RBI’s provisioning rule proposal for bad loans is good for banks

Source– The post is based on the article “RBI’s provisioning rule proposal for bad loans is good for banks” published in the mint on 27th February 2023.

Syllabus: GS3- Indian economy and mobilisation of resources

Relevance: Issues related to banking sector

News- The Reserve Bank of India recently proposed to adopt the Expected Credit Loss (ECL) approach under the International Financial Reporting Standard (IFRS-9).

What is the current RBI approach for NPAs?

RBI regulations consider non-payment of 90-plus days for classifying an asset as “non-performing”. Banks are currently making provisions after assets are identified as non-performing.

For provisioning, Indian banks are subjected to a gradual age-wise provision rule for sub-standard assets. It starts from 15% in the first year and goes to 100% in the fourth year. This is irrespective of whether collateral is available or not.

What are some facts about Expected Credit Loss?

An Expected Credit Loss is defined as a loss anticipated on a credit exposure or credit portfolio due to defaults expected to occur during the normal course of business.

The major inputs of ECL are: a) Probability of Default (PD); b) Exposure at Default (EAD); and c) Loss Given Default (LGD).

The PD is an estimate of the likelihood of default over a given time horizon.

EAD provides an estimate of the exposure at a future default date, taking into account expected changes in the exposure after the reporting date.

LGD is an estimate of the percentage loss arising from default. It is based on the difference between the contractual cash flows due and those that the lender would expect to receive, including from any collateral.

What are some facts about the Expected Credit Loss approach for NPAs?

ECL-based provisioning norms under IFRS-9 require institutions to use point-in-time projections of PDs, LGDs and EADs.

The new financial accounting system requires banks and other financial institutions to internally model the key elements of their credit risk loss, stay forward-looking and derive more risk-sensitive measures for loan-loss provisions.

IFRS-9 or Ind-AS-109 accounting standards explicitly require provisions and loss allowances to be made as per ECL data. RBI’s prescribed expected credit loss principle is in line with the IFRS-9 standard.

ECL-based provisions are to be applied at origination and for all subsequent reporting periods of loan assets till their de-recognition.

Three stages have been specified under the new accounting standard to determine the amount of impairment to be recognized as ECL at each reporting date.

For Stage 1 assets that at initial recognition show low credit risk on the reporting date, a 12-month ECL based provisioning is applicable.

Banks need to assess at each reporting date whether the credit risk on a corporate loan has increased significantly since initial recognition. Thus, the asset reaches Stage 2. At this stage, allowances are to be made based on lifetime analysis of any expected loss.

If the loan is credit impaired, it will be put under Stage 3. The standard requires that provisions be based on lifetime expected losses with the probability of default taken as 100%.

What are the positive aspects of ECL based provisioning approach for NPAs?

The new accounting standards aim to simplify and strengthen risk measurement and the reporting of financial instruments in an efficient and forward-looking manner.

The ECL based provision measure will enable banks to more pro- actively identify credit impairment and make necessary loss provisions.

Early detection of a significant increase in credit risk may incentivize banks to go in for better credit portfolio planning and lower their prospective non-performing asset burdens.

The ECL methodology takes into account historical PD trends as well as current and future economic scenarios and predictions. Thus, it significantly changes the incentives of banks by inclining them to manage and dispose of bad loans much more actively.