Government has however finally veered to the view that ARCs only can be seen as a solution to the problems faced by banks and other financial institutions in our country. An ARC establishes a market for NPAs. Bank A may have an NPA worth Rs 50 crore, from which it reckons that no more than Rs 10 crore is recoverable. If there is an institution or individual which perceives the NPA to be worth more than Rs 10 crore, then the latter can buy the NPA for more than Rs 10 crore and both the buyer and the seller (Bank A) can be better off from the trade. Recovering NPAs not only depend on the legal and regulatory framework, but also involves considerable amount of time. "Work-out" periods can stretch into years, and no institution will be keen to "buy" NPAs if it perceives that there will be no one else, in the interim, to whom it could resell it at a fair price. Thus, the success of ARCs also depends on the depth and breadth of a secondary market for NPAs.

Two of the East Asian Countries, i.e. Malaysia and Thailand set up ARCs to tackle problem of NPA in their respective countries. Their experience is worth examining.

After the crisis in mid-1997, in October 1997, Thailand set up the Financial Sector Restructuring Agency (FRA) consisting of representatives of the ministry of finance, the central bank (Bank of Thailand), and the private sector. Encouraged by the government, as many as 15 ARCs were set up by the commercial banks by end-2000. The FRA conducted auctions of the NPAs where the ARCs could bid. However, these ARCs were not successful in solving the NPA problem. The government had to step in with a national ARC called the Asset Management Corporation (TAMC) with an initial capital of Baht 15 billion to buy up to Baht 1.35 trillion worth of NPAs from banks

In Thailand and Malaysia as well as other countries of East Asia, all ARCs had to be supported with government funds. In Thailand, the government created a Financial Institutions' Development Fund (FIDF) by issuing bonds worth Baht 500 billion to cover its liabilities. The government pays the interest on these bonds from its budget, while the Bank of Thailand repays from its profits the principal of these bonds on maturity. The TAMC acts as the bidder of the last resort at the auctions of NPAs conducted by the FRA and manages the assets thus acquired for up to five years. TAMC finances its operations through the issue of 10 year bonds guaranteed by the FIDF.

In Malaysia, Danaharta, established in June 1998 as a wholly owned government company, was provided, by the government with, Ringgit 1.5 billion in capital. It raised Ringgit 5 billion by the issue of zero-coupon bonds. Danaharta purchased NPAs worth Ringgit 30 billion from banks and swapped them for five year zero-coupon government-guaranteed bonds with an option to roll over for another five years

By way of summarising the international experience, it is observed that barring a very recent case of Xinda asset Management Corporation in China - which has barely begun its operations - every instance of setting up an ARC has been preceded by massive and systemic banking collapse. This was true of the Resolution Test Corporation (RTC) in the US, which came into being in 1989 after the failure of the savings-and-loan industry; of four ARCs in Scandinavia in the early 1990's; of Danaharta in Malaysia in 1998; of the Financial Restructuring Authority in Thailand in 1997; of Korea Asset Management Corporation; and of FOBAPROA after the December 1994 peso crisis in Mexico. Although the financial system in India suffers from a large burden of NPAs, there has been no systemic banking crisis that automatically warrants an ARC-type bailout. Moreover, only two countries have had successful ARCs : the US and Scandinavia. Most others have been either abject failures or shown no sign of success.

The Government of India, have therefore, formulated the scheme for formation of ARC/SC Companies registered under the Indian Companies Act, 1956 and promulgated an Ordinance in June 2002 taking into account the experience of these countries.

The Ordinance seeks to set up ARCs with minimum contributed capital (not exceeding 15% of the value of the assets taken over and a minimum of Rs.2 Crores). ARCs can thereafter securitise the assets taken over and sells the negotiable instruments to qualified institutional buyers. The proceeds of the sale to be used for payment to the secured creditor for the assets taken over. Further ARCs are also vested with powers to enforce security interest and take over possession of assets/management of defaulters' units without involving the present lengthy procedures prescribed under law. ARCs are to be regulated and registered with RBI. There will also be a Central Registry and Central Registrar to whom details of individual transactions particulars are to be reported on an on-going basis.

A problem that may be faced by the Banks after transferring non-performing assets to the ARC comes to the forefront. This relates to the need for recapitalisation of some of the financial institutions after the NPAs are sold to the ARC. The ARC is likely to buy the NPAs at a considerable discount. The experience of Malaysia shows that for the bulk of the NPAs, the average discount rate applied by Danaharta has been almost 48 per cent. The sale of NPAs by some of our financial institutions to the proposed ARC at such discounts will create a hole in their balance sheet and lead to problems of capital-adequacy. In Indonesia, Asset Management Kredit was set up within the finance ministry's Indonesian Bank Restructuring Agency to handle the problem of NPAs. The government recapitalised the banks only if they transferred their severe NPAs - the "loss" assets, which are fully provided for in the books - to Asset Management Kredit.

Another loose end to be tied up is the issue of pricing and profit or loss sharing. In Malaysia, recoveries over and above Danharta's acquisition cost plus other expenses are shared on a 80:20 basis between the banks and Danaharta. In Thailand also, the TAMC operates on the basis of a complicated profit and loss-sharing with the banks from whom it acquires the NPAs.

Banks are clamouring for possible amortisation of losses in the sale of non-performing assets to asset reconstruction companies (ARCs), which have come up to ferret out locked up loans.

Many banks have expressed concern over the losses in the sale of impaired assets, which are likely to change hands at a heavy discount to the original price. There are scary estimates suggesting banks would lose half of the Rs 80,000-crore NPAs if they sold these to ARCs. Officials acknowledge the fair value would turn out to be less than book value of the loan account in almost all cases, but they are worried about the adverse impact this could have on the books of banks/institutions.

To solve the problem, they have suggested amortising the loan - similar to what has been done in voluntary retirement schemes - as a way to mitigate the impact of a loss on the balance-sheet of banks. The time-frame for this could be at least five years.

Though there is general agreement that the worth of an asset to be transferred from a bank to an ARC must be based on an independent valuation, there are various options on how the price can be fixed.

While transfer at market price is an alternative, another approach being suggested is to tie it to their net book value. Market-determined pricing, however, has emerged the most preferred way. "The valuation of assets sold by banks as well as securities with investors should be done on the basis of market pricing, on an arms length basis. Such a system would factor in all risks," D. Thyagarajan, Crisil's director of structured finance ratings, said.

ARCs might work for the better-off banks and FIs, provided that the NPAs are transferred at an early stage of default when there are still securities worth recovering. Even so, an ARC needs to be structured very carefully like a professional, private sector run mutual fund.

The Industrial Finance Corporation of India (IFCI) has decided to form an asset reconstruction company (ARC) with an authorised capital of Rs 200 million.

The ARC company is intended to provide focussed attention to the process of recovery of non-performing assets (NPA), thereby reducing the overall NPA level of the company and strengthe

The main object of the company, planned before the issue of the recent Ordinance of the Government will be to acquire, restructure and dispose of sick companies. It will also manage the loan assets of banks, financial institutions or other lending bodies and corporates that have turned bad. Some banks and institutions have shown interest in participation in the company and IFCI is reported to be engaged in discussions with them to finalise their participation.

The validity of the Ordinance Issued by the Government has recently been challenged in the Courts by certain borrowers. Presently the matter is sub-judice. However the process has started and one may hope that the measure may fetch results in the future after the pending references to the Courts are disposed of and loopholes observed, if any, are rectified.