explained | How did the RBI change the quick corrective action standards for banks?

What will the supervised commercial banks have to do to get out of the restrictions imposed by the central bank?

The story so far: The RBI issued a notification on November 2 revising the standards for commercial banks to be placed under the regulator’s Rapid Corrective Action (PCA) framework if any of their key measures did not match. The revision takes effect on January 1, 2022.

What is the purpose of the PCA framework?

In the RBI’s own words, “the objective of the PCA framework is to enable timely prudential intervention and to require the supervised entity to initiate and implement timely corrective actions in order restore their financial health. The PCA framework is also intended to serve as a tool for effective market discipline. The CPA framework does not prevent the Reserve Bank of India from taking any other action it deems appropriate at any time, in addition to the corrective actions prescribed in the framework ”. Over the past almost two decades – the PCA was first notified in December 2002 – several banks have been placed under the framework, with restricted operations. In 2021, UCO Bank, IDBI Bank and Indian Overseas Bank left the framework improving their performance. Only the Central Bank of India now remains there.

What are banks measured against?

In accordance with the revised PCA standards published in 2017, banks were to be assessed on capital, asset quality, profitability and leverage. The capital adequacy ratio governs the capital that a bank must hold as a percentage of its total assets. If the prescribed ratio is 11.5%, a bank must contribute its own capital of 11.50 for every 100 it intends to lend. The adequacy measure includes cushions such as the capital conservation cushion (2.5%), which can be used to strengthen capital in good times, but which can be relaxed to encourage new lending during economic crises. Asset quality tells us how much of the loans are unlikely to be repaid, reflected in the ratio of net non-performing assets, that is, the portion of total advances marked “non-performing” after the provisioning of bad debts. Return on Assets (RoA) measures profitability, derived from net income (profit) as a percentage of total assets. The leverage ratio shows how much a lender has stretched by borrowing funds to generate income. The greater the leverage, the more risky the land on which the lender stands.

What obstacles do banks face in the context of the PCA?

Banks move from risk thresholds 1 to 3 with increasing restrictions if they are unable to stop the deterioration. First, banks face restrictions on dividend distribution / profit remittance. For foreign banks, promoters must provide capital. In the second category, banks also face obstacles to branch expansion. In the last category, the bank additionally faces restrictions on capital spending with certain exemptions. The RBI also has the ability to take discretionary action on strategy, governance, credit risk, market risk and human resources.

What changed?

The notification removed asset performance as an indicator to qualify for the PCA. In addition, the 2017 notification applied to scheduled commercial banks but excluded regional rural banks from its scope, while the 2021 version also excluded small financing banks and payment banks. In the latest set of rules, the RBI made it clear that the exit from the PCA would be based on four rolling quarterly results, one being the annual financial statements audited under the new framework, with the exception of the RBI’s oversight comfort. , from the assessment of sustainability to profitability.

Risk threshold 3 has been further refined for the capital adequacy conditions. It is not known why the RBI chose to remove the RoA metric. One view in the financial industry is that RoA should have been kept because it indicates the performance of the company. Another view is that the RBI shouldn’t be monitoring RoA – and profitability is monitoring the bank and its shareholders. Controls over capital adequacy indirectly include profitability. After all, retained earnings become reserves that help consolidate capital.

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