What ails asset reconstruction firms?

The business model of Indias eight-year-old asset reconstruction industry is under the central banks scanner. The Reserve Bank of Indias (RBI) inspection team has found that Asset Reconstruction Co. (India) Ltd (Arcil), the countrys oldest and biggest asset reconstruction firm, is not driven by its board but its major shareholdersState Bank of India, ICICI Bank Ltd and IDBI Bank Ltdand its accounting policies are not in line with the regulators norms. Asset reconstruction firms in India, through a trust, buy stressed assets of banks and financial institutions at a discount, recover them, and earn a fee for managing the trust. There are at least a dozen asset reconstruction companies (ARCs) in India. Collectively they have been managing assets valued at about Rs 15,000 crore bought from banks. Also Read | Tamal Bandyopadhyays earlier columns The origin of ARCs was probably a 1991 report on financial sector reforms by a panel chaired by former RBI governor M. Narasimham. Corporate financial management in India until the early 1990s was easygoing and accounting policies of the banking system didnt include any prudential norm for setting aside money against bad loans. With RBI issuing its first set of norms to classify bad loans, or non-performing assets (NPAs), in October 1990, a pile of bad loans in most public sector banks and development financial institutions was unearthed. The Narasimham panel recommended the establishment of an asset reconstruction fund to flush bad loans out of the system. Globally, asset management companies play the role of bad banks and tackle the stock of bad assets as a one-time phenomenon; they have a sunset clause for winding down the assets. The Indian banking system had for years been hiding its bad assets as governance in public sector banks before they were listed was questionable, with the political system misusing them. The government, the sole owner of banks, was happy with a substantial portion of bank deposits being used to buy government bonds to bridge the countrys fiscal deficit. The Board for Industrial and Financial Reconstruction, a reconstruction agency, and its appellate body showed little success in tackling industrial sickness. That and delays in winding-up procedures led to the establishment of debt recovery tribunals (DRTs). The objective was speedy recovery of money from defaulters who had borrowed from banks and financial institutions. But DRTs, too, could not speed up the recovery procedures in most cases as they lack sufficient judicial experience in complex company law, lender-borrower contracts, and claims of other constituents, including employees and the state and Union governments. Typically, a DRT takes three-four years to issue a recovery certificate, and the process of sale of assets takes even longer. Moreover, since DRTs dont permit all stakeholders to participate in its proceedings, creditors other than banks and financial institutions need to follow the long-winding liquidation process to recover their dues. As a panacea for all ills, the government passed the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, clearing the decks for setting up ARCs that could buy bad assets from Indian banks and financial institutions. At a parallel level, some weaker banks were capitalized by the government and a corporate debt restructuring (CDR) platform was formed to recast troubled debt without classifying them as bad assets. RBI also issued norms for restructuring loans outside CDR.

Financial institution ICICI converted itself into a bank as its business model was turning unviable with the source of long-term cheap funds drying up fast. Industrial Development Bank of India (IDBI) followed suit by merging itself with IDBI Bank and creating a stressed asset stabilization fund (SASF) to alienate Rs 9,000 crore worth of bad assets from its books. But two other development finance institutions could not become banks. IFCI Ltd, Indias oldest financial institution, is alive but not kicking, and Industrial Reconstruction Bank of India died a quiet death. Globally, AMCs tackling bad assets are formed as a response to a systemic crisis to protect commercial banks by creating one bad bank that takes over the stressed loans of the entire system. Typically, the government provides legal, regulatory, fiscal and administrative support to such institutions. The central idea behind the creation of such an AMC is to protect the capital of the banking system as banks need to set aside money for bad assets and this erodes their capital. Typically, AMCs buy bad assets from banks at a discount and issue bonds against them. The government offers fiscal support by guaranteeing the bonds to protect any erosion in value of assets in the books of the banks that are selling stressed loans. A case in point is Pengurusan Danaharta Nasional Bhd, an AMC set up in Malaysia in the aftermath of the Asian crisis. In this model, AMCs acquire bad assets not through price negotiations or auctions; they are simply transferred from banks books. In a sense, its an accounting jugglery where the government takes a call on the ultimate recovery amount from the asset pool over time and doesnt recognize the so-called present value of such loans. The expectation is that over the life of the AMC, the recovery amount from the asset pool will equal the price at which the assets have been transferred. The formation of an SASF by IDBI Bank with government support in some sense resembles the structure of global AMCs, except that the sunset clause in case of the SASF is 20 years against 510 years globally. Under this structure, IDBI Bank subscribed to Rs 9,000 crore, 20-year, zerocoupon government bonds. The government received the money and transferred it to the SASF, a trust, which in turn gave this money back to IDBI Bank as consideration for the transfer of NPAs from the books of the bank. The SASF is expected to recover the amount in 20 years and pay back the government. Meanwhile, in the books of IDBI Bank, the bonds, though zero-coupon, will continue to be accounted for at their original investment value, sparing the government from the pain of recapitalizing the bank. In the Indian context, ARCs are allowed to buy bad assets from banks and financial institutions and recover them. The Securitisation Act enables them to take possession of physical assets of defaulting firms without the intervention of the judiciary when at least three-fourth of the lenders by value support such an action. The Indian ARC model doesnt envisage any fiscal support or tax forbearance from the government. It also doesnt call for mandatory transfer of bad assets of the banking system. In sum, the model doesnt envisage ARCs as a tool of resolving the one-time problem of bad loans of the banking sector, and its not a policy response to a systemic crisis. Its a market-driven model that allows banks to take their own decisions to sell bad loans to ARCs, based on bilateral negotiations and/or auctions. ARCs, on their part, are required to mobilize capital and arrange for money to pay for the acquisition of bad loans by themselves, without any fiscal support from the government. They are not allowed to access debt or the capital market, but can securitize their portfolios by creating a pool of bad assets of different banks and issuing security receipts (SRs) to pay for the

acquisition of bad loans. Being a qualified institutional buyer, banks themselves buy the securitized papers. Theoretically, there is nothing wrong with the structure, but it is spoilt, with many sellers insisting that bad assets of different banks cannot be pooled to create SRs. This means ARCs need to acquire bad assets of individual banks as separate pools, and banks need to subscribe to SRs of their own assets. Indeed, combining reconstruction of financial assets with the concept of securitization in one package is a fine example of financial engineering, but the devil lies in the details. The Indian ARC model encourages the worst kind of financial incest. This is the first in a two-part series on asset reconstruction companies.

In the banking system, high level of NPAs can be serious drag on overall performance of economy on account of diversion of its management and financial resources towards recovery of NPAs. Greater the resources needed by banks to reserve for losses, lesser is the amount of capital they can leverage. Consequently it makes the banks risk averse in providing new loans leading to credit crunch in the financial market, amounting to economic and financial degradation. ARCs are established to acquire, manage, and recover illiquid or NPAs from lenders, unlocking value trapped in them via an institutional platform. Benefits

Relieving banks of the burden of NPAs would allow them to focus better on managing the core business including new business opportunities. The transfer should help restore depositor and investor confidence by ensuring the lenders financial health. ARCs are meant to maximise recovery value while minimizing costs. ARCs can also help build industry expertise in loan resolution, besides serving as a catalyst for important legal reforms in bankruptcy procedures and loan collection. ARCs can play an important role in developing capital markets through secondary asset instruments.

ARC Ownership Models Different countries have tried out varying models of ownership of ARCs. The options range from asset workout departments or units of banks, bank-owned subsidiaries or affiliated companies, private companies, and government owned asset management agencies. The severity or systemic nature of a countrys NPA problem usually dictates the NPA resolution strategy and the parameters for judging its success. A countrys institutional, legal, and market conditions also influence the decision. Typically, the primary goal is to maximise net present value recovery in order to minimise losses to either the selling bank or the government, depending on the ARC model used. Government-based ARCs may have additional challenges such as minimising adverse market impact from the asset recovery process or helping to rehabilitate troubled banks and distressed borrowers. In general, most bank resolution programs involve removing NPA from normal bank operations. ARCs usually operate through one of the two basic models namely bank based model, which is a decentralised approach or a government based model, centralised approach. Government Based ARCs In a government based model, an agency is sponsored by government which acquires and resolves the bad assets. The NPAs are owned by the government and managed by the ARC or partially contracted out to private managers. The ARC can be a special-purpose organisation which will be entrusted to acquire, manage and recover NPAs. It can also have other operations like deposit insurance or bank recapitalisation. Moreover in this model, centralisation of NPA

provides effective asset packaging and marketing, ensuring consistency and transparency within the ARC. In addition, the risk of decrease in sale values of assets by the competing bank based ARCs is also reduced. Bank based ARCs A bank based model has two approaches viz workout units and bad banks. In workout units, NPAs are moved to a separate bank department but remain in the banks books. On the other hand, the bad bank approach includes the transfer of NPAs to a separate affiliated organisation i.e. ARC, which specialises in the management of bad assets. However, a government based model is more effective in an economy where the NPA problem is more pervasive and business environment or legal infrastructure is less developed. A bank based model is generally appropriate when the NPA problems are limited and concentrated. Valuing Distressed Asset Valuation techniques are needed in order to make informed decisions regarding asset purchase price as well as the timing and the nature of sales transactions and other sales strategies. The valuation process can also influence other decisions, such as whether or not to provide seller financing or to fund asset enhancements (or even the operations of a business). Valuation should play a major role in deciding whether or not to engage in debt-for-equity swaps with borrowers or in determining the funding cost of providing equity participation. Additionally, asset valuation procedures are necessary in monitoring and reporting on the financial condition of the ARC. The first step in valuation is to collect the necessary information about the loan and then to stratify and segment the asset pool by size, industry, operating condition, and location. Sources of information include loan files, bank files, service providers, bankruptcy procedures, the trustee/ receiver, feasibility studies, appraisals, industry and sector details. The ARC specifies the minimum level of information desired for each category of loans, based on the availability of information and asset value. It should require selling banks to furnish asset information to guide better-than -liquidation pricing. The type of information that is necessary for analysis may include rescheduled loan payment and workout plans, payment history, rank of obligation in priority of claims, property descriptions, and description and value of collateral. With this information, the ARC should determine a valuation methodology, based on asset categories and recovery strategies, and then develop an appropriate model to derive the investment value. The more significant an asset, the more rigorous the valuation effort should be. The AMC should develop due-diligence material, ideally in a standard format, taking the asset information into account. Resolution Strategy for NPA After acquiring the NPA from the sellers, the ARC will implement the resolution strategy for the underlying assets of the non performing loan. The ARC has been given powers by the SARFAESI Act to execute the resolution of NPA whereby it can:

Restructure the loan. Sell or lease part/whole of the assets or the business to a third party. Change the management structure by introducing its own personnel in the management. (presently this section has been kept in abeyance by the regulator) Restructure the business operations including diversification of business operations or discontinue the loss making business segment.

Disposition Strategies A number of sales techniques are possible. These include

Portfolio sales Open outcry and sealed-bid auctions Securitisation Equity participation transactions

Transaction Structures Stage 1: Initially, an ARC acquires NPA by floating an SPV which acts as a trust whereby the ARC is a trustee and manager. NPA are acquired from banks/FIs at fair value based on assessment of realisable amount and time to resolution. The banks/FIs may receive cash/bonds/debentures as consideration or may invest in securities issued by the ARCs. The trust acquires NPAs from banks/FIs and raises resources by formulating schemes for the financial assets taken over. Accordingly, it issues securities to the investors which are usually QIBs. Securities represent undivided right, title and interest in the trust fund. Subsequently, the ARC redeems the investment to the bank/FIs out of the funds received from the issued securities. After acquiring the NPA, the trust becomes the legal owner and the security holders its immediate beneficiaries. The NPAs acquired are held in an asset specific or portfolio trust scheme. In the portfolio approach, due to the small size of the aggregate debt the ARC makes a portfolio of the loan assets from different banks and FIs. Whereas when the size of the aggregate debt of a bank/FI is large, the trust takes asset specific approach.

Stage 2: Thereafter, different fund schemes are pooled together in a master trust scheme and sold to other investors. The ARC periodically declares the NAV of respective schemes.