The Reserve Bank of India (RBI) is gearing up for a significant shift in the way Indian banks handle provisioning for bad loans. In a recent announcement, RBI Governor Shaktikanta Das revealed that a draft circular on Expected Credit Loss (ECL) will be released soon. This cautious yet determined move could transform the Indian banking sector’s approach to risk management.
But why is the heads-up by the Governor so critical, and what does it mean for banks and their customers? Let’s dive in.
What’s the challenge with the current approach?
Indian banks currently follow the Incurred Loss Approach to provisioning for loan defaults. Here’s how it works:
- Banks allocate a fixed percentage of their loan portfolio as provisions, based on regulatory classifications like ‘Standard,’ ‘Doubtful,’ or ‘Non-Performing Assets (NPA)’.
- These percentages are specified by the regulator. The ‘Non-Performing’ category has the highest percentage.
- Such provisions are a charge (deduction) against the available profits.
- These provisions are recalculated periodically, with any shortfall or surplus adjustments made through the profit-and-loss (P&L) account.
This sounds straightforward, but it’s far from efficient or fair. Why?
Because this approach takes a “one-size-fits-all” view, often ignoring the unique risk profile of each bank or macroeconomic realities. Besides this, the Incurred Loss Model requires banks to account for losses only after they have occurred. So, it’s a reactive rather than proactive approach.
For instance, a loan is classified as a Non-Performing Asset only after the borrower has been overdue for more than 90 days. This may lead to significant delays in provisioning.
Key flaws in the Incurred Loss Model include:
- Backward-looking nature:
Provisions are made only after defaults have occurred. Oftentimes it’s too late to mitigate risks effectively. For example, they do not consider the impact of any foreseeable adverse macroeconomic impact like the probability of recession or high unemployment/inflation. - Unscientific estimates:
The provision percentages are specified by the regulator and may not reflect the underlying riskiness of the portfolio, i.e. the bank-specific characteristics are not captured. For example, a bank may be witnessing very high default rates due to its aggressive underwriting policy. - Cyclicality:
During periods of economic stress, banks are forced to provision more due to rising defaults. This further weakens their financial health and potentially slows economic recovery.
There are also other reasons such as inability to account for potential recoveries, changes in exposures, and collateral values.
A scientific way: Expected Credit Loss (ECL)
In contrast, the Expected Credit Loss framework is a forward-looking approach that’s already adopted by many countries successfully. Unlike the Incurred Loss method, ECL focuses on anticipating defaults and their financial impact long before they happen.
What sets ECL apart?
Imagine you’re managing a credit card portfolio for a bank. Instead of waiting to see which customers miss payments, you use data and foresight to prepare in advance, like below:
- Estimating defaults and recoveries: It’s like predicting which customers are more likely to struggle with payments by analyzing patterns such as their spending habits and past payment behavior (probability of default and loss given default). This helps you plan for potential losses.
- Tracking exposure values: Suppose a customer has a loan tied to property. If property prices are expected to drop, you factor in how that might affect the recovery value if the loan isn’t repaid.
- Preparing for economic shifts: You account for macroeconomic events, like an impending economic slowdown, which might make defaults more likely.
- Classifying loans by risk: Loans are sorted into buckets or stages to ensure you’re always provisioning for risk accurately.
This proactive approach allows banks to adjust their credit and collections strategies early, minimizing shocks to financial stability.
Why does this matter for India?
The shift to ECL isn’t just a regulatory update; it’s a game-changer. ECL offers a more transparent and proactive approach to managing credit risk. Indian banks will finally operate on a level playing field with global counterparts with smaller countries like Sri Lanka and Nepal already adopting ECL.
Moreover, ECL aligns better with India’s evolving economic landscape. With mounting pressures from climate change, rising inflation, and on the sustainability front, banks need frameworks that reflect the real risks of their portfolios.
Challenges and the road ahead
While the ECL framework promises numerous benefits, implementing it won’t be a walk in the park. Here’s why:
- Regulatory adjustments:
Formal adoption of ECL requires amendments to the regulatory act, which will take time.
- Data and technology requirements:
Banks must invest in robust data analytics and modeling capabilities to estimate PD, LGD, and macroeconomic impacts accurately. - Timelines to be finalized:
Most banks have a shadow ECL book, but the roadmap for adoption is still evolving. (A point to note here is that India’s non-banking financial sector is already in ECL mode.) - Capacity building:
The shift demands significant upskilling of personnel across risk, compliance, and IT functions. - Financial impact:
Transitioning to ECL may initially strain bank profitability as higher provisions are made upfront.
But these hurdles are worth the effort. In the long run, the ECL framework will not only strengthen India’s banking system but also protect customers and investors by offering greater stability and resilience.
The RBI’s careful approach underscores the importance of getting this transition right. More discussions are expected to unfold around governance, skills, culture and qualifications and so on as the country’s banks await this crucial announcement.
Have a question on ECL? Connect with our experts to learn more.
Author
Kasthuri Rangan Bhaskar
Vice President, Products – BCT Digital
Kasthuri Rangan has 18+ years of diverse techno-functional exposure spread across roles in commercial banking, lending, digital transformation, risk management, technology & B2B product leadership. He holds an MBA from IIM Indore and a Chartered Accountancy degree.
