Prudential Norms in India

Prudential norms are regulatory guidelines prescribed by the Reserve Bank of India to ensure that banks and other regulated financial institutions operate in a safe, sound, and sustainable manner. These norms are designed to limit excessive risk-taking, ensure adequate financial buffers, and promote accurate, timely, and transparent financial reporting. In the Indian context, prudential norms form the backbone of banking regulation and are central to depositor protection, financial stability, and orderly credit growth.
Prudential norms cover income recognition, asset classification, provisioning, capital adequacy, exposure limits, and risk management practices. Together, they ensure early recognition of financial stress, absorption of losses, and the continued solvency of institutions even during adverse economic conditions.

Background and Evolution of RBI Prudential Norms

Before the 1990s, India’s banking system operated under an administered and highly regulated framework, with limited alignment to international accounting and risk standards. Weak income recognition and provisioning practices often concealed asset quality problems, leading to a lack of transparency.
Following economic liberalisation and financial sector reforms in the early 1990s, RBI introduced prudential norms aligned with global best practices. Major reforms included scientific asset classification, objective income recognition rules, and the introduction of capital adequacy requirements based on international standards. Over time, these norms have evolved in response to domestic banking stress, the global financial crisis of 2008, and subsequent international regulatory developments, shifting supervision from a purely rule-based approach to a risk-based and forward-looking framework.

Key Components of RBI Prudential Norms

RBI prudential norms consist of several interrelated components that collectively ensure financial stability and resilience.

Income Recognition Norms

Banks are required to recognise income on loans and advances only when it is actually realised or reasonably certain. Interest on non-performing assets (NPAs) is not recognised on an accrual basis and is booked as income only upon actual recovery. This prevents overstatement of profits and ensures that financial statements reflect the true earning capacity of banks.

Asset Classification Norms

Asset classification norms require banks to categorise loans and advances based on repayment performance measured in time, reflecting the degree of credit impairment. As per the latest prudential guidelines of the Reserve Bank of India, classification is primarily driven by the number of days a payment remains overdue. This time-based system ensures uniformity, early detection of stress, and timely supervisory intervention.

• Standard Assets: These are performing assets where principal and interest are serviced on time. An account remains a standard asset as long as there is no overdue beyond the specified threshold. Standard assets carry normal business risk and do not show any signs of default. Banks are required to maintain a general provision on standard assets as a prudential measure, despite their performing status.
• Sub-standard Assets: A loan is classified as sub-standard when it becomes a Non-Performing Asset (NPA) and remains so for a period of up to 12 months. An account is treated as NPA when interest and/or principal remains overdue for more than 90 days in the case of term loans, or when the account remains “out of order” for more than 90 days in the case of cash credit or overdraft accounts. Sub-standard assets exhibit clear credit weaknesses and attract higher provisioning.
• Doubtful Assets: An asset becomes doubtful when it has remained in the sub-standard category for a period of more than 12 months. At this stage, the recovery of the full amount is highly uncertain, and the loss potential is significant. Provisioning for doubtful assets depends on the secured and unsecured portions of the advance and the length of time the asset has remained doubtful.
• Loss Assets: Loss assets are those where loss has been identified by the bank, internal or external auditors, or RBI inspectors, but the amount has not yet been written off wholly. These assets are considered uncollectible or of such little value that their continuance as bankable assets is not warranted. Loss assets require 100 per cent provisioning, even if legal recovery proceedings are still in progress.

This classification framework enables early identification of stressed assets and forms the basis for provisioning and supervisory intervention.

Provisioning Norms

Provisioning norms require banks to set aside a portion of their income to cover potential loan losses. The provisioning requirement increases as asset quality deteriorates, with higher provisions mandated for sub-standard, doubtful, and loss assets. These provisions act as a financial cushion, absorbing losses and protecting the bank’s capital and balance sheet strength.

Capital Adequacy Norms

Capital adequacy norms ensure that banks maintain sufficient own funds to absorb unexpected losses and protect depositors. India follows the Basel III capital framework with RBI-prescribed enhancements.
As per current norms, scheduled commercial banks in India are required to maintain:

• Minimum Capital to Risk-Weighted Assets Ratio (CRAR): 11.5%, comprising:
  • Common Equity Tier 1 (CET1): 8.0%
  • Additional Tier 1 (AT1): 1.5%
  • Tier 2 Capital: 2.0%
• This includes a Capital Conservation Buffer (CCB) of 2.5%, to be maintained in normal times.

Risk-weighted assets reflect the credit, market, and operational risks undertaken by banks. Higher-risk exposures attract higher risk weights, requiring more capital backing. Capital adequacy norms are a central pillar of prudential regulation and a key determinant of banks’ lending capacity.

Exposure and Concentration Limits

RBI prescribes prudential limits on exposure to single borrowers, borrower groups, and specific sectors. These limits are designed to prevent excessive concentration of credit risk and encourage portfolio diversification. By spreading risk across sectors and regions, banks reduce vulnerability to sector-specific or borrower-specific shocks.

Role of Prudential Norms in the Banking Sector

Within the banking sector, prudential norms directly shape lending decisions, accounting practices, capital planning, and risk management frameworks. Banks are required to continuously monitor asset quality, capital adequacy, liquidity, and risk exposures in compliance with regulatory standards.
Adherence to prudential norms strengthens governance and accountability by linking reported financial performance with underlying risk. Banks with weak capital positions or deteriorating asset quality are subjected to closer supervisory scrutiny and corrective action. Compliance also enhances market confidence, enabling banks to access funding at competitive costs.

Significance for the Financial System

At the systemic level, prudential norms reduce both the probability and severity of banking crises. Early recognition of stress through asset classification and provisioning prevents the build-up of hidden risks, while capital buffers ensure that losses can be absorbed without destabilising the system.
Uniform prudential standards facilitate effective regulatory oversight and peer comparison, enabling RBI to identify systemic vulnerabilities and take timely preventive measures. By promoting consistency and transparency, prudential norms enhance the credibility and resilience of India’s financial system.

Impact on the Indian Economy

A stable and well-capitalised banking system is essential for sustained economic growth. Prudential norms ensure that banks remain financially sound and capable of supporting uninterrupted credit flow even during economic downturns.
By discouraging reckless lending and encouraging prudent risk-taking, these norms promote efficient allocation of capital across sectors. From a macroeconomic perspective, strong prudential regulation reduces the likelihood of bank failures and costly public sector bailouts, thereby protecting fiscal stability and maintaining investor confidence.

Prudential Frameworks Supporting RBI Norms

In addition to core prudential standards, RBI employs specialised regulatory and supervisory frameworks to enforce discipline and manage emerging risks.

Prompt Corrective Action Framework

The Prompt Corrective Action (PCA) framework acts as an early warning and corrective mechanism for weak banks and systemically important financial institutions. PCA is triggered when a bank breaches specified thresholds related to capital adequacy, asset quality, profitability, or leverage.
Depending on the severity of stress, RBI imposes graduated corrective measures, ranging from restrictions on dividend distribution and branch expansion to limits on lending and management compensation. In extreme cases, PCA may result in restructuring, merger, or resolution. Banks exit PCA only after restoring key financial parameters on a sustained basis. In recent years, the PCA framework has been extended to large non-banking financial companies, reflecting their growing systemic importance.

Risk-Based Supervision

Risk-Based Supervision (RBS) represents a shift from uniform, compliance-driven inspections to a forward-looking, risk-focused supervisory approach. Under RBS, RBI allocates supervisory resources based on the risk profile and systemic importance of each institution.
Greater scrutiny is applied to high-risk banks and activities through continuous off-site surveillance and targeted on-site inspections. RBS emphasises governance quality, risk management effectiveness, and internal controls, encouraging banks to strengthen their risk culture and internal systems.

Risk-Based Internal Audit

Risk-Based Internal Audit (RBIA) is a prudential requirement aimed at strengthening internal control mechanisms within banks. Audit priorities are aligned with the institution’s risk profile rather than fixed audit cycles.
High-risk areas are audited more frequently and in greater depth, while low-risk areas receive proportionate attention. RBI has mandated RBIA for banks, large urban cooperative banks, and certain non-banking financial companies. A robust RBIA framework serves as a critical internal line of defence and complements RBI’s supervisory oversight by enabling early detection of vulnerabilities.

Role in Financial Reforms and Modernisation

Prudential norms have been central to India’s financial sector modernisation. They enabled the transition from an administered banking system to a market-oriented, risk-based regulatory framework aligned with international standards.