Forward Thinking

In early January, this year, the Reserve Bank of India (RBI) put on public domain a 'Discussion Paper on Introduction of Expected Credit Loss Framework for Provisioning by Banks' for comments and suggestions from all stakeholders including the general public. The document provides a new framework to assess the credit risks of the banking system well in advance of any actual slippages so that no systemic risks ensue from such incidence in the future.

To put it simply, RBI’s move to introduce provisioning for bad loans based on expected losses rather than incurred losses will act as an insurance against any systemic risks stemming from potential episodes of bad loan cycle, if any, in the fu- ture. Such a framework, in my view, will fortify the asset quality of the financial sector further so that the system can side step any surprises from credit risks during the business cycles going forward.

To elucidate, let me quote from the document: “The exposures taken by banks are inherently susceptible to various risks, of which credit risk is of primary importance. Credit risk represents the risk that the loans given by a bank will not be paid in full, i.e., the bank is likely to suffer some level of losses on its exposures. Such credit losses are a natural corollary of banking business which involves lending to ventures based on reasonable assessment of their viabilities. Since such assessments involve estimations of future trajectories of the performance of a venture as well as that of the macroeconomy in which such ventures are embedded, an element of uncertainty is inherent in such assessments, especially since the assessments would also involve biases such as projections of the bank’s own historical experiences into the future. Thus, the probability of deviations from such assessments is non-zero at any point. It thus follows that the probability of losses arising out of such assessment is also nonzero at any point.” That makes up the case for a better risk assessment and provisioning framework for the commercial lenders.

The central bank’s document also sheds light on the drawbacks of the current framework and high- lights the merits of the new norms.

To quote the document again, “Standard approaches of regulating credit risk classify the losses that banks may face on their credit portfolio broadly into two categories – expected losses and unexpected losses. While unexpected losses are to be mitigated through maintaining capital, expected losses are to be mitigated through pricing policies and loan loss provisions. Such classification intuitively highlights the importance of loan loss provisioning – the burden of mitigating expected losses uncovered by the provisions maintained by the banks would also fall on the capital maintained by the banks, which then leaves the banks vulnerable to materialisation of unexpected losses thereby increasing the probabilities of bank failure”.

In India, the commercial lenders are to follow the incurred loss – based provisioning which was the standard framework globally till the other day. Under this framework, banks make provision for bad as- sets on an ex post basis. This meant that loan loss provisioning happens with a lag thus impairing the asset quality of the banks. As evident from the financial crisis of 2007-09, such delays in recognising expected losses further weakened the bank’s balance sheets and was fraught with the danger of contagion. As the RBI documents rightly pointed out, faced with a systemic increase in defaults, the delay in recognising loan losses resulted in banks having to make higher levels of provisions which ate into the capital maintained precisely at a time when banks needed to shore up their capital, thereby affecting their resilience and posing systemic risks. “Further, the delays in recognising loan losses overstated the income generated by the banks which, coupled with dividend payouts, impacted the capital base of banks because of reduced internal accruals, which also affected the resilience of banks,” the RBI document points out.

However, under the expected loan loss framework, banks are required to estimate expected credit risks/losses based on forward-looking estimations, a marked departure from the incurred loss framework that leaves room for forecast errors and wait for loan losses to actually materialize before making provisions. Under the proposed rules, commercial banks will have to classify financial assets into three categories; stage I, stage II, and stage III based on the assessed credit losses on them, at the time of initial recognition as well as on each subsequent reporting date, and make necessary provisions based on the assessment.

RBI has defined all three stages as follows.

Stage I includes 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 (that is, without deduction for credit allowance).

Stage II includes financial instruments that have had a significant increase in credit risk since initial recognition (unless they have low credit risk at the reporting date) but that do not have objective evidence of impairment. For these assets, lifetime expected credit losses are recognized, but interest revenue is still calculated on the gross carrying amount of the asset.

Stage III includes 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 (that is, net of credit allowance).

The immediate impact of switching to the forward-looking expected credit loss approach to estimating loss provisions may result in excess provisioning as compared to shortfall in provisioning by banks. This may land several banks with low capital cushion or runway in a spot as they will have to go for capital raising either through initial public issues or follow-on public issues or through raising additional Tier I capital. However, banks with sufficient capital buffers will have no issues in switching over to the new framework.

In my view, the new approach to loan loss provisioning will increase the resilience of the Indian banking system further. As evident from the past, and corroborated by many studies, the financial agents have a tendency to show what is called 'credit exuberance’ through business cycles that sometimes lead to lowering the vigil against credit risks. This can lead to systemic episodes as markets across asset classes are now co-integrated. This was demonstrated through the South East Asian contagion as well through the sub-prime crisis of 2007-09.

Such episodes also demonstrated the incidence of market failure in the absence of right regulations. Therefore, I would like to conclude by saying that RBI’s new loan loss framework is the need of the hour and ensures financial stability like never before by enhancing the resilience of our banking system. It will also leave the financial system with enough capital to navigate through any shocks in the future. Such forward looking regulation will only strengthen the financial system’s capacity to withstand and recover from any future shocks