The Reserve Bank of India (RBI) is preparing for a major change in the banking system and will implement expected credit loss (ECL) on banks soon.
What is Expected Credit Loss (ECL)?
ECL is a method of accounting for credit risk based on the loss likely to occur on a loan or portfolio of loans.
It is used to get an understanding of the potential future losses on financial assets and how those losses can be identified and addressed in the financial statements.
Public sector Banks have travelled a long distance since 2017 when they posted a net loss of Rs 85,390 crore to a profit of Rs 66,539 crore in FY22
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.
The resulting value multiplied by the likely exposure at default is the expected loss for each loan, and the sum of these values is the expected loss for the entire portfolio.
Significance: The new mechanism will recognise problems ahead of time and make the banking system more resilient in the long run.