The Reserve Bank of India (RBI) takes specific actions on banks if they are not performing well or becoming financially weak. These actions come under one framework called the PCA (Prompt Corrective Action). Remember, whether it is public sector banks or private banks, both come under this framework.
Now, we understand that RBI deems financially weak banks, but what are metrics to draw the conclusion. RBI audits the financial aspects of every bank yearly or at regular intervals. Thus, it is important to know on what basis the RBI takes any action. To make your understanding easier, we have brought this post.
Table of Contents
Things to know about the PCA
1. Lending restrictions
Although there were certain lending restrictions to banks in the demonetization period, that was not under the PCA. To understand it better, we have certain cooperative banks or NBFCs which face lending restrictions from the RBI. As a result, the bank has to restrict its capital for a certain tenure, ultimately leading to no expansion of the bank’s name.
Due to lending restrictions, the depositors get into trouble. This PCA is implemented fail banks fail to meet any of the three parameters, which are:
- NPA (Non Performing Assets)
- CRAR ratio (Capital To Risk-Weighted Asset Ratio)
- Return on assets (ROA)
In simpler words, these act like a quarantine measure for banks to enhance their financial credibility and meet all parameters that RBI guides.
2. Restore the financial health
Although depositors face a certain crisis for a certain period, it is for their financial wellbeing only. It is because when RBI imposes such PCA, banks get time to sound financially healthy for long. The PCA helps the banking sector to evaluate the breach of risk thresholds like capital, profits, NPA, and much more. So, later they take appropriate action and give their best to restore the bank’s financial health.
Furthermore, the PCA improves the bank’s efficiency and strengthens them for future financial activity. For a common man it might seem a negative step that limits the financial performance of a bank. But in the longer term, it is useful, and banks operate smoothly without going in a negative direction.
3. Factors responsible
To understand how it is calculated, first understand what CRAR is. It is a bank’s capital ratio to its risk. And there are three threshold levels of CRAR, which are as follows:
- Threshold Level 1: Banks with less CRAR 10.25 but more than 7.75
- Threshold Level 2: Banks having CRAR less than 7.75 but more than 6.25
- Threshold Level 3: Banks having CRAR 3.625
Not just about the CRAR aspect, but NPA also plays a crucial role in the PCA activity. If the net NPA breaches the 6% but is less than 9%, then it is under the first threshold level. But if it goes beyond 12% then it lies under threshold level 3.
Now, if we talk about profitability banks give the negative ROA for 2 years, three years and four years consecutively. Then, they will come under threshold levels 1, 2, and 3, respectively.
RBI being one of the leading Financial Regulatory Bodies in India has the power to exercise PCA and improve the financial health of banks. It is because banks run on depositors’ money, and there should be a mutual trust between banks and depositors. Hence, it is advisable for banks to maintain all financial parameters that RBI sets. And for depositors, we recommend checking the financial health of the financial institution. In certain cases, RBI amalgamates banks or recapitalizes them to restructure their financial activity.