ARCs: Boon for banks

After having witnessed a sharp rally in the last three months, banking stocks are now under pressure. Most of the banks declared strong FY02 performance despite having provided a huge amount for non-performing assets. The sector has been suffering with the bad quality of assets, which has also impacted the growth prospects.

To deal with the menace of bad loans, the government has set-up, Asset Reconstruction Company (India) Ltd. (ARCIL), which is expected to become operational soon. ARCIL would tackle the growing problem of non-performing assets (NPAs) on which banks are yielding no income. The company would buy NPAs from banks, securitise it and sell it to the potential investors. Thus helping banks to clean off their balance sheets and create new markets for debt instruments.

As per the current regulations, a loan is considered to be a non-performing if interest on the same is not received for over 180 days or repayment of the principal is doubtful. Currently, banks could lend more funds to borrowers to repay the past dues or interest payments. Thus falling into the vicious chain of refunding nonviable projects. An ARC could be seen as a solution to these problems, as it will establish a market for NPAs. For example bank A with NPAs of Rs 100 m, considers that only Rs 60 m are recoverable. If there is an institution, which recognizes that value of NPA of Rs 60 m is more than its worth, it buys this NPAs. Thus both buyer and seller (banks) are better off from this trade. Banks receives the cash immediately and buyer (ARC) gets premium for recovering these assets. Besides, it will also relieve banks from pressure of capital adequacy.

Government has established debt recovery tribunals (DRTs) to facilitate speedy recovery of funds to banks. In the current budget, it has also clubbed together three separate bills on foreclosure, securitisation and ARC into the Banking Sector Reforms Bill. The proposed bill is expected to help financial institutions and banks to pursue willful defaulters and recover dues through foreclosures. This is likely to augur well for banks and ARC.

ARCIL will have participation from both government and private companies. The government will hold an indirect 49% stake in ARC through 24.5% stake each from IDBI and SBI. The balance 51% will be with four new generation private sector banks, ICICI Bank (24.5%), HDFC Bank (10%), UTI Bank (8.3%) and IDBI Bank (8.3%). ARCIL will come under the regulatory ambit of Reserve Bank of India. It will also comply with SEBI norms while issuing securities to banks and FIs in exchange of assets

As far as the valuations are concerned at which ARCIL will buy these assets from banks, it is likely to be at a considerable discount. The banks will share risks with ARCIL and would be free to arrive at a negotiated discounted price for those assets. ARC would then transfer the asset to a trust, which would be responsible for realising the value of the asset by auctioning them. The trust is expected to operate on a no-profit, no-loss basis. Being a service company it is not expected to require large capital base. Consequently, it would be set-up with an investment of Rs 100 m.

The experience of Malaysia shows that the average discount rate applied has been nearly at 48%. If in India, assets of some of the ailing financial institutions were to be sold at such discount, it will create a hole in their balance sheet and lead to a problem of capital. Without re-capitalisation these institutions would find it difficult to operate and may not be forthcoming in selling their NPAs to ARC.

The proposed ARC is another significant move of the government after having helped create a vibrant debt market. However, ARCIL's success is highly linked to the pricing of NPAs. If managed well, the ARC is expected to clean-off NPAs worth over Rs 740 bn from banking system. Market valuations of PSU banks would also get re-rated once they clean off their balance sheets, as currently their valuations are depressed mainly due to concerns of high level of bad loans.