The Reserve Bank of India (RBI) on Monday released a discussion paper (DP) that aims to comprehensively examine various issues and propose a framework for expected loss-based approach to provisioning for loan losses by banks in India. .
“The proposed approach is to formulate principles-based guidelines, complemented by regulatory backstops wherever necessary,” RBI said.
Regional Rural Banks and Small Co-operative Banks (subject to a limit to be decided on the basis of comments) are proposed to be kept out of the framework.
The main requirement under the framework will be for banks to classify financial assets (primarily loans, including irrevocable debt commitments, and investments classified as held-to-maturity or available for sale) into one of three categories Stage 1, Stage 2, and Stage 3, upon initial recognition as well as at each subsequent reporting date, make further necessary provisions based on the loan losses assessed thereon.
Banks will be permitted to design and implement their own model for measuring expected loan losses for the purpose of estimating loss provisions in line with the proposed principles.
However, in order to mitigate the concerns related to model risk and to consider the significant variability that may arise, RBI will issue comprehensive guidance, which will need to be considered by commercial banks while designing credit risk models.
The guidance will specify detailed requirements on the factors and information that should be considered by banks while assessing credit risk.
The potential credit loss model proposed to be adopted by the banks will have to be independently verified to verify whether the model is based on sound logic, calibrated use of all relevant data available with the bank and issued by the Reserve Bank of India. Follow the guidance done and do what is appropriate. Back-testing and internal validation of the models have been carried out to remove any bias.
Keeping in view the complexities involved in designing the models and the time required for their testing, sufficient time will be provided for implementation of the framework after the final guidelines are issued.
Further, to enable a seamless transition as permitted under the Basel guidelines, banks will be provided with an option to phase out the impact of increased provisions on Common Equity Tier I capital over a maximum period of five years.
The RBI said the DP identifies some important issues, which will be taken a final view on based on comprehensive data analysis along with the feedback received.