RBI Sets up Working Group on Framework for Expected Credit Loss (ECL) Provisions
7th Oct, 2023
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.
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.
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.