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Context

• The Reserve Bank of India (RBI) has placed Dhanlaxmi Bank under tight monitoring with the bank’s financial position coming under greater public scrutiny.

 

Details

• The RBI’s tight monitoring comes in the wake of the intense court battle started by a group of minority shareholders against the bank’s management team over inadequate financial disclosures, rising expenses, and general mismanagement of the business.

 

RBI’s supervision

• The Banking Regulation Act, 1949 empowers the Reserve Bank of India to inspect and supervise commercial banks. These powers are exercised through on-site inspection and off-site surveillance.

 

On site Inspection

• On site inspection of banks is carried out on an annual basis. Besides the head office and controlling offices, certain specified branches are covered under inspection so as to ensure a minimum coverage of advances.
• The Annual Financial Inspection (AFI) focusses on statutorily mandated areas of solvency, liquidity and operational health of the bank. It is based on internationally adopted CAMEL model modified as CAMELS, i.e., capital adequacy, asset quality, management, earning, liquidity and system and control. While the compliance to the inspection findings is followed up in the usual course, the top management of the Reserve Bank addresses supervisory letters to the top management of the banks highlighting the major areas of supervisory concern that need immediate rectification, holds supervisory discussions and draws up an action plan, that can be monitored. All these are followed up vigorously. Indian commercial banks are rated as per supervisory rating model approved by the BFS which is based on ‘ CAMELS ‘ concept.

 

Off-site Monitoring

• As part of the new supervisory strategy, a focussed off-site surveillance function was initiated in 1995 for domestic operations of banks. The primary objective of the off site surveillance is to monitor the financial health of banks between two on-site inspections, identifying banks which show financial deterioration and would be a source for supervisory concerns. This acts as a trigger for timely remedial action.

Prompt corrective action (PCA)

• Prompt corrective action (PCA) is enforced by RBI when banks breach certain regulatory requirements such as return on asset, minimum capital, and quantum of non-performing assets.
• Banks under PCA face restrictions like dividend distribution, branch expansion, and management compensation or may require promoters to infuse capital in the bank.
• Reserve Bank of India had introduced a Prompt Corrective Action Framework (PCA) for Scheduled Commercial Banks in 2002.
• The PCA Framework for NBFCs, came into effect from October 1, 2022. This is to further strengthen the supervisory tools applicable to NBFCs.
• Under the PCA, the RBI places restrictions on lending by troubled banks and keeps a close eye on them until their financial position improves sufficiently.

 

Read all about NBFCs:  https://www.iasgyan.in/blogs/nbfcs-and-its-types

When Does RBI Invoke Prompt Corrective Action?

• RBI takes into account four factors to determine whether it needs to put a bank under the PCA framework. These include profitability, asset quality, capital ratios and debt level.
• The central bank grades each of these factors based on actions depending upon the grade/threshold level, categorized from one to three, where 1 is the lowest of the lot and 3 being the highest based on how banks stand with respective frameworks.

 

Following is a look at these factors and their grades:

Capital Adequacy Ratio (CRAR)

• The CRAR is basically the capital needed for a bank measured in terms of assets (mostly loans) disbursed by the banks.
• The higher the assets, the higher should be the capital retained by the bank.
• This measures how much debt and equity capital banks possess to cover their asset book risk.
• If CRAR is less than 10.25%, but above 7.75%, the bank falls in the first grade.
• Banks having a CRAR of over 6.25%, but below 7.75%, fall under grade 2. However, if a bank's capital adequacy ratio is less than 3.625%, it is categorised under grade 3.

 

Capital Adequacy Ratio (CAR) Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities. It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process. Description: It is measured as Capital Adequacy Ratio = (Tier I + Tier II + Tier III (Capital funds)) /Risk weighted assets The risk weighted assets take into account credit risk, market risk and operational risk. The Basel III norms stipulated a capital to risk weighted assets of 8%. However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12%.

 

Asset Quality

• This parameter refers to the non-performing assets of a bank. If the net NPA of a bank is more than 6%, but less than 9%, it falls under the first threshold.
• If Net NPA crosses the 9% mark, it triggers the second grade. That said, if this metric is 12% or more, the bank will fall in the third grade of PCA.

 

Read all about NPAs: https://www.iasgyan.in/daily-current-affairs/non-performing-assets

 

Profitability

• The regulator considers the return on assets (ROA) of a bank as the key measure for profitability. Note that if a bank's ROA is negative for two, three and four years in a row, it will be categorised as grade 1, grade 2 and grade 3, respectively.

 

Debt Level/Leverage

• The last factor that RBI considers to measure the financial risk of any bank is its overall debt level/leverage.
• The regulator triggers grade 1 if the overall leverage of a bank is more than 25 times its Tier 1 capital.
• However, when total leverage is over 28.5 times its core capital (including disclosed reserves), RBI takes action according to grade 2 of PCA.

 

Corrective Actions that can be taken when a Bank is put under PCA framework

     1. Special Supervisory Actions

• Special Supervisory Monitoring Meetings (SSMMs) at quarterly or other identified frequency
• Special inspections/targeted scrutiny
• Restricted and need based regulatory/supervisory approvals to be given by the Reserve Bank
• Resolution by Amalgamation/ Reconstruction/ Splitting
• File insolvency application under IBC (under Insolvency and Bankruptcy Code, 2016 )
• Winding up of the NBFC

 

     2. Strategy related Actions

• Activate the Recovery Plan that has been duly approved by the Supervisor
• Undertake a detailed review of business model in terms of sustainability of the business model, profitability of business lines and activities, medium and long term viability, etc.
• Review short-term strategy focusing on addressing immediate concerns
• Review medium-term business plans, identify achievable targets and set concrete milestones for progress and achievement
• Undertake business process reengineering as appropriate
• Undertake restructuring of operations as appropriate

     3. Governance related Actions

• RBI may actively engage with the NBFC’s Board on various aspects as considered appropriate
• RBI may recommend to promoters/shareholders to bring in new Management/ Board
• RBI may remove managerial persons under the RBI Act, as applicable
• Removal of Director and/or appointment of another person as Director in his place
• RBI may supersede the Board under the RBI Act and appoint an Administrator
• RBI may require the NBFC to invoke claw back and malus clauses and other actions as available in regulatory guidelines, and impose other restrictions or conditions
• Impose restrictions on Directors’ or Management compensation, as applicable.

 

     4. Capital related Actions

• Detailed Board level review of capital planning
• Submission of plans and proposals for raising additional capital
• Requiring the NBFC to bolster reserves through retained profits
• Restriction on investment in subsidiaries/associates
• Restriction in expansion of high risk-weighted assets to conserve capital
• Reduction in exposure to high-risk sectors to conserve capital
• Restrictions on increasing stake in subsidiaries and other group companies

 

     5. Credit risk related Actions

• Preparation of time bound plan and commitment for reduction of stock of NPAs
• Preparation of and commitment to plan for containing generation of fresh NPAs
• Strengthening of loan review mechanism
• Restrictions/reduction in total credit risk weight density (example: restriction/ reduction in credit for borrowers below certain rating grades, restriction/reduction in unsecured exposures, etc.)
• Reduction in loan concentrations in identified sectors, industries or borrowers
• Sale of assets
• Action plan for recovery of assets through identification of areas (geography-wise, industry segment-wise, borrower-wise, etc.) and setting up of dedicated Recovery Task Forces, etc.
• Prohibition on expansion of credit/ investment portfolios other than investment in government securities / other High-Quality Liquid Investments
• Higher provision

 

https://www.thehindu.com/business/Industry/explained-when-does-rbi-step-in-to-monitor-a-bank/article66044567.ece