Indian Banking system is undergoing significant changes in the recent past where the customers are now more informed about the financial world and the competition among the financial institutions is also very stringent. RBI has been very proactive in the last few years and is keeping a close watch on the working of the financial institutions and is introducing various laws to make sure public interest is protected. PCA is also one of the frameworks introduced by the Reserve Bank of India to safeguard public money and maintain stability in the system.
The Reserve Bank of India, on September 20, pulled out the Central Bank of India from the so-called Prompt Corrective Action (PCA) framework with certain conditions. PCA is a mechanism that will be ordered by the Reserve Bank upon banks that exhibits worries on books on any of the standard stress parameters.
Under the PCA framework, the RBI’s role is not just advisory in nature but it also has authority for changes in banks that the central bank may consider necessary to reduce the strain on the balance sheet of the PCA entrants. The impact of the move is likely to be more painful in the short term due to the disruption it could cause to the banks. However, in the long term, it is likely to infuse customer and investor confidence in the banking system and also put a sword on the banks to clean up their books at the earliest to avoid PCA entry.
What puts a Bank into PCA Framework?
The RBI will consider four major factors to determine whether the bank is to be put into PCA. Each of these factors will also be ranked in terms of the seriousness of the situation and each grade will attract a different set of actions by the RBI.
Let us look at these 4 categories:
- Capital Adequacy Ratio: The CAR is a measure of how much equity and debt capital the bank has to cushion its asset book risk. The RBI monitors the CAR of the bank on regular basis and keeps a close check on it.
- Asset Quality: The first threshold of PCA will be initiated by the central bank if the net NPAs of the bank cross the 6% mark. In the case of IDBI Bank, the Net NPAs surpassed 9% and it came into the second threshold of the framework.
- Profitability Criteria: RBI considers the Return on Assets as the benchmark for determining profitability. The RBI triggers the first threshold of PCA if the bank reports two years of consecutive negative returns on Assets.
- Debt or Leverage: The RBI will trigger Threshold 1 of the PCA when the total leverage crosses 25 times the Tier 1 Capital and on the other hand Threshold 2 of the PCA when the total debt crosses 28.5 times the Tier 1 Capital.
The restriction will depend on the threshold the bank has violated. The breach of the first threshold will have less severe consequences while the breach of the last threshold will attract very drastic measures from the Reserve Bank of India. So, a bank falling in the first threshold is likely to face fewer restrictions while a bank in the third threshold will have to face more heat from the central bank.
To conclude, the PCA mechanism gives full powers to the central bank to clean up the NPA mess in the banking system and make sure the banks have a healthy balance sheet, However, considering that the RBI is the regulator of the Indian banking system, this is one of the best methods to handle the NPA issues and ensure proper compliance mechanism in the banking sector.