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The securitisation/reconstruction companies are gaining importance in the banking system and playing a crucial role in recovery of NPAs. ARCs help in releasing blocked funds in the financial system, thereby creating a vibrant financial environment for investors and lenders.

D&B India, in its quest to provide insights into the industry, sought views of prominent bankers on various facets of securitisation and asset reconstruction. The Banking Perspective gives a gist of opinions expressed by top bankers of the country. This section covers a gamut of issues and challenges faced by the ARCs and banks in present times.

D&B India collated responses through execution of detailed questionnaires and this section covers opinions of 11 prominent bankers. A brief profile of the participating banks is as follows:

Specialisation gives an edge to ARCs in NPA recovery over Banks

ARCs specialise in reconstruction of assets as they are formed for the specific purpose of acquisition and recovery, whereas for a bank, which has a diversified role, recovery is just one of the key functions. The efficient recovery process of ARCs is a result of domain expertise, better understanding of the complexities of each individual asset pool from the point of view of resolution and special empowerment for ARCs that enables them to aggregate debt. The measures normally adopted by the banks are rescheduling of debts payable by the borrower and enforcement of security as per the legal process. Moreover, under the existing multiple/consortium banking system in India, individual banks having less than 75% stake in total secured lending is not in a position to initiate action under SARFAESI Act, 2002.

One explicit area where ARCs do better is where multiple lenders have exposure. Their tool of debt aggregation by buying out all the lenders and concerted action against borrower thereafter, certainly gives better results in recovery or restructuring NPAs. Also, adequate funding options are available to ARCs (unlike banks who have capital constraints) as SEBI registered FIs are allowed to invest only upto 49% in each tranche of SRs and through equity. ARCs are set up with adequate expertise in credit, structured solutions and stressed asset workout. By adopting multi-pronged resolution strategies such as restructuring, sale of business / M & A, sale of secured assets, settlements, sale of portfolio etc, they tend to create value for seller - investors.

However, one major shortcoming an ARC has in comparison to banks is its inability to inject funds for restructuring of the unit if warranted.

ARCs enable easy & quick recovery; however at times banks may prefer to pursue their own path

One of the prime reasons why a bank would opt for securitisation of its assets is that the securitised assets go off the balance sheet of the bank, thereby providing capital relief. The asset base is proportionately pruned which reduces the regulatory capital requirements to support the assets. At the same time, the asset portfolio is liquidated, releasing cash, which in turn reduces the need for demand and time liabilities that are subject to statutory reserves.

Transfer of NPAs to ARCs also enables banks to stay focussed on their core business activities, i.e., lending/ financing. ARCs enable easy and quick recovery considering the time factor involved in realisation of assets and overcoming the lengthy legal procedures. The process not only releases capital but also human resources, both of which can be focussed towards core banking operations – a must today where banks are assuming the role of a multi-specialist bank.

In some instances, it could be possible that the bank may not see much value in selling stressed assets to ARCs, especially if the bank has robust loan provisioning and write-off systems that takes care of balance sheet management. Also, as the industry still is in nascent stage, it faces several challenges including:

Clean exit emerges as the best suited option for NPA recovery

A lot of emphasis is put on the viability of future earnings of defaulting business units before deciding the exit option. The option exercised largely depends on whether the account of portfolio offered to the ARC is secured by tangible assets or not. For assets where there is no potential for revival of unit and the best resolution strategy would be the sale of tangible assets, banks would prefer the clean exit route – a single stop approach. This is because foremost, the clean exit route provides an opportunity to deploy funds into alternative business opportunities; and second, true sale of NPAs as servicing of security receipts depends on realisation from the non-performing loans.

However, banks may prefer security receipts in cases where a unit is viable and have potential for revival and see an advantage in staying invested. Moreover, the discount rate used in a cash transaction would always be higher than the discount rate used in a security receipt transaction. Hence, a lender should do a careful evaluation of their internal NPA resolution efforts before proceeding with an NPA auction.

In some cases, in the accounts where there are securities banks would prefer a combination of the cash option as well as the security receipts, for realisation of securities could be shared, especially when real estate market conditions are upbeat.

Cash mode of acquisition also benefits ARCs enabling them to negotiate better with banks/FIs, driving down the acquisition prices further. Holding investment in SRs also calls for keeping aside capital by assigning risk weight to such investments.

Viewed from the taxation angle, where the transaction involves immediate payment to the bank, then the transaction is liable for a single taxation. In cases where the security receipt is passed on to the bank by the ARC, in consideration of the transfer of NPA which is a separate transaction, the same is considered as an investment which is subject to taxation. On redemption of such SRs, bank is again subject to taxation, which undeniably amounts to double taxation. Since the taxability arises on the receipt and on the sale of the financial assets to ARCs, banks prefer a clean exit rather than the security receipt route.

Most banks prefer to be sellers of stressed assets

In the short-term, most banks have shown a preference to be sellers of stressed assets to be able to focus on core banking operations and clean up the balance sheet. Some of the key factors that restrain banks from becoming buyers are to keep NPAs at minimal levels and lack of specific skills to carry out technical/commercial/legal due diligence, which would be critical. Nevertheless, all have recognised buying stressed assets as a business opportunity, and are targeting to become buyers in the long-term.

Buying stressed assets in certain situations could be a profitable proposition for banks

Improving profitability underpins a banks decision to buy stressed assets, as the assets are purchased at a discount. Once the NPA level is contained by a Bank, the expertise gained on NPA Management can be better deployed in purchasing stressed assets of other banks and resolving them to improve profits. In the process, the portfolio is changed from credit exposure to Investment option.

In respect of consortium accounts (NPAs), buying stressed assets from other banks gives the purchasing bank an opportunity for acquiring a controlling stake through debt aggregation. Gaining control over the financial assets is made easy and this strengthens the Banks position to negotiate for better terms towards resolving the NPAs. This is a position taken by some of the large banks, where they follow of policy of buying only those assets where the bank already has a certain minimum stake. This gives the Bank leverage in negotiating with the defaulters. A single strong lender can strike a better compromise deal than a number of lenders. It has also been observed from the activities of successful ARCs that after acquiring a majority stake and if the security position of the unit is strong, it can fetch higher recovery proceeds and strengthen bottom-lines.

However, some banks have not ventured into this area due to the extant guidelines like only NPAs of more than two years could be purchased by the banks, holding period of fifteen months, stringent asset classification norms, etc.

Vibrant secondary market for stressed assets likely to emerge with growing investors interest

The rapidly changing banking industry, Basel II norms, global competition, a fast growing domestic economy will put enough pressure on banks to reduce NPAs and strengthen their financial base. Under these circumstances, a vibrant secondary market is bound to emerge soon considering the huge amount of stressed assets held by Banks and FIs in India.

The concept of sale of stressed assets is, however, relatively new to India, and will require cultivating investors’ interests in distressed assets to develop a secondary market. Also, entry of more players and increase in volumes of saleable assets, especially in the retail sector, will evolve the market. As NPAs grow as an outcome of a fast growing economy and banks focus on lending to high-yielding retail segments where NPAs are typically high, more ARCs/NBFCs would be set up. The estimated lend of NPAs in the commercial Banks is around Rs one trillion on a conservative basis, and could further increase with the strict implementation of IRAC norms. As the financial sector is likely to further open up by March 2009, there would be umpteen market players contributing to the dynamics of secondary market.

Bankers believe valuation offered by ARCs is not so cost effective

Essentially, sale of stressed assets to ARCs help in unlocking value. Banks are able to circumvent poor credit ratings arising out of high NPAs, which impair their ability to raise fresh capital. ARCs help in releasing capital for credit risk in two ways: when an NPA is purchased by an ARC, the unprovided amount of NPA ceases to attract capital for credit risk and in case the NPA is sold for more than the Net Book Value, the excess amount is transferred to Reserves for meeting the shortfall on account of sale of other non-performing assets. These reserves also augment capital for credit risk.

However, whether such transferring of NPAs will necessarily lead to relieving of capital is a function of the quality of bonds and their ratings for which such portfolios are exchanged. In case where the ARCs do no pay cash for the assets assigned and instead issue security receipts/bonds, which are realisable after a specific period, the ARCs are unable to release capital for credit risk. Also, sometimes there is a substantial expectation gap between ARCs and banks in pricing.

Value offered by ARCs in respect of assets sold on SR basis is generally based on estimated cash flows in the account and there is also a provision for sharing any upside realisation received by ARCs between the Bank and ARC. Valuation offered by ARCs on assets sold on security receipts basis is normally cost effective because of the provision for upside sharing. But since most times NPAs are sold on cash basis, the price received is not very cost effective. This is however debatable, as considering factors like erosion of securities, steep fall in real estate value, etc., such a price could be the optimum price to be accepted.

Regarding valuation, price offered by an NPA Investor is a function of many factors, including quality of portfolio. In addition, an NPA Investor may be willing to pay more due to competitive pressures or its strategic objectives. At the same time, NPA Investors usually provide for higher returns from their investments in the NPAs, as they are perceived to be risky assets. A lender would need to take an informed call in terms of its ability to take quick and flexible decisions for resolving NPAs as value of assets erodes with passage of time.

Credibility of ARCs matters to determine whether transfer of assets is merely a book entry

Transfer of assets being a mere book entry could be true where a Bank as a QIB invests in SRs of Trusts floated by ARCs to whom in fact assets were sold. However, the transaction cannot be viewed in this perspective alone. ARCs are functioning under RBI guidelines on a Trusteeship basis. The main objective of RBI in the formation of ARCs is to give advantage of provisions of SARFAESI Act for the quick resolution of stressed assets. If the ARC has developed domain knowledge and the necessary skills to resolve NPAs, it will not be fair to conclude that only a book entry has been made. Moreover, these investments are also subject to prudential norms and recovery has to be received on continual basis to keep these investments classified as Performing Investments.

Investment in SR and expected return on them is linked to the ARC’s performance and resolution strategy it follows. Investment exposure is to the ARC trust and not the borrower. In the case of master trusts, where there is a mix of portfolio, the doubt that the transaction is a mere book entry does not arise. However, in the case of single asset trusts, such a nagging doubt exists. If the track record of the ARC were good, then investments would reflect true value than mere book entries ultimately to be written off. There is thus a need to allow more independent investors in the NPL space. Also, tax liability arises on the receipt and on the sale of financial assets to ARCs. It is not therefore a mere book entry by which NPAs is converted into investments as banks may face double taxation.

Once the emerging secondary market gathers momentum and the market for SR picks up, the ordinary book entry will be transformed into an active business/investment opportunity towards profit maximisation.