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RBI Sets up Working Group on Framework for Expected Credit Loss (ECL) Provisions

  • 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.

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.
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