UPSC Syllabus Topic: GS Paper 3 -Indian economy.
Introduction
RBI has proposed a shift to a forward-looking Expected Credit Loss (ECL) regime for banks and financial institutions from April 1, 2027. Draft Directions issued on October 7 align asset classification, provisioning, and income recognition with Ind AS 109. The move keeps the 90-day NPA trigger, introduces model-based loss estimates, and offers a phased capital cushion till March 31, 2031. The aim is earlier recognition of stress, stronger risk management, and better comparability across institutions. Banks and ECL norms.
Expected Credit Loss framework
- ECL asks banks to estimate losses before loans turn bad. Banks forecast expected cash shortfalls using Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD). 2. A credit loss equals the gap between contractual cash flows due and cash flows expected to be received. This is a shift from recognising losses only after default.
- Three-stage approach and SICR
- Assets move through Stage 1, Stage 2, Stage 3 based on credit quality at initial recognition and at each reporting date.
- Lifetime ECL is recognised when there is a Significant Increase in Credit Risk (SICR) since initial recognition.
- This promotes early provisioning when risk rises, not only when default occurs.
Key features of RBI’s draft guidelines on ECL
- Scope and timeline
- Applies to Scheduled Commercial Banks (excluding Small Finance Banks, Payment Banks, Regional Rural Banks) and All India Financial Institutions.
- Effective from April 1, 2027.
- A glide path till March 31, 2031 will smooth any one-time increase in provisioning.
- Asset classification rules
| Asset type | Time | Rule (what to check) |
| Term loans; bills purchased & discounted; OD/CC | > 90 days overdue | Classify as NPA if interest and/or principal remains continuously overdue for more than 90 days. |
| Credit cards | > 90 days from statement due date | If minimum amount due remains unpaid within 90 days from the payment due date on the statement → NPA. |
| Agricultural loans | Crop-season based | Classification and provisioning as per crop-season duration. |
| NPA categories | Time in category | Once NPA, classify as Sub-standard, Doubtful, or Loss, based on period the asset remains in that category. |
- Model governance and prudential floors
- If a bank cannot estimate LGD reliably from its own data, it must use regulatory backstops (minimum LGD values): 65% for secured exposures and 70% for unsecured exposures.
- Provisioning will use 12-month ECL or lifetime ECL depending on the stage, with prudential floors to ensure minimum buffers across asset classes.
- Capital transition and CET1 add-back
- If, at transition, the ECL required (as on April 1, 2027, based on March 31, 2027 figures) exceeds provisions held under current norms, the difference (transitional adjustment amount) may be added back to CET1 capital up to March 31, 2031;
- Banks may choose a shorter transition..
- Broader regulatory alignment (related measures)
- From April 1, 2027, revised Basel III capital adequacy norms will apply to eligible commercial banks.
- A draft Standardised Approach for Credit Risk will be issued. It proposes lower risk weights for MSMEs and residential real estate, which can reduce capital needs.
- Risk-based deposit insurance premiums are proposed, with the current flat rate as the ceiling, to reward sound risk management.
- IRDAI is expected to issue similar guidelines for insurers, signalling system-wide convergence.
| Stage | Norms | Rule (guidelines; pointers) | Time/Rates |
| Stage 1 | • No Significant Increase in Credit Risk (SICR) since initial recognition. • Use PD–LGD–EAD model; credit loss = PV of due cash flows − expected cash flows. • LGD backstops apply if bank cannot estimate reliably. | • Keep in Stage 1 if credit quality broadly unchanged. • Assess at each reporting date using forward-looking data. | • 12-month ECL provisions. • Provisioning floors: 0.40%general floor. 0.25% for small & micro enterprises. • 1% for unsecured retail. |
| Stage 2 | • SICR since initial recognition (risk has risen). • 30+ days past due is a presumption of SICR; rebuttal allowed with evidence. • PD–LGD–EAD with governance; LGD backstopsavailable. | • Move to Stage 2 when SICR is observed (including 30+ Days Past Due presumption). • If improving after irregularities, remain at least 6 months before any move to Stage 1. | • Lifetime ECL provisions. • Provisioning floors: 5%general floor. 1.5% for home loans, loans against property, gold loans. |
| Stage 3 | • Credit-impaired assets (aligns with NPA condition). • PD–LGD–EAD; apply LGD backstops if needed. | • Classify as Stage 3 when credit-impaired. • Upgrade path: Stage 3 → Stage 2 only after all irregularities are rectified; then stay in Stage 2 for ≥6 months before eligible for Stage 1. | • Lifetime ECL provisions• • Provisioning: “in line with current NPA norms.” • LGD floors (backstops) if not reliably estimated: • 65% for secured exposures. • 70% for unsecured exposures. |
Table : ECL Staging & Provisioning (Draft RBI Directions)
Impact of ECL
Positive:
- Earlier recognition and stronger buffers: Early detection of stress through SICR and staging leads to timely provisioning and cleaner books. Prudential floors and LGD backstops add consistency and resilience.
- Comparability and alignment with Ind AS: Alignment with Ind AS 109 improves comparability across institutions and brings banks close to the standard already adopted by India Inc. Reporting becomes more risk-sensitive and transparent.
- Orderly transition and credit flow stability: The CET1 add-back and glide path to FY31 smooth the one-time capital impact. This reduces the risk of abrupt credit tightening as banks adapt to higher upfront provisioning.
- Ecosystem readiness and spillover benefits: Branch-level provisioning and upgraded CBS/MIS improve data quality and risk analytics. Auditor upskilling supports better assurance.
Negative / Challenges:
- Initial capital and provisioning strain: There can be a one-time rise in provisions at transition. Some banks may face capital pressure despite the CET1 add-back window.
- Model risk and operational load: ECL needs robust models, quality data, and governance. Weak models or data gaps create estimation risk. Upgrading systems, training branches, and auditor reorientation add operational burden.
- Execution complexity : Under ECL, each branch must compute provisions for its own loan accounts using expected cash-flow estimates. This account-level calculation at every branch adds operational load and requires standardised methods, consistent assumptions, clean data, and strict controls so results are uniform across the network. Coordination with head office systems and reviews is essential to keep calculations consistent.
Conclusion
From April 1, 2027, the ECL regime—using staging/SICR, prudential floors, and LGD backstops—will drive earlier and consistent provisioning. A CET1 add-back until March 31, 2031 will smooth the transition. Banks must upgrade CBS/MIS, enable branch-level execution, and upskill auditors. Related measures, including revised Basel III norms, will strengthen system-wide resilience
Source – TH Business Line
