India’s asset reconstruction companies, entities which buy soured loans from banks for recoveries, have had limited success and more specialised firms should be let in to speed up resolution of bad debt. That’s according to Srini Sriniwasan, managing director, Kotak Investment Advisors Ltd., which runs the Kotak Special Situation Fund - it also invests in stressed assets.
Sriniwasan’s comments come at a time when the Reserve Bank of India has initiated a review of ARCs. A panel set up in April to review the role and business model of ARCs is due to submit its report in three months.
ARCs can buy bad loans from banks by paying a minimum of 15% upfront in cash while offering the remaining 85% in security receipts to be redeemed over a period of time as recoveries from the account come in. The security receipts are included in the investment portfolio of banks and have to be marked-to-market each year. ARCs are allowed a period of five years, extending up to a maximum of eight years, to recover the dues of an account after which these securities have to be written down.
Sriniwasan, in an interview with BloombergQuint, said ARCs have been unable to achieve resolution for most accounts under their control. They have also seen limited recoveries, with little accountability to the lenders they buy the loans from, he said.
ARCs were enjoying the right to issue this monopoly paper (security receipts), which had no adverse consequences to them for non performance.Srini Sriniwasan, MD, Kotak Investment Advisors
Srini Sriniwasan, MD, Kotak Investment Advisors Ltd. (Source: KIAL)
Srini Sriniwasan, MD, Kotak Investment Advisors Ltd. (Source: KIAL)
Sriniwasan’s concerns aren't unfounded.
Data released by the RBI in a paper in its April 2021 bulletin showed the track record of ARCs in recovering dues has been modest.
- First, the recovery rate for ARCs has been consistently declining. The percentage of total amount recovered fell to 30.5% in 2019-20 from 83% in 2014-15. This recovery rate includes recoveries in a given year for assets acquired that year or in previous years.
- Second, an analysis of the vintage of security receipts pending on the books of banks showed that 42% of the outstanding receipts as on March 2020 are more than five years old and would have to be redeemed before the eight-year deadline to avoid write-offs for banks.
- Third, the industry remains highly concentrated. Of the total AUM, about Rs 1.22 lakh crore was managed by the top three ARCs. About Rs 1.49 lakh crore was held by the top five ARCs. There are close to 30 ARCs in operation, the RBI data showed.
As of March 2020, ARCs controlled Rs 1.97 lakh crore of the Rs 7.42 lakh crore worth bad loans which were either sold or put up for resolution through legal mechanisms, according to the RBI data.
While the amount recovered through ARCs as a percentage of amount involved was significantly higher in the initial years since their inception, in recent years it has dipped below 30%, except for a spurt in 2017-18.RBI Paper — ARCs In India
The Fee Game
Apart from the non-performance, Sriniwasan flagged another concern.
The security receipts issued by ARCs to banks have to be d by a rating agency each year and banks have to mark-to-market these investments. But there could be chinks in the valuation exercise, Sriniwasan said. “The ARC provides the business plan on recoverability to the rating agency, which only looks at whether these numbers are reasonable, right or not. Unlike in the case of bonds, the rating agencies don't pass any judgment on the serviceability of the paper.”
They also rely on the “independent” r report which, he suspects is generally based on questionable assumptions and results in distortion on .
Importantly, the management fee earned by an ARC each year is linked to the NAV of the securities. This, according to him, could potentially lead to the NAV being kept high for the first few years to ensure adequate fees, only to be written down later.
The ARCs fee is linked to the NAV of the security receipts, so there is a perverse incentive to keep the NAV high.Srini Sriniwasan, Managing Director, Kotak Investment Advisors
According to Sriniwasan, the ARC industry should have worked on raising more capital from investors to ensure that bad loan sales in India focus on the key metric of price discovery. Neither of these objectives, however, were met.
“ARCs failed to raise capital because of investment restrictions on equity and debt of ARC as well as riding the gravy train on fees,” Sriniwasan said.
In 2016, the government allowed foreign institutional investors to own up to 100% in ARCs, with prior approval from the RBI. However, any such investor cannot further invest in security receipts issued by the ARC they own, for purchase of bad loans. Similarly, banks which own equity in an ARC aren't allowed to enter into bilateral deals with them.
In its monthly bulletin for April, the RBI noted that ARCs continue to struggle with capital constraints. According to its data, the top three ARCs account for 62% of the industry’s total capitalisation. Domestic banks and financial institutions are the major providers of capital for ARCs and foreign capital remains limited.
ARCs Vs Stressed Asset Funds
At present, only banks, non-bank lenders and ARCs can purchase bad loans directly from other lenders. Distressed asset funds are allowed to invest in debt securities of stressed firms but cannot enter into direct deals with the banks.
Sriniwasan argued the only way to make the bad loan purchase system a viable model is by expanding the number of people who can directly buy accounts from the banks.
“Unless you free the participation of various actors to purchase the loans, the banks will not get a fair price on the loan. You can put regulations around the process where the promoters are not participating in the purchase,” said Sriniwasan, arguing that funds such as Kotak Special Situations Fund should be allowed to buy bad debt directly.
Not everyone agrees that expanding the base of investors is the answer.
"The idea that funds are better placed to resolve the assets than ARCs isn't fully accurate," said Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services. "The focus has to be toward a holistic approach for actual resolution to happen.”
The holistic approach must include sectoral experience at the entity level, experienced professionals to take over management and the right kind of legal framework. “Without such an approach, we will always come back to a flawed resolution process," Parekh said.
RK Bansal, chief executive officer of Edelweiss Asset Reconstruction Company, said a number of regulations have to be ironed out to ensure a level-playing field between ARCs and other stressed asset funds.
As ARCs we aren’t against the demand that funds could be allowed to participate in sale of bad loans. We, however, seek that there be a level-playing field for all investors and ARCs in such cash deals. Currently, if an ARC wants to do a full-cash deal to buy an asset, it must invest 15% of the amount from its own sources, raising the rest from other investors. A stressed asset fund does not have that requirement as contribution of sponsor is only 2.5% or Rs 5 crore, whichever is less.RK Bansal, MD & CEO, Edelweiss Asset Reconstruction Company
According to Securities and Exchanges Board of India guidelines, the sponsor or manager of an AIF must maintain certain continuing interest in the fund they manage. This is to ensure skin in the game for the sponsor or manager of the fund. The interest must be either 2.5% of the corpus of the fund or Rs 5 crore, whichever is lesser.
Slow Decision Making
One aspect of resolution which hurts all potential investors, be its ARCs or distressed asset funds, is slow decision making by the consortium of lenders. This is impacting the overall recovery prospects for the Indian banking system, Sriniwasan said.
Loan aggregation in India is worse than land aggregation. There is never any consensus among banks, which causes long delays and it’s a very painful process. The banking system’s indecision is what is fetching them a lower recovery rate.Srini Sriniwasan, MD, Kotak Investment Advisors
The proposed National Asset Reconstruction Company aims to solve the problem.
According to Sriniwasan, the National ARC must not become a “parking spot” for retired bankers. Otherwise, it will be fraught with the same indecision and weak resolution process which the current system is dealing with. The National ARC must have a limited lifespan and the process must ensure that if it is unable to achieve recovery in a short span of time, its management fee is stopped, he said.
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