Why stressed assets resolution tools need overhaul

The fraudulent activities of the four private asset reconstruction companies (ARCs) that the IT department alleged after its search and seizure operations at 60 places in Mumbai, Delhi and Ahmedabad a few days ago are not just shocking but mind-numbing in their sweep. They point to the failures of extant regulatory and oversight mechanisms.

Here are the key fraudulent activities alleged by investigators against the four ARCs: (a) an “unholy nexus” between the ARCs and the loan defaulters in which “a maze of shell/dummy concerns” were involved (b) the ARCs acquired the NPAs at “far less than the real value of the collateral securities” (c) the ARCs “usually” took money from the defaulters to pay the banks for acquiring the NPAs (d) “more often than not” the stressed assets were “re-acquired” by the defaulters from the ARCs “at a fraction of their real values” (e) the ARCs “concealed the profits on disposal”, thereby “evaded” tax and “deprived” the banks their share of actual profits (f) the ARCs used “non-transparent methods” and maintained “a parallel set of accounts” containing “cash transactions” of more than ₹850 crore and (g) funds were routed through “offshore structures (tax havens) to acquire the assets”.

Financial frauds are not uncommon but what the IT department has revealed points to the missing-in-action regulator- the RBI, which awards license and regulates these ARCs since 2002.

This doesn't bode well for the National Asset Reconstruction Company Limited (NARCL), also called the Bad Bank, the government set up recently. The NARCL is in line with the 28 private ARCs already operating: incorporated under the Companies Act of 2013, licensed by the RBI under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act of 2002 and governed by the “extant regulations” of the RBI.

At a fundamental level, there are two big differences between the ARCs and the NARCL: Public sector banks (PSBs) are the majority stakeholders (51%) in NARCL and the central government guarantees Security Receipts (SRs) issued by the NARCL to the extent of ₹30,600 crore.

Going by the wide sweep of alleged fraudulent activities by the ARCs, such minor tinkering in the NARCL is unlikely to make a big difference. Here is why.

RBI’s lack of control over regulatory lapses

The first is the RBI’s lack of hold over the regulatory failures. Just after giving license to NARCL in October 2021, the RBI published its study on private ARCs on November 2, 2021. Even though the terms of reference included “existing legal and regulatory framework”, the 98-page report found no regulatory lapses to address, although it did recommend a “separate online platform” for transparency and uniformity of processes in sale of stressed assets.

It was more focused on enabling growth of private ARCs and recommended allowing them to participate in the resolution process of the Insolvency and Bankruptcy Code (IBC) of 2016 “as a Resolution Applicant”. ARCs are meant to resolve NPAs outside courts, under the SARFAESI Act of 2002, while the National Company Law Tribunal (NCLT) is integral to the IBC.

In recommending ARCs to participate in the IBC, the RBI not only (i) failed to observe the low debt recovery under it but also (ii) failed to note the parliamentary standing committee’s report (August 2021) strongly objecting to high haircuts (90-95%) and failure to protect creditors’ interests under the IBC.

Both the claims are akin to ‘half glass full’ arguments. Analysis of the debt recoveries from 2016 to September 2021 under the IBC shows that (a) the resolution process under the IBC led to 35.9% recovery and (b) the liquidation process led to 4.9% recovery. Taken together, the total recovery is only 19.4%.

In contrast, the recovery rate under the failed and much maligned BIFR process was 25%, as the IBC regulator Insolvency and Bankruptcy Board of India (IBBI) declared in 2019.

The RBI report did acknowledge that the private ARCs have failed too. It said: “Data shows that the performance of the ARCs has been lacklustre, both in terms of ensuring recovery and revival of businesses. Banks and other investors could recover only about 14.29% of the amount owed by borrowers in respect of stressed assets sold to ARCs during the FY 2004 - FY 2013 period.”

But it also sought to explain away such failures to many factors unconnected to the ARCs, and none to poor regulatory oversight that the IT department’s search and seizure operations pointed to.

The RBI listed several factors for the failures of ARCs: “These primarily include vintage NPAs being passed on to ARCs, lack of debt aggregation, non-availability of additional funding for stressed borrowers, difficulty in raising of funds by the ARCs on their balance sheet, etc. Also, ARCs have lacked focus on both recovery and acquiring necessary skill sets for holistic resolution of distressed borrowers.”

Growing NPAs and write-offs

The basic purpose of ARCs and NARCL are to resolve the NPA crisis in Indian banking. But these are aimed at the existing NPAs, not the NPAs created every year (the process) for various reasons, which is equally critical to stop the NPAs rising again.

The above RBI report says, at the end of FY21, gross NPAs (GNPAs) of scheduled commercial banks (SCBs) stood at 7.5% and is expected to grow to 9.80% in the baseline scenario and to 10.36% and 11.22% under the other stress scenarios by March 2022. This may reflect the pandemic disruptions but also points to continuous creation of NPAs in the banking sector.

Here is another evidence of the obvious failures of the ARCs operating since 2003, and the IBC of 2016.

In response to an RTI query, the RBI recently revealed that banks (SCBs) wrote off ₹2 lakh crore in FY21. It also revealed that banks have written off ₹11.68 lakh crore as NPAs in the past 10 years, 91.7% of which was written-off since FY15 – when the Modi government came to power. The total NPA write-off in the past 10 years is very close to the government’s gross market borrowing of ₹12.05 lakh crore for FY22, as projected by the budget of 2021-22.

Had the IBC been effective, there would have been no need for huge NPA write-offs year after year since then. The implication of all the above facts and evidence is clear. The multitude of stressed asset resolution mechanisms need to be completely overhauled to address both the issues: high NPA write-offs year after year and build up of huge NPAs year after year.