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ARCs in India

The foremost cause for emergence of ARCs in India wasthe implementation of prudential norms which exposedthe seriousness of Non Performing Assets (NPAs) in thebanking system to the external world. Further, theNarasimham Committee Report also reiterated the need topay focused attention on NPAs and suggested creation ofan 'Asset Recovery Fund' with the objective of isolatingNPAs from the financial system, freeing the banks / FIs toconcentrate more on their core activities and facilitatingdevelopment of market for distressed assets. The conceptof ARC has gained further importance in the light ofenactment of SARFAESI Act, 2002.

Internationally, the bankruptcy codes and effective legalmechanisms ensure speedy disposal of stressed assets inthe normal course and thus ARCs came into existence asspecial purpose vehicles to resolve systemic crises.However, the ARC experiment in India is distinctive asARCs were set up as perpetual entities to fix NPAsresulting mainly from corporate lending coupled withinability of the judicial system to adjudicate the matterspeedily.

The broad functions of ARCs in India are acquisition offinancial assets, change or takeover of management, sale orlease the business of the borrower, rescheduling of debts,enforcement of security interest and settlement of duespayable by the borrower. It is a market-driven model thatallows banks to take their own decisions to sell bad loansto ARCs, based on bilateral negotiations and / or auctions.The present model does not envisage any fiscal support ortax forbearance from the government.When a bank sellsstressed assets to an ARC, the bad loan moves out of thebank's book and becomes a standard investment against

36 The Indian Banker

Role of ARCs inNPA Resolution

Progress So Far and Future Strategy

NSN Reddy

Security Receipt (SR) under Available for Sale (AFS)category, thus freeing the bank from making a provisionagainst the loan resulting in improved profit. ARCs formtrusts to acquire assets from banks and financial institutionsand the maximum life of these trusts can be five years,which is extendable up to eight years, with the board'sapproval. Trust becomes the legal owner of the asset andSR holders become its beneficiaries. The trust redeemsmoney to the investors in proportion to the recovery fromunderlying assets. The SRs are rated by external agenciesand quarterly NAVs are published.

The main source of ARC revenue is from the surplusgenerated from recovery over the acquisition cost. Out ofthe above, ARCs keep around 20 percent as managementincentive and the rest is distributed to holders of SRs.ARCs charge a fee of 0.5 to 2 percent of the asset's valueas management fee.

Performance of ARCs

As on 31stMarch 2015 there are 15 ARCs operating inIndia out of which five are functioning as privatecompanies. It is reported that so far all the ARCs puttogether have acquired assets worth INR 1.90 lac crore forINR 63000 crore at 67 percent discount. As per theFinancial Stability Report 2015, the discount rate has beencoming down in the recent years and stood at 58 percent in2015. The business handled by the ARCs in the recent yearsis furnished in Table 1. Though, there is a reasonable goodgrowth in operations of ARCs, the revival process is takinginordinate delay, say,beyond five years, coupled with tardyrecovery rate (12% of acquisition cost) which is a cause ofserious concern. Further, the cumulative redemption ratioof SRs since inception stood at 53 percent only which is farbelow the expected level.

Vol III No. 11 - June 2016

ARCs - Opportunities

• With the slowdown of the global economy, a numberof companies / projects are under stress and as a result,the lenders are saddled with stressed assets (NPAs andRestructured loans). The estimated stressed assets areabout 15 percent of total credit portfolio of thebanking industry at the end of March 2016.

RBI has announced a host of measures since 2013 thathave fuelled distressed asset sale business: tightening theCorporate Debt Restructuring (CDR) mechanism,setting up a Joint Lenders' Forum OLF), pushing banksto disclose the real picture of bad loans, advising themto increase provisioning for stressed assets, introducing5:25 scheme where loans are to be amortised over 25yearswith refinancing option after every five years,empowering them to take majority control in defaultingcompanies under the Strategic Debt Restructuring(SDR) scheme and allowing the banks to sell even theloans where the principal or interest was overdue by 60days compared to 90 days earlier.

However, the biggest trigger is the recent RBIguidelines to the banks to clean up their balance sheetsby March 2017 which forced the banks to approachARCs to sell part of their stressed asset portfolio.

Of late, global investors are showing interest in ARCswhich is a positive sign for the industry as they providetransfer of technical knowledge, information andcapabilities,which definitely paves the way to handlecomplex cases with ease and confidence.

ARCs - Challenges

TypicallyARCs undertake two important activities viz,Resolution and Recovery. Resolution is more ofaggregatingdebt, infusion of capital, identification of non-core assets and bringing in a strategic partner. Of late, theunits coming under resolution process are coming downand found not feasible for reconstruction within short or

medium term.Thus, ARCs largelyfocus on recoveryprocess byliquidating theassets. In thiscontext, ARCs areconfronting thefollowingchallenges whichneed to beaddressed onpriority.

Table 1: Sale of StressedAssets by Banks to ARCs

2009-10 18002010-11 2QOO2011-12 12002012-13 21002013-14 20585

226582014-15Source: Business Today -Allgllst 2015 issue

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The recent guidelines require the ARCs to pay 15percent upfront (earlier 5%) which has direct bearingon the operations of the ARCs as they are operatingwith low capital funds. At present, the options availableto ARCs are limited as the fragmented ownership iscoming in the way to attract foreign capital and unableto raise money from public as legal issues remain thebiggest hurdle for the recovery of NPAs.The ability ofthe ARCs to raise capital will now become a keydifferentia tor.

ARC industry opines that banks should lower thereserve price as they are paying 15 percent upfrontwhile acquiring the asset. Banks, however, are not readyto buy this logic as the value of the asset does notcome down irrespective of upfront fee. Pricing alwaysremains a bone of contention for the sale of bad assetsand the best way to address this could be a recoveryrating of such assets before they are sold, instead ofrating them later.

ARCs have successfully reconstructed several largeaccounts, and have demonstrated their ability torecover dues through asset sales. But recovery levelsand the cumulative redemption ratio of SRs is notencouraging.

Currently, ARC officials are not allowed to visit thefactories of a company offered as a security of theloans that are being sold. Unless they get a sense of thevalue of the securities, how would they make a fairoffer to buy them? Thus, there is need to have a fairpractice code both for the banks as well as ARCs tomake the business a success.

PSBs are scared to sell their assets to private ARCs forfear that the quantum of hair cut can alwaysbequestioned by the Government, Regulator andinvestigation agencies (CBI/CVC) at a later date.

Despite challenges, the ARCs remain enthusiastic to be inthe business due to increased pile of stressed assets aroundINR8 trillion as on 31srDecember 2015 and the majorchunk of these assets are likely to be made available toARCs for sale in the ensuing years. While the banks arebeing pushed by the regulator to clean up their books,ARCs see it as a business opportunity.

Critics are of the view that today banks found ARCs as asafe route to suppress their NPAs by shifting from 'LoanBook to Investment Book' since SRs are treated as securityunder AFS. There are instances where defaulters arebuying back from the ARCs the underlying securities ofthe loans at cheaper rate through back-to-backarrangements.

The Indian Banker 37

Table 2: Percent of total advances vis-it-visstressed assets - Sector-wise::~?~;-~t~-';~.'tfi;,~~;?)i'r~_r t ' £ ,:; ~A¥,"~ ~~,~~'!~~~:.~ , ,,~#

~~ >' ~. -"'"',,,,,.~.. 'r~ ;"'!/' i> ''1" E"$ ", ' ~ ~~k <\ "''>:~Ji'''i''''''I!";'.,;(;~ 11;,¥f<'. "" i;~ ¥ .<rt( "'1 ~J!> 1 ~ ~!i> ~' " ; •• ~ •• ,r, ""1 ~ ,.,~~""''''' -',~~",*"'j"i/.i f< "

Infrastructure 15.00 29.80Iron & Steel 4.50 10.20Textiles 3.40 7.30Mining 1.30 1.40Aviation 0.50 2.40Total 24.70 51.10

Source: RBI REports

ARC Bank (Bad Bank)

RBI reports on sectoral data Oune 2015) indicate thatamong the broad sectors, industry continued to record thehighest stressed advances ratio of about 19.50 percent,followed by services and retail with 7 percent and 2 percentrespectively. In terms of size, medium and large industrieseach had this ratio at 21 percent, whereas it is 8 percent inthe case of micro industries. Out of total INR 11 lac crorestressed assets of the banking system, around INR 5.50 laccrore pertains to the sectors shown in Table 2.

Infrastructure sector has been in the lime light over theyears on account of its importance from the point of itsshare in total credit portfolio of the banking industry aswell as its present share in stressed assets too. This sector isconfronting structural issues such as legal and proceduralhurdles in land acquisition, delays in perrnissions anduncertainties in planning and execution of the projects.These issues coupled with long gestation period have directbearing on the timely repayment of loans due to mismatchin cash flows.

Going forward, further credit flow to infrastructure sector,which is vital for economic development, is likely to beconstrained due to the growing trend in stressed assets.Thus, it should be of utmost priority for all thestakeholders to resolve this issue at the earliest both interms of kick-starting viable stalled projects and findingalternate funding sources.

The recent SDR provisions issued by RBI Oune 2015)allows the banks to convert debt into equity in defaultingcompanies. Post conversion, banks have 18 months time tofind new buyers for their stakes. Since in many SDR cases,the deadline is coming closer, the pressure on banks to findbuyers is increasing. Banks are primarily interested incontaining their losses and not on making money and thisis what is attracting Private Equity (PE) investors. Hopethere will not be any regulatory hurdles as the governmentand RBI are also interested in cleaning up the bankingsystem.

38 The Indian Banker

There are some comments on the rise of bad loansespecially in PSBs attributing for their reckless lendingwithout looking into viability of the projects. However, thefact remains that all these bad loans are not because of badbanking but also due to' contagious effect of globalmeltdown and steady slowdown of the Chinese economycoupled with increased incidence of stalled projects,delayed policy decisions, economic slowdown, macrofactors related to supply and demand and mismanagement.

Stressed assets affect profitability of the banks in two waysviz, loss of interest income and increased provisioning onthese assets. Data over the last few quarters indicate thatseverity is more in PSBs than Private Sector counterparts.This lowers the ability of banks to lend to borrowers thatgenuinely require capital to expand their businesses, whichwould create economic activity and jobs. In addition, thismay translate into a higher burden for taxpayers in thebroader economy. Further, the systemic risk of a contagiondue to large scale defaults would be disastrous for theeconomy.

Globally, entities tackling bad assets are formed as aresponse to a systemic crisis to protect commercial banksby creating one 'Bad Bank' that takes over the stressedloans of the entire system. Typically, governments providelegal, regulatory, fiscal and administrative support to suchinstitutions. The aim of creating such an entity is to protectthe capital of the banking system as banks need to set asidemoney for bad assets and this erodes their capital.

Presently, the existing operations of majority ARCs areconfined to small or medium ticket advances on account ofresource constraints. The stressed assets scenario of Indianbanking system is posing a unique challenge as the presenceof big ticket advances is expected to rise in the ensuingyears. Given the scale, complexity and rapid increase ofstressed assets, the present model is not adequate and thereis an urgent need to look for alternatives.

Currently, the capacity of ARCs to expand operations islimited because of their low capital base. It is reported thatthe current capitalisation of all ARCs put together isaround INR3000 crore only. With the cash componentincreased to 15 percent of acquisition, the net worth ofARCs would be sufficient to acquire only INR 20000 croreof stressed assets. Assuming that ARCs acquire the NPAsat 60 percent discount of the book value, the capacity ofthe ARCs to handle is just INR 33000 crore stressed assetportfolio where as the requirement is huge.

Banks can explore the possibility to setup ARC assubsidiary or acquire a joint venture with other ARCs orthrough a project with other ARCs. While the RBI hasbarred ARCs from acquiring bad loans from sponsor banks

Vol III No. 11 - June 2016

on a bilateral basis, it has allowed such transactions if theasset is auctioned in a transparent manner on an arm's-length basis and if prices are determined by market factors.

Against the above backdrop, the government isdeliberating on a proposal to set up a 'Bad Bank' withequitycontribution from the Government / RBI asconsolidation of bad loans can simplify resolutions andallowthe banks to focus on lending rather than recovery ofstressed assets.

The transfer of PAs from PSBs to 'Bad Bank' wouldbring about greater transparency and revive investorconfidence in the real book value of bank assets and itenhances access to capital markets at reasonable valuationsand addresses the capital related constraints. It would alsobring better management in resolving stressed assets andimprove the quality of credit portfolio of PSBs to thedesired leveLFurther, it enables the banks to cater thegrowing credit requirements of the economy, presentand future projects, and put the banks on a growthtrajectory.

On the flip side - the critics are not comfortable with theidea of government equity in 'Bad Bank' and feared a'moral hazard'. With a national ARC (Bad Bank), bankersespeciallyPSBs could again be short on due diligence whilegranting loans as they have the comfort of transferring dudloans to 'Bad Bank' tantamount to 'Old Wine in NewBottle'. This could also make them complacent at initiatingneeded reforms in credit appraisal and recovery process.Thus, the defaulters are likely to get long rope tocircumvent payment of dues on frivolous grounds andfinallysettle the account with paltry amounts, which isdetrimental to the interest of all stakeholders.

It appears that RBI is also averse to the idea ofcontributing equity to the 'Bad Bank' by the Government /RBI. In this context, the views expressed by Sri RaghuramRajan,Governor, RBI is worth noting 'there is no need toset up separate Bad Bank to deal with stressed assets ofPSBs,as these banks themselves have the backing of theGovernment. The issue is now clean it up'.

Way forward

ARCs or Bad Banks - be in Private Sector or Joint Venturewith banks or owned by Government or RBI, they have nomagicwand to revive stressed business units instantly.Mostly they use the bilateral route by working alongside thepromoter to de-leverage the business.

It is the fact that ARCs are not business restructuringexperts but they are only financial restructuring specialists.Often, bankers hold a grudge against ARCs as they are

Vol III No. 11 . June 2016

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unable to turn around the units due to limited financialmuscle, which leaves little scope for revivaL

The performance of ARCs or Bad Banks has direct bearingon the banks as banks will get their money back throughredemption of SRs only when ARCs recover the dues orliquidate the assets by auction. If ARCs fail to recoverloans, it is merely a book entry of transfer of a junk assetfrom a bank to an ARC. In order to protect the interests ofall the stakeholders.jhe Government, Regulator and legalsystem should ensure to make the system to workeffectively.

While ensuring better and speedier recovery of loans isundoubtedly important, deeper structural reforms andsystemic changes are needed to ensure that the cleanedbalance sheets remain clean.

Securitisation, which involves pooling various types ofcontractual debt and selling their related cash flows to thirdparty investors as securities, is an important tool toimprove infrastructure financing, Banks can particularlytake advantage of securitisation route for freeing up capital,rebalancing risks and more efficiently to manage theirApplication Lifecycle Management CALM).

As per the press reports, it is believed that Government ofIndia proposed to allow 100 percent foreign ownership inARCs; and offering them tax sops besides allowing singleownership in the trustee firms are the positive moves tobuilt a vibrant corporate bond market. Further, it wouldalso bring in much needed technical expertise, which iscritical in enhancing the viability and competitiveness ofinfrastructure projects.

'Distressed Debt and Securitisation' is the asset instrumentof the future. Investors with their detailed knowledgeof

Continued onpage 46 .

About the AuthorN S N Reddy is currently working as

assistant general manager at Andhra

Bank. A commerce graduate, he has

professional qualifications in CAIIB and

PGDBM (NIBM).

He has written a number of papers on

various topics published in The Indian

Banker, Bancon Papers and various other financial journals.

He is also associated with the 'Banker's Digest', an annual

publication covering macro issues related to the banking

industry for Andhra Bank employees.

He can be reached at nsn6507@yahoo.com.

The Indian Banker 39