Prompt Corrective Actions For Banks

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The central bank has imposed certain restriction on banking activities of Oriental Bank of Commerce which has suffered huge losses due to sharp rise in bad loan.

This will be the seventh bank among the 21 PSU banks to be placed under restrictions since March this calendar year.

OBC will face restrictions in terms of opening new branches, hiring staff and lending to sub-investment grade companies. PCA is imposed when thresholds related to capital, asset quality and earnings are breached. The bank can continue to accept deposits and give small tickets loans.

Now Let’s See What Is Prompt Corrective Action, When and How PCA is invoked

What is Prompt Corrective Action?

  • PCA norms allow the regulator to place certain restrictions such as halting branch expansion and stopping dividend payment. It can even cap a bank’s lending limit to one entity or sector.
  • Other corrective action that can be imposed on banks include special audit, restructuring operations and activation of recovery plan. Banks’ promoters can be asked to bring in new management, too. The RBI can also supersede the bank’s board, under PCA.

When is PCA invoked?

  • The PCA is invoked when certain risk thresholds are breached. There are three risk thresholds which are based on certain levels of asset quality, profitability, capital and the like. The third such threshold, which is maximum tolerance limit, sets net NPA at over 12% and negative return on assets for four consecutive years.

What are the types of sanctions?

  • There are two type of restrictions: mandatory and discretionary. Restrictions on dividend, branch expansion, directors compensation, are mandatory while discretionary restrictions could include curbs on lending and deposit.
  • In the cases of two banks where PCA was invoked after the revised guidelines were issued — IDBI Bank and UCO Bank — only mandatory restrictions were imposed. Both the banks breached risk threshold 2.

Image result for RBI images on Prompt Corrective Action

What will a bank do if PCA is triggered? 

  • Banks are not allowed to renew or access costly deposits or take steps to increase their fee-based income. Banks will also have to launch a special drive to reduce the stock of NPAs and contain generation of fresh NPAs. They will also not be allowed to enter into new lines of business. RBI will also impose restrictions on the bank on borrowings from inter-bank market.

Why the need for PCA?

  • The 1980’s and early 1990’s were a period of great stress and turmoil for banks and financial in stitutions all over the globe. In USA, more than 1,600 commercial and savings banks in sured by the Federal Deposit Insurance Corporation (FDIC) were either closed or given financial assistance during this period. The cumulative losses incurred by the failed institutions exceeded US $100 billion. These events led to the search for appropriate supervi sory strategies to avoid bank failures as they can have a destabilising effect on the economy.

What does the RBI stipulate?

  • RBI has set trigger points on the basis of CRAR (a metric to measure balance sheet strength), NPA and ROA. Based on each trigger point, the banks have to follow a mandatory action plan. Apart from this, the RBI has discretionary action plans too. The rationale for classifying the rule-based action points into “mandatory“ and “discretionary“ is that some of the actions are essential to restore the financial health of banks while other actions will be taken at the discretion of RBI depending upon the profile of each bank.

Due to the adverse impact on the economy , medium sized or large banks are rarely closed and the governments try to keep them afloat. Bank rescues and mergers are far more common than outright closures. If banks are not to be allowed to fail, it is essential that corrective action is taken well in time when the bank still has adequate cushion of capital to minimise the losses.

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