A fair playing field for ARCs to rival our new bad bank

In most jurisdictions, national bad banks, set up to help clean the balance sheets of banks, make losses as they buy non-performing assets (NPAs) from banks at inflated values, and sell them at market values after efforts to revive the underlying businesses. Thus, they require government support. India has a golden opportunity to buck the trend, as it has a long-standing industry of privately-held asset reconstruction companies set up in 2002 under the SARFAESI Act. Bank balance sheets comprise a large stock of fully written-off NPAs; for these, any positive price represents a profit for banks, so deal-value inflation can be avoided.

As per SARFAESI, ARCs are permitted to buy NPAs from banks with a combination of cash and securities. They are expected to engage in loan-recovery activity and thus the revival of underlying businesses. Typically, they charge management fees for the securities they manage on behalf of a bank. ARCs are also permitted to sell these securities in the secondary market to qualified buyers.

The performance of ARCs has been lacklustre. During the period from 2003-04 to 2012-13, banks and other investors were only able to recover about 14.29% of the amount owed by borrowers, mostly through measures unrelated to business revival. Adequate infusion of capital, a pre-condition for successful recovery, was limited by regulations that constrain an ARC’s ability to take control of a distressed company.

A raft of recommendations has been made by a panel set up by the Reserve Bank of India (of which I was a part) to ensure that ARCs truly become vehicles of business revival. For instance, ARCs should be allowed to set up alternate investment funds for the purpose of bringing in capital and competencies for reconstruction. Once RBI decides on the way forward, we can expect to have an ARC industry that can participate in the process of price discovery in competition with the national bad bank. This can reduce the burden on taxpayers. Hopefully, an ongoing probe against certain ARCs that allegedly are a front for promoters trying to settle debt cheaply will also serve to separate the grain from the chaff.

To leverage ARCs, it is essential to create a fair playing field between private ARCs and the National Asset Reconstruction Company Ltd (NARCL). The current proposal envisages the NARCL buying NPAs with a 15-85 split between cash and securities, with the value of these securities guaranteed by the government. Private ARCs will be allowed to place counter-bids, but on an all-cash basis. This does not create a fair playing field. For seller banks, on account of the guarantee, transactions with the NARCL are tantamount to all-cash deals, albeit with a payment delay in 85% of their value. The NARCL, though, is only required to pay 15% in cash, while private ARCs must pay 100% cash.

An economic model developed by Yogesh Mathur and myself shows that the maximum amount any ARC (NARCL included) would be willing to bid rises steeply, even going beyond fair value, as the cash proportion of the deal falls. Thus the NARCL will be able to bid high amounts while private ARCs will be constrained to bid conservatively. Both private ARCs and the NARCL will have the same ability to raise capital after the proposed creation of the Indian Debt Resolution Company (IDRC), linked with the NARCL, as a private entity. All things considered, the NARCL has a distinct advantage.

Some have argued that aggregated NPAs could be sold in a competitive market to private ARCs or the IDRC after the NARCL aggregates debt. However, NPAs acquired from banks by the NARCL without the application of market discipline are likely to be mispriced. This raises the possibility of losses in down-the-line sales. The sale of NPAs should be subjected to competitive forces at the time they move off a bank’s books, not when the NARCL is ready to sell them. With a thriving private ARC industry expected to emerge, the NARCL should be treated as just another ARC. If necessary, the Centre can infuse capital into it, but it should have no backing of a government guarantee.

The RBI committee recommended that if banks sell NPAs with a cash proportion of more than 51%, banks need not make further provisions with respect to these NPAs (today’s threshold is 90%). However, for fully written-off NPAs, the minimum cash proportion can be stipulated at 35% while making the management fees contingent on the percentage of value realization. This cash proportion is high enough to avoid sales at higher than fair value. To prevent market rigging, the actual cash proportion should be determined through a two-dimensional bid comprising deal value and cash proportion.

The suggested cash proportions of 35% and 51% for fully written-off NPAs and for other NPAs respectively is higher than the 15% cash proportion currently suggested for the NARCL. The higher capital requirements implied by this proposal may slightly slow down the process of cleaning bank balance sheets. However, setting reserve prices conservatively and adopting a multi-round auction format will result in NPAs moving off the books of banks at fair prices, using a combination of bank capital, private capital channelled by ARCs and infusions by the Centre. Market-determined prices will ensure that down-the-line sales happen expeditiously, leading to optimal recovery and revival.

The experience of national bad banks in jurisdictions like China are cautionary tales that warn against ignoring market processes. We can surely do better.

Yogesh B. Mathur, senior advisor, contributed to this column.

Rohit Prasad is professor, MDI Gurgaon