The Reserve Bank of India (RBI) on Monday proposed a framework for banks to adopt an “expected loss-based” approach to risk provisioning.
Currently, banks are required to establish loan loss provisions based on an incurred loss approach, which until recently was the global standard.
“To further enhance the resilience of the banking system, the Reserve Bank proposes to amend the prudential rules for bank provisioning to include the more forward-looking expected credit loss approach versus the existing ‘incurred loss’ approach,” the RBI said in the essay Discussion paper on the expected loss (EL) based approach to bank risk provisioning.
The impact of adopting the forward-looking approach of expected credit losses to estimate loss provisions is likely to result in an over-provisioning versus under-provisioning.
The main requirement of the proposed framework is that banks classify financial assets (principally loans, including irrevocable lending commitments, and investments classified as held-to-maturity or available-for-sale) into one of three categories – Level 1, Level 2 and Level 3, depending on the credit losses identified, at the time of initial recognition and at each subsequent reporting date and form the necessary provisions.
The standards allow banks to design and implement their own expected credit loss measurement models to estimate loss provisions under the proposed principles.
The proposed standards apply to all proposed commercial banks, excluding regional rural banks. RBI has requested feedback on the paper until February 28, 2023.
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