Asset Reconstruction Companies (ARCs) have been created internationally to bring about system-wide clean up of Non Performing Assets (NPAs) in the financial sector. The Government of India and Reserve Bank of India (RBI) have taken measures to regulate and control NPAs in the financial system to facilitate faster debt recovery. Strengthening of credit appraisal and monitoring system, risk based supervision, institution of Debt Recovery Tribunals and Corporate Debt Restructuring (CDR) are some of the key initiatives taken in this regard. Enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002) has boosted these initiatives. This Act has paved the way for formation of Asset Reconstruction Companies.
ARC models (International experience)
Broadly 3 different models have been adopted internationally:
Model I: Government owned ARCs came into existence to deal with banking crisis to find a system-wide solution and act as nodal entities to address NPA “stock”. The success of this model is predicated on fiscal support (by way of recapitalisation of banks) and forbearance from the Government and the regulator. This model results in a clean exit from NPAs to the banks. Resolution and consequent risks-rewards remains with investors.
Model II: Non-governmental ARCs model has been adopted in situations of high level of NPAs but without crisis dimensions. This model adopts a market based approach to address NPA “stock” & “flow”. There is no direct participation by Government. Only a conducive framework is provided by Government and Regulator for resolution and exit. This model requires presence of willing sellers and investors. Attendant risk and reward remain with investors. A strong regulatory inducement is essential for the success of this model.
Model III: A “Bad Bank” is carved out within a bank by isolation of stressed assets as the bank’s work - out group / affiliate. This is a “self help” mechanism without any special powers from Government and Regulator. In this model, the focus is on NPA workout. This model leaves the NPAs with banks and consequently, the attendant risk and reward remains with them. This model has achieved limited success due to the absence of debt aggregation.
ARCs in India have been set up as non-government vehicles, not government owned/supported, with elements of Models II & III detailed above. Government is facilitator, not participant in ARCs. ARCs act as resolution agencies, not rapid disposition agencies as in the South East Asian region. There is provision for multiple ARCs in the Indian model for value maximisation.
Opportunities for investment in distressed assets have increased for investors since the demand-supply dynamics have become favourable. Further, a robust view is being taken on the operational nature of underlying assets and accordingly the demand for underlying assets is increasing. With the Indian economy in a capacity-additive mode and legal and regulatory framework becoming increasingly hospitable to resolution of NPAs, combined with the increasing interest evinced by new investors, ARCs have become the ideal vehicles to channel investment in distressed debt.
Factors impeding resolution of NPAs
Public Sector Banks (PSBs), which account for a major share of the NPAs, primarily focus on net NPA percentage and draw comfort from its improvement, which can happen, more often than not, by growth in their loan book. The focus on the reduction of the gross NPA block has emerged only recently.
Inter-creditor issues come into play between the term lenders and working capital bankers because of the borrowers’ propensity to service the working capital bankers for a longer period of time, while letting the term loans go unserviced. Different security profiles of the term lenders and working capital bankers (because of the depletion in value of current assets), pose difficulties in achieving convergence of approach amongst the lenders required for the achievement of 75% debt acquisition (for invocation of the powers under SARFAESI Act provisions).
Due to logistical reasons, it is not cost effective for the PSBs to have a focussed expert attention at a centralised point, leading to wastage of resources and delay in NPA resolution.
Transparent practices are important to encourage bidders’ participation in the NPA auction undertaken by the banks/FIs. It has been observed that, at times, the price expectation of the selling banks is higher than the best bid price discovered through the auction process. It is the desire of the bid participants that more transparent practices be followed by the selling banks for evolving a mature market. In several cases, reserve price is not being disclosed. Bidders often spend substantial resources and monies to participate in the bidding process, however, sometimes deals are being called off by the sellers without citing convincing reasons. The end effect is that few deals of sale of NPAs on cash basis can be concluded, resulting in large quantum of NPAs (on gross basis) remaining in banks books.
Additionally, the factors which may still impede the working of ARCs and need immediate attention are inadequate transparency in accounting causing distortions in valuation and delay in recognising the impending loss in value (due to non classification of assets so as to reflect their true value). Further, lack of up-to-date data on statutory and other liabilities, and high stamp duty and registration charges in certain states adversely impacts the value that can be offered to the selling banks/FIs.
ARCs in unique position to resolve NPAs
ARCs are required to take up the aforesaid challenges for effective and speedy action by invoking SARFAESI Act and other measures by bringing into play their expertise in asset resolution.
RBI guidelines for ARCs provide a strict time frame of 5 years (including 1 year planning period) for resolution, thus bringing in a sense of urgency for the ARCs, right at the acquisition stage itself. Debt aggregation in the hands of ARCs not only releases the bandwidth of the banks/FIs for their core activities and recycling of the capital available to the banking system, but also makes it worthwhile for the lenders to cooperate with the ARCs, given the position of strength and expertise with which the ARCs tackle the errant borrowers.
Given the industrial nature of most of the large NPAs and lack of significant exposure to the real estate sector, restructuring either with the existing promoters or business sale to strategic investors is the key for value maximisation for which the ARCs are uniquely placed, given their expertise and tight time frame prescribed by RBI.
Accordingly, ARCs are in a strategic position to bring stability to the financial system and facilitate revival of economic growth. The conducive factors in favour of ARCs are legal empowerment and booming economic conditions potent with possibilities of unlocking the value of collateral based loans. ARCs with pragmatic approach towards debt restructuring and flexibility to explore multiple resolution strategies in a dynamic framework, can achieve successful resolution.
NPAs in banking system and the role of ARCs
NPAs in the Indian Financial system, though substantial, are still lower as a proportion of the GDP at current factor cost, as compared to other countries in the region. However, standard assets restructured by banks (including cases restructured through the CDR process) do not figure as NPAs. Assets that have been restructured continue to require significant amount of lender supervision. There is always a likelihood that some of these assets may turn into NPAs again. Net NPAs of Scheduled Commercial Banks as a percentage of Net Advances have steadily reduced from 8.1% in 1996-97 to 4.4% in 2002-03 and further to 1.1% in 2006-07 (Source: RBI Deputy Governor’s speech at FICCI-IBA Conference on “Global Banking: Paradigm Shift” on September 14, 2007). However, the increase in Gross NPAs is continuing. Thus, there is ample scope in the current context for ARCs to add value to the financial system. With the present upturn in the economy, ARCs would be able to deliver value by resolution through a concerted approach, particularly in light of the fragmented debt structure in most large NPAs, where invocation of SARFAESI powers would be crucial for resolution.
Boost in Credit GDP Ratio will increase fresh flow of NPAs
India has a very low, though improving, Credit-GDP ratio (51% as on March 31, 2007 as compared to 30% as on March 31, 2000, as per RBI’s annual report for FY07). With the increase in this ratio, the flow of NPAs would also increase. NPAs are mostly industrial assets – exposure to ‘bubble sectors’ being minimal. Further, the resolution of larger cases (80% by value) requires intense workout by way of corporate restructuring, business sale or combination of both.
Accelerated provisioning norms (Basel II) for banks to result in increased flow to the NPA market
Indian Banking Industry has low provisioning coverage on account of time based provisioning as against cash flow based provisioning in developed countries. From FY 07 banks have to provide 100% provision in respect of doubtful assets over 3 years old, which will increase fresh flow of NPAs into the system. Tough provisioning requirement will enable banks to sell their NPAs without taking any hit in their P&L A/c. Stricter provisioning norms / write offs after 3 years will compel banks to shift towards “Write-Off and Sell” approach from the present “Provide and Hold” approach.
With the implementation of BASEL II norms, the capital adequacy ratio of banks needs to be improved. As per the BASEL II accord, the minimum capital to be maintained by a bank for operational risk is 15% of the average gross total assets of previous 3 years. Additional capital will also be required to cover for credit risk and market risk. In order to raise this additional capital, a number of banks approached the capital markets in FY 2006 and FY 2007. Unlocking the capital locked in NPAs will help the banks to mobilise the required additional resources and also reduce capital requirements.
Banking statistics all over the world indicate that NPAs are a natural bi-product in any economy. In the developed economy of USA around 1% of the loan book is written off every year. Therefore, in the Indian context, given the growth rate of the economy, it is unlikely that the accretion rate will go down significantly in the near future.
Recent dispensations expected to facilitate induction of new investors
Inter-bank purchase/sale of NPAs has been allowed in July 2005, leading to significant portfolio buy-outs through competitive bidding process. Further, Foreign Direct Investment in equity of ARCs and participation of Foreign Institutional Investors (FIIs) in Security Receipts (SRs) of ARCs has been allowed by RBI in November 2005. The said dispensations are expected to facilitate cash buy out of NPAs through induction of third party investor money. The above measures are a welcome development for creation of a vibrant market for investment in NPAs, in the country.