RBI proposes expected loss-based approach for provisioning by banks.

The Reserve Bank of India (RBI) proposed a framework for adoption of an ‘expected loss-based’ approach for provisioning by banks.

Presently, banks 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, Reserve Bank proposes to amend the prudential regulations governing loan loss provisioning by banks to incorporate the more forward looking expected credit losses approach as against the extant ‘incurred loss’ approach,” the RBI said in the discussion paper on expected loss (EL)-based approach for loan loss provisioning by 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.

The key requirement under the proposed framework shall be for the banks to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into one of the 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.

As per the norms, banks will 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.