Context: In the wake of the ongoing nationwide lockdown, halted economic growth and the resulting rise in bad loan provisions, Credit rating agencies have warned of the impacts of such events on capital adequacy of banks.
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- It has been speculated that the ripple effects will be felt more vis-a-vis public sector banks (PSBs), given that there has been no announcements regarding any capital infusion plan for the next financial year.
- Even Moody’s, a credit rating agency has revised the outlook from stable to negative for the Indian banking system.
- The factors that are taken into account for such revisions are mounting loan loss provisions, a decline in revenue.
- It has been stated that these will bring down the profitability of banks, resulting in a deterioration of capitalization.
- It backed the case for more capital infusions into PSBs to mitigate Capital pressures, in line with the set precedence (₹70,000 crore in FY20, and over ₹1 trillion in FY19)
Impact of Lockdown on the Banking Sector
- A deterioration of global economic conditions and a 21-day lockdown in India will severely hamper domestic demand and private investment.
- Credit supply to the economy will be hindered by volatility in global financial markets.
- Even banks will not be in a position to participate in the debt market and extend loans.
- The increase in stressed assets would continue to increase capital pressures on the banks.
- In the present scenario of lockdown, owing to no or low economic activity, equity mobilization will be a daunting task, and so will be the loan recovery.
- It all will hamper the stretch of solvency.
- Solvency can be defined as the ratio of net stressed assets to core equity or net NPAs to core equity.
- Private investment too may be restricted to PSBs given the funding challenges, uncertain asset quality, bank consolidation bottlenecks.
RBI’s Prompt Corrective Action(PCA) Framework
- It is a framework under which banks with weak financial metrics are put under watch by the RBI.
- The RBI introduced the PCA framework in 2002 as a structured early-intervention mechanism for banks that become undercapitalised due to poor asset quality, or vulnerable due to loss of profitability. The framework was reviewed in 2017.
- It aims to check the problem of Non-Performing Assets (NPAs) in the Indian banking sector.
- Essentially PCA helps RBI monitor key performance indicators of banks, and take corrective measures, to restore the financial health of a bank.
- The PCA framework is applicable only to commercial banks and not to co-operative banks and non-banking financial companies (NBFCs).
- It may be noted that of the 21 state-run banks, 11 are under the PCA framework.
- The PCA framework deems banks as risky if they slip some trigger points - capital to risk weighted assets ratio (CRAR), net NPA, Return on Assets (RoA) and Tier 1 Leverage ratio.
- If the banks hit such trigger points certain structured and discretionary actions are initiated.
Capital Adequacy Ratio (CAR)
- The Capital Adequacy Ratio, also known as capital-to-risk weighted assets ratio (CRAR) is a measure of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures.
- It is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Capital requirements under Basel 3 norms
- The capital norms recommend Capital Adequacy ratio (CAR) be increased to 8 percent internationally, while in India it is 9 percent.
- Out of the 9 percent of CAR, 7 percent of Risk-Weighted Assets (RWA) has to be met by Tier 1 capital while the remaining 2 percent by Tier 2 capital.
- So, if the bank has risky assets worth Rs 100, it needs to have Tier 1 capital worth Rs 7. This capital can be easily used to raise funds in times of troubles.
- In addition, banks also have to hold an additional buffer of 2.5 percent of risky assets, called Capital Conservation Buffer (CCB).
- Banks maintain 5.5 percent Common Equity Tier 1 (CET 1) as against 4.5 percent required under the Basel III framework.
- The banking regulator introduced Basel III norms in India in 2003 and aims to bring in all commercial banks by March 2019.
RBI’s word on Capital Infusion
- RBI’s Report on Trend and Progress of Banking in India called for an end to the PSBs dependence on the government for capital.
- It noted that the government infusion is just enough to meet the regulatory minimum including capital conservation buffer (CCB)
- Down the line, ,the financial health of PSBs should be judged by their ability to access capital markets instead of their excessive reliance on the government.
Image Source; Mint