Public sector banks, of late, have been aggressively selling their bad loans to asset reconstruction companies (ARCs), in a bid to reduce their pile of bad loans. But this may come to a standstill after the RBI’s new directive to securitisation and reconstruction companies. Here’s why.

Sale of bad loans to ARCs gained momentum in 2013-14 mainly because banks were able to obtain better prices for these sales. ARCs which usually offer to take the loan off the banks’ books at a discount, were paying 55-60 per cent of the value of loans, as against just 30 per cent in the past.

This significant jump in pricing was possible due to a shift in deals from the cash route to the security receipts (SR) route. So instead of taking an upfront cash payment, banks were willing to accept delayed payment, in the form of ‘security receipts’ or SRs. ARCs were thus making a down payment of minimum 5 per cent and the balance 95 per cent was paid to the bank against the SR.

But the RBI has now raised the bar, by demanding a minimum of 15 per cent down payment from ARCs. This is likely to dissuade ARCs from offering a better price, since they will now have to make a higher upfront payment.

But that seems to be the intent of the RBI—to ensure a realistic pricing of the assets.

“ARCs were able to pay a higher price of Rs 60-75 (for Rs 100 worth of bad loan) against Rs 30 earlier, because only 5 per cent of this was to be paid in cash. This was leading to unrealistic pricing of assets. The RBI clearly wants to address the issue before it gets out of hand,” says Nirmal Gangwal, Founder and MD of corporate debt restructuring advisory firm, Brescon Corporate Advisors.

Both banks and ARCs are mostly concerned about their balance sheet, and are not putting in the effort to rehabilitate stressed assets, he adds.

When banks sell to ARCs, they stop recording the assets as bad loans in their books, and do not have to make provision for them. They instead record the SR portion as investments in their book, which is rated every year by rating agencies. Based on the amount expected to be recovered on these loans, banks need to do a mark-to-market provisioning every year.

“Recently, banks were able to sell for a price higher than the book value of the loan (net of provisions). This additional amount was used to set off against other bad loans,” says Gangwal.

The RBI’s latest directive will put a stop to such unrealistic pricing. Among other tweaks, the RBI has now asked reconstruction companies to disclose the basis of their valuation if the asset is bought at a price higher than the book value.

For ARCs, who are already starved for capital, the higher cash payment is likely to impede their acquisition of assets from banks.

In 2013-14, for the first time in history, close to Rs 50,000 crore assets were offered by banks to these ARCs. In 2012-13, this figure was only Rs 12,000 crore.

“There may be some slowdown in the pace of asset sales, particularly for ARCs who do not have enough resources. We are better placed than others to manage the additional cash payment”, says P Rudran, Managing Director and CEO, ARCIL, the first ARC to be set up in India.

But he feels that the RBI’s directive is in the right direction and will ensure that ARCs have more skin in the game.

“The latest move by the RBI will ensure that the valuations are more realistic, there is more discipline in pricing and will also improve disclosures”, says Rudran.

But the profitability of ARCs may get impacted.

Earlier ARCs were charging management fees varying between 1-2 per cent on the outstanding SRs i.e. face value. The SRs are required to be rated by a rating agency after the initial planning period (period allowed for ARCs to formulate a plan for realization of non-performing assets). The rating will indicate the net asset value (NAV) of SRs. The RBI has now directed that the management fee be calculated on the NAV rather than on the SR amount.

“This means that if the rating goes down, let us say below the face value, then there will be a reduction in the management fee paid to the ARC,” says Rudran.

The planning period has also been reduced from 12 to 6 months. This means that the first rating has to be done after 6 months.

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