In August this year (2019), the Asset Reconstruction Companies (ARCs) had their annual flagship event — ARCON — with the theme being how ARCs can play an effective role in extending a helping hand in India’s march towards a $5-trillion economy in the next five years.

The underlying assumption was that for India to grow at an accelerated pace, the financial sector plays an important role in extending credit and infusing liquidity into the system to support growth drivers.

Such a role can be optimized to reducing stress in the financial system, which, with more than 9 per cent gross Non-Performing Assets (NPAs) in the banking system, is still at an elevated level and needs to be fixed quickly. And herein comes the role of ARCs.

ARCs were created through a central legislation, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002, as an institutional framework to address NPAs of the financial system.

Subsequently, in 2011, the Ministry of Finance had constituted a Key Advisory Group (KAG) on ARC sector reforms. consisting of all stakeholders — like banks, regulators, industry bodies, legal firms, consulting firms and ARC representatives, etc.

After several rounds of deliberations, the KAG came out with a set of recommendations relating to regulatory, legal, accounting and taxation aspects. It suggested that the KAG on ARCs should function as a standing committee and meet at regular intervals to review the progress and developments on an ongoing basis.

However, no further follow up in this regard was undertaken. And issues relating to the ARC Sector did not get the attention that it deserved.

With the introduction of the Insolvency and Bankruptcy Code (IBC) in 2016, the attention of stakeholders and regulators shifted towards the new mechanism. IBC has completed three years recently and there is a growing realization that IBC is not a magic wand to solve all NPA problems.

In terms of the latest data available in IBBI (Insolvency and Bankruptcy Board of India) for the June 2019 quarter, financial creditors could realize only 14 per cent of their total admitted claims for the cases resolved during the April- June 2019 quarter.

Since the inception of IBC, 2162 cases have been admitted and only in 120 cases, there has been a resolution plan so far.

There are certain categories of assets like power and EPC companies, where the future realizable potential is substantially higher than the present value but they have no takers. Value maximization can be done by ARCs holding on to these assets in their books and passing on the bulk of upside to the seller bank at a later date.

In a capital-scarce country like India, the move towards a $5-trillion economy requires preservation of capital value in such companies to enhance capacity utilisation at a later date, with an optimal contribution to gross output.

With this background, the five steps to improve the functional effectiveness of ARCs to contribute towards the $5-trillion economy are listed below.

1. Recognise: The ecosystem should recognize the systemic importance of ARCs as a class of entity for stress resolution. ARCs, under a statute, are permitted to issue Security Receipts, an instrument with cash-flow from the underlying NPAs.

Today when we are talking about a secondary market of loans, we must keep in mind that there is a group of entities with the instrument, issuer and a fairly-stabilized transaction structure already in place.

What is most important at this juncture is to acknowledge the existence of the ARC framework and restore the consultative process with ARCs to understand their operating constraints.

2. Regulatory Symmetry: While IBC encourages ARCs to play the role of a Resolution Applicant and gives certain exemptions available to banks and financial institutions — clear guidelines on investing in equity by ARCs in distressed companies directly and extending working capital to them are still awaited from regulators.

3. Review and Rationalization: At present, with cash transactions dominating the NPA sales, ARCs are effectively working as fund managers. While fund managers under Alternative Investment Funds (AIF) mandates only 2.5 per cent margin requirement from a sponsor, with a broadly similar role-play now in many cases, ARCs have to put in a whopping 15 per cent.

So, while guidelines for FPIs (Foreign Portfolio Investors) permit them to subscribe 100 per cent in each tranche of SRs (security receipts), because of this 15 per cent stipulation, they cannot put in more than 85 per cent, practically. This needs review and rationalization.

4. Liquidity Support: ARCs are starved of funds. There is no uniform policy across banks to extend financial assistance to ARCs.

Since cleansing of bad debt is required to enhance credit-creation capabilities of banks to kickstart growth, banks should be encouraged to extend need-based finance to ARCs co-terminus with a resolution plan, which could be treated as a priority sector advance.

5. Good Bank, Bad Bank: In 2014, the RBI came out with a framework for revitalizing distressed assets in the economy, which stipulated that ARCs should be construed as a supporting system for stressed asset management.

Strengthen the ARCs — as a proxy for a bad bank — so that mainstream banks can do good. A relaxed banking system can address the challenges of the economy if the stressed baggage is decoupled and transferred to ARCs.