Need of the Hour: Prompt Corrective Action

The Global ANALYST, December 2018
The submitted version of my article published in the above magazine follows:
Prompt Corrective Action(PCA)
Need of the hour

M G Warrier

The Reserve Bank of India notified a “Revised Prompt Corrective Action (PCA) Framework” for all scheduled commercial banks on April 13, 2017. The PCA Framework was in vogue since 2002 and the revised PCA Framework was for a three-year period commencing April 1, 2017, to be reviewed thereafter. Even prior to 2002, when banks showed signs of incipient sickness, like mismatches in Asset-Liability Management, fall in rate of return, inability to meet statutory requirements relating to maintenance of cash reserves and liquid assets and/or erosion in capital, RBI as banking regulator took cognizance and initiated corrective action. The salient features of revised PCA Framework for Banks are given in Appendix 1.
Thought of going to the basics first, because the recent media reports give the common man an impression that “PCA” was something new introduced recently by RBI against the wishes of GOI and therefore, is one of the contentious issues in the so called GOI-RBI confrontation post-Viral Acharya speech of October 26, 2018.
PCA is just an improvement of the concept of “narrow banking” or restrictions on operations used to bring back individual banks which became ‘sick’ due to inefficient management or insufficient resources base to support expanding business. In one form or the other, the concept was in use universally since 1960’s. In India, where PCA didn’t yield desired results, public interest (read depositors’ interest) was safeguarded by RBI/GOI, to the extent possible by voluntary/forced closures/mergers. This has happened in the case of several primary (urban) cooperative banks and the Global Trust Bank in the private sector, in not so distant past.
The background in which the ten plus PSBs which are under PCA now (some of them have recovered health and may be back to normal operations soon) should be studied for correcting the GOI’s own approach to institutions in which there is substantial government shareholding. While there is nothing wrong in cross-subsidization among PSUs, indiscriminate demands from profit-making PSUs to part with funds without allowing them to grow or augment their reserves do not augur well for the economy.
I am amused by the overenthusiasm in a section of the media to prove that RBI and GOI are traveling on parallel tracks. In a way, perhaps, some accusations and counter arguments on policy issues may help the concerned sides think differently. But that cannot happen by sensationalizing ‘anecdotes’ from interactions or speeches on a selective way. Fortunately, RBI has a tradition of sorting out issues with GOI at the highest level and the dialogue is never broken when the regulatory and monetary policy interests appear to be in conflict with the short term fiscal policy targets of GOI. Some of the contentious issues between GOI and RBI have been sorted out in the November Board Meeting of RBI, with agreement to continue dialogue on remaining ones. Please see the press release issued by RBI after the central board meeting on November 19, 2018 (Box 1).
Box 1
Press Release dated November 19, 2018 issued by RBI
RBI Central Board meets at Mumbai
The Reserve Bank of India’s (RBI) Central Board met today in Mumbai and discussed the Basel regulatory capital framework, a restructuring scheme for stressed MSMEs, bank health under Prompt Corrective Action (PCA) framework and the Economic Capital Framework (ECF) of RBI. The Board decided to constitute an expert committee to examine the ECF, the membership and terms of reference of which will be jointly determined by the Government of India and the RBI. The Board also advised that the RBI should consider a scheme for restructuring of stressed standard assets of MSME borrowers with aggregate credit facilities of up to 250 million, subject to such conditions as are necessary for ensuring financial stability. The Board, while deciding to retain the CRAR at 9%, agreed to extend the transition period for implementing the last tranche of 0.625% under the Capital Conservation Buffer (CCB), by one year, i.e., up to March 31, 2020. With regard to banks under PCA, it was decided that the matter will be examined by the Board for Financial Supervision (BFS) of RBI.

Raghuvir Srinivasan (The Hindu, November 20) has summed up the episode excellently well. I quote:
“The Reserve Bank of India seems to have carried the day, after all, in Monday’s  marathon 9-hour board meeting.
Going by the brief statement that it put out, of the six deliveries that it had to play, the RBI has shouldered arms to two — PCA relaxation and capital framework which have been referred for expert study; deftly glanced two more — on liquidity for NBFCs and governance of the central bank — to the next board meet, and effectively fended off the last two bouncers on capital norms and MSME borrowings. 
Interestingly, of the two issues on which the RBI has seemingly conceded, the concessions are minimal and appear mainly designed for optics so that the government can have something to take back to Delhi from Mumbai.
The deferment by a year for a part of the additional capital framework is a small give-away in the face of the Centre’s demand for relaxation of the capital ratio itself.
Similarly, the MSME credit recast concession is not a big one considering the demand from the Centre was for easier NPA norms for the sector and more credit flow.
Finally, after all the pre-match sledging, the game seems to have gone off smoothly with both sides playing responsibly”.
The subject selected for the A. D. Shroff Memorial Lecture in Mumbai  delivered by RBI Deputy Governor Viral Acharya on October 26, 2018 was “The Importance of Independent Regulatory Institutions –The Case of the Central Bank”. We will revisit this in coming months.
Dr Acharya spoke in some detail on Prompt Corrective Action while addressing an elite audience at the Indian Institute of Technology, Bombay on 12th October 2018. Excerpts from the speech titled “Prompt Corrective Action: An Essential Element of Financial Stability Framework” can be accessed at RBI’s website. Dr Acharya sought to explain why the Prompt Corrective Action (PCA) framework of the Reserve Bank of India (RBI) was an essential element of its financial stability framework. Acharya said, ‘It (the speech) lays out the case for structured early intervention and resolution by regulators for banks that become under-capitalized due to poor asset quality or vulnerable due to loss of profitability’.
In a recent interview with a financial newspaper, former RBI Governor Dr Bimal Jalan expressed the view that ‘there can be no two views that PCA is desirable because so far we have not taken as many steps as required on NPAs and for handling defaults in the banking sector’. Of course, there could be scope for improvement in content and methods of implementation of PCA package which may have to be institution-specific and subject to close monitoring.

Before proceeding further, let us take note of certain ground level realities about policy formulation and administration of regulatory norms. In India, institutions like Election Commission, Comptroller and Auditor General and Reserve Bank of India commanded respect from central and state governments and were trusted by citizens irrespective of their political or religious convictions. Though after some delay in some cases, the Apex Court’s (Supreme Court of India) verdicts were treated as ‘law of the land’ except in exceptional situations where Centre resorted to overcome or circumvent such verdicts through legislative processes. But, of late, there is a disturbing tendency to resist differences in policy perceptions by public statements, where in-house discussions/consultations can amicably resolve the differences through informed debates. There is a felt need for restraint on the part of government officials, executives, board members and other stakeholders while making public statements on policy issues affecting sensitive sectors of economy or supervisory or regulatory actions by bodies of which they are representatives.  This should not be taken as a lament against sharing of personal perceptions while delivering speeches or responding on the background or impacts of decisions for which one is responsible. They are necessary and desirable especially from transparency angle.
Accept “Prompt Corrective Action” as a necessary approach
It is comforting to see that there has been perceptible improvement in the financial health of some of the PSBs placed under PCA. The coming out of those banks will save the face of those who have been pleading for ‘relaxations’ in the PCA norms. Let us not forget that PCA is about ongoing health check up of institutions and, perhaps, could be adapted for implementation in respect of several other organizations in the financial and industrial sectors.
*************

Appendix 1
The salient features of revised PCA Framework for Banks
A. Capital, asset quality and profitability continue to be the key areas for monitoring in the revised framework.
B. Indicators to be tracked for Capital, asset quality and profitability would be CRAR/ Common Equity Tier I ratio1, Net NPA ratio2 and Return on Assets3respectively.
C. Leverage would be monitored additionally as part of the PCA framework.
D. Breach of any risk threshold (as detailed under) would result in invocation of PCA.
PCA matrix - Areas, indicators and risk thresholds

Indicator
Risk Threshold 1
Risk Threshold 2
Risk Threshold 3
Area




Capital
(Breach of either CRAR or CET 1 ratio to trigger PCA)
CRAR- Minimum regulatory prescription for capital to risk assets ratio + applicable capital conservation buffer(CCB)
current minimum RBI prescription of 10.25% (9% minimum total capital plus 1.25%* of CCB as on March 31, 2017)
And/ Or
Regulatory pre-specified trigger of Common Equity Tier 1 (CET 1min) + applicable capital conservation buffer(CCB)
current minimum RBI prescription of 6.75% (5.5% plus 1.25%* of CCB as on March 31, 2017)
Breach of either CRAR or CET 1ratio to trigger PCA
upto 250 bps below Indicator

<10 .25="" but="">=7.75%


upto 162.50 bps below Indicator

<6 .75="" but="">= 5.125%
more than 250 bps but not exceeding 400 bps below Indicator
<7 .75="" but="">=6.25%


more than 162.50 bps below but not exceeding 312.50 bps below Indicator


<5 .125="" but="">=3.625%
-

-

In excess of 312.50 bps below Indicator

<3 .625="" p="">
Asset Quality
Net Non-performing advances (NNPA) ratio
>=6.0% but <9 .0="" p="">
>=9.0% but < 12.0%
>=12.0%
Profitability
Return on assets (ROA)
Negative ROA for two consecutive years
Negative ROA for three consecutive years
Negative ROA for four consecutive years
Leverage
Tier 1 Leverage ratio4
<=4.0% but > = 3.5%
(leverage is over 25 times the Tier 1 capital)
< 3.5% (leverage is over 28.6 times the Tier 1 capital)

*CCB would be 1.875% and 2.5% as on March 31, 2018 and March 31, 2019 respectively.
i.            Breach of ‘Risk Threshold 3’ of CET1 by a bank would identify a bank as a likely candidate for resolution through tools like amalgamation, reconstruction, winding up, etc.
ii.            In the case of a default on the part of a bank in meeting the obligations to its depositors, possible resolution processes may be resorted to without reference to the PCA matrix.
E. The PCA framework would apply without exception to all banks operating in India including small banks and foreign banks operating through branches or subsidiaries based on breach of risk thresholds of identified indicators.
F. A bank will be placed under PCA framework based on the audited Annual Financial Results and the Supervisory Assessment made by RBI. However, RBI may impose PCA on any bank during the course of a year (including migration from one threshold to another) in case the circumstances so warrant.
Mandatory and discretionary actions
Specifications
Mandatory actions
Discretionary actions
Risk Threshold 1
Restriction on dividend distribution/remittance of profits.
Promoters/owners/parent in the case of foreign banks to bring in capital
Common menu
Special Supervisory Interactions
Strategy related
Governance related
Capital related
Credit risk related
Market risk related
HR related
Profitability related
Operations related
Any other
Risk Threshold 2
In addition to mandatory actions of Threshold 1,
Restriction on branch expansion; domestic and/or overseas
Higher provisions as part of the coverage regime
Risk Threshold 3
In addition to mandatory actions of Threshold 1,
Restriction on branch expansion; domestic and/or overseas
Restriction on management compensation and directors’ fees, as applicable
Common menu for selection of discretionary corrective actions
1. Special Supervisory interactions
·         Special Supervisory Monitoring Meetings (SSMMs) at quarterly or other identified frequency
·         Special inspections/targeted scrutiny of the bank
·         Special audit of the bank
2. Strategy related actions
RBI to advise the bank’s Board to:
·         Activate the Recovery Plan that has been duly approved by the supervisor
·         Undertake a detailed review of business model in terms of sustainability of the business model, profitability of business lines and activities, medium and long term viability, balance sheet projections, etc.
·         Review short term strategy focusing on addressing immediate concerns
·         Review medium term business plans, identify achievable targets and set concrete milestones for progress and achievement
·         Review all business lines to identify scope for enhancement/ contraction
·         Undertake business process reengineering as appropriate
·         Undertake restructuring of operations as appropriate
3. Governance related actions
·         RBI to actively engage with the bank’s Board on various aspects as considered appropriate
·         RBI to recommend to owners (Government/ promoters/ parent of foreign bank branch) to bring in new management/ Board
·         RBI to remove managerial persons under Section 36AA of the BR Act 1949 as applicable
·         RBI to supersede the Board under Section 36ACA of the BR Act 1949/ recommend supersession of the Board as applicable
·         RBI to require bank to invoke claw back and malus clauses and other actions as available in regulatory guidelines, and impose other restrictions or conditions permissible under the BR Act, 1949
·         Impose restrictions on directors’ or management compensation, as applicable.
4. Capital related actions
·         Detailed Board level review of capital planning
·         Submission of plans and proposals for raising additional capital
·         Requiring the bank to bolster reserves through retained profits
·         Restriction on investment in subsidiaries/associates
·         Restriction in expansion of high risk-weighted assets to conserve capital
·         Reduction in exposure to high risk sectors to conserve capital
·         Restrictions on increasing stake in subsidiaries and other group companies
5. Credit risk related actions
·         Preparation of time bound plan and commitment for reduction of stock of NPAs
·         Preparation of and commitment to plan for containing generation of fresh NPAs
·         Strengthening of loan review mechanism
·         Restrictions on/ reduction in credit expansion for borrowers below certain rating grades
·         Reduction in risk assets
·         Restrictions on/ reduction in credit expansion to unrated borrowers
·         Reduction in unsecured exposures
·         Reduction in loan concentrations; in identified sectors, industries or borrowers
·         Sale of assets
·         Action plan for recovery of assets through identification of areas (geography wise, industry segment wise, borrower wise, etc.) and setting up of dedicated Recovery Task Forces, Adalats, etc.
6. Market risk related actions
·         Restrictions on/reduction in borrowings from the inter-bank market
·         Restrictions on accessing/ renewing wholesale deposits/ costly deposits/ certificates of deposits
·         Restrictions on derivative activities, derivatives that permit collateral substitution
·         Restriction on excess maintenance of collateral held that could contractually be called any time by the counterparty
7. HR related actions
·         Restriction on staff expansion
·         Review of specialized training needs of existing staff
8. Profitability related actions
·         Restrictions on capital expenditure, other than for technological upgradation within Board approved limits
9. Operations related actions
·         Restrictions on branch expansion plans; domestic or overseas
·         Reduction in business at overseas branches/ subsidiaries/ in other entities
·         Restrictions on entering into new lines of business
·         Reduction in leverage through reduction in non-fund based business
·         Reduction in risky assets
·         Restrictions on non-credit asset creation
·         Restrictions in undertaking businesses as specified.
Any other specific action that RBI may deem fit considering specific circumstances of a bank.

1 CET 1 ratio – the percentage of core equity capital, net of regulatory adjustments, to total risk weighted assets as defined in RBI Basel III guidelines
2 NNPA ratio – the percentage of net NPAs to net advances
3 ROA – the percentage of profit after tax to average total assets
4 Tier 1 Leverage ratio – the percentage of the capital measure to the exposure measure as defined in RBI guidelines on leverage ratio.
Source: RBI

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