1. Asset reconstruction companies: Distressed loan buyers muddy bad debt picture

Asset reconstruction companies: Distressed loan buyers muddy bad debt picture

Set up over a decade ago to absorb country's mountain of distressed loans, asset reconstruction companies (ARC) have done little to recover cash or relieve a debt-choked banking system.

By: | Updated: December 23, 2015 3:31 PM

Set up over a decade ago to absorb country’s mountain of distressed loans, asset reconstruction companies (ARC) have done little to recover cash or relieve a debt-choked banking system.

Instead, at a time when regulators are pressing the banking sector to clean up balance sheets, the so-called ARCs are striking mostly paper deals that help lenders extend provisioning by years, camouflaging the scale of their woes.

“Banks are the risk takers of last resort. It’s a vessel that contains all the risk and it has no outlet – that is a problem,” said Harsh Vardhan, partner with Bain & Co.

“You have to create an outlet which allows at least part of the risk to flow to ARCs.”

RBI has set a clean-up target for the banking sector of March 2017, and has already started cutting off what it calls “forbearance”, a sort of benevolent regulatory tolerance, when it comes to bad debts and provisioning.

That has placed under close scrutiny any measures or tools seen to allow extra wriggle room for banks.

That includes the ARCs, originally designed to foster a much-needed market for distressed debt in India, critical to lowering the cost of capital and boosting investment. The market remains in its infancy, as even ARCs face restrictions on selling on bad loans.

ARCs make money from management fees and recoveries. They typically pay 15 percent of the loan purchase price in cash, with the rest funded by IOUs issued to the bank. The required cash portion was increased by the central bank last year from an initial 5 percent, in an effort to make ARCs more accountable and control a spurt of overpriced bad loan sales.

As the bank finances 85 percent of the deal, the risk remains with the bank – in its investment portfolio rather than its loan book – a fact that also encourages lenders not to take a hit to book value when selling loans.

At the same time, ARCs themselves have been choked by restrictive ownership rules that have made them less attractive investments, and kept them poorly capitalised. Their assets under management more than a decade after they were created amount to a paltry $8.3 billion, less than 10 percent of India’s over $110 billion stressed loan mountain.

“DELAYED PROVISIONING”

If little is recovered from the errant borrowers, ARCs will struggle to make a return on their investment.

But banks, who have already moved the loans off their main books, will have been allowed a period of up to eight years to write them down: attractive for the bosses of India’s state-run banks who rarely stay longer than three years and have little incentive to take the pain.

“(Under) normal provisioning norms … within a four-year period you have to write off an entire (non-performing) asset,” said Anjali Sharma, who works with the Finance Research Group at Mumbai’s Indira Gandhi Institute of Development Research, which worked on India’s new bankruptcy code.

“If you sell it to an ARC and you invest in the security receipt of that same asset, you can get a much longer period to write it off. It enables delayed provisioning on banks’ books.”

ARCs, stung by regulatory demands for higher cash payments upfront, say they can no longer afford what Birendra Kumar, chief executive of International Asset Reconstruction Co, called “the luxury of accruing management fees to eternity”, and are being more careful.

Kumar, whose backers include KKR & Co LP, estimated 400 billion to 500 billion rupees ($6 billion to $7.54 billion) of bad debt was brought to auction by banks between April and December: “I don’t think more than 15 pct will have been sold.”

That’s bad news for lenders and India’s central bank, which this month said it would encourage more foreign investment into ARCs – but is struggling to get banks to take the hit of a correctly priced loan sale.

Arcil, the oldest ARC, reports an internal rate of return of “low single digits” – too low to secure a sustainable profit.

“It’s just that what is being traded in the market is being looked at with two different pairs of eyes,” said Vinayak Bahuguna, chief executive at Arcil.

ARCs have, of course, been able to recover debt from some companies.

“Despite this, we believe that the recovery experience has been below the expected potential of the industry,” said Pawan Agrawal, chief analytical officer at Crisil.

(Reporting by Devidutta Tripathy; Editing by Sam Holmes)”

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