Context: The Reserve Bank of India (RBI) on released the Discussion Paper (DP) that aimed to comprehensively examine various issues and proposed a framework for the adoption of an expected loss-based approach for provisioning against loan loss by banks in India.
About the News
- The Reserve Bank of India (RBI) published a discussion paper on “loan loss provision”, proposing a framework for adopting an expected loss (EL)-based approach for provisioning by banks in case of loan defaults.
- Presently, banks are required to make loan loss provisions based on an ‘incurred loss’ approach, which used to be the standard globally till recently.
- The RBI’s proposal is based on the premise that the present “incurred loss”-based approach for provision by banks is inadequate, and there is a need to shift to the “expected credit loss” regime in order to avoid any systemic issues.
What is loan-loss provision?
- The RBI defines a loan loss provision as an expense that banks 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 its loan loss reserves to cover the loss.
- Since the bank does not expect all loans to become impaired, there is usually enough in the loan loss reserves to cover the full loss for any one or a small number of loans when needed.
- An increase in the balance of reserves is called loan loss provision. The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.
What is the expected loss-based approach?
- Under this practice, a bank is required to estimate expected credit losses based on forward-looking estimations, rather than wait for credit losses to be actually incurred before making corresponding loss provisions.
Discussion paper on “loan loss provision”
In the discussion paper on expected loss (EL)-based approach for loan loss provisioning by banks explained that “To further enhance the resilience of the banking system, Reserve Bank proposes to amend the prudential regulations governing loan loss provisioning by banks to incorporate the more forward looking expected credit losses approach as against the extant ‘incurred loss’ approach,”
The key requirement under the proposed framework shall be for the banks to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into one of the three categories – Stage 1, Stage 2, and Stage 3, depending upon the assessed credit losses on them, at the time of initial recognition as well as on each subsequent reporting date and make necessary provisions.
- Stage 1 assets are financial assets that have not had a significant increase in credit risk since initial recognition or that have low credit risk at the reporting date. For these assets, 12-month expected credit losses are recognised and interest revenue is calculated on the gross carrying amount of the asset.
- Stage 2 assets are financial instruments that have had a significant increase in credit risk since initial recognition, but there is no objective evidence of impairment. For these assets, lifetime expected credit losses are recognised, but interest revenue is still calculated on the gross carrying amount of the asset.
- Stage 3 assets include 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.
What are the benefits of this approach?
- The forward-looking expected credit losses approach will further enhance the resilience of the banking system in line with globally accepted norms.
- It is likely to result in excess provisions as compared to shortfall in provisions as seen in the incurred loss approach, RBI said in the discussion paper.
What is the problem with the incurred loss-based approach?
- The incurred loss approach requires banks to provide for losses that have already occurred or been incurred.
- The delay in recognising expected losses under an “incurred loss” approach was found to exacerbate the downswing during the financial crisis of 2007-09.
- Faced with a systemic increase in defaults, the delay in recognising loan losses resulted in banks having to make higher levels of provisions which ate into the capital maintained precisely at a time when banks needed to shore up their capital. This affected banks’ resilience and posed systemic risks.
- Further, the delays in recognising loan losses overstated the income generated by the banks which, coupled with dividend pay-outs, impacted their capital base because of reduced internal accruals — which too, affected the resilience of banks.