A shot for NBFC health: Given the public money at stake, revised PCA framework for NBFCs is welcome

By Ashvin Parekh

The Reserve Bank of India (RBI) had introduced the Prompt Corrective Action (PCA) Framework for Scheduled Commercial Banks in 2002. The objective of the PCA framework is to enable supervisory intervention at the appropriate time and requires the supervised entity to initiate and implement remedial measures in a timely manner to restore its financial health. The financial health is determined based on parameters relating to capital, quality of assets and the profitability of the entity. The PCA framework is also intended to act as a tool for effective market discipline. The market discipline is reviewed on the quality of governance, which includes board and senior management decisions that may impact the financial health of the bank. After having successfully introduced the PCA framework and its regular evaluation, both the regulator and the system have restored the financial health of the banks

NBFCs, in the last five years, have grown their share in savings and credit (loans) intermediation and have acquired a much larger role in the economy. The NBFCs, deposit taking and non-deposit taking as also other categories, depend on public funds to a significant extent. Their financial health imposes systemic risk and, to that extent, RBI’s introduction of the Scale Based Regulation (SBR) and a revised framework for NBFCs is a welcome control.

In October 2021, RBI introduced the extent of applicable regulations and the supervisory intervention based on the size of operations of an NBFC, for different categories of such entities. In the revised framework, there is a recognition of the extent of systemic risk the entities pose for financial stability.

The December iteration of the PCA framework for NBFCs adds more clarity with regard to the extent of supervisory intervention, and compliance on the part of NBFCs, to reduce the surprises of NBFC failures by observing the financial health on an ongoing basis. The framework articulates the financial parameters on capital, quality of assets, profitability, net worth and leverage ratios (as applicable to different categories of NBFCs); risk thresholds have been announced to determine the financial health of an NBFC. Different thresholds are defined once an NBFC crosses the basic health line, and starting from threshold 1, the framework imposes corrective actions of mandatory and discretionary nature. If an NBFC improves its financial health and comes out of threshold 1, then the corrective actions are gradually withdrawn. On the other hand, if its financial health deteriorates or an entity is already in threshold 2 or 3, then, in addition to the corrective actions applicable to the first threshold, further actions are mandated. Almost like in the case of scheduled commercial banks, the corrective actions are aimed at strengthening the capital of that NBFC and placing greater responsibility on the promoters to bring in more capital. In addition to this, there are further actions prescribed in the area of recovery of bad debts, governance—ranging from engaging with the board of the NBFC on various aspects, as deemed appropriate. The actions may lead to resolution of an NBFC into an amalgamation of different entities, or its reconstruction or splitting. It could also lead to filing for insolvency or the issue of show-cause notice for cancellation of licence or even winding up of the NBFC.

There has been a healthy debate on whether PCA frameworks work or they merely expedite the closure of a financial institution. Those who do not favour restricting the working of a financial institution argue that an institution may become healthy if the economic parameters of the geography in which they function become more conducive. Their arguments blame external factors, including the regulatory framework in operation, for the performance of the NBFCs. It should be recognised however that such arguments do not hold water when the underlying facts behind the performance of the institution is examined. More significantly, the fact that such institutions draw funds from the public should not be forgotten. Deployment of public funds need constant vigilance and zero tolerance for non-performance. An assessment of financial statements of the NBFCs suggest large reliance on funds from the public and the banking system, both in the form of debt and equity in case of listed entities

An evaluation of the PCA framework in the banking system throws up some very interesting outcomes. Out of the total number of banks placed under PCA—about 11 banks in 2018—many have already come out of the framework by substantially strengthening their financial parameters and focusing on recovery. Their success story should encourage the industry to evaluate the change in the approach these banks designed and implemented successfully, and evolve a way of strengthening their performance. Even large banks in this list have managed to come out of the framework. The NBFCs with weak financial parameters should focus on developing their plans for short, medium and long term to have a sustained recovery. The key message here is to restore health rather than find excuses.

The author is Managing partner, Ashvin Parekh Advisory Services LLP. Views are personal.