RBI new rules for ‘loan loss provision’ by banks

20/01/2023

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RBI new rules for ‘loan loss provision’ by banks

The Reserve Bank of India (RBI) has released a discussion paper on “loan loss provision”, proposing a framework for adopting an expected loss (EL)-based approach for provisioning by banks in case of loan defaults.

The RBI’s proposal is grounded on the premise that the present “incurred loss”-based approach for provision by banks is short, and there is a need to shift to the “expected credit loss” regime in order to avoid any systemic issues.

The loan-loss provision:

The RBI sets a loan loss provision as an expense that banks lay aside for defaulted loans. Banks lay aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially. At the time of a loss the bank uses its loan loss reserves to cover the loss.

An increase in the balance of reserves is known as loan loss provision.

The level of loan loss provision is decided based on the level expected to protect the safety and soundness of the bank.

The benefits of new rules of RBI:

The forward-looking anticipated credit losses approach might be further enhance the resilience of the banking system in line with globally accepted norms.

The positive side of this approach is that it might be resulted in excess provisions as compared to shortfall in provisions as seen in the incurred loss approach.

Challenges about incurred loss-based approach:

The incurred loss approach demands banks to provide for losses that have already occurred or been incurred.

The delay in recognizing carried losses under an “incurred loss” approach was experienced to worsen the downswing during the financial crisis of 2007-09.

Further, the delays in recognising loan losses hyperbolised the income generated by the banks which, coupled with dividend payouts, impacted their capital base because of reduced internal accruals — which too, affected the resilience of banks.