The distressed assets situation in India has gradually worsened over the past few years. The stressed loans issue in banks has resulted from a combination of factors including a) undercapitalised projects; b) continued focus on expansion by optimistic promoters who believed that India is decoupled from global trends; c) undercapitalised banks leading to delayed recognition of stressed situations and a consequent debt trap; and d) policy paralysis.

Consequently, bad loans (NPAs + restructured loans) at Indian banks have jumped to ~INR8 trillion representing ~11.5% of gross advances as of March 2016, and things are likely to get worse. This follows an official review in the last quarter of FY2016 by Reserve Bank of India, when India's banking regulator started a bank-by-bank review of stressed accounts as part of an asset quality review (AQR). For all the past few years of growth and reform, banks in India have continued rolling over troubled loans or restructured them, thus deferring the problem at hand. In view of this, Indian banks needed immediate and systemic approaches to ensure sustained recoveries and bring about a turnaround.

Most current slippages pertain to restructured assets that had a moratorium period of 2 years with respect to the repayment of principal. We expect the trend of failed cases coming out of moratorium to continue. Banks have three options: (a) immediately provide for these accounts by recognizing them as NPAs, or (2) put them through another round of restructuring under the Strategic Debt Restructuring (SDR) or 5:25 schemes or the more recently introduced Scheme for Sustainable Structuring of Stressed Assets (S4A), or (3) sell the accounts off to asset reconstruction companies (ARCs) at a discount, thereby providing for a loss. Of the three options, accounts involving large sums are increasingly being restructured either under SDR or 5:25 refinancing.

However, we expect the landscape to change. The recent changes proposed in the Union Budget 2016-17 allowing for 100% foreign direct investment in the ARC space will bring in the much needed capital for ARCs and provide a fillip to the industry. On the back of these developments, ARCs are at a crossroad to make a paradigm shift in their approach and functioning – from asset resolution vehicles to a platform for revival of large businesses by bringing in operational capabilities.

As a global thought leader in the turnaround and restructuring of stressed assets, EY has always been at the forefront in assisting stressed and distressed borrowers, creditors and policy makers. This report aims to outline the current status of the stressed asset market in India, key challenges faced by ARCs, a perspective of the accounting and taxation considerations and puts forth a few strong suggestions and recommendations that could help develop meaningful exit options for lenders and improve liquidity in the market for stressed assets. It also brings to the forefront, the new Bankruptcy Law which could help transform the stressed assets landscape in India, if implemented in the right spirit.

We hope this report will be of value to anyone with an interest in the stressed assets market and also to the decision makers who can genuinely influence a reversal in recent trends. The extent of success of turnaround will also depend on a mutual trust amongst promoters, borrowers and external stakeholders for the genuine revival of companies. As a firm, we remain committed to further developing the knowledge in this field through its wide experience in revitalizing stressed assets.

Executive summary

In the last few years, as the Indian economy registered a downturn, the banks have been straddled with high levels of stressed loans. Macro-economic dynamics have been a major contributor; however, inadequate credit assessments and monitoring are also partially responsible for this situation. Things are not likely to reverse very soon - this follows an official review during the quarter ended March 2016 by the (RBI), when India's banking regulator started a bank-by-bank review of stressed accounts as part of an asset quality review (AQR) – broadly on the lines of stress tests conducted by the US and European authorities after the global financial crisis.

Reviewing the trend of growth in the number of stressed loans, about 30% are from the infrastructure sector – with a significant portion emanating from the power sector. A large proportion of these loans are to government controlled power generation and distribution companies. Operational inefficiencies (technical and commercial), lack of adequate availability of cheaper domestic coal and inability to pass on the increased costs to consumers have impacted these companies adversely. In addition, there are certain issues that are discussed later in the report, which are specific to iron and steel, textiles, aviation and mining - sectors that, along with infrastructure, contribute to over half of the total stressed loans.

On the current distressed asset situation, the RBI Governor shares, "There are two polar approaches to loan stress. One is to apply band aids to keep the loan current, and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists. The fresh lending intended to keep the original loan current grows. Facing large and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the project goes into further losses. An alternative approach is to try to put the stressed project back on track rather than simply applying band aids. This may require deep surgery. Existing loans may have to be written down because of the changed circumstances since they were sanctioned. If loans are written down, the promoter brings in more equity, and other stakeholders chip in, the project may have a strong chance of revival, and the promoter will be incentivized to try his utmost to put it back on track."

Traditionally, banks have preferred to restructure the debt of stressed borrowers through the corporate debt restructuring (CDR) mechanism or the joint lenders forum (JLF). While the CDR mechanism was used extensively, the objective seems to have been to provide temporary relief to the borrower rather than making active efforts to revive businesses. CDRs have met with limited success in reviving stressed assets due to poor evaluation of business viability and lack of effective monitoring. These "living dead" companies limp along, just about servicing their debts but with no hope of recovery or growth. In effect, banks have continued rolling over troubled loans or restructured them, thus postponing the problem at hand.

Initially, the system of selling NPAs to ARCs was popular - certain banks offloaded big chunks of stressed loans to ARCs via the security receipts route. However, in the past few years with a change in acquisition norms (upfront cash component increased from 5% to 15%), this option has not been exercised by the banks due to the expectation gap in the pricing of security receipts (SRs). 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 ARCs to participate in auctions as the reserve price tends to be high. As a result, banks are forced to continue holding these positions until most of their value has deteriorated, resulting in larger losses.

Poor performance of ARCs in resolution of the stressed loans has also affected the industry in two ways – first, the overall deals between ARCs and banks have reduced considerably; second, more banks prefer cash sale to SRs. In view of this, exit through sale of stressed loans to ARCs has been largely underutilized. With the exception of FY14/early FY15, wherein the banks resorted to mass sale of NPAs to ARCs, the overall ARC scenario has been subdued since then.

Until FY15, the RBI and the government had largely stayed away from devising a mechanism that will enable the banks/ lenders to play a direct role in the turnaround of stressed borrowers. However, the strategic debt restructuring (SDR) introduced by the RBI in June 2015 and the Insolvency and Bankruptcy Code, 2016 (the Code) passed by both Houses of the Indian Parliament are significant actions that empower banks to deal with stressed situations rationally. Having said this, our analysis of the SDR cases suggests that this scheme is in no way a magic wand for addressing the Indian banks' deteriorating asset quality – instead it could bring in a high risk into the system by deferring ~INR 1.25 trillion of NPA formation to later years. We also estimate the haircut in case of an SDR exit to be high, resulting in higher provisions for banks even if the SDR is successful.

More recently, with a view to encourage alternative sources of capital, the Union Budget 2016-17 has increased the ceiling on foreign investment in ARCs to 100% (the same is subject to an amendment of the SARFAESI Act), that could provide the much needed fillip to the industry. Distressed asset funds have traditionally been wary of this market due to legal and regulatory issues. However, with the overhaul of the legal framework in the country, this scenario appears to be changing, with the investment by a Hong Kong based distressed and special situations fund in one of the ARCs in the third quarter of FY15. Further, a leading global investment PE firm is in the process of acquiring majority ownership in another ARC in a multi-stage transaction. In our estimate, there are at least 6-8 players that have applied for a license to RBI to operate as an ARC.

The distressed assets space in India is gaining traction on the back of a conducive environment. The regulator and the government have been constantly working on encouraging alternative sources of capital to come into the market, which is a step in the right direction. In order to further strengthen the lenders' ability to deal with stressed assets in an efficient manner and to put good operational companies back on track by providing an avenue for reworking the financial structure of entities facing genuine difficulties, the regulator has issued guidelines on a 'Scheme for Sustainable Structuring of Stressed Assets'. The new restructuring window allows lenders to bifurcate the debt of stressed borrowers into sustainable and unsustainable portions.

Going forward, we see ARCs participating in the revival of large borrowers that have a good turnaround potential by adopting this strategy. We expect to see a massive shift in the resolution mindset of ARCs – from merely liquidating assets to recover their dues to participating in the long term revival of borrowers by estimating sustainable debts and carving out core operational businesses from the non-core assets. However, to make this successful in the long run, it could be the most opportune time for ARCs to place greater emphasis on revival and strengthen capabilities around restructuring and reconstruction. While few ARCs are looking to build up operational skill-sets, others are looking to partner with credible turnaround professional firms with a view to bring in sectoral expertise.

Further, in our view, ARCs should be brought on par with the banking system and be allowed to hold majority equity so as to have an alignment of interest. The success in sustained revival would lie in - ARCs aggregating a minimum of 75% aggregate debt from banks – convert part of the unsustainable debt into equity or other instrument – followed by induction of risk capital towards scaling up of operations/last mile funding. This would go a long way in providing the much needed stimulus to the industry.

The two main impediments to successful and timely resolution that we see on the ground are common decision making between lenders and a timely resolution. Aggregation of debt either in an ARC or for decision making takes over a year as respective Boards have to approve the same. The RBI/Ministry of Finance/government could work on two potential solutions:

  • As discussed in Gyan Sangam (a yearly retreat for banks and financial institutions), all exposures over say INR5 billion needs to be aggregated in the top 5 bankers with all others selling their exposures under guarantee to these top bankers. This way decision making is restricted to five banks and the smaller exposures go with the larger majority.
  • Banks do not believe their actions will not be judged at every stage. Given that they may be questioned on using discretion or innovation is a key impediment to constructive and quick decision making. It may be worthwhile considering forming an aggregating agency which will accumulate debts and then auction the same out based on bids by ARCs and special situation funds. The pricing would be based on commercial discovery and the aggregating agency would then pass on that pricing to the respective banks.

India has taken the bad debt issue very seriously. The RBI has unequivocally directed banks to "clean up" their balance sheets by March 2017 while empowering them with many tools to deal with the situation in the process. The Government has responded with a clear intent to bring about a bankruptcy law that will facilitate the revival and closure of businesses in a timely manner. With these initiatives being implemented in the right spirit, it would be important for ARCs to now transform themselves into turnaround funds with deep operational capabilities to bring about a long-term revival in business value of stressed companies.

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