Working Group on Framework for Expected Credit Loss (ECL) Provisions

06 Oct Working Group on Framework for Expected Credit Loss (ECL) Provisions

This article covers “Daily Current Affairs” and the topic details “Working Group on Framework for Expected Credit Loss (ECL) Provisions”. This topic has relevance in the Economy section of the UPSC CSE exam.

For Prelims:

About ECL Provisioning?

About RBI’s Working Group?

About NPA?

For Mains:

GS 3: Economy

Phasing Out ECL-Based Provisioning Benefits?

About NPA and its Impact?

 

Why in the news?

The Reserve Bank of India has formed a working group to suggest a framework for a smoother transition to the proposed expected credit loss-based provisioning system.

 

• About ECL Provisioning: Expected Credit Loss (ECL) provisioning is a financial practice employed by banks and financial institutions. It involves allocating a portion of their earnings to create provisions aimed at covering potential losses stemming from non-performing assets (NPAs) in their portfolios.
• RBI’s Working Group Formation: The Reserve Bank of India (RBI) has recently announced the establishment of a nine-member working group, with R. Narayanaswamy, a former faculty member at IIM Bangalore, serving as its chairperson. This working group has been tasked with addressing various aspects related to ECL provisioning in the banking sector.

 

• Terms of Reference for the Working Group: The RBI has outlined the following terms of reference for the working group:
  • Principles for Credit Risk Models: The group is expected to elaborate on the principles that banks should consider while designing credit risk models for assessing and measuring expected credit losses.
  • Determining Credit Risk Factors: Recommendations should be made regarding the factors that banks should take into account when determining credit risk.
  • Validation Methodology: The working group is tasked with suggesting the methodology to be employed for conducting external, independent validation of these credit risk models.
  • Prudential Provisioning Floors: Based on comprehensive data analysis, the group should recommend prudential floors for provisioning.

 

• Scope of ECL Provisioning Framework: Under this new framework, all scheduled commercial banks, with the exception of regional rural banks, are expected to be brought under the ECL provisioning framework, in cases where the risk of default increases, banks will be required to set aside provisions equivalent to the estimated lifetime credit losses, as determined by the credit risk models.

 

• Phasing Out ECL-Based Provisioning Benefits: The benefits of Expected Credit Loss (ECL)-based provisioning will be gradually phased out over a period of five years. This transitional arrangement aims to prevent a sudden “capital shock” by allowing banks sufficient time to rebuild their capital resources, mitigating potential adverse impacts resulting from the implementation of ECL accounting.

 

• RBI’s Directive on ECL-Based Provisioning: The Reserve Bank of India (RBI) has issued directives to all banks mandating the introduction of ECL-based provisioning during the fiscal year 2023–24. This initiative is part of RBI’s efforts to strengthen the system for resolving bad loans.

 

• Understanding Non-Performing Assets (NPAs): NPAs are loans or advances that are either in default or in arrears, signifying instances where the principal or interest payments are delayed or unpaid. The classification of an asset as NPA occurs based on certain criteria.

 

• Criteria for Classifying an Asset as NPA: In India, the timeline for classifying an asset as NPA is 180 days, which contrasts with international norms that range from 45 to 90 days.

 

• Importance of NPA Recognition: The recognition of NPAs is essential for providing government and regulatory authorities with a clear understanding of the financial system’s health. India has adopted a more aggressive approach to recognizing bad loans, particularly from 2014 to 2015, with measures such as the periodic asset quality review and regulatory actions to prevent the practice of “ever-greening” loans.

 

• Impact of NPAs on Financial Operations: NPAs have several adverse effects on financial operations:
  • Reduced bank profits.
  • Decreased capital adequacy of banks and financial institutions.
  • Heightened risk aversion, leading to a decline in lending and increased conservatism.
  • Shifting focus from profit generation to credit risk management.
  • Increased cost of funds due to NPAs.

SOURCE: rbi: RBI forms working group to find a framework for the transition to credit-loss based provisioning system – The Economic Times (indiatimes.com)

 

Q.1 What is the primary purpose of Expected Credit Loss (ECL) provisioning, and how does it relate to non-performing assets (NPAs)?

1. ECL provisioning aims to maximize bank profits by allocating earnings to high-risk investments.
2. ECL provisioning helps banks accumulate capital to cover potential losses resulting from NPAs.
3. ECL provisioning is a strategy to reduce interest rates on loans to prevent NPAs.
4. ECL provisioning is designed to encourage banks to increase lending to minimize NPAs.

How many of the above statement/s is/are NOT correct? 

(a) Only one 

(b) Only two 

(c) Only three 

(d) All four

 

ANSWER: C

 

Q.2 Consider these statements:

1. All scheduled commercial banks, except regional rural banks, must adopt ECL provisioning for increased default risk.
2. ECL-based provisioning benefits will be gradually phased out over five years to avoid a sudden capital shock.

Which of the statements given above is/are correct? 

(a) 1 only

(b) 2 only

(c) Both 1 and 2

(d) Neither 1 nor 2

 

ANSWER: C

 

Q.3 Discuss the significance of Expected Credit Loss (ECL) provisioning in mitigating Non-Performing Assets (NPAs) and its role in strengthening the stability of the banking sector.