10.5 Priority Sector Lending (PSL), Non-Performing Assets (NPAs), SARFAESI, IBC & Basel III

The core function of commercial banking involves mobilizing deposits and allocating credit. However, financial stability requires strict regulatory oversight regarding directional credit allocation (Priority Sector Lending), credit risk management (NPA classification and provisioning), legal recovery mechanisms (SARFAESI & IBC), and global prudential capital standards (Basel III norms). Banking examinations place paramount emphasis on these operational and regulatory directives.

1. Priority Sector Lending (PSL) Directives

Priority Sector Lending (PSL) is a regulatory framework mandated by the RBI requiring commercial banks to dedicate a fixed portion of their credit to vulnerable, credit-constrained sectors essential for national economic development.

Target Mandates by Bank Category

• Domestic Commercial Banks (Public & Private) & Foreign Banks with $\ge 20$ Branches: 40% of ANBC (Adjusted Net Bank Credit) or CEOBE (Credit Equivalent Amount of Off-Balance Sheet Exposure), whichever is higher.
• Regional Rural Banks (RRBs) & Small Finance Banks (SFBs): 75% of ANBC or CEOBE.
• Foreign Banks with $< 20$ Branches: 40% of ANBC (up to 32% can be in the form of export credit, and $\ge 8%$ in other priority sectors).
• Primary Urban Co-operative Banks (UCBs): Target phased up to 75% of ANBC by March 31, 2026.

Sectoral Sub-Targets for Domestic Commercial Banks

1. Agriculture: 18% of ANBC (with a mandatory sub-target of 10% eamarked for Small and Marginal Farmers - SMFs).
2. Micro Enterprises: 7.5% of ANBC.
3. Weaker Sections: 12% of ANBC (includes SC/ST, women beneficiaries, PwDs, SMFs, distressed farmers, and MUDRA loan beneficiaries).

Non-Achievement Penalties & PSLCs

• Fund Allocation: Shortfalls in meeting PSL targets are deposited into designated funds earning sub-market interest rates: Rural Infrastructure Development Fund (RIDF) managed by NABARD, or funds with SIDBI, MUDRA, or NHB.
• Priority Sector Lending Certificates (PSLCs): Traded on RBI's e-Kuber portal. Banks exceeding their PSL targets can sell PSLCs (PSLC-Agriculture, PSLC-SFM, PSLC-Micro, PSLC-General) to banks facing shortfalls without transferring the underlying loan risk.

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2. Non-Performing Assets (NPAs) and Asset Classification

An asset (loan or advance) becomes a Non-Performing Asset (NPA) when it ceases to generate income for the bank.

Criteria for NPA Classification

• Term Loans: Interest or instalment of principal remains overdue for more than 90 days.
• Overdraft / Cash Credit (OD/CC): Account remains 'Out of Order' (no credit for continuous 90 days or credits insufficient to cover interest).
• Agricultural Loans:
  • Short Duration Crops (e.g., paddy, wheat): Overdue for more than 2 crop seasons.
  • Long Duration Crops (e.g., sugarcane, banana): Overdue for more than 1 crop season.

Early Warning Framework: Special Mention Accounts (SMA)

To detect stress early, banks categorize overdue accounts into SMA levels before they turn into NPAs:

• SMA-0: Principal or interest overdue for 1 to 30 days.
• SMA-1: Principal or interest overdue for 31 to 60 days.
• SMA-2: Principal or interest overdue for 61 to 90 days.

Asset Categories & RBI Provisioning Norms

                          ┌────────────────────────┐
                          │   BANK ADVANCES ASSETS  │
                          └───────────┬────────────┘
                                      │
            ┌─────────────────────────┴─────────────────────────┐
            ▼                                                   ▼
┌──────────────────────┐                             ┌──────────────────────┐
│   STANDARD ASSETS    │                             │ Non-Performing Assets│
│ (Performing: <90 days│                             │    (NPAs > 90 days)   │
└──────────────────────┘                             └──────────┬───────────┘
                                                                │
               ┌────────────────────────────────────────────────┼────────────────────────────────┐
               ▼                                                ▼                                ▼
    ┌──────────────────────┐                         ┌──────────────────────┐         ┌──────────────────────┐
    │ Sub-Standard Assets  │                         │   Doubtful Assets    │         │     Loss Assets      │
    │  (NPA <= 12 months)  │                         │   (NPA > 12 months)  │         │(100% Loss Identified)│
    └──────────────────────┘                         └──────────────────────┘         └──────────────────────┘

1. Standard Assets (Performing): Operational loans without default. Provisioning ranges from 0.25% (agri/MSE) to 0.40% (general corporate) to 1.00% (commercial real estate).
2. Sub-Standard Assets: Remained an NPA for a period less than or equal to 12 months.
   • Provisioning: 15% for secured portion, 25% for unsecured portion.
3. Doubtful Assets: Remained in the sub-standard category for exceeding 12 months.
   • Doubtful 1 (D1, up to 1 year): 25% secured, 100% unsecured.
   • Doubtful 2 (D2, 1 to 3 years): 40% secured, 100% unsecured.
   • Doubtful 3 (D3, > 3 years): 100% secured, 100% unsecured.
4. Loss Assets: Asset identified as uncollectible by the bank, internal/external auditors, or RBI inspectors, but not yet written off completely. Provisioning: 100%.

Core NPA Ratios

$\text{Gross NPA Ratio} = \left( \frac{\text{Gross NPAs}}{\text{Gross Advances}} \right) \times 100$

$\text{Net NPAs} = \text{Gross NPAs} - \text{Provisions Held} - \text{Claims Received (ECGC/DICGC)}$

$\text{Net NPA Ratio} = \left( \frac{\text{Net NPAs}}{\text{Net Advances}} \right) \times 100$

$\text{Provision Coverage Ratio (PCR)} = \left( \frac{\text{Total Provisions Held}}{\text{Gross NPAs}} \right) \times 100$

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3. NPA Resolution Frameworks: SARFAESI Act & IBC 2016

SARFAESI Act, 2002

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 empowers banks and financial institutions to enforce underlying security interests without judicial intervention.

• Pre-requisites: Account must be classified as NPA; minimum default amount must be $\ge$ ₹1 Lakh; and remaining debt must be $\ge 20%$ of principal and interest.
• Procedure: Bank serves a 60-day demand notice under Section 13(2). If the borrower fails to discharge liabilities within 60 days, the bank can take possession of secured assets, take over management, or auction the collateral.
• Exclusions: Agricultural land cannot be seized under the SARFAESI Act.
• Asset Reconstruction Companies (ARCs): Specialized institutions registered under RBI that acquire bad loans from banks. The National Asset Reconstruction Company Limited (NARCL / Bad Bank) was established with government guarantees to resolve mega-NPA stress.

Insolvency and Bankruptcy Code (IBC), 2016

The IBC, 2016 provides a consolidated, time-bound legal framework for insolvency resolution of corporate debtors, partnership firms, and individuals.

• Adjudicating Authorities:
  • NCLT (National Company Law Tribunal): Adjudicating authority for Corporate Debtors and LLPs.
  • DRT (Debt Recovery Tribunal): Adjudicating authority for Individuals and Partnership firms.
• Insolvency Regulator: Insolvency and Bankruptcy Board of India (IBBI).
• Threshold: Minimum default threshold for initiating Corporate Insolvency Resolution Process (CIRP) is ₹1 Crore.
• Time Limit: CIRP must be completed within 180 days (extendable by 90 days, with a mandatory upper ceiling of 330 days including legal litigation time).

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4. Basel III Capital Framework

Developed by the Basel Committee on Banking Supervision (BCBS) at the Bank for International Settlements (BIS) in Basel, Switzerland, Basel III accords establish international capital and liquidity standards.

Three Pillars of Basel III

1. Pillar 1: Minimum Capital Requirements: Quantitative rules covering Credit Risk, Market Risk, and Operational Risk.
2. Pillar 2: Supervisory Review Process: ICAAP (Internal Capital Adequacy Assessment Process) enabling regulators to evaluate risk profiles.
3. Pillar 3: Market Discipline: Public disclosures to enhance market transparency.

Capital Structure & RBI Mandated Ratios for Indian Banks

$\text{CRAR (Capital to Risk-Weighted Assets Ratio)} = \left( \frac{\text{Tier 1 Capital} + \text{Tier 2 Capital}}{\text{Total Risk Weighted Assets (RWA)}} \right) \times 100$

• Tier 1 Capital (Going-Concern Capital): Common Equity Tier 1 (CET1: equity shares, retained earnings) + Additional Tier 1 (AT1: perpetual non-cumulative preference shares, AT1 bonds).
• Tier 2 Capital (Gone-Concern Capital): Subordinated debt, general provisions, revaluation reserves.

Basel III Liquidity Standards

• Liquidity Coverage Ratio (LCR): Requires banks to hold sufficient High-Quality Liquid Assets (HQLA) to survive a 30-day severe stress scenario ($LCR \ge 100%$).
• Net Stable Funding Ratio (NSFR): Requires banks to maintain a stable funding profile in relation to off-balance sheet and on-balance sheet activities over a 1-year horizon ($NSFR \ge 100%$).

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5. Step-by-Step Worked Example

Problem Scenario

A scheduled commercial bank presents the following financial health data:

• Gross Total Advances = ₹10,000 Crore
• Gross NPAs = ₹600 Crore
• Provisions Held against NPAs = ₹360 Crore
• Tier 1 Capital = ₹720 Crore
• Tier 2 Capital = ₹240 Crore
• Total Risk-Weighted Assets (RWA) = ₹8,000 Crore

Calculate:

1. Gross NPA Ratio
2. Net NPA Ratio
3. Provision Coverage Ratio (PCR)
4. Capital to Risk-Weighted Assets Ratio (CRAR / Capital Adequacy Ratio)

Step-by-Step Solution

1. Gross NPA Ratio: $\text{Gross NPA Ratio} = \left( \frac{600}{10,000} \right) \times 100 = 6.0\%$

2. Net NPA Ratio: $\text{Net NPAs} = \text{Gross NPAs} - \text{Provisions} = 600 - 360 = \text{INR }240\text{ Crore}$ $\text{Net Advances} = \text{Gross Advances} - \text{Provisions} = 10,000 - 360 = \text{INR }9,640\text{ Crore}$ $\text{Net NPA Ratio} = \left( \frac{240}{9,640} \right) \times 100 = 2.49\%$

3. Provision Coverage Ratio (PCR): $\text{PCR} = \left( \frac{360}{600} \right) \times 100 = 60.0\%$

4. Capital to Risk-Weighted Assets Ratio (CRAR): $\text{Total Capital} = \text{Tier 1 Capital} + \text{Tier 2 Capital} = 720 + 240 = \text{INR }960\text{ Crore}$ $\text{CRAR} = \left( \frac{960}{8,000} \right) \times 100 = 12.0\%$ Interpretation: The bank's CRAR of 12.0% comfortably exceeds RBI's minimum requirement of 9.0% (and 11.5% including CCB).

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6. Exam Strategies & Common Traps

• Trap 1: PSL Target Percentages. Domestic commercial banks must achieve 40% of ANBC, while RRBs and Small Finance Banks (SFBs) must achieve 75% of ANBC.
• Trap 2: SMA Categorization Windows. SMA-0 = 1-30 days; SMA-1 = 31-60 days; SMA-2 = 61-90 days. Defaulting beyond 90 days moves the asset into NPA (Sub-Standard).
• Trap 3: SARFAESI Exceptions. Agricultural land cannot be seized under SARFAESI. Also, SARFAESI cannot be invoked if the remaining default amount is less than 20% of the principal + interest or under ₹1 Lakh.
• Trap 4: Basel III CRAR Comparison. Basel Committee prescribes minimum 8.0% CRAR, but RBI mandates a stricter 9.0% minimum CRAR for Indian banks (11.5% including CCB).