This paper considers the possibility that the prices bid by asset reconstruction companies (ARCs) in India under a security receipt mechanism may not reflect the ultimate recoverable value of non-performing loans. A model is developed that establishes conditions under which the bids by ARCs are expected to exceed true intrinsic value. The paper examines 18,750 unique scenarios under auction rules used by Indian banks today and demonstrates that the bids made by ARCs exceed the true intrinsic value in almost 70% of cases. Evidence of overbidding by ARCs is found in all instances, though with decreasing frequency as the percentage of security receipts retained by ARCs increases.
The paper also analyses the impact of inflated bids on the financial statement of the selling banks. The paper establishes that due to the buyer’s limited participation in the purchased assets and the contingent nature of bid payments, the buyer’s value bears a limited relationship to the seller’s exit value in certain instances. In such situations, use of fair value accounting on the selling bank’s financial statements can lead to a misrepresentation and an overstatement of asset values. The paper recommends that the shortcoming in the auction mechanism design be addressed by banks and regulators. The solutions recommended in the paper include instituting a floating ARC participation interest as a core bid parameter along with the loan value besides mandating that the payment of a management fee to ARC will be contingent upon achieving certain minimum recovery rate.
