What is an Asset Reconstruction Company?

Posted by Enterslice on August 3rd, 2018

Nowadays the main problem faced by our banking industry is nothing but the burden of Non-Performing Assets (NPA) in the loan book. Such NPA is nothing but the amount lent by the banks to the borrowers and which is not realizable at present by the banks. The bank takes several steps to overcome this NPA problem and one of such remedies is to take help of Asset Reconstruction Companies or ARCs.

ARC’s is a financial institution having its main activity to buy bad assets or NPAs from banks at a negotiable price and thus assist the banks to remove such NPAs from their books of account.  

What are ARCs?

An Asset Reconstruction Company (ARC) is a specific type of financial institution (having registered with the RBI) purchasing the NPAs or bad assets from banks so that the latter can clear such debts from their balance sheets. Thus, ARCs are in the activities of purchasing the bad loans from the banks or even financial institutions.

Thus, the balance sheet of the banks is cleaned up when they sell their NPAs to the ARCs. This will help the banks to focus on their routine banking activities and save their time of chasing the defaulters for recovery. The banks sell the bad assets (NPAs) to the ARCs at a mutually agreed value.

SARFAESI Act 2002 - Origin of ARCs set up

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002; which came in force in December 2002 gives the legal basis for the setting up ARCs in India. Section 2 (1) of the Act clearly explains the meaning of Asset Securitization and Section 3 of the Act explains in details the ARCs.

The SARFAESI Act predominantly assists the reconstruction of NPAs (bad assets) without court intervention in the matter. Since then, many ARCs were formed and registered with the RBI being the sole regulator for ARCs.

Capital Requirement for ARCs

Recently the RBI has raised the capital requirement for (ARCs) to Rs 100 crore, from the previous limit of Rs 2 Crore as the often very high amount is required to buy bad loans (NPAs) from the banks. Further, the ARCs have to maintain a capital adequacy ratio of 15% of its risk-weighted assets on an ongoing basis. The RBI has prescribed a process for ARC registration.

Working of ARCs and method to procure funds to buy bad assets (NPA) from banks?

  1. Generally, ARC will take over the NPA's from banks for fixed cost which is less than the NPA amount.
  2. Then such NPA is transferred to ARC along with any security which is pledged by the borrower while taking a loan from the bank.
  3. Now, in order to raise the funds, ARC will issue security receipts for the fixed interest rate. Such raised monies can be invested in financial institutions.
  4. Then ARC will initiate a legal procedure to sell the pledged security of the borrower in the market. This may take quite some time to realize the money. Meanwhile, the ARC will utilize the money raised for meeting its expenses. Further, ARC has to pay timely interest on security receipts to the qualified institutional buyers.
  5. On completion of selling the bad asset by clearing all litigations, ARC Company will take back the security receipts which are issued by it earlier for an agreed price.

The calculation of the profit earned by ARC in such transaction is done as follow:

Profit earned by ARC = sale price of security + interest on investment - purchase cost of NPA - interest on security receipts issued – its expenses.

Thus Asset Reconstruction Companies or ARCs purchase bad assets or NPAs from banks at a negotiable price and help banks to clean up their balance sheets by purchasing the NPAs.

Such "security receipt" denotes a receipt or other security, issued by an ARC to any qualified institutional buyer(QIB) in connection with a scheme of purchase of NPAs, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in the securitization;

To meet the requirements of the funds, an ARC may also issue bonds and debentures however the main source of funds is the issue of Security Receipts (SR). As per the SARFAESI Act, security receipt is a type of receipt or any security, issued by an ARC to any QIBs for a particular scheme under consideration. Such holder of the SR gets a right, title or interest in the financial asset that is acquired/purchased by the ARC and further this SR is supported by impaired assets purchased by ARC from the bank. 

The "qualified institutional buyer" (QIB) here means and includes a financial institution, banks, insurance company, state industrial development corporation, state financial corporation, trustee or registered securitization company or reconstruction company or any asset management company.

ARC shall acquire such NPAs at a ‘fair price’ in an arm’s length principle in an objective manner and use a uniform process for assets having the same features.

Further, SARFAESI Act permits ARCs to possess financial assets through an agreement with the banks and FIs and they, in turn, may receive bonds/ debentures in exchange for NPAs transferred to such ARCs. However, a part of such value of NPA can be paid to the banks by ARC in the form of Security Receipts and as per the latest regulations ARCs should give 15% of the value of such assets in cash to the banks.

There is ample scope for the activities of the ARC companies in India.

In India, currently “ARCIL” is the biggest and the oldest ARC.

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