External Non-Bank Capital and Re-orienting ARCs the Key to Kick-starting the Process
The INR 6trillion bad debt in Indian banks currently would require asset reconstruction companies (ARCs) to re-orient themselves if they are to facilitate the resolution process, says India Ratings and Research (Ind-Ra). With the 15% mandatory investment rule and capital constraints, ARCs would need to be supported by third-party capital for any meaningful movement on the bad debt issue. Ind-Ra believes that the current capital position of ARCs can at most take care of 10% of the bad debt in the Indian banking system. Additionally, a debt-led strategy for investing in security receipts (SRs), leading to a debt/equity ratio of more than 2x, could create liquidity issues for ARCs and may not be in tandem with the long gestation period for recovery in India.
While the current model, wherein banks invest in SRs backed by their own distressed debt has its own limitations, it could be useful for cases of liquidation in which further capital commitment is not required. The benefit of the prevailing model is that it allows banks to capture the contingent upside and, in some cases, support provisioning norms by investing in SRs. However, this model has a number of issues such as misalignment of interests between banks and ARCs, the existence of an unsustainable level of debt delaying the restructuring of companies and banks having to subsist with the problem in their investment books. This problem can be solved if banks are allowed to transact at realistic hair-cuts with the benefit to amortise the losses on sales as long as third-party investors are ready to fully step into their positions.
Ind-Ra’s analysis of four key sectors where most of the stressed debt is concentrated (iron and steel, construction and infrastructure, power and textiles) indicates that for the 240 companies the agency analysed, the hair-cuts needed to arrive at sustainable debt for these sectors ranges from 40%-70%. Ind-Ra believes for most of these sectors, under the most likely scenario of an EBITDA margin of 10%-12% (FY15 and FY16: 8%-10%), continued operation as a going concern may provide better realisations. However, in the event of an incremental stress wherein margins reduce to 6%-7.5%, liquidation could be the only solution. Ind-Ra notes that in developed countries such as the United States, continued operation as a going concern after the emergence from bankruptcy as a reorganised company, or via the sale of the whole company as a going concern, is a much more common outcome than liquidation.
The adoption of the Insolvency and Bankruptcy Code, 2016 in India is likely to streamline debt resolution. However, it is important that the impact of the new regime is reflected in better recoveries or lower loss given default over a period of time. Currently, India is classified as a Group D country by Fitch Ratings with 30%-50% recoveries expected given the level of creditor-friendliness of its insolvency regime. An improved recovery in at least the 50%-70% range will be the real achievement of the effective implementation of the code.