Recent deals to acquire stressed assets from banks have put the spotlight back on a category of institutions that make money by turning around or recovering such dud assets. Mint reported last month about how asset reconstruction companies (ARCs) are capitalising on the opportunity to acquire written-off loans. Mint takes a closer look at ARCs and how they make money.
What are ARCs?
Banks and non-bank lenders use asset reconstruction companies (ARCs) to clear their balance sheet of non-performing assets. Empowered by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, these institutions act as focussed recovery and turnaround specialists that buy bad debt and pay either in cash or a mix of cash and security receipts. The set up is beneficial to lenders, who can spend fewer man hours on recovery and focus on fresh loans. As of 31 July 2022, there were 29 ARCs registered with the Reserve Bank of India (RBI).
What is their business model?
Lenders sell stressed loans to ARCs at a discount. Unless the transaction is entirely in cash, the ARC issues security receipts that are redeemable as and when it recovers the specific loan. ARCs also charge bad-loan sellers a management fee of 1.5% to 2% of the value of the asset every year. That apart, they earn from the recoveries made, and upsides are shared with the selling bank or non-banking financial company (NBFC).
How have they performed so far?
In November 2021 a central bank committee on ARCs said their performance has been lacklustre in terms of recovering assets and reviving businesses. It said banks and others could recover only about 14.29% of the amount owed by borrowers in stressed assets sold to ARCs from FY04 to FY13.
However, the committee ascribed this performance to the sale of vintage NPAs to ARCs, the inability to aggregate debt from all lenders to the same borrower, the lack of additional funding for stressed borrowers, and the ARCs’ difficulty in raising funds on their balance sheet, among other things.
According to the RBI’s latest Report on Trends and Progress of Banking in India, released in December, sales of stressed assets to ARCs have gradually decreased over the years. In 2021-22, only 3.2% of the previous year’s gross NPAs were sold to ARCs.
What are some of the recent changes RBI has made to ARC regulations?
Based on the recommendations of the committee on ARCs RBI issued revised guidelines for ARCs in October. As part of its plan to strengthen corporate governance at ARCs, RBI mandated that the chair of the board and at least half the directors in a board meeting must be independent directors.
To increase transparency, the RBI said ARCs must disclose their track record on returns generated for the security receipt investors, and engagement with ratings agencies of schemes floated in the last eight years, among others.
ARCs must also invest in security receipts at a minimum of either 15% of transferors’ investment in such receipts or 2.5% of the total receipts issued, whichever is higher, as against the previous requirement of 15% of total security receipts in all cases.