The IMF recently released a Financial Stability Report that contains a section on asset quality and capital indicators for emerging market banks. In the list of countries whose banks are most vulnerable, India joins Russia, Colombia and Saudi Arabia. The quantum of NPAs with banks in India varies depending on whom one asks but everyone agrees that there is a problem and it is gargantuan.

Accounting standards

The RBI has been doing its bit to ensure that banks report NPAs accurately. The Prudential Norms for Income Recognition and Asset Classification (IRAC) issued by the RBI have been regularly amended to ensure that they capture the correct amount of NPAs.

Accounting standards were blamed for perpetuating the 2009 credit crisis as the diktats of the accounting standards guided banks to provide for too little losses, too late. Accounting regulators amended their standards by moving from an incurred loss model to an expected loss model to provide for bad loans. Ironically, banks in India will transition to these new standards only in 2019. The expected credit loss approach forces banks to not only look into the past but also gaze into the future by developing a specific model to make loss allowances for bad debts.

If banks were to practice this approach, it would mean that provisioning would need to be done at the bank level and not on RBI notifications. An RBI committee has suggested that the IRAC norms would be the minimum amount that banks would need to provide and if they feel that the amount is insufficient, they are free to provide more. The concept of providing for NPAs based on expected credit losses is based on the premise that none knows the borrower better than the bankers which provided the loan and hence they are the best people to estimate the amount of losses.

Advisory matters

In slow doses, the RBI appears to be forcing banks to increase their provisions for NPAs so that by the time they adopt the new accounting standard, at the least they do not have an opening baggage of bad loans. The Asset Quality Review (AQR) was the first step in this direction. Recently, RBI advised all banks that the provisioning rates prescribed by them are the regulatory minimum and banks are encouraged to make provisions at higher rates in respect of advances to stressed sectors of the economy.

The advisory asks banks to put in place a board-approved policy for making provisions for standard assets at rates higher than the regulatory minimum, based on evaluation of risk and stress in various sectors. The policy has to be reviewed every quarter based on various parameters. As an example, RBI states that as the telecom sector is reporting stressed financial conditions with interest coverage ratio less than one, banks may review the telecom sector latest by June 30, 2017, and consider making provisions for standard assets in this sector at higher rates.

The intent of the RBI to encourage banks to provide more is to be welcomed. To apply the advisory would require banks, which till date have been guided by RBI instructions, to change their culture by resorting to proactive provisioning. Banks can make a start by listing out sectors that are stressed instead of blindly making additional provisions for telecom loans just because the RBI says so.

The writer is a chartered accountant

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