ARC’s may insulate banking business from vulnerability

“Bad Bank may ease the bad loan crisis when lenders keep their NPAs in
check and borrowers to improve their credit response”.
What’s the New Regulation on Street?
As per the new regulation, the Reserve Bank of India states that new Asset Reconstruction Company
(ARC) also called as Bad Bank, will be set up as a different entity, not interfering with the existing
structure of ARC entities with a main purpose of taking over large stressed assets from the
commercial banks. The ARC will pay 15% of upfront cash immediately to the banks and 85% will be
paid in security receipts. They will consolidate all the bad assets of different banks and take them
forward for selling off in the secondary market.

What are ARC’s?

Asset Reconstruction Companies (ARCs) / bad bank have been in the financial system since 17 years
under the enactment of The Securitization and Reconstruction of Financial Assets and Enforcement
of Security Interest (SARFAESI) Act, 2002 and has set the legal framework for ARCs in India. ARC’s are
the specialised financial institutions that securitise and reconstruct the bad debts of the bank and lay
stress on toxic assets problem in the banking sector. These entities clean up the balance sheets of
the bank in order to unlock the capital that augment the lending and borrowing operations thereby
increasing their profitability.

How Do ARCs Work?

The commercial banks sell their stressed assets like Nonperforming assets (NPAs) or unpaid
debentures and bonds to ARCs at a mutually agreed net book value deal (value of assets minus the
provisioning already been done) and are required to do the provisioning for it. From ARCs, the assets
then move to AMC (a team of experts who are registered with SEBI) who finds the potential investor
or an Alternate Investment Fund (AIF) and sell these toxic assets for realisation and raise funds for
the stressed bank. The bad banks would have to sell the loans at a higher price than what it paid to
acquire the loan from a commercial bank, however, profit is not the primary purpose of bad banks.

Background Check –
ARCs have matured with expertise and hands-on experience in value-creation by absorbing the bad
assets over time. These entities had gained significant popularity by purchasing large quantity of
NPAs in FY14, FY 15 and FY 17. But, ARCs were also quite the underperformers seeing the massive
scale of NPAs rising in India in FY16 and FY18 accompanied with stricter norms raised by RBI like -
capital restrictions only up to 49% via automatic route, their cash deal with banks had increased
from 5% to 15% and the minimum capital base had risen to Rs 100 crore. This gradually led to a
slowdown in the asset reconstruction business.

Why should we have A New ARC now?

The NPA’s have shrunk from Rs 10.36 trillion to Rs 8.08 trillion in Mar’18 - Sept’20. The disruption
induced by the pandemic in FY 2020-21 had forced the regulator to maintain sustainable demand to
keep the economy running. Hence, RBI had provided a 2-year loan restructuring to retail and
corporate borrowers and the Supreme Court had declared that the loan accounts till August 31,
2020 would not been classified as NPA. However, once the extended moratorium of the Supreme
Court order is lifted, the NPAs could surge to 13.5% in Sept’21 from 7.5% in Sept’20. This justifies the
need for more vigorous structures like ARCs and AMCs to manage the considerable stress in banking
sector.

Why need ARCs?

It is quite evident that if bad assets are not securitised then their value will erode with time and no
buyer would be willing to buy these stressed assets, hence asset reconstruction is imperative for
value creation in long term. However, it is also imperative that the bankers must not give away the
loans randomly to corporates and keep NPAs in check all the time. If the banks do not conduct their
business operations in tight vigilance and allow the NPAs to rise all over again, then even ARCs would
not remain a viable option going forward.

Enhancing Effectiveness of ARC’s –

Currently we observe that existing ARC structure has 100% allowance of foreign institutional
investors/portfolio investors (FDI/FPI) in ARCs, the foreign investors can also take over the stressed
assets and sponsor funds. This brings in more liquidity and builds extra capacity to sell bad assets
and replenish the banking business. Secondly, ARCs have adequate capital with a RBI mandated net
worth of Rs 100 crore to carry out a seamless securitisation and reconstruction process.

How would ARC’s become more effective in the new structure?

 Debt consolidation - ARCs can consolidate and acquire loans from different banks at the
same time to enable speedy resolution of stressed assets.

 Governance – ARCs must have private ownership yet stay under RBI scanner to avoid pitfalls
like mismanagement.

 Timely resolution - ARCs can assure quicker resolution of bad debts of banks and restore the
business of lending and borrowing. These entities can run parallel with Indian Bankruptcy
code as both intend to resolve the stressed book of accounts of the banks.

 Key Advisory Committee - Setting up an advisory group consisting of RBI, regulators and
rating agencies to ensure smooth functioning of ARC, provide necessary amendments and
keeping a track on timely resolutions of bad assets.

Concluding Thoughts –
How will the bad banks function and carry out the entire reconstruction of assets? What options
does it have for raising funds for the banks that are in trouble? Will banks abstain from generously
giving away loans? Is there a required amount of zeal in running the banking business by the top
management? Can we ensure that borrowers improve their responses in honouring their debt?

The banks, ARCs and AMCs have to work in congruence consistently to expand the opportunities
that can emerge out of the asset reconstruction sector in redesigning the banking business for good.
The eco-system of the trio will prevent tarnishing of the credibility of the banking business that
successively will spur and guide the future economic growth of India.