PCA will curtail NBFC sector growth; but accretive in long run

The Prompt Corrective Action (PCA) framework that has been in existence for banks has now been extended to non-banking financial companies (NBFCs). The Reserve Bank of India (RBI) issued the framework this week. Its objective is to enable supervisory intervention into these entities to implement timely remedial measures to restore their financial health, whenever necessary. PCA will also act as a tool for market discipline and allow the RBI to take any corrective action as it deems fit at any time. The rules will come into effect from October 2022, based on the financial position of NBFCs in March 2022.

This has come about because NBFCs are deeply inter-connected with other segments of the financial system, particularly the banking system.

Yet, Abizer Diwanji, who heads financial services at Ernst and Young, calls it ‘delayed action’: “Though it is called prompt corrective action, nothing has been prompt about it as far as banks are concerned. Prompt action means there has to be a quick infusion of capital. The RBI should have put timelines, too, specifically that if an NBFC can't get capital in six months, we’ll wind you down or sell you off. The RBI has the right to participate in the management of these PCAs, putting some constraints on their operations much earlier than when action is taken under the insolvency framework.”

But it’s not all bad. The PCA framework is a positive move. It works as an early-warning system. “As NBFCs always had light-touch regulation, they were not actively followed up by the RBI as banks are. The central banker has realised that there is a systemic risk in an NBFC’s failure, because they leverage from banks and the banks have public money. So NBFCs have the same risk as any bank,” says Diwanji.

NBFCs have to maintain 16% net worth as a capital cushion. This net worth protects the deposit holder. However, when that 16% starts depleting, systemic risk increases and what RBI intends to do is capture that upfront and impose restrictions.

However, experts believe ‘restrictions’ are, at times, counter-productive. PCA prohibits expansion, lending, increase in manpower, addition of new branches. This leaves NBFCs with restrictive turnaround plan.

RBI could react immediately when it discovers that thresholds have been breached. Experts say the RBI needs to react fast if it finds things amiss in its monthly filings or if an NBFC owns up to a deficit of capital or another parameter. Waiting for audited results is a mistake as they are often too late.

“NBFCs should be allowed to submit a recovery roadmap, and that roadmap will obviously include raising capital. It should mean an immediate exit out of PCA,” says a consultant.

If an NBFC is put under PCA, it needs to perform well for four quarters and then be allowed to run operations normally. “Restrictions never work because you cannot attract private capital for a recovery. Once the capital cushion is in place, they should immediately come out of PCA and the investor should have the right to manage the business appropriately, ” says the consultant.

This flexibility might mean more branches or hiring people. And this should apply to both deposit-taking and non-deposit-taking NBFCs, Diwanji says.

After the spate of insolvencies in NBFCs such as IL&FS, the RBI would like to be more vigilant. But now there are thousands of NBFCs and getting a handle on them all is tough. However, since there have been many excesses in the sector, the regulatory arbitrage is no longer applicable.

Alok Misra, Chairperson of Micro Finance Institutions Network (MFIN), says the landscape for NBFCs changed post 2015, especially as NBFCs grew or graduated to other forms. “Some NBFCs turned into banks. For instance, Bandhan was an NBFC. Then in 2016, eight micro finance institutions (MFIs) became small finance banks, but their business model remained focussed on microcredit. By 2011, the market share of MFIs had become 35% and the rest had become bigger like banks, small finance banks (SFBs). So NBFCs were no longer MFIs.”

However, the existing rules were framed keeping only smaller institutions in mind — regulations such as taking household income and indebtedness into account. As per Misra’s estimate, only 35% of the lenders were following rules. “We know that if as an industry we won't work together, the customer will be impacted and lead to collateral damage."

As MFIs are self-regulated, they only follow rules if they wish to. “We kept saying to RBI that this needs to be looked at or there will be problems. The market becomes a level-playing field, then. These rules are good from a sustainability and from a client-protection angle,” says Misra.

A.M. Karthik, VP and Sector Head (financial sector ratings), ICRA Limited, believes the thresholds around total capital adequacy and Tier-I capital for classification of an NBFC in the PCA category are liberal. “However, some entities could breach the net NPA (non-performing asset) criterion of more than 6%, if the asset quality did not improve. Among the large NBFCs (of asset sizes more than ₹25,000 crore),” Karthik says, “about three entities are in breach of the net NPA criterion as of September 2021.”

Karthik says: “The tightened NPA recognition and upgrade norms became applicable in November, and because of this, NPA levels of NBFCs are expected to remain under pressure in the near-term.”

“As PCA guidelines become applicable from October 2022, entities are expected to bring the NPA levels under control by improving provisions or effecting write-offs. NBFCs have good pre-provision profits to absorb these, without adversely impacting their capital profile. However, in view of the regulatory changes, ICRA expects the sectoral growth to be impacted in the near-term, as entities tighten their credit norms and as operational focus may shift towards collections,” says Karthik.

Jaya Vaidhyanathan, CEO at BCT Digital—a financial services AI (artificial intelligence) firm—welcomes the RBI rules. “Globally, shadow banking or lending entities outside the banking system have been under observation for possible excesses in credit due to their lax regulation compared to banks. Though regulation for these NBFCs is deliberately more lenient than banks, recent episodes like IL&FS and DHFL in India, and many in China have made regulators realise that checks and balances are required. Especially because NBFCs borrow from banks and lend it to customers whom banks may not want to finance.”

Now since NBFCs and banks have been practically de-segregated, safer NBFCs will also translate into a safer financial system. It's short-term pain for long-term gain.