Interpretation of ARC maladies

News: Search and seizure operations at 60 premises of four ARCs have exposed the “unholy nexus” between the borrowers and the ARCs.

The four are accused of “unfair and fraudulent trade practices in acquiring” the stressed loans.

– The bad loans acquired by them were “far less” than the real value of the securities covering such loans.

– Also, the minimum cash the ARCs paid to the lenders for such loans, typically 15% of the value, came from the defaulting borrowers. The money had been routed through several layers of dummy companies controlled by the borrowers or through hawala channels.

In light of these events, the regulatory oversight and supervision of ARCs need a revamp and, like other regulated entities, rogue ARCs should be punished.

What are the key recommendations of RBI’s committee on ARCs?

1) The minimum capital required for an ARC sponsor to be increased from 10 to 20 per cent to ensure the infusion of capital from financially strong entities.

Meanwhile, the minimum requirement of net owned funds to be raised from Rs 100 crore to Rs 200 crore. This should curb the tendency of some smaller ARCs to acquire financial assets by any means, since they don’t have enough capital.

2) Allow the ARCs to establish alternate investment funds (AIFs). This would not only invest in security assets (SRs) but also provide them with the resources to revive sick but potentially viable companies.

3) Widen the investor pool: Broaden the group of qualified buyers who can invest in SRs by bringing in high net worth individuals, corporations, non-banking financial companies, housing finance companies, trusts etc. This will widen the investor pool and deepen the SR market.

4) Reduce the ARCs’ minimum investment in SRs from 15% to 2.5% where they have investors in their SRs. This will arm the ARCs with additional resources to acquire bad loans, while the seller banks will get more cash.

5) Creating a secondary market for SRs: Banks should fix the reserve price for SRs because presently there is a mismatch in prices since most SRs are not backed by underlying securities.

6) Permit the ARCs to acquire stressed loans taken by borrowers from overseas banks and financial institutions, asset management companies etc. The rise in the number of sellers of bad assets will facilitate debt aggregation, leading to an early resolution.

7) Lenders should prepare a list of bad loans up for sale every year and share it with the ARCs. They should also give reasons why they are not selling all old bad loans and fix the reserve price of assets to be sold based on two external valuations.

What is the way forward?

Here are a few suggestions given by the author himself:

The management fee should be linked to the actual recovery/SR redemption instead of the net asset value, based on the ratings of the SRs. This will ensure that the earnings are based on recovery and not management fees alone.

ARCs should be mandated to have a board with at least 50% independent directors meeting the RBI’s fit and proper criteria. This will help in raising AIF and bring in independent perspective in decision-making and monitoring performance.

Finally, a sunset clause for the ARCs, which is a global norm, should be looked into too.

Source: This post is based on the article “Interpretation of ARC maladies” published in Business Standard on 19^th Dec 2021.