The Reserve Bank of India (RBI) has warned asset reconstruction companies (ARCs) of regulatory or supervisory actions against them in extreme cases even as it has found some of them following wrong practices of evergreening distressed loans.

RBI Deputy Governor Swaminathan Janakiraman has said that during onsite inspections, it was found that some ARCs have been circumventing regulations and have allowed themselves to be used for evergreening of distressed assets.

In a speech addressed to the board of directors of ARCs, Swaminathan said that their boards should give due importance to assurance functions such as risk management, compliance and internal audit. He noted that such functions play a critical role in identifying and mitigating risks, ensuring compliance and safeguarding the organisation's reputation.

"Some ARCs, while enjoying the full benefits of the special position granted to them... have been found to be using innovative ways to structure transactions in a manner to circumvent regulations," Swaminathan said.

"During the course of our onsite examinations, we have come across instances where ARCs have been used or allowed themselves to be used, if I may say so, as a conduit to evergreen distressed assets."

Evergreening is the practice of granting further credit to firms close to defaulting to help them repay existing loans.

Swaminathan said that the RBI has observed that a few entities found new ways to get around the regulations when a particular practice was called out as a violation or deviation.

"We directed the entities to arrange for remediation, including setting aside capital charge on gains thereon, but only responsible conduct by the supervised entities themselves can bring the required efficiency to the system," Swaminathan said.

"In extreme cases, it may call for regulatory or supervisory actions, which, of course, we would like to use only as a last resort," he added.

The RBI deputy governor urged ARCs to adopt a regulation-plus approach where they not only comply with the letter of the regulation but also its spirit.

“Very often, he said, “We get representations to our observations stating this is industry practice or clarifications are pending from the RBI. Sometimes there are incorrect or intelligent interpretations of the circulars.”

These are not acceptable excuses for failing to do the right thing, he said, adding that the boards of ARCs should ensure that they do the right thing without needing the regulator to point it out to them.

“The ARC framework was intended to allow loan originators to focus on their core function of lending by removing the sticky stressed assets from their books… A review of the data indicates that one-time settlements and rescheduling of debt are the predominant measures of reconstruction employed by ARCs. Arguably, these measures could have been taken by the lenders themselves,” he said.

He emphasised that ARCs’ potential for resolving stressed assets within the system can only be realised with sound governance and adherence to ethical practices by responsible ownership and professional management.

He said the RBI’s supervisory team has found that some ARCs have acquired assets on their books but the selling bank does the recovery. “We have also come across instances where ARCs have warehoused the stressed assets, while the originator has continued to remain responsible for the collection and custody of the security provided by the borrower,” he added.

“ARCs may like to introspect whether they would like to be a warehousing agency for a fee, which is certainly not in consonance with the underlying intent of the framework,” Swaminathan said.

The deputy governor gave examples where the post of chairperson was vacant for long in some ARCs. There were also instances where the Chair of the audit committee of the board was also chairing the board meetings, as well as a non-independent director chairing the board meetings, which is contrary to the norms.

“These things only go to show that governance has not been receiving the required attention,” he said.

He also said there are instances where there were not enough independent directors on the board or a sufficient number of independent directors did not attend board meetings.

“Prior preparation and diligence by board members are sine qua non for effective governance and decision-making by the board. I would urge board members to insist on receiving the agenda papers well in advance and thoroughly review them,” he said.

The deputy governor raised concern about the process followed for the disposal of assets.

He said that at times, the proposals are not even placed before the independent advisory committee, contrary to regulatory instructions.

He was also critical of the way ARCs disposed of assets. “Assets are sold to group entities without following the arms-length principle and without subjecting them to scrutiny under related party transactions,” he said.

Another surprising behaviour is the ‘Swiss challenge’ process for disposing of assets, which often goes unchallenged. “This has become a routine affair giving rise to a suspicion that there may be some implicit understanding among the various participants,” he added.