By Ruma Dubey

The big news today in the Indian financial markets is most obviously that of the largest bank of India, State Bank of India (SBI) planning to sell its Non performing assets (NPAs) to Asset Reconstruction companies (ARCs) to the tune of Rs.5000 crore of its Rs.67.799 crore. And there is bound to be a mad rush to do this as all this has got to be done before the end of this fiscal, which is within the next 12-13 days. ARCs pay 5-10% of the total bad loans being bought I cash and the balance is in the form of security receipts.

The rush to bring down the NPAs, using such methods, is on account of the fast approaching deadline for the new RBI diktat to kick in.  Starting FY15, provisioning on the newly restructured account has been more than doubled from current 2% to 5% while old CDR accounts would be done in a phased manner till April 2015.  It has also stated that an account after restructuring would henceforth be treated as NPA.

NPAs are essentially bad loans or debt which borrowers have not bothered to repay;  so one could not help but wonder why on earth would someone want to buy these rotten apples or NPAs?   And that is what we will try to throw some light on today.

What are ARCs?

These are Asset Reconstruction Companies and as the name suggests, it is engaged in acquisition of NPAs from the banking system and resolving the assets acquired.  These are neither owned nor supported by the Govt. These ARCs are basically something like facilitators and they exist because there is a business opportunity even in distressed assets. They buy the NPAs and then try to unlock value and maximize returns to the investors. They do so by trying to restructure the distressed assets, either by formulating a CDR type package with the existing promoters or sell the business to strategic investors, who are willing to buy or see a potential in such assets. It is indeed something like buying old and dead goods and then recycling it, giving it some life and then putting it back on the block for sale. In short, refurbishing NPAs and then either reviving it or selling it is the business of ARCs.

How are these NPAs sold to the ARCs?

It is usually through an NPA auction by the aforesaid bank, with payment coming in either in cash or security receipts. As expected, the selling price of the NPAs put up by the bank is almost always much higher than the best bid price discovered through the auction process. The big grouse is that there is very little transparency in this auction. Banks do not offer any floor price but once they get the price, usually the highest bid from the ARCs, they go and negotiate with the borrower for a settlement and this underhand settling leads to the asset being withdrawn abruptly from the auction. This is how majority of the distressed assets are ‘sold’.

Why is it that banks have not taken to selling NPAs in a more vigorous manner?

Well, just as there is a laxity in credit history check, there is laxity in selling these NPAs too. The same ‘chalta hai’ attitude comes into play with banks becoming very lenient, especially with errant big companies, allowing them to instead opt for restructuring the stressed assets and thus increasing the burden further on the banking system. Some banks even offer fresh funds to beleaguered promoters to pay up the same bad loans! Thus despite a solution being at hand, banks prefer to work out solutions which eventually become problematic.

But banks opting for these routes too has a reason – if banks sell distressed assets to an ARC, it has to provide for the difference between the book value of the loan and the value at which it was sold to the ARC; this has to be shown immediately which impacts profits unlike its provisions on bad assets, which the bank can carry forward for few years, lessening the impact. Thus selling to ARCs is a last resort.

So is the money accrued from the sale of NPAs shown as profits in the bank books?

The rules have been tweaked and now banks are allowed to directly book the profit or sale of a bad asset to an ARC in the profit or loss account and not a separate account.

What about the Security Receipts? What do they actually do?

Referred to as SRs, suppose the ARC needs Rs.100 crore to buy a NPA, it will issue SRs worth Rs.100 crore. When the ARC puts up the asset for sale, it will get Rs.100 crore from the buyer, which it will in turn give to the bank as cash. They are not like a bond or debenture and do not carry any coupon/interest rate.  SRs are thus issued to banks pending recovery from an account and encashed by the bank once loan is recovered. shed after the loan is recovered. On the other hand, when book value is higher than sale value, RBI has stated that the shortfall can be spread over a period of two years, available for NPAs sold up to March 31, 2015.

There is the 5:95 rule which many in the ARC sector needs a relook as under this RBI stipulation, the ARC needs to subscribe to 5% of the SRs issued by them for the NPAs while banks will subscribe to the balance 95%.

Once the ARC buys the NPAs, do they show as bad loans in their books?

ARCs can buy the bad loans either directly or through a trust. Of the 14 ARCs in India, 98% of the acquired assets are through the trust structure, which means ARCs do not own the assets but they only manage the assets held by the trust. Thus their books do not show the NPAs but RBI has stipulated that when ARCs do not recover the assets with the given time frame, it has to be shown as  NPA is the ARCs books and that means no management fee for the ARC.

ARCs are essentially partners of the banks and both need to work hand-in-hand to help clean-up and strengthen the system. The step taken by SBI is excellent and other banks will also follow suit. Some Rs.43,000 crore of bad loans are expected to be sold to ARCs  before the end of this fiscal. The total bad assets is the Indian banking system is currently at 4.1% of the total advances. And if ARCs can help clean-up, more power to the ARCs!