Asset Reconstruction: Time for Pro-active Action by RBI
The assumption that 15:85 structure would enhance ARC’s cash commitment is erroneous. RBI needs to urgently allow banks' provisioning, resulting from sale of assets to ARCs, to be spread over three years as against two years
 
The 15:85 structure introduced by Reserve Bank of India (RBI) in August 2014 raising asset reconstruction companies (ARCs) minimum Security Receipts (SR) subscription to 15% of the cost of acquisition of non-performing assets (NPAs) from banks was designed to enhance cash commitments by ARCs. The underlying assumption was that the acquisition cost was sacrosanct, and with 15:85 structure, the ARCs’ 15% investment in the acquisition would mean “skin in the game” for ARCs. 
 
Was the assumption correct? The returns to ARCs, and banks under the 5:95 and 15:85 structures were based on the assumption that the acquisition cost, management fee, upside sharing, ARC’s required return, expenses, and back-ended recovery profiles are the same for a portfolio over a 5-year horizon.
 
 
Over a five-year horizon, with back-ended recovery profile, the ARCs internal rate of return (IRR) in 5:95 structure varies between about 20% to 50% for recovery ratios of 30% and 150%, respectively (line “AB”). However, in 15:85 structure, the ARC’s IRR varies between around minus 13% to 21% for the same recovery levels (line “CD”). Hence pricing of the portfolios under 15:85 and 5:95 structures cannot be the same. Assuming that in the above scenarios, if the required IRR of the ARC is 20%, the acquisition cost works out to 2.88 times the estimated recovery under 5:95 structure due to management fee exceeding ARC’s investment, and only 0.68 times under the 15:85 structure due to limited impact of management fee. 
 
However over the same time horizon if the recovery is front-ended, for the same 20% IRR, the ARC will price the portfolio at 2.32 times and 0.80 times under 5:95 and 15:85 structures, respectively. As a result, contrary to the expectations of the banks, under 15:85 structure, ARC’s cash investment is lower than in 5:95 structure for the same portfolio. Thus the assumption that 15:85 structure would enhance ARCs’ cash commitment was erroneous. This is logical since recovery from a portfolio is independent of the structures adopted.
 
In a 15:85 structure, even with a recovery ratio 100%, the ARCs’ return is less than 8% with back-ended recovery. Hence with a target return of 15-20%, the portfolio pricing by ARCs ensures 100% redemption of SRs with likely upside share -- unlike in 5:95 structure, which sees loss in SR value over years. However, pricing in 15:85 structure also tends to cause notional losses to the banks when the asset sale price being lower than net debt outstanding. If such notional loss exceeds the normal provisioning during the year of sale, the banks have no incentive to sell the asset to ARC, particularly the new NPAs and Special Mention Accounts (SMA). In other words, the 15:85 structure results in front-ending of the provisioning by the banks whereas 5:95 structure resulted in back-ending of the same. 
 
Interestingly the banks’ IRR remains almost unchanged in both the structures (line "EF") confirming that the 15:85 structure cannot offer any advantage to the banks. This has not been comprehended by the banks who have been fixing reserve prices at the levels, which leave nothing for the ARCs. Consequently, acquisitions by ARCs have shrunk drastically. Out of about 94,000 put for sale by the banks, in FY-2015, the ARCs acquired only about Rs20,000 crore with major acquisitions done prior to introduction of 15:85 structure.
 
In sum, ARCs impinge cost on the banks by virtue of returns required from investment in risk-proven assets. The banks, therefore, need to accept this cost and weigh it against the benefit of freeing large manpower for productive asset building. Nevertheless, the banks’ anxiety to avoid additional provisioning at a time when the profitability is under stress is understandable. This needs to be urgently addressed by RBI by allowing the banks’ provisioning resulting from sale to ARCs to be spread over three years as against two years permitted now. Further, this facility should be extended for four years so that banks are enabled to offload major part NPAs to the ARCs.
 
Need for pro-active action
As on 31 March 2015, of the total SRs outstanding of Rs61,364 crore, while ARC held SRs of Rs8,819 crore (14.4%), the banks held SRs of Rs50,305 crore (82%). Holding by qualified institutional buyers (QIBs) and foreign institutional investors (FIIs) was low at Rs2,120 crore (3.4%) and Rs120 crore (0.2%), respectively. Redemption of existing SRs has been an issue with cumulative redemptions being low at 22-25% till May 2015 (ASSOCHAM / CRISIL). It has to be recognized that the portfolios acquired under now defunct 5:95 structure will generally result in part SR redemption. 
 
Alternate models with incentive for recovery under 15:85 structure will not raise ARCs’ bids significantly. For ARCs’ bids in 15:85 structure to equal the same in 5:95 structure, banks will have to raise the management fee to over 5%, which is not feasible as it will invite swift regulatory action. Hence acceptance of ARCs’ highest bids under 15:85 structure by the banks is the best way forward as it results in efficient price discovery and releases SRs with 100% redemption characteristic, with likely upside distribution. Such SRs might also generate premium, improve the demand for SRs and provide a market for profitable exit to the SR holders. It is time RBI took a pro-active action and rationalized provisioning norms for banks for NPA sale to the ARCs. This will also help the ARCs to grow by attracting capital and enable them to acquire even SMA assets for reconstruction.
 
(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)
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    COMMENTS

    Ashish Shah

    4 years ago

    The author has made an excellent analysis to clarify the misunderstanding of banks that 15:85 structure gives better returns. ARCs play an important role in allowing banks to free up their resources, however banks need longer time to make provisions. Therefore, it would be a win win for all if RBI gives longer time for provisions to banks and revert to 5:95 structure.

    Ramesh Kubde

    4 years ago

    The author has rightly stated that the RBI and banks are unable to comprehend full impact of 15:85 structure. This is very much evident from the poor response from ARCs to the auction sale. Therefore, there is an urgent need for RBI to intervene in the matter and find a solution to this impasse. Thanks to author for bringing in much needed clarity to the subject.

    Sanjay kumar

    4 years ago

    Very good insight into sale of assets to ARC and it's dynamics . Agree with Mr. Ganatra views on elongating the provision for 3 years as it will incentivise the Bank to clean up the Balance sheet .

    Nagraj Rao

    4 years ago

    Mr.Ganatra has pragmatically explained with well illustrated graphic that the current structure of 15:85 has drawback clearly seen by ARC's minimum participation in the acquisition of Bank's NPA's. The article also focuses on the measure which it suggests will be appropriate to address it.Now banks have to work on it.

    Sunil Karunakaran

    4 years ago

    Once again the author gives a lucid account supported by graphic illustration of the reasons for the poor off-take of NPAS by ARCs from banks post the regulatory changes from a 5:95 structure to 15:85 structure along with suggested measures to remedy the situation.

    Economy & Nation   Exclusive
    Asset quality of PSBs set to worsen
    New norms of provisioning with effect from the beginning of this year will affect the profitability of banks further
     
    The Financial Stability Report (FSR) of June 2015 released by Reserve Bank of India (RBI) last week says that the Indian economy is resilient but there is no room for complacency due to the continued uncertainty over global growth and absence of effective international monetary policy coordination.
     
    On the domestic banking sector the report says: “while risks to the banking sector have moderated marginally since September 2014, concerns remain over the continued weakness in asset quality indicated by the rising trend in stressed advances ratio of scheduled commercial banks (SCBs), especially of public sector banks (PSBs).”  
     
    It further states that the macro stress tests suggest that current deterioration in the asset quality of banks may continue for few more quarters, and PSBs may have to bolster their provisions for credit risk from present levels, to meet the ‘expected losses’ if macroeconomic environment were to deteriorate under assumed stress scenarios.  
     
    The RBI further says that this assessment of the banking sector by the FSR reflects the collective assessment of the Sub-Committee of the Financial Stability and Development Council (FSDC) on risks to financial stability. But the report unfortunately does not spell out any concrete steps to improve the situation, except to say that the policy initiatives for improving the governance and management processes at public sector banks become significant.  
     
    Asset Quality of banks:
    The present level of both non-performing and restructured assets of public sector banks are quite high (see Charts below) and they are expected to worsen further before any improvement is expected as stated in the report.
    The gross non-performing advances (GNPAs) of SCBs as percentage of gross advances increased to 4.6% as on 31 March 2015. The restructured standard advances during the period also increased, pushing up the SCBs’ stressed advances to 11.1%. PSBs recorded the highest level of stressed assets at 13.5% of total advances as of March 2015, compared to 4.6% in the case of private sector banks (PVBs). 
    The following charts sourced from the RBI’s Financial Stability Report clearly brings out the steep deteriorating NPA position both at the gross and the net level for PSBs from March, 2011 to March, 2015. 
     
    (PSBs = Public Sector banks. PVBs= Private Sector Banks. FBs = Foreign banks. 
    GNPA = Gross Non-performing Assets.  NNPA = Net Non-performing Assets.) 
     
    Capital Requirements of PSBs:
    As per the latest estimate, PSBs in India require additional equity capital to the tune of Rs2.4 lakh crore by 2018 to meet Basel III norms as ordained by RBI. And during the current financial year PSBs were looking to raise over Rs21,000 crore from the capital market as the Government has allocated only a sum of Rs7,940 crore for this purpose in the current year’s budget. The Finance Secretary, however, announced last week that the government is proposing to inject Rs11,500 crore in addition to the earlier budgeted amount during the current year.  And as per media reports, the Finance Ministry has now asked banks to explore innovative strategies to attract investors for their future stake sale.
     
    How do you attract investors for subscribing to bank shares? There is only one obvious factor that determines the interest of investors in share investment and that is company’s performance.  It is a well known fact that investors will come flocking to you if you show continued improvement in the performance quarter after quarter. Due to the subdued performance of PSBs during the last three years, their performance in the stock market has also been impacted and most of the PSBs have very low valuations in spite of majority ownership resting with the central government.
     
    The following chart shows the relative performance of SCBs during 2012-2014. 
     
     
    Perceptible fall in net profits impacting growth:
    Despite a few relaxations in provisioning requirements by RBI, most of the public sector banks have been showing fall in their net profits and three of the PSBs have for the first time declared net loss for the fourth quarter of last financial year. With the introduction of new norms of provisioning for restructured accounts with effect from the beginning of this year, and with banks having to make more provisions for restructured accounts, profitability of banks will be further impacted putting pressure on the banks to raise more  capital from the market. This again is constrained by the fact that government is required to hold a minimum of 51% of the share capital of every public sector bank, with little leeway available to raise capital from the market. What is adding insult to injury is the poor valuation of these banks at the bourses, putting the public sector banks in a bind of helplessness that will ultimately affect their growth due to their inability to fund the growing needs of the economy. 
     
    This should open the eyes of the powers that be to ensure that the public sector banks are not left high and dry, but out of the box solutions are found to improve the functioning of these banks to make them more agile, more competitive and more profitable to enable them to stand on their own legs without depending too much on the tax payers’ money to boost their capital requirements in the coming years. The future looks challenging for the banking industry and the government has a tough task in hand to meet these challenges.
     
     (The author is the financial analyst writing for Moneylife under the pen-name ‘Gurpur)
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    COMMENTS

    Mahesh S Bhatt

    4 years ago

    Await great Indian Banking meltdown.All media is raking revenues advertising 8000 plus crores ( last years number) from Real Estate Sales.

    But Real Estate is not so real with lot of Gas/huge inventories saleable over 55 months /political parking of investments/ghost towns across India.

    God Bless Rajan & Company one day he says Global recession few days later he says he was misquoted( good guy with bad company gets corrupted).

    Mahesh

    manoharlalsharma

    4 years ago

    Asset quality of PSBs set to worsen./its' an STYLE to do an age old INDIAN-GOVERNANCE it was the matter with UTI and even IDBI/IFCI but nothing done to PREVENT whoever comes to sitting as GOVERNMENT can not survive without

    SuchindranathAiyerS

    4 years ago

    To expect decades of loot to be written off in a few years is a pipe dream. Even if Government loots the temples to write off its deficit and injects fresh capital into its private coffers also known as "Banks". The Indian Republic's Constitution that enshrines inequality under the law, exceptions to the rule of law and "Many Nations Theory" provided a suitable or "Animal Farm" framework for plundering other people's wealth and opportunities for a select neo aristocracy or, kleptocracy. This enjoyment of other people's wealth began with deficit financing of Government profligacy and corruption as well as with the nationalization of temples in 1959 and did not not culminate in 2012 with "Retrospective" laws and the nationalization of 20% of non Christian and non Moslem private education. The 1969 nationalization of banks widened the scope for plunder of public wealth for the personal pelf, pomp, pleasure, perversions and perpetuation of India's Neta-Babu-Cop-Milard-Crony-Vote Bank Kleptocracy.

    Gopalakrishnan T V

    4 years ago

    The PSBs assets both human resources and business assets need a total review and call for out of the box solution to make them perform. Right from Board level to the last grade of staff they require training, knowledge up gradation,skill development and interpersonal relationship improvement. Involvement and commitment are essential to ensure quality performance. On the business side, ALM needs drastic quality approach and the cost of funds has to be brought down considerably. The costs on account of NPAs have to be reduced and this cannot be cross subsidised by the depositors and other stakeholders. The management of assets particularly credit and cash requires fine tuning and a lot needs to be done to improve the credit appraisal, credit recovery, fast recycling of funds, lower costs on account of inspection, insurance, legal costs and maintenance of assets.Window dressing of assets and hiding bad loans with all possible ingenuity presently resorted by the banks has to be forcefully avoided. Action is what is called for and not rising expectations and hopes by words sounding very high optimism.

    ICICI Bank reduces base rate; others expected to follow
    Days after the government urged banks to cut interest rates in line with the apex bank's earlier monetary policy easing, the country's leading private sector lender ICICI Bank on Thursday announced a reduction of 0.05 percent in its base rate.
     
    According to the bank, the reduction in the "ICICI Bank Base Rate" (I-Base) will come into effect from Friday June 26. 
     
    "The revised rate will be 9.70 percent per annum as against 9.75 percent at present. With effect from July 1, 2010, interest rates on new loans and advances, including consumer loans, are determined with reference to I-Base," the bank was quoted in statement. 
     
    During April major lending firms had reduced home loan rates after the Reserve Bank of India (RBI) had asked them to transmit the benefit of past policy rate-cuts to consumers.
     
    The reserve bank and the government are concerned that the three repurchase rate cuts in January, March and June have not been transmitted by banks to consumers.
     
    The RBI has reduced the repo rate, at which it lends to commercial banks, by 0.75 percent in three trenches.
     
    The repurchase rate is the interest commercial banks pay for borrowing money from the central bank to meet short-term fund requirements. The reverse repurchase rate is the interest central bank pays when surplus short-term funds are parked with it by commercial banks.
     
    Currently, the repurchase rate and reserve repurchase rate have been maintained at 7.5 percent and 6.5 percent respectively.
     
    Commercial banks have been reluctant to lower their base rates, or minimum lending rates, citing high cost of deposits.
     
    Another major reason for banks' reluctance stems from the fact that most of them are burdened by enormous non-performing assets (NPAs) in the form of bad loans to finance infrastructure projects.
     
    On June 12, Finance Minister Arun Jaitley meet with bank chiefs and discussed the transmission of rate cuts by the lenders.
     
    Jaitley expressed hope that banks will be able to further lower lending rates following a series of rate cuts
     
    State Bank of India (SBI) has lowered its base rate by 30 basis points this year, it's base rate stands at 9.70 percent.
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