Tamal Bandyopadhyay: Prompt correction or slow destruction?

Liberal and conflicting triggers mean that, by the time the RBI takes action, the bank is already in serious trouble.

The Reserve Bank of India (RBI) took exactly a month to lift the moratorium on the beleaguered United Western Bank. This is not too long a period, particularly if one considers the sensitivity of the issue. Banks are different than, say, a manufacturing company, where often the cost of death is less than to keep it alive. A bank's death is not only expensive, as the depositors need to be compensated (up to a certain amount), but it also leads to a crisis of confidence for the banking system. The Bank of England, too, took about a month to settle the dust on the collapse of the 233-year-old Barings, Britain's oldest merchant bank.

However, Barings's collapse in January 1995 was sudden as it could not meet the enormous trading obligations established by Nick Leeson on the Japanese and Singapore futures exchanges. Barings went into receivership on February 27, 1995. United Western Bank's case is very different. It has been on a slow road to death for quite some years with its capital adequacy ratio (CAR) dipping to 4.86 per cent on March 31, 2005 against the mandatory requirement of 9 per cent.

The RBI had placed the bank on its watchlist in June 2001 to monitor its poor financials, especially high non-performing assets (NPAs). In January 2003, the central bank issued 13 directions relating to the maintenance of CAR and reduction of high-cost deposits and NPAs, and clamped down on its branch expansion. It also repeatedly advised the bank to arrange for fresh capital.

The RBI action was in accordance with the prompt corrective action (PCA) norms formulated in December 2002. These norms are based on the core principles for effective banking supervision (Principle 22) of the Basel Committee on Banking Supervision, which mandates that banking supervisors must have at their disposal adequate supervisory measures to bring about timely corrective action when a bank fails to meet the prudential requirements.

However, the PCA norms in the Indian context have turned out to be slow destructive action! This is because the action has been rather slow "" not taken at a time when the affected bank still has adequate cushion of capital. In fact, the action starts only after the capital is eroded.

The three pillars of PCA are CAR, net NPAs and return on assets (RoA). These three critical parameters indicate capital adequacy, asset quality and profitability. There are three trigger points for CAR "" less than 9 per cent but at least 6 per cent, between 6 and 3 per cent, and less than 3 per cent. Similarly, there are two trigger points for net NPAs "" over 10 per cent but less than 15 per cent and over 15 per cent. For RoA, the trigger point is below 0.25 per cent.

The moment the CAR drops below 9 per cent but remains over 6 per cent, there is a clamp down on expansion of assets. There are other actions as well, like restriction on branch expansion and dividend payment but the restriction on asset expansion alone can kill a bank. Since it is not allowed to expand assets, its income level goes down and health deteriorates further. Capital is the lifeline of a bank which is into a highly leveraged business and once the rubicon of 9 per cent CAR is crossed, the point of no-return is reached. So, action must be taken before the CAR dips below the 9 per cent level. Triggering PCA after a bank's CAR drops below 9 per cent is like sending a dead body to an ICU!

This apart, the trigger points related to net NPA and RoA are out of sync with reality. When most commercial banks have NPA levels of less than 1 per cent, a 10 per cent net NPA is not a realistic trigger point. Similarly, a 0.25 per cent threshold limit for RoA is also quite a liberal trigger.

In 2002, United Western's net NPA level was 10.72 per cent. Subsequently, it dropped to 9.5 per cent in 2003, 8.95 per cent in 2004, 5.83 per cent in 2005 and 5.66 per cent in 2006. But this alone is of no consequence as its capital adequacy eroded fast "" from 10.13 per cent in 2004 to 4.86 per cent in 2005 and 0.53 per cent in 2006. Similarly, its RoA dropped from 0.43 per cent in 2004 to minus 1.4 per cent in 2005 and minus 1.55 per cent in 2006. In other words, once a bank's CAR is allowed to slip below the 9 per cent level, it is extremely difficult to nurse it back to health. So, the RBI must focus on "discretionary actions" under PCA such as change of promoters and mergers, and not "mandatory actions", such as restriction on business growth.

It can even consider a differential CAR approach. The Financial Services Authority (FSA) in the UK prescribes different minimum capital ratios for different banks which must meet their trigger ratios at all times. In fact, the FSA expects the banks to maintain capital at a level higher than the trigger ratio, which is the "target" ratio "" generally 1 per cent above the trigger ratio. It acts as a regulatory buffer.

An International Monetary Fund study has reported that over 130 of the 181 member countries reported banking crises since 1980. In the early 1980s and 1990s, in the US alone, more than 1,600 commercial and savings banks insured by the Federal Deposit Insurance Corporation (FDIC) were either closed or given FDIC financial assistance. More than 900 savings and loan associations were closed or merged with assistance from Federal Savings and Loan Insurance Corporation (FSLIC). The cumulative losses incurred by the failed institutions were over $100 billion.

The frequency of bank failures is much less in India and there has not been any systemic crisis. However, if the RBI wants to avoid the United Western Bank experience, it must relook the PCA model. It must act fast and take a bank-specific supervisory corrective action. There are explicit provisions in the Banking Regulation Act, 1949 (Sections 35A, 36AA, 36AB, 37, 46 to 48) which empowers the RBI to do so.