RBI proposed a forward-looking approach for loan losses

The Reserve Bank of India (RBI) has 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.

About the loan loss provisions:

• It is based on the premise that the present incurred loss-based approach for the 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.

• 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.
• An increase in the balance of reserves is called a 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.

How the loan loss provision will work?

• Shifting policy framework: 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.
• Classification of loan assets: The banks will need to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into one of three categories — Stage 1, Stage 2, or Stage 3.
• 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.
• The classification of loans will depend 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.