Banks unwilling to offload bad assets to ARCs

While distressed assets and delinquent accounts continue to erode banks’ profitability, very few
favour offloading bad loans to asset reconstruction companies (ARCs)

Banks have been dealing with non-performing loan (NPL) recovery for quite some time now.
Tough economic conditions brought upon by the financial meltdown contributed to rising
NPL numbers of banks. The gross NPLs in the Indian banking system have increased about
22% from $12 billion in FY08 to $14 billion in FY09. However, instead of giving way to
opportunities for NPL sales, the impact of recession on pricing has only made it more
difficult to strike good deals with ARCs.
Banks are not selling bad loans to ARCs in good measure. The economic downturn marked a
significant change in the way banks dealt with bad loans. Banks alleged that ARCs were
asking for unrealistic discounts on substandard assets. They would rather attempt at
recovering the money themselves than sell such loans to ARCs at hugely discounted prices.
A senior official at a leading foreign bank explains, “The reason why this is happening is
because there is a wide wedge between valuation that banks place on their assets and what
ARCs are willing to pay. Typically the ARC would look at the liquidation value of the asset.
The bank, on the other hand, would place it as a going concern as it has seen the
company’s operations. Also ARCs are keener in buying assets where the security is more
tangible, like property or fixed assets, as against working capital. Banks’ valuation of fixed
assets is much higher.” A PricewaterhouseCoopers report ‘NPL Asia’ confirms, “A relatively
weak market environment after the economic downturn, reduced investor risk appetite, and
issues relating to valuations were some of the key factors that affected the activity level.”
Some ARCs were asking discounts as steep as 70%-80% on some sour commercial loans at
the height of the recessionary phase. This was not a viable option for the banks as they had
a feeling that recovery was still possible eventually. Says the bank official, “In case of
distressed assets merely two-three years old, banks would not be willing to accept such
discounts. But if nothing works out for five years, obviously 10%-20% salvage of value isn’t
a bad deal. But the same discount offered earlier wouldn’t make sense.”
ARCs on their part claim that banks have unreasonable value expectations, on the basis of
prices realised from isolated cases of recovery. This claim is also somewhat justified, given
that ARCs also need to make profits, which are highly uncertain in this kind of business. The
bank contact said, “Unlike a manufacturing business, the business of loan recovery involves
high degree of uncertainty in terms of profit margins. Their model of business would not
allow such small margins; hence they have to ask for higher margins.”
Also, when banks offload their bad loans to an ARC, it usually issues them security receipts
(SRs) rather than paying cash upfront. Banks only make money through these SRs as and
when the ARC recovers these stressed assets. Banks instead prefer to restructure loans and
salvage value from distressed assets themselves or liquefy through the auction route and
get cash upfront. CARE Research reports that India’s 12 leading banks have restructured
loans worth around Rs32,530 crore in Q1FY2010 alone, to help them contain their NPA
levels. This was in response to an RBI guideline, permitting accounts which were
restructured prior to 30 June 2009 to be treated as standard accounts. However, a part of
these restructured assets are expected to slip going forward. The PWC report states that
NPL activity typically picks up in the second half of the financial year (ending March 2010)
and many banks, including Bank of India, Bank of Baroda, UCO Bank, Dena Bank, Central
Bank of India, State Bank of Hyderabad, State Bank of Bikaner and Jaipur and State Bank of
India, have indicated their intentions to undertake portfolio auctions (largely corporate) in
the next few months.
With banks frowning upon ARCs and restructuring assets on their own accord, ARCs like
ARCIL will be under pressure to generate business. According to reports, ARCIL has
acquired retail loans worth $330 million to date. However, bulk of these loans comprise of
bilateral acquisitions from ICICI Bank, which has always had its own motives behind
pushing bad loans to ARCIL.
Banks should also realise that in some cases, ARCs are much better at extracting the last
pound of flesh, as they are more empowered to negotiate with borrowers and have better
recovery processes in place. For banks, recovery of NPLs is a protracted process and they
have to be wary of taking a hit to their image while initiating recovery proceedings.