Regulatory oversight and supervision of ARCs need a revamp and, like other regulated entities, rogue ARCs should be punished
A December 14 late evening release by the income tax department has confirmed the worst fears of many in the Indian financial system on how some asset reconstruction companies (ARCs) function. Search and seizure operations at 60 premises of four ARCs have exposed the “unholy nexus” between the borrowers and the ARCs.
The four are accused of “unfair and fraudulent trade practices in acquiring” the stressed loans. The bad loans acquired by them were “far less” than the real value of the securities covering such loans. What’s more, the minimum cash the ARCs paid to the lenders for such loans — typically 15 per cent of the value — came from the defaulting borrowers! The money had been routed through several layers of dummy companies controlled by the borrowers or through hawala channels.
Not just the borrowers and the ARCs, lenders, too, cannot escape scrutiny. Other investigative agencies will surely join the Central Board of Direct Taxes to get to the bottom of yet another scam that will embarrass the Reserve Bank of India (RBI).
Against this backdrop, let’s take a close look at the recommendations of an RBI committee on ARCs, which have been in the business of buying bad loans and making money by recovering them. There are 28 of them — large, medium and small.
The recommendations range from the acquisition of financial assets to their resolution and restructuring; meeting the capital and funding requirements of the ARCs to deepen the market; liquidity and trading of the security receipts; transparency and governance; besides making legal and regulatory changes to strengthen their operations.
Let’s focus on a few of them.
The minimum capital required for an ARC sponsor is being increased from 10 to 20 per cent to ensure the infusion of capital from financially strong entities. Meanwhile, the minimum requirement of net owned funds is being raised from Rs 100 crore to Rs 200 crore. This should curb the tendency of some smaller ARCs to acquire financial assets by any means since they don’t have enough capital. Those ARCs that are unable to pump in capital within, say, two-three years could be asked to confine their business to retail and the micro, small and medium enterprises.
Allowing the ARCs to establish alternate investment funds (AIFs) is welcome since such funds would not only invest in security assets (SRs) but also provide them with the resources to revive sick but potentially viable companies.
The group of qualified buyers who can invest in SRs is being broadened by bringing in high net worth individuals, corporations, non-banking financial companies, housing finance companies, trusts, family offices and distressed asset funds. This will widen the investor pool and deepen the SR market but the rules and regulations must be crafted with care, leaving no scope for discretion.
Under the norms, ARCs must offer at least 15 per cent cash while buying the bad loans; the rest can come in the form of SRs. The ARCs themselves must subscribe to 15 per cent of SRs, increased in August 2014 from the earlier limit of 5 per cent.
The recommendation is to reduce the ARCs’ minimum investment in SRs from 15 per cent to 2.5 per cent where they have investors in their SRs. In other cases, the floor remains 15 per cent. This will arm the ARCs with additional resources to acquire bad loans, while the seller banks will get more cash.
The toughest task is the creation of a secondary market for SRs. This doesn’t exist primarily for two reasons: There is a mismatch in prices since most SRs are not backed by underlying securities; and the ARCs can only redeem the SRs issued by them to the extent that they are able to resolve the bad loans. The committee is in favour of banks fixing the reserve price for SRs. This will have an impact on the value of SRs and encourage the ARCs to resolve bad assets optimally.
There is also a recommendation for selling fraud-hit bad loans to the ARCs. Has this been done to bring in uniformity with the newly established National Asset Reconstruction Company? It is in the process of acquiring some of the banks’ large loans that have turned sour because of frauds. Aren’t the banks themselves better equipped to handle such accounts? Can the ARCs deal with the investigating agencies after acquiring such accounts?
Yet another interesting idea is to permit the ARCs to acquire stressed loans taken by borrowers from overseas banks and financial institutions, asset management companies, foreign portfolio investments and AIFs. The rise in the number of sellers of bad assets will facilitate debt aggregation, leading to an early resolution.
The panel wants the lenders to prepare a list of bad loans up for sale every year and share it with the ARCs. They should also give reasons why they are not selling all old bad loans and fix the reserve price of assets to be sold based on two external valuations in the case of large bad loans and one for small ones. Also, instead of the current norm of 75 per cent, the panel says if 66 per cent of the lenders agree to sell a bad asset to the ARCs, the offer will be binding on all others. Those who don’t agree will have to make full provisions for such a loan.
Here are some unsolicited suggestions:
Ideally, the management fee should be linked to the actual recovery/SR redemption instead of the net asset value, based on the ratings of the SRs. This will ensure that the earnings are based on recovery and not management fees alone.
The success of the business model depends on the lenders’ willingness to sell to the ARCs, following a laid down approach towards the identification, valuation and realistic reserve price, based on external valuations. Indeed, the panel has extensively dealt with these aspects but it would ultimately depend on whether the bankers are compelled to follow the norms.
The panel is silent on mandating the ARCs to have a board with at least 50 per cent independent directors meeting the RBI’s fit and proper criteria, not only for raising AIF but also for bringing in independent perspective in decision-making and monitoring performance.
Finally, why can’t we have a sunset clause for the ARCs, which is a global norm?
Even such a comprehensive review of the working of the ARCs will come to naught unless the unholy nexus between some ARCs and the borrowers/bankers is broken. The committee is silent on the wrong practices followed by some ARCs, denting the credibility of the sector. The regulatory oversight and supervision of ARCs need a revamp and, like other regulated entities, rogue ARCs should be punished. A committee cannot cover up the regulator’s failure on this count.The writer, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd
His latest book: Pandemonium: The Great Indian Banking Story
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