What is a Provision Coverage Ratio?
Provisions are set aside by businesses in case they are anticipating any losses or unexpected bad loans. It is mandatory for Indian banks to create a provision fund to cover their anticipated bad loans, and this is the provision coverage ratio. Banks set aside provisions for bad loans from the bank’s own funds, mostly from the profits. Also, it is mandatory for the banks to disclose the Provision Coverage Ratio (PCR) in their annual financial statements in Notes to Accounts to the Balance Sheet.
RBI has initially set a 70% benchmark as PCR. This means the bank has to set aside 70% of its loans as a provisional buffer. The higher the PCR, the better it is for the banks as it is useful when their NPAs grow at a faster rate. Ideally, a PCR above 70% is good.
By looking at the PCR, one can tell how vulnerable the bank is to NPAs. RBI has further advised banks to park their additional provisions as countercyclical provisioning buffer. The banks have to take special permission from the RBI to use these funds whenever needed.
RBI also wants banks to set up a ‘Dynamic Provisioning Account’ during their profitable years so that it can be of use during their downturn.
Importance of Provision Coverage Ratio
- Banks set aside a portion of their profits as a provision against bad loans to deal in times of default (prospective losses).
- The PCR helps in estimating the financial health of a bank. PCR of 70% is the benchmark as set by the RBI. A high PCR is good.
- Higher provision coverage ratio means the bank is not vulnerable and the asset quality issue is taken care.
- The PCR helps in understanding the asset quality. Lower the asset quality, high will be the PCR.
- The ‘Provisioning Buffer’ that the banks create is useful when the banks’ non-performing assets (NPA) are on the rise. Therefore, banks should aim to have a higher PCR when they are making profits.
How to Calculate Provision Coverage Ratio?
PCR is the ratio of provisions to gross NPAs.
The formula to calculate Provision Coverage Ratio (PCR) is as follows
Provision Coverage Ratio (PCR) = Provisions/Gross NPA
A PCR of 70% or more tells us that the bank is not at risk and the asset quality is taken care of. Also, the bank will be strong enough to withstand NPAs.