Reserve Bank of India<\/strong><\/a>\u00a0has introduced important changes in the way banks identify and classify bad loans.\u00a0<\/p>\nBorrower-Level Classification of Non-Performing Assets:\u00a0<\/strong>A major change introduced is the shift from loan-level to borrower-level classification.<\/p>\n\n- Under the revised framework, if any single credit facility of a borrower becomes a Non-Performing Asset, then all other credit facilities extended to the same borrower will also be classified as Non-Performing Assets.<\/li>\n
- This represents a stricter and more holistic approach to credit risk recognition, replacing the earlier loan-specific classification method.<\/li>\n<\/ul>\n
Continuation of Ninety-Day Overdue Norm:\u00a0<\/strong>The basic definition of a Non-Performing Asset remains unchanged.\u00a0<\/p>\n\n- A loan will continue to be classified as a Non-Performing Asset if interest or principal payments remain overdue for ninety days or more.\u00a0<\/li>\n
- However, the impact of such classification has now been widened across all credit facilities of the borrower.<\/li>\n<\/ul>\n
Conditions for Reclassification as Standard Asset:\u00a0<\/strong>A borrower who has been classified as a Non-Performing Asset can be reclassified as a standard asset only after full repayment of all outstanding arrears, including both principal and interest, across all credit facilities.\u00a0<\/p>\n\n- Partial repayment or settlement of a single account will not be sufficient for reclassification.<\/li>\n<\/ul>\n
Mandatory Automation in Classification:\u00a0<\/strong>The Reserve Bank of India has directed banks to implement automated systems for identification and classification of Non-Performing Assets.\u00a0<\/p>\n\n- This reduces reliance on manual processes, improves accuracy, and ensures timely recognition of stressed accounts.<\/li>\n<\/ul>\n
Introduction of Expected Credit Loss Framework<\/strong><\/h2>\nA significant reform is the introduction of the Expected Credit Loss framework for provisioning against potential loan losses.\u00a0<\/p>\n
Earlier Framework: Incurred Loss Model<\/strong><\/p>\n\n- Under the earlier system, banks were required to make provisions only after a loan became non-performing, that is, after ninety days of default. This approach was reactive in nature and often led to delayed recognition of stress.<\/li>\n<\/ul>\n
New Framework: Expected Credit Loss Model<\/strong><\/p>\n\n- The Expected Credit Loss model is forward-looking in nature. Banks are now required to estimate potential credit losses based on expected future risk rather than waiting for actual default.<\/li>\n
- The Expected Credit Loss framework classifies loans based on rising credit risk and requires banks to create buffers accordingly.<\/li>\n<\/ul>\n
Expected Credit Loss Model is structured into three stages:<\/strong><\/p>\n\n- Stage 1 (Low Credit Risk)<\/strong>: These are normal, safe loans where there is no major risk. Banks keep a small buffer based on expected losses over the next one year.<\/li>\n
- Stage 2 (Significant Increase in Credit Risk)<\/strong>: These are loans where risk has started increasing, but the borrower has not yet defaulted. Banks keep a higher buffer because there is a greater chance of future loss.<\/li>\n
- Stage 3 (Credit-Impaired Assets)<\/strong>: These are bad or defaulted loans.Banks keep the highest buffer because the risk of loss is already very high.<\/li>\n<\/ul>\n
This structure ensures earlier recognition of credit stress and strengthens the resilience of bank balance sheets.<\/p>\n
Effective Interest Rate Methodology<\/strong><\/h2>\nThe Reserve Bank of India has also introduced the concept of Effective Interest Rate for calculating Expected Credit Loss provisions.<\/p>\n
\n- Under this method, interest income is computed based on expected cash flows from financial instruments, taking into account all contractual terms except potential credit losses. This replaces the earlier reliance on contractual interest rates.<\/li>\n
- The change ensures that income recognition and provisioning reflect a more realistic assessment of risk-adjusted returns.<\/li>\n<\/ul>\n
Implementation Timeline<\/strong><\/h2>\nThe transition to the new framework will be gradual:<\/p>\n