Explained Prompt corrective action framework by IFS Vandna Phogat

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In this article we will understand what is Prompt Corrective Action of RBI and when does it comes into play, what are the criteria of prompt corrective action. And we will also see what happens when Prompt Corrective Action (PCA) is implemented and is it enough for the stability of our financial system?

What is the Prompt corrective action (PCA) framework

It is a structured supervisory intervention tool by the RBI to monitor the financial health of banks and take corrective measures timely if the risk threshold is breached.

What is the meaning of PCA in banking?

The objective of PCA(Prompt corrective action)

PCA is intended to help alert the regulator as well as investors and depositors if a bank is heading for trouble. The idea is to head off problems before they attain crisis proportions.

What are the criteria for PCA?

Financial health indicators covered under PCA 

So what are the indicators which point to the regulator that a bank is heading towards crisis or not

prompt corrective action
prompt corrective action

What is the Risk threshold?

When Risk Threshold is breached Prompt Corrective Action (PCA) comes into action

It is dependent on the limit imposed by RBI concerning financial health indicators. Such as NPA ratio, Tier 1 capital, CRAR ratio etc. And it is revised by RBI depending on the health of the economy and the banking sector.

History and background of Prompt Corrective Action (PCA)

The Prompt Corrective Action (PCA) framework was introduced in December 2002 as a structured early intervention mechanism along the lines of the Federal Deposit Insurance Corp.’s (FDIC) PCA framework. These regulations were later revised in April 2017 and now in 2021.

The objective of the PCA Framework is to enable supervisory intervention at the appropriate time and require the Supervised Entity to initiate and implement remedial measures promptly, to restore its financial health.

Applicability of Prompt Corrective Action (PCA)

All commercial banks including foreign banks operating in India.

Note: Prompt Corrective Action (PCA) excludes Cooperative and Regional rural banks.

Financial health indicators of PCA

Prompt Corrective Action (PCA) helps RBI monitor key performance indicators of banks, and take corrective measures, to restore the financial health of a bank. Now let’s look at the indicator in some details

Capital Adequacy Ratio

Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital with its risk-weighted assets and current liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.

Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk-weighted assets.

Note: PCA covers only tier 1 capital It calculates CRAR/Tier 1 capital.

The capital adequacy ratio, also known as the capital-to-risk weighted assets ratio (CRAR), is used to protect depositors and promote the stability and efficiency of financial systems around the world.

Asset Quality

Loans granted to businesses and households are assets for banks. The interest banks earn on these assets is a key component of their income and profit, and the risk of the loans not being paid back is their main riskThe higher this credit risk, the lower the quality of the loan, or “asset quality”.

Under the PCA framework and in general, also this is measured through the NPA ratio.

Banks must classify a loan as non-performing when it has been past due for 90 days, or if they deem the borrower to be unlikely to pay back the loan. Non-performing loans are a major issue that banks and supervisors must tackle.

Leverage Ratio

Leverage ratio or Tier 1 leverage ratio measures a bank’s core capital relative to its total assets. The ratio looks specifically at Tier 1 capital to judge how leveraged a bank is based on its assets. Tier 1 capital are those assets that can be easily liquidated if a bank needs capital in the event of a financial crisis. The Tier 1 leverage ratio is thus a measure of a bank’s near-term financial health.

The higher the Tier 1 leverage ratio is, the higher the likelihood that the bank could withstand a negative shock to its balance sheet

Tier 1 leverage ratio was introduced by the Basel III accords, an international regulatory banking treaty proposed by the Basel Committee on Banking Supervision in 2009.

Restrictions imposed on banks under PCA

So we have learn what are the criteria of PCA, Now let’s see what happens when PCA comes into action.

The restrictions under Prompt Corrective Action (PCA) are of two kinds – 

they can be Mandatory and Discretionary.

Restrictions on the dividend, branch expansion, and the director’s remuneration are mandatory.

In short, the restriction imposed can be of the following kind under PCA:

  • Dividend distribution
  • Profit remittance
  • Branch expansion
  • Capital infusion (foreign banks)
  • Capital Expenditure

NOTE: Contrary to the perceptionPrompt Corrective Action (PCA) does not limit the normal lending operations of banks. While the RBI has placed restrictions on credit by PCA banks to unrated borrowers or those with high risks, it hasn’t invoked a complete ban on their lending.

Significance of PCA

Prompt Corrective Action (PCA) promotes financial stability and help solve the NPA problem.

Essentially PCA helps RBI monitor key performance indicators of banks, and takes corrective measures, to restore the financial health of a bank and hence promotes overall financial stability of the economy.

Is PCA enough?

No Prompt Corrective Action (PCA) alone is not enough.  A lot needs to be done to further strengthen India’s Banking Sector. A new radical governance structure for the banks, a robust risk management framework is the need of the hour. Further, there is a need for the timely appointment of higher board members in banks and the board being professional and accountable for their decisions.

A gist of Other Bank Reforms taken in India is shown in the fig below

bank reforms in india
bank reforms in india

FAQ

What is a Prompt Corrective Action?

It is a structured supervisory intervention tool by the RBI to monitor the financial health of banks and take corrective measures timely if the risk threshold is breached.

What is meaning of PCA in banking?

PCA is intended to help alert the regulator as well as investors and depositors if a bank is heading for trouble. The idea is to head off problems before they attain crisis proportions.

What is the criteria for PCA?

Capital Adequacy Ratio, Asset quality and Leverage Ration are the three criteria of PCA framework of RBI in India in 2021.

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