An end to the spat between the RBI and the government could be in sight as the board of the central bank prepares to meet next week

• The central government has asked the RBI to dilute its Prompt Corrective Action (PCA) framework to increase the flow of credit to small-and-medium-sized enterprises.
  
• The RBI is reportedly mulling a plan to allow some state-run banks to leave the PCA programme ahead of time if they demonstrate a turnaround in their non-performing asset ratios and profitability.
  
• The central bank is also expected to relax certain requirements imposed on all banks with regards to secured and unsecured loans to SMEs.

The current clash between India’s central bank and the BJP-ruled government has roiled markets and stoked fears among investors. Thankfully, the two parties may reach a compromise as the board of the Reserve Bank of India (RBI) prepares to sit down on 19 November.

In the wake of the recent IL&FS crisis and the drying up of funds at the nation’s non-banking financial companies, the central government has asked the RBI to dilute its Prompt Corrective Action (PCA) framework so as to increase the flow of credit to small-and-medium-sized enterprises (SME). This framework is aimed at putting certain lending and operational restrictions on banks with high rates of non-performing assets.

After initially refusing to loosen restrictions under the framework, it appears that the RBI might be open to meeting the central government halfway in this regard.

BI is reportedly mulling a plan to allow some state-run banks to leave the PCA programme ahead of time in the event that they demonstrate a turnaround in their non-performing asset ratios and profitability, sources told the Indian Express. As per the RBI’s current norms, struggling banks are only taken off the watchlist after reporting a net profit for two consecutive years.

The central government has not presented its proposal as a dilution, however. It has maintained that is asking the RBI to bring the PCA programme in line with the intervention programmes of global central banks and the international Basel III risk framework. It has also argued that the PCA framework needs to be revised because a restriction on lending, a core operation, prevents a bank from increasing its profits.

Around 11 of India’s 21 state-run banks are on the PCA watchlist, which places limits on the extension of loans, branch expansion and issue of dividends. As a result of restrictions on these banks, SMEs have suffered from a slowdown in financing.

In addition, the central government is also pushing for the RBI to reduce the capital-to-risk-weighted assets ratio, a key indicator of financial stability, that it imposes on the nation’s banks from 9% to the 8% prescribed by the Basel III framework. The move could give state-run banks an additional ₹550 billion of funds for lending purposes, Anil Gupta, the head of credit ratings agency ICRA, told BloombergQuint.

Finally, the RBI is also expected to relax certain requirements imposed on all banks with regards to secured and unsecured loans to SMEs. In line with international standards, India’s central bank could lower the risk weightage, which influences the amount of capital set aside, for SME loans to 75% from a current level of 150%. SME loans are considered more risky than loans to larger companies and hence require higher risk provisioning.

While the RBI could accede the government’s requests keeping in view the dire liquidity situation in the short term, it will be wary of precipitating a further build-up in bad loans.

The current risk requirements are a preventive measure that were implemented in response to the burgeoning bad loan problem in India’s banking sector. It’s a classic case of the conflict between a short term boost to the economy and long term stability. Given that we’re headed for general elections, it isn’t difficult to ascertain which one will win out.

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