Explainer | New PCA rules for NBFCs suggest RBI has learned its lessons from IL&FS, DHFL episodes 

The RBI’s PCA Framework was introduced in December 2002 as a structured early intervention mechanism along the lines of the US Federal Deposit Insurance Corporation’s PCA framework.

Finally, non-banking financial companies (NBFCs) have been brought under the prompt corrective action (PCA) framework of the Reserve Bank of India (RBI). To begin with, what is PCA?

In simple words, PCA is the regulator’s action on weaker entities if the financial performance falls below certain thresholds. The regulator then imposes certain restrictions on the business operations till the entities get back to satisfactory performance levels. The PCA system was already in place for banks.

The RBI’s PCA Framework was introduced in December 2002 as a structured early intervention mechanism along the lines of the US Federal Deposit Insurance Corporation’s PCA framework. Subsequently, the RBI reviewed the framework, keeping in view international best practices and recommendations of the Working Group of the Financial Stability and Development Council on Resolution Regimes for Financial Institutions in India (January 2014) and the Financial Sector Legislative Reforms Commission (March 2013). The revised PCA Framework was issued by the RBI on April 13, 2017, and implemented with respect to banks’ financials as of March 31, 2017.

When does PCA trigger for banks?

The RBI has specified certain regulatory trigger points with respect to three parameters of banks, i.e., capital-to-risk weighted assets ratio (CRAR), net non-performing assets (NPAs) and return on assets for the initiation of the process. There are various stages. If CRAR falls to less than 9 percent, the RBI asks banks to submit a capital restoration plan, and restricts new businesses and dividend payments.

The RBI also orders recapitalisation, restrictions on borrowings from the interbank market, reduction of stake in subsidiaries and reduction of exposure to sensitive sectors like the capital markets, real estate or investments in non-statutory liquidity ratio securities.

For instance, if the CRAR is less than 6 percent but equal to or more than 3 percent, the RBI could take additional steps if the bank fails to submit a recapitalisation plan. These measures include bringing in a new management/board, appointing consultants for business/organisational restructuring, taking steps to change ownership and also initiating the process for merger of the bank.

Similarly, if net NPAs rise beyond 10 percent but are less than 15 percent, a special drive to reduce bad loans and contain the generation of fresh NPAs begins. The RBI reviews the bank’s loan policy and takes steps to strengthen credit-appraisal skills.

Subsequently, the follow-up of advances and suit filed/decreed debt starts. Also, the RBI puts in place proper credit-risk management policies and will reduce loan concentration. Further, there will be restrictions on entering new lines of business, making dividend payments and increasing its stake in subsidiaries. In addition to the actions upon hitting the initial trigger point, the bank’s board is called for discussion on the PCA.

How is it for NBFCs?

The PCA framework that the RBI has introduced now for NBFCs are largely on similar lines. The core focus is on capital adequacy and NPA levels. The RBI framework has created three risk thresholds, failing each of which will attract different levels of regulatory actions.

According to the framework, the apex bank will impose PCA on NBFCs if there is any breach of risk threshold. For instance, if the CRAR falls up to 300 basis points (bps) below the regulatory minimum CRAR, tier-1 capital ratio falls up to 200 bps below the regulatory minimum and net NPA ratio goes beyond 6 percent, the NBFC will fall under risk threshold-1.

The RBI will then impose restrictions on various business operations and will conduct special inspections and targeted scrutiny of the company. For an NBFC under threshold-1, the RBI will impose restrictions on dividend distribution/remittance of profits; also, there will be restrictions on the issue of guarantees or taking on other contingent liabilities on behalf of group companies.

Similarly, if the CRAR falls more than 300 bps but up to 600 bps below the regulatory minimum, and the tier-1 capital ratio falls more than 200 bps but up to 400 bps below the regulatory minimum and net NPA shoots up beyond 9 percent, the NBFC will fall into risk threshold-2.

For such companies, in addition to the restrictions mentioned above, the RBI will impose restrictions on branch expansion, the central bank said.

If the CRAR falls 600 bps below the regulatory minimum, the tier-1 capital ratio falls more than 400 bps below the regulatory minimum and the net NPA is greater than 12 percent, the NBFC will fall in the risk threshold-3 category.

In such cases, in addition to the mandatory actions of threshold 1 and 2, the RBI will take appropriate restrictions on capital expenditure and will impose restrictions on variable operating costs.

Once an NBFC is placed under PCA, taking it out of the framework or withdrawal of restrictions imposed under the it will be considered if no breaches in risk thresholds in any of the parameters are observed according to four continuous quarterly financial statements, one of which should be the annual audited financial statement, the RBI said.

Also, this will be based on the supervisory comfort of the RBI, including an assessment on the sustainability of the NBFC’s profitability, the RBI said

Why now?

NFFCs have traditionally enjoyed light-touch regulation by the RBI compared with banks. The RBI started paying more attention to NBFCs after the collapse of Infrastructure & Leasing Financial Services (IL&FS) in late 2018 which was followed by the crisis in Dewan Housing Finance Ltd. These episodes triggered high risk aversion and severe liquidity problems in the NBFC sector. The regulator stepped up scrutiny on non-banks subsequently to avert similar episodes.

On October 22, the RBI said the scale-based regulation (SBR) for NBFCs shall be effective from October 1, 2022. Under this, the regulatory structure for NBFCs comprises four layers based on their size, activity and perceived riskiness.

The base layer is for NBFCs with an asset size up to Rs 1,000 crore including NBFCs-P2P (platforms offering peer-to-peer lending and borrowing) and NBFC Account Aggregators (where customer information is shared between RBI-regulated entities). The middle layer is for NBFCs having an asset size over Rs 1,000 crore and housing finance companies, core investment companies, infrastructure finance companies.

The upper layer NBFCs will be identified by the RBI as warranting enhanced regulatory requirements based on a set of parameters and scoring methodology. The top 10 eligible NBFCs in terms of their asset size shall always reside in the upper layer, irrespective of any other factor, the RBI said.