The main reasons responsible for underperformance of ARCs are as under:

a.    Capital Inadequacy: With the NPAs increasing day-by-day, the current net worth of all the ARCs put together will be adequate to acquire only 4% of stressed assets from banks (assuming current capitalisation of all ARCs at Rs.3000 Crore and the same would be spent in 15% cash up front, the book value of assets that can be acquired by the ARCs would be around Rs.33,000 Crore (sold at 60% book value), as against the gross NPA of all banks assumed at Rs.8,00,000 Crore)

b.    Inability to fund working capital needs of stressed loans: It is hard to obtain working capital for a distressed asset and even when it is made available, the cost is very high. Therefore, there have been very few cases of genuine restructuring thus far.

c.    Valuation mismatch: New capital norms have significantly increased the cost of asset acquisition for ARCs. To offset this, ARCs have been seeking higher discounts to buy NPAs; however, banks are unwilling to reduce price, resulting in an expectation mismatch. This has led to a sharp decline in the transaction closure rate.

The main reason for this gap appears to be the vastly different discounting rate used by banks and ARCs. While banks use discount rates in the range of 10% to 15%, given their access to cheap capital in the form of public deposits, ARCs use much higher discount rates of 20% to 25% as their cost of funds is relatively higher than that of banks. Without realistic valuation guidelines, there is no incentive for private investors to participate in auctions as the reserve price tends to be high, given the low discount rate used by banks vis-à-vis ARCs and private investors.

d.    Prolonged focus on agency model: Till August 2014, Indian ARCs were driven completely by the agency business model of generating plush internal rates of return (IRRs) based on the management fee. Since IRRs were topping 20%, ARCs had no real incentive to really opt for recoveries or rehabilitation. However, after the keynote change of increased investment to 15% and basing the management fee on the lower spectrum of NAV, ARCs are gradually turning to fund-based models, with a focus on recoveries and realistic pricing.

e.    Lack of mature secondary market for SRs: Due to an unrealistic pricing mismatch, intense scrutiny and regulatory changes, there is a general lack of investor appetite that is leading to the absence of a secondary market for SRs. Banks are hence forced to buy SRs backed by their own stressed assets. Currently, over 80% of SRs are held by seller banks themselves.

f.     Lack of professional expertise for turnaround: Professionals such as bankers, lawyers and chartered accountants who join ARCs usually expect employee stock ownership plans (ESOPs) as a major mode of compensation. Since any person with more than 9% shareholding in an ARC is designated a ‘deemed promoter’ by the RBI, this actually deters professionals from joining ARCs because of the responsibility associated with the ‘promoter’ status. This only increases the cost of functioning of ARCs. The general dearth of talent and skill sets required to revive and turn around a unit is also a big challenge.

g.    Inter Creditor issues: The Indian banking landscape is characterised by a consortium/multiple lending with different classes of security. This results in significant inter-creditor issues, which inhibits the prompt implementation of the most appropriate resolution strategy. Most resolution approaches require the consent of secured lenders, representing 75% of the total debt by value. The intermediation by ARCs towards aggregations and bringing all stakeholders to a common ground is often painstakingly slow and causes a loss of value to everyone concerned.

h.    Lengthy Resolution Process of NPAs: NPA resolution in India is complex, tedious and time consuming. It takes 4.3 years, on an average, for any resolution. The process is long mainly due to two factors: slow judicial processes with repeated protracted appeals in higher courts of law, thereby delaying judgements (corporates find grounds to drag debt recovery cases to civil courts and stall the proceedings of tribunals) and market value of stressed assets remaining much lower than what the banks currently reflect on their balance sheets. International experience shows that speedy judicial systems are imperative for effective asset resolution.

i.      Regulatory Constraints: ARCs are subject to many regulatory constraints as summarised below:

With foreign capital coming into the distressed market ARCs may be willing to take more risks and bid for bigger assets. The new capital flows will also address the shortage of working capital funding that ARCs face when restructuring distressed assets.

Foreign capital is coming in amid the hope that the implementation of the Insolvency and Bankruptcy Code (IBC) will lead to faster resolution and recovery. In India, recovery has been a slow and painful process. As per the World Bank, the resolution time in India extends beyond four years (See: Timeless classic) and going by a Crisil estimate, for ARCs, the recovery rate has been 36% and the average resolution time taken for ARCs has been about five years.