Qualitative Assessment to Drive Resolution of Banks under New PCA Framework: Ind-Ra

The new Prompt Corrective Action (PCA) framework introduced by the Reserve Bank of India (RBI) makes the resolution of banks through amalgamation, reconstruction, winding-up or other means necessary as a discretionary corrective action unlike the erstwhile guidelines where a breach of CET I conditions under ‘Risk Threshold 3’ was a specified condition for the same. With this, one may argue that the erstwhile assumption by some market players of CET I + capital conservation buffer falling 3.125% below the regulatory requirements (currently at 5.5% + 2.5%) as one of the quantitative thresholds for a bank’s non-viability no longer exists.

The RBI has also introduced leverage ratio as one of the three factors to be considered for placing banks under the revised PCA framework, replacing the profitability variable.

11 public sector banks (PSBs) had been placed under PCA in 2017 and the road to recovery for these banks has been arduous since then, where most weak and small franchises were amalgamated to create larger self-sufficient organisations and thus cease to exist.

Evaluating the indicators under the PCA framework, Ind-Ra opines that banks today are in better position with sufficient buffers above the thresholds. The revised PCA framework puts various restrictions including paying dividends under ‘Risk Threshold 1’ along with branch expansion under ‘Risk Threshold 2’ and further. With UCO Bank (UCO: 'IND AA-'/Negative) and Indian Overseas Bank (IOB; bonds rated at ‘IND AA-’/Negative) exiting recently, Central Bank of India (CBOI; bonds rated at ‘IND AA-’/Negative) is the only PSB left under the framework. The agency understands that under the new framework Central bank of India would also pass the thresholds.

Profitability Criterion Removed, Leverage Ratio Makes Entry: In the agency’s opinion, the RBI’s move to exclude the profitability metrics, which was prescribed in its last update released on 13 April 2017, possibly as the measure on capital, is over-arching and captures the near to medium-term impact on profitability due to a credit cycle. In its earlier approach, negative return on assets for two consecutive years or more was a key indicator that the RBI was monitoring.

The inclusion of Tier I leverage ratio (leverage ratio) signifies the RBI according greater importance to the leverage of an institution and to supplement existing risk-based capital adequacy requirements. The RBI prescribes a minimum leverage ratio of 3.5% for banks at all times with an additional 0.5% requirement for domestic systemically important banks (which include State Bank of India (SBI: ‘IND AAA’/Stable); HDFC Bank Limited (HDFC; ‘IND AAA’/Stable) and ICICI Bank Limited). This has been in practice since 1 October 2019.

Exit Conditions from PCA now Clearly Laid Out: The updated PCA framework also lays down clear guidelines on the exit conditions from PCA. The exit from PCA and withdrawal of restrictions under PCA will be considered: a) if no breaches in the risk thresholds in any of the parameters are observed as per four continuous quarterly financial statements, one of which should be an audited annual financial statement (subject to assessment by the RBI) and b) an assessment of sustainability of profitability of the bank based on the RBI’s supervisory comfort.

Changes in Conditions in Risk Thresholds 2 and 3: The PCA framework specifies three risk thresholds based on the severity of the shortfall in the key indicators ranging from Risk Threshold 1 to being the one with least shortfalls versus Risk Threshold 3 which has the highest deviation from the benchmark levels. As part of its review while the restrictive conditions have been unchanged for Risk Threshold 1, the RBI has excluded the condition of the requirement of higher provisions as part of the Provision Coverage Regime under Risk Threshold 2. This is in line with the significant increase in the provision coverage ratio of PSBs to 68% in FY21 (FY18: 49%).

Furthermore, the RBI has removed the restriction on management’s compensation and directors’ fees in Risk Threshold 3 and instead introduced a restriction on capital expenditure, other than for technological upgradation within board approved limits (included under discretionary corrective actions in the April 2017 update). This the agency believes has been done so that the continuity of management is not impacted in such cases. The restriction on management’s compensation and directors’ fees continues to be present under discretionary corrective actions.

Changes in Discretionary Corrective Actions: In addition to the mandatory restrictions placed on banks under the risk thresholds, there are additional discretionary corrective actions under the PCA framework. In comparison to the discretionary actions laid out in the 13 April 2017 update, the following key provisions have been added under various categories of discretionary corrective actions: