The Reserve Bank of India on Monday published draft guidelines for banks to provision on an expected credit loss (ECL) basis compared to the current incurred loss method framework. The RBI has proposed that banks will be able to design their own credit loss models and spread the highest provisions over a five-year period under a newer system of reserve money for loans. However, banks are free to choose a shorter transition period.

Banks will also have to make provisions for borrowers’ late repayments under the proposed framework, in addition to the existing provisioning requirement. This may result in increased provisions, as lenders will have to calculate the estimated loss of interest income and anticipate it. Under current regulations, banks build loan provisions after incurring loss of interest income.

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The RBI has sought comment on the issues by February 28.

The measures will be applicable to bank loans and advances, including the limits sanctioned under revolving credit lines, lease receivables, financial guarantee contracts, and investments in the debt and equity markets.

Banks will have a free hand to design their own models to measure ECL based on the guidelines given by the RBI. If a lender has outsourced their validation to an external entity, the bank will be responsible for the validation work. ECL estimates will be subject to a prudential floor prescribed by RBI as regulatory support, RBI said.

The discussion paper said that banks will have to classify financial assets, including primarily loans, irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale, into one of three categories: Stage 1, Stage 2, and Stage 3, depending on the credit losses assessed on them.

The central bank has proposed that banks will have to consider lifetime ECL if the credit risk of the financial asset has increased significantly since initial recognition.

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In the event that the financial health of the account has not deteriorated, lenders will need to recognize the 12-month ECL.

The central bank has also proposed that a Stage 3 asset not be taken directly to Stage 1 even after irregularities are rectified. Banks will have to classify a Stage 3 asset in Stage 2 for a minimum of six months after all irregularities are corrected, and then move it to Stage 1. Restructured assets that perform satisfactorily will be subject to a prudential floor fixed for loss provisions regardless of time spent as a Stage 3 asset.