n the banking system, high level of NPAs can be serious drag on overall performance of economy on account of diversion of its

management and financial resources towards recovery of NPAs. Greater the resources needed by banks to reserve for losses, lesser is the amount of capital they can leverage. Consequently it makes the banks risk averse in providing new loans leading to credit crunch in the financial market, amounting to economic and financial degradation. ARCs are established to acquire, manage, and recover illiquid or NPAs from lenders, unlocking value trapped in them via an institutional platform. Benefits

Relieving banks of the burden of NPAs would allow them to focus better on managing the core business including new business opportunities. The transfer should help restore depositor and investor confidence by ensuring the lenders financial health. ARCs are meant to maximise recovery value while minimizing costs. ARCs can also help build industry expertise in loan resolution, besides serving as a catalyst for important legal reforms in bankruptcy procedures and loan collection. ARCs can play an important role in developing capital markets through secondary asset instruments.

ARC Ownership Models Different countries have tried out varying models of ownership of ARCs. The options range from asset workout departments or units of banks, bank-owned subsidiaries or affiliated companies, private companies, and government owned asset management agencies. The severity or systemic nature of a countrys NPA problem usually dictates the NPA resolution strategy and the parameters for judging its success. A countrys institutional, legal, and market conditions also influence the decision. Typically, the primary goal is to maximise net present value recovery in order to minimise losses to either the selling bank or the government, depending on the ARC model used. Government-based ARCs may have additional challenges such as minimising adverse market impact from the asset recovery process or helping to rehabilitate troubled banks and distressed borrowers. In general, most bank resolution programs involve removing NPA from normal bank operations. ARCs usually operate through one of the two basic models namely bank based model, which is a decentralised approach or a government based model, centralised approach. Government Based ARCs In a government based model, an agency is sponsored by government which acquires and resolves the bad assets. The NPAs are owned by the government and managed by the ARC or partially contracted out to private managers. The ARC can be a special-purpose organisation which will be entrusted to acquire, manage and recover NPAs. It can also have other operations like deposit insurance or bank recapitalisation. Moreover in this model, centralisation of NPA provides effective asset packaging and marketing, ensuring consistency and transparency within the ARC. In addition, the risk of decrease in sale values of assets by the competing bank based ARCs is also reduced. Bank based ARCs A bank based model has two approaches viz workout units and bad banks. In workout units, NPAs are moved to a separate bank department but remain in the banks books. On the other hand, the bad bank approach includes the transfer of NPAs to a separate affiliated organisation i.e. ARC, which specialises in the management of bad assets. However, a government based model is more effective in an economy where the NPA problem is more pervasive and business environment or legal infrastructure is less developed. A bank based model is generally appropriate when the NPA problems are limited and concentrated. Valuing Distressed Asset Valuation techniques are needed in order to make informed decisions regarding asset purchase price as well as the timing and the nature of sales transactions and other sales strategies. The valuation process can also influence other decisions, such as whether or not to provide seller financing or to fund asset enhancements (or even the operations of a business). Valuation should play a major role in deciding whether or not to engage in debt-for-equity swaps with borrowers or in determining the funding cost of

providing equity participation. Additionally, asset valuation procedures are necessary in monitoring and reporting on the financial condition of the ARC. The first step in valuation is to collect the necessary information about the loan and then to stratify and segment the asset pool by size, industry, operating condition, and location. Sources of information include loan files, bank files, service providers, bankruptcy procedures, the trustee/ receiver, feasibility studies, appraisals, industry and sector details. The ARC specifies the minimum level of information desired for each category of loans, based on the availability of information and asset value. It should require selling banks to furnish asset information to guide betterthan -liquidation pricing. The type of information that is necessary for analysis may include rescheduled loan payment and workout plans, payment history, rank of obligation in priority of claims, property descriptions, and description and value of collateral. With this information, the ARC should determine a valuation methodology, based on asset categories and recovery strategies, and then develop an appropriate model to derive the investment value. The more significant an asset, the more rigorous the valuation effort should be. The AMC should develop due-diligence material, ideally in a standard format, taking the asset information into account. Resolution Strategy for NPA After acquiring the NPA from the sellers, the ARC will implement the resolution strategy for the underlying assets of the non performing loan. The ARC has been given powers by the SARFAESI Act to execute the resolution of NPA whereby it can:

Restructure the loan. Sell or lease part/whole of the assets or the business to a third party. Change the management structure by introducing its own personnel in the management. (presently this section has been kept in abeyance by the regulator) Restructure the business operations including diversification of business operations or discontinue the loss making business segment.

Disposition Strategies A number of sales techniques are possible. These include -

Portfolio sales Open outcry and sealed-bid auctions Securitisation Equity participation transactions

Transaction Structures Stage 1: Initially, an ARC acquires NPA by floating an SPV which acts as a trust whereby the ARC is a trustee and manager. NPA are acquired from banks/FIs at fair value based on assessment of realisable amount and time to resolution. The banks/FIs may receive cash/bonds/debentures as consideration or may invest in securities issued by the ARCs. The trust acquires NPAs from banks/FIs and raises resources by formulating schemes for the financial assets taken over. Accordingly, it issues securities to the investors which are usually QIBs. Securities represent undivided right, title and interest in the trust fund. Subsequently, the ARC redeems the investment to the bank/FIs out of the funds received from the issued securities. After acquiring the NPA, the trust becomes the legal owner and the security holders its immediate beneficiaries. The NPAs acquired are held in an asset specific or portfolio trust scheme. In the portfolio approach, due to the small size of the aggregate debt the ARC makes a portfolio of the loan assets from different banks and FIs. Whereas when the size of the aggregate debt of a bank/FI is large, the trust takes asset specific approach.

Stage 2: Thereafter, different fund schemes are pooled together in a master trust scheme and sold to other investors. The ARC periodically declares the NAV of respective schemes.