Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Opinion | Don’t throttle the banking sector clean up

Any dilution in the PCA framework or other measures that have been taken to clean up the banking system will only increase the cost in the long run

It has been reported that, as expected, the government representatives raised the issue of prompt corrective action (PCA) framework at the Reserve Bank of India (RBI) board meeting on Tuesday. The motivation, of course, is that a dilution will enhance the lending capacity of banks. An improvement in the lending capacity will help fund investments, which are expected to pick up from here on. It could also be useful in the present situation when non-banking financial companies are facing liquidity issues and are not in a position to extend loans in a significant way. The banking regulator has put 11 banks, including Central Bank of India, Allahabad Bank, Indian Overseas Bank, Corporation Bank and Bank of India, under the PCA framework.

However, RBI would do well to hold its ground. It is important to note that putting banks under the PCA framework is part of a broader action plan to bring the ailing banking system back on track. Among other measures, RBI created a central repository of information on large credits, undertook asset quality review, which exposed the actual extent of the bad loan problem, and used new powers to push banks to take large non-performing accounts to the bankruptcy court under the Insolvency and Bankruptcy Code (IBC). The government also deserves credit for having implemented the IBC, which will not only help resolve the current bad loan problem but will also improve the credit culture in the economy over time. The banking regulator also issued a new framework for the resolution of stressed assets with IBC as the mainstay. Therefore, putting weak banks under the PCA framework is part of a bigger exercise. Dilution will only kick the can down the road with longer term consequences.

To be sure, the suggestion to relax the PCA framework is not new. The Parliament’s standing committee on finance in its report in August, for example, noted: “…the PCA framework may end up bringing more and more PSBs (public sector banks) under its ambit, which may aggravate matters and culminate in a vicious cycle in the banking sector and the economy at large. The Committee would therefore urge both RBI and the government to constantly monitor the situation for each of these banks and relax/review the PCA framework…"

Earlier this month, RBI deputy governor Viral Acharya in his remarks at the Indian Institute of Technology, Bombay, comprehensively explained the rationale behind the PCA formwork. Banks under the framework face certain restriction, such as on branch expansion and management compensation, and have to comply with higher provisioning requirements. This is to prevent further capital erosion and stabilize the bank. The basic idea, as Acharya noted, is “…to intervene early and take corrective measures in a timely manner, so as to restore the financial health of banks that are at risk by limiting deterioration in their health and preserving their capital levels."

Relaxing PCA norms could worsen the problem. It is likely that weak banks will end up accumulating more bad loans, which will erode their capital further. This will lead to demands on taxpayer money for recapitalization of PSBs. Besides, having too many weak banks will increase risks to financial stability. Notably, NPAs in banks under PCA were similar to other banks until 2014 but went up sharply after the asset quality review. Asset quality was worsening at a much faster pace in these banks, indicating poor recognition of bad loans. Thus, it is essential that the risk on the books of these banks is reduced by lending restrictions before they get back to normal business. Meanwhile, banks should work on increasing their credit appraisal capacity.

Further, it is argued that putting banks under the PCA is affecting the flow of credit in the economy. As Acharya has shown, contraction in lending by banks under PCA is being compensated by healthier banks. This is what is required at this stage—a shift towards better-managed banks. This will also lead to better allocation of resources and reduce the need for recapitalization of PSBs in the long run.

Any dilution in the PCA framework or other measures that have been taken to clean up the banking system will only increase the cost in the long run. For instance, if companies in one sector are given an exemption from the resolution mechanism, others will demand similar treatment with their own set of reasons. Reversing the progress made so far in resolving the banking mess will not only increase the actual long-term cost for the economy but will also be seen as a failure on the part of the policy establishment in taking tough decisions.

What should be done to put the banking sector back on track? Tell us at views@livemint.com

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