RBI’s Proposed “Expected Loss-Based Approach” for Provisioning by Banks

January 17, 2023

The Reserve Bank of India (RBI) recently proposed a framework for the adoption of an expected loss-based approach for provisioning against loan loss by banks in India.

Background

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. 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.

Expected Loss-Based Approach

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 guidance will specify detailed expectations on the factors and information that should be considered by banks while making determination of credit risk. 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 sought feedback on the paper till February 28, 2023. Considering the complexities involved in designing the models and the time required to test them, sufficient time will be provided for implementation.

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