RBI introduces prompt corrective action framework for NBFCs

• Reserve Bank of India (RBI) has introduced the prompt corrective action (PCA) framework for non-banking financial companies (NBFCs).
• The central bank has defined three risk thresholds for applying prompt corrective action to NBFCs.

Prompt Corrective Action (PCA) Framework

• PCA is a framework under which banks with weak financial metrics are put under watch by the RBI.
• The RBI introduced the PCA framework in 2002 as a structured early-intervention mechanism for banks that become undercapitalised due to poor asset quality, or vulnerable due to loss of profitability.
• It aims to check the problem of Non-Performing Assets (NPAs) in the Indian banking sector.
• The framework was reviewed in 2017 based on the recommendations of the working group of the Financial Stability and Development Council on Resolution Regimes for Financial Institutions in India and the Financial Sector Legislative Reforms Commission.
• It has three risk threshold levels (1 being the lowest and 3 the highest) based on where a bank stands on these ratios.
• On breach of any of the risk thresholds mentioned above, the RBI can invoke a corrective action plan.
• Depending on the threshold levels, the RBI can place restrictions on dividend distribution, branch expansion, and management compensation.
• Only in an extreme situation, breach of the third threshold, would identify a bank as a likely candidate for resolution through amalgamation, reconstruction or winding up.

About Non-Banking Financial Company (NBFC)

• A (NBFC) is a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business.
• Exclusions: It does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of immovable property.

PCA for NBFC

• The new NBFC framework will be applicable to all deposit taking NBFCs in middle, upper and top layers.
• The PCA framework for NBFCs will come into effect from October 1, 2022, based on the financial position of NBFCs on or after March 31, 2022.
• Recently, the RBI has made NPA recognition norms for NBFCs tighter, bringing them at par with banks.

Risk threshold

• Under the framework, the RBI has set three risk thresholds, after which the NBFCs will be put under prompt corrective action.

Risk Threshold 1

• Capital adequacy ratio 300 basis points below minimum requirement
• Tier-1 capital ratio 200 basis points below minimum requirement
• Net non-performing asset ratio between 6-9%

Risk Threshold 2

• Capital adequacy 300-600 basis points below minimum requirement
• Leverage ratio more than 3 times but less than 3.5 times
• Net NPA ratio 9-12%

Risk Threshold 3

• Capital adequacy more than 600 basis points below minimum requirement
• Tier-1 capital ratio more than 400 basis points below minimum requirement
• Net NPA ratio above 12%

Restrictions on breach

• NBFCs breaching the first risk threshold will be put under restrictions on dividend distribution, promoters or shareholders will be required to bring additional equity to reduce leverage.
• In case of core investment companies, an additional restriction on issuance of guarantees or taking on contingent liabilities will be put.
• In the event of breaching the second risk threshold, the RBI will put restriction on branch expansion, apart from the restrictions under threshold one.
• In case the NBFC has breached the third risk threshold, the RBI will put appropriate restrictions on capital expenditure, and restrictions on variable costs, apart from the restrictions mentioned above.