PCA framework for NBFCs

Why in news?

The Reserve Bank of India (RBI) has decided to put in place a prompt corrective action (PCA) framework for troubled non-banking finance companies to restore their financial health.

What is Prompt Corrective Action (PCA)?

• History - RBI initiated the Scheme of Prompt Corrective Action (PCA) in 2002.
• In early 2018, there were 12 banks under PCA framework. Of these, 11 were PSBs.
• Due to recapitalization & corrective measures there were only six banks (all PSBs) under the PCA framework as of March 2019.
• Objective - Prompt Corrective Action or PCA is a framework under which financial institutions with weak financial metrics are put under watch by the RBI.
• Until now, the RBI had imposed PCA only on banks. This is the first time PCA framework is extended to NBFCs.
• The move comes in the wake of large NBFCs such as IL&FS, DHFL, SREI Group and Reliance Capital getting into financial trouble over the last few years.
• Applicability - The PCA framework for NBFCs comes into effect from October 1, 2022, based on their financial position on or after March 31, 2022.
• The framework will apply to all deposit-taking NBFCs, excluding government companies, and all non-deposit taking NBFCs in the middle, upper and top layers.
• Implications - This is a welcome move as it will stop bad lenders from going worse rather than brushing the issue aside.
• Safer NBFCs will translate to a safer overall financial system.
• The PCA framework for NBFCs will be reviewed after 3 years.

What are the tracking indicators?

• The central bank will track three indicators
  • Capital To Risk-Weighted Assets Ratio (CRAR) - It is bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures.
  • Tier I leverage ratio - It is the relationship between a banking organization's core capital and its total assets.
  • Net Non-Performing Assets (NNPAS) Including Non-Performing Investments (NPIS). NPA are loans for which the principal or interest payment remained overdue for a period of over 90 days
• In the case of core investment companies (CICs), the RBI will track
  • Adjusted Net Worth/Aggregate Risk Weighted Assets.
  • Leverage Ratio
  • NNPAs, including NPIs.
• A breach in any of the three risk thresholds under the above mentioned indicators could result in invocation of PCA.

What is the Threshold limit?

• Threshold limit 1 
  • If CRAR fall more than 300 basis points below the minimum required 15% (for both deposit or non deposit taking NBFCs)
  • Tier 1 capital ratio drops 200 basis points below the minimum required 8%
  • NNPA ratio increases above 6%.
• Threshold limit 2 
  • If capital adequacy falls a further 300 basis points,
  • Tier 1 capital ratio drops another 200 basis points below the minimum required
  • NNPA rises above 9%.
• Threshold limit 3 
  • Fall in capital adequacy to less than 9%
  • Tier 1 capital to less than 6%
  • NNPA rises above 12%.

What Corrective Actions will be taken under PCA?

• There are 2 types of Corrective Actions.
  • Mandatory Corrective Actions
  • Discretionary Corrective Actions
• Based on the risk threshold, the RBI may prescribe discretionary corrective actions in addition to mandatory corrective actions.

Mandatory Corrective Actions under PCA are as follows.

• For Threshold limit 1 - There will be restriction on
  • Dividend distribution/remittance of profits,
  • Requiring promoters/shareholders to infuse equity and reduce leverage,
  • Restriction on issue of guarantees or taking on other contingent liabilities on behalf of group companies (only for CICs).
• For Threshold limit 2 -  In addition to restrictions under condition 1, the RBI may
  • Restrict branch expansion.
• For Threshold limit 3 - In addition to restrictions under condition 1 & 2, the RBI may
  • Impose curbs on capital expenditure other than for technological upgradation.
  • Restrict/ directly reduce variable operating costs.

Discretionary Corrective Actions - Under this, the RBI may 

• Undertake resolution of NBFC by amalgamation, reconstruction, splitting.
• File an insolvency application under the IBC and issue show-cause notice for cancellation of certificate of registration and winding up of the NBFC.
• Recommend to promoters/shareholders to bring in new management/board;
• Remove managerial persons under the RBI Act, as applicable;
• Seek removal of director and/or appointment of another person as director in his place;
• Supersede the board under the RBI Act and appoint an administrator among others.
• PCA restrictions will be withdrawn if there is no breaches in risk thresholds in any of the parameters  are observed as per four continuous quarterly financial statements
• However, one of statements should be annual audited financial statement (subject to assessment by RBI) after a RBI led supervision.

What will be the implications?

• The thresholds around total capital adequacy and Tier-I capital for classification of an NBFC in the PCA category are liberal
• However some entities could breach the net NPA criterion of more than 6%, if the asset quality does not improve.
• Once PCA guidelines are applicable entities are expected to bring the NPA levels under control by improving provisions or effecting write-offs.
• However the sectoral growth will be impacted in the near term, as entities tighten their credit norms and operational focus shifts towards collections.

Quick Facts

• NPA - Nonperforming assets (NPAs) are recorded on a bank's balance sheet after a prolonged period of non-payment by the borrower.
• NPAs place financial burden on the lender.
• NPAs can be classified as a substandard asset, doubtful asset, or loss asset, depending on the length of time overdue and probability of repayment.
• Lenders have options to recover their losses, including taking possession of any collateral or selling off the loan at a significant discount to a collection agency.
• If no assets were pledged, the lender might write-off the asset as a bad debt and then sells it at a discount to a collection agency.
• Capital Adequacy Ratio – It is also known as capital-to-risk weighted assets ratio (CRAR). It is used to protect depositors and promote the stability and efficiency of financial systems.
• CAR is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures.
• Two types of capital are measured.
  • Tier-1 Capital, which can absorb losses without a bank being required to cease trading.
  • Tier-2 Capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
• The downside of using CAR is that it doesn't account what would happen in a financial crisis.
• The tier 1 leverage ratio – It is the relationship between a banking organization's core capital and its total assets.
• It is calculated by dividing tier 1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures.
• A bank with a high capital adequacy ratio is considered to be above the minimum requirements needed to suggest solvency.

Reference

1. https://economictimes.indiatimes.com/industry/banking/finance/rbi-comes-out-with-pca-framework-for-nbfcs/articleshow/88277487.cms

2. https://www.thehindubusinessline.com/money-and-banking/with-growing-in-size-rbi-issues-pca-framework-for-nbfcs/article37952943.ece

3. https://www.investopedia.com/

4. https://www.indianeconomy.net/splclassroom/what-is-rbis-prompt-corrective-action-pca-framework/