top of page
Writer's pictureManal Shah

Prompt Corrective Action


[This post was first published on indiacorplaw.in]


Prompt corrective action (“PCA”) is intended tointervene early and take corrective measures in a timely manner, so as to restore the financial health of banks that are at risk by limiting deterioration in their health and preserving their capital levels”.


The PCA framework was introduced by the Reserve Bank of India (“RBI”) in December 2002. With a view to keeping pace with international best practices, the RBI on recommendations of the Group of Financial Stability and Development Council (“FSDC”) on Resolution Regimes for Financial Institutions in India (January 2014) and the Financial Sector Legislative Reforms Commissions (“FSLRC”) (March 2013), issued the ‘revised PCA framework’ on 31 March 2017. Viral Acharya, the Deputy Governor, RBI considers PCA to be an essential element of financial stability.


Why PCA?

PCA first developed during the Savings & Loans Crisis (one of the worst financial crises since the Great Depression). It developed from a curative approach and led to the adoption of the Structural Early Intervention and Restructuring (“SIER”) and the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991.


Core principles of SIER include the following: firstly, thresholds of performance such as capitalization are identified to classify the banks in breach of thresholds into categories, for instance, in FDIC they were categorized as ‘under-capitalized’, ‘significantly under-capitalized’ and ‘critically under-capitalized’ in which the first threshold levels are set at levels safely above what would allow for an effective resolution/ revival of banks; secondly, the banks not meeting the thresholds are subjected to a layered, progressively stringent ‘program’ consisting of mandatory and discretionary regulatory actions aiming to prevent further hemorrhaging, effectively quarantining the banks in breach until they are resolved; and thirdly, to assist supervisors to enforce corrective measures in a rule-based manner to reduce forbearance risk.


In his speech, Acharya also explained how important bank capital is in loss absorption as it acts as a means of protection against the asset losses of a bank. Bank capital must be high enough to couch through unanticipated losses with enough margin to inspire confidence and enable the bank to continue as a going concern. Basel III norms act as a floor to the minimum capital ratio to be maintained by banks. In addition, the ratio is higher depending on the jurisdictions


India – Recent Ripples

The Indian PCA framework is greatly influenced by the American SIER which still stands as a benchmark. The framework includes the following determinants:


Capital to Risk-weighted Assets Ratio (“CRAR”) measures the available capital of a bank expressed as the percentage of a bank’s risk-weighted credit exposures. It assists in protecting depositors and promoting stability and efficiency of financial systems around the world. Banks risk insolvency from excessive losses.


CRAR is calculated by dividing the total capital (sum of tier I capital and tier II capital) of the bank divided by the risk weighted average. Tier I capital (also called core capital) consists mainly of share capital and disclosed reserves (minus goodwill, if any) and tier I items are deemed to be of the highest quality considering its full availability to cover losses. Tier II capital (also called supplementary capital) consists of certain reserves and types of subordinated debt[1]and also hybrid debt capital instruments[2]. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank’s activities. Risk weighted assets refers to the notional amount of the asset multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number. Risk weight for different assets varies, e.g., 0% on a government dated security and 20% on a AAA rated foreign bank etc. The higher the CRAR of a bank the better capitalized it is.


Non-Performing Assets (“NPA”) is an asset including a leased asset which ceases to generate income for the bank.


Finally, Return on Assets (“RoA”) is a profitability ratio which indicates the net profit (net income) generated on total assets. It is computed by dividing net income by average total assets. Formula – (profit after tax/av. total assets)*100. It reflects the efficiency of conversion of invested money into net income.


The RBI imposes PCA on banks whose capital, asset quality and/or profitability do not meet pre-specified thresholds available here. Allahabad Bank in January 2018 was included within the PCA Framework as a result of its breach of the first risk threshold prescribed therein when it fell short of the requisite CRAR. On 8 November 2018, the Bank announced the Centre’s decision to inject it with INR 3,054 Crore towards contribution of the Central Government in the preferential allotment of equity shares (special securities/bonds) of the Bank during the financial year 2018-19, as the Government’s investment.


As of 16 March 2018, there were eleven public sector banks (“PSBs”) within the PCA framework (Dena Bank, Central Bank of India, Bank of Maharashtra, UCO Bank, IDBI Bank, Oriental Bank of Commerce, Indian Overseas Bank, Corporation Bank, Bank of India, Allahabad Bank and United Bank of India). The scheme of the PCA involves the initiation of certain structured actions in respect of banks which the trigger points. The RBI places restrictions such as on dividend distributions and can decide to require the bank to undergo special supervisory monitoring meetings (SSMMs) at quarterly or other identified frequency, special inspections/targeted scrutiny of the bank and special audit of the bank. In addition, strategy related advisory is provided by the RBI to the board. The government intervention and restrictions increase with crossing to a riskier risk threshold.


Comments

The revised framework is stricter than the previous one in terms of the restrictions it poses, making credit growth difficult to achieve. Financial services secretary Rajiv Kumar and economic affairs secretary Subhash Chandra Garg, who represent the ministry on the board, are learnt to have argued at a recent RBI board meeting that a relaxation under the PCA would not only give the stressed PSBs headroom for growth but also enable them to lend more and support the efforts to ease liquidity crunch being faced by non-banking financial services companies.


The criticisms on the result of PCA on depriving the economy of credit have been rebutted by the Government by highlighting the need to provide banks with capital to enable them to lend again. The framework might be suitable now; however, in the near future things might change considering most government banks have reported losses in FY18 and can be considered waitlisted to be brought in. Banks like the Punjab National Bank and Andhra Bank would have defaulted on meeting the minimum capital requirements; however, earlier this year, the Government recapitalized them.


T.T. Ram Mohan, Prof. of Finance at IIM Ahmedabad analysed the situation critically and opined that a better suited remedy would be an overhaul of management and boards. He also suggested the Government accept that there might be a need for mergers and consolidations and also privatization.


 

[1] Subordinated debt refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid.

[2] Hybrid debt capital instruments is a category which includes a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.

17 views0 comments

Recent Posts

See All

Comments


bottom of page