The Reserve Bank of India (RBI) has proposed a framework for the adoption of an expected loss-based approach for loan provisioning by banks.

What is 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.
• Since the bank does not expect all loans to become impaired, there is usually enough in the loan loss reserves to cover the full loss for any one or a small number of loans when needed.
• An increase in the balance of reserves is called loan loss provision.
• The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.

And what is the expected loss-based approach?

• 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.
• As per the proposed framework, banks will need to classify financial assets (primarily loans, including irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale) into one of three categories — Stage 1, Stage 2, or Stage 3.
• This depends 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.

1. Stage 1 assets are financial assets that have not had a significant increase in credit risk since initial recognition or that have low credit risk at the reporting date. For these assets, 12-month expected credit losses are recognised and interest revenue is calculated on the gross carrying amount of the asset.
2. Stage 2 assets are financial instruments that have had a significant increase in credit risk since initial recognition, but there is no objective evidence of impairment. For these assets, lifetime expected credit losses are recognised, but interest revenue is still calculated on the gross carrying amount of the asset.
3. Stage 3 assets include financial assets that have objective evidence of impairment at the reporting date. For these assets, lifetime expected credit loss is recognised, and interest revenue is calculated on the net carrying amount.

What are the benefits of this approach?

• The forward-looking expected credit losses approach will further enhance the resilience of the banking system in line with globally accepted norms.
• It is likely to result in excess provisions as compared to shortfall in provisions as seen in the incurred loss approach.

What is the problem with the incurred loss-based approach?

• The incurred loss approach requires banks to provide for losses that have already occurred or been incurred.
• The delay in recognising expected losses under an “incurred loss” approach was found to exacerbate the downswing during the financial crisis of 2007-09.
• Faced with a systemic increase in defaults, the delay in recognising loan losses resulted in banks having to make higher levels of provisions which ate into the capital maintained precisely at a time when banks needed to shore up their capital.
• This affected banks’ resilience and posed systemic risks.
• Further, the delays in recognising loan losses overstated the income generated by the banks which, coupled with dividend payouts, impacted their capital base

Which banks are covered under this approach?

• The proposed norms are for all scheduled commercial banks, excluding regional rural banks.
• Regional rural banks and smaller cooperative banks (based on a threshold to be decided based on comments) are proposed to be kept out of the framework.

Crack Prelims 2023! Talk to our Rankers

(Click) FREE 1-to-1 on-call Mentorship by IAS-IPS officers | Discuss doubts, strategy, sources, and more

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now

The Reserve Bank of India (RBI) is said to have put on hold licensing of the New Umbrella Entity (NUE) network, a fintech institution planned as a rival to National Payments Corporation of India (NPCI).

Why in news?

• Six groupings, which included Facebook, Google, Amazon, Flipkart and others, had applied for NUE licences.

What is New Umbrella Entity (NUE)?

• NUE is an entity (under the Companies Act 2013) that will manage and operate the new payment system in the retail sector such as ATMs, POS, UPI etc.

• NUEs will be set up for profit entities that will manage payments in the retail space.
• These could offer a host of retail payment services, including setting up of ATMs, offering white-label, point of sale terminals, Aadhaar-based payments, remittance services, and develop newer payment methods.

• They will also manage clearing and settlement systems that could be an alternative to the bank-promoted NPCI.
• They will be allowed to charge fees for transactions (unlike the existing NPCI).
• All NUEs will have to be interoperable with the National Payments Corporation of India (NPCI).

Why need NUEs?

• The NPCI is at the epicentre of the digital payments in the country.
• RBI has introduced NUEs to end the so-called monopoly of NPCI.
• The central bank also noted that during the pandemic, with people spending more time at home the usage of e-commerce has increased, and there’s been a significant rise in the incidence of internet fraud, cyber-crimes.

If NPCI is doing its job well, then why NUE?

• 48% of all electronic retail payments in the country pass through the NPCI infrastructure.
• RBI’s concern stems from having the operations of so much of the country’s payment system concentrated in one entity.

How will NUE aid Consumers?

• With the introduction of NUEs, options for payment will increase for users.
• This will result in more competition and eventually help boost transaction volumes for both platforms as e-commerce expands and reaches deeper into India’s unbanked hinterland.
• In the World Bank’s most recent report on financial inclusion in 2017, some 190 million Indians did not have a bank account and more than half did not make or receive digital payments.
• Customers who face frequent sever transaction due to server overload currently have few options.
• In the new regime, they’ll be able to try the other platform.

What about Data Safety?

• Compliance as far as data safety and privacy is concerned holds good for all and sundry in the payments and banking space.
• Every entity involved in payments and settlement have to follow the same set of rules.
• RBI already have a new set of guidelines on “Regulation of Payment Aggregators and Payment Gateways” .
• It ensures that neither the authorised Payment Aggregators (PAs) nor the merchants on-boarded by them can store customer card credentials within their database or server to avoid data breaches and potential abuse.

Will NUEs replace NPCI?

• NUEs will co-exist with NPCI to strengthen the payment infrastructure network.
• A robust and resilient infrastructure is needed to ensure the government’s ambitious target of one billion digital transactions per day is achieved.
• NUEs will not replace but complement NPCI in taking India’s digital payment success story to new heights.
• By establishing a neutral and independent standards-setting body, we can make sure that the system as a whole in our country evolves in the best traditions of digital infrastructure adopted anywhere in the world.

Crack Prelims 2023! Talk to our Rankers

(Click) FREE 1-to-1 on-call Mentorship by IAS-IPS officers | Discuss doubts, strategy, sources, and more

Get an IAS/IPS ranker as your 1: 1 personal mentor for UPSC 2024

Attend Now