The Reserve Bank of India (RBI) has announced that bankers will be allotted ample time to adapt to the Expected Credit Loss (ECL) based loan loss provisioning norms. These norms are designed to aid in combating the problems of loan loss and fortify the banking sector.
Expected Credit Loss (ECL) and Its Background
In the past, the RBI proposed the adoption of an ECL approach for dealing with credit impairment. Banks were granted a year to implement these guidelines following their finalization. Even though these guidelines haven’t been officially issued yet, they are predicted to be announced by FY2024 and implemented starting April 1, 2025. The Indian Banks Association has entreated the RBI to allot another year for lenders to prepare for the initiation of the norms.
RBI’s Proposed Framework
RBI has put forward a framework for the adoption of an expected loss-based method for provisioning by banks in case of loan defaults. Here, banks would have to categorize their financial assets into one of three stages- Stage 1, Stage 2, or Stage 3. Each stage carries its own set of classifications and provisions which are decided based on the credit risk and impairment of the financial assets.
Benefits of the Expected Credit Loss Approach
The ECL approach is anticipated to solidify the resilience of the banking system, conforming to globally accepted standards. This approach will likely result in higher provisions as compared to the shortcomings seen under the incurred loss approach.
Comparison: ECL vs IL Model
The ECL model replaces the current “incurred loss” model which tends to delay loan loss provisioning, therefore augmenting credit risk for banks. With the IL model, provisions were frequently made post factum, after the borrower may have already experienced financial hardship. This delay in acknowledgment of loan losses often resulted in an overstatement of banks’ income, compounded with dividend payouts, which further deteriorated their capital base.
Transitional Arrangement
To avert a capital shock, the RBI has proposed a transitional arrangement for the ECL norms launch. This step-by-step introduction will assist banks in absorbing any additional provisions without negatively impacting their profitability.
The Concept of Loan-Loss Provision
According to the RBI, loan-loss provision refers to the allocation of funds that banks reserve to cover losses from defaulted loans. This provision functions as an expense on the bank’s income statement and can be used when the borrower is unlikely to repay their loan. Using loan-loss reserves, banks can cover these losses instead of facing a direct fall in their cash flow.
Current Approach of Loan Loss Provisions
In India, banks follow the incurred loss model for making loan loss provisions. This model presumes that all loans will be paid back unless contrary evidence is presented, such as an event indicating a loss. When such an event transpires, the impaired loan or cluster of loans is written down to a lower value.
Challenges Faced
The incurred loss approach demands banks to provide for losses that have already been incurred. But during the financial crisis of 2007-09, this delayed acknowledgment of anticipated losses exacerbated the downturn. As defaults rose across the system, the belated recognition of loan losses compelled banks to make higher provisions, in effect depleting their capital reserves. This situation in turn weakened the resilience of banks and posed systemic risks.
Capital Adequacy Ratio (CAR)
The Capital Adequacy Ratio (CAR) is a measure of a bank’s obtainable capital articulated as a percentage of a bank’s risk-weighted credit exposures. It is used to safeguard depositors and advance the stability and efficiency of financial systems. CAR is determined by the Central Bank or RBI to restrain commercial banks from taking excessive leverage and risking insolvency. The Basel III norms stipulate a capital to risk-weighted assets of 8%. However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9%, with Indian public sector banks urged to uphold a CAR of 12%.
