Financial Standards and Codes: Report of Advisory Group on Banking Supervision

Appendix to Chapter "Core Principles for Effective Bankin
Supervision - Prompt Corrective Action

Various banking crises have reinforced the need for having an efficient early warning system so that timely and adequate policy measures could be initiated to arrest any destablising effects and thereby arrest contagion. In both industrial and emerging market economies, mergers and rescue measure of banks are more common than outright closure of banks in view of the deleterious impact of precipitate action on the payment system in particular and on the economy in general. Outright closure is not contemplated by the national authorities as it has many social and political consequences. In this background, positioning Prompt Corrective Action (PCA) is considered as an important step so that the regulator/supervisor in consultation with the concerned bank could initiate corrective actions early in the remedial process. PCA is important as the cost of restructuring/liquidation of a bank only increases with delays in the initiation of appropriate policies. PCA includes various measures pertaining to supervision and monitoring of banks with potential troubles and those that are already troubled.

1. The Core Principles for Effective Banking Supervision (Principle 22) of BCBS clearly indicate that banking supervisors must have at their disposal sufficient supervisory measures complemented by legal sanctions to bring about timely corrective action when banks are showing signs of deteriorating compliance with various prudential norms relating to income recognition, asset classification, capital adequacy, etc.

2. The experience of various countries in this regard indicates that supervisors and regulators have both discretionary and mandatory actions. Although revoking the banking licence could be construed as an ultimate step, this is rarely resorted to. Once banks exhibit persistent deteriorating conditions, various actions, supportive as well as penal, are initiated ranging from restricting the current activities, placing a cap on their branch expansion, close scrutiny of asset transfers, examining the possibility of takeover or merger with healthier banks, etc.

3. As per the Banking Regulation Act, 1949, RBI has been taking bank-specific corrective actions when warranted. Various sections of the BR Act empower RBI to initiate appropriate corrective actions when banks start showing some kind of deterioration, but these are not properly structured. It has, therefore, been felt that an objective and rule-based set of corrective actions which are transparent in addressing problems of deteriorating banks would be necessary. Accordingly, RBI has formulated a draft PCA framework which is in the course of being finalised.

4. Under the proposed PCA framework, trigger points have been set up with reference to three principal parameters, viz., Capital to Risk Weighted Assets Ratio (CRAR), net NPA and Return on Assets. The PCA framework also mentions the rationale for classifying the rule-based actions into mandatory and discretionary. Under each of the three parameters, a trigger ratio is prescribed and once the problem bank reaches the trigger ratio, the PCA framework prescribes a set of mandatory and discretionary action to be taken. In case banks do not show any improvement despite these actions, RBI would be taking further steps mandatorily. While the PCA framework provides that, in exceptional cases, RBI will have the right to waive mandatory provisions, it is important to recognise here that misplaced flexibility could delay the positioning of corrective actions and in producing required results.

5. The proposed PCA framework of RBI prescribes three trigger points with respect to CRAR, two trigger points with respect to net NPAs and a single trigger point with respect to return on assets. Based on the level of the bank's performance, mandatory and discretionary actions are prescribed.

6. An important lacuna in this approach is that the three parameters are independently viewed and various mandatory and discretionary actions are to be initiated accordingly. However, these three parameters are interlinked and in assessing the actual state of health of a bank one has to take into account the various levels of deterioration/deviation from compliance, which are signified by the appearance of one or more of the identified trigger points, which means occurrence of one or more combination of events.

7. The Group is of the view that although the three parameters which form the PCA framework are sufficient at this stage these would need to be reviewed in the coming years in the light of developments in information technology, payment systems and in other important areas which influence the banking sector. It is important to recognise that no PCA framework should be treated as permanent in nature. The other important point, in the opinion of the Group, is that PCAs need to have some mandatory elements in order that all stakeholders as well as the supervisors are prepared for a certain course of corrective action in the event of the performance of banks falling below a given level. This will add strength to the system and is likely to keep banks on greater alert against any deterioration in their performance.