Opinion | Diluting corrective action rules for NPA-laden banks a bad idea

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26 Aug, 2025 12:21

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There is a lack of capital but no dearth of bad ideas when it comes to state-owned banks. Two months after the government first floated the idea that the Reserve Bank of India (RBI) should dilute its prompt corrective action (PCA) framework, it is again took up the matter in the central bank's board meeting on October 23.  The justification this time: if RBI relaxes theses norms, public sector banks (PSBs) will get more freedom and money to provide liquidity to the banking system. In other words, they can also buy debt paper of non-banking finance companies (NBFCs) which are currently facing a liquidity crunch.

This idea should be nipped in the bud. As RBI deputy governor Viral Acharya pointed out in a speech earlier this month, the PCA framework helps in financial stability by allowing the regulator to intervene in the affairs of weak banks in an early and effective manner. Such norms are an important part of banking regulatory frameworks in other nations as well.

What does the PCA framework do? It identifies banks which are facing troubles based on three quantitative parameters: capital adequacy, asset quality and profitability. Restrictions on management compensation, dividend distribution, branch and credit expansion are then placed on these banks to rehabilitate them.

In the absence of PCA, banks are free to carry out business as usual. Past experiences, both in India and other countries, shows that when such strictures are not implemented, banks tend to delay recognising bad loans and roll over debt of borrower who otherwise might have defaulted. In other words, extend and pretend.

Indeed, as Acharya’s paper shows, credit growth in PCA banks from 2008-2014 was as strong as that of other PSU banks. Typically such banks tend to lend to riskier borrowers in an effort to increase credit growth and in the process even crowd out healthier borrowers. Restrictions under the PCA framework will force them to cut back on lending and shift their exposure to government securities and more credit-worthy borrowers.

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Banks under PCA and the government are not buying this theory. They are arguing that their growth is constrained because of the PCA strictures and this lack of growth will hinder them in coming out of the framework. For the government, relaxing PCAs (and the capital adequacy norms) will serve two purposes. It will allow New Delhi to save an estimated Rs 65,000 crore which it otherwise might have to inject into banks. Second, it helps in opening another source of funding for NBFCs, which are becoming a significant source of credit.

With mutual funds shying away from the NBFC space, these financial institutions are looking to banks for funding and also looking to sell loan portfolios. While a State Bank of India might have the appetite and capability to buy Rs 45,000 crore of NBFC loans, most state-owned banks are constrained thanks to lack of capital.

In this scenario, opening up the tap of these banks by relaxing PCA norms or risk weights is a bad idea. Bank credit to NBFC is already high. Some of the NBFCs facing a liquidity crunch are those who lend to a risky set of borrowers such as the commercial real estate sector. With banks already sitting on already sitting on Rs 10 lakh crore of bad loans, taking on more risk is ill-advised.  Note that the government is already finding it difficult to infuse adequate capital to the banks it owns and a further rise in bad loans spell disaster.

The key point about PCA, as Acharya pointed out, is that it limits capital erosion and taxpayer losses. With time, PCA banks will de-risk balance sheets and emerge out of the framework. This should not be sacrificed at the altar of expediency. Yes, the NBFC problem could spiral into a credit crunch for the real economy and hobble economic growth. But that calls for a different set of tools from the regulator such as easing systemic liquidity, targeted liquidity for NBFCs and so on.