The author is Tanisha Taneja, a third year student at Maharashtra National Law University, Mumbai.
The origin of imprudent bank lending can always be traced back to the saga of the 1980s. While international economic crises have plagued the world economies before, none have left their impact like the Great Recession- the deepest international recession since the 1930s’. India was one such economy, which under the garb of internal exigencies and the changing global financial order was forced to liberalise its economy. The problem of distressed debts began when these socialist countries transformed into market economies in the sudden wave of liberalisation. This led the banks to carry the inherited portfolios of dubious quality as economies transformed themselves into free market-based institutions. The dawn of Non-Performing Assets (NPA) lay in the hands of mismanaged policies of government clubbed with unsuitable market forces which ultimately led to approximately 5.42 trillion Indian rupees of NPAs in Public Sector Banks in 2022.
The oldest measure in the 2000s was acting up on the recommendations of the Narasimhan Committee which led to the enforcement of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI). Under the provisions of the Act, Asset Reconstruction Companies (ARCs) were instituted to securitise distressed debts and remove them from the balance sheets of banks.
To the contrary, the book value of assets transferred to ARC’s have been constantly declining at the same time when NPAs are drastically rising. Furthermore, the year-on-year growth, if any, is only but a meagre percent of the sharp rise in NPA’s in the banks. The underlying issues are multifarious but for the purposes of this article, the author has restricted herself to analysing the two most relevant types namely: structural issues and market side issues. While Structural issues are problems directly linked to the incentivized internal functioning of the ARC’s, the latter are external demand-supply issues that are much harder to thematize for the RBI. The ignorance of these market issues coupled with a failure to properly understand them by the RBI, trapped the ARCs in a vicious cycle ultimately leading to their failure.
Functioning of ARCs
Under SARFAESI, banks are allowed to sell nonperforming loans to ARCs at a discount rate which normally is a rate that is lower than the face value of the loan. Financial institutions are permitted to recoup loans under the SARFAESI Act by selling the defaulter's assets at an auction. Securitization can be defined as the process of pooling financial assets into marketable securities that can then be sold to investors. The SARFAESI Act deals with this process, of asset reconstruction, and security enforcement, and the Reserve Bank of India regulates it.
The NPAs are sold through an auction and the cost at which they are acquired is known as acquisition cost. The payment can be made either in the form of upfront cash or security receipts. Security receipts (SRs) are consideration issued by ARCS in exchange of purchase of distressed debts. The SR reflects an interest in the underlying distressed asset or pool of distressed assets.
Initially there was no defined investment required for ARCs, so they purchased all NPAs in exchange for SR but in 2006 RBI mandated a 5% investment requirement by ARCs which was further increased to 15% in 2015.
The ineffective change in the business model
Prior to 2014 in the 5/95 rule, the ARCs received a management fee for all the Assets under Management (AUM), irrespective of whether it led to the revival of an asset or not. So technically higher the number of NPAs, the higher will be the management fee received by them. The constant incoming management fee with a negligible amount of investment (5%), created a lack of motivation among ARCs to function and transform the NPAs. This led to ARCs buying NPAs even at a higher rate to increase their profitability from the management fee. Due to this, the debt restructuring motive remained futile. To gain from the capitalistic instinct of ARCs, the tool of incentivisation had to be adopted to usher structural reforms in the functioning of ARCs
Therefore in 2015, the 15/85 rule was adopted, under which 15% investment in the NPAs was made mandatory. Additionally, the management fees would be calculated and charged as percentage of the net asset value (NAV), at the lower end of the range of the NAV specified by the credit rating agency (rather than on the outstanding value of SRs as at present), provided that the same is not more than the acquisition value of the underlying asset.
This reform indeed ushers the much-needed structural reforms, linking the incentive of profit-making to the social goal of NPA revival. These efforts remained ineffective as the market problems were not first adequately addressed. The book value of assets transferred to ARC’s has been constantly declining at the same time when NPAs are drastically rising. Furthermore, the year-on-year growth, if any, is only but a meagre percent of the sharp rise in NPA’s in the banks. The transition from Management Fee Model to Asset Revival Model failed to take into consideration the market forces i.e., lack of fund, absence of secondary market for SRs etc, which bind the ARCs into a vicious cycle of failure. No matter what structural incentivisation is done, unsuitable market conditions bring down the optimum performance of ARCs.
Pieces to stop the vicious cycle
To understand why ARCs are failing, it is also important to lay stress on the unsuitable market conditions, namely-
Price mismatch and Lack of fund
Pricing mismatch refers to the mismatch between the discounting rate at which banks are willing to sell NPAs’ and the discounting rate at which ARCs are willing to buy them. Until there is a pricing equilibrium between Banks and ARC’s, the sale of NPA’s at an agreeable price becomes increasingly difficult. The business model of ARCs is heavily dependent upon collateral disposal rather than genuine business turnaround, which creates capitalistic constraints for private sector entities.
Additionally, the unavailability of funds and the huge amount of NPA market lays additional stress on the performance of ARCs. These issues are corelative as there is no prior investment or support given by the government for the functioning of ARCs. The problem of lack of fund exacerbates in the light of structural reforms which mandates ARCs to invest 15% in SRs, which would create a demand for more capital.
Loss of investor appetite and absence of secondary market
If due to price mismatch, the ARCs are forced to buy NPA’s at a higher rate, the additional cost gets borne by the investor. The return on the investment made by him remains stagnant while the risk quotient increases significantly. In light of this, an investor would opt for an investment which is offering a high return in case of high risk. This leads to depletion of investor appetite clubbed with an absence of secondary markets for the sale of SRs, creating a monopoly in the hands of banks who in turn get a stronger negotiating power as they are the only ones left who are willing to purchase these securities. Thereby banks end up buying most of the SRs. This monopoly again allows the banks to sell the NPAs at an unreasonable price. Hence, failure to arrive at a reasonable price for the sale of NPAs, directly impacts investor appetite for funding in ARCs which further reduces their capital and gives them less bargaining power in the market.
Therefore, no actual sale of NPAs is done rather the balance sheets of the banks are cleared up by a backdoor mechanism. The vicious cycle of lack of investor appetite and absence of secondary markets leads to banks monopolising the purchase of SRs, and continues in the absence of any measure taken to transform the market forces.
Conclusion and Policy Suggestions
Due to this cycle, the function of ARCs in India remains unachieved and their purpose of establishment, highly ineffective. Without first addressing the market issues at hand, any structural reform would remain futile, however well-intentioned and effective it may seem. To target the below-average performance of ARCs, government needs to create suitable market conditions for their functioning. Not dealing with these issues can result in a vicious cycle leading to destructive systematic failures. Though RBI has taken the initiative by increasing FDI in ARCs to 100% to help with the lack of funds, it has not taken any corrective measure to increase investor appetite to purchase SRs which is critical to improving the performance of ARCs.
A direct solution would be to make the SRs more liquid by transforming them into openly tradeable securities in the secondary market. Allowing listing and free transferability of SRs, can help snatch the monopoly from banks in their purchase thereby increasing investor appetite. As per RBI only qualified institutional buyers can hold and trade in SRs, widening its definition can lead to investment from high net-worth individuals increasing its capital quotient. Under SARFAESI, ARCs are only allowed to acquire debt, but to cater to effective resolution- debt and equity go hand in hand. Therefore, ARCs should be allowed to take part in the equity of a stressed company directly within the Insolvency and Bankruptcy Code (IBC) resolution framework. Lastly, a standing committee on the ARC sector should be formed with all the stakeholders to review its operations and suggest ways to improve its functional effectiveness.