Published: 5th Oct, 2023
Context
As per the press release by the Reserve Bank of India (RBI), it announced to form a working group for recommendations on provisioning by banks based on the Expected credit loss (ECL) framework.
What is Expected credit loss (ECL) based provisioning?
- ECL provisioning refers to the practice followed by banks and financial institutions to set aside a portion of their earnings as a provision to cover potential losses arising from non-performing assets (NPAs).
About the announcement:
- The nine-member working group will be formed, chaired by R. Narayanaswamy, former faculty at IIM Bangalore.
- The terms of reference for the working group, as detailed by the RBI, are as follows:
- Elaborate on the principles that must be considered by banks while designing the credit risk models to be used for assessing and measuring expected credit losses.
- Recommend factors that banks should consider for determining credit risk.
- Suggest the methodology to be used for undertaking external, independent validation of the models.
- Recommend, based on comprehensive data analysis, prudential floors for provisioning.
- All scheduled commercial banks, except regional rural banks, are considered to be brought under the ECL provisioning framework.
- If the risk of default rises, banks will be required to set aside a provision equivalent to the estimated lifetime credit losses.
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Currently, the banks provide it after a borrower fails to repay the loan for over 90 days. |
- The benefits of ECL-based provisioning would be phased out over five years.
- Aim: The primary objective of such a transitional arrangement is to avoid a “capital shock” by giving banks time to rebuild their capital resources following a probable negative impact arising from the introduction of ECL accounting.
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RBI had ordered to all Banks, that ECL-based provisioning would be introduced during 2023–24 as part of its efforts to bolster the bad loan resolution system. |
What are Non-Performing assets (NPAs)?
- They are loans or advances that are in default or in arrears.
- In other words, these are those kinds of loans wherein principal or interest amounts are late or have not been paid.
When a loan is classified as NPA?
- Non-Performing Assets are basically Non-Performing Loans.
- In India, the timeline given for classifying the asset as NPA is 180 days. As against 45 to 90 days of international norms.
Why is there a need to recognise NPAs?
- In the banking system, the government and regulatory authorities need to have a good view of how healthy the financial system is.
- India became more aggressive in recognising loans as ‘bad’ in the 2014 to 2015 period.
- The periodic asset quality review was introduced. Further, the regulator stepped in to prevent ever-greening of loans (i.e., lending more to an already stressed asset in the hope that it could be brought back to its feet).
What process does a bank undertake to recover NPA?
- The banks employ the Lok Adalats for settling the NPA loans. The Lok Adalats help in settling the NPA between the banks and defaulters.
Impact of NPAs on Financial Operations
- This reduces the profits of the banks.
- This reduces a bank or financial institution’s capital adequacy.
- The banks have become averse to giving loans and taking risks of zero per cent. Thus, the creation of fresh credit is debarred.
- The banks start concentrating on the management of credit risk instead of the bank becoming profitable.
- The funds happen to cost due to NPA.
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