Broadly, there are two kinds of loans-good loans and bad loans. Good loans are those that can be recovered by the bank and bad loans are bad debts or non performing loans (NPL). Let me explain it with the help of an example. If a bank has 10 billion worth of assets, of which 8 billion constitutes good assets and the rest 2 billion of it are non-performing assets (NPAs). Now there are several reasons why the bank would want to get rid of its NPAs. The first reason is that NPAs are essentially loss assets, ie. they pose a very high risk in terms of recovery. Secondly, bank’s NPAs cause problems in its valuation- the balance sheets of the bank do not sufficiently disclose this distinction in its assets. Though the total value of its assets amounts to 10 billion, only 8 billion of it is actually in circulation. Thirdly and most importantly, the 2 billion worth capital of the bank gets locked up and cannot be utilized. Thus, till the bank realises the amount from the debtor by way of litigation, there is excessive opportunity loss and this lock up acts as an impediment to the free cash flow. All of this put together causes fiscal instability in the market.
This issue of bad loans or inefficient NPAs resulted in the birth of asset reconstruction companies (ARCs). The bank basically sells its NPAs to an ARC at a lesser price. These ARCs inturn use their skill and expertise to sell these NPAs, thereby recovering not only the capital invested, but also making profits over it. Relating this to the above example, the bank would sell its 2 billion worth of NPA to an ARC for say 0.75 billion. The ARC would sell this NPA for 1 billion, thereby recovering the 0.75 billion and mking a profit of 0.25 billion over it. The reason why the bank would sell its ARCs at a lower price is-
1. By selling the bad loans to the ARC, the bank’s balance sheets will no longer have any NPAs, there will only be good performing loans;
2. NPAs would now have some value, as against their zero value while they are locked up.
There are three approaches that an ARC could take in order to sell the NPAs-
1. Rapid disposal approach: In this approach the ARC immediately finds a bidder and sells the assets. This approach is used by the U.S.A and China
2. Warehousing approach: In this approach the ARC holds on to the NPAs (hoarding), till the price of the security increases and then sell it.
3. Combination of the above two: In this approach the ARC sells certain assets immediately, while few are held on for some time.
There are two types of ARC on the basis of ownership. Countries like the USA, Malaysia, Thailand have a centralised ARC- ie. there exists only one ARC in the country which deals with asset reconstruction and which is usually set up by the government, banks and financial institutions of the country, together.
Whereas, countries like India, China and Korea have private companies as ARCs. There are currently 13 ARCs which are registered in India under the SARFAESI Act. The disadvantage of having multiple ARCs as against a single ARC is that there is excessive competition between these companies to procure the bad loan for reconstruction. As a result of which these companies are ready to pay a higher amount than the actual valuation of the NPA. For instance, in the above case, if there are many ARCs who want to reconstruct the bad debt, though their valuation indicates the value to be paid for the 2 billion worth NPA should be 0.75 billion, they would be ready to pay a higher price say 0.80 billion for the same NPA.
This is essentially how an ARC works. There are several other interesting issues which I would like to discuss. I will delve into them in my next post. Till then, if there are any comments or corrections or additions, please do feel free to contribute :)