One of the leading issues related with the banking sector nowadays is the rising level of NPAs. Higher NPAs worsens the financial health of a bank. To tackle the NPA or bad assets problem, RBI has designed several mechanisms. An import one among them is the Provisioning norms. Provisioning is a part of the RBI’s prudential regulation norm.
Under provisioning, banks have to set aside or provide funds to a prescribed percentage of their bad assets. The percentage of bad asset that has to be ‘provided for’ is called provisioning coverage ratio. The provisioning coverage ratio is the percentage of bad assets that the bank has to provide for (keep money) from their own funds –most probably profit.
For example, if the provisioning coverage ratio is 70% for a particular category of bad loans, banks have to set aside funds equivalent to 70% those bad assets out of their profits (in most cases).
Assets of a bank means loans they have given and investment they have made. If the loans are not coming, there should be provisioning for such bad debts. The assets are classified by the RBI in terms of their duration of non-repayment.
Provisioning differs with asset quality
Provisioning coverage ratio differs in terms of the quality of assets. Some assets may be lost forever and they are categorized as loss assets. This implies that such loans will never be repaid. For such assets, bank has to set aside 100% of such loss assets out of its profit. Similarly, there may be substandard assets where the loans are not repaid for a shorter period. In this case, less proportion of those assets can be set aside from profit.
When banks report profits, they give low dividends now a day because of the provisioning requirement. Many banks have substantial NPAs now and they are setting apart a major chunk of their profit to meet the provisioning.