With burgeoning of globalization & liberalization, there has been a paradigmatic shift in the role banks and other financial institutions in shaping Indian Economy. Banks & Financial institutions constitute the bedrock of any economy and, for any economy to realize its acme it must have a bolstered banking sector. Albeit in recent times perhaps just after the beginning of this millennium until the devastating financial crisis of 2008 and thereafter, banking sector has been grappled with bad debts and non performing Assets (NPAs). As NPAs and bad debts hinder the credit growth facilities and retard the money lending practices of financial institutions, therefore to curb such invariably rampant borrowings becoming NPA a potent mechanism is required. Hence, this scholarship would delve into a potent panacea to the conundrum of NPAs by explicating the concept of securitization of financial assets to recover secured creditors’ outstanding dues under the SARFAESI Act 2002. Moreover this scholarship would expound the concept & modus operandi of securitization, a brief conspectus on NPA accounts, role of securitization and reconstruction companies to improve capital requirements & liquidity position of bankers to resuscitate their operational efficiency of granting advances and loans with a minimum credit risk for a sound financial health of Indian banking sector.
NPAs & the need for Securitization in Banks: A Prologue
The banking sector is an edifice of any financial system or economy in the world. The smooth functioning of the banking sector ensures the healthy condition of an entire economy. In the process of accepting deposits and lending loans banks create credit against the assets or receivables, which thus act as securities. The funds received from the borrowers by way of interest on loan and repayments of principal are recycled for raising resources to further infuse capital by way of loans or advances in the economy. However in the process, building up of non-performing assets (NPAs) by defaults of the borrowers disrupts this flow of credit. It hampers credit growth and affects the profitability of the banks as well since the main source of income of banks is through the interest earned on loans and advances and repayment of the principal. If such assets fail to generate income, then they are classified as non-performing assets (NPA). NPAs herald the performance of the banking sector and as per Reserve Bank of India (RBI) report in November 2018, the gross amount of poor quality loans is in excess of Rs 9 lac crores , which shows the deleterious impact it has on lending practices of banks and their liquidity positions.
Healthy and efficient financial sector is indispensable for any economy to rapidly climb the ladder of success. Therefore, RBI attempted to bring about structural and administrative changes in the banking sector to introduce various norms and guidelines to obliterate the menace of NPAs in financial institutions like the Securitization Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003 to regulate the trusteeship of the Securitization & Reconstruction Companies to aid banking institutions to recover their outstanding dues. Moreover, prior to SARFAESI enactment in 2002, banks were bereft of any power to take possession of securitized assets and sell them off to investors to expunge the credits accorded to defaulting borrowers from their balance sheets. Therefore, SARFAESI enactment salvaged the wrecked ship of bankers from sinking as it had been insurmountable to resuscitate the credit facilities which hitherto became stagnant on the account of assets turning NPA, had there not been any provision for creating security backed assets to improve banking institutions’ liquidity under SARFAESI Act 2002.
A Brief Conspectus on the menace of NPA & its deleterious Consequences:
One of the major causes of financial crisis of 2008 was the poor money lending practices coupled with high credit risks undertaken by the various financial institutions of the world. The entire world economy was in the doldrums and perhaps the situation exacerbated by the surging number of borrowers’ accounts becoming NPA, thereby reducing the capital adequacy for the banks to extend loans to other potential business houses and entrepreneurs. An asset, including a leased asset, becomes non-performing asset when it ceases to generate income for the bank and therefore such NPAs plummets the profits earned by banking institutions by way of interest on loans and repayment of the principal since all loans and advances that it issues to its borrowers are considered as assets as it results in revenue generation for bank by collecting interest. However, these institutions do not undertake a coherent due diligence and investigations to scrutinize the authenticity of the underlying collateral or the capability of the borrowers to repay their debts and hence it makes the credit facilities extended by these institutions vulnerable to abuse as the funds borrowed by the customers may be diverted for some other transaction than for which the loan was sought without communicating or intimating the banking institution.
With the proliferation and development of banking activities, number of NPA accounts surged considerably in last decade. More so, when ambitious program for branch development and extension of banking services led to new recruitments, transfers, relocation & unhealthy competition amongst offices of the same bank. And often, for achieving business targets, the prudential banking norms were forgotten and proper appraisal of the loan proposals, the provisions of standard bank sanction letter, errors in execution of the loan agreements, deed of hypothecation and mortgages were also often overlooked for compliance in the hurry for disbursement and achievement of set targets for purposes of building-up record of a generous banking institution garnering more loan applicants.
A “non-performing asset” (NPA) was defined as a credit facility in respect of which the interest and/or installment of principal has remained past due for a specific period of time. The NPA has been defined under the SARFAESI Act 2002 to expedite the recovery mechanism of the outstanding dues. The SARFAESI Act 2002 defines non performing asset as thus:
“Non-performing asset means an asset or account of a borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset,-
a) In case such bank or financial institution is administered or regulated by any authority or body established, constituted or appointed by any law for the time being in force, in accordance with the directions or guidelines relating to assets classifications issue by such authority or body;
b) In any other case, in accordance with the directions or guidelines relating to assets classifications issued by the RBI.”
Classification of NPA: The non-performing Assets are classified into 3 categories namely:
a) ‘Sub-standard asset’ for a period not exceeding 12 months from the date it was classified as non-performing asset;
b) ‘Doubtful asset’ if the asset remains a sub-standard asset for a period exceeding 12 months;
c) ‘Loss asset’ if:
1. The asset is non- performing for a period exceeding 36 months;
2. The asset is adversely affected by a potential threat of non-recoverability due to either erosion in the value of security or non-availability of security;
3. The asset has been identified as loss asset by the Securitization company or Reconstruction company or its internal or external auditor; or
4. The financial asset including Security Receipts is not realized within the total time frame specified in the plan for realization formulated by the Securitization company or Reconstruction company under the RBI guidelines, and the Securitization company or reconstruction Company or the trust concerned continues to hold these assets.
An asset is classified as non-performing asset (NPA) if dues in the form of principal and interest are not paid by the borrower for a period of 180 days, however, with effect from March 2004, default status would be given to a borrower if dues are not paid for 90 days. After making improvements in the payment and settlement systems, recovery climate, upgradation of technology in the banking system, etc., prudential norms issued by RBI declared to do away with the concept of ‘past due’ concept and accordingly redefined the concept of NPA which shall be an advance where-
1) Interest and/or installment of principal remain overdue for a period of more than 180 days in respect of a term loan.
2) The account remains “out of order” for a period of more than 180 days, in respect of an overdraft/cash credit (OD/CC).
3) The bill remains overdue for a period of more than 180 days in the case of bills purchased and discounted.
4) Interest and/or installment of principal remains overdue for two harvest seasons but for a period not exceeding two and a half years in the case of an advance granted for agricultural purposes, and
5) Any amount to be received remains overdue for a period of more than 180 days in respect of other accounts.
Deleterious Consequences of NPA:
The problem of NPAs in the Indian banking system is one of the abominable and the most formidable problems that had impact the entire banking system. NPA on the balance sheets of the banking Institutions trembles the confidence of investors, depositors, lenders etc. few of the most deleterious impacts of NPA on banking institutions are as follows:
I. Profitability: NPAs put detrimental impact on the profitability as banks stop to earn income on one hand and attract higher provisioning compared to standard assets on the other hand. On an average, banks are providing around 25% to 30% additional provision on incremental NPAs which has direct bearing on the profitability of the banks.
II. Asset (Credit) contraction: The increased NPAs put pressure on recycling of funds and reduces the ability of banks for lending more and thus results in lesser interest income. It contracts the money stock which may lead to economic slowdown. Moreover, genuine borrowers face the difficulties in raising funds from the banks due to mounting NPAs because either the bank is reluctant to extend credit facilities to the genuine borrowers of even if the funds are extended, they come at a very high interest rate to compensate the lender’s losses caused due to mounting levels of NPAs.
III. Liability Management: In the light of high NPAs, Banks tend to lower the interest rates on deposits on one hand and likely to levy higher interest rates on advances to sustain the impact of NPA. This may become hurdle in smooth financial intermediation process and hampers banks’ business as well as economic growth.
IV. Capital Adequacy: As per Basel norms, banks are required to maintain adequate capital on risk-weighted assets on an ongoing basis. Every increase in NPA level adds to risk weighted assets which warrant the banks to augment their capital base further. Capital has a price ranging from 12% to 18% since it is a scarce resource.
V. Shareholders’ confidence: Normally, shareholders are interested to enhance value of their investments through higher dividends and market capitalization which is possible only when the bank posts significant profits through improved business. The increased NPA level is likely to have adverse impact on the bank business as well as profitability thereby the shareholders do not receive a market return on their capital and sometimes it may erode their value of investments. As per extant guidelines, banks whose Net NPA level is 5% & above are required to take prior permission from RBI to declare dividend and also stipulate cap on dividend payout.
VI. Public confidence/Bank’s reputation: Credibility of banking system is also affected greatly due to higher level NPAs because it shakes the confidence of general public in the soundness of the banking system. The increased NPAs may pose liquidity issues which may have them in a stagnant financial position.
Hence, it may be concluded that the increased incidence of NPAs has a cascading impact not only on the banking institutions but also the economy of the nation as a whole.
Internal Regulatory Framework to curb NPAs:
Banks must have an appropriate internal system to eliminate the tendency to procrastinate the identification of NPAs, especially in respect of high-value accounts. Moreover, the RBI had issued guidelines in 2004 that if any credit facility accorded by bank to a borrower becomes non-performing, then the bank will have to treat all the advances/credit facilities accorded to that borrower as non-performing without having any regard to the fact that there may still exist certain advances/credit facilities having performing status. Also, the banks may fix a minimum cut-off point to decide what would constitute a high-value account depending upon their respective business levels. The cut-off point should be valid for the entire accounting year. Responsibility and validation levels for ensuring proper asset classification may be fixed by the banks. The system should ensure that doubts in asset classification due to any reason are settled through specified internal channels within one month from the date on which the account would have been classified as NPA as per extant guidelines. Also, various public sector banks including few private banks have evolved a concept of credit score based on the guidelines and directions issued by the RBI in 2004 to mitigate bad loans and to enhance the operational efficiency of extending credit facilities. According to the guidelines issued by the RBI in2004, all the banks and financial institutions are required to obtain the consent of all their borrowers for pooling of data for development of a comprehensive credit information system which would be maintained by Credit Information Bureau India Ltd. and the data may be accessed through their website which would facilitate to have a comprehensive information as to the accounts which have the potential of becoming NPA, so that timely intimation can be accorded to the borrowers’ about their accounts becoming NPA.
Potent Panacea of Securitization in Recovery Mechanism of NPAs under SARFAESI Act 2002:
In the year 1969 the Government of India felt the need to bring uniformity in the functioning of banks and to bring them under a single umbrella of regulatory mechanism and hence 14 largest private banks were nationalized and again in the year 1980, 6 more banks were nationalized. Furthermore, it was also exhorted by the RBI along with the central government to extend advances for agricultural, micro, small and medium enterprises to propel India’s fledgling agrarian and other sectors to market success. All these loans and advances were given without any security and therefore defaulting borrowers could abuse the inability of banks to recover their dues, which ultimately resulted in the menace of NPA, which had pernicious ramifications for the profitability of the banking sector. Earlier, a secured creditor’s sole recourse to realize an unpaid loan was a long drawn process to initiate a suit in a court of law to execute the underlying collateral property. The creditors were at a comparatively weaker position in this scenario as the judicial process was lengthy and exorbitant. Therefore, the main objective of the SARFAESI Act was to truncate the delay in the process of adjudication by empowering secured creditors to realize the underlying collateral without knocking the doors of the court. Further, unlike international banks, the banks and financial institutions in India do not have power to take possession of securities and sell them. Our existing legal framework relating to commercial transactions has not kept pace with the changing commercial practices and financial sector reforms. This has resulted in slow pace of recovery of defaulting loans and mounting levels of non-performing assets of banks and financial institutions. Narasimham Committee I &II and Andhyarujina Committee constituted by the central government for the purpose of examining banking sector reforms have considered the need for changes in the legal system in respect of these areas. These Committees have suggested enactment of a new legislation for securitization and empowering banks and financial institutions to take possession of the securities and to sell them without the intervention of the court and therefore, the SARFAESI Act was enacted in 2002 to regulate the securitization transactions in Indian capital market. This enactment would enable banks and financial institutions to realize long-term assets, problem of liquidity, asset liability mismatches and improve recovery by exercising powers to take possession of securities, sell them and reduce non-performing assets by adopting measures for recovery of outstanding dues or reconstruction. Securitization is thus defined under the SARFAESI Act 2002 in the following words:
“Securitization means acquisition of financial assets by any asset reconstruction company from any originator, whether by raising of funds by such asset reconstruction company from qualified buyers by issue of security receipts representing undivided interest in such financial assets or otherwise.”
Asset securitization has emerged to be a recent potent tool to obliterate NPAs in banks and financial institutions. Asset securitization is a process whereby a financial institution creates a homogeneous pool and packages of individual loans and receivables, creates securities against them, gets them rated, and sells them to investors in a market. This way the process of securitization stimulates assets into securities and securities into liquidity, thereby increases turnover of business and profits and salvage banks from the quagmire of NPAs.
Modus Operandi of Securitization:
A Securitization transaction involves three parties, the obligor or the borrower, the originator or the lender usually banking institutions and the special purpose vehicle which is generally the securitization and asset reconstruction company. Securitization transaction may have a series of stages, which are as follows:
1) Creation of a special purpose vehicle (SPV) or transferring the assets to securitization or an asset reconstruction company, whereby the lender will liquefy its assets underlying the securities through what is called, a pass through transaction.
2) Sale of the financial assets by the originator or holder of the assets by transferring the secured assets to the SPV or Asset Reconstruction Company for consideration or for a collateralized loan. Moreover, these SPVs are an extended arm of the originator and its entire activities are controlled by the latter.
3) Issuance of securities by these SPVs or Asset Reconstruction Companies against the financial assets held by it, by raising funds to potential investors and institutional buyers by issuing security receipts.
After undergoing these 3 stages of securitization, the process leads to the NPAs in the balance sheet of the banking institutions getting expunged therefrom, thereby relieving pressures of capital adequacy, and provides immediate liquidity to the banking institutions to meet the exigencies of extending new loans to borrowers and to facilitate their daily operations.
Procedure engrafted in the SARFAESI Act 2002 to recover NPAs:
Procedure engrafted under the Securitization & Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 lays down a lucid recovery mechanism of NPAs that retard financial health of banking institutions. The procedure of realizing and enforcing the security interest is enumerated in Section 13 of the SARFAESI Act 2002, whereby under section 13(2), banks can issue notices to the defaulters to pay off the dues and the borrowers are required to discharge the outstanding dues within 60 days from the date of notice and in case if the borrower fails to pay off his dues within 60 days limit as prescribed under Section 13(2), the banking institutions may have a recourse under section 13(4) to the following measures to recover its dues:
1. Take possession of the secured assets of the borrower including the right to transfer by way of lease, assignment or sale for realizing the secured asset.
2. Take over the management of the business of the borrower including the right to transfer by way of lease, assignment or sale for realizing the secured asset.
3. Appoint any person thereafter referred to as the manager , to manage the secured assets the possession of which has been taken over by the secured creditor.
4. Require at any time by notice in writing, any person who has acquired any of the secured assets from the borrower and from whom any money is due or may become due to the borrower, to pay the secured creditor, so much of the money as is sufficient to pay the secured debt.
Perhaps, the process of securitization must be conducted smoothly and in a time bound manner. Also the assets held as securities by the banking institutions to recover their NPA must be disposed off in a diligent manner taking into account the depleting recoverable value of the asset and the contingency of not fetching a good price. If such a situation is allowed to prevail by not disposing off the NPAs in a timely and a diligent fashion, then the whole object of the SARFAESI Act may be frustrated by not providing to them the capital requirements to enhance its liquidity position, and this may disincentivize the banking sector to grant advances and funds to the borrowers and other entrepreneurs for various infrastructure projects to boost the Indian economy.
The SARFAESI enactment passed in 2002 came down pretty hard on the borrowers as it ignored the cardinal principle of audi alteram partem. Moreover, such aggrieved borrowers could not approach the Civil Court or the Debt Recovery Tribunal until their secured assets are attached and sold off. Therefore, the whole procedure caused great prejudice to the borrowers whilst disposing off their assets without giving them any right to be heard until the landmark pronouncement of the Supreme Court of India in the case of Mardia Chemicals Ltd & Ors. V UOI , wherein substantial changes in the process of Securitization under the SARFAESI Act were made. The most pertinent corollary of the verdict in the aforesaid case was the interpolation of Section 3-A under Section 13 of the SARFAESI Act, whereby on receiving the notice under Section 13(2), borrower makes any representation or raises any objection, the secured creditors mandated to consider such representation or objection and if he reaches a conclusion that the objection is not tenable, then he shall communicate the reasons in writing for non acceptance within 1 week from the receipt of notice under Section 13(2). Furthermore, the court held that albeit the liquidity and flow of money is essential for any healthy and growth-oriented economy but the SARFAESI act must not be in derogation to the rights of borrowers under the Indian Constitution by extracting exorbitant fees from them to file an appeal in the DRT within 45 days and thus section 17(2) was struck down as unconstitutional. Moreover, court pressed the need for some internal mechanism of the banking institutions and directed banks to have a comprehensive mechanism & logistics in place whereby it can resolve the dues or disputes vis-à-vis classification of NPAs. The court further elucidated that albeit some of the provisions of the SARFAESI Act may be a bit harsh for some of the borrowers but on this sole ground the impugned provisions of the act cannot be said to be ultra vires the Constitution owing to the object sought to be achieved by the act of speedier recovery of the dues declared as NPAs and better availability of capital liquidity and resources to help in growth of economy of the country and welfare of the people in general which would subserve the public interest. Also, the Supreme Court categorically reiterated that the impugned act does not take away from the borrower the right to invoke the writ jurisdiction of the High Court under Article 226 & Article 227 against the bankers not acting bona fide and reasonably before attaching and selling the assets of the alleged defaulters. Henceforth, the verdict in Mardia Chemical case , came to the rescue of the aggrieved borrowers that were subjected to the whims and fancies of the financial institutions to classify the assets as non-performing assets and the aforesaid ruling directed to have a potent internal mechanism of banking institutions that must have the participation of the aggrieved borrowers to truly realize the objectives of the SARFAESI Act 2002.
Role of Asset Securitization/Reconstruction Companies in NPA management:
In the current scheme of SARFAESI Act 2002, Section 5 read with guideline 8 of the Securitization Companies &Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003 adumbrates the rights of the asset Securitization/Reconstruction Companies to acquire the financial assets of any bank or financial Institution by either, issuing a debenture or bond or any other security in the nature of debenture, for consideration agreed upon between such company and the bank concerned, or by entering into an agreement with such bank or financial institution for the transfer of such financial assets to such company on the agreed terms and conditions. Moreover, sub-clause (2) of section 5 confers all the rights of the bank or financial institution in relation to the financial asset upon the Securitization Company. Therefore, it may be conclusively averred that there is a complete takeover of the assets by the asset Reconstruction companies to expunge the NPAs from the balance sheets of the banking institutions.
Major functions of Asset Reconstruction Companies: The Asset Reconstruction Companies are endowed with myriad functions that warrant mention, and these functions are as follows:
1. The proper management of the business of the borrower, by change in, or take over of, the management of the business of the borrower.
2. The sale or lease of a part or whole of the business of the borrower.
3. Rescheduling of payment of debts payable by the borrower.
4. Enforcement of security interest in accordance with the provisions of this Act.
5. Settlement of dues payable by the borrower.
6. Taking possession of secured assets in accordance with the provisions of this Act.
7. Conversion of any portion of debt into shares of a borrower company.
8. Act as an agent for any bank or financial institution for the purpose of recovering their dues from the borrower on payment of such fee or charges as may be mutually agreed upon between the parties.
9. Act as a manager on such fee as may be mutually agreed upon between the parties.
10. Act as a receiver if appointed by any court or tribunal.
In addition to the aforesaid functions, the Asset Reconstruction Companies are an extended arm of the banking institutions, as also mentioned earlier to specifically deal with the NPAs and their recovery mechanism to facilitate the banks to focus on core banking functions by arrogating to themselves the function of rescheduling and restructuring of debts, according certain relaxations to borrowers. The primary objective of any Asset Reconstruction Company is to aggregate the NPAs from various lenders in order to expedite the process of debt restructuring that may include the extension of time for repayment of loan with the consent of the banking institution. Moreover, these companies acquire the bad loans becoming NPA from the banks’ balance sheets at discounted price and to sell them off at a greater price to qualified institutional buyers & other potential investors in consonance with the provisions enumerated in the SARFAESI Act 2002. Therefore, this way they earn profit for themselves and mitigate NPAs from the balance sheet of banking institutions by recovering their outstanding dues through attachment or liquidation of the secured assets of the defaulting borrowers.
Lastly, the Asset Securitization/Reconstruction Company has been endowed with a vicarious responsibility of acting as an agent for banks and other financial institutions to recover the outstanding dues from the defaulting borrowers and also to hold the secured assets of the borrowers in trust. So as far as the issuance of security receipts is concerned, the role of such companies would be of a trustee to the extent of this purpose and the rest of the functions may be discharged as an agent for the banking institutions. So, perhaps the role of such companies is limited for the purpose for which it is created and the nomenclature of their relationship would therefore hinge on the functions or the purpose a company serves. In a nutshell, the general characterization of the relationship of the Asset Reconstruction Companies with the originator as well as the borrowers is that of a liaison or an intermediary between the originator or banking institution and the borrower whose assets it holds in trust.
(The author is a student of National Law University, Shimla).
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