the stock audit report. Increase in Fixed Assets, without corresponding increase in turnover (when project is implemented). Increase in borrowings, despite huge cash and cash equivalents in the borrower’s balance sheet.

• Liabilities appearing in ROC search report, not reported by the borrower in its annual report. • Substantial related party transactions. • Material discrepancies in the annual report. • Significant inconsistencies within the annual report (between various sections). • Poor disclosure of materially adverse information and no qualification by the statutory auditors. • Frequent change in accounting period and/or accounting policies. • Frequent request for general purpose loans. • Movement of an account from one bank to another. • Frequent ad hoc sanctions. • Not routing of sales proceeds through bank • LCs issued for local trade / related party transactions

• Filing Complaints with Law Enforcement Agencies • Banks are required to lodge the complaint with the law enforcement agencies immediately on detection of fraud. • delays may result in the loss of relevant ‘relied upon’ documents, nonavailability of witnesses etc.

• Penal measures for fraudulent borrowers • In particular, borrowers who have defaulted and have also committed a fraud in the account would be debarred from availing bank finance from Scheduled Commercial Banks, Development Financial Institutions, Government owned NBFCs, Investment Institutions, etc., for a period of five years from the date of full payment of the defrauded amount. • No compromise settlement involving a fraudulent borrower is allowed unless the conditions stipulate

• Central Fraud Registry The Reserve Bank is in the process of designing a Central Fraud Registry, a centralised searchable database, which can be accessed by banks.

WHAT IS SPECIAL MENTION ACCOUNTS (SMA)? • The classification of Special Mention Accounts (SMA) was introduced by the RBI in 2014, to identify those accounts that has the potential to become an NPA/Stressed Asset. • Logic of such a classification is because some accounts may turn NPA soon. • Here, an early identification will help to tackle the problem better. • Special Mention Accounts are those assets/accounts that shows symptoms of bad asset quality in the first 90 days itself

WHAT IS THE DIFFERENCE BETWEEN NPA AND SMA?

A non performing asset (NPA) refers to a classification for loans on the books of financial institutions that are in default or are in arrears on scheduled payments of principal or interest. In most cases, debt is classified as nonperforming when loan payments have not been made for a period of 90 days or more.

•On the other hand, the worst type of special mention account (SMA – 2) has less than 90 days’ duration. • The Special Mention Account identification is an effort for early stress discovery of bank loans. It was introduced as a corrective action plan to contain stress.

CLASSIFICATION OF SPECIAL MENTION ACCOUNTS SMA Sub Category

Classification basis

SMA – NF

Non-financial (NF) signals of stress

SMA-0

Principal or interest payment not overdue for more than 30 days but account showing signs of incipient stress, Delay of 90 days or more in (a) submission of stock statement / other stipulated operating control statements or (b) credit monitoring or financial statements or (c) non-renewal of facilities based on audited financials.

SMA- 1

Principal or interest payment overdue between 31-60days.

SMA – 2

Principal or interest payment overdue between 61-90 days.

RECENT NEWS

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The Reserve Bank of India (RBI) has sent commercial banks a second list of at least 26 defaulters with which it wants creditors to start the process of debt resolution before initiating bankruptcy proceedings. These are accounts where 60% of the outstanding amount was classified as non-performing on the books of banks as of 30 June. Videocon Industries Ltd and Jai prakash Associates Ltd (JAL) are the two large companies among the list of 26 defaulters, accounting for over Rs1 trillion of debt. The Reserve Bank of India (RBI) sought to address potentially about one fourth of the Rs 10 lakh-crore non-performing assets (NPAs) on the books of local lenders, mandating that a dozen such accounts be taken to the bankruptcy courts. Although the RBI didn't name any defaulter, bankers say borrowers such as Bhushan Steel, Essar Steel, Lanco, and Alok Textiles may be the first set of companies facing proceedings under stringent recovery laws.