Expected Credit Loss (ECL)-based Loan Loss Provisioning Norms

12-06-2023

Latest Context:

Recently, the Reserve Bank of India (RBI) said that the banks will be given sufficient time to implement Expected Credit Loss (ECL)-based loan loss provisioning norms.

About the Concept of Loan-Loss Provision

Definition: Loan-loss provision, as defined by the RBI, refers to the allocation of funds set aside by banks to cover losses incurred from defaulted loans. In other words, it is a reserve of cash that banks keep to reduce the impact of losses resulting from borrowers' failure to repay their loans.
Can be utilised in unforeseen situation: This provision acts as an expense on the bank's income statement and can be utilized when borrowers are deemed unlikely to repay their loans.
Banks can cover the losses: By using the loan-loss reserves, banks can cover the losses they incur instead of facing a direct reduction in their cash flows. For Eg: Let’s assume that a bank has issued a total of USD 100,000 in loans and has a loan loss provision of USD 10,000. If a borrower defaults on a USD 1,000 loan but repays only USD 500, the bank would deduct USD 500 from the loan loss provision to cover the loss.
Ensure bank’s safety and stability: The level of loan loss provision is determined based on the expected level required to ensure the bank's safety and stability.

So, What is the Expected Credit Loss (ECL) based Loan Loss Provisioning Norms?

Basically, the RBI has proposed a framework for adopting an expected loss-based approach for provisioning by the banks in case of loan defaults.
Under this, the banks will need to classify financial assets into one of three categories (Stage 1, Stage 2, or Stage 3).
Previously, the RBI has proposed the adoption of the ECL approach for credit impairment, and the banks were given a one-year period for implementation once the final guidelines are released.
While the final guidelines are yet to be announced, it is expected that they may be notified by FY2024 for implementation starting from April 1, 2025.
The Indian Banks Association (IBA) has requested the RBI to grant an additional year for lenders to prepare for the implementation of the ECL norms.

About the Asset Classification:

Stage 1 Assets: These are the financial assets that have not experienced a significant increase in credit risk since their initial recognition or have low credit risk at the reporting date. For these assets, 12-month expected credit losses are recognized, and interest revenue is calculated based on the gross carrying amount of the asset.
Stage 2 Assets: These are the financial instruments that have undergone a significant increase in credit risk since their initial recognition, although there is no objective evidence of impairment (reduction in the estimated value of an asset). Lifetime expected credit losses are recognized for these assets, but interest revenue is still calculated based on the gross carrying amount of the asset.
Stage 3 Assets: These are the financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime expected credit loss is recognized, and interest revenue is calculated based on the net carrying amount.

What can be the benefits of Expected Credit Loss (ECL) based Loan Loss Provisioning Norms?

This approach will enhance the resilience of the banking system in line with globally accepted standards.
It is expected to result in higher provisions compared to the shortfall seen under the incurred loss approach.

About the Difference between ECL vs IL Model

This new approach replaces the current "Incurred Loss (IL)" model, which delays loan loss provisioning, potentially increasing credit risk for banks.
The major drawback in the IL model was that usually banks made provisions with a significant delay after the borrower may have started facing financial difficulties, thereby increasing their credit risk. This led to systemic issues.
Furthermore, the delayed recognition of loan losses resulted in an overstatement of banks' income, combined with dividend payouts, which further eroded their capital base.

What is the Current Approach for Loan Loss Provisions in India?

Banks in India follow the incurred loss model for making loan loss provisions.
This model assumes that all loans will be repaid unless evidence suggests otherwise, such as a trigger event indicating a loss.
Only when such an event occurs is the impaired loan or portfolio of loans written down to a lower value.

What are the Challenges?

The incurred loss approach requires the banks to provide for losses that have already occurred or been incurred.
However, during the financial crisis of 2007-09, this delayed recognition of expected losses worsened the situation.
As defaults increased across the system, the delayed recognition of loan losses forced banks to make higher provisions, depleting their capital reserves. This, in turn, weakened the resilience of banks and posed systemic risks.
Another thing is that the delay in recognizing loan losses led to an overstatement of banks generated income.
Combined with dividend payouts, this impacted their capital base by reducing internal accruals, further compromising their resilience.

About the Reserve Bank of India (RBI)

RBI is the central bank of India and was established under the Reserve Bank of India Act of 1934.
It began operations on April 1, 1935, and was nationalized in 1949, with the government of India having major stake in it.
The RBI is responsible for regulating banks under the Banking Regulation Act of 1949 and non-banking financial companies (NBFCs) under the Reserve Bank of India Act of 1934.
It is also the regulator of the digital payment system under the Payment and Settlement Act of 2007.
The headquarter of the RBI is located in Mumbai, and the present governor is Shri. Shaktikanta Das.

Q. Consider the following statements: (2018)

1. Capital Adequacy Ratio (CAR) is the amount that banks have to maintain in the form of their own funds to offset any loss that banks incur if the account-holders fail to repay dues.

2. CAR is decided by each individual bank.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Ans: (a)