What is an asset reconstruction company/ asset management company?

The word "asset reconstruction company"

The word asset reconstruction company is a typical Indian word - the global equivalent of which is asset
management companies. The word "asset reconstruction" in India owes its origin to Narsimham I which
envisaged the setting up of a central Asset Reconstruction Fund with money contributed by the Central
Government, which was to be used by banks to shore up their balance sheets to clean up their non-performing
loans. This idea never worked: so Narsimham II thought of asset reconstruction companies, the likes of which
had already been successful in Malaysia, Korea and several other countries in the World. To keep the tune the
same as the original idea of asset reconstruction fund, as also to give an impression that ARCs are not merely
concerned with realisation of bad loans but they are going to do "reconstruction", that is, try and resurrect bad
loans into good ones, the word ARC has been used in India.

Would the ARCs to any "reconstruction" or merely realisation?

On the face of it, it is difficult to see the ARCs doing substantially more than mere realisation of bad loans.
Even the definition of the word "asset reconstruction" in the Ordinance talks of mere relisation and not
reconstruction. As ARCs would anyway not have the capital to do any further funding of bad loans, it is
difficult to see them doing any such "reconstruction" to qualify for that term.

Why Asset management companies or ARCs?

Asset management companies have been set up in various countries internationally as an answer to the global
problem of bad loans.

Bad loans are essentially of two types: bad loans generated out of the usual banking operations or bad lending,
and bad loans which emanate out of a systematic banking crisis.

It is in the latter case that banking regulators or governments try to bail out the banking system of a systematic
accumulation of bad loans which acts as a drag on their liquidity, balance sheets and generally the health of
banking. So, the idea of AMCs or ARCs is not to bail out banks, but to bail out the banking system itself.

There are essentially two approaches to taking care of these systematic bail out efforts: one, leave the banks to
manage their own bad loans by giving them incentives, legislative powers, or special accounting or fiscal
advantages. The second approach is to do the same thing on a concerted, central level, through a centralised
agency or agencies.

The former approach is called the decentralised approach and the latter approach is called centralised approach.
AMCs arise out of the second approach - that is, a centralised agency for resolving bad loans created out of a
systematic crisis.

Each approach has its own advantages and disadvantages and there is no clear evidence of any of the two being
better over the other. Various countries have tried either of the two approaches with success stories and failures
in either case.

What are the advantages of an AMC approach?

 Centralisation of bad loans in one or a few hands and therefore obviously more clout
 It is possible to give special legislative powers to a few AMCs rather than to each bank
  Banks are left with cleaner balance sheets and do not have to deal with problem clients. Regular banking
relations with the group are not affected.
 Because it deals with a larger portfolio, it can mix up good assets with bad ones and make a sale which
is palatable to buyers.
 It is easier to do a capital-market based funding for an AMC than for the banks themselves.

Non Performing Loans (NPLs) are a natural by-product of the business of lending. Every process or activity
generates by-product(s) during the process intended for certain core product or service. Of course the efficiency
of the overall intended process is inversely proportionate to the quantum of the by-product as certain quantum
of resources is consumed and embedded in such by-product. These being undesired, is often referred as waste
and dealing with the same is perceived as unwanted challenge in the system. However, undesired by-product for
a given system may be a desired input for another system. The overall efficiency from a larger perspective is a
factor of how effectively the resources embedded in such by-product are recovered and probably transformed
for more desired use. Therefore, undesired by-product is a relative position of a particular system that has to be
transformed into more desirable products and services, by deploying specialized processes and know-how.
Banking is no different from the above and as part of its business of contracting credit risks, does generate
distressed loans or NPLs as popularly known. NPLs deprive the bank not only of the income on account of its
exposure, but calls for further investment in resources - financial, managerial, etc. The adverse impact to the
bank's profitability is further compounded on account of the provisioning requirements of the capital blocked in
the NPLs.
The proportion of NPLs in the bank books is an important indicator of financial health of the bank and any
adverse indicator shall impact the bank's rating in the system, its ability to raise capital for its business
efficiently. Result will be the bank's difficulty to price its opportunities competitively leading to compromise in
credit quality. Poor credit quality exposes the banks to vulnerability of further distress in its portfolio and
adverse effect on profitability that leads to vicious cycle.
Experience indicates that any NPL, if not resolved at an early stage loses value over time. Some of them on
account of inability to revive in a fast changing environment, like technological obsolescence, etc. and the
others due to lack of investor’s interests over time. Experience further indicates that both the above work
simultaneously leading to a faster value loss to the banks.
NPLs arise due to many factors including overall performance of the economy, cyclicality of the businesses
supported by the banks, technological obsolescence, managerial deficiencies to deal with the changing business
environment, financial indiscipline and intentional defaults, to name a few. This means resolution of each of the
account is an involved exercise, time consuming and calls for tailor-made solution for each of them. Thus the
need for unlocking the capital blocked in the NPLs can't be undermined, which is better approached effectively
by accessing specialized solutions like transferring the NPAs to distressed debt buyers, like Arcil. Arcil
provides a win-win mechanism for clean-up by offering an optimal structured solutions.

The strategic advantage of addressing the NPA resolution and recovery in a timely manner is well understood
by the banking sector. One of the important aspect being unlocking financial and human capital of the banks, it
is important to decide to deal with it by selling down to ARCs
Once decided, identifying the cases for transfer and constituting a portfolio is the second important step. Due
care must be taken to constitute the portfolio based on the requirements of the selling banks. It is also important
that once a portfolio is constituted, the same should not be modified during the process of sale having regard to
the substantial efforts put in by the prospective buyers as well as the selling banks during the process. The
portfolio is identified as of a reference date commonly known as "cut-off date", with information frozen as of
that date and offered to prospective sellers. The offers are invited as of the cut-off date and any changes in the
portfolio after the cut-off date are promptly informed to the prospective buyers and adjustments made for the
same accordingly.
It is important for either party to be aware and be sensitive to the expectations of the other. While sellers
expectation is to maximize value out of the portfolio on sale, the same is to be seen from perspective of transfer
of various risks relating to the NPLs . The value expectation by the sellers should be from the perspective of net
present value of the expected realization from the underlying NPA related risks, associated probability of
realization after considering costs of resolution, legal and other risks, relative security status with reference to
other participating lenders and most importantly factoring estimated time to realize. While the buyers should be
aware of the maximum value expectation in the hands of the seller based on the above, the sellers should also be
aware that the buyers interest would be waning unless the transaction is commercially viable taking into
consideration the risks and reward equation.
Accordingly the seller establishes documentary back up to justify its value expectation, and shares the same
with the prospective buyers in a transparent manner during the sale process. Any lack of evidence to support the
expected realization for the selling bank shall affect the value perception from the buyer’s view as the same is
predominantly dependant on the information provided by the seller during the due diligence process. Some of
the important value drivers are fair estimation of the realization cash-flow in the NPA accounts, security status
of the bank with respective to other participating lenders, share of each of the participating lenders in the
borrower accounts, legal status of any recovery action, challenges in executing the recovery strategies, crown
liabilities (including worker claims, statutory claims, etc.) decision of other participating lenders, borrower’s
initiative, if any towards resolution etc. In short like any other product sale in a NPA sale situation, it is
critically important for the sell side to provide adequate information to maximize value.
The process then involves setting up a data room by the seller with all the relevant legal and operational files to
support the value expectation for the prospective buyers to conduct their due diligence. The dealing officials of
the accounts are present during the process to address queries with respect to each of the account. The buyers
are assisted to conduct the due-diligence with all the relevant information to facilitate them decide on
appropriate valuation of the portfolio. Information provided by seller is the key for value driver. Whenever the
prospective buyer is in ARC, the selling bank needs to also decide whether to exit clean for cash or risk-
participate by staying invested in the SRs issued by the ARC. The buyers enter into the transaction, where there
are possibilities of value addition and are commercially beneficial. The same is achieved by focused
deployment of resources, legal empowerments and adopting appropriate resolution strategies. The sellers,
depending on the risk appetite may decide upfront, whether to benefit by staying invested in SRs out of the
value addition by the buyers upon resolution or to exit clean by accepting up-front payment.
Maximization of value, which is the primary objective of the selling NPLs can only be achieved by ensuring
active participation by the buyers, sharing maximum information which is the value driver and timely deal
consummation. Any lack of confidence of the buyers leading to failure of or delay in the deal closure can have a
negative impact on overall perception of the market.

FAQs
On Asset Reconstruction Companies:
Q1. What do asset reconstruction companies (ARC) do, and why were they set up?
A. ARCs aqcquire from the banking system and resolve then under legal and regulatory empowerment provided
by the Government. ARCs act as debt aggregators and isolate NPLs from the banking system, allowing banks to
focus more on their core banking business. Globally, ARCs, were formed for a system-wide clean up of the
NPLs in the aftermath of economic crises.

Q2. What is the genesis of ARCs in India?

A. The genesis of ARCs in India can be traced back to constitution of Narasimhan committee by Government of
India (GoI)as far back as 1997. The Committee highlighted the need to reduce the high level of NPLs as a
critical component of the continuing reform process. Unlike other countries where ARCs were set up after the
financial crises for bailing out the banking system, in India the GoI proactively initiated certain measures to
control NPLs and expedite the recovery process. Firstly, nthe Recovery of Debts due to Banks and Financial
Institutions Act, 1993 was enacted, providing for setting up of the Debt Recovery tribunals (DRTs) and Debt
Recovery Appellate Tribunals (DARTs) exclusively to consider the recovery proceedings filed by banks and
Financial Institutions (FIs). As a corollary, the Securatisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act. 2002 (the Securitisation Act, 2002) was enacted by the GoI.

Q3. Which are the models on which ARC are formed?

A. Different countries have tried out varying models of ownership of ARCs. However, two basic models used
are (a) bank based model, which is decentralized approach or (b) government based model, centralized
approach. In a government based model, an agency is sponsored by government which acquires and resolves the
bad assets. The NPLs are owned by the government and managed by the ARC or partially contracted out to
private managers. A bank based model has two approaches viz workout units and bad banks. In workout units,
NPL are moved to a separate bank department but remain in the bank?s books. On the other hand the bad bank
approach includes the transfer of NPLs to a separate affiliated organization which specialized in the
management of bad assets.

Q4. Brief background of the asset reconstruction companies internationally?

A. ARCs have been used world wide to overcome the non-performing loans challenges:

• In 1980s, USA used the government sponsored ARC ? Resolution Trust Corporation to overcome the
thrift crisis
• In the early 1990s, Mexico and Sweden demonstrated successful use of the ARC mechanism (Fobaproa
and Securum respectively) as ?bad bank? and to clean and re-privatize/ re-capitalize the banks
• Korea used KAMCO as the nodal agency for acquiring and disposing NPLs
• In Malaysia, Danaharta is the centralized ARC set up at the instance of the government
• In Taiwan, the ARC model envisages liquidation of assets through sale of assets to investors
• Japan, China, Thailand and Indonesia have also used the ARC mechanism during the South- East Asian
crisis

Q5. What are the criteria for formation of ARCs?

A. Every ARC needs to obtain a certificate of registration under Section 3 of the Securitisation Act, 2002 from
the RBI upon fulfillment of the conditions of the Section 3 (3) thereof. Additionally, it must have an owned
fund of not less than 15 per cent of the aggregate NPLs acquired or Rs. 100 crore, whichever is lower, subject to
a minimum of Rs. 2 crore. Having obtained the certificate of registration, an ARC can undertake both
securitisation and asset reconstruction activities. Any entity not registered with the RBI under Section 3 of the
Securitisation Act, 2002 may also conduct this business, but outside the purview of the Securitisation Act, 2002.

Q6. Who can conduct the business of securitisation and asset reconstruction?
A. A securitisation company or reconstruction company, which has obtained a certificate of registration issued
by RBI under section 3 of the Securitsation Act, 2002, can undertake both securitisation and asset
reconstruction activities.Any entity not registered with the RBI under section 3 of the act may conduct the
business of securitisation and asset reconstruction outside the purview of the Act.

Q7. The acts and laws which guide recovery process of NPA in India?
A. The two important act guiding recovery process of NPA in India is:
i) Recoveries of debt due to banks and financial institutions (RDDBFI) Act, 1993
ii) Securitisation and reconstruction of financial assets and enforcement of security interest act 2002
(Securitisation Act, 2002)

Q8. Which is the regulatory framework for operation of ARCs in India?

A. ARCs in India operate under the regulatory framework covering the Securitisation Act, 2002 and rules
thereunder, applicable corporate laws and guidelines issued by the RBI, i.e. the Securitisation Companies and
Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003 which came into force from April
23, 2003 (the RBI Guidelines) and the Guidelines on declaration of Net Asset Value of Security Receipts issued
by Securitisation Companies / Reconstruction Companies, which were issued on May 28, 2007 (the NAV
Guidelines). ARCs are also ?Financial Institutions? under the Recoveries of Debt Due to Banks and Financial
Institutions Act, 1993 and can file and pursue recovery suits in the DRT / DRAT.

Q9. What is the Securitisation Act, 2002 and how has it empowered secured lenders?
A. The Securitsation Act, 2002 was enacted to regulate securitisation and reconstruction of financial assets,
enforcement of security interest and matters related thereto. The Securitisation Act, 2002, inter-alia, provides
majority (75 per cent or more by value) secured creditors the powers to take possession of defaulting
borrowers? secured assets and sell them without intervention of the judicial system, thus reducing or removing
the NPLs through measures for recovery and reconstruction. The Securitisation Act, 2002 has expedited the
recovery process as the banks and FIs can exercise their unfettered right of recovery, resulting in speedy and
hassle-free realisation from underlying assets. Further, steps initiated by secured creditors for such sale of
secured assets also results in abatement of references pending before the Board for Industrial and Financial
Reconstruction (BIFR).

Q10. How are ARCs more effective in recovery under Securitisation Act, 2002?
A. ARCs are empowered by the SARFEASI act to conduct the business of acquisition and resolution of NPAs.
Their core business being NPL management they possess domain expertise which enables them to be more
effective in recovery.

Q11. Why should banks / fIs sell NPLs to ARCs?

A. Banks / FIs should sell their NPLs to ARCs primarily for the following reasons:

• Sale to ARCs enables the NPLs to be taken off their books, reduces recovery expenditure and releases
capital andresources for core banking operations
• Sale to ARCs brings about faster debt aggregation and resolution of inter-creditor issues, single point
responsibility andensures speedy implementation of resolution strategy. To enable ARCs to achieve this,
banks need to sell their NPLs inrespect of a borrower company in a coordinated fashion
• Sale of NPLs on a portfolio basis enables loss on sale of any one account to be set off against gains on
another, subject to RBI guidelines on provisioning / valuation norms
• Sale of distressed assets to ARCs as a long term business strategy will result in considerable risk
mitigation and consequent value enhancement for the stakeholders
• Since NPLs accumulate simultaneously with growth assets in the books of lenders, by selling such NPLs
to ARCs, banks can send a strong signal to the system that they are dealing with NPLs in the best
possible manner
• ARCs are better positioned to capture value by converting excess debt in the borrower companies into
equity and capturing the upside therefrom. Resolution / recovery being their core activity, ARCs are
expected to be better equipped for the value management of NPLs

Q12. Do lenders need to have a policy for transfer of NPLs to ARCs? What are the key components of such a
policy?
A. The RBI guidelines to banks/ FIs on sale of NPLs to ARCs provide that banks/ FIs should ensure that the
sale is conducted in a prudent manner in accordance with a policy approved by their Board of Directors
covering, inter alia,

• Financial assets to be sold;

• Norms and procedure for sale of such financial assets;
• Valuation procedure to be followed to ensure that the realizable value of financial assets is reasonably
estimated; and
• Delegation of powers of various functionaries for taking decision on the sale of the financial assets etc.

Q13. Can the borrower have any say in the transfer of NPLs to ARCs?
A. Under the Securtisation Act, 2002 an ARC can acquire the NPLs from any bank or FI in India. The
borrower, pertaining to whom the NPLs is acquired by an ARC cannot oppose this move of the banks / FIs.
However, the banks / FIs, if considered appropriate, may give a notice of sale / transfer of NPLs to the
concerned borrower.

Q14. 14. If an ARC acquires 75 per cent of the secured debt of a borrower, what are the options available to the
lenders who have not transferred their debt to the ARCs?
A. The Guidelines issued by the RBI on sale of NPLs by banks / FIs to ARCs provide that in the case of
consortium / multiple banking arrangements, if the banks / FIs holding 75 per cent or more of the debt (by
value) of any borrower have accepted the offer of the ARC, the remaining banks / FIs are obligated to accept
the offer by the ARC.

Q15. 15. Will ARC acquire debt with second charge on fixed assets/first charge on working capital or vice
versa? Will debenture holders also be able to transfer their holdings to ARC?
A. ARCs are empowered to acquire all secured debt (whether carrying first charge and / or second charge on
fixed assets and / or current assets). If banks / FIs hold secured debt in the form of debentures then they will be
able to transfer their holdings to ARCs.

Q16.In case additional funding is required to reconstruct an financial asset, will the existing lenders need to
contribute?
A. ARCs shall arrange for additional funding on a case-to-case basis depending on the nature of fund
requirement. There is no compulsion on the part of the existing lenders to provide additional funding.

Q17. How does the asset resolution strategy of ARC differ from that under the Corporate debt restructuring
mechanism?
A. The essential objective of both CDR and ARCs is the same, which is unlocking value from non-performing /
distressed assets. Hence, they can be seen as complementary resolution efforts in addressing the same problem.
The ARCs route has the advantage of taking the asset off the banks? books and creating a secondary market for
it, thereby enhancing the value potential. ARCs are focused towards resolution rather than the reschedulement
of debt. Debt aggregation by ARC will enable single point responsibility and ensure speedy implementation of
resolution strategy based on sustainable level of debt within a reasonable timeframe.

Q18. How is the purchase consideration in a deal for acquisition of NPLs generally structured?
A. The purchase consideration for acquisition of NPLs may involve the selling lenders? subscription to SRs
where the seller is interested in staying invested or entirely cash consideration where the seller desires a clean
exit. It can be even a combination of the two. The transaction structure for any acquisition deal is finalised after
negotiation with the lenders. The banks / FIs desirous of selling their NPLs to ARCs should ensure that the sale
is conducted in a prudent manner in accordance with a policy approved by their Board of Directors.

Q19. What are security receipts or SRs?

A. ARCs generally acquire NPLs under a trust structure, wherein funds for financing the acquisition of NPLs
are raised by issue of Security Receipts (SRs). SRs are instruments in the nature of pass through certificates,
evidencing an undivided right, title or interest of the holder in the underlying assets. Only Qualified Institutional
Buyers (QIBs) as defined under the SECURITSATION ACT, 2002 Act are authorised to hold or trade in SRs.
QIBs include domestic investors such as banks and FIs, Insurance Companies, Trustee or ARC registered with
RBI under the SECURITSATION ACT, 2002 Act, non-deposit taking Non-Banking Financial Companies
satisfying certain criteria as also Foreign Institutional Investors registered with the Securities and Exchange
Board of India (SEBI). The trustee periodically declares the Net Assets Value (NAV) of the SRs in terms of the
NAV Guidelines issued by the RBI. As regards banks / FIs, the SRs are classified as non-SLR investments and
are valued on the basis of the NAV declared.
  NON-PERFORMING ASSETS
 What is NPA ……
 Non performing advances or non-performing
 Assets (or non-performing loans) are loans
 that are not being repaid or serviced through Interest payments on time.
 def : when interest or other dues to a bank remain unpaid for more than 90 days the entire bank loan
automatically turns a “ Non-Performing Asset ”
 Indian Economy and NPA’s
 The Indian Economy has been much affected due to lack of infrastructure facilities, sticky legal
system, cutting of exposures to emerging markets by FII’s,etc.
 Under such a situation it goes without saying that banks are no exception and are bound to face the
heat of a global downturn.
 Banks and FII’s in India hold NPA’s worth around Rs 1,10,000 crores.
 Global Developments and NPA’s
 The core banking business is of mobilizing the deposits and utilizing it for lending to industry.
 Lending business is encouraged which helps in productive purposes which results in economic
growth.
 However lending also carries credit risk, which arises from the borrower’s inability to repay it .
 How much risk can a bank afford to take?
 Recent happenings in the business world-Enron, Worldcom, Xerox, global crossing do not give much
confidence to banks.
 The history of FII’s also reveals the fact that the biggest banking failures were due to credit risk.
 Due to this, banks are restricting their lending operations to secured avenues only with adequate
collateral on which to fall back upon in a situation of default.
 Why NPA’s have become an issue for banks and FII’s in India?
 The origin of the problem of burgeoning NPA’s lies in the quality of managing credit risk by the
banks concerned.
 What is needed is having adequate preventive measures in place namely, fixing pre-sanctioned
appraisal responsibility & having an effective post-disbursement supervision.
 Banks concerned should continuously monitor loans to identify accounts that have potential to
become non-performing.
 Resolution of NPA’s
 At present, local banks are saddled with the management of NPA’s for which they do not have
management time for proper resolution.
 As a result, they are reluctant to make new loan to industrial or commercial enterprises as NPA’s have
strained their resources.
 The unavailability of new loans has therefore hindered economic growth and development.
 Contd……
 ADB intends to assist local banks resolve their problems with NPA’s by facilitating the financing of
SPV’s and other mechanisms designed to acquire and service such assets.
 This will enable the local banking system to focus on its core operations and provide financing to
productive sectors of economy.
 In addition ADB will assist distressed companies in their restructuring & rehabilitation efforts.
 Indian Banking systems – some hard facts
 Gross NPA’s of the financial system is placed at Rs 1,35,000 crore, of which, over Rs 98,000 crore
pertains to Scheduled Commercial Banks (SCB’s) and FII’s.
 Gross NPA’s showed increasing trend over the yrs and accretion to gross NPA’s by SCB’s during last
two fiscals were Rs 24,824 crore(2001-02) & Rs 21,862 crore(2002-03).
 Contd…….
 This accretion is not considering the cases restructured through CDR mechanism during 2002-03 and
thereafter (Rs 46,000 crore).
 On account of low “Loan to GDP Ratio” (around 60%) in India, the enormity of NPA’s in India in
GDP term appears to be low in comparison with china, korea, etc.
 43% of the capital base of the financial system stands eroded on account of net NPA’s.
 RBI Guidelines on classification of bank advances
 According to RBI guidelines, bank advances are mainly classified into:
 Standard assets: such an asset is not a Non-Performing Asset.
 Sub-standard assets : it is classified as NPA for a period not exceeding 18 months.
 Doubtful assets: Asset that has remained sub standard for a period of 12 months (w.e.f. March 31,
2005).
 Loss Assets: here loss is identified by the banks concerned or by internal auditors or by RBI
inspectors.
 Financial statements in assessing the risk of default for lenders
 For banks and Financial Institutions, both the balance sheet and income statement have a key role to
play by providing valuable information on a borrowers ability
 The key accounting ratios generally used for the purpose of ascertaining the creditworthiness of a
business entity are that of debt-equity ratio & interest coverage ratio.
 Measures to reduce NPA’s
 Provision of bad debts from net profit.
 Implementation of Securitisation Act 2002.
 Increasing the share of Retail business i.e., personal loans, vehicle loans, home loans, credit cards, etc.
 Increasing the deposits.
 Increase lending share to priority sector.
 High cost of funds due to NPA
 Quite often genuine borrowers face difficulties in raising funds from banks due to mounting NPA’s.
 With the enactment of the Securitiastion and Reconstruction of Financial Assets and enforcement of
Security Interest Act, 2002, banks can issue notices to pay up the dues
 And the borrowers will have to clear the dues within 60 days.
 If the defaulters don’t pay the dues, then the banks can takeover the possession of assets & also
takeover the management of the company.
 Credit Risk And NPA
 NPAs are a result of past action whose effects are realized in the present
 Credit risk is a much more forward-looking approach and is mainly concerned with managing the
quality of credit portfolio before default takes place
 Credit Rating
 Credit rating has been explained as forming an opinion of the future ability, legal obligation and
willingness of a bond issuer or obligor to make full and timely payments on principal and interest due to the
investors
 Definition by Moody
 Tangled By Huge NPAs……..WHY
 Indian banks so far were encircled by the chains of regulation and aegis of protection
 No formal policies, procedures, systems, tools and techniques of credit risk assessment
 At The Mercy Of Balance Sheet
 Operating margin
 Current ratio
 cash flow
 Fund flow
 Perception and reality may differ 180*
 Accounting policies has loopholes
 Chartered Accountants make their balance sheet look as they want it to look like
 Past performance is no indicator of the future performance ideally
 Darling Of Bourses Takes A Hit
 Hasty commitments to expand rapidly by rediff have brought it to red
 Its share price is ruling well below its issue price
 So relying completely on the past ratios meant no monitoring of the management decisions and no
control over their decisions
 Collateral-A Defensive Approach
 Collateral was another way to judge the credit quality
 A client is good if she had attractive assets to put as collateral and bad otherwise.
 Poor decision making-accepted clients of poor quality and rejected the clients of good quality
 Collateral is hardly a security
 Credit Risk Techniques
 Quantitative
 Ratio analysis
 Fund flows
 Mathematical models
 Qualitative
 Policies
 Procedures
 Concentration
 Playing with Precision
 Altman's Z Score predicts whether or not a company is likely to enter into bankruptcy within
one or two years
 the algorithm has been consistently reported to have a 95 % accuracy of prediction of bankruptcy
 Consideration-current assets, total assets, net sales, interest, total liability, current liabilities, market
value of equity, earnings before taxes and retained earnings
 Play or Leave
 3.0 or more : Most likely safe
 2.8 to 3.0 : Just safe
 1.8 to 2.7 : likely to bankrupt in two years
 Below 1.8 : Recovery least expected
 Getting The Combination Right
 Credit metrics works on the statistical concepts like probability, means, and standard deviation,
correlation, and concentrations
 Credit Metrics-Application
 Reduce the portfolio risk : reevaluate obligors having the largest absolute size arguing that a single
default among these would have the greatest impact
 reevaluate obligors having the highest percentage level of risk arguing that these are the most likely to
contribute to portfolio losses
 Balancing Act
 Identifying the correlations across the portfolio so that the potential concentration may be reduced and
the portfolio is adequately diversified across the uncorrelated constituents
 Concentration may lead to an undue accumulation of risk at one point.
 ARCIL
 system-wide clean up of NPAs result in creation of Asset Reconstruction Company
 Governments may also provide special powers to ARCs that are not otherwise available to banking
system
 ARCIL Objectives
 Convert NPA into performing assets
 Act as nodal agency for NPA resolution
 Create a vibrant market for NPA estructured debt
 Re-energize the financial sector.
 Transaction Structure
 Transaction Structure- Stage-2
 ARCIL- International Examples
 In 1980s, U.S. used government sponsored ARC - Resolution Trust Corporation (RTC) to overcome
thrift crisis. RTC acted as a “bad bank” and functioned as an effective sales mechanism for disposal of assets
 In early 1990s Mexico and Sweden demonstrated successful use of ARC mechanism (Fobaproa and
Securum respectively) as a “bad bank” and to clean and reprivatise/ recapitalise the banks
 Korea used KAMCO as the nodal agency for acquiring and disposing NPAs. KAMCO has used
securitisation and joint venture route for investor participation in the assets
 Indian Financial System -2003-04
 Quantitative Factors
 Carrying Cost of NPAs 6.50%
 Management Cost 0.75%
 Total Cost 7.25%
 Net NPAs of banks/FIs is Rs. 470 billions
 Total holding Cost comes to Rs. 35 billions p.a. for banks/FIs.
 Which is around 20% of the reported Net profit (i.e., including non-core income)
 Qualitative Factors
 Banks fail to get “Interest spread” on the net realizable value of NPAs so long they carry them in their
books.
 Reduction of Risk Adjusted Capital Adequacy Ratio (RACAR). RBI deducts net NPA from capital
and risk weighted assets to compute RACAR.
 Carrying NPAs in books affects Rating and Capital mobilization.
 MANAGING NPA
 There are two issues, which, if tackled properly, would efficiently solve the problem of NPAs viz.
o ‘STOCK’ ( accumulation of NPAs) problem and
o ‘FLOW’ ( accretion ) problem.
 Several measures like Lok Adalat, DRTs( Debt Recovery Tribunals),Strengthening of credit appraisal
and monitoring system have been initiated by the regulators to tackle the ‘flow’ problem.
 Towards resolution of the ‘stock’ problem of NPAs GOI took proactive steps and enacted the
Securitasation & Reconstruction Act 2002 in December 2002.
 MANAGING NPA- Models
 Globally there have been two models:
o A central disposition agency which takes
 bad loans from all financial institutions or
o An entity specific to a particular bank or a group of banks e.g. Arcil.
 MANAGING NPA- Resolution Strategy
 There are primarily two strategies
 Loan Management Strategy
• Restructuring of loan on sustainable debt considerations
• Maximise overall recovery value
• Fair treatment to all stakeholders
• One Time Settlement
 MANAGING NPA- Resolution Strategy
 Asset Management Strategy
• Disposition by strip sale
• Change in management
• Takeover of assets
• Legal route / Foreclosure
 MANAGING NPA-Indian Approach
 The Indian system envisages multiple ARCs(Asset Reconstruction Company) as non government
entities with equity support of promoters.
 The ARCs in India are not supported by through Govt. funding and are not structured like a Central
disposition agency.
 MANAGING NPA-Through ARCs
 ARCs are governed by the provisions of
 Securitisation Act 2002 and operates within the perview of RBI guidelines.
 The salient features of the Securitisation Act in respect of ARCs are as follows:
• Unfettered right to the lenders acting in majority (> 75% by value) to enforce
security rights without judicial intervention
 Salient Features ….
• Establishment & empowerment of ARCs
 No single investor / sponsor to have majority control over ARCs
• Paves way for debt aggregation in ARCs by enabling acquisition of assets
• Accords ARCs the rights of the lenders
• Additional rights to ARCs – not available with lenders
 Sale or lease of businesses by superceding board powers
 -Enables foreign investor participation
 MANAGING NPA
 MEASURES FOR RECONSTRUCTION ( SECTION 9)
• Change in or takeover of management of business of the borrower
• Sale or lease of part or whole business of the borrower
 (Above two powers not available as of now, because RBI guidelines have not been issued for the
same)
 MANAGING NPA
• Rescheduling of payment of debt
• Enforcement of security interest in accordance with the Act
• Settlement of dues payable by the borrower
• Taking possession of secured assets in accordance with the Act
 Key Isuues before ARCs
 Valuation of NPA
 Debt Aggregation
 Legal & Regulatory
 Suggestions and Conclusion
 Siphoning off money or diversion of loans from banks should be erased from criminal offence.
 Government funding/guarantee in some form should be available for transfer of assets to ARCs.
 Banks should restrain itself from lending to just about anything that is in fashion.