Synopsis: The Reserve Bank of India (RBI) is transitioning banks from an “incurred loss” model to a forward-looking Expected Credit Loss (ECL) framework, effective April 1, 2027. This 3-stage provisioning system requires banks to set aside capital based on anticipated future losses rather than waiting for a loan to default.
With the advent of easier access to credit, from loan approvals to EMIs to credit cards, there is a cultural shift in the consumption patterns and in the frequency of credit use. This culture might soon get impacted with RBI’s updated 3-stage provisioning system. Under RBI’s regulation, banks now have to recognize the loan risks by the Expected Credit Loss (ECL) framework, which will take effect from April 1, 2027.
This framework allows banks to recognize potential losses way before the borrower defaults, through 3-stage examination. It scrutinizes the financial behaviour of the borrower and significantly determines the accessibility of loans, the amount to be paid, and the analysis of credit worthiness.
3-Stage Provisioning System
Under the new regulation of the ECL framework, loans are classified into three stages for risk predictability.
Stage 1: Performing Assets-Low Risk
- Banks set aside provisions for expected losses over the next 12 months, based on 12-month Probability Default (PD)
- The case of the loans in which the borrowers are paying on time falls into the stage-1 of low risk category
Stage 2: Increased Credit Risk – Early Warning Stage
- Delayed payment default or financial stress indications from the borrower
- Credit risk rises
- This moves to lifetime expected losses, not just short-term risks
Stage 3: Credit Impaired Assets – Default Stage
- Default of beyond 90+ days by the borrower
- Loan qualifies under Non-Performing Asset (NPA)
- Credit Score severe damaged
The Need for 3-stage Provisioning System
In the old system, the losses were recognized by the banks only after the default from the borrower. This model was standing on the ‘incurred-loss’ model, and this delayed identification created intractable problems of risks. This new ECL framework improvises this loan system by:
- Identifying risk early
- Raising transparency
- Positioning India with global standards
Impact on Financial Activities
After the introduction of this system, the financial behaviour of the individual will be continuously monitored and a default will cause more harm to the credit profile than it was before.
1. Possibility of Costlier Loans: Banks are now advised to set aside funds in advance for potential loan losses increasing capital pressure on banks, and hence will increase the overall cost of lending. Resulting in,
- Rise in interest rates
- Variability of price loans based on the risk
2. Getting Loan Approvals will be difficult than before: Analysis of risk will be ‘predictive’ and not ‘reactive’ in nature, hence loan approvals might become difficult.
- More stringent eligibility background checks
- Focus on income stability
- Reduced approvals for risky profiles
3. Credit Score becomes Indispensable factor: Banks will have to track payment delays, downgrading of credit, and assess financial stress signals.
- Maintaining a strong credit score becomes important
- Directly linked to borrowing ability
4. Faster Penalty for Late Payments: As the stress is detected early, missing a single EMI could have quicker consequences than before, for example, the loans may move to higher risk categories.
5. Better Safety for Your Savings: By assessing the risk early banks will maintain stronger balance sheets and bad loans are expected to be mitigated. This improves,
- Safer deposits for individuals
- Mitigation of possibilities of bank crises
6. Impact on Credit Cards & Personal Loans: Credit cards and personal loans come under the umbrella of unsecured high risk loans. This means,
- Rise in interest rates
- Reduction in credit limits
- Approvals may be restricted depending on the risk profile of the individual.
Understanding with a Hypothetical Example
Let’s consider a hypothetical example to understand the impact of this new 3-stage loan provisioning system. A salaried employee Reeva, takes a personal loan of ₹4 lakh.
Stage 1: Normal Phase: She pays her EMIs on time
- Bank sees low risk
- Easier access to additional credit
Stage 2: Early Stress Signals Phase: She misses 1 or 2 EMIs due to job switch or other personal circumstances
- Banks flags it as increased risk
- Credit score drops
- Future loan eligibility reduces
Stage 3: Default Phase: She is unable to pay for 90+ days
- The loan becomes Non-Performing Asset (NPA)
- Legal recovery process starts
- Credit score gets severely damaged
- Future credit accessibility becomes uncertain
Through this, it is understood that the individual should,
- Strong credit profile should be sustained
- Delayed repayments should be strictly avoided
- Being financially consistent
Conclusion
In this RBI’s 3-stage loan provisioning framework, the predictive risk analysis of credit worthiness of the individual is directly assessed based on the financial behaviour and discipline of the individual.
Written by Jahnavi
