Expected Credit Loss -Based Loan Loss Provisioning Norms | 10 Jun 2023

Why in News?

Recently, the Reserve Bank of India (RBI) said that the banks will be given ample time to implement Expected Credit Loss (ECL)-based loan loss provisioning norms.

What is the Expected Credit Loss -Based Loan Loss Provisioning Norms?

• 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) have requested the RBI to grant an additional year for lenders to prepare for the implementation of the ECL norms.
• About:
  • RBI has proposed a framework for adopting an expected loss (EL)-based approach for provisioning by banks in case of loan defaults.
  • Under this, banks will need to classify financial assets into one of three categories (Stage 1, Stage 2, or Stage 3).
• Asset Classification:
  • Stage 1 Assets:
    • These are financial assets that have not experienced a significant increase in credit risk since their initial recognition or have low credit risk at the reporting date.
      • For these assets, 12-month expected credit losses are recognized, and interest revenue is calculated based on the gross carrying amount of the asset.
  • Stage 2 Assets:
    • These are financial instruments that have undergone a significant increase in credit risk since their initial recognition, although there is no objective evidence of impairment.
    • Lifetime expected credit losses are recognized for these assets, but interest revenue is still calculated based on the gross carrying amount of the asset.
  • Stage 3 Assets:
    • These are financial assets that have objective evidence of impairment at the reporting date.
      • For these assets, lifetime expected credit loss is recognized, and interest revenue is calculated based on the net carrying amount.
• Benefits:
  • The expected credit losses approach will enhance the resilience of the banking system in line with globally accepted standards.
  • It is expected to result in higher provisions compared to the shortfall seen under the incurred loss approach.
• 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 the Concept of Loan-Loss Provision?

• About:
  • Loan-loss provision, as defined by the RBI, refers to the allocation of funds set aside by banks to cover losses incurred from defaulted loans.
  • In simpler terms, it is a reserve of cash that banks keep to mitigate the impact of losses resulting from borrowers' failure to repay their loans.
• Provision:
  • This provision acts as an expense on the bank's income statement and can be utilized when borrowers are deemed unlikely to repay their loans.
  • By using the loan-loss reserves, banks can cover the losses they incur instead of facing a direct reduction in their cash flows.
    • Example:
      • Consider a scenario where a bank has issued a total of USD 100,000 in loans and has a loan loss provision of USD 10,000.
        • If a borrower defaults on a USD 1,000 loan but repays only USD 500, the bank would deduct USD 500 from the loan loss provision to cover the loss.
• Determinants:
  • The level of loan loss provision is determined based on the expected level required to ensure the bank's safety and stability.

What is the Current Approach for Loan Loss Provisions?

• Banks in India follow the incurred loss model for making loan loss provisions.
  • This model assumes that all loans will be repaid unless evidence suggests otherwise, such as a trigger event indicating a loss.
  • Only when such an event occurs is the impaired loan or portfolio of loans written down to a lower value.

What are the Challenges?

• The incurred loss approach requires banks to provide for losses that have already occurred or been incurred.
  • However, during the financial crisis of 2007-09, this delayed recognition of expected losses worsened the downturn.
  • As defaults increased across the system, the delayed recognition of loan losses forced banks to make higher provisions, depleting their capital reserves.
  • This, in turn, weakened the resilience of banks and posed systemic risks.
• Additionally, the delays in recognizing loan losses led to an overstatement of banks' generated income.
• Combined with dividend payouts, this impacted their capital base by reducing internal accruals, further compromising their resilience.

Source: IE