Provisions to be made on an expected credit loss (ECL)

The Reserve Bank of India on Monday released the draft guidelines for banks to make provisions on an expected credit loss (ECL) basis as against the current framework of incurred loss method.

It means banks have to shift away from the current method – where loan loss provisions are made after a default – to one where banks will need to assess the probability of default upfront and provision accordingly.

According to the discussion paper, if implemented, banks will have to make provisions for delays made by borrowers in their repayments under the proposed framework, in addition to existing provisioning requirements. This may lead to increased provisioning as the lenders will have to calculate the estimated loss of interest income and provide for them. Thus, the potential impact of a shift to the ECL mechanism on bank capital could be significant.

The measures will apply to banks’ loans and advances, including sanctioned limits under revolving credit facilities, lease receivables, financial guarantee contracts, and investments in the debt and equity markets.

The model to calculate the expected credit loss is to be decided by individual banks but is subject to independent evaluation and a floor on provisions set by the regulator, the discussion paper said.

The proposed guidelines if implemented, banks will be given at least a year to transition, the draft said.