The Reserve Bank of India (RBI) was recently approached by Indian lenders, seeking a one-year extension for the implementation of the Expected Credit Loss (ECL)-based loan loss provisioning framework. Earlier in 2023, RBI drafted guidelines proposing the adoption of an ECL approach for credit impairment.
Background of ECL-based Loan Loss Provisioning Framework
The RBI initially proposed the ECL approach for credit impairment and provisioned a one-year period for banks to implement it once the final guidelines are released. Although these guidelines are yet to be announced, it is anticipated they may be notified by FY2024 for implementation starting from April 1, 2025. With this in mind, the Indian Banks Association (IBA) has asked the RBI for an additional year to allow lenders to prepare for the application of ECL norms.
About ECL Framework
The ECL framework mandates banks to predict future credit losses through forward-looking estimations and make matching provisions for those losses. Under this model, banks must classify financial assets into three categories: Stage 1, Stage 2, and Stage 3, based on the evaluated credit losses at the time of recognition and subsequent reporting dates. Provisions will be made for each category accordingly.
ECL vs IL Model
The new ECL approach replaces the existing “incurred loss (IL)” model, which often leads to delayed loan loss provisioning and increased credit risk for banks. A significant drawback of the IL model is that banks usually make provisions with substantial delay after a borrower starts experiencing financial difficulties. This lateness increases their credit risk, leading to systemic issues, and results in an overstatement of banks’ income, combined with dividend payouts, thereby further eroding their capital base.
Transitional Arrangement
As a measure to prevent a capital shock, the RBI has proposed a transitional arrangement for introducing ECL norms. This phased implementation is aimed at enabling banks to absorb any additional provisions without adversely affecting their profitability.
Loan Loss Provisioning Explained
Loan loss provisioning is a regulatory requirement enforced by the RBI to ensure the financial stability of banks and protect depositors’ interests. It involves banks setting aside a portion of their earnings as a provision to cover potential losses arising from non-performing assets (NPAs) or bad loans. According to the RBI, NPAs in India are any advance or loan overdue for more than 90 days. This practice enables banks to assess their overall risk exposure accurately while reflecting the actual value of their loan portfolios.
About the Indian Bank Association
The Indian Bank Association (IBA) is a voluntary association of banks in India established on 26th September 1946 with the goal of promoting and coordinating the interests of the Indian banking industry. Its members consist of Public Sector Banks, Private Sector Banks, Foreign Banks with offices in India, Co-operative Banks, Regional Rural Banks, and All India Financial Institutions.
