Why in News?
- The Reserve Bank of India (RBI) recently proposed to move the banking system to an expected credit loss-based provisioning approach from an “incurred loss” approach.
What is a loan-loss provision?
- The RBI defines a loan loss provision as an expense that banks set aside for defaulted loans.
- Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially.
- In the event of a loss, instead of taking a loss in its cash flows, the bank can use its loan loss reserves to cover the loss.
- The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.
What is the Expected Credit Loss (ECL) regime?
- Under this practice, a bank is required to estimate expected credit losses based on forward-looking estimations rather than wait for credit losses to be actually incurred before making corresponding loss provisions.
- As per the proposed framework, banks will need to classify financial assets (primarily loans) as Stage 1, 2, or 3, depending on their credit risk profile, with Stage 2 and 3 loans having higher provisions based on the historical credit loss patterns observed by banks.
- This will be in contrast to the existing approach of incurred loss provisioning, whereby step-up provisions are made based on the time the account has remained in the Non-Performing Asser (NPA) category.
- Benefits of the ECL regime:
- It will result in excess provisions as compared to a shortfall in provisions, as seen in the incurred loss approach.
- It will further enhance the resilience of the banking system in line with globally accepted norms.
What is the problem with the incurred loss-based approach?
- It requires banks to provide for losses that have already occurred or been incurred.
- The delay in recognizing loan losses resulted in banks having to make higher levels of provisions which affected the bank's capital. This affected banks’ resilience and posed systemic risks.
- The delays in recognizing loan losses overstated the income generated by the banks, which, coupled with dividend payouts, impacted their capital base.
Q1) What is a Non-Performing Asset (NPA)?
A NPA refers to a classification for loans or advances that are in default or in arrears. A loan is in arrears when principal or interest payments are late or missed. A loan is in default when the lender considers the loan agreement to be broken and the debtor is unable to meet his obligations.