Fixing prompt corrective action

Abstract

Prompt corrective action (PCA) requires regulators to sanction banks before they become insolvent and to resolve institutions within 90 days of reaching critically undercapitalised status. Forensic studies of the financial crisis conclude that the PCA process not only failed to rehabilitate troubled banks, it also produced a higher average loss rate when banks failed compared to the pre-PCA period. A promising approach for reforming PCA is to replace capital adequacy ratios with a bank’s nonperforming asset coverage ratio. This simple revision will identify weak institutions long before they fail and could significantly reduce deposit insurance fund losses. The nonperforming asset coverage ratio is also a transparent and useful early warning statistic that depositors and bank-dependent businesses can use to monitor the financial strength of bank counterparties.