The Role of Prompt Corrective Action

The past year has seen a lot of developments in the banking sector. The government has infused over Rs. 1.5 lakh crores in public sector banks. The RBI has also pushed banks to resolve stressed assets making use of the IBC. During this period, and perhaps going a little further back as well, the RBI has brought many banks under the Prompt Corrective Action Framework. These are banks that are weak and their weakness is measured in terms of inadequacy of capital, profit or asset quality.

A bank’s balancesheet has assets and liabilities (like any other balancesheet). A bank’s assets are the loans it issues while on the liabilities side there is capital and deposits (the money we keep in the bank). There are some more nuances, but at a high level, this is how a bank’s balancesheet is structured. Whenever a bank incurs losses, the capital is the main protection. Capital needs to be ‘adequate’ enough to absorb even the unanticipated losses in order to ensure the bank remains a ‘going concern’ and the depositors are protected. When the capital gets completely wiped out, the depositors take a hit. While there are insurance guarantees which protect deposits upto Rs. 1 lakh, there is a loss that is suffered. The government finally ends up bearing a substantial amount of the loss due to political and economic implications.

It is because of this precise role that capital adequacy is stressed upon around the world. The emphasis has been more so since the Great Recession where new global norms such as Basel III emerged in order to ensure transparency, quality and integrity of the capital base. Many inbuilt buffers were also put in place in order to ensure that banks remain healthy throughout the cycles. The guidance values set by Basel norms are only considered as guidance values. Many central banks insist on having higher levels of capital. Having understood the role capital plays, it is understandable why it is also considered a measure while assessing the weakness of a bank. It is also an indicator whose value requires the intervention of the central bank in the interest of financial stability.

Once capital falls below a certain point, it is difficult for the banks to recapitalize. Shareholders are hesitant to inject more liquidity due to the risk emerging from the bank’s losses. On the other hand, in the case of public sector banks, the recapitalization figures are sometime simply too large for the government to be able to inject capital. This also has implications for the government’s fiscal math. This, as we know, has political and economic consequences for the government from increased borrowing costs to reduction in other spending.
Once a bank is undercapitalized, it turns to ‘zombie lending’ where they roll over debt in order delay recognizing the bad asset as it would impact their capital further. This has implications for the overall economy as well as investments take a hit.

It is in such cases that it becomes imperative for the regulator/central bank to step in at an early stage to avoid further deterioration of the situation and things go out of control. The more the situation is allowed to deteriorate, greater will be the cost of correction. This where Prompt Corrective Action (PCA) comes in. The objective is to intervene and restore the bank’s financial health before things get bad. Such actions act as remedial measures as well as good deterrence mechanisms that prevent banks from taking excessive risks. The PCA framework was instituted back in 2002. Since there, it has also evolved and undergone revision. The latest revision took place in 2017.

Once a bank is identified, its performance is assessed and classified into categories ranging from ‘undercapitalized’ to ‘critically undercapitalized’. Based on the severity, the stringency of the program is decided. There are restrictions placed on expansion, dividend payments, loan limits and loan restructuring. The promoters are also required to bring in additional capital with restrictions in management’s compensation. There could also be changes in the bank’s management. While there is no restriction imposed on the acceptance of deposits, they could be discouraged as they add to the costs incurred. The extent of the actions taken are determined by the regulatory powers vested with the central bank.

As seen, PCA plays a very critical role in ensuring the health of the financial sector while also reducing the cost of resolving the problem. It is an essential framework which has been resorted to often in the past few years. There are over 17 banks under the PCA framework, signalling the extent of the banking problem. Without such measures, a full-blown crisis would have been a possibility. Thus, it is important that these measure continue without being diluted.

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