Management of NPAs: Securitization

CoolAvenues Newswire | June 10,2014 11:54 am IST

1. NPAs in India - The Current Scenario
For the past few years, the Indian Banking system has been struggling to manage the vast portfolio of bad loans, popularly known as Non-Performing Assets (NPAs).

The problem is more acute in the case of PSU banks. As of March 2003, the total NPAs of the private and public sector banks put together stood at a whopping Rs 65,000 crore (Source: Trend and Progress of Banking in India, RBI).


NPAs, simply defined, are those loans and advances in respect of which interest and/or principal installment have not been paid for 180 days from the due date. From April 1, 2004, however, any loan on which interest or principal installment is not paid for more than 90 days would be reckoned as NPA. The banking system is, therefore, sure to see a swelling NPA portfolio in the coming years. This poses a serious liquidity and credit risk on the banking system, which unless managed effectively would jeopardize the same.
 

Thus, to prevent the collapse of the whole system due to non-payment of loans by the borrowers, there ought to be some mechanism in place. Two major steps were taken in this regard -
 

1. The RBI directed the banks to maintain compulsory provisions for different types of NPAs;
2. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 was enacted.
 

The SARFAESI Act allowed the banks and financial institutions to take possession of the collateral security given by the defaulting borrowers and sell these assets without having to go through protracted legal procedures.
 

2. Securitization
Securitization is the process of conversion of existing assets or future cash flows into marketable securities. For the purpose of distinction, the conversion of existing assets into marketable securities is known as asset-backed securitization and the conversion of future cash flows into marketable securities is known as future-flows securitization.
 

A typical securitization transaction consists of the following steps: -
 

Creation of a special purpose vehicle (SPV) to hold the financial assets underlying the securities;
Sale of the financial assets by the originator or holder of the assets to the SPV, which will hold the assets and realize the assets;
Issuance of securities by the SPV, to investors, against the financial assets held by it.
 

The purpose of the Securitization Act is to promote the setting up of asset reconstruction / securitization companies to take over the Non Performing Assets (NPA) accumulated with the banks and public financial institutions. The Act provides special powers to lenders and securitization / asset reconstruction companies, to enable them to take over of assets of borrowers without first resorting to courts.
 

The Act was welcomed by the banking community, but resisted by the borrower community. The validity was challenged in various courts on the ground that it was predominantly in favor of lenders. Hence, lenders were unable to enforce the provisions in full. But the crux of the issue was whether the Act would be an effective tool to make a drastic difference to the NPA menace.
 

3. Securitization - Relevance to the Banking Sector
Other than freeing up the blocked assets of banks, securitization can transform banking in other ways as well.
 

The growth in credit off take of banks has been the second highest in the last 55 years. But at the same time the incremental credit deposit ratio for the past one-year has been greater than one. Thus, for every Rs 100 worth of deposit coming into the system more than Rs 100 is being disbursed as credit. The growth of credit off take though has not been matched with a growth in deposits. So, the mismatch between the credit given and the funds received creates an issue of proper management of increased credit off-take.
 

One of the measures adopted by the banks to cater to this credit boom is by selling their investments in government securities and giving the amount raised as loans. But there is a limit to such credit funding due to minimum SLR requirements of 25% in government and semi government securities.
 

As a result of selling government paper to fund credit off take their investment in government paper has been declining. Once the banks reach this level of 25 per cent, they cannot sell any more government securities to generate liquidity. And given the pace of credit off take, some banks could reach this level very fast. So banks, in order to keep giving credit, need to ensure that more deposits keep coming in.
 

One option is to increase interest rates. Another alternative is Securitization. Banks can securitize the loans they have given out and use the money brought in by this to give out more credit. A. K. Purwar, Chairman of State Bank of India, in a recent interview to a business daily remarked that bank might securitize some of its loans to generate funds to keep supporting the high credit off take instead of raising interest rates.
 

Securitization also helps banks to sell off their NPAs to asset reconstruction companies (ARCs). ARCs, which are typically publicly / government owned, act as debt aggregators and are engaged in acquiring bad loans from the banks at a discounted price, thereby helping banks to focus on core activities. On acquiring bad loans ARCs restructure them and sell them to other investors as 'Pass Through Certificates' (PTCs), thereby freeing the banking system to focus on normal banking activities.
 

4. Managing NPAs through Securitization - Facilitating Banks
An interesting shift is noticed in the case of private sector banks. It is common knowledge that these banks have been notably driving the retail banking revolution in the country in the last few years. The Supreme Court verdict would help these banks in a limited manner in respect of their corporate NPAs.
 

However, in case of defaults by retail borrowers, the banks would have to weigh the costs and benefits of tracing each delinquent retail borrower, seizing his assets and trying to sell them off to realize the dues. The lenders may prefer to create homogeneous pools of these assets and securitize them with an asset reconstruction company (ARC) instead.
 

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