Facts For Prelims
Source: Indian Express
Context: Lenders have sought a one-year extension from the Reserve Bank of India (RBI) for implementation of the Expected Credit Loss (ECL)-based loan loss provisioning framework.
What is loan loss provisioning?
Loan loss provisioning refers to the practice of setting aside funds by banks to cover potential losses arising from loans that may default or become unrecoverable.
| Current System | Banks are required to make loan loss provisions based on an “incurred loss” approach. Also, the Loan loss provisioning happens much later, leading to an increase in credit risk for banks. |
| “Incurred Loss” model | This model assumes that all loans will be repaid until evidence to the contrary is identified. Only at that point is the defaulted loan written down to a lower value. This leads to a delay in the recognition of defaults.
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| The New Proposal | RBI has proposed an expected loss (EL)-based approach for provisioning by banks in case of loan defaults. Banks are required to estimate expected credit losses based on forward-looking estimations. Banks have to categorize ECL norms for assessing the quality of assets and the expected loss. |
| ECL Norms | Banks classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into three categories: Stage 1, Stage 2, and Stage 3.
Stage 1: Financial assets that have not had a significant increase in credit risk or with low credit risk at the reporting date.
Stage 2: Financial instruments that have had a significant increase in credit risk but don’t have objective evidence of impairment.
Stage 3: Financial assets that have objective evidence of impairment at the reporting date |
