Can ARCs ease banks’ burden?
With banks reeling under bad loans, talk of setting up a public asset reconstruction company has flowed and ebbed. In this context, we look at the challenges that existing ARCs face
The Finance Minister, Piyush Goyal, recently announced that a committee had been formed to explore the setting up an asset reconstruction company (ARC) to take over bad loans of public sector banks. While the fate of the new ARC hangs in the balance, the idea has once again set off a debate over a national ARC among bankers and analysts.
In this context, we look at the various aspects — implications for banks, existing ARCs in India, regulatory developments and challenges ahead in the distressed assets space.
Implications for banks
Why the idea of a bad bank in the first place? For one, the Centre’s much-touted recapitalisation plan — the first tranche of a massive ₹88,139 crore of capital infused into 20 public sector banks — has been yet another case of throwing taxpayers’ good money after bad. Much of the recap money has gone to fund banks’ losses (aggregate loss of PSU banks for the March quarter alone is over ₹62,000 crore).
Banks are now saddled with ₹10 lakh-odd crore of bad loans on their books, doubling from the levels seen two years ago. Hence, the idea of a public ARC that can lighten banks’ books and free up capital for lending, no doubt, sounds reassuring.
Also, there has been a one-time huge impact of the RBI’s February 2018 circular for stressed assets (that essentially does away with all the old restructuring schemes) in the latest March quarter across banks. But there could be more pain ahead. The RBI’s new framework requires banks to report even one-day defaults hereon and draw up resolution plans within 180 days. This is a niggling worry for banks that are saddled with large stressed power sector accounts — stressed assets of the power sector are pegged at about ₹1.7 lakh crore — that will require a long time to start generating cash flows.
Hence, quarantining these accounts into a national asset management company is an idea that is finding favour in many quarters.
Canara Bank, SBI, Bank of India, Indian Bank, IDBI Bank, ICICI Bank and Axis Bank, that have a relatively higher exposure to the power sector, are likely to benefit, if the transfer of these assets happens at a good price.
Understanding the ARC space
While the reasons for exploring the idea of a bad bank may seem compelling, it is important to understand the current structure and state of affairs at 26 asset reconstruction companies, before creating a new entity.
Lack of consensus on the ‘right’ price at which banks should offload bad loans to ARCs, constant regulatory interventions and capital constraints have been key challenges.
We trace the evolution of the ARC industry to understand the big picture of the distressed assets sale market in India.
Asset reconstruction companies (ARCs) were formed under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, to help banks manage and recover NPAs. The Debt Recovery Tribunals (DRTs) or civil courts present earlier were not very effective and fast. Hence, ARCs were set up to enable faster recovery without the intervention of the court.
But despite the structures in place, there was hardly any activity until about 2012-13. The number of ARCs then in the market was about 14.
The book value of assets acquired by ARCs in 2012-13 was ₹8,000 crore. It was in 2013-14 that the sale of bad loans began to gain momentum. The bad loans’ sale shot up to ₹40,000 crore in 2014-15. Why?
The good times
One obvious reason for banks to offload their bad loans to ARCs was the sharp jump in NPAs in 2013-14. The total GNPAs shot up from 2.2-2.5 per cent levels (until 2013-14) to 3.8 per cent in 2013-14 and then to 4.3 per cent of loans in 2014-15. With pressure building up on banks to put their house in order, and tighter norms on reporting and managing of stressed assets, the sale of bad loans to ARCs gained traction.
The other reason was the better pricing that ARCs seemed to offer. ARCs usually offer to take the loan off the banks’ books at a discount.
The significant jump in pricing in 2013-14 happened due to a shift in deals from the cash route to the security receipts (SR) route. From about 30 per cent in the past, ARCs started paying 55-60 per cent of the value of loans. This was possible because, instead of taking an upfront cash payment, banks were willing to accept delayed payment in the form of SRs.
ARCs were making a down-payment of minimum 5 per cent and the balance 95 per cent was paid to the bank against the SR. When the amount is finally recovered, it is redeemed against the SR to the banks.
The clamp down
But the sudden rush to sell off bad loans caught the regulator’s eye, that turned wary of the unrealistic pricing of assets.
For one, the regulator was concerned about the use of ARCs as yet another tool to dress-up banks’ balance sheets. Banks stop recording the assets as bad loans in their books and do not make provisions for them. Instead, they record the SR portion as investments in their book, which is rated every year by rating agencies.
Two, most sales happening against SRs did not improve the bank’s cash flows. Unrealistic pricing of assets only aggravated the problem.
It was due to such risks that the RBI intervened in August 2014. To ensure more skin in the game for ARCs, the RBI tweaked the rules, and increased the upfront payment to be made by ARCs from 5 per cent to 15 per cent.
The RBI’s 15:85 diktat marked the beginning of the slew of regulatory changes that has left a lasting impact on the ARC industry.
The capital crunch
The mandate for a higher upfront payment impacted the returns for ARCs, which until then were able to make an internal rate of return (IRR) of 20-22 per cent on their investment.
Industry sources suggest that the IRR has fallen to single-digits since then, as the management fee only covers the cost of capital. If an ARC had to make 18-20 per cent IRR, it needed to show recovery.
While this led to more realistic pricing of assets — based on a more proper assessment of what was truly recoverable — it also led to a substantial slowdown in the sale of bad loans to ARCs in 2015-16 (₹19,700 crore).
While there was a pick-up in 2016-17 and 2017-18 to ₹30,000-35000 crore, given the sharp rise in bad loans over the past two years within the banking sector, the sale of bad loans to ARCs has been tepid. Remember in 2015-16, thanks to the RBI’s asset quality review, banks’ NPAs nearly doubled from the previous year.
Importantly, the issue of insufficient capital became more pronounced after the RBI’s directive on higher down-payment. As per an RBI report in October 2015, the net worth of 15 ARCs then was only around ₹4,000 crore.
In a bid to offer some respite to ARCs on the capital front, the 2016-17 Budget ushered in some changes in the existing regulations. One, necessary amendments in the SARFAESI Act 2002 were made to enable the sponsor of an ARC to hold up to 100 per cent from the earlier 49 per cent. Easing of cap on single ownership that turned investors wary, is likely to attract investors and bring in capital for ARCs.
The Budget had also provided for 100 per cent FDI in ARCs through the automatic route, against the earlier threshold limit of 74 per cent.
Last December, SEBI allowed the listing of security receipts of ARCs — only qualified institutional buyers through private placement are allowed. For now, the SR market is still quite illiquid. If it gains momentum, it could lead to acquisition of stressed assets at realistic prices, offering an exit route, in particular to banks sitting on the SR book.
But while leading ARCs such as Edelweiss and JM Financial, have been able to attract more capital in the past few years, the overall situation is still sombre. Despite the jump in the number of ARCs to 26 now, the overall net worth is just about Rs 5,000 crore.
More regulatory challenges: Just when the industry was adjusting to the new 15:85 set up, the RBI came up with another stringent regulatory norm from April 1, 2017.
In order to make sure that the sale of stressed assets by banks actually result in ‘true sale’ of assets, the RBI tightened the provisioning requirement for banks. With effect from April 1, 2017, where the investment by a bank in SRs is more than 50 per cent of SRs, backed by its sold assets, the provisioning requirement will be as per asset classification norms — before the asset was sold.
With effect from April 01, 2018, this threshold of 50 per cent has been reduced to 10 per cent.
What this implies is that there will be a decline in the sale of assets through the SR route and more cash deals in the market are expected — yet another herculean challenge for capital-strapped ARCs. The RBI had also raised the minimum capital requirement (net-owned funds) for ARCs last year from ₹2 crore to ₹100 crore — to be achieved by March 31, 2019.
Recoveries to improve: Under the 5:95 structure, as pricing was unrealistic and difficult assets (to resolve) were sold, the recovery rate was low.
From hereon, it will be the 15:85 asset sales (with more realistic pricing) that will see resolution, and the recovery rate is expected to improve.
IBC, a game changer: The biggest challenge in drawing capital into ARCs , has been the undue delays in the recovery process.
The IBC has been a giant leap forward. It may take a year or two for the code to stabilise, as the ongoing amendments to the code and court rulings set the path for smoother resolution.
Once that happens, it is likely to kindle investor interest and help capital flow into the industry.
Creating a new entity may not work
Looking at the evolution of ARCs in India and the challenges that lie ahead, it is evident that setting up another entity on the same lines can achieve little.
Lack of consensus on the ‘right’ price for sale of bad loans and capital constraints, will still remain an issue.
Hence a bad bank or not, the Centre, should ensure that it leverages the potential of the existing ARCs, that are likely to attract more capital from hereon and see better recovery–as the dust settles on past regulatory interventions.
According to the Standing Committee on Energy, March 2018 report, there are 40,130 MW of stressed power projects across 34 projects, with an outstanding debt of ₹1.74 lakh crore.
Given the size of the problem, if the main objective of setting up a national ARC/AMC is to take over power assets from the banks, it is evident that the capital requirements of this new entity will be massive.
PSU Banks have been reluctant to take huge haircuts. An opaque or unrealistic pricing of assets to benefit banks may be detrimental.
What could work
The new entity should focus on resolving capital-intensive assets along with a clear time-frame.
Rather than an ARC structure, what could work is a model based on an asset management company (AMC). Under this structure, the focus should be on managing the assets — primarily technical expertise in turning around will be imperative. AMC is either partner or a subsidiary of the hedge fund or distressed fund.
If the Centre decides on a public ARC structure, the pricing should be transparent.