PCA Framework for NBFCs – Explained, pointwise

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Introduction

A Prompt Cor­r­ective Action (PCA) framework for the non-banking financial companies (NBFCs) was recently introduced by the Reserve Bank of India (RBI).

Essentially, deposit-taking NBFCs and those with systemic impact will now be subject to a PCA framework similar to that for scheduled commercial banks (SCBs). This will allow various controls to be imposed.

The RBI decision has come after four big finance firms, IL&FS, DHFL, SREI and Reliance Capital, collapsed in the last three years despite the tight monitoring in the financial sector. They collectively owe over Rs 1 lakh crore to investors.

It may be recalled that the revised PCA framework for Scheduled Commercial Banks (SCBs) was issued on November 2, 2021.

Let’s take a deep dive into the topic.

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What is the rationale behind this move?

Tight supervision of NBFCs: 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. Moreover, as per RBI, with strong linkages with the other parts of the financial system, their asset quality must be closely observed. The impact of an NBFC collapse on the overall system became evident when the Infra­structure Leasing & Financial Services (ILF&S) crumbled in August 2018.

Hence, 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.

Core objective: Enable supervisory intervention at appropriate time and require the supervised entity to initiate and implement remedial measures in a timely manner, to restore its financial health.

What does the PCA Framework say?

PCA delineates three risk thresholds. Triggering of each threshold will result in invocation of PCA, with a gradually increasing set of restrictions.

ParametersRisk Threshold 1Risk Threshold 2Risk Threshold 3
Capital Adequacy Ratio, falls300 basis points from current level of 15-12%300-600 bps from 12-9%600 bps from 9%
Net Non-Performing Assets is b/w6-9%9-12%>12%
Tier 1 capital ratio, fallsUp to 200 bps below the min Tier I Capital Ratio [10% – 8%]More than 200 bps but up  to 400 bps below min Tier I capital ratio [8% – 6%]More than 400 bps below the min Tier I capital Ratio [<6%]

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.

– The RBI will also restrict issuance of guarantees or taking other contingent liabilities on behalf of group companies, in case of core investment companies.

After hitting risk threshold 2, the NBFC will be prohibited from opening branches, in addition to restrictions under Threshold 1.

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.

It is also important to note that apart from the actions mentioned in the PCA framework, the RBI can take any other action as it deems fit at any time.

Exclusions: The PCA framework excludes government firms, non-deposit taking NBFCs with asset size of less than Rs 1,000 crore, as well as private sector housing finance companies.

The framework will come into effect from October 2022, based on the financial position of NBFCs on or after March 31, 2022.

The PCA framework will be reviewed after being three years in operation.

Will all NBFCs get affected?

No. Only a few NBFCs will potentially face these PCA restrictions.

As on July 16, 2020,

NBFCs-ND-SI (non-deposit taking systemically important) constitute 85.7% 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.

What are the implications of new norms?

The norms may not have an immediate impact on the sector but will surely act as a deterrent and discipline the sector, going forward.

These controls will, in a graded manner, prevent NBFCs from taking on more risk and control their promoters’ behaviour.

The restrictions under the framework will enable NBFCs to take corrective action when they breach stipulated thresholds. That would reduce the chances of insolvency.

The restrictions, if imposed on any smaller player, will weed out competition for bigger NBFCs. Hence, highly capitalized NBFCs, with a good NPA-check mechanism in place, need not worry, while smaller financiers will have to tread carefully from now on.

The move may hit the NBFCs that are struggling to compete with banks and do not have access to easy funding.

Also, the pandemic might not really be the right time to introduce new and more stringent regulations to govern already stressed institutions, as some assets might be non-performing because of the pandemic.

What is the way forward?

The RBI should be on guard that, if for some reason the pandemic conditions worsen, the timeline need to be extended without compromising on the overall direction of reform.

The RBI should also be careful that, while it continues to take due precautions about the risks posed by the sector, it does not stifle the innovative and inclusive quality that sets NBFCs apart from banks.

Conclusion

The PCA being extended to NBFCs may prove to be a good decision for the long-term as it will encourage good practises and is also expected to improve governance.

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