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