Note4Students
From UPSC perspective, the following things are important :
Prelims level: Loan-Loss Provision
Mains level: NPA crisis
The Reserve Bank of India is moving closer towards ring-fencing the banking system from credit losses as it proposes to move to provision on the principles of ‘expected losses’ from ‘incurred losses. ‘
What is a Loan-Loss Provision?
- The RBI defines a loan loss provision as an expense that banks set aside for defaulted loans.
- Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially.
- In the event of a loss, instead of taking a loss in its cash flows, the bank can use its loan loss reserves to cover the loss.
- The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.
What is Expected Credit Loss (ECL) regime?
- The Expected Credit Loss (ECL) regime is a new accounting standard that was introduced by the International Financial Reporting Standards (IFRS) in response to the global financial crisis of 2008.
- The ECL regime requires banks and other financial institutions to estimate and report the expected losses from their loan portfolios over the lifetime of the loans.
- Under the ECL regime, financial institutions must assess the credit risk associated with each loan and estimate the expected losses that will result from default or other credit events.
- These expected losses must be recognized in the financial institution’s accounts and reported to investors and other stakeholders.
- Under this practice, a bank is required to estimate expected credit losses based on forward-looking estimations rather than wait for credit losses to be actually incurred before making corresponding loss provisions.
Benefits of the ECL regime
- ECL will result in excess provisions as compared to a shortfall in provisions, as seen in the incurred loss approach.
- It will further enhance the resilience of the banking system in line with globally accepted norms.
Issues with this regime
- It requires banks to provide for losses that have already occurred or been incurred.
- The delay in recognizing loan losses resulted in banks having to make higher levels of provisions which affected the bank’s capital.
- This affected banks’ resilience and posed systemic risks.
- The delays in recognizing loan losses overstated the income generated by the banks, which, coupled with dividend payouts, impacted their capital base.
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