Introduction of Prompt Corrective Action (PCA) Framework for Non-Banking Financial Companies (NBFCs)

Blog   wpadmin   January 7, 2022

Executive Summary:

This article covers:

      • This article focuses on the newly introduced Prompt Corrective Action (PCA) Framework for Non-Banking Financial Companies (NBFCs)
      • Highlights about Risk Threshold Limits and Corrective Action on breach of the Threshold.

Introduction:

Reserve Bank of India (RBI) has vided its notification dated December 12, 2021, newly introduced Prompt Corrective Action(PCA) Framework for Non-Banking Financial Companies (NBFCs). This concept of Prompt Corrective Action (PCA) framework is not new for Banking Sectors, RBI has launched this concept of PCA for Scheduled Commercial Banks in 2002, and from time to time it got reviewed. In the same line to monitor the financial sustainability ofthe banking sector, RBI has come up same PCA framework for Non-banking financial companies (NBFCs).

What is the Prompt Corrective Action (PCA) Framework?

It is a kind of framework introduced by RBI in 2002 for an early-inventions mechanism for Banks that became undercapitalized due to a major part of Non-performing Assets (NPA), continues downfall in profitability. Under this PCA Framework, RBI has put some financial matrices to identify financial health, sustainability of the Banks and Banks which do not fulfill set parameters or matrices shall fall under this framework. Under this PCA Framework, RBI typically puts up lending restrictions on the banks and doesn’t let them expand among other things. It is a confinement measure by the central government so that the weak bank can heal and get back on its feet.

Need for Prompt Corrective Action (PCA) Framework for Non-Banking Financial Companies (NBFCs)

Over the years, the NBFC segment has grown rapidly. NBFC in the Indian sector is playing a critical role in the development of Core infrastructure, transport, employment generation, wealth creation, economic development of the weaker sections in India.

The RBI has done so as NBFCs have grown in size significantly and their operations have also become complex. With their grow­th in size, their interconnectedness has also increased. But whenever any sector expands enormously it always gives triggering an alarm to Regulators to look into its proper functioning. And especially after the cases of IL&FS, DHFL, SREI, and Reliance Capital— which collected public funds through fixed deposits and non-convertible debentures collapsed in the last three years despite the tight monitoring in the financial sector. They collectively owe over Rs 1 lakh crore to investors. To safeguard the interest of Investors, RBI took the NBFCs also under the Umbrella of Prompt Corrective Action (PCA) framework to monitor the financial health of NBFCs.

Applicability of PCA Framework for NBFCs

As per RBI Circular, PCA Framework shall apply to:

  • i. All Deposit-Taking NBFCs but it Excludes Government Companies,
  • ii. All Non-Deposit Taking NBFCs in Middle, Upper and Top Layers which includes Core Investment Companies (CICs), Infrastructure Debt Funds, Infrastructure Finance Companies, Micro Finance Institutions and Factors, Investment and Credit Companies
    It excludes – (i) NBFCs not accepting/not intending to accept public funds;(ii) Government Companies, (iii) Primary Dealers and (iv) Housing Finance Companies

This PCA Framework for NBFCs shall be applicable with effect from October 01, 2022 based on the financial position of NBFCs on or after March 31, 2022.

Financial Parameters and Risk threshold Limit

Any NBFCs which shall not comply with the financial parameters, thresholds prescribed by RBI, shall fall under the PCA Framework. Following are the parameters set by RBI for NBFCs:

For Core Investment Companies (CICs):

  • A. Adjusted Net Worth / Aggregate Risk-Weighted Assets (ANW/ARWA)
  • i. Risk Threshold limit-1: It shall be up to 600 bps and ANW/RWA shall be less than 30% and but more than 24%.
  • ii. Risk Threshold-2: It shall be more than 600 bps but up to 1200 bps and ANW/RWA shall be less than 24% and but more than 18%.
  • iii. Risk Threshold-3: It shall be more than 1200 bps and ANW/RWA shall be less than 18%.
  • B. Leverage Ratio (L.R.)
  • i. Risk Threshold limit-1: L.R. shall be more than 2.5 times but less than 3 times.
  • ii. Risk Threshold limit-2: L.R. shall be more than 3 times but less than 3.5 times.
  • iii. Risk Threshold limit-3: L.R. shall be more than 3 times.
  • C. NNPA Ratio (including NPIs)
  • i. Risk Threshold limit-1: NNPA Ratio shall be more than 6% but less than 9%.
  • ii. Risk Threshold limit-2: NNPA Ratio shall be more than 9% but less than 12%.
  • iii. Risk Threshold limit-3: NNPA Ratio shall be more than 12%.

For Excluding Core Investment Companies (CICs):

A. Capital to Risk-Weighted Assets Ratio (CRAR)
CRAR is also known as Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk. CRAR is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process. It is available capital expressed as a percentage of a bank’s risk-weighted credit exposures.

  • i. Risk Threshold limit-1: If CRAR fall more than 300 basis points below the minimum required 15% but more than 12%.
  • ii. Risk Threshold-2: If CRAR falls more than 300 bps but up to 600 bps. Currently, it is more than 12% but less than 9%.
  • iii. Risk Threshold-3: If CRAR falls more than 600 bps. It is less than 9%.

B. Tier I Capital Ratio
It is the relationship between core capital and its total assets. The tier 1 capital ratio is the ratio of a bank’s core tier 1 capital—that is, its equity capital and disclosed reserves—to its total risk-weighted assets. It is a key measure of a bank’s financial strength.

  • i. Risk Threshold-1: If the capital ratio drops 200 basis points below the minimum required more than 10% but less than 8%.
  • ii. Risk Threshold-2: If capital adequacy falls more than 200 bps but upto 400 bps i.e. more than 8% but less than 6%.
  • iii. Risk Threshold-3: If capital adequacy falls more than 400 bps i.e. less than 6 %.

C. Net NPA Ratio (NNPA)
NPA are loans for which the principal or interest payment remained overdue for over 90 days. Net NPA is the actual loss faced by the lending institution.

  • i. Risk Threshold-1: NNPA ratio increases above 6% but less than 9%.
  • ii. Risk Threshold-2: NNPA ratio increases above 9% but less than 12%.
  • iii. Risk Threshold-3: NNPA ratio increases above 12%.

A breach in any of the three risk thresholds under the above-mentioned indicators could result in inclusion under PCA Framework.

Corrective Action in case of violation of Risk Threshold under PCA Framework.

In case, there is a violation by NBFC while complying with the Risk Thresholds as we have seen in the above para, as per the category mentioned, RBI shall take two types of Corrective Actions.

A. Mandatory Corrective Action
When the Risk threshold limits are crossed, depending upon the violations, banks are categorized in successive thresholds. Following are the mandatory actions taken in case of defaults/violations: –

  • In case RBI has observed, NBFCs are crossing Risk Threshold limit-1 then RBI shall put the following restrictions on NBFCs:
    • i. Such NBFCs are not allowed to distribute their dividends among their shareholders.
    • ii. Promoters and Shareholder of that NBFCs are forced to infuse equity and reduce leverage,
    • iii. In the case of CICs, RBI can put restrictions on the issue of guarantees or take on other contingent liabilities on behalf of group companies.
  • In case RBI has observed, NBFCs are crossing Risk Threshold limit-2 then RBI shall put the following restrictions on NBFCs
    • i. In addition to mandatory actions of Threshold 1,RBI shall put restrictions on the expansion of Branches for that NBFC.
  • In case RBI has observed, NBFCs are crossing Risk Threshold limit-2 then RBI shall put the following restrictions on NBFCs
    • i. In addition to restrictions under conditions 1 & 2, the RBI may
    • ii. Impose curbs on capital expenditure other than for technological upgradation.
    • iii. Restrict/ directly reduce variable operating costs.

B. Discretionary actions
Apart from these mandatory actions, there are a series of corrective actions listed by RBI.  After further investigation, RBI can also take some Discretionary actions against such NBFCs which are crossing Threshold limits which are listed below:

  • i. Special Supervisory Actions
  • ii. Strategy related
  • iii. Governance related
  • iv. Capital related
  • v. Credit risk related
  • vi. Market risk related
  • vii. HR-related
  • viii. Profitability related
  • ix. Operations/Business related

Conclusion:

This is a welcome move as it will stop-over bad lenders from going worse rather than brushing the issue aside and which shall be converted into big financial scams. Safer and Trusted NBFCs will interpret a safer healthy financial system. A review of the PCA framework for NBFCs shall help to improve the overall functioning of NBFCs. The PCA Framework shall come in the wake of large NBFCs such as IL&FS, DHFL, SREI Group, and Reliance Capital getting into financial trouble over the last few years. With this PCA Framework, NBFCs would be treated on a par with banks in terms of supervision. This prevents NBFCs from taking on more risk and controlling their promoters’ behavior and reduces the chances of insolvency. The PCA framework being extended to NBFCs shall result in a good decision for the long run as it will encourage good practices and is also expected to improve good corporate governance.

Regards,
Legal Team

Proind Business Solutions Private Limited
306, Tower B, I-thum, Plot No A-40, Sector 62, Noida, UP, India- 201301
No.: +91 120 4224203
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