More rules, less discretion?

Provisioning norms in India are strictly rule-based. Being more conservative helps in withstanding crisis and enables timely corrective measures

There is a public debate regarding relaxation of the Prompt Corrective Action (PCA) norms imposed on 11 public sector banks (PSBs). The PCA framework is employed internationally by regulators as a form of structured early-intervention and resolution mechanism, designed to help banks regain health by preserving capital.

In India, the Reserve Bank of India’s PCA framework was introduced in December 2002 along the lines of the the Federal Deposit Insurance Corporation’s (FDIC) PCA framework and was implemented with respect to bank financials on March 31, 2017. In the US, the PCA framework is based more on constrained discretion rules that are applied contextually. The PCA framework in India is more rule-based and hence more stringent. A comparison of the Indian and the US PCA framework reminds us of Ben Bernanke’s (former chair of the US Federal Reserve) comment (2003) that constrained discretion rules might achieve the desired objective of monetary policy making rather than a strict rule-based approach. To borrow from behavioural economics, regulators can be expected to employ their discretion advantageously when there is an opportunity for "learning by doing". Perhaps the US PCA framework encompasses more learning by doing and hence is less stringent. 

While it may be difficult to vouch for either a rule-based approach or a discretion-based approach to policy making, empirical research does suggest (Greg Mankiw) that a discretion-based approach also serves the desired purpose if the regulator has credibility.

As far as provisioning is concerned, Indian banks are subjected to gradual age-wise provision for substandard assets starting from 15 per cent in the first year to 100 per cent in the fourth year, irrespective of whether collateral is available or not. In the US, provisioning norms are purely discretion-based and are provided for by banks as per estimated credit losses associated with the loan portfolio. In case of a commercial loan, the fair value of the collateral is taken into consideration to account for provisioning, if any. For a mortgage loan, only on 270 days delinquent, all mortgages are placed on non-accrual status only if the realisable value of the collateral is inadequate in servicing the loan value. In fact, if a mortgage loan is fully insured, it is not even placed on non-accrual status even after 90 days. While the FDIC triggers the PCA, based on bank capital threshold and leverage, the RBI’s PCA thresholds also include asset quality and profitability.

To summarise, provisioning norms in India are strictly rule-based. Being more conservative also helps in withstanding crisis and entails timely corrective measures in certain circumstances. But even after all this, Indian banks’ recapitalisation over the years is not even 1 per cent of that of US banks, even after considering the current asset quality issues. 

The author is group chief economic advisor, State Bank of India. Views are personal