THE growing tendency of state-owned banks to hawk their bad loan portfolios to asset reconstruction companies has been red-flagged by the Reserve Bank of India.

The central bank, in its half yearly financial stability report, has warned that banks might tend to use the option of securitising their bad loans in exchange for so-called securities receipts (SRs) and not cash ‘to evergreen their balance sheets’.

According to the RBI, the fact that the banking industry has a significant stake in the ownership of most asset reconstruction companies (ARCs) functioning in India, “the spread of risks may not be taking place effectively”. If the banks who are selling their bad loans to ARCs had accepted cash, there would have been no problem. But they are given SRs, which remain on the books of the lenders.

Estimates are that the sale of non-performing assets (NPAs) to ARCs shot up from just Rs80bn in fiscal 2012-13 to Rs270bn a year later. The figure is expected to more than double in the current fiscal.

The business of buying stressed assets from banks has taken off only over the past two years in India. Today, more than a dozen asset reconstruction companies are actively buying bad loans from banks, much to the concern of the central bank

P Rudran, managing director and CEO of the Asset Reconstruction Company of India Ltd (ARCIL) — the largest player in the sector with 70pc share of the market — notes that the first quarter of the current fiscal (April-June) has seen banks wanting to sell Rs250bn worth of bad loans.

ARCs are able to recover less than half the assets they buy from banks at a discount. They buy the assets from banks at hefty discounts and even then pay just 5pc in cash. The rest is paid through SRs, which are redeemed only when the ARC recovers the loans. ARCs opt for compromise settlements, or restructure the bad loans, or go through a long-drawn legal process to recover the loans.

The business of buying stressed assets from banks has taken off only over the past two years in India. Today, besides ARCIL, there are more than a dozen ARCs that are actively buying bad loans from banks. In the early days, ARCs were not willing to pay more for the bad loans and banks were also chary about off-loading their NPAs.

But with the growing competition, the discounts have been squeezed and some ARCs are now willing to even pay the book value of the bad loans.

Indeed, the spurt in the number of ARCs and the bad loans being off-loaded by banks has resulted in the banking industry regulator issuing a warning. “A spurt in activity of ARCs, driven by banks’ efforts to clean up their balance sheets, calls for a closer look at the extant arrangements between ARCs and banks,” said the RBI’s financial stability report.

The central bank also feels there is a need to monitor the efficacy of the processes at ‘entry’, ‘restructuring’ and ‘exit’ stages of restructuring proposals, under a robust framework of accountability of different agencies and stakeholders.

Recently, lenders to two borrowers — Hotel Leela Venture and Bharati Shipyard — decided to sell outstanding loans, adding up to over Rs120bn, to ARCs. Interestingly, the ‘haircut’ that they had to take — the shaving off of a part of the bad loan portfolio — has come down dramatically.

In the past, the ‘haircut’ used to range between 50pc and 95pc, but now banks are disposing their bad loan portfolios almost at book value. But again, the ARCs will be paying just 5pc in cash, with the remaining being accounted for by SRs.

WITH the asset reconstruction business taking off in India, there has been talk of the government itself setting up a national asset management company that would take on all the bad loans of public sector banks. There have been suggestions that the government set up a corpus of Rs500bn to take the toxic loans of state lenders.

But the problem of bad loans on the books of public sector banks is enormous. Estimates are that the NPAs of the industry are around Rs2.5trn. Indian banks also need to boost their capital by a whopping Rs5trn over the next four years to meet the Basel-III norms related to capital adequacy.

The central government, which owns public sector banks, is unable to rustle up that kind of cash. Divesting its stake in banks is also a politically sensitive matter, which the previous United Progressive Alliance (UPA) government had been unable to tackle. A high-level committee has provided the roadmap for the dilution of the government’s equity, suggesting that its stake be brought down to less than 51pc, without it losing control.

It remains to be seen whether the new BJP government will go ahead with the much-needed reforms in the banking sector and sell off its stake in public banks. The capital markets have revived and several companies have been raising funds of late.

According to Pranav Haldea, managing director of Prime, a leading provider of database on primary capital markets, the total amount raised by companies through qualified institutional placements (QIPs) in the first quarter of this fiscal represents a 10-fold increase from the same quarter last year.

Companies mobilised Rs125.69bn from institutions through QIPs, says Haldea. The largest QIP was from Reliance Communications (Rs48.08bn), followed by Idea Cellular (Rs30bn) and Yes Bank (Rs29.42bn).

“It is significant to note that all QIP issues in the quarter have taken place after the election verdict was announced on May 16, thus clearly showcasing the revival of investor sentiment, backed by a strong secondary market,” explains Haldea. “There has been a pent up demand for capital, which is now being released. The pipeline too is extremely robust.”

Major expected QIP issues include those from Adani Enterprises and Larsen and Toubro, besides several banks. About Rs300bn worth of QIPs have been announced over the last three months, including those by many public sector lenders.

Analysts feel this would be the right time for the government to go for selling its shares in banks and other public sector undertakings.

Published in Dawn, Economic & Business, July 7th, 2014