ECL Based Loan Loss Provisioning Framework | 20 May 2023

Why in 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.

• Earlier in January 2023, the RBI came out with a draft guidelines proposing adoption of expected credit loss approach for credit impairment.

What is ECL-based Loan Loss Provisioning Framework?

• Background:
  • The RBI had previously proposed the adoption of the ECL approach for credit impairment, and 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 ECL Framework:
  • In the expected credit loss framework, banks are mandated to forecast anticipated credit losses through forward-looking estimations, rather than waiting for credit losses to materialise 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.
      • Provisioning will be made accordingly for each category.
• 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.
  • A key 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.
• Transitional Arrangement:
  • To prevent a capital shock, the RBI has proposed a transitional arrangement for the introduction of ECL norms.
    • This phased implementation will help banks absorb any additional provisions without adversely impacting their profitability.

What is Loan Loss Provisioning?

• It is a regulatory requirement enforced by the RBI, to ensure the financial stability of banks and protect the interests of depositors.
• It refers to the practice followed by banks and financial institutions to set aside a portion of their earnings as a provision to cover potential losses arising from non-performing assets (NPAs) or bad loans.
  • RBI defines NPAs in India as any advance or loan that is overdue for more than 90 days.
• It helps banks to accurately reflect the true value of their loan portfolios and assess their overall risk exposure.
  • Adequate provisioning also enhances the transparency of a bank's financial statements and provides a more accurate picture of its financial health to stakeholders.

Source: IE