Loan loss provision by banks: Why has RBI proposed a new forward-looking approach?

Source: The post is based on the article “Loan loss provision by banks: Why has RBI proposed a new forward-looking approach?” published in Indian Express on 19th January 2023.

What is the News?

The Reserve Bank of India(RBI) has published a discussion paper on “loan loss provision”, proposing a framework for adopting an expected loss(EL)-based approach for provisioning by banks in case of loan defaults.

What is 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.

Since the bank does not expect all loans to become impaired, there is usually enough in the loan loss reserves to cover the full loss for any one or a small number of loans when needed. An increase in the balance of reserves is called Loan Loss Provision.

What is the current approach followed by banks for Loan loss provision and what are its problems?

Currently, banks follow an “incurred loss”-based approach. This approach requires banks to provide for losses that have already occurred or been incurred.

The delay in recognising expected losses under this approach was found to exacerbate the downswing during the financial crisis of 2007-09.

Further, the delays in recognising loan losses overstated the income generated by the banks which, coupled with dividend payouts, impacted their capital base because of reduced internal accruals — which too, affected the resilience of banks.

What is the expected loss-based approach proposed by RBI?

RBI has proposed a framework for adopting an expected loss (EL)-based approach for provisioning by banks in case of loan defaults.

Under this approach, a bank is required to estimate expected credit losses based on forward-looking estimations.

Under this, banks will need to classify financial assets into one of three categories — Stage 1, Stage 2, or Stage 3 — depending upon the assessed credit losses on them, at the time of initial recognition as well as on each subsequent reporting date, and make necessary provisions.

What are the benefits of this new approach?

The expected credit losses approach will further enhance the resilience of the banking system in line with globally accepted norms.

It is likely to also result in excess provisions as compared to the shortfall in provisions as seen in the incurred loss approach.