Leveraged balance sheets and the resultant debt overhang is at the forefront of economic issues facing India Inc (and the regulators) these days. With debt burdens rising and Interest coverage ratio dwindling, Companies have little incentive to generate capacity; in other words, have little incentive to buy new machinery, invest in R&D and generate fresh employment (in simpler terms, the incremental earnings go to servicing all that debt that has been built up and very little remains for capital expenditure. The stress felt by India Inc. is also shared down by the Lenders, predominantly, banks, that have to make provisions for the losses and curtail fresh lending, thereby further impacting the real economy. Even if the Central Bank does cut benchmark interest rates, as indeed the RBI has recently, banks cannot "transmit" that reduced cost of capital down the value chain to their borrowers. Since India still lacks a developed bond market, we have increasingly relied on the banking/credit channel to transmit monetary policy shocks. Thus, the clog in the banking/credit channel(caused by increased leverage and rising NPAs) is a critical bottleneck to monetary transmission.
Now, asset reconstruction companies (ARCs) is the kind of financial intermediary that can really help in such situations. Basically, ARCs work as follows: They purchase bad assets from the banks against consideration, that is partly cash, and resolve the bad asset; in other words, recover the debt and distribute the proceeds among their investors. The banks can lend further from all the cash they have booked upfront from the sale and the real economy thus is saved from the costs of rising NPAs and excessive leverage. The RBI of course regulates both sides of this deal including the portion of cash that ARCs ought to pay upfront in such deals. Hitherto, the RBI required 5 % of the asset value to be paid in cash. With the onset of this crisis in August 2014, in an apparent attempt to incentivize banks to sell, the RBI raised the mandatory cash component to 15 % of the net asset value. But the RBI forgot the law of unintended consequences rule: it takes two to tango and while the rule-change potentially motivated banks, it clearly demotivated the ARCs, in the opposite direction (given their obvious reluctance to pay such a huge cash component in face of uncertainty that comes with NPAs). The number of securitization transactions has therefore declined in the aftermath of this rule-change in stead of increasing.
Meanwhile, leveraged balance sheets, debt overhang and rising NPAs continue to impact the real economy by reducing capex and thwarting credit flow. It is important for the RBI to roll back the 15 % mandatory cash rule and retain the earlier 5 % rule to incentivize banks and ARCs alike, to clear these transactions. A still better idea 'd be for the parties to decide for themselves. While the need for broader structural reforms like a bankruptcy Code cannot be overstated, these non-legislative fixes will greatly contribute to revitalize the economy over the short-term.
Now, asset reconstruction companies (ARCs) is the kind of financial intermediary that can really help in such situations. Basically, ARCs work as follows: They purchase bad assets from the banks against consideration, that is partly cash, and resolve the bad asset; in other words, recover the debt and distribute the proceeds among their investors. The banks can lend further from all the cash they have booked upfront from the sale and the real economy thus is saved from the costs of rising NPAs and excessive leverage. The RBI of course regulates both sides of this deal including the portion of cash that ARCs ought to pay upfront in such deals. Hitherto, the RBI required 5 % of the asset value to be paid in cash. With the onset of this crisis in August 2014, in an apparent attempt to incentivize banks to sell, the RBI raised the mandatory cash component to 15 % of the net asset value. But the RBI forgot the law of unintended consequences rule: it takes two to tango and while the rule-change potentially motivated banks, it clearly demotivated the ARCs, in the opposite direction (given their obvious reluctance to pay such a huge cash component in face of uncertainty that comes with NPAs). The number of securitization transactions has therefore declined in the aftermath of this rule-change in stead of increasing.
Meanwhile, leveraged balance sheets, debt overhang and rising NPAs continue to impact the real economy by reducing capex and thwarting credit flow. It is important for the RBI to roll back the 15 % mandatory cash rule and retain the earlier 5 % rule to incentivize banks and ARCs alike, to clear these transactions. A still better idea 'd be for the parties to decide for themselves. While the need for broader structural reforms like a bankruptcy Code cannot be overstated, these non-legislative fixes will greatly contribute to revitalize the economy over the short-term.
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