Panel suggests broad changes on asset reconstruction

Livemint Jan 17, 2012

Mumbai: A finance ministry-constituted advisory group on the workings of asset reconstruction companies (ARCs) has recommended sweeping changes to develop the industry and help banks reduce bad assets even as the Indian banking sector is seeing a record rise in bad loans.

ARCs are in the business of buying bad loans from banks at a discount and recovering them. They buy loans by paying cash or offering security receipts (SRs) that get redeemed after a few years.

Introduction of a standard process for the sale of bad loans to ARCs and allowing banks to write off bad loans gradually rather than taking a one-time hit are essential to revive the industry, said the 41-page report submitted to the ministry on 30 December.
Mint has reviewed the report.

The advisory group has made 18 recommendations, including allowing ARCs to trade debt among themselves, letting non-banking financial companies sell bad loans to ARCs, increasing foreign participation and allowing bad debts to be converted into equity.


It has also suggested that the Reserve Bank of India (RBI) issue standard guidelines for the sale of bad loans to make such transactions transparent.

The total bad loans of Indian banks crossed Rs. 1 trillion in the quarter ended September.

A Mint analysis in November showed that gross bad loans of banks have increased to Rs. 1.07 trillion, up 33% from last year, the fastest growth in any quarter in at least the last five years.

Data of 36 listed banks showed that the lenders added Rs. 14,273.62 crore of bad loans in the July-September period, up 15% from the quarter ended June, because of rising interest rates, an adverse regulatory environment in some sectors such as mining, and migration to a computerized calculation of bad debts.

Kalpesh Gada, head of structured finance with credit rating agency Icra Ltd, said the asset recast business has not picked up because banks’ price expectations are always different from that of ARCs.

“Many times ARCs want to buy an asset cheap, while banks look for higher prices. Most of the recovery of bad loans is done through sale of securities where both the quantum and timing of the sale is uncertain, which doesn’t help,” he said.

Karthik Srinivasan, co-head (financial sector rating) at Icra, said rising non-performing assets have also forced banks to shore up their recovery departments in the last couple of years.

“Only chronic cases are now sold to ARCs. Also, with the real estate environment tough, valuations are lower, which is dissuading banks from selling bad loans,” he said.

Rajesh Mokashi, deputy managing director at ratings agency CARE Ratings, said recovering a bad loan is a time-consuming process.

“There are many processes involved and even after that an ARC may offer a higher discount than what a bank expects,” he said.

Mokashi pointed out that banks also have active recovery departments of their own, which do the same job.
“Ultimately, these assets are sold at a loss with a charge to the P&L (profit and loss) and banks always try to minimize that charge,” he said.

Indeed, there is always a gap between what an ARC is willing to offer and a bank expects when selling a bad asset. Besides, banks pay a management fee, between 1% and 2% of the size of the asset, in case of sale through SRs.

The advisory panel, which included representatives from RBI, the Securities and Exchange Board of India, ARCs, the Indian Banks’ Association, and industry lobby groups, was formed in September.
A former managing director and chief executive of a large ARC, who was on the panel, said the increasing trend of banks restructuring loans has delayed the development of the market.

“Debt restructuring was started as a one-off case in 2002, but now it is a way of life. By restructuring loans, banks are now redefining bad loans. ARCs have become the last resort,” he said.
According to him, a standardized sale process, marking the assets to the market rate, will create a transparent system for bad loan sales.

Last year, an RBI inspection report accused the main shareholders of Asset Reconstruction Co. (India) Ltd, or Arcil, India’s largest and oldest ARC, of influencing the company’s management to help them clean up their own books by buying their bad assets.

RBI had also pointed out a string of accounting and transaction irregularities in Arcil, including inflated earnings. The RBI action forced Acril to restate its profits for fiscal 2010-11 and shelve dividend payments to shareholders.

Arcil has restated its net profit for 2010-11 to Rs. 3.3 crore, from Rs. 51 crore approved by its board.
State Bank of India, the nation’s largest lender, is the largest shareholder in Arcil with a 19.95% stake, followed by IDBI Bank Ltd (19.18%), ICICI Bank Ltd (13.26%) and Punjab National Bank (10.01%).
The report said that though banks invite competitive bids to dispose of bad loans, transactions are not completed many times because the bids are lower than the bank’s expectations.

“At times the deal closure process is modified after the receipt of the bids and a different approach is adopted to close transactions,” it said.

The group has suggested that RBI should issue guidelines for a standard process, which includes a reserve price and conclusion of the deal if bids are received above that price.

“After an auction, the best bid received can be treated as price discovery of underlying security. Banks have to be mandatorily required to adopt it as reference value for mark to market,” the report said.
Gada of Icra said a totally transparent system may not be possible in the bad loan market. “There are many uncertainties on the timing and valuations of such assets... One of the things that can be done is to make banks share more information because they know more about the assets on the block,” he said.
Other suggestions include allowing ARCs to acquire assets from each other and allowing insurance companies to treat SRs as a separate category of investment.

Since capital is a constraint for ARCs, the advisory group has suggested an increase in the foreign institutional investment cap. It has suggested that the sub-cap of 10% for participation by individual foreign institutional investors (FIIs) in SRs be removed.

Currently, 49% FII investment is allowed in SRs, but there is a sub-cap of 10% for individual FIIs.
“ARCs need capital and banks cannot continue to do what they are doing and push bad loans under the carpet. They have to bundle loans and sell them for better price discovery instead of selling them individually. Only then investors will come in and money will flow,” said the panel member cited earlier in the story.
Mokashi of CARE Ratings said the concerns are part of the evolution of the business. “The skill in recovery is itself going through an evolution, but the very fact that there are multiple ARCs out there looking for business, means it is evolving,” he said.