Ever since the global financial crisis, there has been a push for banks to move from an ‘incurred loss’ to an ‘expected credit loss’ approach for recognising doubtful loans. International Financial Reporting Standards (IFRS) and Ind AS incorporated this framework in January 2018. With global banks adopting them by January 2020, it was only a matter of time before Indian banks which still follow the incurred loss approach, were pushed to follow suit. With credit offtake rising and recent financial stability studies showing Indian banks to be sitting pretty on asset quality and capital adequacy norms, this is the right time for RBI to propose this long-overdue shift.

In its discussion paper, RBI has proposed a one-year window after final guidelines, for banks to transition to the ECL framework, with a further five-year transition period for Tier 1 capital to reflect ECL provisions.

The ECL framework offers distinct advantages to stakeholders. In the incurred loss approach, banks classify loans as non-performing or doubtful after they’ve been in default for between 90 days and 2 years. It takes another 1 to 6 years to fully provide for such loans in their books. With loss provisions lagging defaults, it is no surprise that banks’ capital buffers prove grossly inadequate when economic or business conditions go suddenly downhill. Promoters including the government (for PSU banks) are called upon to make large capital infusions, when they can least afford it. The ECL framework, by requiring banks to take stock of risks on a forward-looking basis, leads to early provisioning and front-ended capital cushions.

That said, there are challenges. While the incurred loss approach operates on a black-and-white notion of default, the ECL approach calls for lenders to subjectively estimate the future probability of default and provide for lifetime credit losses on their loans. This clearly calls for banks to have strong in-house macro and business risk evaluation teams, to keep a close eye on both the borrower’s business and macro data. Evidence from the previous NPA cycles suggests that this is a weak link for many large banks — especially in the public and co-operative sectors. The IFRS-based approach to ECL, which RBI is adopting, allows individual banks to design their own credit evaluation models. This can lead to some banks adopting more conservative accounting than others. Regulators may need to insist on detailed disclosures to iron out inconsistencies.

While the challenges may lead to banks bargaining for more time, RBI should refrain from giving in to such requests. ECL transition tends to substantially push up bank capital requirements and capital-raising is easier in a reviving economy, when bank financials are on a strong footing. An early shift to ECL will also help investors and policymakers proactively spot emerging stress in the retail loan books of banks in this economic cycle. RBI should also resist any pressure to exempt PSU or co-operative banks from the ECL framework.