Five PSBs not meeting capital criterion can trigger contagion sans govt support

MUMBAI: The Reserve Bank of India (RBI) warned that the absence of perceived sovereign guarantees to banks under the Prompt Corrective Action would amplify the contagion risk of default in the banking industry as five state-owned lenders would fall below the minimum capital requirements.

For stress test purposes if it is assumed that state-owned banks dont have the backing of the government, “then (it) implies that the five PSBs which dont meet the criterion of Tier-1 capital of 7 per cent would default and start a contagion process on their own,” said RBIs Financial Stability Report.

For the FSR, the RBI conducts various kinds of stress tests – liquidity, credit and macro-economic developments. It mostly assesses the impact on the assumption that the state would back government banks. But for theoretical purposes, it conducted such tests without state backing this time.

“So now, when we consider the hypothetical failure of a trigger bank, the losses that would accrue to the system would not only be because of the trigger bank in consideration, but also because of the five PSBs that were automatically triggered,” said the report.

The RBI defended its Prompt Corrective Action framework for the state-run banks, a framework that became a major point of contention between the regulator and the government. The RBI said the capital erosion of the 11 banks under the PCA showed that solvency losses have reduced.

“Solvency losses due to a simultaneous failure of 11 PCA banks have declined from Rs 73,500 crore to Rs 34,200 crore (3.1 per cent of total Tier-1 Capital) in the past four quarters, and to this extent the PCA framework has been successful in reducing the systemic footprint of the PCA banks,” said the report.

Under the PCA, banks that have high bad loans and low capital are barred from setting up new branches, hiring staff and giving big-ticket loans and in some cases, even advance funds to small businesses.

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