ARC fees: RBI restores sanity
RBI has replaced the 5:95 model with 15:85. Can something be done to retain the current cost structure for ARCs and mitigate the management-fee driven model? Here are the options
Stung by the aggressive management-fee based model adopted by Asset Reconstruction Companies (ARC), Reserve Bank of India (RBI), on August 5, 2014, has disbanded popular 5:95 model by enhancing ARC’s minimum Security Receipt (SR) subscription to 15%. In the 5:95 model, ARCs could fund their NPA acquisition by issuing Security Receipts (SRs) to the seller banks for up to 95% of NPA acquisition cost, with a minimum of 5% of the SRs being funded in cash by the ARCs. The management fee that was earlier linked to the outstanding SR value has now been linked with the lower end of the Net Asset Value (NAV) of SR based on the credit rating. What will be the impact of the new 15:85 model? See the graph below.
The 5:95 model with back-ended recovery profile gave attractive returns to the ARCs for different levels of recovery (30% to 110% of acquisition cost) from 21% (pre-tax Internal Rate of Return) to 32% over 5-year resolution horizon. For the same recovery range, the 15:85 model delivers poor returns, ranging from -11% to 10%. In order to match the 5:95 returns, the acquisition costs have to be substantially lower, ranging from 17% to 37% of the 5:95 acquisition cost. For a modest 20% return in the above range, the acquisition cost has to be 18-66% of the 5:95 acquisition cost. What do we infer from this?
First, correlation between acquisition cost and recovery has been restored. The ARCs will have to assess recovery prospects carefully. Even for a modest 15% return, with back-ended recovery profile, ARCs will  have to clock total recovery of app. 135%. As we have seen earlier, for recovery beyond acquisition cost, front ended recovery is most beneficial to the ARCs. Hence for enhancing returns, ARCs will have to speed up the recovery process.
Second, in 15:85 structure, probability of SR write off and back-ended provisioning by the banks will tend to be zero. This will result from acquisitions by ARCs at realistic values, which would evidently entail immediate provisioning by the banks. The banks will now have to be bold to sell the portfolios notwithstanding immediate provisioning. The bank chiefs will no more be able to leave this unpleasant job to their successors.
Third, acquisition volumes will shrink. No wonder the RBI is considering licences for new entrants. Could something be done to retain the 5:95 structure and mitigate the management-fee driven model? Yes. There are options.
Lower management fee: In the above model, with 5:95 structure, same returns as with 15:85 models are achieved if the management fee is reduced from 1.5% pa (on outstanding SRs) to app. 0.50% pa. The banks are aware of the impact of management fee, and have been allowing 2% management fee to attract aggressive bidding for certain portfolios.
Link the management fee to recovery: Equitable cash distribution is possible, if the management fee is linked to the actual recovery. The graph below shows that the management fee of 0.75% of the cash recovery with a back-ended recovery profile results in positive IRR to the ARC beyond 60% recovery, and a modest 16% IRR at 110% recovery, with no SR write off and loss to the banks. Linking the fee to actual recovery poses income recognition problems which can be resolved. 
The major challenge with the recovery model is the bid evaluation by banks. If the management fee is linked only to the recovery, what is the utility of the acquisition cost quoted by the ARCs? And how will the banks evaluate the bids? The conflict can be resolved easily by linking the recovery to the acquisition quote on the lines the private equity fund managers share the upsides. Even with 5:95 structure, the recovery based model can be designed sans the moral hazard with current 5:95 model. This model will do away with the need to determine NAV based on the subjective and often unrealistic credit rating needed in 15:85 structure, and will, therefore, be more scientific and cost efficient. It is expected that in due course, RBI will adopt this alternative recovery based fee model.
To sum up, the 15:85 structure is the right move but not final. ARCs will come into being only when the legal system is revamped as I mentioned earlier.
(Rajendra M Ganatra is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)



Prem Shinkar

3 years ago

Great & comprehensive assesment of the changes. Thankyou Sir.

Sunil Karunakaran

3 years ago

This simply gets better and better. The writer has very quickly assessed the likely impact of the recent changes by the regulator and more importantly even suggested better options for consideration. It will be interesting to see how things pan out.

G Sampath Kumar

3 years ago

A good move by RBI to increase the stake of ARCs in Security Receipts. The authour may indicate whether this move will lead to additional due diligence, more caution while bidding for portfolios by ARCs, consolidation of ARCs, etc.?

Ramesh Kubde

3 years ago

Both the articles of the author on ARCs are very informative and analytical. It gives insight to the working of ARCs as well explains the reasons for spurt in sell of NPAs by Banks to ARCs. Expects many more such thought provoking articles.
However, I do not agree with Mr.Gopalkrishnan's comments of collusion between Banks and ARCs in sell of NPAS. Such cases, if any would be an exception.

Ebola: WHO declares the epidemic as global emergency

US health authorities had admitted that Ebola's spread beyond west Africa was inevitable. Even medical charity Doctors Without Borders had warned that the deadly virus was now "out of control" with more than 60 outbreak hotspots


The World Health Organisation (WHO) on Friday declared the killer Ebola epidemic ravaging parts of west Africa as an international health emergency and appealed for global aid to help afflicted countries.


The decision after a two-day emergency session behind closed doors in Geneva means global travel restrictions may be put in place to halt its spread as the overall death toll nears 1,000.


The WHO move comes as US health authorities admitted that Ebola's spread beyond west Africa was "inevitable", and after medical charity Doctors Without Borders (MSF) warned that the deadly virus was now "out of control" with more than 60 outbreak hotspots.


WHO director Dr Margaret Chan appealed for greater international aid for the countries worst hit by the outbreak, which she described as the most serious in four decades, echoing an earlier claim by MSF that the "epidemic is unprecedented in terms of geographical distribution, people infected and deaths".


States of emergency were in effect across overwhelmed west African nations, including Liberia, Guinea and Sierra Leone.


Soldiers in Liberia's Grand Cape Mount province - one of the worst-affected areas - set up road blocks to limit travel to the capital Monrovia, as bodies reportedly lay unburied in the city's streets.


Two towns in the east of Sierra Leone, Kailahun and Kenema, where put under quarantine on Thursday, as nightclubs and entertainment venues across the country were ordered shut.


Public sector doctors in Nigeria suspended a month-long strike with fears rising that the virus is taking hold in sub- Saharan Africa's most populous country. The deadly disease has already killed two and infected five others in Lagos.


Ebola has claimed at least 932 lives and infected more than 1,700 people since breaking out in Guinea earlier this year, according to the WHO.


Ebola causes severe fever and, in the worst cases, unstoppable bleeding. It is transmitted through contact with bodily fluids, and people who live with or care for patients are most at risk.


First discovered in 1976 and named after a river in what is now the Democratic Republic of Congo, Ebola has killed around two-thirds of those infected, with two outbreaks registering fatality rates approaching 90%. The latest outbreak has a fatality rate of around 55%.


There is no specific treatment for the disease; efforts to help persons who are infected include giving either oral rehydration therapy (slightly sweet and salty water to drink) or intravenous fluids. The disease has high mortality rate: often killing between 50% and 90% of those infected with the virus, says Wikipedia.


Can Bitcoins remain unregulated?

While Bitcoin investors have been quick to revolt against regulations, the system reeks of a lack of transparency and Bitcoins have exhibited a characteristic typical of a highly speculative market


Bitcoin is a highly speculative and unregulated virtual instrument, which has been the subject of a global controversy since its genesis. Bitcoin was created by an anonymous hacker to facilitate decentralised online transactions using Bitcoins as a quasi currency.


Transactions in this system are made with no intermediaries, banks or regulatory agencies. Bitcoins are a completely decentralised form of money, which is not regulated or issued by any government. To classify Bitcoins as a virtual currency is wrong. It is an undefined virtual exchange without any economically or empirically sound price discovery mechanism or rationalised process for generation.

Bitcoin has been created by cryptographic software running on a network of volunteers’ computers, making the system both hard to track, and decentralised to operate on exchange platforms set up in various jurisdictions, which results in regulatory issue in regulating of such a currency. Clearly, Bitcoins do not fit the legal definition of “money” that is a medium of exchange authorised or adopted by a domestic or foreign government, whereas there exists no such central authority to govern Bitcoins. The promoters of Bitcoins have naively argued that the decentralised system ensures that there is no control dependence on a particular centre of control. This also ensures that inter-jurisdictional regulation of Bitcoins is impossible.

Bitcoins have a striking and rather ominous similarity to the derivatives, which were designed to challenge the most financially literate investors. Since Bitcoins are neither stable in terms of price, nor underwritten by any government, they fail to serve as a virtual currency. Potential investors in Bitcoins are lured into ‘investing’ in Bitcoins merely by the promise of riding the speculative wave, which has incentivised by the skyrocketing price of Bitcoins.

Although the Bitcoin has been tremendously successful, it has been wildly volatile as the its value is pegged to the whim of investors and can only be assessed by speculation. The market value of the Bitcoin has exhibited a characteristic typical of a highly speculative market, starting with a rapid, parabolic jump to the top, followed by an inevitable crash. Bitcoins have continued to operate solely on the naïve trust of online purchasers who continue to purchase Bitcoins from Bitcoin miners, who generate Bitcoins.

In a press release, the Reserve Bank of India (RBI) has pointed out glaring issues with the virtual currencies, including Bitcoin and has raised concerns about the potential hazards of trading on an anonymous peer-to-peer basis without an authorised central agency, which regulates such payments.

Market manipulators could potentially inflate prices of the Bitcoin, and then offload their entire holdings, leading to a cataclysmic meltdown. Using a modus operandi similar to that of a Ponzi scheme, market manipulators could allow the Bitcoin bubble to grow till there is a critical mass of investors who have earned from the speculative trade and lure more investors into the scheme. What remains to be seen if the entire system collapses after a massive disposal of Bitcoins.

This concern has been underscored by the bankruptcy of Mt.Gox, the world’s largest Bitcoin exchange in 2013. The implosion was triggered when half a billion dollars worth of Bitcoins ‘disappeared’ triggering a mass withdrawal and raising allegations that the collapse was an orchestrated scheme. The price of Bitcoins on Mt.Gox eventually became completely disengaged from the wider Bitcoin market, and in the days leading to its collapse, the exchange’s total Bitcoin holdings were just at 2,000, while customer deposits totaled 6,24,408.

This highlights the fact that there is no established framework for Bitcoin users and investors to recover their investment in Bitcoins in the event of market manipulation or any economic offense for that matter. In the absence of regulators, the possibility of market rigging and price manipulation is a very real possibility.
This dilution of control has become a critical concern as the decentralisation could lead to serious jurisdictional issues when there is an attempt to regulate the currency is a serious regulatory challenge. The amorphous classification of the Bitcoin also raises concerns as to the actual value of the Bitcoin, which neither has any inherent value nor is it pegged to the value of any underlying asset or commodity.

Regulators around the world, including the US Securities and Exchange Commission (SEC) and Federal Bureau of Investigation (FBI) have been grappling with the jurisdictional issues due to the ambiguity of Bitcoins being a currency, a derivative and an investment contract. While Bitcoin investors have been quick to revolt against regulations, the system reeks of a lack of transparency in the asset structure, and any rationalised, empirical basis for the generation or appreciation in the value of the Bitcoin.

A critical issue that continues to plague regulators is this classification of Bitcoins. Since its value is not pegged to any underlying asset, it cannot be classified as a derivative. The incredible part about Bitcoins is that it does not qualify as a fiat currency since there is no central authority that issues Bitcoins. This raises concerns about the sustainability of Bitcoin, but since it is the first decentralised digital currency, perhaps a new regulatory framework needs to be set up to retrospectively regulate such instruments and prevent their misuse.

With the current rhetoric surrounding the legitimacy and classification of Bitcoins it may be prudent to desist from investing in an instrument which has the dubious distinction of being beyond regulatory purview in most countries.


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