The RBI recently called for applying the Prompt Corrective Action (PCA) formula on IDBI Bank. Another 6-7 PSU banks which are currently having stretched balance sheets are also expected to be candidates for PCA. So what exactly is PCA and how is it likely to impact banks. PCA is a mechanism that will be forced by the RBI upon banks that show signs of stress on any of the standard stress parameters. The total stressed assets of the Indian banking system today, including NPAs and Restructured Assets are estimated to be in the range of $160-$170 billion. In a nutshell, this is roughly equal to 7% of India’s annual GDP and therefore the matter becomes urgent.
The PCA Rules were passed and approved in the previous year but it was only in April 2017 that the detailed rules delineating the role of the RBI and giving the RBI full powers was passed. Under the PCA, the RBI’s role is not just advisory in nature but it can also push for changes in banks that the RBI may consider necessary to reduce the stress on the balance sheet of banks. The impact of the move is likely to be painful in the short run due to the disruption it could cause to the banks under PCA. However, over the longer run, it is likely to improve the faith of the people in the banking system and also put greater pressure on banks to clean up their books at the earliest.
What could push banks into Prompt Corrective Action (PCA) mechanism?
The RBI will consider 4 key factors to determine whether the bank in question deserves to be brought under the PCA. Remember, each of these factors will also be graded in terms of the seriousness of the situation and each grade (threshold) will attract a different set of action by the RBI. Let us look at these 4 categories and their thresholds..
1. The first criterion is the Capital Adequacy Ratio (CAR). The CAR is a measure of how much equity and debt capital the bank has to cushion its asset book risk. Normally, the benchmark CAR is globally defined by the Bank for International Settlements (BIS), Basel in Switzerland. The starting point will be the CAR defined by the BIS and the RBI will add a further capital cushion to arrive at its own modified CAR benchmark. The PCA will start kicking in if the actual CAR of the bank falls more than 250 bps short of the modified CAR as defined by the RBI. That will be the first threshold. As the gap widens, higher thresholds will be initiated.
2. The second criterion is asset quality which is defined as the net Non Performing Assets of the bank, net of provisions. The first threshold of PCA will be initiated by the RBI if the net NPAs of the bank crossed the 6% mark. In the case of IDBI Bank, the net NPAs had gone beyond 9% which actually triggers the 2nd threshold of PCA.
3. The third criterion is profitability. For the banks, the RBI considers the Return on Assets (ROA) as the benchmark for profitability. The RBI triggers the first threshold of PCA if the bank reports 2 years of consecutive negative ROA. 3 years of consecutive negative ROA will trigger the second threshold of PCA for the bank.
4. The last criterion is the total debt level or leverage, which measures the financial risk of the bank. The RBI will trigger Threshold 1 of the PCA when the total leverage crosses 25 times the Tier 1 Capital and will trigger Threshold 2 of the PCA when the total leverage crosses 28.5 times the Tier 1 Capital.
What mandatory action will the RBI take when thresholds are breached?
When each threshold is breached, there are some steps that are mandatorily taken by the RBI and some are at the discretion. When a bank breaches Threshold 1 the RBI will insist on the bank imposing restriction in quantum of dividend distribution and repatriation of profits in case of foreign banks. The RBI may also call on the promoters of the banks to shore up the capital base through infusion of fresh funds.
The breaching of Threshold 2 is of a more serious degree from the RBI’s perspective. The measures in this case will be addition to the measures already taken on the breach of Threshold 1. Additional measures will include restrictions on the domestic and overseas branch expansion of the bank. The RBI may also instruct the banks to provide more for asset impairment.
The breach of Threshold 3 constitutes a very grave situation. Before looking at remedial measures like mergers, acquisitions, strategic sale of the bank’s assets etc, the RBI will impose restrictions on pay hikes, director’s fees promotions, annual hikes and recruitments. Senior management compensation will come under severe restraint in this situation.
What are some of the discretionary measures that the RBI can initiate?
Apart from the mandatory actions, the RBI also has the discretion to initiate other measures which may, inter alia, include; special inspections and audit of the bank, detailed review of the bank in terms of manpower, investments and process re engineering etc. The RBI has full powers to implement most of these measures without the approval of the bank.
In short the PCA mechanism gives almost a free hand to the RBI to clean up the NPA mess in the banking system. One will still have to look at the implementation and legal implications. However, considering that the RBI is the principal regulator of the Indian banking system, this is the best bet to resolve the NPA crisis in the best possible manner. The first step may have just been taken. A lot will not depend on how swiftly and effectively these measures are implemented.