Context:
The Reserve Bank of India (RBI) has proposed a shift from the current incurred loss model of provisioning to a forward-looking Expected Credit Loss (ECL) framework for scheduled commercial banks. This move aims to enhance the early recognition of credit stress and strengthen the resilience of the banking system.
Current Model – Incurred Loss
- Definition: Banks make provisions for non-performing assets (NPAs) only after a loss event has occurred.
- Limitations:
- Delayed recognition of stress in loans.
- Weakens early warning systems for credit deterioration.
- Can amplify shocks during economic downturns.
Proposed Model – Expected Credit Loss (ECL)
- Definition: Forward-looking approach where banks estimate and provision for potential future losses on loans.
- Key Features:
- Provisions are based on probability of default (PD), exposure at default (EAD), and loss given default (LGD).
- Requires banks to continuously monitor and update credit risk parameters.
- Enhances capital adequacy and financial stability.
Benefits of ECL Framework
- Early Recognition of Stress: Detects potential NPAs before defaults occur.
- Improved Risk Management: Banks adopt proactive measures to mitigate losses.
- Resilient Banking System: Strengthens buffers against economic shocks.
- Alignment with Global Standards: Consistent with IFRS 9 and Basel III guidelines for credit risk provisioning.
Implications for Banks
- Banks will need to upgrade data analytics and risk assessment capabilities.
- May increase short-term provisioning, affecting reported profits initially.
- Encourages prudent lending practices and better credit monitoring.
