The Reserve Bank of India's (RBI) updated "prompt corrective action" (PCA) framework could suggest a greater willingness to take regulatory action to address problems at struggling banks, but its implementation is only likely to be effective if it is matched by credible plans to address banks' significant asset quality issues and capital shortages, says Fitch Ratings.
The RBI has tightened the thresholds - for capital ratios, NPLs, profitability and leverage - at which banks enter the PCA framework. This appears to be an acknowledgement of the significant asset quality stress in the system and that more banks are in need of regulatory intervention.
PCA was previously viewed as an extraordinary step, which the RBI urged banks to make great efforts to avoid. That now looks likely to change.
More than half of state-owned banks would breach at least one of the new thresholds, mainly owing to high NPLs, based on their latest financial reports. The new PCA framework will be invoked on the basis of the banks' FY17 financials, which they are still reporting.
The RBI has also given itself greater discretion in terms of the measures it can use to intervene in banks once they fall under the PCA framework, which suggests it has recognized a need to take corrective action at an earlier stage when banks run into difficulties.
The previous PCA, in contrast, explicitly reserved the most interventionist actions for banks that had breached more extreme thresholds. It is possible that intervention could involve forcing banks to conserve capital, if other actions do not address problems. The risk of non-performance on bank capital instruments may therefore have risen.
The actual impact of the new PCA rules will depend on how the RBI uses them. Two circulars released on Tuesday, which pressure banks to make provisions above the regulatory minimum and require further disclosures on NPLs, point to the RBI's seriousness. These circulars might weigh on bank earnings in the next round of reports. Should the additional disclosures reveal weaknesses that are greater than expected there could be further pressure on the banks' Viability Ratings.
The RBI primarily limited itself to restricting bank lending under the previous PCA framework. The scope for possible regulatory actions has been broadened under the amended framework, but it remains uncertain to what extent the RBI will use the tools it has just made available.
Moreover, the RBI will not be able to address problems in the banking sector on its own. Significant efforts to resolve bad loans, for example, would leave banks in need of recapitalization, given that haircuts and increased provisions would be required. State banks are generally in a poor position to raise new capital, which makes them largely reliant on the government for recapitalization.
The RBI may use the PCA framework to identify weak banks as candidates for mergers. State Bank of India took over five smaller lenders earlier this month, and further consolidation could be part of the overall strategy to clean up the banking system. However, mergers would also require the support of the government.