NPAs processed by asset reconstruction companies -- where did we go wrong?

by Ajay Shah, Anjali Sharma, Susan Thomas.

Background

Asset reconstruction companies (ARCs) in India came about after the SARFAESI Act of 2002 empowered banks and some financial institutions to seize collateral in secured loans, without the intervention of courts. This is about the in-sourcing vs. out-sourcing choice of banks. Some banks could choose to build internal distressed assets teams. Others could choose to sell distressed assets to specialised firms that have skills in dealing with distressed assets. This is a good thing because: (a) In general, specialisation is a good thing and (b) Processing distressed assets requires a certain kind of toughness that PSU banks are often unable to muster.

So far, this approach has not worked. Stressed assets at banks (NPAs + restructured loans) have increased from Rs. 0.7 trillion in 2003 to Rs. 5.3 trillion in 2013. In this period, the annual sale of assets by banks to ARCs has stagnated at Rs.0.05 to Rs.0.1 billion a year.

At the outset, the Indian approach to ARCs was better than that seen in many other countries, where specialised `asset management companies' (AMCs) were just a thinly disguised method for government recapitalisation of banks. But this clear thinking at the outset has not been translated into a well functioning private ARC industry.

In this post, we look at what went wrong with ARCs, recent developments and the way forward.

What went wrong?

1. Excessive regulatory interference. The right way to think about an ARC is that the ARC is a buyer of distressed debt. After that, what the ARC does is the business of the ARC. The ARC might be an individual, or a private equity fund, or any other structure. The sale should be a clean transaction where distressed debt is sold and cash is paid to the lender. There are no problems with the working of the ARC on the counts of consumer protection, micro-prudential regulation or systemic risk, therefore the working of ARCs should be completely unregulated. This clarity of thought has been absent, and the working of ARCs has been riddled with poorly thought out RBI regulations.
   
2. Mistakes in regulations about how banks sell distressed assets. Micro-prudential regulators of banks are often keen to cover up the problems of bank fragility. This problem has hampered sound thinking about regulations governing provisioning and the sale of assets by banks to ARCs.
   Provisioning norms by Indian banks, are driven by regulatory prescriptions rather than risk assessment. Even though an asset becomes non-performing after being overdue for 90 days, provisions for the loss associated with this are spread over a period of four years. This generates a perverse incentive to not sell NPAs: provisioning for an NPA has a gradual impact on the balance sheet of the bank while sale of the NPA has to be booked as an upfront loss. As a result banks either hold on to these assets for longer than it is economically sensible, or sell assets to ARCs only when the transaction is at or above book value. In addition, there are a variety of procedural problems with the process of banks selling NPAs including auctions that do not give adequate time for due diligence by ARCs, and auctions that are cancelled after bids are received.
   A closely related issue is the approach that the sale of bad assets is not a true sale for hard cash. Banks would think in a sensible and commercial way when and only when: (a) Tough provisioning rules kick in the moment an asset is NPA and (b) The sale of distressed debt is a simple sale in return for cash. Neither of these conditions holds today, reflecting poor thinking in banking regulation.
   The mistakes in regulation of banks interact with the HR practices of PSU banks. The typical CEO of a bank has a horizon of two years. On that horizon, it's been made preferable for him to hide bad news by not selling as compared with recognising bad news by selling. This peculiar situation represents a juxtaposition of mistakes at the Ministry of Finance in HR practices of PSU banks and mistakes at RBI in the regulation of banks.
3. Weak bankruptcy process. The ability of ARCs to realise value is defined by the bankruptcy process. The legal framework for recovery are the debt recovery tribunals (DRTs), set up under the RDDBFI Act, 1993, and the enforcement of security interest under the SARFAESI Act. Both these mechanisms have performed poorly in resolving NPAs. Recovery as a percentage of the outstanding amount for cases filed was at 17 percent and 14 percent for DRTs, in 2012 and 2013 respectively. The recovery percentages were 24 percent and 22 percent under SARFAESI, in the same period.
   While RBI has allowed ARCs to takeover the management of the defaulting firm, restructuring under the provisions of the Companies Act is a time taking process. It requires specialised management skills and long term financing, both of which ARCs may not currently possess. Given the time and cost involved in this type of restructuring, only NPAs with very high recovery potential will be selected for this type of resolution.
   
4. Is insourcing vs. outsourcing of distressed asset management a level playing field? Ideally, the rules about resolution should be neutral to the identity of the debt holder. However, in India, at numerous points, the powers in processing distressed debt favour banks and do not give non-bank actors comparable powers. This creates incentives for insourcing of the distressed debt function.
   SARFAESI provides for several mechanisms to enable ARCs to carry out recovery. These include taking possession of the collateral security, settlement or rescheduling of payments, sale or lease or takeover of the borrower's business and conversion of debt into equity. But the operational guidelines for many of these were issued by RBI much after 2002. For example, the guidelines for management takeover of the defaulting firm were issued in 2010, eight years after the Act was passed, with subsequent amendments in 2011, 2012, 2013 and 2014. The guideline allowing ARCs to sell assets to each other, which enables them to aggregate assets of a borrower for a management takeover, came in 2013. As a consequence, from 2002 to 2013, ARCs were handicapped.
   Banks have been given additional mechanisms for dealing with stressed assets, that are not available to ARCs. These include loan restructuring for individual assets, and the corporate debt restructuring (CDR) mechanism for dealing with stressed consortium loans. Banks have greater restructuring flexibility, under the CDR process, than do ARCs. For example, both the CDR lenders and ARCs have been allowed to convert debt of the borrower firm to equity. SEBI guidelines on lock-in period for share issuance, have been relaxed for issuance under the CDR mechanism. Unlike the requirement in the Indian Takeover Code, the acquirer of shares in the CDR process is exempted from making an open offer. No such exemptions have been provided for the conversion of debt to equity by ARCs.
   
5. Barriers to foreign skills and capital. A natural pool of expertise are global firms with a specialisation in distressed debt management. Perhaps the only pool of capital that can pay cash for distressed assets is found overseas. However, autarkic policies by RBI have hampered the entry of foreign players, and capital controls have been used to block the inflow of foreign capital. This choked ARCs of both capital and knowledge.

In an environment riddled with mistakes in regulation, how have ARCs survived at all? There are two things that enable ARCs to remain viable even in such a market. The first is the low levels of capital that ARCs need to acquire NPAs. When ARCs issue SRs to finance the NPA acquisition, it is done through trusts in which ARCs, as per RBI guidelines, need to have at least 5 percent of own investment. These SRs have a maturity of 5 years, which can be extended to 8 years in special cases. This is the time-frame that ARCs have, in order to recover value from the acquired assets. Any loss at the end of this period has to be borne by SR holders proportionately. Since the ARC share in the loss from the asset is limited to 5 percent, it allows ARCs to acquire assets even at uneconomic valuations. In most cases, the seller bank, who can sell assets at close to book value, itself subscribes to the balance 95 percent SRs.

The second is the annual management fee that ARCs receive from the seller bank. This is typically 1.5-2 percent of the acquisition value of the asset. The fee has no link with the recovery from the asset. Hence, the ARC has little incentive to recover or resolve assets. They just need to hold the assets till maturity of the SRs, during which they continue to earn the management fee income.

This yields an exercise in sound and fury that achieves little. In this form of the sale transaction, the NPA risk remains in the bank balance sheets -- it is merely being reclassified as investment in SRs. Further, there is little improvement in the overall economic efficiency in resolution of NPAs. With this, the ARC industry in India suffers from the syndrome of numerous other parts of finance (e.g. the bond market or the currency market), where there is a show on display with apparent institutional arrangements and plenty of huffing and puffing, but the actual soul of a market economy is absent.

Recent developments

1. On 30th January, RBI released the Framework for Revitalising Distressed Assets in the Economy, with several changes in the operational framework for ARCs.
   
2. In April, a report estimated that banks sold Rs. 270 billion of non-performing assets (NPA) to ARCs in FY 2014, with most of the sale taking place during January to March 2014.
   
3. The June release of the Financial Stability Report raised concerns that bank-ARC transactions were being used by banks as an option of evergreening their balance sheets. The report also questioned the 'real' incremental value addition of ARCs in the process of 'reconstruction' of assets, over banks' traditional skills and informational advantages.
   
4. On 5th August, 2014, RBI issued a notification with amendments to the regulatory framework for securitisation companies and ARCs.

Evaluating recent policy changes

In the January 30th 2014 Framework for Revitalising Distressed Assets in the Economy, RBI proposed the following changes in the ARC framework:

• Assets in the 61 to 90 days category can also be sold to ARCs. This would encourage early sale of distressed assets and better recovery.
  
• Banks allowed to spread loss on sale over a two year period, for assets sold till March, 2015. They are also allowed to reverse provisions made for NPA, if there is gain on sale. This would address banks' concerns on loss on sale of assets.
  
• It is mandatory for banks to accept bids in an auction that are above reserve price and fulfill conditions specified.
  
• Steps to be taken to improve price transparency in bilateral sale of assets.
  
• Sale of assets between ARCs and their sponsor banks is permitted only through a transparent and arms length auction. These would improve transparency in the sale process.
  
• Promoters of companies allowed to buy-back assets from the ARCs, with ARCs demonstrating no prior collusion between the ARC and the defaulting borrower, to the RBI.

On one hand, these measures removed procedural hurdles faced by ARCs. On the other, there is pressure on PSBs to offload their growing NPAs or face an erosion of profits in the medium term. Both factors contributed to a sudden spurt in sale of NPAs from banks to ARCs in the last quarter of FY 2014. Most of this sale was by public sector banks (PSBs). For example, State Bank of India (SBI) in its Annual Report for FY 2014, has reported a sale of Rs. 36 billion of NPAs to ARCs. The book value and the sale value of these assets are Rs.15 billion and Rs.16 billion respectively, with SBI making a profit of Rs.1 billion on these transactions.

The spurt in NPA sale transactions in 2014 led to further changes through the 5th August, 2014 notification:

• Increase ARCs capital commitment in the acquired asset from 5 to 15 percent.
  
• ARCs fees linked to the net asset value (NAV) of the acquired assets rather than the outstanding value of the security receipts. Shortfalls in recovery now affect ARC fees.
  
• Increased reporting and disclosure requirements for ARCs, specially for asset sale by banks above book value and for asset sale by ARCs at a significant discount.
  
• Increased time that ARCs get for due diligence at asset auctions, at least two weeks.
  
• Reduced planning period for acquired assets from one year to six months. This is also the time frame within which the acquired asset need to be rated and re-valued.
  
• Inclusion of ARCs in the Joint Lenders Forum (JLF) and a mandate for them to put up a list of willful defaulters on their website.

These changes will help reduce three aspects of bank-ARC transactions as they have been proceeding:

• Banks selling assets to ARCs without actual risk transfer, since 95 percent of the value of the sale got back into banks' balance sheets as investment in SRs.
  
• ARCs earning fee income linked to the book value of the asset and not to its recovery value. Low levels of ARCs capital commitments meant no real incentive for them to resolve NPAs.
  
• Promoters, even the willful defaulters, getting relief from repaying their dues under the ARC model, which was focused on warehousing instead of resolution of NPAs.

These latest amendments have increased the ARCs risk in acquiring assets. ARCs will now need to make recoveries to earn fees and to get returns on invested capital. However, the larger problems of these arrangements remain unresolved.

The way forward

In order to make distressed debt processing and ARCs work, the work plan for policy makers consists of the following elements:

1. A clear understanding is required that the role of RBI in regulations should stop at the point of sale of distressed assets to the ARC. The working of the ARCs should be unregulated as there is no market failure there.
   
2. Mistakes in micro-prudential regulations of banks, in recognition and provisioning by banks, need to be addressed.
   
3. Banks should be required to do true sales in exchange for cash of distressed debt. This will yield closure on the books of the bank. After the transaction, the ARC would work to obtain recovery with no relationship to the original lender.
   
4. The bankruptcy process should be improved.
   
5. ARCs should be first class participants in the bankruptcy process. There should be no bias in the bankruptcy process in favour of any one kind of financial firm such as bank.
   
6. Establishment of operations by foreign ARCs should be feasible with 100% equity ownership. Foreign capital into ARCs (whether private or foreign) should be welcome through private equity structures. All institutional investors in India -- but not banks -- should be able to invest capital into these private equity structures. Banks should only face the choice of selling (in exchange for cash) or not selling.

We are grateful for Harsh Vardhan of Bain Consulting and Badri Narayanan of Third Eye Capital for useful discussions.

---

Finance Research Group, IGIDR, Bombay