Impact of Global Financial Crisis: Role of Asset Reconstruction

Contents

Impact of global financial crisis: Role of asset reconstruction Sub-Prime reasons cause a prime crisis All eyes on the governments All thoughts on asset reconstruction Prime issues for considerations NPA valuation Standardised sale process approved by the regulator Flexibility in controlling structure of an ARC Reduction and standardization of registration fee and stamp duty Simplification of consent required for enforcement of security Relaxation of the requirement to take consent of the borrower Life of trust set up by ARC for asset resolution Abbreviations used

Impact of global financial crisis: Role of asset reconstruction

Sub-Prime reasons cause a prime crisis The sub-prime crisis and its consequent effects on the global economy saw some of the established financial institutions getting consumed in the turmoil that ensured; many others have been pushed to the brink. The crisis itself is a manifestation of aggressive lending with inadequate appraisals, lax regulatory supervision and questionable credit ratings of complex instruments. Nationalisation of institutions a thought inconceivable a couple years back is turning out to be an attractive option for institutions grappling for survival. The crisis originating in the US has now spread across the integrated financial world engulfing countries and sectors that have little to do with the root causes. The economic indicators are gloomy as the recessionary phase sets in and market indices have reduced investors wealth across the globe by a whopping US$ 50 trillion.

GDP growth trend 14% 12% 10% 8% 6% 4% 2% 0% -2% 2005 2006 2007 2008 USA UK Japan Germany China Australia India Source: EIU Reports

Movement of stock indices 500 450 400 350 300 250 200 150 100 50 2005 2006 2007 2008 USA - S&P 500 Japan - Nikkie China - Shangai A India - BSE 30 UK - FTSE 100 Germany - DAX 30 Australia Base year 2005 =100 Source: EIU Reports

All eyes on the governments The sheer magnitude and enormity of the crisis have left no option for Governments, but to intervene. It is realised that simultaneous increase in spending by the Governments is the best bet to beat the crisis. Concerted and supplementing efforts by various Governments could be expected in the next fiscal. Governments across the globe have announced economic stimulus packages and have earmarked funds to bail out financial institutions.

Stimulus packages by select countries

Country US Japan* China India UK# Germany Australia

*Slated to increase by US$ 320 bn. #Rescue plan for UK banking system of US$ 692 bn Source: EIU Reports

Stimulus package (US$ bn) 787 38 586 14 180 693 35

Various governments while extending the helping hand to overcome the immediate challenges, are likely to review policies and state new measures to ensure long term stability of their respective financial markets: thus 2009 could very well turnout to be a year which would be all about policy. China and India have been the fastest growing economies and are relatively better positioned to tide over the crisis. In India, the crisis induced problems have relatively been contained due to factors like: A well capitalised and prudently regulated Indian banking system Domestic demand which constitute 60% of GDP and is likely to be only moderately affected by the ongoing crisis

Lack of exposure to equity and asset markets for a significant proportion of the Indian population Liquidity crunch unlikely to affect agriculture and mandatory priority sector lending At the same time bringing the Indian GDP growth back to the 9% trajectory, from the below 7% levels projected for the next fiscal, is going to be a daunting task. Going forward, asset reconstruction would be the focus area for all - to salvage, preserve and rejuvenate assets of economic value.

All thoughts on asset reconstruction Asset reconstruction is likely to play an increasingly important role as (a) the number of impaired assets in the financial system increase and (b) learnings from the ongoing crisis lead to evolution of speedy systems and procedures for asset reconstruction. In India, ARCs came into being in response to the growing NPL levels in the financial system and the need to have mechanisms to resolve them in a timely manner. At the same time, there was no imminent financial crisis to justify direct Government intervention. As a result, and rightly so, GoI has encouraged the asset reconstruction space to develop in a competitive manner.

Simultaneously, the legal system has been revamped to enable the institutions and ARCs implement quick resolutions of impaired assets. The legal framework, has over a period of time, has become more conducive for resolution of impaired assets with the introduction of Lok Adalats, Debt Recovery Tribunals and SARFAESI. The actions and recoveries across these resolution channels are as under:

Recoveries through various channels

(Amount in Rs. bn)

Resolution/recovery channel Lok Adalat

Particulars No. of cases referred Amount involved (a) Amount recovered (b) (b) as a % of (a)

FY 2006 268,090 21.44 2.65 12.36% 3,534 62.73 47.35 75.48% 41,180# 85.17 33.63 39.49%

FY 2007 160,368 7.58 1.06 13.98% 4,028 91.56 34.63 37.82% 60,178# 90.58 37.49 41.39%

FY 2008 186,535 21.42 1.76 8.22% 3,728 58.19 30.20 51.90% 83,942# 72.63 44.29 60.98%

DRTs

No. of cases referred Amount involved (a) Amount recovered (b) (b) as a % of (a)

SARFAESI Act

No. of cases referred Amount involved (a) Amount recovered (b) (b) as a % of (a)

#: Number of notices issued under section 13(2) of the SARFAESI Act. Source: RBI

The creditor friendly provisions of SARFAESI has seen intense activity in the Indian reconstruction space that resulted in the formation of as many as 11 ARCs in quick succession. SARFAESI has been conceived to provide the required teeth to secured creditors to pursue rapid resolutions. Certain gaps like procedure for change of management in a distressed company by an ARC should be specified at the earliest so that the objective of the Act can be operationalised. Certain other suggestions with respect to the Act are highlighted in the sections below.

With the deepening of the asset reconstruction space, the number of NPL transactions is on the rise. Deloitte, as an advisor, has been associated in many of these transactions that have resulted in resolution of NPLs aggregating approximately to Rs.35 bn. Deloitte has been associated with institutions like Industrial Investment Bank of India Ltd., Union Bank of India and Bank of Baroda on sell side mandates and Bank of America and Barclays Bank on buy side mandates. The table below provides a snapshot of the resolution activity done by ARCs in recent times.

Snapshot of resolution activities by ARCs

(Amount in Rs. bn)

Sr. No. 1. 2. 3. a. b. c. 4.
Source: RBI

Particulars Book value of assets acquired Security receipts issued Security receipts subscribed by Banks SCs / RCs Others (QIBs) Amount of security receipts completely redeemed

As on 30th June, 2007 285.44 74.36

As on 30th June, 2008 414.14 106.58

68.94 4.08 1.34 6.60

83.19 16.47 6.92 12.99

The efforts by the government to develop the asset reconstruction space and make the legal framework more effective, prudent regulation by RBI, concerted efforts by banks to reduce NPA levels and the role played by ARCs have collectively resulted in marked improvement in the NPA levels in the banking system.

NPA movement as a % of advances of SCBs 8% 7% 6% 5% 4% 3% 2% 1% 0% FY 04 FY 05 FY 06 FY 07 FY 08

Gross NPA to gross advances (SCB - %) Net NPA to net advances (SCB - %) Source: RBI

Although the situation until the end of FY 08 has been encouraging in the Indian context, signs of economic distress have become visible from the second quarter onwards of FY 09. GoI has initiated measures to contain the impact by announcing a stimus package of US$ 14 bn. Going forward, the focus should be retained or else the encouraging numbers of FY 08 can get changed in a flash. Some of the reasons which compel us to be cautious are enlisted below: Fall in total foreign investments Foreign investments in the country has seen a growing trend during the period FY 04 to FY 08. During FY 08, India received total foreign investment of US$ 45 bn. This encouraging trend has been reversed as the available data for FY 09 indicates. During the period

April November, 2008 total foreign investment was a mere US$ 12 bn. The ongoing liquidity crunch in the global markets is unlikely to hold promise for the remaining months of the current fiscal. While RBI has announced series of reductions in the repo rate, concerns on liquidity remain. As foreign inflows dry up and government borrowings increase to finance increased spendings in the backdrop of reduction in its own revenues, pressure on interest rates to harden could build. If interest rates were to spike, financial viability of many projects would become uncertain resulting in the possibility of an increase in impaired assets.

 Rapid growth in the advances by SCBs The advances by SCBs have far exceeded the growth in GDP. During the period FY 04 to 08, while the GDP grew at a CAGR of 11%, advances by SCBs grew at a CAGR of 23%. During FY 08, the advances by SCBs as a percentage of GDP reached an all time high of 58%.

Formation of NPA is a natural phenomena to lending: higher the quantum of lending, greater the probability of NPA formation. It will be reasonable to expect that level of NPA could increase from current levels not only because of the ongoing economic crisis but also because of the sheer increase in advances by SCBs.

Advance to GDP 50 45 40 35 30 25 20 15 10

Rs. in tn 70%

60%

50%

40%

30%

20%

10% 5 0 FY 04 FY 05 FY 06 FY 07 FY 08 0%

GDP at current price (base 1999-2000) Gross advances to GDP (%)

Source: RBI

 Corporate results are worrisome In the first three quarters of FY 09, the companies in BSE 500 (excluding banks) recorded lower profits as compared to the corresponding periods in FY 08.

PAT of BSE 500 (excluding banks) 800 700 600 500 400 300 200 100 Q1 FY 08 FY 09 Source: Capitaline Q2

Rs. in bn

Q3

Lending to corporates is the most remunerative earning channel for the lending institutions. As companies experience profit reductions, it is likely that some would record losses and a few would become unviable. This would lead to generation of fresh NPL accounts in the Indian banking system. In this regard, it may be noted that the relaxation in guidelines for NPA recognition may not lead to immediate rise in NPA levels but during the course of next fiscal or so, increased NPA levels are likely to be observed. On the balance, while India is not affected as much as its western counterparts, there are reasons, as enlisted above, which are worrisome. The efforts initiated by GoI, RBI, the lending institutions and ARCs needs to be further bolstered to ward off the stress that the economy may experience. Having an efficient asset

reconstruction mechanism would be the key to enable the Indian economy to sharply and swiftly recover as the global situation improve. It is supremely important for the above reasons that the transactions in the asset reconstruction space get consummated in a timely manner to preserve the economic value of assets and to ensure faster turnaround of capital. Deloitte, in its role as an advisor for many successful transactions in this space, has made certain observations which, if addressed, could result in quicker resolution, optimal price discovery and higher number of successful transaction closures all of which would result in maximisation of economic benefit. These thoughts have been outlined in the next section.

Prime issues for considerations NPA valuation With an increase in the number of transactions in the Indian asset reconstruction space, instances of transactions that have fallen through at the last stages due to irreconcilable valuation differences between the seller and the buyer are on the rise. Valuation of NPA has emerged as the most prevalent deal breaker. While business valuation would always remain an area where diversity of viewpoints of sellers and buyers is certain, in case of NPA transactions, the number of parameters where the seller and the buyer could potentially differ is far more as the underlying asset is non-performing to start with. Some of the key issues that need to be addressed in this regard are discussed below: Estimating the recovery period Valuation of NPA involves estimation of recovery periods to arrive at present value. As NPA resolution often involves resorting to legal options, estimation of recovery period becomes tricky as legal proceedings could become lengthy. Resolution options like SARFAESI, OTS, CDRs etc. have better process visibility; resolution through these means, wherever possible, is likely to result in better valuations by potential buyers. Otherwise, concerns on estimating resolution period would come in the way of attractive valuations by potential buyers. Setting pre-specified timelines for legal proceedings would facilitate convergence of views of buyers and sellers as far as estimation of recovery period is concerned.

Early sale of NPAs for better valuations A contentious issue for the sellers is that buyers rarely offer bids that value the account on a going concern basis even though grounds for such valuation exist. In almost all transactions, buyers offer bids based on asset valuation. There is hardly any valuation in the Indian context where valuation is carried out on a going concern basis. The main reason is that the NPL accounts that are typically offered for sale have a long history of being non-operational which obviates the possibility of valuation assuming business continuity. As sellers originate transactions, it is important to expedite the process that the sellers undertake from the point of recognition of a NPA to its eventual transfer to an ARC. Unless there are real opportunities to rapidly restructure an account while ensuring its continuity, bridging the valuation gap would remain a challenge for successful transaction closure especially for accounts that have a turnaround potential. The sellers need to make the first move by offering such accounts for transfer in a timely manner before significant value erosion of the account happens.

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 Account information and data collation One of the key reasons that inhibit proper valuation by potential buyers is the lack of adequate information that is made available for the account offered for sale. NPL transactions hinge critically on the quality of the underlying data. Better the underlying data, steeper is the valuation. Seller banks should engage in active monitoring and follow up of the NPL accounts so that updated information is shared during the sale process. In consortium funded accounts, there is always the problem of accurately determining the share of the seller in a particular loan account offered for sale as the outstandings for other lenders are often unavailable, as are legal updates. In the absence of such critical information, buyers heavily discount their bids. There is a need to improve inter-lender communication and coordination that would result in better exchange of information. It has also been observed that at times even the available information could not be shared with bidders. The key reason for this has been fragmented data sources that need to be referred to when sellers launch processes which require buyers to visit branches where the account is based rather than making all the relevant information available at one central data room which is manned by professionals who understand the accounts offered for sale and also the sale process. A fragmented data room process also requires buyers to incur significant upfront costs and often many buyers choose not to participate. Centralised data room with adequate senior level supervision is not an option but a necessity for successful transaction closure.

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Standardised sale process approved by the regulator Bid representing the highest value, received as a result of a competitive bid process is often subjected to a fresh evaluation by the seller. While the seller bank should have a right to negotiate with the highest bidder to explore the possibility of enhancement of the highest bid, the disposition of the seller should be to close the transaction when the fair market price has been discovered. It is necessary that all stakeholders address these problems so that processes that are conducted in good faith and in a transparent manner are not shelved. As it would not be possible for the regulator to prescribe valuation methodologies that the seller banks could follow as the conditions associated with each asset varies thereby making any standardisation attempt ineffective, the next best option would be to have sale processes prescribed by the regulator for sale involving a single asset or a portfolio. Transparent and competitive bid processes are already being conducted. A formal approval by the regulator and a buy in of the stakeholders would go a long way in instilling confidence to sellers to close such transactions. Flexibility in controlling structure of an ARC Depending on the background under which ARCs are formed in a country, we have now the following structures that are prevalent globally: ARCs that are owned / sponsored by the government ARCs that are owned by the banks ARCs that are in the private sector domain

In India, ARCs came into being in response to the growing NPL levels in the financial system and the imperative need to have mechanisms to resolve them in a timely manner. At the same time, there was no imminent financial crisis that was emerging to galvanise direct government intervention. As a result, and rightly so, GoI has encouraged the asset reconstruction space to develop in a competitive manner. The ARCs in India consequently either have a private sector ownership or have bank based ownership. Nevertheless, there are restrictions on controlling stake by a single party in an ARC which in the background of allowing competitive forces to develop the asset reconstruction space appears to be restrictive. A relaxation of this norm would encourage more private sector entities, including foreign players, to have a presence in this space bringing more depth to this sector. There are firms who specialise in resolution of stressed assets in specific industries and have an edge over generic reconstruction companies as they bring in superior industry specific knowledge and expertise. Presence of such firms would expedite the resolution process and is also likely to enhance realisation which would eventually maximise benefit for the overall economy. It should be possible to introduce guidelines to check potential for misuse which a flexible ownership structure could be prone to. Reduction and standardisation of registration fee and stamp duty The registration fee and stamp duty payable at the time of assignment to the buyer varies from state to state. GoI should initiate the process of rationalisation of the registration fee and the stamp duty to simplify the post sale processes and reduce the overall transaction cost across all states.

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Simplification of consent required for enforcement of security SARFAESI specifies that secured lenders, in case of joint financing, can enforce securities only if they have the consent of 75% of lenders in value. It can be safely concluded that in most of the complex and sticky NPL accounts, the number of secured creditors are too many which acts as a major deterrent in aggregation efforts. The Act does not modify the charge to any lender group in any manner but the consent of junior charge holder becomes necessary nonetheless. This provision needs to be modified to enable speedy recovery when the assets underlying a NPL account is still in good condition and worthy of productive economic use. Consequently, it would be appropriate to have consent of only the senior and pari- passu charge holders for security enforcement and only the loan amounts pertaining to such senior and pari-passu charge holders should be considered for evaluating the applicability of 75% of value requirement. The junior charge holders do not stand to lose in the process, as they would get compensated to the extent possible after the claim of the senior charge holders have been settled.

Relaxation of the requirement to take consent of the borrower Rule 9(2) of The Security Interest (Enforcement) Rules, 2002 specifies that if for sale of an immovable property, no bids are received at price above the reserve price, consent of the borrower and the secured creditors would be required to conclude the sale at a price lower than the reserve price. The requirement to take the consent of the borrower often results in avoidable delays and further erosion of the underlying asset value. It would, therefore, be helpful if the said rule is relaxed. Life of trust set up by ARC for asset resolution The life of the trust set up for asset reconstruction has been specified to be a maximum of five years in accordance with the Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003. There should be flexibility for extending the life of the trust if resolution is ongoing or appears to be likely in the foreseeable future.

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In this report, we have highlighted some of the important issues which can encourage faster transaction closure in the asset reconstruction space which is going to become increasingly important for the long term stability of the financial sector. For further information and thoughts, please feel free to contact one of the specialist listed below.

Avinash Gupta National Leader, Financial Advisory Services Tel: +91 22 6622 0515 Email: avinashgupta@deloitte.com

Deepak Netto Head, Reorganisation Services Tel: +91 22 6622 0506 Email: dnetto@deloitte.com

Rahul Choudhry Director Tel: +91 22 6622 0517 Email: rachoudhry@deloitte.com

Rajgopal Pai Manager Tel: +91 22 6622 0563 Email: rpai@deloitte.com

Deloitte Touche Tohmatsu India Private Limited Maker Towers E, 4th Floor, Cuffe Parade Mumbai 400 005, India Tel: +91 22 6622 0500 Fax: +91 22 6622 0501

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Abbreviations used ARC: Asset Reconstruction Company CAGR: Compounded Annual Growth Rate CDR: Corporate Debt Restructuring DRT: Debt Recovery Tribunal FDI: Foreign Direct Investment FY: Financial Year GDP: Gross Domestic Product GoI: Government of India NPA: Non Performing Asset 15 NPL: Non Performing Loans OTS: One Time Settlement RBI: Reserve Bank of India SARFAESI Act: Securitisation and Reconstruction of Financial Asset and Enforcement of Security Interest Act SC / RC: Securitisation Company / Reconstruction Company SCB: Schedule Commercial Bank QIB: Qualified Institutional Buyers

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