The concept of Asset Reconstruction Company is very important for UPSC exam due to the proposal of setting up bad banks. This proposal was put forward by the government in the recent Union Budget 2021-22.
List of Contents
- What is an Asset Reconstruction Company (ARC)?
- Origin of Asset Reconstruction Companies (ARCs) in India
- Functions of an Asset Reconstruction Company (ARC)
- What are the resolution strategies that an ARC can employ?
- What are the sources of funds for an Asset Reconstruction Company?
- How an ARC works?
- Has the ARC model achieved success?
- Challenges faced by ARCs
- Steps that can be taken
- Additional info
What is an Asset Reconstruction Company (ARC)?
- Asset Reconstruction Company (ARC) is a specialized financial institution that buys the Non-Performing Assets (NPAs) from banks and financial institutions. It helps banks in cleaning up their balance sheets by buying their bad loans
- Bad loan = NPA (Non-Performing Asset)
- Thus, it helps banks to concentrate on normal banking activities. Banks, instead of going after the defaulters, can focus on selling their bad assets to the ARCs at a mutually agreed value.
- ARC is a company registered under the Companies Act and registered with Reserve Bank of India under section 3 of The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
- Securitization refers to the conversion of loans such as auto, house, credit cards, etc. of banks and lenders into debt instruments
- Legal basis of an ARC: SARFAESI Act provides the legal basis of setting up an Asset Reconstruction Company (ARC) in India
- Regulation: ARCs are regulated by RBI as a Non-Banking Financial Company [NBFC] (under RBI Act, 1934). They function under the supervision and control of the Reserve Bank of India (RBI)
- 100% foreign direct investment (FDI) in asset reconstruction companies (ARCs) under the automatic route.
- ARCs are not permitted to undertake lending activities. They can only do securitization and reconstruction activities.
- One ARC can be a sponsor or investor in another ARC or it can acquire debt from another ARC.
What is an Asset?
In literal terms, asset means
- a useful thing or an item of property owned by a person or company, regarded as having value
So, for a bank, an asset would be anything that it owns or anything that it loans out. For eg:
- Cash in bank’s vaults
- Interest on loans (this forms a major part of bank’s assets)
- Physical assets like branch buildings, computer systems, furniture, etc.
- Investment in government securities like bonds etc
So now that you know what an asset is for a bank. Let us understand what is a Non-Performing Asset (NPA)
What are Non-Performing Assets (NPAs) and how are they classified?
A Non-Performing Asset (NPA) is a loan or advance for which the principal or interest payment is overdue for a period of 90 days.
Banks are required to classify NPAs further into the following categories:
- Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.
- Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
- Loss assets: A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection. Such an asset is considered uncollectible and of little value. Although it’s not written off completely as it might still be of some recovery value.
What is Asset Reconstruction?
SARFESI Act defines ‘asset reconstruction’ as the acquisition of any right or interest of the bank by a reconstruction company.
What is the minimum capital requirement for setting up an Asset Reconstruction Company (ARC)?
As per the SARFAESI Act, ARCs should have a minimum net owned funds of Rs. 100 Cr.
- The ARCs also have to maintain a capital adequacy ratio (CAR) of 15% of its risk-weighted assets.
- CAR is a measure of how much capital a bank has available. It is also known as Capital to Risk (Weighted) Assets Ratio (CRAR)
- Regulatory authorities monitor this ratio to see if any banks are at risk of failure
- A high CAR indicates that a bank has an adequate amount of capital to deal with unexpected losses.
- A lower CAR means, a bank is at a higher risk of failure
Origin of Asset Reconstruction Companies (ARCs) in India
The origin of ARCs is normally credited to a 1991 report on financial sector reforms by a panel chaired by former RBI governor M. Narasimham. Accounting policies of the banking system until the 1990s didn’t include any norms for setting aside funds against bad loans.
RBI released its first set of norms to classify bad loans, or non-performing assets (NPAs), in October 1990. It led to a pile of bad loans in most public sector banks and development financial institutions was unearthed.
The Narasimham panel recommended the establishment of an asset reconstruction fund or asset reconstruction company to flush bad loans out of the system.
Establishment of BIFR: The Board for Industrial and Financial Reconstruction, as a part of the Department of Financial Services of the Ministry of Finance, was set up in January 1987. Its objective was to determine the sickness of industrial companies and to assist in reviving those that may be viable and shutting down the others.
- Note: BIFR was dissolved in 2016 and all of its proceedings were referred to NCLT and NCLAT as per provisions of the Insolvency and Bankruptcy Code (IBC)
Establishment of DRTs: BIFR showed little success in tackling industrial sickness. That and delays in winding-up procedures led to the establishment of debt recovery tribunals (DRTs). The objective was a speedy recovery of money from defaulters who had borrowed from banks and financial institutions. But DRTs, too, could not speed up the recovery procedures in most cases as they lacked sufficient judicial experience. This resulted in a lot of pending cases.
Hence, ARCs were set up to enable faster recovery without the intervention of the court.
ARCs set up under SARFAESI Act: The government eventually passed the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, clearing the stage for setting up ARCs that could buy bad assets from Indian banks and financial institutions.
Functions of an Asset Reconstruction Company (ARC)
As per RBI, ARC performs the following functions
- Acquisition of financial assets
- Change or takeover of Management / Sale or Lease of Business of the Borrower
- Rescheduling of Debts
- Enforcement of Security Interest
- Settlement of dues payable by the borrower
What are the resolution strategies that an ARC can employ?
As per the SARFAESI Act, an ARC can:
- Restructure or reschedule the loan
- Enter into settlements,
- sell or lease the borrower’s business,
- takeover or change the management, and
- Also, engage in security interest enforcement (sell, take possession, or lease the owned asset).
But enforcement or security interest can only be conducted when at least 75% of secured creditors and the ARC are in agreement.
What are the sources of funds for an Asset Reconstruction Company?
An ARC can issue the following to meet its funding requirements:
- Debentures, and
- Security Receipts (SRs)
How an ARC works?
Working of an Asset Reconstruction Company (ARC)
- Consider a bank that has an NPA (bad loan) of Rs. 100 Crore.
- ARC and the bank agree on a deal for around Rs. 50 Crore to buy it.
- ARC then transfers the assets to one or more trusts established under SARFAESI Act.
- Now, ARC won’t give all of 50 Crore upfront. It shall first give a certain percentage (say, 5%) of the amount to the bank as cash and for the remaining amount (that is, 95%) issues Security Receipts (SRs)
- SARFAESI Act provides for the issue of Security Receipts (SRs) to only Qualified Institutional Buyers (QIBs) for raising funds for the acquisition of any financial asset.
- QIB includes the following:
- Financial Institution
- Insurance Company
- State Financial Corporation
- State Industrial Development Corporation
- Trustee or any asset management company making investment on behalf of a mutual fund or provident fund or gratuity fund or pension fund
- Foreign Institutional Investor registered under the Securities and Exchange Board of India Act, 1992 (15 of 1992) or regulations made thereunder, or
- Any other body corporate as may be specified by SEBI
- Funds raised by an Asset Reconstruction Company from a QIB is used to make the upfront payment to buy the NPA
- Bank gets the rest of the amount when ARC makes recovery after selling the NPA. At this point, the bank redeems the Security Receipts and pays a management fee to the ARC.
- Here, the bank only gets half of the original value, but something is better than nothing and moreover, it can now remove that NPA from its balance sheet
- This results in a clean-up of the bank’s balance sheet, allowing it to focus on banking activities rather than recovery of bad loans.
Note: In Aug 2014 RBI made some changes wherein it increased the upfront payment that an ARC must make, from 5% to 15%.
- It was done so that an ARC has more stake in the final outcome of the entire process. This meant increased risk for an ARC. This eventually resulted in a slowdown in the sale of bad loans
Has the ARC model achieved success?
The policy has achieved only modest success.
- The RBI’s Financial Stability Report (June 2019) indicates fairly low recovery for banks through the ARC model between 2004 and 2018.
- The maximum average recovery by ARCs as a percentage of total bank claims stood at 21.5% in 2010.
- Since then, it has steadily declined and reached 2.3% in 2018
- Opting for other alternatives: During 2019-20, asset sales by banks to ARCs declined, which could probably be due to banks opting for other resolution channels such as IBC (Insolvency & Bankruptcy Code) and SARFAESI.
Challenges faced by ARCs
- Lack of funding: Indian ARCs have been private sector entities registered with the Reserve Bank. Public sector AMCs in other countries have often enjoyed easy access to government funding or government-backed. Capital constraints have often been highlighted as an area of concern for ARCs in India
- Lack of consensus on the ‘right’ price at which banks should sell bad loans to ARCs
- Constant regulatory interventions
- Flawed model: Such low recovery is also a likely outcome of a resolution model heavily dependent on collateral disposal rather than genuine business turnarounds
- Collateral is any property or asset that is given by a borrower to a lender in order to secure a loan
Steps that can be taken
- Solving the capital constraints:
- The present requirement of 15% investment by ARCs themselves which was not in the SARFAESI Act and was added in 2014, should be done away with.
- Besides, it will align with the government’s FIPB Guidelines of 2016, permitting 100% investment by FPIs in SRs issued by ARCs (so no investment by ARC is required, as per the government’s Guidelines).
- Allow bank/market borrowing by ARCs similar to NBFCs
- SARFAESI allows ARCs to acquire debt only. For effective resolution- debt and equity have to work together. ARCs should be allowed to take part in the equity of a stressed company directly. ARCs may be freely permitted to take an equity stake in companies within the IBC resolution framework.
- Loan product for ARCs: In a paper ‘Framework for revitalising Distressed Assets in the Economy in January 2014, RBI had suggested allowing banks to extend finance to ‘specialised’ entities put together for the acquisition of troubled companies. ARCs should have a standardised loan product so that they can finance the acquisition and resolution of stressed assets
- A standing committee on the ARC sector should be formed which should meet quarterly to take stock of the developments and ways to improve the functional effectiveness of ARCs.
Asset Reconstruction Companies (ARC) have more than two decades of experience in the resolution of stressed assets in India. We should leverage this capacity to the fullest. By tweaking some regulations, ARCs can become a potent solution to the growing crisis of NPAs
To resolve the underlying issue of NPAs, the government has proposed setting up a bad bank.
What is a bad bank?
Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them, and finally recovers the money over a period of time.
- The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans
- Bad loans are taken over below the original value and every possible effort is made to recover as much as possible
- First bad bank was created by US-based Mellon Bank in 1988. Afterwards, the concept has been implemented in other countries including Sweden, Finland, France and Germany
- Different banks shall own the proposed bad bank. Government will not fund the project or take ownership in the entity.
Do we need a bad bank?
- Rise in NPAs: NPAs in the banks are around 7% currently. If situation deteriorates, then by Sep 2021, these are expected to rise to 15%. The Covid disruption has already created a lot of stress in the banking system.
- Problems with IBC: The bad bank idea was first floated in the Economic Survey 2017. In fact, there is already IBC (Insolvency and Bankruptcy Code) to deal with bad loans, but the recovery rate is not higher. The current framework of bankruptcy code is not yielding a good value for banks
- Limitations of existing ARCs: In addition, there are a dozen of ARCs in the market. The existing ARCs also have limitations in terms of capital or the funds to buy large assets. Existing ARCs have acquired a debt of ₹3.88 trillion as of June 2019. However, there are still nearly ₹10 trillion worth of stressed assets in the system so clearly the extent of the problem (and opportunity for ARCs) continues to be immense
So, a bad bank might not be a bad idea.
How is this bad bank different from already existing ARCs?
- Ownership: Unlike the present ARCs which are private entities, the proposed bad bank will have public character since the majority ownership would likely be with public sector banks (PSBs)
- Valuation issues: As of now, individual banks have to sell their stressed assets to ARCs. This process gets stuck because ARCs typically seek a steep discount on loans. The valuation becomes a problem. With the proposed bad bank being set up, the valuation issue is unlikely to come up since this is a government initiative.
- No capital constraints: Smaller ARCs do not have the ability to buy large assets. Hence, banks are often stuck with these accounts or have to move to NCLT court. Chances of resolution in NCLT are relatively less. The process is also time-consuming. As against this, the government-backed ARC will have sufficient resources to buy out big accounts and thus free up banks from carrying these accounts on their books
- Relaxations by RBI: Being a government initiative, the RBI is likely to extend certain rule relaxations when the new bad bank comes into operation. These relaxations will be likely related to the provisioning norms for banks on assets sold to an ARC. Requirement of 15% upfront capital payment will also be a condition.
Can a bad bank solve the NPA issue?
Experts feel that a professionally-run bad bank, funded by the private lenders and supported by the government, can be an effective mechanism to deal with NPAs. Thus, concept of a bad bank is in some ways similar to an ARC with initial funding from the government. Banks and other investors co-investing in come into picture in due course.
International Experience of bad bank
- It helps in combining all bad loans of banks under a single exclusive entity. Countries like the US, Germany, and Japan have used this concept.
- The US implemented the Troubled Asset Relief Program (TARP) after the 2008 financial crisis. TARP is based on the idea of bad bank. The US Treasury earned nominal profits under the TARP.
Other Important Current updates:
- In 2019, The Reserve Bank of India(RBI) allowed asset reconstruction companies (ARCs) to acquire financial assets from other ARCs
- Bad bank proposed: In the latest Union budget, govt has proposed setting up of a bad bank or an Asset Reconstruction Company (ARC) to resolve the NPA crisis.
- Sudarshan Sen committee: The Reserve Bank of India(RBI) has set up the Sudarshan Sen committee to review the working of Asset Reconstruction Companies (ARCs) Comprehensively. It will recommend suitable measures for enabling them to meet the growing requirements.
- Headed by: Sudarshan Sen, the former executive director of Reserve Bank of India (RBI)
- The committee shall submit its report in 3 months time