Close on the heels of a new asset reconstruction company (ARC) to be set up by public sector banks, the Reserve Bank of India (RBI) has announced the formation of a high-level committee to review the working of existing ARCs. There are over a dozen ARCs in the private sector, though only 3-4 dominate the bad loan resolution business. The RBI-appointed committee would review the existing legal and regulatory framework, suggest measures to improve efficacy, study the role of ARCs in the resolution of stressed assets under Insolveny and Bankruptcy Code (IBC), and recommend ideas for improving liquidity and trading of security receipts (SRs). Let's take a look at the five big changes that are needed to strengthen the ARC framework in India.
Transformation from recovery agent of banks, NBFCs to resolution agent
The ARCs were set up under the the SARFAESI Act 2002 for bad loan resolution in the banking industry. They were designed to act as an agent for banks and NBFCs. The idea was to free up the institutions from the hassles of handling NPAs by setting up a specialised agency to restructure and resolve the loans. When ARCs were set up, they were considered to be a better recovery mechanism by virtue of being a specialised entity going after the defaulters and restructuring the loan or sale of assets. But a lot has changed in the last decade post the Insolvency and Bankruptcy Code (IBC). The Act governing the ARCs needs to be changed to give them more freedom and flexibility. "ARCs should acquire whichever assets in whichever form," says an expert.
Permitting acquisition of assets under investigations for fraud
The RBI doesn't allow ARCs to buy fraudulent loans from banks and NBFCs. In any bad loan, the chances of fraud are very high because of multiple borrowers. In fact, as the banks have started using forensic audits and more digital tools, the instances of fraud in corporate loans are on the rise. But the RBI's diktat comes in the way of ARCs buying such assets. Take, for instance, the Piramals' recent purchase of Dewan Housing Finance (DHFL), where auditors revealed several instances of fraud. 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. The SARFESI Act, which came much before IBC, is naturally silent. It may be pointed out that the RBI had turned down the application of an ARC some years ago to participate in the resolution of a failed telecom company as a resolution applicant. The ARC industry has been demanding amendments in the SARFESI Act. The IBC has been the most pathbreaking reform in the NPA resolution space. In 2019-20, the amount recovered as per cent of the amount involved under IBC was the highest at 45.5 per cent, followed by ARCs at 26 per cent.
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.
Redesigning the asset buying structure
Some eight years ago, the RBI had revised the 5:95 structure of sale of assets by banks to ARCs to 15:85 structure. This meant the ARCs' investment limit in security receipt was hiked to 15 per cent as against 5 per cent earlier. Under the new rule, the trust created by ARC for resolving bad loans is paying cash of 15 per cent of the value and the money is going to selling banks. The SRs are issued to banks for the remaining 85 per cent. The idea was to have more skin in the game. While ARCs earn management fee, the recovery rate or the redemption of SRs have been abysmal. There are also challenges for ARCs to protect their capital in the 15:85 structure if the assumed recovery doesn't happen.