Context: Lenders have sought a one-year extension from the Reserve Bank of India (RBI) for implementation of the Expected Credit Loss (ECL)-based loan loss provisioning framework.
A loan loss provision is an expense that is 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 loan loss reserves to cover the loss.
- An increase in the balance of reserves is called loan loss provision. The level of loan loss provisions is determined based on the level expected to protect the safety and soundness of the bank.
What is the current approach for Provisioning?
- Presently, banks are required to make loss provisions based on ‘Incurred Loss Approach’, where banks need to provide for losses that have occurred/incurred.
- Example: Banks in India are required to make provisions of 15% of outstanding in case of secured loans and 25% of outstanding for unsecured loans, when a loan exposure is classified as NPA. This provisioning must be made after the loan has been classified as an NPA.
- However, there have been issues of lag in identifying credit risks and the procyclical nature of incurred loss approach. This leads to significant delays and erosion of bank capital during downturns respectively.
Expected Loss Approach for Provisioning
- In January 2023, the RBI came out with a draft guidelines proposing adoption of expected credit loss approach for credit impairment. As per the draft, banks will be given a one year period after the final guidelines are released for implementation of expected credit loss approach for loss provisioning.
- Expected credit losses represent a probability weighted estimate of the present value of all cash shortfalls from an instrument.
- Banks will classify financial assets (primarily loans, including irrevocable loan commitments and investments classified as held-to-maturity or available for sale) into following three categories:
- Stage I: Includes financial assets that have not had a significant increase in credit risk since initial recognition or that have low credit risk at reporting date.
- Stage II: Includes financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment.
- Stage III: Includes financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime expected credit loss is recognised and interest revenue is calculated on the net carrying amount.