Prompt Corrective Action (PCA) is a monitoring method employed by the Reserve Bank of India (RBI) to check and stabilize the health of the country’s banking system. PCA is usually implemented by the RBI when a bank’s performance slips below a certain threshold to stop its further deterioration and encourage compliance with remedial actions. The PCA framework plays an important role in protecting depositors’ interests and the bank’s stability in general.
Prompt Corrective Action (PCA) was launched in 2002 to keep a check and apply corrective measures for banks that are under stress. Thus, the PCA framework is an early warning that provides guidelines in terms of numerical criteria on capital adequacy, asset quality, profitability, and leverage ratios. Accordingly, the RBI can issue restrictions on the activities of a bank and suggest remedial measures. The main objective of PCA is to rectify a bank’s situation and avoid a systemic crisis in the banking system.
When does RBI invoke Prompt Corrective Action?
The RBI uses PCA in banking when a bank’s condition becomes risky, in any of the crucial aspects, of the defined benchmark such as Capital Adequacy Ratio (CAR), Asset Quality, Profitability, and Leverage. The given parameters have their levels or triggers. For instance, the RBI may impose restrictions on dividend distribution and opening new branches, or even put a ceiling on managerial remuneration if the banks’ financial ratios are poor.
Capital Adequacy Ratio (CAR)
Capital adequacy ratio (CAR) is an essential measure of capital to total amount of risks a bank has, which is calculated as capital to risk-weighted assets ratio. It is an important measure that determines the capability of a bank to manage possible losses and ensure the security of depositors’ money. Under PCA, the RBI prescribes a minimum capital-to-risk weighted asset ratio, popularly known as CAR.
When a bank’s CAR is below the set level, the RBI may resort to PCA, thus forcing the bank to undertake suitable actions to enhance its capital position. This may be in the form of getting more capital, cutting down on risk-weighted assets, or even controlling credit extension to risky areas.
Asset Quality
Asset quality indicates the health of a bank’s loan portfolio, which is typically measured using the level of non-performing assets (NPAs). If NPAs are abnormally high, it reveals that the bank’s assets are not generating enough returns due to poor credit lending and possible losses. The PCA framework also has provisions to take action if a bank has an exceeding level of NPAs. The RBI may ask the bank to set aside more funds against non-performing assets and refrain from giving new loans.
Profitability
Profitability also comes under the PCA framework. It is evaluated with the help of indicators like Return on Assets (ROA). However, if a bank records a negative ROA or profits that it generates are not adequate over one or more periods, it is a sign that something is wrong.
Being unprofitable means that the capital of the bank gets depleted so that the entity cannot support losses. Under PCA in banking, the RBI has powers to restrict some of the business operations, seek a cost-cutting plan from the bank, or recommend the bank to work out a merger or consolidation to make it profitable.
Debt Level/Leverage
The debt or leverage of a bank means the level of debt to equity of a particular bank, or how much of the bank’s financing sources is obtained through borrowings. High leverage ratios mean that the proportion of debt in the capital structure of a bank is high and this can be dangerous.
Leverage ratio under PCA is also managed by the RBI. Once the threshold limit is breached, the bank would be asked to trim its debt. This may require an issue of more equity, disposal of a non-strategic business, or lowering its risk to achieve a better leverage ratio.
What happens when RBI puts a bank under PCA?
When a bank is under the PCA framework, the RBI puts certain restrictions and supervisory measures strictly according to the weaknesses of the particular bank. These actions are meant to stop further erosion and get the bank to start seeking ways to correct its financial problems.
Such measures would include restrictions in the extension of lending and deposit products, constraints in capital spending, control on branch openings, or a hold on dividends. The RBI could also ask the bank to restructure, enhance its corporate governance practice, or seek M&A to bolster its capital base.
How do banks benefit from PCA?
Prompt corrective action can appear rigid, but PCA imposed by RBI can be beneficial for banks that face financial stability issues. First, it gives a signal to banks to manage their affairs to avoid avertible crises. Secondly, PCA enables the RBI to reinstate public confidence among depositors and investors. Banks must take corrective actions as early as possible to restore stability to their activities, ensure quality of assets, and consolidate capital from where they could rebound to a path of sustainable growth.
Should depositors care if their bank is on PCA?
Generally speaking, depositors should not be overly concerned should their bank be placed under PCA by RBI. The PCA framework has been put in place by the RBI to prevent the risks from impacting depositors and the stability of the banking systems. The need for PCA implies that the RBI is keeping a close check on the financial well-being of the bank in question, and is actively trying to curb the decline of the quantum of capital it possesses.
The main goal is to have the bank regain its soundness while at the same time not putting depositors’ money at risk. Besides, deposits are also protected under the DICGC for up to ₹5 lakh so that the depositors can feel secure. Nevertheless, it is helpful for depositors to keep up with the actual financial status of the banking firm and the report of RBI.
How can banks come out of RBI’s PCA list?
For a bank to exit the PCA framework, there must be a material and sustained recovery by the bank from its current vulnerability status as measured by its capital-to-risk weighted assets ratio, non-performing asset ratio, return on assets, and leverage ratio. The parameters should fall within the regulations set by the RBI as the banks’ minimum requirements.
The bank must also demonstrate steady compliance with corrective measures recommended by RBI including capital mobilization, reduction of NPAs, governance system improvement, and, profit increase. Once the RBI is fully convinced that the bank has stabilized its financial position and will not violate PCA parameters again, the bank is deemed free to operate without restrictions.
Here, we discuss two of the common remedial measures often suggested for banks operating under RBI’s Prompt Corrective Action. (PCA)
Mergers and Amalgamation
The use of mergers or amalgamation can act as a strategic option for banks that are operating under PCA in banking since it tightens the credit facilities. RBI may compel the weak bank to merge with a stronger bank to augment its capital structure, quality of its assets, and general soundness. Such mergers can bring synergies, operational cost efficiencies, and better competitive positioning for the merged entity. The amalgamation also enables the promotion of mergers of weaker banks with properly capitalized banking institutions to guarantee a continuation of services and protect the interests of depositors.
Bank Recapitalization
Another measure commonly availed by banks under PCA is bank recapitalization. Recapitalization means infusing fresh capital into the bank to boost capital adequacy to absorb losses. The capital could be provided by the government or the bank’s shareholders. Recapitalization enables banks to enhance their capital adequacy ratio, reduce the level of leverage, and boost market confidence. It also helps banks to normalize their lending functions.
Why PCA?
It should be evident to you by now that PCA is important to maintain the stability and profitability of the banking sector. It serves as a red signal for regulators to identify threats in advance and eliminate them without worsening the situation. Therefore, an early and appropriate corrective action is done by PCA to minimize the effect of one bank’s failure on the financial system. This helps protect the interests of depositors and enhance confidence of the public in the banking system.
PCA is a powerful measure employed by the RBI to improve stability of the banking sector. Although the PCA framework might appear constrained, it is favorable to banks since it presents a path to revival and protects depositor cash.
