This article is written by Kashish Khattar, a 4th-year student at Amity Law School, Delhi. This article is a discussion about the various aspects related to Prompt Corrective Action.  

Introduction

This year has seen the exit of several banks from the Prompt Corrective Action (“PCA”) framework. This is the scheme which had the RBI and the Centre on the different sides of the fence.

PCA typically puts up lending restrictions on the banks and doesn’t let them expand among other things. PCA kicks in when banks fall short on any of the three parameters – capital to risk-weighted ratio; non-performing assets; and return on assets.

However, unlike its desi version, global PCA is kicked in when the banks fall short of their capital adequacy ratio only. The union government and some of the independent directors of the RBI are trying to get the PCA framework in consonance with the global standards. They believe the desi PCA is too restrictive on banks and eventually hurts the business side of the banking companies in the country. Let us try to understand everything there is to know about this framework.

What is PCA?

Prompt Corrective Action (“PCA”) is a framework under which banks with weak financial thresholds are put under the lens. Basically, RBI is the teacher who picks out the weak students (read: weak banks) in class and gives them extra attention until they can function at a normal pace like the rest of the class (read: banks with normal thresholds). It is a quarantine measure by the central government so that the weak bank can heal and get back on its feet.

What is the purpose of PCA?

PCA is said to be a framework which is there to maintain the sound financial health of banks. It helps banks to keep in check breach of risk thresholds such as capital, asset quality, and profitability, to take corrective measures in a timely manner, in order to restore their financial health.

Thus, it is used as an indicator for the banks to be very sure about certain riskier activities, improve the efficiency of the system and focus on conserving the capital to strengthen the bank. The framework is surely not intended to limit the performance of general operations of the banks as a whole.

How did it come into being?

The PCA finds its origins in 2002 circular issued by the RBI stating that it will take structured actions towards banks who have hit the trigger points in terms of CRAR, NPA, and ROA. It gave out the structured actions or the disciplinary actions that it could take and the thresholds that needed to be maintained. The PCA was then revised in 2017 and was said to be reviewed after three years. The capital, asset quality and profitability are said to be the areas that are concerned with the PCA framework.

What is CRAR, RoA, and NPA?

To understand how and when the PCA is invoked, we first have to understand what all the three thresholds that are to be maintained actually mean. Let us start with CAR or capital to adequacy ratio or capital to risk-weighted asset ratio (“CRAR”). It stems from the Basel norms concept. It is the measure of a particular part of the bank’s capital.

The CRAR is basically the capital needed for a bank measured in terms of assets (mostly loans) disbursed by the banks. Higher the assets higher should be the capital retained by the bank. The main feature of CRAR that should be noted is that CRAR actually measures the capital adequacy in terms of the riskiness of the loans given.

How is CRAR calculated?

The typical way of calculating CRAR is adding up Tier I and Tier II capital of the bank and then dividing them by risk-weighted average of the bank. Tier I capital or core capital mainly includes share capital. It is mostly in the form of equities. Tier II capital is mostly in the form of reserves and debts.

But, how do you calculate the risk-weighted average of a bank?  

This is done by multiplying the notional amount of the asset or the theoretical value of the asset without considering factors such as inflation, depreciation or other forms of impairment with the risk weight assigned to the asset (for example, it is 100% for corporate loans and 50% for mortgage loans.)

Hence, Capital Adequacy Ratio (“CAR”) = (Tier I + Tier II + Tier III ((Capital funds)) / Risk-weighted assets.

What do you mean by NPA?

The assets of the banks which fail to perform are known as NPAs, basically, the assets which don’t bring anything in return.

What is RoA?

RoA actually shows how profitable a bank is, when compared to its total assets. Typically, it tries to measure the efficiency of utilizing the bank assets to generate profit for themselves and is calculated out by dividing net income by average total assets. A higher RoA indicates a better managed and more efficient bank.

RoA  = net income/average total assets

What are the threshold values? When is it invoked?

PCA has three risk threshold levels. 1 being the lowest of the lot and 3 being the highest based on how banks stand w.r.t this framework.

Banks who the CRAR of less than 10.25% but more than 7.75% fall under threshold 1. Those with CRAR of more than 6.25% but less than 7.75% will fall in the second threshold. In a case where the bank’s common equity Tier 1 (the bare minimum capital under CRAR) falls below 3.625 percent, it will be mentioned under the third threshold level of the framework.

Banks which have a net non-performing assets (“NPA”) of 6 percent or more but less than 9 percent fall under threshold number 1, and the ones with  12 percent or more fall under the third threshold limit.

Lastly, banks with a negative return on assets (“RoA”) for two, three and four years consecutively will fall under threshold 1, threshold 2 and threshold 3, respectively.

What are the restrictions that the PCA invokes?

The restrictions are of two kind – they can mandatory and discretionary. Restrictions on the dividend, branch expansion, and the director’s remuneration are mandatory.

Further, RBI in its discretion can carry out the following actions:

1. Recommend the owner of the bank (whosoever it may be – the government, private players – promoters, parents of foreign bank branch) to bring in new management and board;
2. Advise the bank’s board to activate the resolution plan approved by the supervisor;
3. Advise the bank’s board to carry out a detailed review of the business model, the profitability of business line and activities, assessment of medium and long term viability and on balance sheet projections;
4. Review the short term strategies and the medium term business plans and also carry out any other corrective actions such as removal of officials and suppression of the board.

Impact of PCA on affected banks? How does a bank get out of a PCA?

The two ways that the government has tried to pull out a PSB out of a PCA is through two methods, the government likes to amalgamate a bank which cannot get out of the PCA or recapitalise them so that they can manage to get out of the PCA by improving their CRAR ratio which eventually helps them in improving their NPAs and RoAs.

Bank recapitalization

Why exactly is the government even trying to recapitalize the banks which are not doing so great? The simple answer to that is to have a thriving economy. A weak bank which is on the PCA is not going to lend to the businesses because it is not allowed to do so. Lending will be cut short which will affect the business side of the economy.

Getting them out of the PCA and trying to get things back to normal with the added advantage of the implementation of the IBC, 2016 is what is motivating the govt to recapitalize banks. A livemint article debates about how the current government’s investment has been much more than expected in the recapitalization plans.

Further, the plan was to recapitalize better-performing banks rather than the weaker ones. However, the opposite has taken place and the government has put in the most capital in the banks with the highest high bad loan ratios. Furthermore, Moody’s point out that recovery of bad loans can be a long drawn process and can take up to 2 years.

I agree with the writer when he talks about the government’s plan to have a broader vision than just managing and providing cash to its weakest links. It has to come up with a greater accountability system for these banks and make sure that history does not repeat itself and these banks do not find themselves back in this shape.

Amalgamation

You must have heard of the one of the biggest public lending entity being formed after the SBI which starts operations from the coming financial year. I am talking about the Dena, Baroda and Vijaya bank merger. Amalgamation may have also IDBI bank which will eventually help it get out the PCA, this is because of LIC infusing 21cr into the bank.

Merger and amalgamations of public sector banks have been one of the most highly sought out rescue operation being carried out by the government. However, the problem with the amalgamation of weak public sector banks still remains. The bank could not help strengthen the weak bank’s balance sheet and helped merge it with the stronger and well to do banks in the economy. It does not make business sense, as seen in the share swap ratio problem of the Dena Bank and the Bank of Baroda. This did not help the plaguing NPA problem in any way. The merged entity would now have much bigger exposure to the NPA problem.

It may have given a breather to the weak bank but does it solve the root cause of the problem in hand – NPAs. Amalgamation can be seen as a way of achieving growth and sustainability. It would have made much more sense to amalgamate the bigger and better banks which would have a strong balance sheet to back them.

Conclusion

In the infamous speech where the deputy governor of RBI, Viral Acharya called PCA, the required medicine to prevent further hemorrhaging of bank balance sheets.

Under the PCA, banks are mandated to reduce their lending to corporates. Further, they are expected to focus on the reduction of loans to some sectors of the economy.

PCA can be seen as a stringent action towards the weak banks of the economy and the RBI showing no plans to ease the norms, I think it is here to stay.

A business standard article that I read asked the million dollar question – Is PCA enough? It suggests a new radical governance structure for the banks, a robust risk management framework. Further, there is a need for the timely appointment of higher board members in banks and the board being professional and accountable with respect to their decisions.