I mentioned in
my previous piece that asset overstatement by the borrowers can only compound banks' valuation bias and impede non-performing asset (NPA) sales.
The new guidelines by the Reserve Bank of India (RBI) have introduced "other banks, non-banking financial companies (NBFCs) and financial institutions (FIs) etc." also to bid for NPAs for “better price discovery”. There has been no bar on acquisition of bank debt by other banks and NBFCs, who must hold the securitized loans up to one year and meet minimum retention requirement of up to 10%. It is unclear whether these guidelines would apply to the banks or NBFCs acquiring non-performing assets (NPAs). Irrespective of this, migration to all-cash deals for NPA sale has put the ARCs to disadvantage due to significant regulatory constraints in raising equity and debt from the public, investment of surplus funds, the minimum stipulated security receipts (SRs) holdings, and the prior approvals for management and board changes.
While the ARCs cannot meet non-fund working capital needs of the operating assets, they are unable to meet fund-based requirements due to high cost of funds. Hence, ARCs restructure only the accounts whose working capital requirements are insignificant, and which attain viability with substantially reduced debt, something that is possible only when the NPAs are acquired at reasonable cost. Such accounts are rare, and over 90% of the NPAs acquired by the ARCs are liquidated piecemeal or settled out of court. The new entrants, particularly the private sector banks, will have advantage over ARCs since they will be able to fund full working capital requirement. However, this will apply only to a small percentage, and ARCs will continue to hold edge for assets getting liquidated.
The high level of NPAs and stressed assets of public sector banks’ aggregating 11.6% of gross advances as on March 2016 are not the result of market meltdown, but significant asset overstatement by the promoters and leniency of the banks. Sale of such assets at realistic prices to is a historical opportunity to spawn lean companies, which can be competitive and viable. It is not the dearth of capital, but lack of worthwhile acquisition opportunities that has stunted the market, and unless the regulation driven symptomic treatment gives way to transparent market driven price discovery for sale of NPAs, addition of new participants will not energise the market.
Consider the acquisition pricing of Asset reconstruction companies (ARC) under the 15:85 structure and all-cash over a resolution horizon of 1-5 years. They show wide variations (Graph-3). For a modest 20% pre-tax returns to ARCs, the bid price under 15:85 structure, varies from 69% to 93% of estimated recovery for resolution periods of 1-5 years (curve AB).
As all-cash acquisition entails higher risk premium, for a modest 25% return, the figures vary from 47% to 86% (curve EF). If the average recovery of 25.6% as observed by the World Bank is taken, the all-cash acquisition price for 25% returns varies from 12% to 22% of the loan outstanding (curve GH), and is comparable with the actual average NPA acquisition cost of 17.2% to 20.8% of loans outstanding during FY-2010 to FY-2013 (Graph-2). This validates the robustness of the market driven process for price discovery.
Delays destroying value
It is self-evident that the pricing of NPAs is impacted by the resolution period. Graph-2 shows that ARC’s acquisition price of NPA for the 20% return based two-year resolution period would be 68% higher than that based on five-year period. This happens since over years, the unused and underused asset suffers impairment in value. In other words, an efficient legal system delivers substantial value through speedy disposal. This has been demonstrated in UK also where the liquidation process gets concluded in less than one and a half years and delivers to the lenders, recovery of about 75% with recovery cost of 15% of the asset value. Speedy adjudication ensures productive use of the asset, apart from acting as disincentive for the defaulters.
In contrast, the average resolution period in India is five years. At present, there are over about 1.03 lakh cases pending in 33 DRTs under Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI) and SARFAESI Acts involving outstanding debt of about Rs4 lakh crore. The surest way to enhance the bid prices is to ensure that the legal adjudication is hastened. The economic gains will ensure that the payback period for the cost of efficient legal administration is negligible. The government, therefore, needs to match legislative reforms with speedy adjudication on a war-footing. Same approach should be adopted in setting up and operationalizing National Company Law Tribunals (NCLTs) for migration to Insolvency and Bankruptcy Code, lest the history repeats itself to the detriment of the banks.
Change or perish
Barring exceptions, ARCs worldwide (called asset management companies -AMCs) are special purpose vehicles, which are wound up after resolving NPAs emerging from economic meltdown. Perpetual ARCs are few, and constitute part of financial conglomerates such as Woori F&I and UAMCO in South Korea. Numerous stand-alone ARCs as in India cannot be sustained perpetually since no country can survive churning out high level of NPAs permanently. Thus, an evolutionary change in India’s ARC landscape was expected in course of time. The new RBI guidelines will hasten the change.
The SR structure used by ARCs is a risk-reward sharing structure in which ARC’s risk is 15% and seller bank’s risk is 85% of the value. While the ARC’s reward is entirely financial, the bank’s reward is less financial since it is happy with just SR redemption, and is not concerned with returns thereon as long as it can avoid further provisioning, and this has changed now. With migration to all-cash deals, the banks would be replaced by other investors as risk-reward sharing participants who would seek returns comparable with those of ARCs. This would become possible if the assets are bought at reasonable prices and returns are derived from value addition. Even if the new participants cannot adopt SR structure, they will be able to adopt tax transparent pass-through structures under the existing laws.
It is a matter of time before the NPA acquisition based on market driven pricing assume primacy since the economy cannot afford loss due to delay. ARCs have expertise in NPA management, and to survive and prosper, they will have to focus on restoring NPAs and deriving gains from value addition instead of acting as recovery specialists as hitherto. Efficient implementation of Insolvency and Bankruptcy code will hold key to the qualitative change in the landscape.
This is concluding part of a two part series.
(
Rajendra M Ganatra, PhD is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 26 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)
Arlington, Va,22204, USA.
banks need to revisit reserve price and respect cash deals by understanding time value for money
Risk Capital is plenty but only at a minimum return of 24%