Development Banks – 07
Twin Balance Sheet Problem
The twin balance sheet problem refers to the ballooning of debt on the books of corporate entities and the estimated Rs10 trillion of stressed assets that have piled up at banks because of the inability of borrowers to repay.
Thus, TBS is two-fold problems for Indian economy which deals with:
- Overleveraged companies– Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans. Note: 40% of corporate debt is owed by companies who are not earning enough to pay back their interest payments. In technical terms, this means that they have an interest coverage ratio less than 1.
- Bad-loan-encumbered-banks– Non Performing Assets (NPA) of the banks is 9% for the total banking system of India. It is as high as 12.1% for Public Sector Banks contributing to four-fifths of the total NPAs. As companies fail to pay back principal or interest, banks are also in trouble.
Public sector Asset rehabilitation Agency
To resolve the TBS problem the Economic Survey 2016-17 suggested the government to set up Public Sector Asset Rehabilitation agency (PARA). It is set up to assume the Non-Performing Assets (NPA) of public sector banks in India and to deal with the recovery of the bad loans. It is called as Bad banks. The main function of PARA would be to take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt. The funding of this body would come either by selling the bonds or by inviting private companies to buy its equities. The survey also suggests that instead of investing funds and recapitalizes the banks year after year, it would be better for the government to focus on recovery.
Prompt Corrective Action (PCA) Framework
PCA 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. It aims to check the problem of Non-Performing Assets (NPAs) in the Indian banking sector.
The framework was reviewed in 2017 based on the recommendations of the working group of the Financial Stability and Development Council. PCA is intended to help alert the regulator as well as investors and depositors if a bank is heading for trouble. Essentially PCA helps RBI monitor key performance indicators of banks, and taking corrective measures, to restore the financial health of a bank.
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.
The PCA framework is applicable only to commercial banks and not to co-operative banks and non-banking financial companies (NBFCs).
- RBI can place restrictions on dividend distribution, branch expansion, and management compensation.
- Only in an extreme situation, would a bank be a likely candidate for resolution through amalgamation, reconstruction or winding up.
- RBI may place restrictions on credit by PCA banks to unrated borrowers or those with high risks, but it doesn’t invoke a complete ban on their lending.
- RBI may also impose restrictions on the bank on borrowings from interbank market.
- Banks may also not be allowed to enter into new lines of business.
Risk threshold levels based on where a bank stands on these ratios.
Threshold 1: 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.
Threshold 2: Those with CRAR of more than 6.25 per cent but less than 7.75 per cent fall in the second threshold.
Threshold 3: 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.
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.
Capital Adequacy and Basel Norms
Capital Adequacy ratio is the percentage of total capital to the total risk of weighted assets of the bank. In simpler terms it the percentage of capital the banks has to maintain in order to handle risk situations where the banks run out of money. It is used to protect the depositors and promote the stability and efficiency of financial systems around the world.
CRAR = total of Tier 1 and Tier 2 capital divided by risk weighted assets.
Tier 1 capital: it can absorb losses without bank being required to cease trading.
Tier 2 capital: can absorb losses in the event of a winding up and provide lesser degree of protection to depositors.
Tier 3 capital: given by the latest Basel III norms it is the capital adequate for banks known as Tertiary Capital which is used to meet/support market risks, commodities risk and foreign currency.
RBI introduced CRAR (capital to risk weighted asset ratio) system for banks operating in India in 1992 in accordance with standards of BIS as part of financial sector reforms.