Asset Reconstruction

From the 15 years the economies around the world have seen the problem of NPAs that is Non Performing Assets. A high stage of Non Performing Assets in the banking system can harshly affect the economy in different ways. The high stage of Non Performing Assets shows the way to deviation of banking resources towards resolution of such problem. This causes an opportunity loss for high productive utilization of resources. The banks likely to become risk disinclined in making new loans in particular to medium and small sized companies. It causes economic and financial dilapidation of the country at large Non Performing Assets when left unattended. This problem has leaded to the great attention for the resolution of Non Performing Assets. Asset Reconstruction Companies have been used world as a whole, mainly in Asia, for resolving the bad-loan problems. And this company has got very successful in different countries. Asset Reconstruction Companies has mainly focuses on NPAs and permit the banking system to act as "clean bank"
Clause (o) of sub-section (1) of Section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 defined a NPA as follows:
'Non-Performing Asset' means an asset or account of a borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset.
It is apparent from the above definition that any asset of a borrower has been intentionally (that is, deliberately or with an express purpose in mind) incorporated by the legislature in the definition of 'non-performing asset' and therefore, the term NPA cannot be limited to mean only an account of a borrower under all situation.
Non-Performing Asset' in respect of mortgage guarantee asset means,
'An asset acquired from the credit institution on the happening of trigger event which is straight away classified as non-performing asset and shall thereafter be classified according to the age of NPA' .

Need and scope
The need for Asset reconstruction occurred from the need to resolve the bad loans originating out of systemic banking crises. A systemic banking crisis occurred out of a domino effect of bad loans and their interdependence causing more such failure in the banking system creating a brutal circle. The banking regulators or governments tries to bail out the banking system of a systematic collection of bad loans which acts as a drag on their liquidity, balance sheets and generally the health of banking. They can do so by two approaches:

1. Decentralized Approach which leaves the banks to manage their own bad loans by giving them incentives, legislative powers, or special accounting or fiscal advantages.
2. Centralized Approach to manage these bad loans on a determined, central level, through a centralized agency or agencies. like Asset Reconstruction Companies

The advantages of the Centralized Approach are as follows:

' More clout and controllability as bad loans in one or a few hands
' Easier and safer to give special legislative powers to a single (few) firms than the whole banking system.
' Regular banking unaffected with lesser burden on their balance sheets
' Economies of scale, it can mix up good assets with bad ones and make a sale which is palatable to buyers.
' Funding is easier for an ARC than banks themselves .
The financial sector has been one of the key drivers in India's efforts to achieve success in rapidly developing its economy. While the banking industry in India is progressively complying with the international prudential norms and accounting practices there are certain areas in which the banking and financial sector do not have a level playing field as compared to other participant in the financial market in the world. There is no legal provision for facilitating securitisation of financial assets of banks and financial institutions. Further, unlike international banks, the banks and financial institutions in India do not have power to take possession of securities and sell them. Our existing legal framework relating to commercial transactions has not kept pace with the changing commercial practices and financial sector reforms. This has resulted in slow pace of recovery of defaulting loans and mounting levels of non-performing assets of banks and financial institutions. Narasimham Committee I and II and Andhyarujina Committee constituted by the Central Government for the purpose of examining banking sector reforms have considered for changes in the legal system in respect of these areas. These committees, inter alia, have suggested enactment of a new legislation for securitisation and empowering banks and financial institutions to take possession of the securities and to sell them without the intervention of the court. Acting on these suggestions, the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Ordinance, 2002 was promulgated on the 21st June, 2002 to regulate securitisation and reconstruction of financial assets and enforcement of security interest and for matters connected therewith or incidental thereto. The provisions of the Ordinance would enable banks and financial institutions to realise long-term assets, manage problem of liquidity, asset liability mismatches and improve by exercising powers to take possession of securities, sell them and reduce non-performing assets by adopting measures for recovery or reconstruction.
It is proposed to replace the Ordinance by a Bill, which, inter alia, contains provisions of the Ordinance to provide for -
' Registration and regulation of securitisation companies or reconstruction companies by the Reserve Bank of India.
' Facilitating securitisation of financial assets of banks and financial institutions with or without the benefit of underlying securities.
' Facilitating easy transferability of financial assets by the securitisation company or reconstruction company to acquire financial assets of banks and financial institutions by issue of debentures or bonds or any other security in the nature of a debenture.
' Empowering securitisation companies or reconstruction companies to raise funds by issue of security receipts to qualified institutional buyers.
' Facilitating reconstruction of financial assets acquired by exercising powers of enforcement of securities or change of management or other powers which are proposed to be conferred on the banks and financial institutions.
' Declaration of any securitisation company or reconstruction company registered with the Reserve Bank of India as a public financial institution for the purpose of section 4-A of the Companies Act,1956.
' Defining 'security interest' as any type of security including mortgage and charge on immovable properties given for due repayment of any financial assistance given by any bank or financial institution.
' Empowering banks and financial institutions to take possession of securities given for financial assistance and sell or lease the same or take over management in the event of default, i.e., classification of the borrower's account as non-performing asset in accordance with the directions given or guidelines issued by the Reserve Bank of India from time to time.
' The rights of a secured creditor to be exercised by one or more of its officers authorised in this behalf in accordance with the rules made by the Central Government.
' An appeal against the action of any bank or financial institution to the concerned Debts Recovery Tribunal and a second appeal to the Appellate Debts Recovery Tribunal.
' Setting-up or causing to be set up a Central Registry by the Central Government for the purpose of registration of transactions relating to securitisation, asset reconstruction and creation of security interest.
' Application of the proposed legislation initially to banks and financial institutions and empowerment of the Central Government to extend the application of the proposed legislation to non-banking financial companies and other entities.
' Non-application of the proposed legislation to security interests in agricultural lands, loans not exceeding rupees one lakh and cases where eighty per cent of the loans are repaid by the borrower.
The concept of asset reconstruction is defined in the Act as under-
The activity of Asset reconstruction comprises of:
' Formation of Securitisation Companies and Reconstruction Companies.
' Acquisition of right or interest of any bank or Financial Institution in Financial Assistance.
' Realisation of Financial Assistance.
The current news regarding India's framework to resolve troubled assets which was updated on 7th Feb 2014 is as follows:
The Reserve Bank of India, the country's central bank, published new rules to improve and go faster with the identification and resolution of banks troubled assets which will be effective from April. The framework is credit positive for Indian banks, particularly public-sector banks that have higher amount of impaired loans, because it requires early recognition of stressed assets and incentivizes banks to cooperate with one another to resolve those assets. The framework also provides for penalties for so-called wilful defaulters and non-cooperative borrowers, and encourages the development of an active market for distressed assets. If implemented as designed, these measures will improve banks' ability to resolve distressed assets.
The framework will require banks to segment special-mention loans into three sub-categories: loans overdue for less than 30 days but showing signs of incipient stress, loans overdue 31-60 days and loans overdue 61-90 days. If a loan becomes overdue for 61-90 days, and the aggregate exposure of banks to the borrower exceeds INR1 billion, the RBI will require the affected banks to form a joint lenders forum and put together a joint corrective action plan to resolve the borrower's distressed assets. The joint lenders forum must decide on terms of the resolution package to the borrower, and convey these terms to the borrower within 15-90 days, depending on the size of the loan and the resolution plan.
The RBI will establish a centralized database to collect, store and disseminate data on large borrowers to all lenders in the banking system, which will lead to a more transparent recognition of the extent of distressed assets. Currently, it is possible for a borrower to be overdue on its obligations with one bank, but still be treated as a standard account at a different bank. The new mechanism will ensure that such assets are recognized as distressed assets across the system. This new transparency may increase the level of reported nonperforming assets in the system.
The framework also has incentives for lenders and borrowers to adhere to these guidelines, and penalizes those that do not. Any asset that has been restructured as part of a corrective asset plan will retain its existing asset qualification after the restructuring. However, if any of the lenders that have agreed to the restructuring later back out of the plan, the lender will be subject to accelerated provisioning requirements.
Also subject to the accelerated provisioning requirements are lenders that fail to convene a joint lenders forum or fail to agree to a plan within the stipulated timeframe and loans to companies whose directors' names appear on the wilful defaulters list more than once. Any new loans to borrowers indentified as non-cooperative, or new loans to companies that have non-cooperative borrowers as directors, will also be subject to the accelerated provisioning requirements. The RBI said the measures against non-cooperative borrowers seek to remove bottlenecks to banks' bona fide resolution efforts.
The RBI's framework also seeks to encourage the growth of an asset-reconstruction industry in India. It incentivizes banks to sell their bad loans by allowing them to recognize any gains on such sales upfront, to recognize losses over two years, and to use floating provisions as specific provisions for those assets that are being sold off. The RBI proposes to ease regulations on bilateral sales of nonperforming assets. To encourage demand for such assets, the RBI will consider allowing asset-reconstruction companies to raise debt funds, and allow banks to extend financing to specialized entities established for the acquisition of distressed assets. The RBI also proposes to encourage participation of select private-equity and non-banking finance companies in the asset-reconstruction industry.
Benefits of Asset Reconstruction Companies
' Asset Reconstruction Companies acquire and aggregate the Non Performing Assets from various lenders in order to quicken the process of corporate restructuring.
' The major objective is to acquire and rapidly liquidate Non Performing Assets.
' Clean books of accounts by reducing Non Performing Assets.
' Less to deals with Non Performing clients.
' Special legislative powers to fewer Asset Reconstruction Companies rather than to each bank.

The current news regarding the benefit of the Asset Reconstruction Company which was updated on 15 July 2013 is:
Asset reconstruction firms may benefit as bad debts pile up:-
Bad debts are rising as borrowers default due to slowing economy, high interest rates
Mumbai: Slowing economic growth is crimping the ability of companies to repay their debt, in turn adding to the bad-loan burden of banks, but at least one entity is anticipating a business opportunity out of this gloomy scenario.

The expectant beneficiary is Asset Reconstruction Co. India Ltd (Arcil), India's oldest and largest buyer of dud loans from banks. Arcil expects to acquire Rs. 1,000-1,300 crore of assets this year, up from Rs. 20-24 crore in the last fiscal, managing director and chief executive officer P. Rudran said in an interview.

'Bad debts in the banking industry have crossed Rs. 1 trillion and are rising as slowing economic growth, which fell to 6.5% in the last fiscal from 8.4% in the previous year, and high interest rates cause borrowers to default on their debts. He said they are observing the capacity to sustain NPA's (non performing assets) of banks.

Business for asset reconstruction companies (ARCs) is expected to also come from banks shifting to Basel III regulations, the new international accounting practices enforced by the Bank for International Settlements (BIS), which would require banks to raise an estimated Rs. 2.7 trillion by March 2017.

Being the majority owner of public sector banks that control more than 70% of the banking industry, the government has to bear the responsibility to top up their capital.
Banks can also raise resources themselves by liquidating their bad debts and this is what Arcil is counting on.
Another potential opportunity is on the horizon. A government advisory group on ARCs suggested in December that they be allowed to buy bad debts from non-banking financial companies (NBFCs) as well. This will enlarge the pool of assets available for ARCs and will give them better negotiating power as well. The Reserve Bank of India (RBI) is yet to approve the plan. The managing director and chief executive officer of ARCIL said in that interview that they are equipped to acquire Rs. 2000 crore worth of assets. However, it all depends on how much banks are willing to sell

Last year was a bad year for the asset reconstruction industry as a whole,
India's banks have traditionally been reluctant to sell bad loans, which ARCs seek to acquire at a discount to their face value and then try to recover the money from defaulters.
India has more than 50 ARCs, with Arcil controlling more than 70% of the distressed assets market. Banks tend to use the market as a price-discovery mechanism-to get an idea of how much their bad debts are worth'when they aren't really interested in selling their bad debts.

"They (banks) could be offering Rs. 10,000-12,000 crore of assets, but sell not even Rs. 2,000 crore. They are not selling their assets; rather they are announcing the auctions (of bad debts) for a price discovery,"

The entire business model is dependent on the portfolios of banks and housing finance companies, and price negotiations are hectic. Deals often fall through because of differences on valuations'the price at which banks are willing to sell their bad loans and the price that ARCs are willing to pay .

Securitisation in India
According to Kenneth Cox securitisation is a process in which pools of individual loans or receivables or actionable claims are packaged, under written and distributed to investors in the form of securities. It is a process of liquidizing assets appearing in the balance sheet of a Bank or financial institution which represent long term receivables by issuing marketable securities there against. It involves conversion of cash flow from a portfolio of assets in negotiable instruments or assignable debts which are sold to investors. The name securitization is derived from the fact that the form of financial instruments used to obtain funds from the investors is securities. All assets can be securitised so long as they are associated with cash flow. Hence, the securities which are the outcome of securitisation processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.
Securitisation often utilizes a special purpose vehicle (SPV), alternatively known as a special purpose entity (SPE) or special purpose company (SPC), in order to reduce the risk of Bankruptcy and thereby obtain lower interest rates from potential lenders. A credit derivative is also generally used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors. Securitization, in its most basic form, is a method of selling assets. Rather than selling those assets 'whole', the assets are combined into a pool, and then that pool is split into shares. Those shares are sold to investors who share the risk and reward of the performance of those assets. It can be viewed as being similar to a corporation selling, or 'spinning off', a profitable business unit into a separate entity. They trade their ownership of that unit, and all the profit and loss that might come in the future, for cash right now.

A very basic example would be as follows: X Bank loans 10 people Rs100, 000 a piece, which they will use to buy homes. X Bank has invested in the success and failure of those 10 home buyers, if the buyers make their payments and pay off the loans, X Bank makes a profit. Also if we look at it in another way, X Bank has taken the risk that some borrowers won't repay the loan. In exchange for taking that risk, the borrowers pay X Bank interest on the money they borrow. From the perspective of X Bank, those loans are 10 different assets. They have value- one, if the loan fails, X Bank takes ownership of the house. Two, if the loan succeeds, X Bank gets their money back along with the interest they charge.

X Bank can do two things with those loans. They can hold them for 20 years and, they would hope, make a profit on their investment. Or they could sell them to some other investor, and walk away. In doing this, they would make less profit than if they held onto them long term, but they would benefit in that they make some profit while also getting their original investment back. They give up some of the profit in exchange for not having face the risk. So X Bank decides they would rather have the cash now. They could sell those 10 loans to 10 investors. Each investor would be taking a risk in buying those loans, because if any loan defaults, that one investor loses.
Asset securitization began with the structured financing of mortgage pools in the 1970s. For decades before that, banks were essentially portfolio lenders; they held loans until they matured or were paid off. These loans were funded principally by deposits, and sometimes by debt, which was a direct obligation of the bank. But after World War II, depository institutions simply could not keep pace with the rising demand for housing credit. Banks, as well as other financial intermediaries sensing a market opportunity, sought ways of increasing the sources of mortgage funding. To attract investors, investment bankers eventually developed an investment vehicle that isolated defined mortgage pools, segmented the credit risk, and structured the cash flows from the underlying loans. Although it took several years to develop efficient mortgage securitization structures, loan originators quickly realized the process was readily transferable to other types of loans as well.

In February 1970, the U.S. Department of Housing and Urban Development created the transaction using a mortgage-backed security. The Government National Mortgage Association sold securities backed by a portfolio of mortgage loans. Securitization only reached Europe in late 80's, when the first securitizations of mortgages appeared in the UK. This technology only really took off in the late 90's or early 2000, thanks to the innovative structures implemented across the asset classes. Securitisation as a financial instrument has been in practice in India since the early 1990s essentially as a device of bilateral acquisitions of portfolios of finance companies. As would be the case elsewhere too, securitisation in its initial form finds its way in loan sales. There were quasi-securitisations for quite a while where creation of any form of security was rare and the portfolios simply ended from balance sheet of one originator over to that of another. Most of these transactions were backed by extensive originator support. As there were no rules as to regulatory capital requirements, most of the so called securitization investors were actually taking exposure on the balance sheet of the originator. Having started sometime in 1996 or thereabouts, securitization volumes have been scaling new peaks every year. The party continued till about 2005. In early 2006, the RBI came out with guidelines on regulatory capital treatment for securitization ' these dealt a severe blow to the securitization market and in 2006, the volumes are expected to be lower than those in 2005.
Advantages of securitisation
To the originator
1. Financing sources relating to third party claims will be available earlier than yield to maturity, even as the Financial Service Provider generally continues to provide credit and loan administration and collection services, which generates a fee type income and through which the relationship with the Client remains.
2. In case the Originator is a bank:
' more opportunities for new loan and credit placing, due to capital relief,
' enables for active management of capital and asset-liability structure
' the Asset Backed Securities (ABS) can be used as a collateral in central bank transactions in the Eurozone,
' more efficient credit risk management (e.g.: mitigating the excess client- and sector concentration)
' by eliminating the highest quality assets (so generally with the lowest return) from the balance sheet, it is becoming possible to shape the financial indicators according to the strategically desired risk profile. (ROE/ROA)
3. improve indicators based on the balance sheet figures,
4. decrease cost of the source of finance,
5. optimizing the yield to maturity both of assets and liabilities.

To the company
1. Improve capital returns: To improve their return on capital, since securitisation normally requires less capital to support it than traditional on-balance sheet funding.
2. Raise finance: To raise finance when other forms of finance are unavailable (in a recession Banks are often unwilling to lend - and during a boom, Banks often cannot keep up with the demand for funds);
3. Better return on assets: Securitisation can be a cheap source of funds, but the attractiveness of securitisation for this reason depends primarily on the costs associated with alternative funding sources;
4. Diversify portfolio: To diversify the sources of funding which can be accessed, so that dependence upon Banking or retail sources of funds is reduced;
5. To lower risk: To reduce credit exposure to particular assets for instance, if a particular class of lending becomes large in relation to the balance sheet as a whole, then securitisation can remove some of the assets from the balance sheet;
6. Manage Mortgage Assets: To match-fund certain classes of asset - mortgage assets are technically 25 year assets, a proportion of which should be funded with long term finance; securitisation normally offers the ability to raise finance with a longer maturity than is available in other funding markets;
7. Benefits: To achieve a regulatory advantage, since securitisation normally removes certain risks which can cause regulators some concern, there can be a beneficial result in terms of the availability of certain forms of finance (for example, in the UK building societies consider securitisation as a means of managing the restriction on their wholesale funding abilities .
To the Issuer
1. Lower cost- Cost reduction is one of the most important motivations in securitisation. Securitisation seeks to break an originating company's portfolio into echelons of risks, trying to align them to different investors risk appetite. This alchemy supposedly works the weighted overall cost of a company that has securitised its assets seems to be lower than a company that depends on generic funding. It is important to note here that one of the most tangible effects of securitisation is to reduce the extent of risk capital or equity required (being off balance sheet for regulatory purposes, off balance sheet requirements are dealt with separately) for a given volume of asset creation. Assuming that equity is the costliest of all sources of capital, lower equity requirements do result into lower costs.
The direct impact of lower borrowing costs is on lower lending costs. Mortgage rates in many countries fell after securitisation was introduced or became popular. Many banks also claim to be running on lesser lending costs due to securitisation.
2. Alternative investor base- Without disturbing the existing lenders, securitisation extends the pool of available finding sources to an entity by bringing in a new class of investors. For many entities, typical securitisation investors such as insurance companies, asset managers, pension funds and the like may not just be available for access, other than for investment in a securitisation programme.
3. Perfect matching of assets and liability- Asset liability mismatch is a serious issue for financial intermediaries such as banks and finance companies. It refers to the maturity mismatch between assets and liabilities. Mismatch spells either higher risk, or higher costs, and therefore, intermediaries try to strike a near perfect match between maturities of assets and liabilities.
4. Makes the issuer rating irrelevant- Being an asset based financing, securitisation may make it possible even for a low rated borrower to seek cheap finance, purely on the strength of the asset quality. Hence, the issuer makes himself irrelevant in a properly structured securitisation exercise. One of the common statements rating companies have to make is: in a normal debt issuance, we rate a product. In structured finance issues, the issuer dictates the rating and the structure is worked out accordingly.
5. Multiplies asset creation ability- Securitisation makes it possible for the issuer to create any amount of asset with given equity. The securitiser creates assets and then parts with the same. In essence, therefore, the issuer acts as a manufacturer and inventorisor of assets. The extent of assets he can create is therefore, solely dependent on his 'conversion cycle,' that is, the period that elapses between the dates an underlying receivable is created and is marketed. While in a traditional borrowing case, the amount of capital restrains the maximum amount of assets that can be generated: capital adequacy requirements normally put an upper limit of 12.5 times of risk capital (8% requirements). However if securitisation attains off- balance sheet treatment for regulatory purposes, the amount of capital required is limited by only the extent of credit enhancement provided by the originator.
6. Allow higher funding- A traditional financier looks at the assets on the balance sheet and lends a fraction thereof. For example, a typical bank funding working capital will look at the working capital gap and fund a certain percentage. Securitisation investors look at the cash flows in future, which are not necessarily on the balance sheet. So the issuer might end up getting a higher amount of funding through securitisation than by conventional funding methods.
7. Helps in capital adequacy requirements- Capital adequacy requirements are the requirements relating to minimum regulatory capital for financial intermediaries. One of the very strong motivations for securitisation is that it allows the financial entity to sell off some of its on balance sheet assets, and thus, remove them from the balance sheet, and hence reduce the amount of capital required for regulatory purposes. Alternatively, if the amount raised by selling on balance sheet assets is used for creating new assets, the entity is able to increase its asset creation without cutting capital.
8. Improves capital structure- By being able to market an asset outright (while not losing the stream of profits therein) securitisation avoids the need to raise a liability, and hence, it improves the capital structure. Alternatively if securitisation proceeds are used to pay off existing liabilities, the firm achieves a lower debt equity ratio. The improvement of capital structure as a result of lower debt equity ratio may not be a mere accounting gimmick if securitisation results into either transfer of risks inherent in assets, or capping of such risks, there is a real re- distribution of risks taking place, leaving the firm with a healthier balance sheet and reduced risk.

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