Bad loans, ARCs and asset reconstruction

Non-performing loans, or NPLs, are commonly generated in a fast-growing economy and are rather unavoidable in a credit delivery system which has unstable or uncertain policies and practices. The situation is termed normal as long as NPL generation is contained within 1-2% of the aggregate credit, but aggregate stressed loans with NPLs at over 4.4% and restructured loans at over 6% can raise concerns.

This is certainly not the first time that the situation has been as alarming. Gross NPA (non-performing assets) ratio was 14.7% of total advances in fiscal 1999, and steadily declined to around 2% by fiscal 2008, with net NPA at 1%.

The dramatic improvement in the bad loan situation to a reasonably respectable level was the result of the introduction of a few government/regulator measures such as the SARFAESI Act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002), CDR (corporate debt restructuring) mechanism, SASF (stressed asset stabilization fund) for IDBI Ltd, etc.

By fiscal 2008, India had established itself as one of the fastest growing economies of the world with gross domestic product (GDP) growth at about 9%. But for such economic growth, the decline in NPA ratio would not have occurred. The improvement in the economic environment is therefore an essential condition for better NPA ratio in the banking sector.

What has led to the current state of affairs?

Deficiencies in the credit risk assessment by lenders and unholy intentions of some borrowers, no doubt, are responsible for the problem, albeit partly.

This time around, a preponderance of factors external to the lenders, borrowers and promoters has contributed more to the NPAs than any of the above factors.

Undoubtedly, stunted growth of the domestic economy, the economic crises in the US and European Union countries post 2008, together with a policy slowdown and virtual “standstill” for nearly five years of political governance have together harmed almost all industries and infrastructure projects.

Allegations of corruption and so-called scams have affected economic decision making. Inflation and high rates of interest continue to affect profit margins across sectors.

Debt restructuring exercises by banks were rendered unsuccessful due to the prolonged industry and economic recession. One can see under-utilization of capacities already created during the high growth phase and a large number of unfinished/under construction projects, be it in core sector infrastructure, hotels or real estate. A large number of metals and mining companies have turned sick due to a “man-made scarcity” of raw materials such as coal and iron ore in a mineral-rich country.

So why have effective tools such as CDR or SARFAESI failed in such crucial times?

The basic tenet of debt restructuring is to render time to the turbulent period of the economy, normally one to two years. But the steady decline in economic growth for four-five years has been too much for any restructuring pundit to factor into a restructuring package.

CDR was a great success in the initial years, primarily because the economic upsurge supported the industry in the revival path. That has not happened this time around, and lenders collectively chose to declare debt restructurings as a failure. Lenders also opted not to utilize the ARC (asset reconstruction companies) infrastructure to manage their NPAs until the regulator, under the leadership of a dynamic governor, encouraged them to do so through a series of incentives. As a result, it is only in recent months that banks have decided to sell new NPAs to ARCs—before the financial and technical viability of the borrowing companies are not lost.

In the nine months ended 31 July, banks have come out with the sale of NPLs amounting to about ₹ 85,000 crore and it is estimated that about 65% of these have been sold to ARCs. Security receipts issued against such sale may be about ₹ 35,000 crore at the rate of about 55-60 cents per dollar.

A majority of the sale has been through the vanilla structure of 5% cash by ARC and issue of security receipts for the balance 95%. While the selling bank continues to be the 95% beneficiary even after the sale, the responsibility of resolution is transferred to ARCs which are very focused on a single business, namely asset reconstruction.

It is important to mention here that it is the first time that ARCs are getting an opportunity to engage in real asset reconstruction. Therefore, the next couple of years will be testing time for ARCs and they have to prove to the regulator, as well as to the banking system, that practical restructuring and successful revival can happen in the ARC infrastructure.

There are challenges for ARCs, the first one being debt aggregation. Unless a majority of debt is aggregated in one ARC, expeditious and efficient resolution will be difficult to achieve.

The second challenge is provision of fresh financial support for revival.

Thirdly, and most importantly, the creation of a favourable economic climate is necessary for business to operate smoothly.

Fortunately, the time is just right as India is on the verge of an economic upsurge.

A stable government with single-party majority is in place already. With further economic reforms on the anvil, the economic environment is expected to be conducive to an industrial recovery.

Therefore, critical issues that need to be addressed are speedier debt aggregation and availability of necessary funds for resuscitation of weak industrial units. ARCs may not be in a position to arrange adequate funds for revival. Several hedge/vulture funds are evincing interest in providing last mile funding for projects for completion of their brown field expansion/diversification. The high return expectation for these funds makes the proposal costly for companies already reeling under stress. In this scenario, it may be desirable to set up a fund by cash-rich public sector companies/banks to meet this need of the projects. If funds are accessible at reasonable rates, a mechanism could be worked out whereby seniority in servicing of fresh finance will be ensured by the ARC which drives the revival strategies.

Without expeditious steps for debt aggregation (which can happen only through consortium sale of debts) and provision of fresh funds to industry, the revival process can be time consuming. Recent regulatory modifications in the sale of NPAs to ARCs will put a break in the sale of NPAs by banks and the immediate impact will be on the debt aggregation efforts of those ARCs which have already acquired loans from some banks.

Unless rigorous and a realistic approach to pricing is not agreed between the banks and ARCs, the resolution of these large cases could be delayed, hurting all the stakeholders.

Therefore, there is an urgent need for all stakeholders, including the regulator, to come together to make the entire process of NPA sale, resolution, recovery and revival fast and smooth.

(Views are personal.)

Siby Antony is managing director and CEO, Edelweiss ARC.