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Source: The post is based on the article “Banks request RBI for more time to implement new ECL-based loan loss provisioning norms” published in Indian Express on 22nd May 2023
What is the News?
Lenders in India have approached the Reserve Bank of India (RBI) seeking a one-year extension for the implementation of the Expected Credit Loss (ECL)-based loan loss provisioning framework.
What is a loan-loss provision?
The RBI defines a loan loss provision as an expense that banks set aside for defaulted loans.
Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially.
In the event of a loss, instead of taking a loss in its cash flows, the bank can use its loan loss reserves to cover the loss.
What is the current approach followed for loan-loss provision?
The current “incurred loss approach” requires banks to provide for losses that have already occurred or been incurred.
This delay in recognising expected losses under this approach was found to exacerbate the downswing during the financial crisis of 2007-09.
Faced with a systemic increase in defaults, the delay in recognising loan losses resulted in banks having to make higher levels of provisions which reduced the capital maintained precisely at a time when banks needed to shore up their capital. This affected banks’ resilience and posed systemic risks.
What is Expected Credit Loss (ECL)-based loan loss provisioning framework?
Under this approach, banks are mandated to forecast anticipated credit losses through forward-looking estimations, rather than waiting for credit losses to materialize before making corresponding provisions for those losses.
Banks will be required to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into three categories: Stage 1, Stage 2 and Stage 3 based on the assessed credit losses at the time of recognition and subsequent reporting dates.
What are the benefits of this approach?
The forward-looking expected credit losses approach will further enhance the resilience of the banking system in line with globally accepted norms.
It is also likely to result in excess provisions as compared to the shortfall in provisions as seen in the incurred loss approach.
