On January 16, 2023, Reserve Bank of India (“RBI”) released a Discussion Paper (“DP”) that comprehensively examines various issues and proposes a framework for adoption of an expected loss-based approach for provisioning by banks in India.

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. Since the bank does not expect all loans to become impaired, there is usually enough in the loan loss reserves to cover the full loss for any one or small number of loans when needed. An increase in the balance of reserves is called loan loss provision. The level of loan loss provisions is determined based on the level expected to protect the safety and soundness of the bank.

It is generally assumed that unexpected losses by banks would be covered by bank capital, whereas expected losses would be covered by loan loss provisions. In reality, however, the distinction may be blurred. The proposed approach is to formulate principle-based guidelines supplemented by regulatory backstops wherever necessary.

The key requirement under the proposed framework shall be for the banks to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into one of the three categories – Stage 1, Stage 2, and Stage 3, depending upon the assessed credit losses on them, at the time of initial recognition as well as on each subsequent reporting date and make necessary provisions.

• Stage 1 assets are financial assets that have not had a significant increase in credit risk since initial recognition or that have low credit risk at the reporting date. For these assets, 12-month expected credit losses are recognised and interest revenue is calculated on the gross carrying amount of the asset. 
• Stage 2 assets are financial instruments that have had a significant increase in credit risk since initial recognition, but there is no objective evidence of impairment. For these assets, lifetime expected credit losses are recognised, but interest revenue is still calculated on the gross carrying amount of the asset. 
• Stage 3 assets include financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime expected credit loss is recognised, and interest revenue is calculated on the net carrying amount. 

Banks would be allowed to design and implement their own models for measuring expected credit losses for the purpose of estimating loss provisions in line with the proposed principles. However, to mitigate the concerns relating to model risk and considering the significant variability that may arise, the DP proposes the following mitigants:

• RBI shall be issuing broad guidance that will be required to be considered while designing the credit risk models. The guidance shall specify detailed expectations on the factors and information that should be considered by banks while making determination of credit risk, drawing from the guidance provided in IFRS 9 and principles laid out by BCBS.
• The expected credit loss models proposed to be adopted by banks shall have to be independently validated to verify whether the models follow the guidance issued by RBI, based on sound reasoning, calibrated use of relevant data that is available with the bank and, whether proper back-testing and internal validation of the models have been done to remove any bias, etc. 
• The provisions as per the banks’ internal assessments shall be subject to a prudential floor, to be specified by the RBI based on comprehensive data analysis, rather than merely re-prescribing extant provisioning norms.
• A non-exhaustive list of disclosures by banks shall be prescribed.

Considering the complexities involved in designing the models and the time required to test them, sufficient time shall be provided for implementation of the framework after issue of the final guidelines. Further, in order to enable a seamless transition, as permitted under the Basel guidelines, banks shall be provided an option to phase out the effect of increased provisions on Common Equity Tier I capital, over a maximum period of five years. Comments are sought on the specific discussion questions articulated in the DP that may be submitted by February 28, 2023 to The Chief General Manager, Credit Risk Group, Department of Regulation, Central Office, Reserve Bank of India, 12th Floor, Central Office Building, Shahid Bhagat Singh Marg, Fort, Mumbai – 400001 or by e-mail at strcrgdor@rbi.org.in with the subject line “Discussion Paper on expected credit loss approach for provisioning by banks”.