MUMBAI: The Reserve Bank’s recent proposal for a phased implementation of an expected credit loss (ECL) framework is credit positive for banks as it will strengthen their resilience through early risk recognition and forward-looking provisions, aligning them with global standards, with manageable capital cost and minimal impact on profitability, says a report.
According to Moody’s Ratings, the October 7 circular is credit positive as it marks a significant shift from the current incurred-loss model to a forward-looking approach. This will strengthen bank resilience with early risk recognition and forward-looking provisions, aligning with the global IFRS 9 (international financial reporting standard) standards. The agency sees only manageable impact on capital as it expects the regulations to reduce tangible common equity for banks by 50-80 bps.
However, the impact will be manageable as the implementation is phased over four years beginning April 2027, allowing banks to absorb the decline through measures like more conservative dividend payouts.
“We expect the proposed regulations to reduce the tangible common equity for banks by 50-80 bps. Since the implementation will be phased over four years, allowing banks to avoid a significant day-one reduction of capital, most banks are likely to absorb the decline in capital ratios through more conservative dividend payouts," said Moody’s analysts.
“The reduction in regulatory total capital adequacy ratio will be greater due to the proposed exclusion of loan loss allowances for stage 2 assets, in addition to the existing exclusion for stage 3 provisions. Also, the recent improvements in asset quality will result in lower model-driven ECL provisions, making the overall capital reduction from the transition less pronounced,” they added.
The report also says the proposal for unique provisioning floors will act as a safeguard for banks as the proposed regulations overlay additional requirements, including regulatory provisioning floors, making India the only major jurisdiction in Asia to mandate such a measure. These floors act as a safeguard against under-provisioning and model risk, with higher floors for inherently riskier exposures like unsecured retail loans.
Regulatory provisioning floors are proposed based on combination of loan product, security and aging of impairment. While unsecured retail products have higher provisioning floors to maintain a conservative buffer for these inherently riskier exposures, lower minimum provisioning requirements are set for priority sectors such as SMEs and agriculture, supporting credit flow to these segments.
Stating that the new regulations will not hit the bottom line of banks, it said the proposed rule on interest recognition for stage 3 assets is unlikely to significantly weaken profitability, as existing regulations already have similar effects. In fact, the new deduction will reduce earnings volatility and further strengthen loan loss reserves.
The new framework also brings in improved governance and transparency as the new guidelines require banks to establish robust governance frameworks, including board oversight and risk committees, and to follow standardized disclosure formats. This will improve transparency and comparability across institutions. The new guidelines require banks to classify financial assets into three stages based on credit risk.
Stage 1 assets will be provisioned at 12-month ECL; stage 2 assets at lifetime ECL for significant increase in credit risk; and stage 3 assets at lifetime ECL for credit-impaired exposures. This marks a significant shift from the current incurred-loss model to a forward-looking approach, requiring institutions to estimate and provision for credit losses based on expected future defaults.
Banks with a longer track record of consistent asset quality will benefit from lower model-based ECL estimates. But these benefits are capped by the provisioning floors, which act as a safeguard against under provisioning and model risk. Per proposed regulations, interest recognized on stage 3 assets must be deducted from profit and loss as additional ECL provisions, unlike IFRS 9 standards.
However, this is unlikely to significantly weaken banks’ profitability since, under existing regulations, interest on NPLs was already recognized only on a cash basis. The proposed deduction of interest on stage 3 loans will reduce earnings volatility and strengthen loan loss reserves.
The RBI has also proposed to overlay the regulatory NPA classification on top of the ECL staging framework, requiring banks to comply with both. We expect stage 3 loans under the ECL framework to be only slightly higher than regulatory NPAs primarily because of the inclusion of off-balance-sheet exposures related to NPA borrowers. Moreover, banks have strengthened their loan loss reserve coverage from an asset-weighted average of 79 percent in fiscal 2020 to 103 percent in fiscal 2025.
