Economy Simplified: Prompt Corrective Action (PCA) explained.

PCA is a system that the RBI imposes on those banks which show signs of financial stress. The regulator considers banks as unsafe if they fail to meet the standards on certain financial metrics or parameters.

When does RBI invoke Prompt Corrective Action?

1. RBI takes into account four factors to determine whether it needs to put a bank under the PCA framework. 

2. These include 1. Profitability 2. Asset Quality 3. Capital Ratio and 4. Debt Level.

3. The central bank grades each of these factors based on actions depending upon the grade/threshold level, categorised from one to three, where 1 is the lowest of the lot and 3 being the highest based on how banks stand with respective frameworks.

Four Factors to invoke PCA

1. Capital Adequacy Ratio (CRAR)

• Capital adequacy ratio (CAR) is the ratio of a bank’s available capital, in relation to the risks involved in terms of loan disbursement.  In other words, capital adequacy ratio is the ratio of a bank’s capital in relation to its assets and liabilities.
• Capital Adequacy Ratio (CAR) is the measurement ratio that assesses the ability of banks to absorb losses.
• It standardizes the banks’ abilities to pay off its liabilities, tackle credit and operational risks. 
• CAR measures the ratio of two tiers of capitals: tier 1 capital that absorbs the risks during the working of the bank, and tier 2 capital that absorbs losses during its liquidation so as to provide necessary compensation to the customers of the bank.
• The formula for CAR is: (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets.
• If CRAR is less than 10.25% but above 7.75%, the bank falls in first grade. Banks having CRAR of over 6.25%, but below 7.75%, fall under grade 2. If bank’s CRAR falls below 3.625%, it is categorised as grade 3. 

2. Asset Quality

Loans granted to businesses and households are assets for banks. The interest banks earn on these assets is a key component of their income and profit, and the risk of the loans not being paid back is their main risk. The higher this credit risk, the lower the quality of the loan, or “asset quality”.
This parameter refers to Net Non performing Assets of a bank. If the net NPA of a bank is more than 6%, but less than 9%, then it falls under grade 1. If it crosses 9% then grade 2 and 12% or more, then grade 3 is triggered.

3. Profitability

The regulator considers Return on Assets (ROA) of a bank as the key measure for profitability. If a bank’s ROA is negative for two, three, and four years in a row, it will be categorised as grade 1, grade 2 and grade 3 respectively.

4. Debt Level/Leverage

The regulator triggers grade 1 if the overall leverage of the bank is more than 25 times its Tier 1 capital. 

What Happens When RBI Puts a Bank under PCA?

When RBI puts a bank on its PCA watchlist, it imposes two types of limitations on it: mandatory and discretionary. These include restrictions related to the expansion of a branch, dividend and director’s remuneration and so on.

The Central Bank may choose to take the following actions at their discretion: 

• Ask the bank’s board to reassess its business model and evaluate the profitability of the business line and operations.
• Advise banks to reassess their business plans and strategy to take remedial measures, which may include dismissing certain officials from employment.
• Ask a Bank’s board to implement a resolution plan after seeking approval from the supervisor.
• Advise banks to gauge their viability over the medium to long term besides evaluating balance sheet estimates.
• Lastly, RBI may allow PCA banks to incur capital expenditure only to upgrade technology.

How do Banks Benefit from PCA?

• One of the objectives of PCA is to amend a bank’s mistakes before they lead to a crisis.
• RBI controls the loan disbursal of banks belonging to the PCA watchlist. That said, note that the regulator does not entirely prohibit PCA banks from disbursing loans.
• RBI’s PCA framework has been designed to improve a bank’s financial performance by tracking vital metrics. In other words, it involves the RBI taking remedial measures.
• PCA banks cannot enter a new line of business, which improves their core financials.
• Only in some rare cases, RBI might choose to close down non-compliant banks or initiate amalgamation for them.

It is crucial that RBI undertakes the remedial measures on time, or else banking institutions may not have sufficient capital to cover the losses.