The Reserve Bank of India (RBI) on Monday, January 16, floated a discussion paper to move the banking system’s provisioning principles from the current ‘incurred loss’ approach to a new ‘expected credit loss’ (ECL) approach. The step is under consideration to further enhance the resilience of the banking system, the central bank said.
Analysts believe that the migration to this forward-looking model will be smoother for private sector banks than their public sector counterparts. Before we understand why, let us first find out what the new approach means
Incurred loss vs expected loss model
Currently, banks make provisions for loans that have not been repaid 90 days past the due date. The 90-day norm for non-performing asset (NPA) classification was introduced in 2001. “It was done to achieve convergence with international best practices and to ensure greater transparency,” the RBI said in its discussion paper.
Under the ECL approach, provisions will have to be made based on ‘probability of default’. Like non-banking financial companies (NBFCs), the key requirement will be for banks to classify financial assets into Stage 1, Stage 2 and Stage 3 categories.
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“The expected credit losses are to be measured as a probability-weighted estimate of credit losses (the present value of all cash shortfalls) over the expected life of the financial instrument,” the paper added.
Why is the move being considered?
As per the central bank, the current approach is “inconsistent with the prudential separation of credit risk mitigation responsibilities assigned to capital and to provisions”.
What this means is that since provisions are not maintained with a forward-looking perspective currently, a sudden trigger can prove overburdening and eat into the capital maintained by banks.
Also, delays in recognising expected losses worsened the downswing during the financial crisis of 2007-09, noted the paper. Thus, the RBI has proposed to move banks towards the new framework, in line with NBFCs.
How are banks placed to handle this transition?
According to market experts, the classification into different categories will give a truer picture of banks’ asset quality. They are confident that the Indian banking system can handle this as most dead assets have been provided for.
The key challenge will be the data that goes behind making the credit loss assumptions. According to Kotak Institutional Equities, “Estimating default probabilities or losses requires rich data sets that capture various cycles. We have had two long credit cycles in India in the past three decades.”
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“While ECL is the best way forward, we need to acknowledge that we are also moving with less quality of data as well,” it added.
The central bank has also permitted a five-year transition period which will make it comfortable for lenders. “Impact may be felt in FY26 and banks will have to start preparing in FY25 to raise capital,” noted foreign brokerage firm Macquarie.
Most analysts believe the migration for large private sector banks will be smooth with limited impact on P&L (profit and loss) statements, as they have higher contingency buffers. Smaller banks and public sector lenders may see a rise in provisioning levels. “Small private sector banks like City Union Bank, DCB and Equitas may have to accelerate provision buffers and even replenish capital levels faster than planned,” said Emkay Global.
The RBI has sought feedback on the paper by February 28. It has proposed all scheduled commercial banks to implement the new framework, excluding regional rural banks.
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