Government Should Not Interfere In The Prompt Corrective Action

The Ministry of Finance (MOF) of the Indian government has, in the recent past, been actively trying to dilute the regulatory and supervisory efforts of the Reserve Bank of India (RBI). The latest instance of the same is the public announcement by the Finance Minister (FM) that the government is favourably inclined to discussing with the RBI for relaxing the latter's norms on the prompt corrective action (PCA) for weak banks.

The concept of PCA is globally administered in several advanced economies including the United States of America (USA). The Federal Reserve Bank (Fed) of USA mandates progressive penalties against banks that exhibit progressively deteriorating capital ratios. The RBI has also notified the norms for applicability of PCA to weak banks. These norms are objective, transparent, and non-discretionary, which are the hallmarks of sound a regulatory directive. Under these norms, a bank is placed under PCA in case of a breach of threshold limits with respect to a set of three pre-specified triggers, viz capital to risk-weighted assets ratio (CRAR), net NPA ratio, and return on assets.

The three ratios are a good representative of a bank's financial health. The model for selecting the three ratios and the threshold levels may be debated. It is not clear if the RBI has a robust predictive model supporting the selection of these. It is, therefore, open for anyone to reject these ratios based on a counter-validated model. However, in the absence of any robust evidence to the contrary, one cannot reject the assertion of the RBI that a bank can be classified as weak on the basis of its PCA model.

The government has not shared any evidence in the public domain to the effect that the RBI's model is either weak or counter-productive. It has however directly taken a stand to that effect.

The posture by the government is worrying. It is the largest shareholder in the public sector banks (PSBs) under PCA. It must appreciate that it is using its advisory powers over RBI in direct conflict to its position as a de facto, if not de jure, regulated entity. This violates the sanctity of its relationship with the RBI. It also diminishes the independence of the RBI in administering its regulations in a non-partisan manner. 

The RBI would do well to nip the suggestion in the bud itself. It should reject any suggestion from anyone, including the government, to review its guideline in a partial or ad-hoc manner. It had, earlier, rejected the pressure to dilute the norms, selectively for the power sector borrowers, for the resolution of nonperforming assets (NPAs). Likewise, it should reject any such ad-hoc suggestion relating to the dilution of PCA.

The government must realise that the RBI has set on a path that is in the interest of the long-term health of the banking sector. It may, in the process, cause short-term pain to a few specific banks. But if the course is right, the RBI, as well as the government, must stick to it in a disciplined manner.

As an aside, the government should actually use this opportunity provided by RBI, as a neutral referee, to call out the weak banks. The long-continued practice of putting good money after bad money through the repeated recapitalisation of the weak PSBs needs to be seriously questioned and tested for efficacy of economic as well as political outcomes. A more efficient allocation of capital to stronger banks would be constructive for output and employment. My belief is that it can also be politically constructive if the capital deployment is done smartly. Will that happen? That's anybody's guess.