Increasing levels of gross non-performing assets (GNPAs) have been plaguing the Indian banking sector over the last few years and the situation has only worsened with the passage of time.

This has serious implications not only for banks but also for the health of the nation’s financial system as a whole. GNPAs have adversely impacted the profitability, capitalisation and the solvency levels of banks in the past two fiscals, FY16 and FY17. The financial system too is weakened as banks are constrained in growing their lending business.

Cleaning up the Indian banking system of non-performing assets therefore has been one of the key priorities of the regulator, the Reserve Bank of India (RBI) and it has taken many steps in this regard.

One of the important steps recently initiated is the revision of the prompt corrective action (PCA) framework for banks wherein it has tightened the requirements. The revised guidelines take into account the higher capital requirements and liquidity criteria under Basel III as also the current status on asset quality and profitability.

Given the mess that Indian banks find themselves in, this is a welcome and a positive measure. The situation is more precarious in public sector banks than private banks. Revised PCA has increased the required overall capital levels and introduced the minimum core equity (CET) capital levels required to be maintained by the banks, to stay out of the PCA.

The PCA framework has also reduced the net NPA levels for banks from 10 per cent earlier to 6 per cent now for remaining outside the PCA framework. The parameters on leverage ratios have been added while the minimum profitability requirements, however, have been relaxed as compared to the older guidelines. The PCA framework has three threshold levels, and any breach on any of the above parameters would result in banks being classified in one of the three threshold levels. Depending on the levels, there will be restrictions on dividend pay-outs, branch expansion and management compensation. There are other measures too that the RBI can take, like Special Audit, a detailed review of the business model of the bank, engage with the bank’s Board and more.

While the guidelines would be applicable from April 1, 2017, based on December 2016 financials, 16 PSBs out of 21 and two out of 16 private banks would need to take some form of corrective action as they fail on at least one of the parameters. Further, one PSB also would be in the highest risk threshold level, suggesting a possible stricter action.

The road ahead for Indian banks is tough and there are no quick fixes. Expect a further weakening in asset quality during FY18 and consequently pressure on internal capital generation and increasing capital requirements under the Basel III capital adequacy framework. PSBs have huge capital requirements -- during FY18 and FY19, it is estimated at ₹1.25-1.35 trillion of which ₹800-850 billion has to be by way of CET. Most of the PSBs are in a weak capital position vis-à-vis the strong capital levels of private banks. PSBs are also on weak ground as regards the net NPA levels under PCA.

As on December 31, 2016, the net NPAs of PSBs were at 7.02 per cent as against 2.0 per cent of private banks. Further, while none of the PSBs will breach the risk threshold levels mentioned under the PCA plan on leverage ratios, some of the PSBs will need to raise capital to prevent a breach on this parameter.

Going forward, it is expected that adherence to the PCA framework will be favourable to the banking system. It will only make the banking system robust and strong in the medium term. While stronger banks will grow, weaker banks will have to perform better. Though consolidation is not a panacea for banking sector woes, the PCA framework may be used to initiate the same. The onus of performance will definitely be on their promoters/management.

The writer is Senior Vice-President and Group Head, Financial Sector Ratings at ICRA

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