Recognising bad loans: SMA, NPA classification and provisioning (IRAC norms)

Detail

1. What IRAC norms are and why they exist

• IRAC = Income Recognition and Asset Classification. These are RBI rules on:
• when a bank may count interest as income
• how it must label each loan by quality

• how much money it must set aside against each label (provisioning)

• RBI brought in these prudential norms (safety rules for banks) step by step. The aim was to make bank accounts more consistent and transparent [2][3].

• Income recognition rule: a bank must not book interest as income just because it has fallen due (accrual basis) if the interest or principal is unpaid for more than 90 days. It counts that income only when cash actually comes in [3].

• Why this matters: before these norms, banks could show unpaid interest as "profit". This made weak banks look healthy.

• Recognition depends on repayment record. RBI says a loan is classified as NPA based on whether money is actually being repaid [3].

• Short-term paperwork gaps do not make a loan an NPA by themselves. Examples: a late stock statement, a limit not renewed on time, or a balance briefly above the limit [3].

2. The classification ladder

Standard asset

• The borrower pays on schedule.
• The loan carries no more than normal business risk [2].

Special Mention Accounts (SMA): the early-warning stage

• SMA = a loan that shows early signs of stress. It is still not an NPA [3].
• It is sorted by how many days payment is overdue:

Class	Days overdue	Meaning
SMA-0	1-30	first missed payment
SMA-1	31-60	stress building
SMA-2	61-90	one step away from NPA

• CRILC (Central Repository of Information on Large Credits): RBI's central database of big loans.
• Banks must report every borrower with total exposure of Rs 5 crore and above to CRILC, along with its SMA status.
• Why: a borrower who is in SMA-2 at Bank A becomes visible to Banks B and C. This stops a company from quietly defaulting at one bank while borrowing from others.

Non-Performing Asset (NPA)

• Definition: a loan on which interest or a principal instalment stays overdue for more than 90 days [2].
• History: the limit was 180 days before 2004. The 90-day rule brought India close to international practice under the Basel norms (global banking-safety standards set by the Basel Committee).
• Special cases:
• Overdraft or cash-credit account (a running credit line, not a fixed loan): NPA once it is "out of order" for more than 90 days [2]. "Out of order" broadly means the balance stays above the sanctioned limit, or no credits come in to cover the interest.
• Farm loans follow the crop cycle, not a calendar:
  • Short-duration crops: NPA if overdue for two crop seasons [2]
  • Long-duration crops: NPA if overdue for one crop season [2]
  • Long-duration crop = a crop season longer than one year. All other crops are short-duration [2].
  • Why: a farmer can repay only after harvest, so a 90-day clock would be unfair.

3. NPA sub-classes: the longer a loan stays bad, the worse its label

Sub-class	Rule	D-bucket
Sub-standard	NPA for up to 12 months, with clear credit weakness [2]	—
Doubtful	stayed sub-standard for 12 months. Full recovery is "highly questionable and improbable" [2]	D1 = up to 1 year as doubtful · D2 = 1-3 years · D3 = over 3 years
Loss	named as uncollectible by the bank, its auditors or RBI inspection, but not yet written off [2]	—

• Worked timeline (a term loan):
• An instalment is due on 1 January 2024 and is not paid.
• It becomes SMA-0 (Day 1), then SMA-1 (Day 31), then SMA-2 (Day 61).
• It becomes an NPA/sub-standard on Day 91 (about 1 April 2024).
• It becomes Doubtful D1 from about April 2025, D2 from about April 2026 and D3 from about April 2029.
• It can be moved to Loss at any stage if the bank, its auditor or RBI finds it cannot be recovered.

4. The November 2021 clarification (tightening)

• Daily tagging: NPA status is checked and tagged every day, on the actual date the overdue period is crossed. Earlier, some banks checked only at quarter-end or month-end.
• Upgrade only on full repayment: an NPA returns to standard only when all arrears of interest and principal are cleared.
• Paying only the interest is no longer enough.
• Why: this stops "evergreening", where a borrower pays a small amount to make a bad loan look healthy.

5. NCERT link: why a bad loan hurts the bank's capital

• NCERT Class 12 (Money and Banking) gives two equations:
• Assets = Reserves + Loans

• Net Worth = Assets − Liabilities

• The chain of effect:

• A loan goes bad, so the value of the bank's assets falls.
• Deposits (liabilities) do not fall, because the bank still owes depositors in full.

• So the entire loss comes out of net worth (the owners' capital).

• Worked example:

• Assets are Rs 1,000 crore (Reserves Rs 100 crore + Loans Rs 900 crore). Liabilities are Rs 920 crore. So net worth = Rs 80 crore.
• Now Rs 50 crore of loans turns bad and is fully provided for. Assets fall to Rs 950 crore.
• Net worth falls to Rs 30 crore, which is 62.5% of the capital gone.
• This is why high NPAs lead to recapitalisation (the government or other owners put in fresh capital).

6. Provisioning: setting money aside for expected losses

• Loan-loss provisioning = keeping part of profits aside, in advance, to absorb likely losses on loans. The worse a loan's label, the higher the provision.

Category	Provision (current)
Standard	0.25-1%: general 0.40%; farm/SME 0.25%; commercial real estate 1%
Sub-standard	15%; unsecured exposures 25%
Doubtful: secured part	D1 25% · D2 40% · D3 100%
Doubtful: unsecured part	100%
Loss	100%. If a loss asset stays on the books for any reason, the full outstanding amount must be provided for [3]

• The rules have tightened over time. RBI's July 2011 master circular prescribed a 10% general provision for sub-standard assets and 20-100% for the secured part of doubtful assets [2]. Today's figures are 15% and 25-100%.
• Worked example (doubtful loan):
• Loan outstanding = Rs 100 crore. Realisable value of the security (the collateral) = Rs 60 crore. The loan has been in D2.
• Secured part: 40% × Rs 60 crore = Rs 24 crore
• Unsecured part: 100% × Rs 40 crore = Rs 40 crore
• Total provision = Rs 64 crore. This amount comes straight out of profit.

7. Measuring bad loans: key metrics

• Gross NPA (GNPA) = the total of all non-performing loans. The GNPA ratio = GNPA ÷ gross advances (total loans).
• Net NPA (NNPA) = Gross NPA − provisions held. This is the part of bad loans that is not yet covered.
• Provisioning Coverage Ratio (PCR) = provisions ÷ Gross NPA × 100. It shows what share of bad loans has already been covered. RBI earlier used a 70% benchmark.
• Worked example: GNPA = Rs 100 crore and provisions = Rs 75 crore. So NNPA = Rs 25 crore and PCR = 75%.

• How PCR has moved:

  • All scheduled commercial banks (SCBs): 48.3% (March 2018) → 52.4% (September 2018) → 60.6% (March 2019) [6]
  • Public sector banks (PSBs): from 46.0% to 89.9% (December 2022) [7]

• Stressed assets = Gross NPA + restructured standard advances + written-off loans.

• This is a fuller measure. Restructuring (changing the loan terms) or writing a loan off takes it out of the NPA count, but the stress is still there.

8. From "incurred loss" to "expected credit loss" (ECL)

• Incurred-loss model (current): the bank provides for a loss only after a default has happened. Provisions come late and in large jumps, which hits profits and capital all at once.
• Expected Credit Loss (ECL) model: the bank provides for likely future losses from the day a loan is made. The estimate is based on the chance of default.
• It follows IFRS 9 / Ind AS 109 (international and Indian accounting standards for financial instruments).

• It has three stages:

  • Stage 1, performing loan: provide for 12-month expected loss
  • Stage 2, significant rise in credit risk: provide for lifetime expected loss
  • Stage 3, credit-impaired loan: provide for lifetime expected loss

• Timeline:

• RBI released a Discussion Paper on the ECL framework on 16 January 2023. It called ECL a forward-looking, principle-based shift away from the incurred-loss regime. This approach is already used under IASB and US FASB standards [8].
• RBI's Statement on Developmental and Regulatory Policies (1 October 2025) proposed draft directions for an ECL approach "subject to a prudential floor" (a minimum provision set by RBI) for SCBs and All India Financial Institutions [9].
  • The existing asset-classification norms will be kept.
  • The move will be non-disruptive, with a suitable glide-path (a gradual phase-in) [9].
• The effective date is 1 April 2027. (Verify current: the RBI sources retrieved here do not confirm this date for ECL.)

9. Data: the rise and fall of bad loans

• The chain of events:
• Asset Quality Review (AQR), 2015: RBI forced banks to recognise hidden bad loans [5].

• The Government followed with a 4R strategy [5]:

  • Recognise NPAs transparently
  • Resolve and recover value from stressed loans (including through the IBC, 2016)
  • Recapitalise PSBs
  • Reform banks and the financial system

• Data points:

• Peak: SCB GNPA was about 11.2% (March 2018).
• Recovery: GNPA was 2.31% (end-March 2025), the lowest in 20 years [5].
• Latest: GNPA was 2.15% (end-September 2025, provisional), a historic low after eight years of steady fall [4].
• By bank group (September 2025): PSBs 2.50%, private banks 1.73%, foreign banks 0.80%. (Verify current: latest FSR.)

Prelims Hooks

• NPA = interest or principal overdue for more than 90 days. The limit was 180 days before 2004.
• SMA-0 / SMA-1 / SMA-2 = 1-30 / 31-60 / 61-90 days overdue. SMA accounts are still not NPAs.
• Farm loans: short-duration crops become NPA after 2 crop seasons; long-duration crops (season longer than 1 year) after 1 crop season.
• Sub-standard = NPA for up to 12 months. Doubtful = sub-standard for 12 months (D1 <1 yr, D2 1-3 yrs, D3 >3 yrs). Loss = uncollectible but not yet written off.
• CRILC reporting threshold: aggregate exposure of Rs 5 crore and above.
• Net NPA = Gross NPA − provisions. PCR = provisions ÷ Gross NPA. Trap: PCR goes up when provisions rise, while NNPA goes down.
• November 2021 rule: an NPA is upgraded only after all arrears are cleared. Paying interest alone is not enough. NPA status is tagged daily.
• ECL follows IFRS 9 / Ind AS 109 and has 3 stages. RBI discussion paper: January 2023.
• Provisioning trap: the unsecured part of a doubtful loan needs 100% at every stage (D1, D2 and D3). The secured part needs 25% / 40% / 100%.
• SCB GNPA was 2.15% (September 2025), a historic low. The peak was about 11.2% (March 2018).

Mains Points

• Recognition comes before resolution.
• Under soft rules (180 days, restructuring freedom, interest-only upgrades), banks hid stress and evergreened loans.
• The AQR of 2015 and the 2021 IRAC clarification exposed and closed these gaps.
• Together with the IBC (2016) and recapitalisation, this cut GNPA from about 11.2% (2018) to 2.15% (2025).

• Useful for GS-III answers on banking reform and the twin balance-sheet problem (both companies and banks under debt stress at the same time).

• Provisioning is procyclical under the incurred-loss model.

• Losses are provided for only after default, and defaults bunch up in downturns.
• So capital shrinks just when credit is most needed, and a credit crunch deepens.

• ECL, phased in with a prudential floor, spreads the cost over the life of the loan. But it needs good data and models, and it may cause an early one-time hit to capital.

• Trade-off: strict recognition vs credit flow.

• A tight 90-day rule and daily tagging protect depositors and financial stability.
• But they can hurt seasonal or small borrowers (for example MSMEs and farmers).

• Hence the special crop-season rules and time-bound restructuring windows. Too much forbearance (relaxing the rules for borrowers) brings back hidden NPAs.

• Net worth link (NCERT): every rupee of unprovided bad loan reduces bank capital. This connects NPAs to Basel III capital adequacy, government recapitalisation bonds, and the fiscal cost of stress in public sector banks.