RBI Extends PCA Framework to Government NBFCs

  • October 11, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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RBI Extends PCA Framework to Government NBFCs

Subject: Economy

Section: Monetary Policy

Context:

  • The Reserve Bank of India (RBI) has extended the Prompt Corrective Action (PCA) framework for Non-Banking Financial Companies (NBFCs) to government NBFCs starting from October 1, 2024.

Background:

  • The PCA Framework for NBFCs was introduced by the RBI on December 14, 2021.
  • The framework aims to address financial risks and safeguard the health of NBFCs.
  • Prior to this extension, the PCA framework was in place for Scheduled Commercial Banks since 2002.

About Prompt Corrective Action (PCA):

  • PCA is a structured framework established by the Reserve Bank of India (RBI) to monitor and intervene in banks with weak financial metrics.

Objective:

  • The primary aim of PCA is to address issues related to undercapitalization, poor asset quality, and declining profitability in banks.
  • It focuses on tackling the problem of Non-Performing Assets (NPAs) in the Indian banking sector.
  • The PCA framework enables supervisory intervention when necessary and compels the supervised entity to implement corrective actions promptly to restore its financial health.
  • It serves as a tool for maintaining market discipline within the financial sector.
  • This extension of the PCA framework to government NBFCs aligns with the RBI’s efforts to ensure the stability and soundness of financial institutions in India.

History:

  • The RBI introduced the PCA framework in 2002 as a mechanism for early intervention when banks face financial stress.
  • It was reviewed in 2017 based on the recommendations of the working group of the Financial Stability and Development Council on Resolution Regimes for Financial Institutions in India and the Financial Sector Legislative Reforms Commission.

Role:

  • PCA serves as an alert system for regulators, investors, and depositors to recognize potential banking troubles in advance.
  • It enables the RBI to monitor key performance indicators of banks and take corrective actions to restore a bank’s financial health.

PCA Framework Criteria:

  • Banks are classified as risky if they trigger certain thresholds. The key triggers include:
    • Capital to Risk-Weighted Assets Ratio (CRAR).
    • Net Non-Performing Assets (NPA).
    • Return on Assets (ROA).
    • Tier 1 Leverage Ratio.

Function:

  • The PCA framework helps the RBI track and assess the performance of banks in relation to these trigger points.
  • If a bank’s financial indicators breach these thresholds, the PCA framework outlines corrective measures to be taken to prevent the situation from deteriorating.

Need for PCA Framework:

  • The PCA framework was introduced in response to the collapse of major finance firms like IL&FS, DHFL, SREI, and Reliance Capital, which had collected public funds through fixed deposits and non-convertible debentures. These firms owed over Rs 1 lakh crore to investors.

Impact of PCA Invocation:

  • When PCA is invoked for an NBFC, the RBI may enforce mandatory corrective actions, such as:
    • Restrictions on dividend distribution and remittance of profits.
    • Requiring promoters or shareholders to infuse equity.
    • Reducing leverage.
    • Limiting branch expansion.
    • Imposing capital expenditure constraints (except for technological upgrades within board-approved limits).
    • Restricting or directly reducing variable operating costs.
  • For Core Investment Companies (CICs), the RBI may also restrict the issuance of guarantees or the assumption of other contingent liabilities on behalf of group companies.

About Capital to Risk-Weighted Asset Ratio (CRAR):

Definition:

  • CRAR is a financial ratio used to measure a bank’s capital in relation to its risk exposure.
  • It indicates the amount of capital a bank holds as a buffer to cover potential losses on its loans and other assets.

Calculation:

  • The CRAR ratio is calculated by dividing a bank’s capital (Tier 1 and Tier 2 capital) by its risk-weighted assets.
  • CRAR = (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets.

Components of Capital:

  • Tier 1 Capital (Core Capital): This includes equity capital, ordinary share capital, intangible assets, and audited revenue reserves.
  • Tier 2 Capital: This comprises unaudited retained earnings, unaudited reserves, and general loss reserves.

Importance of CRAR:

  • CRAR is a critical tool for assessing a bank’s financial health.
  • It ensures that banks have sufficient capital to absorb potential losses and continue lending safely.
  • It protects depositors and provides assurance of a bank’s ability to sustain its operations.

Benefits of CRAR:

  • Risk Management: CRAR helps banks manage and mitigate risks effectively.
  • Depositor Protection: It safeguards depositors’ funds by ensuring banks have enough capital to cover losses.
  • Sustainability: It contributes to the stability and sustainability of banks’ operations.
  • Lending Capacity:Maintaining a healthy CRAR allows banks to continue lending money to businesses and individuals.

In summary, CRAR is a key financial metric that provides insights into a bank’s financial strength and its ability to withstand financial challenges and risks.

Core Investment Companies (CICs) – A Quick Overview

  1. Specialized NBFCs: CICs are specialized Non-Banking Financial Companies (NBFCs) with a specific focus.
  2. Asset Size Requirement: To be registered with the RBI as a CIC, a company needs to have an asset size exceeding Rs 100 crore.
  3. Primary Business: The main business of CICs is the acquisition of shares and securities. However, specific conditions apply to their investment portfolio.
  4. Investment Conditions: CICs are required to have at least 90% of their net assets invested in equity shares, preference shares, bonds, debentures, debt, or loans in group companies.
  5. Group Companies: Group companies are defined as entities related through various relationships such as subsidiaries, joint ventures, associates, promoter-promotee relationships (for listed companies), related parties, common brand names, and investments in equity shares of 20% and above.

In summary, Core Investment Companies are specialized NBFCs with a significant asset size that primarily engage in acquiring shares and securities, subject to specific investment conditions primarily related to group companies.

economy RBI Extends PCA Framework to Government NBFCs