1. RBI had released the Discussion Paper on "Introduction of Expected Credit Loss Framework for Provisioning by Banks" on January 16, 2023, soliciting inputs from all stakeholders. The ECL approach to provisioning is a paradigm shift from the current incurred loss-based provisioning regime. The Discussion Paper envisages a forward looking, principle-based framework for provisioning for credit risk, which has already been implemented under International Accounting Standards Board (IASB) and US Financial Accounting Standards Board (FASB).
2. Several comments have been received from various stakeholders on the issues flagged in the Discussion Paper, which are being examined by the Reserve Bank. While the regulatory stance to be taken in respect of each of the issues shall be examined by the Reserve Bank, it has been decided to constitute a Working Group in order to get independent inputs on some of the technical aspects having a bearing on the significant transition involved.
3. The Working Group will be chaired by Prof. R. Narayanaswamy, former Professor, IIM Bangalore and shall consist of domain experts from academia and industry as well as representatives from select banks.
4. The Terms of Reference for the Working Group would be as follows:
- Delineate the principles that will be required to be considered by banks while designing the credit risk models to be used for assessing and measuring expected credit losses.
- Recommend factors that banks should consider for determination of credit risk based on the guidance provided in IFRS 9 and principles laid out by BCBS.
- Suggest the methodology to be used for undertaking external independent validation of the models.
- Recommend, based on comprehensive data analysis, prudential floors for provisioning.
- Any other issue incidental to the above.
5. The recommendations of the Working Group would be duly factored in while framing the draft guidelines, which shall be put in the public domain for comments before issue of final guidelines.
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Discussion Paper - Brief
As part of the Statement on Developmental and Regulatory Policies released on September 30, 2022, RBI had proposed to adopt an expected loss-based approach for loss allowances required to be maintained by banks in respect of their loan exposures. It was announced that a discussion paper on the various aspects of the transition will be issued shortly.
The proposed approach is to formulate principle-based guidelines supplemented by regulatory backstops wherever necessary. Further, regional rural banks and smaller cooperative banks (based on a threshold to be decided based on comments) are proposed to be kept out of the above framework.
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.
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.
The DP flags certain critical issues on which a final view shall be taken based on the feedback received as well as comprehensive data analysis. Comments are sought on the specific discussion questions articulated in the DP, supported by well-reasoned arguments and wherever necessary, supported by detailed data analysis and quantitative evidence.
