Prompt corrective action: A clear framework to help NBFCs remain in shape

The Reserve Bank of India (RBI) introduced a prompt cor­r­ective action (PCA) framework for the non-banking financial companies (NBFC) on Tuesday. Why was the need for such a framework felt and what will it do? Let’s look into it.

What is a PCA framework?

A prompt corrective action framework, introduced for banks in 2002 and upgraded a couple of times thereafter, works as an early warning signal for banks in stress. The framework gets activated when banks fail to meet certain financial parameters that the regulator has sent as the minimum. In RBI’s own words, the objective of the PCA framework is to enable “supervisory intervention at appropriate time and require the supervised entity to initiate and implement remedial measures in a timely manner, so as to restore its financial health”.

The framework also acts as a tool for effective market discipline.

Why has it been imposed upon NBFCs now?

That’s because the NBFCs have, in recent years, grown enormously in size. Some of them are almost as big as small banks. With their grow­th in size, their interconnectedness has also increased. The NBFCs are today the largest borrowers in the banking system. The impact of an NBFC collapse on the overall system became evident when the Infra­structure Leasing & Financial Services (ILF&S) crumbled in August 2018.

At the end of March 2020, pre-pandemic, the total lending by the NBFC sector was about Rs 23.6 trillion, according to RBI data. This is about 20 per cent of the banks’ credit books combi­ned. Therefore, the RBI recently introduced a scale-based regulation framework where the largest of the NBFCs would be treated on a par with banks in terms of supervision. The PCA is one step towards that.

What does the PCA framework say?

It basically says if an NBFC’s total capital adequacy ratio falls below 15 per cent, or tier 1 capital falls below 10 per cent, or net non-performing asset (NPA) ratio rises above 6 per cent by March 31, 2022, an NBFC will trigger the first risk threshold, and the PCA will be imposed. It will immediately prompt the RBI to impose many restrictions on the NBFC and invite greater regulatory scrutiny. There are three such risk thresholds, as the financial ratios deteriorate further. The restrictions rise as higher risk thresholds get triggered.

How many NBFCs are there? 

Will everybody get affected?

There are about 10,000 NBFCs registered with the RBI, but only a few that can potentially face these PCA restrictions. As on July 16, 2020, there were 64 NBFCs-D (deposit taking) and 292 NBFCs-ND-SI (non-deposit taking systemically important). These NBFCs-ND-SI constitute 85.7 per cent of the total assets of the sector. Among these, too, there are only a few that have a total asset book of Rs 1,000 crore and above. The RBI PCA framework mainly targets these NBFCs.

Interestingly, analysts’ say RBI’s strict PCA criteria can potentially impact only three large NBFCs based on their second quarter numbers. However, the PCA will be based on March-end numbers, and will be implemented from October 2022. It is likely that these three NBFCs will repair their financial numbers by March.

What will happen to an NBFC if PCA is invoked?

With the first risk threshold breached, the RBI can restrict dividend distribution, or remittance of profits. The promoters and shareholders of the NBFCs will be asked to put in more capital. If the third risk threshold is triggered, the RBI can even restrict capital expenditure. There are other discretionary actions that the RBI can take — for example, special supervisory actions, or even removing the key executives.

But the RBI did take action on NBFCs in the recent past even without PCA.

Yes, it did. PCA or not, the RBI can take any action it considers fit if it deems a particular entity could cause financial instability. But a PCA is a clear laid-out structure that helps NBFCs to remain in shape to avoid a sudden RBI action.