The Reserve Bank of India (RBI) recently placed Thrissur (Kerala)-based private bank Dhanlaxmi under close scrutiny.
What is happening?
- The RBI’s decision to increase its oversight of Dhanlaxmi Bank’s financial position is seen as a reaction to the bank’s capital adequacy deterioration.
- Dhanlaxmi Bank’s capital adequacy has previously fallen below required levels and it has even been placed under the RBI’s prompt corrective action framework (PCA) to deal with serious deteriorations in its financial position.
About Prompt Corrective Action –
Prompt Corrective Action or PCA is a framework under which banks with weak financial metrics are put under watch by the RBI.
How is it applied?
The PCA framework deems banks as risky if they slip below certain norms on three parameters — capital ratios, asset quality and profitability.
It has three risk threshold levels (1 being the lowest and 3 the highest) based on where a bank stands on these ratios.
- Banks with a capital to risk-weighted assets ratio (CRAR) of less than 10.25 per cent but more than 7.75 per cent fall under threshold 1.
- Those with CRAR of more than 6.25 per cent but less than 7.75 per cent fall in the second threshold.
- In case a bank’s common equity Tier 1 (the bare minimum capital under CRAR) falls below 3.625 per cent, it gets categorised under the third threshold level.
Other criteria – Banks that have a net NPA of 6 per cent or more but less than 9 per cent fall under threshold 1, and those with 12 per cent or more fall under the third threshold level. On profitability, banks with negative return on assets for two, three and four consecutive years fall under threshold 1, threshold 2 and threshold 3, respectively.
What happens when PCA is invoked?
Depending on the threshold levels, the RBI can place restrictions on dividend distribution, branch expansion, and management compensation. Only in an extreme situation, breach of the third threshold, would identify a bank as a likely candidate for resolution through amalgamation, reconstruction or winding up.
What is ‘Capital Adequacy Ratio’?
- The capital adequacy ratio (CAR) norm has been the last provision to emerge in the area of regulating the banks in such a way that they can sustain the probable risks and uncertainties of lending.
- The capital adequacy ratio is the percentage of total capital to the total risk—weighted assets.
- CAR, a measure of a bank’s capital, is expressed as a percentage of a bank’s risk weighted credit exposures.
- Also known as ‘Capital to Risk Weighted Assets Ratio (CRAR)’ this ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.