The Reserve Bank of India (RBI) has proposed a new set of rules governing loan loss provisioning by banks as it looks to enhance the resilience of the banking system. The central bank proposes to amend the regulations governing loan loss provisioning to incorporate a more forward looking “expected credit losses approach” as against the current “incurred loss” approach, the RBI says in a discussion paper.
What is 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.
What is the problem with the incurred loss-based approach:
The incurred loss approach requires banks to provide for losses that have already occurred or been incurred.
The delays in recognising loan losses overstated the income generated by the banks which, coupled with dividend payouts, impacted their capital base because of reduced internal accruals — which too, affected the resilience of banks.
Need of The Amendment:
The incurred loss approach used to be the global standard as well till very recently. However, this meant that loan loss provisioning used to happen much later to the increase in credit risk to the banks. Such delays in recognising expected losses under the “incurred loss” approach were found to exacerbate the downswing during the financial crisis of 2007-09, the RBI says.
What The RBI Proposed:
The banking regulator has proposed that each bank will be permitted to design and implement its own models for measuring expected credit losses for the purpose of estimating loss provisions.
The expected credit loss models adopted by the banks should be subject to rigorous validation. Where a bank has outsourced its validation function to an external party, the bank remains responsible for the effectiveness of all model validation work and should ensure that the work done by the external party meets the elements of a sound model validation framework on an ongoing basis.
What are the benefits of this approach:
The forward-looking expected credit losses approach will further enhance the resilience of the banking system in line with globally accepted norms. It is likely to result in excess provisions as compared to shortfall in provisions as seen in the incurred loss approach.