Consumer Protection Act, 2019

Asset Reconstruction Company: Need and Challenges

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Asset Reconstruction Company

Asset Reconstruction Company (ARC) is a specialized financial institution that buys the Non-Performing Assets (NPAs) from banks and financial institutions. It helps banks in cleaning up their balance sheets by buying their bad loans.

Thus, it helps banks to concentrate on normal banking activities. Banks, instead of going after the defaulters, can focus on selling their bad assets to the ARCs at a mutually agreed value.

Key Points:

  • ARC is a company registered under the Companies Act and registered with Reserve Bank of India under section 3 of The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
  • Securitization refers to the conversion of loans such as auto, house, credit cards, etc. of banks and lenders into debt instruments.
  • Legal basis of an ARC: SARFAESI Act provides the legal basis of setting up an Asset Reconstruction Company (ARC) in India
  • Regulation: ARCs are regulated by RBI as a Non-Banking Financial Company [NBFC] (under RBI Act, 1934). They function under the supervision and control of the Reserve Bank of India (RBI)
  • 100% foreign direct investment (FDI) in asset reconstruction companies (ARCs) under the automatic route.
  • ARCs are not permitted to undertake lending activities. They can only do securitization and reconstruction activities.
  • One ARC can be a sponsor or investor in another ARC or it can acquire debt from another ARC.

Asset means a useful thing or an item of property owned by a person or company, regarded as having value.So, for a bank, an asset would be anything that it owns or anything that it loans out. For eg:

  • Cash in bank’s vaults
  • Interest on loans (this forms a major part of bank’s assets)
  • Physical assets like branch buildings, computer systems, furniture, etc.
  • Investment in government securities like bonds etc.

Non-Performing Asset (NPA) is a loan or advance for which the principal or interest payment is overdue for a period of 90 days.

Banks are required to classify NPAs further into the following categories:

  • Substandard assets: Assets which have remained NPA for a period less than or equal to 12 months.
  • Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
  • Loss assets: A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection. Such an asset is considered uncollectible and of little value. Although it’s not written off completely as it might still be of some recovery value.

Asset Reconstruction:SARFAESI Act defines ‘asset reconstruction’ as the acquisition of any right or interest of the bank by a reconstruction company.

About ARCs:

  • As per the SARFAESI Act, ARCs should have a minimum net owned funds of Rs. 100 Cr.
  • The ARCs also have to maintain a capital adequacy ratio (CAR) of 15% of its risk-weighted assets.
  • CAR is a measure of how much capital a bank has available. It is also known as Capital to Risk (Weighted) Assets Ratio (CRAR).
  • Regulatory authorities monitor this ratio to see if any banks are at risk of failure.
  • A high CAR indicates that a bank has an adequate amount of capital to deal with unexpected losses.
  • A lower CAR means a bank is at a higher risk of failure.

Background:

  • The origin of ARCs is normally credited to a 1991 report on financial sector reforms by a panel chaired by former RBI governor M. Narasimham. Accounting policies of the banking system until the 1990s didn’t include any norms for setting aside funds against bad loans.
  • RBI released its first set of norms to classify bad loans, or non-performing assets (NPAs), in October 1990. It led to a pile of bad loans in most public sector banks and development financial institutions were unearthed.
  • The Narasimham panel recommended the establishment of an asset reconstruction fund or asset reconstruction company to flush bad loans out of the system.
  • Establishment of BIFR: The Board for Industrial and Financial Reconstruction, as a part of the Department of Financial Services of the Ministry of Finance, was set up in January 1987. Its objective was to determine the sickness of industrial companies and to assist in reviving those that may be viable and shutting down the others.
  • BIFR was dissolved in 2016 and all of its proceedings were referred to NCLT and NCLAT as per provisions of the Insolvency and Bankruptcy Code (IBC)
  • Establishment of DRTs: BIFR showed little success in tackling industrial sickness. That and delays in winding-up procedures led to the establishment of debt recovery tribunals (DRTs). The objective was a speedy recovery of money from defaulters who had borrowed from banks and financial institutions. But DRTs, too, could not speed up the recovery procedures in most cases as they lacked sufficient judicial experience. This resulted in a lot of pending cases.
  • Hence, ARCs were set up to enable faster recovery without the intervention of the court.
  • ARCs set up under SARFAESI Act: The government eventually passed the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, clearing the stage for setting up ARCs that could buy bad assets from Indian banks and financial institutions.

Functions of an Asset Reconstruction Company (ARC):

  • Acquisition of financial assets
  • Change or takeover of Management / Sale or Lease of Business of the Borrower
  • Rescheduling of Debts
  • Enforcement of Security Interest
  • Settlement of dues payable by the borrower

What are the resolution strategies that an ARC can employ?

As per the SARFAESI Act, an ARC can:

  • Restructure or reschedule the loan
  • Enter into settlements,
  • sell or lease the borrower’s business,
  • takeover or change the management, and
  • Also, engage in security interest enforcement (sell, take possession, or lease the owned asset).
  • But enforcement or security interest can only be conducted when at least 75% of secured creditors and the ARC are in agreement.

Sources of funds for an Asset Reconstruction Company:

  • Bonds
  • Debentures, and
  • Security Receipts (SRs)

Challenges faced by ARCs

    • Lack of funding: Indian ARCs have been private sector entities registered with the Reserve Bank. Public sector AMCs in other countries have often enjoyed easy access to government funding or government-backed. Capital constraints have often been highlighted as an area of concern for ARCs in India
    • Lack of consensus on the ‘right’ price at which banks should sell bad loans to ARCs
  • Constant regulatory interventions
  • Flawed model: Such low recovery is also a likely outcome of a resolution model heavily dependent on collateral disposal rather than genuine business turnarounds
    • Collateral is any property or asset that is given by a borrower to a lender in order to secure a loan

Need to do:

  • Solving the capital constraints:The present requirement of 15% investment by ARCs themselves which was not in the SARFAESI Act and was added in 2014, should be done away with.
  • Besides, it will align with the government’s FIPB Guidelines of 2016, permitting 100% investment by FPIs in SRs issued by ARCs (so no investment by ARC is required, as per the government’s Guidelines).
  • Allow bank/market borrowing by ARCs similar to NBFCs
  • SARFAESI allows ARCs to acquire debt only. For effective resolution- debt and equity have to work together. ARCs should be allowed to take part in the equity of a stressed company directly. ARCs may be freely permitted to take an equity stake in companies within the IBC resolution framework.
  • Loan product for ARCs: In a paper ‘Framework for revitalising Distressed Assets in the Economy in January 2014, RBI had suggested allowing banks to extend finance to ‘specialised’ entities put together for the acquisition of troubled companies. ARCs should have a standardised loan product so that they can finance the acquisition and resolution of stressed assets
  • A standing committee on the ARC sector should be formed which should meet quarterly to take stock of the developments and ways to improve the functional effectiveness of ARCs.

Conclusion:

Asset Reconstruction Companies (ARC) have more than two decades of experience in the resolution of stressed assets in India. We should leverage this capacity to the fullest. By tweaking some regulations, ARCs can become a potent solution to the growing crisis of NPAs