CRAR: Why in news?
- The Reserve Bank of India (RBI) has placed Dhanlaxmi Bank under tight monitoring with the Thrissur-based private bank’s financial position coming under greater public scrutiny.
- Dhanlaxmi Bank’s capital-to-risk-weighted assets ratio (CRAR) dropped to around 13% at the end of March this year from 14.5% a year ago, prompting the RBI to take stock of the financial health of the bank.
What is CRAR: What do Basel-III norms say about CRAR?
- The capital adequacy ratio measures a bank’s capital in relation to its risk-weighted assets.
- Under Basel-III norms, which were adopted by financial regulators across the globe in the aftermath of the financial crisis of 2007-08 that involved major failures in the banking system, banks are supposed to maintain their CRAR at 9% or above.
What is CRAR: What is the prompt corrective action framework (PCA)?
- Prompt Corrective Action (PCA) is a framework under which banks with weak financial metrics are put under watch by the Reserve Bank of India (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 on Resolution Regimes for Financial Institutions in India and the Financial Sector Legislative Reforms Commission.
- PCA is intended to help alert the regulator as well as investors and depositors if a bank is heading for trouble.
The idea is to head off problems before they attain crisis proportions.
- Under the PCA, the RBI places restrictions on lending by troubled banks and keeps a close eye on them until their financial position improves sufficiently.
Why is capital adequacy important for a bank?
- Capital adequacy ratio is an indicator of the ability of a bank to survive as a going business entity in case it suffers significant losses on its loan book.
- A bank cannot continue to operate if the total value of its assets drops below the total value of its liabilities as it would wipe out its capital (or net worth) and render the bank insolvent.
- So, banking regulations such as the Basel-III norms try to closely monitor changes in the capital adequacy of banks in order to prevent major bank failures which could have a severe impact on the wider economy.
- The capital position of a bank should not be confused with cash held by a bank in its vaults to make good on its commitment to depositors.
- The CRAR, which is a ratio that compares the value of a bank’s capital (or net worth) against the value of its various assets weighted according to how risky each asset is, is used to gauge the risk of insolvency faced by a bank.
- The riskier a type of asset held in a bank’s balance sheet, the higher the weightage given to the value of the asset while calculating the bank’s capital adequacy ratio.
- This causes the capital adequacy ratio of the bank to drop, thus signalling a higher risk of insolvency during crises.
- In other words, the CRAR tries to gauge the risk posed to the solvency of the bank by the quality or riskiness of the assets on the bank’s balance sheet.
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