Asset Reconstruction Companies (ARCs) : Cure for NPAs

ARCs are still at a nascent stage of development and market dynamics is likely to change with the entry of new players.

It has been observed that high levels of Non-Performing Assets (NPAs) in the banking system can adversely affect economy in many ways such as, financial crisis, under-utilization of the productive resources, and deteriorating the investment climate in the country. Many nations have started Asset Reconstruction Companies (ARCs) to solve the problem of bad loans only after experiencing a financial crisis. However, the Government of India has proactively taken steps to clean up bad loans in the banking system even before NPAs have become a burden on the financial system.

The primary objective of ARCs is rapid disposal of bad assets owned by banks to cleanup their balance sheets. With quick resolution process of NPAs, banks can concentrate on core business activities and other business opportunities. In 2004, Gross NPAs pegged at 90,000 crores, representing about 9% of the total advances, and net NPAs at 5% of the total advances. A large chunk of bad assets are from the industrial sector. Resolution of these assets would largely be through operation of the industrial assets over an extended time frame. These assets requires in-depth skills for operational and financial restructuring for the speedy resolution process. However, India is better positioned in comparison with its Asian peers.

ARCs are a product of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act). The act provides full right to the lenders to acquire the assets without any judicial intervention. Banks are the major beneficiaries of the resolution of NPAs as multiple costs are associated with keeping NPAs for a longtime. Estimates show that the holding cost of NPAs is at 8.1% annually, and it can dent net profits of banks at 22% annually. Apart from the above quantitative factors there are also opportunity loss of interest-rate spread, impact on the credit rating resulting from the poor performance, diminishing ability to raise capital, and distract the core banking activities. The resolution of bad assets at early stages would enhance the recovery as value decreases with the passage of time. Also, it can protect the intangible assets such as brand, human resources, and distribution network to enhance the realization.

For the past few years, economy is growing at a healthy rate and NPA levels in the Indian banking are declining. Even they represent lower proportions of the bank assets, only 16% of the bad loans are transferred to ARC. Banks may have some reservations in moving the bad loans to ARCs due to the lower valuation than what they can show by keeping in their books. But the magnitude of NPAs is very large to deal with them, and they lose value of 20-30% every year. Ultimately, to deal with the bad loans, either they have to start separate departments within banks or outsource loan resolution process to ARCs. Ample opportunities are available for them in NPA portfolio of corporate loans, SME (Small and Medium Enterprises), and retail loans. Industry experts opine that, the ARCs will have a role to play and the actual effectiveness will depend on whether they have the right capabilities, skills, and resources as well as the capital.

Business model

Role of ARCs is the same everywhere, i.e., acquiring the bad loans to resolve them. Unlike other Asian countries, in India, it is a purely private-enterprise model funded by a consortium of banks. ARCs acquire the assets through trusts set up by them. Valuation of these assets depends on many factors such as, nature of the assets that lender has over the borrower's assets, value that can be realized from the security, and time taken to liquidate the assets. Trust raises the resources through the issue of Security Receipts (SRs) to eligible investors and money realized through the issue of Security Receipts is utilized towards the payment of purchase consideration to the bank or FI. SRs represent undivided rights, title, and interest of the investors on the financial assets held in the fund floated by the Trust. SRs can only be converted out of the realization from financial assets held under the Trust, and they carry no fixed returns. SRs may also be sold in the secondary market. The domestic investor, thus, has the twin-advantage of higher returns and diversified risk.

ARC led resolution approach, which is followed by the private-sector model, has a few merits in terms of engaging the borrower appropriately for resolution and establishing the accurate data. In the process, ARCs acquire/develop the resolution skills. Hence, these developments results in the enhancement of market liquidity and the availability of information. Resolution framework followed by the ARCs depends upon the management quality and the industry viability of the acquired asset. They follow the settlement, restructuring, sale of business or M&A, and strip-sale of assets routes depending on the prevailing conditions. Corporate Debt Restructuring (CDR) and ARCs are a double pronged strategy for the resolution of assets. CDR mechanism is effective in the early stages of the distress. In the later stages of resolution, ARCs can sell the businesses and assets of the borrower.

The role and present status of ARCs in India ARCs are organizational units created to manage and recover NPAs acquiredfrom the banking system. Thus, ARCs provide an intermediation in NPA resolution process. The role of ARCs in the NPA resolution process would be critical as the Indian banking landscape is characterized by the consortium/multiple lending, with different classes of security. This results in significant inter-creditor issues inhibiting prompt implementation of the appropriate resolution strategy, and causing loss of value. Debt aggregation from various lenders andfocused handling of the resolution process in order to quicken the realization,is the important value addition by the ARCs. We understand that three ARCs have obtained certificate of registration so far. However, Arcil is the only operational ARC till date. Arcil has completed two years of operations. It has so far acquired total dues of Rs. 16,500cr of 368 borrowers from 25 banks and financial institutions. Arcil has puton the resolution path about 40% of cases by value. NBFCs entry and their impact on ARC business model RBI Guidelines allowing the purchase/sale of NPAs amongst banks/FIs/NBFCsincreases the options available to the selling banks/ FIs. With more players onthe buyer side, it would lead to price discovery and benchmarking. However,it would not make any significant impact on the model of Arcil, which can offer both cash and SRs. In fact, one of the key advantages that the sellers would find in dealing with Arcil, would be the structuring of the purchase consideration to suit their needs, as they have an option to receive cash and obtaincle an exit or receive SRs to participate in the potential upside or a combination of both. We also believe that Arcil would be in a better position to acquire andresolve large NPAs accounts compared to the banks. This would naturally reflect in the pricing/valuations offered by ARCs. ARCs are sponsored or funded by the banks in India whereas in the other countries they are government sponsored companies. So, whatare those advantages/disadvantages that Indian companies can haveby following this mechanism? The Indian ARC model envisages market forces to consolidate and attractively package lender interests, arrange funding to provide a clean exit to the seller banks, and lend focused attention for NPA resolution. The key advantageof the Indian model is the development of a market for the NPAs, wherethe transactions can take place on a sound commercial platform, without any implicit tax on the system or on the exchequer. FDI/FII participation and impact In order to give a clean exit to banks/FIs from NPAs, attracting new investment is critical. ARCs may require over Rs. 20,000 cr for this.The domestic market has no appetite for such an investment considering the risk associated with it and the resultant capital requirements.FIIs specialized in distressed debt would be the primary source of such new funding. Government and the regulators are examining this issue. Fiscal incentives and taxing issues The government may consider 'tax-exempt' status to the trusts set up by the ARCs for acquisition, management, and resolution of NPAs similar to the Mutual Funds as the Trusts set up by the ARCs are 'pass through' in natureakin to mutual funds. Secondly, there is a need to reduce stamp duty and registration charges on the transfer of financial assets from banks/ FIs to ARCs to notional levels considering the nature of underlying transaction. While several large states such as Maharashtra, Gujarat, and Tamil Nadu have implemented the reduction, the other States need to take a cue from these states and implement the reduction. Major factors in the successful functioning of ARCs ARCs are adequately empowered to resolve the NPAs. As mentioned earlier, ensuring the participation of FIIs, which would bring in new money, and providing tax-exempt status to the Trust SPVs of ARCs, would reduce theintermediation costs further. The banks/FIs need to accelerate the sale ofNPAs to ARCs, thereby converting their illiquid, capital-consuming NPAs tocash. Lessons from the global experiences of selling bad loans ARCs need to provide an early exit to the banks from NPAs. They also have to focus on the acceleration and maximization of recoveries through the resolution of NPAs, thereby improving the efficiency of capital in both real and financialsectors. Future of ARCs As mentioned earlier, the Indian ARC model has been founded upon soundbusiness platform, where willing buyer and willing seller participate on anarms-length basis. Participation of several players is desirable as it provides price and performance benchmarking, bringing in market efficiencies critical for the development of a vibrant market for NPAs.

Critical success factors

As ARCs are a risky business to operate, the critical success factors in the wellfunctioning of ARCs are different from the other businesses. The foremost factor is quality of the team and the resources available with them. People with right experience and maturity, technical skills as well as other soft-skills such as, negotiating and dealing with the complex situations in a multi-lender situation, are much needed in the resolution. Having the ability to work with the legal system always proves to be a principle factor in achieving the success. The second part is the availability of capital, as the availability of capital in the system often makes crucial difference in many businesses.

NPA financing is a highly risky business and in India, it is further compounded by the absence of a market for the NPAs and benchmarks. The sustainability of ARCs depends upon their ability to attract the capital. Also, patience is needed, as resolution process takes a longer time in the case of really bad assets. Above all these, positioning is yet another differentiating factor as new markets are developing in NPA portfolio such as consumer loans.

ARCIL – Buying NPAs (in crores)
Bank/FI	Total Dues	Acquisition Price	Principal Debt	No. of Cases
ICICI Bank	9,028	2,395	4,529	136
State Bank of India	2,634	428	1,402	189
IDBI	1,334	349	497	20
IFCI	1,144	172	348	9
Punjab National Bank	842	54	371	40
Bank of India	431	78	199	7
Canara Bank	192	14	73	6
Exim Bank	155	105	138	4
Others	4,208	119	387	72
Total	16,492	3,714	7,944	483
Source: ARCIL

Issues hindering growth

Investments are needed to set up ARCs, and domestic players alone can't meet the capital requirements. Going by this, government is in the process of opening the sector for FDI. There are two levels of FDI; one at the share-capital level and the other at security receipts level. It will be more difficult for foreign players if investments in SRs are restricted to 49% than at the share capital level because investors need more liberal environment in case of troubled NPAs. Allowing FDI into ARCs can be a lesson for India to learn from the global experience. There is another route now, in which RBI is allowing banks and NBFCs to buy and sell loans. Besides NBFCs, foreign banks such as, Deutsche Bank, Bank of America, and Barclays Bank are also eyeing the NPAs in India. Alongside, the industry is seeking incentives from the government. ARCs are urging the government to tax them on par with the mutual funds because incomes generated by the trust are subject to taxation. They want exemption from the taxing on the trust which is working to resolve the particular barrower's bad loans. So far, ARCs are operating around the recover- able trusts, which are dissolved after the completion of specified task, to avoid double taxation. Also, there is a need for reducing the stamp duty in certain states to quicken the process of transferring the assets to ARCs. Bankers opine that being "such a risky business, it takes time to book profits and enhance the revenues. Tax exemptions, holidays, and avoidance of double tax—all these are quite relevant and most appropriate for the progression of industry".

Future outlook

As of now, RBI has issued licenses to three more companies, and some NBFCs are also readying to enter the business. Competition is likely to grow with the entry of new players into ARC business. These developments are expected to bring more transparency and better valuation of bad loans in future. Arcil, the only player in the asset reconstruction business in India, is not able to acquire 100% of the bad assets, as members of the consortia of lenders are not willing to sell the NPAs because of the low valuation at which the assets are being sold. So, benchmark for valuations should evolve. RBI has now allowed NBFCs to get into asset reconstruction business. NBFCs are willing to pay cash on bad loans instead of Security Receipts issued by the Arcil. According to industry sources, "it won't impact the existing business model of the ARCs in issuing the SRs, as Arcil can follow the same model of paying cash." With the Basel-II norms and the RBI regulations coming into force, it would be difficult for the weaker banks to keep bad loans. Hence, they would be forced to sell off bad assets to ARCs. With weak capital base and low provisioning coverage, they prefer to keep them in their books than with Arcil. ARCs have an edge over the commercial banks in selling NPAs because, according to the RBI norms, banks cannot sell them until they remained as an NPA for at least two years whereas ARCs can sell them at any time.

After the hesitant start of ARCs two years ago, market for the distressed loans is likely to pick-up in the coming years with the implementation of more stringent norms for the banks holding on to the NPAs, and more players entering into ARC business, which has the potential of $20-25 bn of bad loans. An industry expert opines that, "At this juncture, it is unfair to say that India is lacking in following the global best practices because the experiences are not enough and there have been not enough players in the market". Industry players are hoping that the entry of more focused players will bring better valuations and market development for NPAs. A lot of foreign funds are hoping that regulatory framework will permit them to participate soon. However, it is not an easy task to bring the adequate investments into ARCs, until government provide conducive environment.