Understanding the Shift to Expected Credit Loss in Indian Banks

Expected Credit Loss Regime in India

The Reserve Bank of India (RBI) is shifting banks from the “incurred loss” model to an Expected Credit Loss (ECL) regime, aligning Indian banking practices with international standards (IFRS 9).

1. Current Practice vs New System

Current Practice (Incurred Loss Model):

Banks make provisions only after a borrower defaults. For example, if a borrower fails to pay for 90 days, the loan is classified as Non-Performing Asset (NPA), and provisions are made.

New Practice (ECL Model):

Banks must anticipate loan losses in advance by assessing credit risk and setting aside funds before default happens. This reduces sudden shocks to the banking system.

2. Timeline for Implementation

- Proposal Date: January 2023

- Implementation Start: 1 April 2027

- Glide Path: Till 31 March 2031, to allow banks to adjust gradually.

This staggered transition avoids one-time stress on banks’ profits and ensures smooth adoption.

3. How ECL Works

Banks estimate possible loan losses based on:

- Probability of Default (PD): Chances that a borrower will not repay.

- Loss Given Default (LGD): How much the bank will lose if default occurs (e.g., after collateral recovery).

- Exposure at Default (EAD): The total outstanding loan at the time of default.

Formula:

ECL = PD × LGD × EAD

4. Examples

Current Model:

Loan: ₹100 crore to a company.

Default occurs after 2 years.

Bank makes provision after default = ₹30 crore (say 30% loss).

ECL Model:

Same loan of ₹100 crore.

Based on credit rating, bank expects a 10% chance of default, with 50% expected loss if default happens.

Provision in advance = 0.10 × 0.50 × 100 crore = ₹5 crore.

This amount is set aside each year, smoothing impact rather than taking a hit later.

5. Advantages of ECL Regime

- Early recognition of stress in banking books.

- Financial stability, as sudden shocks are avoided.

- Global alignment with IFRS 9 standards.

- Encourages better credit appraisal since riskier loans need higher provisioning.

6. Challenges

- Higher provisioning may reduce short-term profits.

- Requires robust data systems to estimate probability of default.

- Smaller banks may face implementation difficulties.

Synopsis

The Expected Credit Loss (ECL) regime shifts Indian banks from a reactive approach (after default) to a proactive approach (anticipating default). Starting April 2027, with a glide path till March 2031, banks will set aside provisions based on Probability of Default, Loss Given Default, and Exposure at Default. This ensures stronger financial stability but demands better data systems and risk management.