Bad bank can wait, let’s recast ARCs
THE asset reconstruction companies or ARCs in India, which are in the business of buying bad loans from banks and making money by recovering them, had around Rs.50,000 crore worth of bad assets under management in fiscal year 2015. In the first three quarters of the current fiscal year, banks wanted to sell around Rs.90,000 crore of bad loans, but less than one-fourth of it has actually been sold to ARCs, even as gross bad loans of listed banks rose to Rs.4.38 trillion in the December quarter, adding almost a trillion rupees in three months. Will the proposed National Asset Management Company be able to do what 15 ARCs could not in over a decade?
Bank CEOs have started making announcements on fresh packages of bad loans being put on sale, but the pace of sale is unlikely to gather momentum. If you ask the ARCs on why they are not aggressively buying assets, they will blame the Reserve Bank of India (RBI) norms that have raised the minimum investment from 5% to 15% in the socalled security receipts (SRs) or pass-through certificates that are issued against such assets.
The ARCs levy higher discounts when they buy loans offering cash, but when they offer SRs for buying loans, the discount drops. How do the ARCs make money? They get management fees of 1.5-2%. When the investment requirement rises three times, their returns drop dramatically. Also, the fees are now linked to the net asset value (NAV) of the assets and not the outstanding value of the SRs. So, any shortfall in the recovery of bad loans lowers their fees. Six months after buying bad loans, the ARCs are required to get the SRs rated, and based on the ratingwhich takes into account the progress in recovery-the NAV is calculated.
From the ARCs' point of view, cash transactions are always better as they can levy relatively higher discounts, but they don't have the money to do so. Under norms, they can be 100% owned by foreign investors who can lend money muscle and expertise, but none of them is entirely foreign-owned and, in fact, very few have foreign stakes. They blame the 49% cap on single holding for their failure to attract foreign investments. It is unlikely that RBI will allow a higher foreign stake for a single investor as it believes that a widely held shareholding pattern ensures corporate governance in a relatively lightly regulated sector.
SSG Capital Management, a distress and special-situation private equity fund, holds a 49% stake in Asset Care and Reconstruction Enterprise Ltd. KKR and Co. wants to pick up a stake in International Asset Reconstruction Co. Pvt. Ltd, but the investment is awaiting government approval. About half-a-dozen applications for new ARCs have been pending with RBI. Some of them have foreign investors on board.
Capital is the biggest problem for the ARCs. If indeed a fragmented ownership is coming in the way to attract foreign capital, the ARCs should be allowed to tap the capital market by selling shares to the public. It's not clear whether the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, which governs ARCs, allows them to do so. It may not also be easy for them to raise money from public as legal issues remain the biggest hur- dle for the recovery of bad assets, leading to inordinate delays. Till the proposed bankruptcy law is put in place, ARCs will struggle to recover and redeem SRs. There are other issues as well. For instance, the stamp duty is not uniform in Indian states. This influences the pricing of such assets.
Pricing always remains a bone of contention for the sale of bad assets-while banks want a higher pricing, ARCs want to buy at a hefty discount. Nobody has clarity on the fair value of a bad asset put up for sale. One way of addressing this could be a recovery rating of such assets before they are sold, instead of rating them six months later. Recovery ratings reflect a fundamental analysis of the underlying relationship between financial claims on an entity and potential sources to meet those claims. The pricing can be based on such ratings and even if the banks are required to offer high discounts, they will not be afraid of being hounded by agencies like the Central Bureau of Investigation and Central Vigilance Commission.
The auction process must also be transparent. Currently, ARC officials are not allowed to visit the factories of a company offered as a security of the loans that are being sold. Unless they get a sense of the value of the securities that are backing such loans, how would they make a fair offer to buy them? We need a fair practice code both for the banks as well as ARCs to make the business of asset reconstruction a success.