What is a 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.
- The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.
- The Reserve Bank of India (RBI) recently proposed to move the banking system to an expected credit loss-based provisioning approach from an “incurred loss” approach.
What is the Expected Credit Loss (ECL) regime?
- 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.
- As per the proposed framework, banks will need to classify financial assets (primarily loans) as Stage 1, 2, or 3, depending on their credit risk profile, with Stage 2 and 3 loans having higher provisions based on the historical credit loss patterns observed by banks.
- Thus, through ECL, banks can estimate the forward-looking probability of default for each loan, and then by multiplying that probability by the likely loss given default, the bank gets the percentage loss that is expected to occur if the borrower defaults.
- This will be in contrast to the existing approach of incurred loss provisioning, whereby step-up provisions are made based on the time the account has remained in the Non-Performing Asser (NPA) category.
- Benefits of the ECL regime:
- It will result in excess provisions as compared to a shortfall in provisions, as seen in the incurred loss approach.
- It will further enhance the resilience of the banking systemin line with globally accepted norms.
What is the problem with the incurred loss-based approach?
- It requires banks to provide for losses that have already occurred or been incurred.
- The delay in recognizing loan losses resulted in banks having to make higher levels of provisions which affected the bank's capital. This affected banks’ resilience and posed systemic risks.
- The delays in recognizing loan losses overstated the income generated by the banks, which, coupled with dividend payouts, impacted their capital base.
