RBI proposes expected loss-based approach for provisioning by banks
RBI proposes expected loss-based approach for provisioning by banks: The Reserve Bank of India (RBI) has proposed a framework for the adoption of an ‘expected loss-based approach for provisioning by banks. Presently, banks in India are required to make loan loss provisions based on an ‘incurred loss’ approach, which used to be the standard globally till recently.
Aim: To further enhance the resilience of the banking system, the RBI is proposing to amend the prudential regulations governing loan loss provisioning by banks to incorporate the more forward-looking expected credit loss approach as against the extant ‘incurred loss’ approach.
January 2023 Current Affairs Quiz
Under the proposed framework, banks will be required 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, and Stage 3, depending 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. Banks would be allowed to design and implement their own models for measuring expected credit losses for the purpose of estimating loss provisions in line with the proposed principles.
Mitigating Model Risk
To mitigate the concerns relating to model risk and considering the significant variability that may arise, the RBI will be issuing broad guidance that will be required to be considered while designing the credit risk models by commercial banks. The precise expectations on the information and factors that banks should take into account when determining credit risk will be specified in the guidance. The expected credit loss models proposed to be adopted by banks will have to be independently validated to verify whether the models follow the guidance issued by RBI, based on sound reasoning, calibrated use of all relevant data that is available with the bank and, whether proper back-testing and internal validation of the models have been done to remove any bias.
Impact on Banks
The impact of adopting the forward-looking expected credit loss approach to estimating loss provisions, is likely to result in excess provisions as compared to shortfall in provisions.
Exclusion
The proposed norms are for all scheduled commercial banks, excluding regional rural banks and smaller cooperative banks (based on a threshold to be decided based on comments)
Timeline
The RBI has until February 28, 2023, to receive comments on the paper. Considering the complexities involved in designing the models and the time required to test them, sufficient time will be provided for implementation.