a global financial crisis

8/11/2019 A Global Financial Crisis

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Impact of Global Financial Crisis:Role of Asset Reconstruction


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Contents

Impact of global financial crisis: Role of asset reconstruction

Sub-Prime reasons cause a prime crisis

All eyes on the governments

All thoughts on asset reconstruction

Prime issues for considerations

NPA valuation

Standardised sale process approved by the regulator

Flexibility in controlling structure of an ARC

Reduction and standardization of registration fee and stamp duty

Simplification of consent required for enforcement of security

Relaxation of the requirement to take consent of the borrower

Life of trust set up by ARC for asset resolution

Abbreviations used


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Impact of global financial crisis:Role of asset reconstruction

Sub-Prime reasons cause a prime crisis

The sub-prime crisis and its consequent effects on the

global economy saw some of the established financial

institutions getting consumed in the turmoil that

ensured; many others have been pushed to the brink.

The crisis itself is a manifestation of aggressive lending

with inadequate appraisals, lax regulatory supervision

and questionable credit ratings of complex instruments.

Nationalisation of institutions a thought inconceivable

a couple years back is turning out to be an attractive

option for institutions grappling for survival. The crisis

originating in the US has now spread across the

integrated financial world engulfing countries and

sectors that have little to do with the root causes.

The economic indicators are gloomy as the recessionary

phase sets in and market indices have reduced investors

wealth across the globe by a whopping US$ 50 trillion.

14%

12%

10%

8%

6%

4%

2%

0%

-2% 2005 2006 2007 2008

GDP growth trend

USA

UK

Japan

Germany

China

Australia

India

Source: EIU Reports

Movement of stock indices

500

450

400

350

300

250

200

150

100

50

-

2005 2006 2007 2008

USA - S&P 500

Japan - Nikkie

China - Shangai A

India - BSE 30

UK - FTSE 100

Germany - DAX 30

Australia

Base year 2005 =100

Source: EIU Reports


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All eyes on the governments

The sheer magnitude and enormity of the crisis have

left no option for Governments, but to intervene. It

is realised that simultaneous increase in spending by

the Governments is the best bet to beat the crisis.

Concerted and supplementing efforts by various

Governments could be expected in the next fiscal.

Governments across the globe have announced

economic stimulus packages and have earmarked funds

to bail out financial institutions.

Stimulus packages by select countries

Country Stimulus package (US$ bn)

US 787

Japan* 38

China 586

India 14

UK# 180

Germany 693

Australia 35

*Slated to increase by US$ 320 bn.

#Rescue plan for UK banking system of US$ 692 bn

Source: EIU Reports

Various governments while extending the helping hand

to overcome the immediate challenges, are likely to

review policies and state new measures to ensure longterm stability of their respective financial markets: thus

2009 could very well turnout to be a year which would

be all about policy.

China and India have been the fastest growing

economies and are relatively better positioned to tide

over the crisis. In India, the crisis induced problems have

relatively been contained due to factors like:

A well capitalised and prudently regulated Indian

banking system

Domestic demand which constitute 60% of GDP

and is likely to be only moderately affected by the

ongoing crisis

Lack of exposure to equity and asset markets for a

significant proportion of the Indian population

Liquidity crunch unlikely to affect agriculture and

mandatory priority sector lending

At the same time bringing the Indian GDP growth back

to the 9% trajectory, from the below 7% levels projected

for the next fiscal, is going to be a daunting task.

Going forward, asset reconstruction would be the focus

area for all - to salvage, preserve and rejuvenate assets

of economic value.


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Recoveries through various channels (Amount in Rs. bn)

Resolution/recovery channel Particulars FY 2006 FY 2007 FY 2008

Lok Adalat No. of cases referred 268,090 160,368 186,535

Amount involved (a) 21.44 7.58 21.42

Amount recovered (b) 2.65 1.06 1.76

(b) as a % of (a) 12.36% 13.98% 8.22%

DRTs No. of cases referred 3,534 4,028 3,728



(b) as a % of (a) 75.48% 37.82% 51.90%

SARFAESI Act No. of cases referred 41,180# 60,178# 83,942#



(b) as a % of (a) 39.49% 41.39% 60.98%

#: Number of notices issued under section 13(2) of the SARFAESI Act.

Source: RBI

All thoughts on asset reconstruction

Asset reconstruction is likely to play an increasingly

important role as (a) the number of impaired assets in

the financial system increase and (b) learnings from the

ongoing crisis lead to evolution of speedy systems and

procedures for asset reconstruction.

In India, ARCs came into being in response to the

growing NPL levels in the financial system and the

need to have mechanisms to resolve them in a timely

manner. At the same time, there was no imminent

financial crisis to justify direct Government intervention.

As a result, and rightly so, GoI has encouraged the

asset reconstruction space to develop in a competitive

manner.

Simultaneously, the legal system has been revamped

to enable the institutions and ARCs implement quick

resolutions of impaired assets. The legal framework, has

over a period of time, has become more conducive for

resolution of impaired assets with the introduction of

Lok Adalats, Debt Recovery Tribunals and SARFAESI. The

actions and recoveries across these resolution channels

are as under:


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Snapshot of resolution activities by ARCs (Amount in Rs. bn)

Sr. No. Particulars As on 30th June, 2007 As on 30th June, 2008

1. Book value of assets acquired 285.44 414.14

2. Security receipts issued 74.36 106.58

3. Security receipts subscribed by -

a. Banks 68.94 83.19

b. SCs / RCs 4.08 16.47

c. Others (QIBs) 1.34 6.92

4. Amount of security receipts completely redeemed 6.60 12.99

Source: RBI

The creditor friendly provisions of SARFAESI has seen

intense activity in the Indian reconstruction space that

resulted in the formation of as many as 11 ARCs in quick

succession. SARFAESI has been conceived to provide the

required teeth to secured creditors to pursue rapid

resolutions. Certain gaps like procedure for change of

management in a distressed company by an ARC should

be specified at the earliest so that the objective of the

Act can be operationalised. Certain other suggestions

with respect to the Act are highlighted in the sections

below.

With the deepening of the asset reconstruction space,

the number of NPL transactions is on the rise. Deloitte,

as an advisor, has been associated in many of these

transactions that have resulted in resolution of NPLs

aggregating approximately to Rs.35 bn. Deloitte

has been associated with institutions like Industrial

Investment Bank of India Ltd., Union Bank of India

and Bank of Baroda on sell side mandates and Bank of

America and Barclays Bank on buy side mandates.

The table below provides a snapshot of the resolution

activity done by ARCs in recent times.


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NPA movement as a % of advances of SCBs

Although the situation until the end of FY 08 has been

encouraging in the Indian context, signs of economic

distress have become visible from the second quarter

onwards of FY 09. GoI has initiated measures to contain

the impact by announcing a stimus package of

US$ 14 bn. Going forward, the focus should be retained

or else the encouraging numbers of FY 08 can get

changed in a flash. Some of the reasons which compel

us to be cautious are enlisted below:

Fall in total foreign investments

Foreign investments in the country has seen a growing

trend during the period FY 04 to FY 08. During FY 08,

India received total foreign investment of US$ 45 bn.

This encouraging trend has been reversed as the

available data for FY 09 indicates. During the period

April November, 2008 total foreign investment was

a mere US$ 12 bn. The ongoing liquidity crunch in

the global markets is unlikely to hold promise for the

remaining months of the current fiscal.

While RBI has announced series of reductions in the

repo rate, concerns on liquidity remain. As foreign

inflows dry up and government borrowings increase

to finance increased spendings in the backdrop of

reduction in its own revenues, pressure on interest

rates to harden could build. If interest rates were to

spike, financial viability of many projects would become

uncertain resulting in the possibility of an increase in

impaired assets.

The efforts by the government to develop the asset

reconstruction space and make the legal framework

more effective, prudent regulation by RBI, concerted

efforts by banks to reduce NPA levels and the role

played by ARCs have collectively resulted in marked

improvement in the NPA levels in the banking system.

8%

7%

6%

5%

4%

3%

2%

1%

0%

FY 04 FY 05 FY 06 FY 07 FY 08

Gross NPA to gross advances (SCB - %)

Net NPA to net advances (SCB - %)

Source: RBI


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Rapid growth in the advances by SCBs

The advances by SCBs have far exceeded the growth

in GDP. During the period FY 04 to 08, while the GDP

grew at a CAGR of 11%, advances by SCBs grew at a

CAGR of 23%. During FY 08, the advances by SCBs as

a percentage of GDP reached an all time high of 58%.

Formation of NPA is a natural phenomena to lending:

higher the quantum of lending, greater the probability

of NPA formation. It will be reasonable to expect that

level of NPA could increase from current levels not

only because of the ongoing economic crisis but also

because of the sheer increase in advances by SCBs.

GDP at current price (base 1999-2000)

Gross advances to GDP (%)

Source: RBI

50

45

40

35

30

25

20

15

10

5

0

70%

60%

50%

40%

30%

20%

10%

0%FY 04 FY 05 FY 06 FY 07 FY 08

Advance to GDP Rs. in tn


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PAT of BSE 500 (excluding banks) Rs. in bn

Corporate results are worrisome

In the first three quarters of FY 09, the companies in

BSE 500 (excluding banks) recorded lower profits as

compared to the corresponding periods in FY 08.

800

700

600

500

400

300

200

100

-

Q1 Q2 Q3

FY 08 FY 09

Source: Capitaline

Lending to corporates is the most remunerative earning

channel for the lending institutions. As companies

experience profit reductions, it is likely that some wouldrecord losses and a few would become unviable. This

would lead to generation of fresh NPL accounts in the

Indian banking system. In this regard, it may be noted

that the relaxation in guidelines for NPA recognition may

not lead to immediate rise in NPA levels but during the

course of next fiscal or so, increased NPA levels are likely

to be observed.

On the balance, while India is not affected as much as

its western counterparts, there are reasons, as enlisted

above, which are worrisome. The efforts initiated by

GoI, RBI, the lending institutions and ARCs needs to

be further bolstered to ward off the stress that the

economy may experience. Having an efficient asset

reconstruction mechanism would be the key to enable

the Indian economy to sharply and swiftly recover as

the global situation improve. It is supremely importantfor the above reasons that the transactions in the asset

reconstruction space get consummated in a timely

manner to preserve the economic value of assets and to

ensure faster turnaround of capital.

Deloitte, in its role as an advisor for many successful

transactions in this space, has made certain observations

which, if addressed, could result in quicker resolution,

optimal price discovery and higher number of successful

transaction closures all of which would result in

maximisation of economic benefit. These thoughts have

been outlined in the next section.


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Prime issues for considerations

NPA valuation

With an increase in the number of transactions in

the Indian asset reconstruction space, instances of

transactions that have fallen through at the last stages

due to irreconcilable valuation differences between the

seller and the buyer are on the rise. Valuation of NPA

has emerged as the most prevalent deal breaker.

While business valuation would always remain an area

where diversity of viewpoints of sellers and buyers

is certain, in case of NPA transactions, the number

of parameters where the seller and the buyer could

potentially differ is far more as the underlying asset is

non-performing to start with. Some of the key issues

that need to be addressed in this regard are discussed

below:

Estimating the recovery period

Valuation of NPA involves estimation of recovery

periods to arrive at present value. As NPA resolutionoften involves resorting to legal options, estimation of

recovery period becomes tricky as legal proceedings

could become lengthy. Resolution options like

SARFAESI, OTS, CDRs etc. have better process visibility;

resolution through these means, wherever possible, is

likely to result in better valuations by potential buyers.

Otherwise, concerns on estimating resolution period

would come in the way of attractive valuations by

potential buyers. Setting pre-specified timelines for legal

proceedings would facilitate convergence of views of

buyers and sellers as far as estimation of recovery period

is concerned.

Early sale of NPAs for better valuations

A contentious issue for the sellers is that buyers rarely

offer bids that value the account on a going concern

basis even though grounds for such valuation exist. In

almost all transactions, buyers offer bids based on asset

valuation.

There is hardly any valuation in the Ind ian context

where valuation is carried out on a going concern

basis. The main reason is that the NPL accounts that

are typically offered for sale have a long history of

being non-operational which obviates the possibility

of valuation assuming business continuity. As sellers

originate transactions, it is important to expedite the

process that the sellers undertake from the point of

recognition of a NPA to its eventual transfer to an ARC.

Unless there are real opportunities to rapidly restructure

an account while ensuring its continuity, bridging the

valuation gap would remain a challenge for successful

transaction closure especially for accounts that have a

turnaround potential. The sellers need to make the firstmove by offering such accounts for transfer in a timely

manner before significant value erosion of the account

happens.


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Account information and data collation

One of the key reasons that inhibit proper valuation by

potential buyers is the lack of adequate information

that is made available for the account offered for sale.

NPL transactions hinge critically on the quality of the

underlying data. Better the underlying data, steeper

is the valuation. Seller banks should engage in active

monitoring and follow up of the NPL accounts so that

updated information is shared during the sale process.

In consortium funded accounts, there is always the

problem of accurately determining the share of the

seller in a particular loan account offered for sale as the

outstandings for other lenders are often unavailable,

as are legal updates. In the absence of such critical

information, buyers heavily discount their bids. There

is a need to improve inter-lender communication and

coordination that would result in better exchange of

information.

It has also been observed that at times even theavailable information could not be shared with bidders.

The key reason for this has been fragmented data

sources that need to be referred to when sellers launch

processes which require buyers to visit branches where

the account is based rather than making all the relevant

information available at one central data room which is

manned by professionals who understand the accounts

offered for sale and also the sale process. A fragmented

data room process also requires buyers to incur

significant upfront costs and often many buyers choose

not to participate. Centralised data room with adequate

senior level supervision is not an option but a necessityfor successful transaction closure.


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Standardised sale process approved by the

regulator

Bid representing the highest value, received as a result

of a competitive bid process is often subjected to a fresh

evaluation by the seller. While the seller bank should

have a right to negotiate with the highest bidder to

explore the possibility of enhancement of the highest

bid, the disposition of the seller should be to close

the transaction when the fair market price has been

discovered.

It is necessary that all stakeholders address these

problems so that processes that are conducted in good

faith and in a transparent manner are not shelved. As

it would not be possible for the regulator to prescribe

valuation methodologies that the seller banks could

follow as the conditions associated with each asset

varies thereby making any standardisation attempt

ineffective, the next best option would be to have

sale processes prescribed by the regulator for sale

involving a single asset or a portfolio. Transparent andcompetitive bid processes are already being conducted.

A formal approval by the regulator and a buy in of

the stakeholders would go a long way in instilling

confidence to sellers to close such transactions.

Flexibility in controlling structure of an ARC

Depending on the background under which ARCs

are formed in a country, we have now the following

structures that are prevalent globally:

ARCs that are owned / sponsored by the government

ARCs that are owned by the banks

ARCs that are in the private sector domain

In India, ARCs came into being in response to the

growing NPL levels in the financial system and the

imperative need to have mechanisms to resolve them

in a timely manner. At the same time, there was no

imminent financial crisis that was emerging to galvanise

direct government intervention. As a result, and rightly

so, GoI has encouraged the asset reconstruction space

to develop in a competitive manner.

The ARCs in India consequently either have a private

sector ownership or have bank based ownership.

Nevertheless, there are restrictions on controlling stake

by a single party in an ARC which in the background

of allowing competitive forces to develop the asset

reconstruction space appears to be restrictive.

A relaxation of this norm would encourage more

private sector entities, including foreign players, to have

a presence in this space bringing more depth to this

sector. There are firms who specialise in resolution of

stressed assets in specific industries and have an edgeover generic reconstruction companies as they bring

in superior industry specific knowledge and expertise.

Presence of such firms would expedite the resolution

process and is also likely to enhance realisation which

would eventually maximise benefit for the overall

economy. It should be possible to introduce guidelines

to check potential for misuse which a flexible ownership

structure could be prone to.

Reduction and standardisation of registration fee

and stamp duty

The registration fee and stamp duty payable at the timeof assignment to the buyer varies from state to state.

GoI should initiate the process of rationalisation of the

registration fee and the stamp duty to simplify the post

sale processes and reduce the overall transaction cost

across all states.


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Simplification of consent required for enforcement

of security

SARFAESI specifies that secured lenders, in case of joint

financing, can enforce securities only if they have the

consent of 75% of lenders in value. It can be safely

concluded that in most of the complex and sticky NPL

accounts, the number of secured creditors are too many

which acts as a major deterrent in aggregation efforts.

The Act does not modify the charge to any lender group

in any manner but the consent of junior charge holder

becomes necessary nonetheless.

This provision needs to be modified to enable speedy

recovery when the assets underlying a NPL account

is still in good condition and worthy of productive

economic use.

Consequently, it would be appropriate to have consent

of only the senior and pari- passu charge holders

for security enforcement and only the loan amounts

pertaining to such senior and pari-passu charge holdersshould be considered for evaluating the applicability of

75% of value requirement. The junior charge holders

do not stand to lose in the process, as they would get

compensated to the extent possible after the claim of

the senior charge holders have been settled.

Relaxation of the requirement to take consent of the

borrower

Rule 9(2) of The Security Interest (Enforcement) Rules,

2002 specifies that if for sale of an immovable property,

no bids are received at price above the reserve price,

consent of the borrower and the secured creditors

would be required to conclude the sale at a price

lower than the reserve price. The requirement to take

the consent of the borrower often results in avoidable

delays and further erosion of the underlying asset value.

It would, therefore, be helpful if the said rule is relaxed.

Life of trust set up by ARC for asset resolution

The life of the trust set up for asset reconstruction

has been specified to be a maximum of five years in

accordance with the Securitisation Companies and

Reconstruction Companies (Reserve Bank) Guidelines

and Directions, 2003.

There should be flexibility for extending the life of the

trust if resolution is ongoing or appears to be likely inthe foreseeable future.


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In this report, we have highlighted some of the

important issues which can encourage faster transaction

closure in the asset reconstruction space which is going

to become increasingly important for the long term

stability of the financial sector. For further information

and thoughts, please feel free to contact one of the

specialist listed below.

Avinash GuptaNational Leader, Financial Advisory Services

Tel: +91 22 6622 0515

Email: [email protected]

Rahul Choudhry

Director

Tel: +91 22 6622 0517


Deepak NettoHead, Reorganisation Services

Tel: +91 22 6622 0506


Rajgopal Pai

Manager

Tel: +91 22 6622 0563


Deloitte Touche Tohmatsu India Private Limited

Maker Towers E, 4th Floor, Cuffe Parade

Mumbai 400 005, India

Tel: +91 22 6622 0500

Fax: +91 22 6622 0501


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Abbreviations used

ARC: Asset Reconstruction Company

CAGR: Compounded Annual Growth Rate

CDR: Corporate Debt Restructuring

DRT: Debt Recovery Tribunal

FDI: Foreign Direct Investment

FY: Financial Year

GDP: Gross Domestic Product

GoI: Government of India

NPA: Non Performing Asset

NPL: Non Performing Loans

OTS: One Time Settlement

RBI: Reserve Bank of India

SARFAESI Act: Securitisation and Reconstruction of Financial Asset and

Enforcement of Security Interest Act

SC / RC: Securitisation Company / Reconstruction Company

SCB: Schedule Commercial Bank

QIB: Qualified Institutional Buyers


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