Expected Credit Loss Framework: How It Will Affect Banks

The Reserve Bank of India's draft guidelines to replace the incurred-loss model with an expected credit loss framework, effective April 1, 2027, align with global standards such as IFRS 9.

Under the new model, assets are classified into three stages based on credit risk, with 12-month ECL provisions required for Stage 1 assets and lifetime ECL provisions for Stage 2 and 3 assets.

Additionally, the RBI has mandated "prudential floors" to set minimum provisioning levels.

To facilitate a smooth transition to the ECL framework and manage the potential impact on capital, the central bank has allowed flexibility in modeling and a five-year transition period until March 31, 2031.

The ECL framework is a proactive approach to risk management that incorporates forward-looking estimates, unlike the procyclicality inherent in the traditional incurred-loss models. Banks can build provisions during economic expansions, thereby smoothing loss recognition and promoting financial stability.

As banks integrate forward-looking risk assessments into their origination and monitoring processes, their lending standards will become more rigorous. This will lead to tighter underwriting, refined portfolio management and enhanced long-term credit quality.

Moreover, ECL will introduce a more nuanced risk-reward mechanism for asset quality, especially in the case of provisioning within the same class (standard, Special Mention Accounts, etc.), further widening the gap between well-managed banks and those with weak portfolios.

The ECL regime will influence risk-adjusted return-on-capital calculations through increased provisioning expenses. To maintain profitability targets, banks will likely recalibrate their RAROC models and adjust loan pricing to cover anticipated lifetime losses, particularly for riskier assets.

Compared with banks that lend in the riskier segments, those with healthy asset quality historically are likely to reap benefits in the new portfolio they originate with lower provisioning.

While loan volumes may moderate initially, the long-term outcome will be a resilient, transparent and predictable lending environment, characterized by improved capital allocation and stable pricing dynamics.

Banks will now be required to hold provisions against undrawn portions of loan commitments, increasing overall provisioning. This will particularly affect portfolios with working capital limits or high credit card limits.

As a result, banks may temper credit limits, especially in their retail portfolios, where utilization levels have generally been significantly lower than the approved limits.

The ECL framework also establishes a three-stage model risk management process, requiring robust documentation, independent validation and continuous monitoring, which signals heightened regulatory scrutiny.

From a policy perspective, the Stage 1 floor for loans to micro, small and medium enterprises is set at 0.25%, lower than the floor for corporate loans, to support credit flow to the sector despite likely higher credit risks.

Although non-banking finance companies will follow the existing Indian Accounting Standard (Ind AS)-based ECL provisioning, their regulatory floors will need to be reassessed in the future to align with the banking system, at a minimum.

The transition to an ECL-based system is a strategic imperative for banks, not just a compliance exercise. The phased rollout until March 31, 2031, provides a buffer against capital impact, but banks must utilize this time to develop sophisticated risk management capabilities.

To achieve this, immediate priorities include conducting gap assessments of models, data and governance, and investing in robust systems for macroeconomic overlays.

Financial institutions that successfully integrate forward-looking ECL principles into their core business strategy will gain a competitive advantage through enhanced risk assessment and informed decision-making.

The article has been authored by Siddharth Shah and Kaushal Bhatia, directors and consultant at Crisil Intelligence.

Disclaimer: The views expressed in this article are solely those of the authors and do not necessarily reflect the opinion of NDTV Profit or its affiliates. Readers are advised to conduct their own research or consult a qualified professional before making any investment or business decisions. NDTV Profit does not guarantee the accuracy, completeness, or reliability of the information presented in this article.