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PROMPT CORRECTIVE ACTIONS
What and Why?
In the recent past, most of us came across the news that some PSBs are under the PCA, RBI’s scanner.
What does PCA mean, what are the considerations to be taken into account for declaring a bank under PCA, what are the measures taken by the Central Bank on such banks are some of the topics we are going to discuss.
And to answer why, being a to-be banker you need to know what’s all happening in the world of banking and finance. They might not be much important to you today, but just knowing them is nothing wrong either! 📷;)
What is meant by PCA?
what does PCA mean, whose initiative is it and from when there was such framework available in our country.
PCA – Prompt Corrective Action
PCA framework is operational since December 2002
The revised guidelines with certain amendments were brought into force from 13th April, 2017.
PCA is an initiative by the Reserve Bank of India.
What is the need of PCA?
Is PCA really needed? Why does RBI initiate it??
To explain this, first let me give an example of Bank X, which has been doing business since years and has a capital of, say, Rs 100 Crore. After opening branches, it is obvious that people come to deposit with you and save their hard-earned money. And in this case Bank X received Rs 100 Crore in the form of deposits too! Now, what will bank X do? Will they keep this money with them in the safe and do nothing? If that’s the case, how are going to payback their depositors with interest? So, banks do lend the money to the needy with interest more than that on the deposits so that they can get some profit (obviously, banking is a business and we do need profits for us to run in the long term).
As per RBI’s policy, we can’t lend all the Rs 100 Crore. The banks have to keep aside or park some money with the RBI in the form of government securities, cash and gold (we better know them as Cash Reserve Ratio and Statutory Liquidity Ratio). In this case, let us assume that, summing up CRR and SLR together we have to park Rs 25 Crore with the central bank. This means that Bank X is eligible to borrow only Rs 75 Crore. After lending, there might a case arise where none of the lent money comes back to you, neither principal nor the interest. What does a bank do in such a case? How will bank repay the depositors? The first step banks take with the consent of the RBI is that, they will take the money they had parked with the RBI and repay them to the depositors. Even then if the shortage does fall, the bank takes money from their capital which was kept aside to repay the depositors.
Such situations lead to decline in the reputation of all the banks and there will be a crisis like situation where all the depositors will ask for repayment of their deposited money. To avoid such drastic situations, the apex bank initiated the PCA, where in it will be monitoring some key areas of all the banks and based on some trigger points it will take the banks under their scrutiny and focus on improvising the business and financial stability of those banks.
Definition of Prompt Corrective Action:
To ensure that banks don’t go bust, RBI has put in place some trigger points to assess, monitor, control and take corrective actions on banks which are weak and troubled. The process or mechanism under which such actions are taken is known as Prompt Corrective Action or PCA.
What is the benefit of introducing PCA?
With banks coming under PCA, the Reserve Bank can concentrate on certain regulations or tighten some rules for those banks to get them back to financial stability.
It also allows the RBI to engage closely with the bank’s management in order to improve their financial health
When a bank is under PCA, does their normal operation get affected?
The answer is NO!! Under PCA, banks do have some limitations. This doesn’t mean that they are going to close/shut. THERE WILL BE NO MATERIAL IMPACT ON PERFORMANCE OF BANKS.
What does the RBI monitor?
The RBI checks or monitors closely the following key areas, in order to confirm that the banks are financially healthy, through the annual audits and inspections of banks by RBI:
Capital
Asset quality
Profitability
(TIPS: In short you can remember the key areas as: CAP)
Triggered Points or Indicators that are tracked:
From the start, we have been telling you that there are some trigger points or indicators on which RBI depends to monitor or decide on the strength and stability of the banks. These indicators are as follows:
CRAR/Common Equity Tier 1 ratio
Net NPA ratio
Return on Assets
Bank rate
Bank rate is the rate of interest which RBI charges from banks while lending to Banks. When Bank rate is increased, it increases the cost of borrowing by banks from RBI. Thus banks tend to reduce their borrowing from RBI, which lowers the lendable resources of banks and consequent decline in money supply increases the interest rates. The opposite happens when RBI reduce bank rate.
Role of Bank rate has been very limited in affecting the. 1 end able resources with banks.
CASH RESERVE RATIO
CRR refers to the ratio of bank's cash reserve balances with RBI with reference to the bank's net demand and time liabilities to ensure the liquidity and solvency of the scheduled banks.
Extent of CRR
Under RBI Act 1934 (Section 42(1) all scheduled banks are required to keep certain minimum cash reserves with RBI. important features are:
· Wef June 22, 2006 (as per RBI Amendment Act 2006), RBI has been empowered to fix CRR (without any floor or ceiling) at its discretion (instead of earlier 3 to 20% range by notification) of the net demand and time liabilities.
· It is to be maintained at a fortnightly average basis (Saturday to following Friday- 14 days) on reporting Friday (advised by RBI to banks at the commence of the year).
· On a daily basis it should be minimum 70% of the average balance wef Dec 28, 2002.
In order to check inflation, when RBI intends to reduce money supply with the banking system, it increases the CRR. On the other
hand in the recessionary situation, when RBI wants to increase the liquidity, it reduces the CRR.
STATUTORY LIQUIDITY RATIO
Section 24 (2A) of Banking Regulation Act 1949 requires every banking company to maintain in India equivalent to an amount
which shall not at the close the business on any day be less than as prescribed by RBI (earlier 25%) as a percentage of the total of
its net demand and time liabilities (to be computed as in case of CRR) in India, which is known as SLR.
RBI powers - RBI can change SLR with the minimum at its discretion and maximum 40%).
SLR is to be maintained as at the close of business on every day i.e. on daily basis based on the
NDTLs as obtaining on the last Friday of the 2nd preceding Fortnight.
Components of SLR
RIM issued the notification dated Sept oS, 2009 giving the list of assets to be maintained by the banks for Sec 24 of Banking
Regulation Act, 1949, as under:
(a) Cash, or (b) Gold valued at a price not exceeding the current market price, or (c) Unencumbered investment in the following
instruments which will be referred to as "Statutory Liquidity Ratio (SLR) securities":
Objective of maintaining SLR :
33 | P a g e1. It helps RBI to control the growth of bank credit. By changing SLR, RIM can impact the availability of funds with the banks for
lending purpose.
2. Maintenance of SLR enhances the solvency position of the banks
3. RBI can compel banks to meet the govt. borrowing program by subscribing to Govt. securities.
OPEN MARKET OPERATIONS
It refers to buying and selling of govt. securities by RBI in the open market. By its impact on the reserves of banks, OMO help
control the money supply in the economy.
When RBI sells Govt. securities to banks, the lendable resources of the latter are reduced and banks are forced to reduce or contain
their lending, thus curbing the money supply. When money supply is reduced, the consequent increase in the interest rates tends
to limit spending and investment.
Repo and Reverse Repo
Under a Repo transaction RBI purchases govt. securities from banks and thus inducts liquidity in the banking system. Repo
transactions are undertaken at Repo rate, which keeps on changing from time to time. By increasing repo rate, RBI increases the
cost of borrowing by banks.
Under a Reverse Repo transaction, RBI sells govt. securities to banks and thus absorbs, liquidity in the banking system.
Sterilization Operation (Market Stabilization Scheme)
Under this mechanism, RBI uses MSS Bonds, with a view to absorb liquidity created by inflow of foreign exchange in to India. The
MSS instruments are in the form of treasury bills or dated securities which RBI issues through auction.
This is also knows as Sterilization operation.
FISCAL POLICY
The fiscal policy is the policy relating to government expenditure and revenue collection, to influence the economic activity. The two
main instruments of fiscal policy are government expenditure and taxation.
The change in the level and composition of taxation and government spending can impact the following variables :
1. Aggregate demand and the level of economic activity;
2. The pattern of resource allocation;
3. The distribution of income.
Stance of fiscal policy
The 3 possible stances of fiscal policy are neutral, expansionary and contractionary.
(a) A neutral stance of fiscal policy implies a balanced economy. This results in a large tax revenue. Government spending is fully
funded by-tax revenue and overall, the budget outcome has a neutral effect on the level of economic activity.
(b) An expansionary stance of fiscal policy involves government spending exceeding tax revenue.
(c) A contractionary fiscal policy occurs when government spending' is lower than tax revenue.
Deficits
If the govt. spending is higher than the govt. revenue, there will be deficit, which can be a revene deficit, fiscal deficit or primary
deficit
(a) Revenue deficit = Revenue expenditure - revenue receipts.
(b) Fiscal deficit = Total expenditure - (revenue receipts + capital receipts other than borrowing).
(c) Primary deficit = Fiscal deficit - interest payments.
There are various methods of funding of these deficits. Fiscal deficit is generally financed by borrowing by the govt. by sale of treasury ,bilis or by
raising long term loans etc. This borrowing entails interest cost and in case it increase beyond the reasonable level, it can create default problem
and resultant effects as happened In certain European countries during 2010.
Methods of funding
Govt spends money on a wide variety of things, from general administration to the military and police to services like education and healthcare,
as well as transfer payments such as welfare benefits. This expenditure can be funded by way of Taxation, Seigniorage (by printing money),
Borrowing money from the population or from abroad, Consumption of fiscal reserves, Sale of fixed assets (e.g., land) i.e. disinvestment. All of
these except taxation are forms of deficit financing.
Economic effect of fiscal policy
Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives
of price stability, full employment, and economic growth. Increasing the govt spending and decreasing tax rates are the methods to
stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the
framework for strong economic growth and working towards full employment.
Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives
of price stability, full employment, and economic growth. Increasing the govt spending and decreasing tax rates are the methods to
stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the
framework for strong economic growth and working towards full employment.
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