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PCA Framework for NBFCs: An Overview

PCA Framework for NBFCs - Prompt Corrective Action Framework

Recently, the Reserve Bank of India (RBI) came up with a Prompt Corrective Action (PCA) Framework for NBFCs with a view to introduce supervisory tools and provide remedial measures to protect the financial health of the NBFCs. This is not the first time when such a framework is introduced by the RBI. Earlier in 2002 a similar kind of protective framework was introduced by RBI to protect the financial health of Scheduled Commercial Banks. This programme was introduced with the objective of intervening in the functioning of the banks and forcing such banks to take corrective actions. Another motive was to inculcate discipline in the market and improve their financial health. As far as this PCA Framework for NBFCs, RBI has the mandate to take the below mentioned corrective decisions and any other action as it deems fit to intervene in the functioning of the NBFC and enforcing remedial measures.

What is a ‘Prompt Corrective Action Framework’?

In order to protect the financial health of a lender or protect it from defaulting, the banking regulators of the country lay down certain financial metrics or parameters which must be followed by the lenders. If the lenders breach the risk thresholds listed out in the framework, then the banking regulator will impose restrictions on the operations conducted by the lenders.

Since these lenders are interconnected with other constituents of the market such restrictions are necessary for maintaining the balance and security of investments in the market.

Which NBFCs fall under the purview of PCA Framework introduced by RBI?

The RBI came up with a PCA Framework and included the following entities within its purview:

  1. All the NBFC’s taking deposits (NBFCs-D) but excludes the government companies
  2.  All the Non-Deposit taking NBFC’s (NBFCs-ND) in Middle, Upper and Top layers but exclude the:
    • NBFC’s which do not accept or do not intend to accept public funds.
    • Housing finance companies
    • Government companies
    • Primary Dealers.

However, following are the entities that are included within the scope of NBFCs-ND:

  1. Core Investment Companies (CICs)
  2. Infrastructure Finance Companies
  3. Investment and Credit companies
  4. Micro Finance Institutions and Factors
  5. Infrastructure Debt Funds
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PCA Framework monitors the NBFCs in the following areas

  1. NBFCs-D and NBFCs-ND are monitored in the areas of Asset Quality and Capital
  2. CICs are monitored in the areas of Asset Quality, Capital and Leverage.

PCA Framework tracks the following indicators of NBFCs

  1. For NBFCs-D and NBFCs-ND the framework will track indicators like Capital to Risk (Weighted) Assets Ratio (CRAR), Net NPA Ration (NNPA), Tier-1 Capital Ratio.
  2. For CICs, the indicators are NNPA, Adjusted Net Worth/Aggregate Risk Weighted Assets and Leverage Ratio.

The NBFCs will be put under the PCA Framework on the basis of the audited Annual Financial Results along with the Supervisory Assessment done by the RBI[1]. However, RBI can impose this framework during the course of the accounting year itself if the existing circumstances so demand.    

PCA Framework has been introduced by the RBI for NBFCs

The market size and the share of the NBFCs have been growing. Given the fact that the NBFCs have been interconnected with the other parts of the market, the Reserve Bank being the banking regulatory authority of India wants to keep the health of these entities in check and introduce a supervisory framework over their activities so that the money invested in them is not squandered and the market as a whole has to bear the brunt of it.

The RBI has come up with a Prompt Corrective Action (PCA) Framework which will come into force from 1st October, 2022 onwards. This framework shall be based on the financial position of the NBFC on and after 31st March, 2022. Therefore, these NBFCs have been asked to adhere to the capital adequacy norms before 31st March 2022.

What is CRAR?

Capital to Risk (Weighted) Assets Ratio (CRAR) also called as Capital Adequacy Ratio which is a representation of the ratio of the bank’s capital to the associated risk weighted assets such as market risk, credit risks etc. A high CRAR represents the entity is highly capitalised. Higher the CRAR, higher the lender is capitalized.

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What is Tier 1 Capital Ratio?

Tier 1 Capital Ratio represents the bank’s core Tier 1 capital i.e. the ratio of the bank’s equity reserves plus disclosed reserves to the total risk weighted assets.

What is NNPA ratio?

NNPA stands for Net Non-Performing Assets, which is the ratio of non-performing assets to the total loans given.

What is Adjusted Net Worth (ANW)?

Adjusted Net Worth refers to the estimated value of the business as per the company’s accounts books after adding unrealized capital gains, voluntary reserves and capital surplus.

What are Aggregate Risk Weighted Assets (RWA)?

It refers to the least amount of capital that is held by the banks in order to avoid the situation of insolvency.

According to the annexed framework:

  1. In case of NBFCs-D and NBFCs-ND:
    • If the CRAR falls upto 300bps below the minimum regulatory level, Tier 1 Capital Ratio falls upto 200bps below the minimum regulatory level and the NNPA ratio goes between 6% to 9%, then the NBFC will breach Risk Threshold-1 which will result in restrictions on issuing dividends and force the shareholder/promoters to reduce leverage or infuse liquidity.
    • If the CRAR falls more than 300bps but upto 600bps below the minimum regulatory level, Tier 1 Capital Ratio falls more than 200bps but upto 400bps below the minimum regulatory level and the NNPA ratio goes between 9% to 12%, then the NBFC will breach Risk Threshold-2 which will result in restrictions as imposed for breaching Risk Threshold-1 along with restrictions on branch expansion.
    • If the CRAR falls more than 600bps below the minimum regulatory level, Tier 1 Capital Ratio falls more than 400bps below the minimum regulatory level and the NNPA ratio goes more than 12%, then the NBFC will breach Risk Threshold-3 which will result in restrictions as imposed for breaching Risk Threshold-1 and 2 along with restrictions on capital expenditure, technological upgradation and variable operating costs.
  2. In case of CICs:
    • If the ANW/RWA falls upto 600bps below the minimum regulatory level, Leverage Ratio falls between 2.5 times to 3 times and the NNPA ratio goes between 6% to 9%, then the CICs will breach Risk Threshold-1, which will result in restrictions on issuing dividends, guarantees, taking on other contingent liabilities of group companies and forcing the shareholder/promoters to reduce leverage or infuse liquidity.
    • If the ANW/RWA falls more than 600bps but upto 1200bps below the minimum regulatory level, Leverage Ratio falls between 3 times to 3.5 times and the NNPA ratio goes between 9% to 12%, then the CICs will breach Risk Threshold-2 which will result in restrictions as imposed for breaching Risk Threshold-1 along with restrictions on branch expansion.
    • If the ANW/RWA falls more than 1200bps below the minimum regulatory level, Leverage Ratio falls more than 3.5 times and the NNPA ratio goes more than 12%, then the CICs will breach Risk Threshold-3 which will result in restrictions as imposed for breaching Risk Threshold-1 and 2 along with restrictions on capital expenditure, technological upgradation and variable operating costs.
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Along with these the RBI can take discretionary corrective actions which are operations related, capital related, Human Resource related, supervisory actions etc. in order to protect the financial health of the above mentioned entities.

Conclusion

As the NBFCs are interconnected with various financial entities of the market, its decision making and functioning has the capacity to influence and affect the economy in a big way. Therefore, it is important the banking regulator of the country should have the ability and capacity to intervene in the operations of the NBFCs and at the same time enforce discipline so that market does not get adversely affected and sentiments remain positive. This PCA Framework for the NBFCs has given the RBI all powers to devise financial metrics, impose restrictions, intervene in operations and take any measure that is necessary to enforce discipline among the NBFCs. The framework introduced for NBFCs is not the final one and shall continue to evolve with the ever evolving market and modus operandi of the NBFCs.

Read our article:RBI announces Revised Regulatory Framework for NBFCs

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