The business model of India’s eight-year-old asset reconstruction industry is under the central bank’s scanner. The Reserve Bank of India’s (RBI) inspection team has found that Asset Reconstruction Co. (India) Ltd (Arcil), the country’s oldest and biggest asset reconstruction firm, is not driven by its board but its major shareholders—State Bank of India, ICICI Bank Ltd and IDBI Bank Ltd—and its accounting policies are not in line with the regulator’s norms.

Asset reconstruction firms in India, through a trust, buy stressed assets of banks and financial institutions at a discount, recover them, and earn a fee for managing the trust. There are at least a dozen asset reconstruction companies (ARCs) in India. Collectively they have been managing assets valued at about 15,000 crore bought from banks.

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The origin of ARCs was probably a 1991 report on financial sector reforms by a panel chaired by former RBI governor M. Narasimham. Corporate financial management in India until the early 1990s was easygoing and accounting policies of the banking system didn’t include any prudential norm for setting aside money against bad loans.

With RBI issuing its first set of norms to classify bad loans, or non-performing assets (NPAs), in October 1990, 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 to flush bad loans out of the system. Globally, asset management companies play the role of bad banks and tackle the stock of bad assets as a one-time phenomenon; they have a sunset clause for winding down the assets.

The Indian banking system had for years been hiding its bad assets as governance in public sector banks before they were listed was questionable, with the political system misusing them. The government, the sole owner of banks, was happy with a substantial portion of bank deposits being used to buy government bonds to bridge the country’s fiscal deficit.

The Board for Industrial and Financial Reconstruction, a reconstruction agency, and its appellate body 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 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 lack sufficient judicial experience in complex company law, lender-borrower contracts, and claims of other constituents, including employees and the state and Union governments. Typically, a DRT takes three-four years to issue a recovery certificate, and the process of sale of assets takes even longer. Moreover, since DRTs don’t permit all stakeholders to participate in its proceedings, creditors other than banks and financial institutions need to follow the long-winding liquidation process to recover their dues.

As a panacea for all ills, the government passed the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, clearing the decks for setting up ARCs that could buy bad assets from Indian banks and financial institutions. At a parallel level, some weaker banks were capitalized by the government and a corporate debt restructuring (CDR) platform was formed to recast troubled debt without classifying them as bad assets. RBI also issued norms for restructuring loans outside CDR.

Financial institution ICICI converted itself into a bank as its business model was turning unviable with the source of long-term cheap funds drying up fast. Industrial Development Bank of India (IDBI) followed suit by merging itself with IDBI Bank and creating a stressed asset stabilization fund (SASF) to alienate 9,000 crore worth of bad assets from its books. But two other development finance institutions could not become banks. IFCI Ltd, India’s oldest financial institution, is alive but not kicking, and Industrial Reconstruction Bank of India died a quiet death.

Globally, AMCs tackling bad assets are formed as a response to a systemic crisis to protect commercial banks by creating one bad bank that takes over the stressed loans of the entire system. Typically, the government provides legal, regulatory, fiscal and administrative support to such institutions. The central idea behind the creation of such an AMC is to protect the capital of the banking system as banks need to set aside money for bad assets and this erodes their capital.

Typically, AMCs buy bad assets from banks at a discount and issue bonds against them. The government offers fiscal support by guaranteeing the bonds to protect any erosion in value of assets in the books of the banks that are selling stressed loans. A case in point is Pengurusan Danaharta Nasional Bhd, an AMC set up in Malaysia in the aftermath of the Asian crisis. In this model, AMCs acquire bad assets not through price negotiations or auctions; they are simply transferred from banks’ books. In a sense, it’s an accounting jugglery where the government takes a call on the ultimate recovery amount from the asset pool over time and doesn’t recognize the so-called present value of such loans. The expectation is that over the life of the AMC, the recovery amount from the asset pool will equal the price at which the assets have been transferred.

The formation of an SASF by IDBI Bank with government support in some sense resembles the structure of global AMCs, except that the sunset clause in case of the SASF is 20 years against 5-10 years globally. Under this structure, IDBI Bank subscribed to 9,000 crore, 20-year, zero-coupon government bonds. The government received the money and transferred it to the SASF, a trust, which in turn gave this money back to IDBI Bank as consideration for the transfer of NPAs from the books of the bank. The SASF is expected to recover the amount in 20 years and pay back the government. Meanwhile, in the books of IDBI Bank, the bonds, though zero-coupon, will continue to be accounted for at their original investment value, sparing the government from the pain of recapitalizing the bank.

In the Indian context, ARCs are allowed to buy bad assets from banks and financial institutions and recover them. The Securitisation Act enables them to take possession of physical assets of defaulting firms without the intervention of the judiciary when at least three-fourth of the lenders by value support such an action.

The Indian ARC model doesn’t envisage any fiscal support or tax forbearance from the government. It also doesn’t call for mandatory transfer of bad assets of the banking system. In sum, the model doesn’t envisage ARCs as a tool of resolving the one-time problem of bad loans of the banking sector, and it’s not a policy response to a systemic crisis. It’s a market-driven model that allows banks to take their own decisions to sell bad loans to ARCs, based on bilateral negotiations and/or auctions.

ARCs, on their part, are required to mobilize capital and arrange for money to pay for the acquisition of bad loans by themselves, without any fiscal support from the government. They are not allowed to access debt or the capital market, but can securitize their portfolios by creating a pool of bad assets of different banks and issuing security receipts (SRs) to pay for the acquisition of bad loans. Being a qualified institutional buyer, banks themselves buy the securitized papers.

Theoretically, there is nothing wrong with the structure, but it is spoilt, with many sellers insisting that bad assets of different banks cannot be pooled to create SRs. This means ARCs need to acquire bad assets of individual banks as separate pools, and banks need to subscribe to SRs of their own assets. Indeed, combining reconstruction of financial assets with the concept of securitization in one package is a fine example of financial engineering, but the devil lies in the details. The Indian ARC model encourages the worst kind of financial incest.

This is the first in a two-part series on asset reconstruction companies.

Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai. Your comments are welcome at