Increased provision on CET1 for loan loss to be phased out: RBI paper

The increase in provisioning requirement on common equity tier-I (CET1) capital for loan loss, which will be incurred by scheduled commercial banks due to transition to expected credit loss (ECL) model, will be phased out in five years, the Reserve Bank of India (RBI) said in a discussion paper released on Monday.

“The RBI proposes to adopt the ECL approach used in International Financial Reporting Standards (IFRS) 9 for prescribing guidelines for loss provisioning by banks,” it said in a statement.

The RBI will introduce an ECL approach for loan loss for banks, as compared to the incurred loss approach at present, one year after announcing the final guidelines.

“A period of at least one year from the date of final guidelines on ECL approach for loss provisioning would be ordinarily required by the banks to put in place the necessary systems and procedures, including the development and validation of ECL models,” RBI said.

The key requirement under the proposed framework will 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.

“The prudential floors will be subject to a step-up prescription depending upon the time that a financial instrument spends as a Stage 2 or 3 asset. Actual specifications shall be included in the Draft guidelines,” the discussion paper said.

Regional rural banks and smaller cooperative banks (based on a threshold) are proposed to be kept out of the above framework.

The RBI has invited comments to the discussion paper by February 28. The discussion paper will be followed by draft guidelines, and based on the feedback, final norms will be announced.

“Banks would be allowed to design and implement their own models for measuring ECL for the purpose of estimating loss provisions in line with the proposed principles,” the regulator said.

“…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 CET1 capital, over a maximum period of five years,” it said. Banks may also choose to spread the transition over a shorter period.

The ECL models proposed to be adopted by banks will 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 RBI said.

“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,” it said.

The RBI has proposed to prescribe a non-exhaustive list of disclosures that banks would be required to make upon adopting ECL approach for loss provisioning.