ARCs: A Panacea Or A Problem In Itself?

Posted in Finance Articles, Total Reads: 3278 , Published on 29 September 2012

ARCs, a term coined for asset reconstruction companies, are a product of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. The act provides full right to the lenders to acquire the assets without any judicial intervention. Asset reconstruction business is complimentary to the core banking business of lending. Accumulation of NPAs is a natural phenomenon in the financial sector and only the amount of NPAs varies according to the economic cycle and the external as well as internal factors affecting the financial sector.

Removing stressed assets from the balance sheet of the banks will help them focus on their core business and save a lot of intangible assets like human capital, brand and distribution network. The structure of ARCs is win-win situation for both banks and ARCs where the banks get rid of bad loans and ARCs recover them with their expertise, thus bringing benefits to the overall financial system. ARCs can acquire the bad loans for either cash or by issuing security receipts (SR) to the seller.

Net non-performing assets (NPAs) of banks rose by 53.5% during the quarter ended March 2012. Bank's gross NPAs are set to increase to 3.2% of advances by March 2013, from 2.9% as at December 2011 and the restructured loan portfolio of banks is set to touch 2 trillion by March 2013, according to CRISIL. The situation seems perfect for the Asset Reconstruction Companies whose objective is the rapid disposal of bad assets owned by the banks to clean up their balance sheets.

But why have they not been able to capitalize on it?

There are four reasons for the under-performance of ARCs. The first and the most important is the price discovery for the acquisition of the stressed asset. Banks tend to demand a higher price due to their limited experience with a small number of bad debts realized and also banking on the expertise of the ARCs whereas ARCs on the hand are not ready to pay such a high price for bad debts. The banks need to realize that recovering a small number of debts does not mean they will be able to realize the same result for the entire pool of assets. The result of not discovering the correct price is that the assets continue to be on bank’s balance sheet and their value erodes further with time.

The second is capital requirements of ARCs. Going by RBI norms, an ARC needs to follow 15% capital adequacy till 100 crore of capital. This norm is relaxed once an ARC has Rs100 crore capital, but all ARCs must pick up at least a 5% stake in the SRs that they sell against the bad assets. Also the ARCs make acquisitions for stressed assets in cash and thus have large requirement of capital. There are two solutions to this problem. First is to allow more foreign players in the sector. Currently, qualified institutional buyers, such as banks and insurance firms, are allowed to subscribe to SRs. Foreign investment in such instruments is capped at 49% and no individual foreign institutional investor, or FII, can hold more than 10%.

Foreign investors should be allowed to play a larger part at the share capital level as well as at the security receipts level. Also if the foreign investor can bring in expertise for recovery and become actively involved, it’s going to be great for ARCs. The domestic market has less appetite for such an investment considering the risks associated with it and the resultant capital requirements.FIIs specialized in distressed debt would be the primary source of funding. Second is to let them function as asset managing companies wherein they will be paid management fees and do not require to make their own investments.

The third is the flawed model of the ARCs that operates in India. Internationally ARCs are funded by the government and receive special support and powers from the government to shorten the legal process of recovery of dues. The central idea behind the creation of an ARC is to protect the capital of the banking system as banks need to provision money for bad assets which erodes their capital. In contrast the Indian ARC model doesn’t envisage any fiscal support or tax forbearance from the government. It also does not get any special powers from the government for a shorter path for recovery of stressed assets and has to follow the same route followed by the banks.

The fourth is the practices followed by the banks with regard to NPAs. Banks only sell the stressed assets to the ARCs when no more provisioning is required against them. This is because when a bank sells a stressed asset to the ARCs it makes to make a full provision of the difference between book value of the loan and the amount paid by ARCs, thus impacting their profitability whereas if they keep the asset on their balance sheet they can provide provisioning over a period of three to four years.

This practise of dressing up the balance sheet is harmful to the system because there is much larger chance of recovering a bad loan in the initial years and the probability of recovery reduces as the time passes. Sometimes the banks have to pay an additional loan amount to a stressed borrower as a last resort to prevent it from becoming an NPA, this is known as “evergreening” and the cost of this is also borne by the bank. Also banks first try to recover the bad loans themselves because the process followed by ARCs is same as them and also try to restructure the loan to help the borrower and when they fail on all fronts the loan is given off to ARCs. What is the point of creation ARCs if anyway the banks are going to put in effort to recover bad loans? This is the job of the ARCs and should be left to them. Also banks use auctions of bad loans to discover the floor price of the stressed asset. After receiving the quotes from the ARCs they start negotiating with the borrower for a settlement using the highest bid as the floor price.

So what key steps need to be taken for a metamorphic change, in making ARCs a panacea for the increasing NPAs?

Firstly banks should appreciate the importance of selling the bad loans to ARCs and focus on their core business. Also the representation of banks in ARCs should be capped so that no bank is able to influence the functioning of an ARC and the way it carries out its business. Secondly the investor base for the SRs should be expanded. Currently the banks sell the bad loans and they are the main buyers of SRs. If securitization has to happen in true sense, then investor base has to be expanded.

Thirdly, ARCs should get more support from the government. ARCs should get monetary help from the government due to their need of capital, more tax holidays and simplified procedure and more power for recovery of stressed assets, so that banks have an incentive to pass the bad loans to ARCs. IDBI Bank came out with the concept of SASF-Stressed asset stabilization fund to alienate the bad assets from its books .Now how the government helps in such a case is that it allowed IDBI bank to borrow the 20 yr zero coupon government bond and thus as it received the money it transferred it to SASF. The SASF on its part transferred it to IDBI Bank as consideration for transferring NPA to its balance sheet.

Thus SASF now has 20 yrs to pay back the money to the government. More such incentives from the government are required for the growth of ARCs. Fourthly, ARCs need to be more efficient in acceleration of resolution of NPA and maximisation of recoveries. This would help in improving the return on capital and generation of more confidence among banks to give stressed assets to them and thus improve the subscriber base of SRs. Fifthly, ARCs is a risky business to operate and the characteristics of the business are very different from other businesses. The major asset with the ARCs is the human capital. ARCs will frequently be involved in negotiating deals with lenders as well as borrowers, so they must have the right balance of soft skills as well as financial knowledge.

Being in existence for the last 8 years and still being able to manage a portfolio of only 15000 crore, in an economy where NPA’s are at an all time high, speaks quantum of the lacklustre growth of the ARCs over the years. Thus, it would require a tripartite partnership between the government, the banks and the ARCs to ensure the ARCs are able to serve the intended purpose of their existence.

This article has been authored by Amit Sharma and Rahul Goel from NMIMS.

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