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Expected Loss-Based Approach by RBI

Published on January 17, 2023
Current Context: A framework for the implementation of an expected loss-based approach for provisioning against loan loss by Indian banks was recently proposed by the Reserve Bank of India (RBI).
Expected Loss-Based Approach by RBI
  • Currently, banks in India are required to make loan loss provisions using the "incurred loss" method, previously the norm worldwide. The RBI is proposing to change the prudential norms regulating loan loss provisioning by banks to integrate the more proactive predicted credit loss strategy as opposed to the existing "incurred loss" method to increase the resilience of the banking sector further.
  • Expected Loss-Based Approach
    • According to the proposed framework, banks will be required to divide financial assets (primarily loans, including irrevocable loan commitments and investments classified as held-to-maturity or available-for-sale) into one of three categories—Stage 1, Stage 2, or Stage 3—depending on the assessed credit losses on them, both at the time of initial recognition and on each subsequent reporting date.
    • Banks will also be required to make the necessary provisions. To estimate loss provisions in accordance with the suggested guidelines, banks would be free to create and use their own models for calculating probable credit losses.
  • Managing Model Risk
    • Broad recommendations from the RBI will be made available for commercial banks to consider when developing their credit risk models. The precise expectations on the information and variables that banks should take into account when determining credit risk will be specified in the advice.
    • The expected credit loss models that banks are proposing to use will need to be independently validated to confirm that they do, in fact, follow RBI guidance, are based on sound reasoning, calibrated use of all pertinent data that is available to the bank, and have undergone proper internal validation and back-testing to eliminate bias.
  • Exemption
    • The proposed standards cover all scheduled commercial banks, except regional rural banks and smaller cooperative banks (based on a threshold to be decided based on comments.
  • Timeline
    • The RBI has until February 28, 2023, to receive comments on the paper. There will be enough time for implementation, given the complexity of the model’s design and the length of time needed to test them.

Question:

Q.1 Who is releasing the expected loss-based approach for provisioning against loan loss by Indian banks?
a. SEBI
b. SBI
c. RBI
d. NABARD
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