Explainer: Why RBI has brought NBFCs under PCA Framework

What is Prompt Corrective Action (PCA) Framework?

The Prompt Corrective Action (PCA) framework is aimed at nursing a lender facing issues on the asset quality, profitability and capital fronts back to health. Since lenders are interconnected (for example, Banks have exposure to other banks through the inter-bank call money market and lend to non-banking finance companies/NBFCs and housing finance companies/HFCs), there can be spillovers and spillbacks, leading to contagion. So, to prevent shocks from spreading in the financial system and preserve financial stability, the Reserve Bank of India (RBI) intervenes when a lender shows signs of distress by invoking PCA.

What does it seek to achieve?

PCA seeks to put a bank, whose financial parameters are out of kilter, back on the rails. The framework is intended to encourage banks to eschew certain riskier activities and focus on conserving capital so that their balance sheets can become stronger. RBI puts a Bank under PCA if the breach any one of the three risk thresholds under the three indicators that it tracks -- capital, asset quality and leverage.

Under PCA, RBI asks a lender to take corrective actions, including preparing a time bound plan for reduction of bad loans; make higher provisions for bad loans/ investments; restrict/ reduce credit for borrowers below certain rating grades and restrict/reduce unsecured exposures, among others.

Additionally, the central bank can also ask a bank to submit plans for raising additional capital; restrict investment in subsidiaries/ associates; restrict expansion of high risk-weighted assets to conserve capital. RBI can also seek resolution of the bank by amalgamation or reconstruction.

Then there are mandatory actions prescribed by RBI such as restriction on dividend distribution/ remittance of profits; requiring promoters to bring in capital; and restriction on branch expansion; and restriction on directors’ or management compensation, as applicable.

Has it been successful in preventing bank failures?

Between February 2014 and September 2019, 13 banks, 11 in the public sector and two in the private sector were under the PCA Framework. Now, barring one bank, all others have been taken out of PCA by RBI’s Board For Financial Supervision (BFS) as their promoters infused capital and the banks upped loan loss provisions. They also focussed on recovery of bad loans and re-oriented their portfolio towards less capital consuming segments such as retail.

Central bank of India, currently the only Bank under PCA, has written to RBI requesting that it be taken out of PCA as it is no longer in breach of the four parameters (capital, asset quality, profitability and leverage) under the 2017 PCA framework.

Why has RBI decided to extend this framework to NBFCs now?

With NBFCs growing in size and having substantial inter-connectedness with other segments of the financial system, it was imperative that a PCA framework be put in place. So far, only scheduled commercial banks (excluding Small Finance Banks, Payment Banks and Regional Rural Banks) had a PCA framework. But the ripple effect of the defaults by systemically important NBFCs such as IL&FS group, Dewan Housing Finance Corporation Ltd (DHFL), SREI Group and Reliance Capital has prompted the RBI to introduce PCA for NBFCs so that structured early intervention and resolution could prevent a fallout on the financial system. The PCA Framework for NBFCs comes into effect from October 1, 2022, based on their financial position on or after March 31, 2022.

How will this impact NBFCs?

The RBI is gradually harmonising the regulations of NBFCs with those of banks. It has decided to put in place a scale-based regulatory framework with effect from October 01, 2022. Further, it has prescribed a phased introduction of a liquidity risk management framework for NBFCs, including a liquidity coverage ratio (LCR). Capital adequacy and asset quality, the key factors influencing balance-sheet resilience, is what the RBI will assess when referring NBFCs to the PCA framework. The graded restrictions under the framework will enable NBFCs to take corrective action when they breach stipulated thresholds. That would reduce the chances of insolvency. Experts do not expect any mid or large NBFCs to face immediate challenges given their comfortable capitalisation levels. They also opine that the regulator has provided reasonable transition time for the NBFCs to strengthen their balance sheet and reduce the net NPA levels.

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