Asset Reconstruction Company (ARC)

WHY IN NEWS:

• Fulfilling a longtime demand of the banking sector, the Budget 2021-22 proposed setting up of an asset reconstruction company and an asset management company (AMC) to clean up non-performing assets in the banking sector

WHAT IS ARC?

• An asset reconstruction company (ARC) is a special type of financial institution that buys the debtors of the bank at a mutually agreed value and attempts to recover the debts or associated securities by itself.
• ARCs are registered under the RBI and regulated under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act, 2002).
• The ARCs take over a portion of the debts of the bank that qualify to be recognised as Non-Performing Assets.
• Thus ARCs are engaged in the business of asset reconstruction or securitisation or both.
  • Asset Reconstruction: It is the acquisition of any right or interest of any bank in loans, debentures, bonds, or any other credit facility extended by banks for the purpose of its realization
  • Securitisation: It is the acquisition of financial assets either by way of issuing security receipts to qualified buyers or any other means. Such security receipts would represent an undivided interest in the financial assets.
• 100% FDI are allowed in ARCs under the automatic route.
• ARCs are not permitted to undertake lending activities. They can only do securitization and reconstruction activities.
• Examples of some existing ARCs in India are:
  • Asset Reconstruction Company (India) Limited (ARCIL)
  • Reliance Asset Reconstruction Company Limited

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, 15%) of the amount to the bank as cash and for the remaining amount (that is, 85%) 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 financial institution, insurance company, Bank etc.
• 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.

ABOUT THE ARC PROPOSED IN THE BUDGET:

• The ARC/bad bank proposed in the Budget will be set up by banks (both state-owned and private sector banks), and there will be no equity contribution from the government.
• It will be named as National Asset Reconstruction Company Ltd (NARCL)
• However, the Government may provide sovereign guarantee that could be needed to meet regulatory requirements.
• It will have an Asset Management Company (AMC) to manage and sell bad assets.
  • AMC manages funds for individuals and companies.
  • They make well-timed investment decisions on behalf of their clients to grow their finances and portfolio.

NEED FOR NARCL:

• Consolidation of bad loans under a single entity:
  • ARC can help consolidate all bad loans of banks under a single exclusive entity.
  • Banks’ gross NPAs is expected to rise sharply from 7.5% of gross advances in September 2020 to at least 13.5% of gross advances in September 2021.
• Reviving post-covid economy:
  • ARC will help in boosting the entrepreneur’s confidence, and gives other options than filing for bankruptcy or insolvency in times of stress
• Complementing the IBC mechanism:
  • While the IBC infrastructure is well capable of handling steady-state incremental stressed assets, the enormous existing stock bad assets need a onetime exceptional resolution mechanism.
• Enhance the lending capacity of banks:
  • Banks have unused funds lying in their balance sheets in the form of provisioning against bad loan.
  • The proposed ARC, by taking up the bad loan, would free up this unused capital and enabled banks to lend again to customers without constraints.
• Increased productivity of banks:
  • Regular banking relations are not affected as banks are left with cleaner balance sheets and do not have to deal with problem clients.

ISSUES

• Limited success:
  • ARC 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 and Bankruptcy Code) and SARFAESI.
• 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
• Lack of capital
  • Of the existing ARCs, only 3-4 are adequately capitalised, while the more-than-dozen remaining are thinly capitalized >> this necessitates the need to set up a new ARC structure to resolve stressed assets urgently.
• Mere shift of bad asset:
  • ARC, as proposed in Budget will merely shift bad assets from the government owned PSBs to government backed ARC
• Risk of poor lending practice:
  • The safety net provided by a bad bank gives commercial banks more reason to lend recklessly. Thus, it may further exacerbate the bad loan crisis.

WAY FORWARD

• Solving the capital constraints:
  • Allow bank/market borrowing by ARCs similar to NBFCs
  • 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.
• Closing the regulatory gap
  • The SARFAESI Act should be amended to allow ARCs to acquire equity directly in companies sold under the IBC. This would improve the probability of distressed companies receiving resolution plans.
• Permitting acquisition of assets under investigations for fraud
  • The RBI doesn't allow ARCs to buy fraudulent loans from banks and NBFCs.
  • This should be changed and the decision to buy or not to buy or at what price should be left to banks and ARCs.
• Allowing ARCs as resolution applicant in the bankruptcy process
  • The ARCs should be allowed to participate as resolution applicants in the IBC process.
• Relaxation in equity cap for ARCs in stressed companies
  • The SARFESI Act allows ARCs to hold up to 26 per cent equity by way of conversion of existing debt into equity.
  • But it doesn't allow ARCs to acquire additional equity directly or invest in fresh equity.
  • The Act also prohibits ARCs to do any business other than that of resolution of bad assets.
  • These guidelines restrict the operations of ARCs in the IBC regime where the resolution would involve infusing fresh equity or holding the assets for some time to create value before exiting the company.
• Governance reforms in the banks:
  • There is a need for reforms in critical governance pillars such as the conduct and operations of risk management departments in financial institutions, auditors, boards, rating agencies, independent analysts and regulatory supervisors.  

PRACTICE QUESTION:

Q. Discuss the measures needed to strengthen Asset Reconstruction Companies in India