At a recent conference, the Reserve Bank of India once again highlighted the need for dynamic provisioning to maintain financial stability in banks. Earlier, in March 2012, the RBI issued a discussion paper on the introduction of dynamic provisioning in India.
But first, let’s understand what a provision is. In accounting terms, it is an amount set aside from profits to cover a future liability. As the exact amount of the liability is unknown, it is estimated.
Now, how do banks make provision for loan impairments globally and in India, and why is the RBI discussing dynamic provisioning?
Under International Financial Reporting Standards, loan loss provisioning is recognised based on the ‘incurred loss model’, under which provision for impairment of financial assets is made only if there is an objective evidence of impairment as a result of loss event(s) that can have a reliably estimated impact on the future cash flows of the asset. The loss events may include significant financial difficulty of borrower, default in interest or principal payments, bankruptcy of borrower, and so on. Similarly, under US GAAP impairment for losses should be recognised when it is probable that a loss has been incurred.
However, this approach has been criticised as pro-cyclical — that is, provisioning tends to move with the business cycles — more provision during recession, when loss events are more frequent, and less provision during an economic boom.
During recession, when banks’ profits are already down, they are required to make more provisions for loan loss. However, they could postpone it to avoid reducing profits and, consequently, share prices and bonuses for the management. Moreover, to avoid future losses banks tighten lending norms and reduce lending. If all banks do this, the whole economy suffers from a credit crunch, as seen during the global financial crisis in 2008.
As a result, international regulators agreed to introduce countercyclical provisions through dynamic provision, which mainly creates a buffer in good times to be used during bad times. Under dynamic provisioning, loan loss provisions are spread across the business cycle, reducing volatility in banks’ profits.
In India, banks generally make two types of provisions in accordance with RBI guidelines — namely, specific provisions on non-performing assets (NPAs), and general provisions on standard assets. Specific provisions are made ex-post (after the fact) based on estimation of impairment (which is pro-cyclical), while general provisions are made ex-ante (before the event) as decided by the RBI or the management. This policy does not have inbuilt countercyclical elements. Though the RBI follows countercyclical provisions through standard asset provisioning rates or Provisioning Coverage Ratio (PCR), this is based on current data and judgment, rather than on an analysis of credit cycles and loss history.
RBI’s Proposed Model
After studying dynamic provisioning in various countries (Spain, Peru among others), the RBI has come out with a model specific to Indian banking system. Here, total provisions would consist of specific provisions made during a year under RBI guidelines and dynamic provisions.
Dynamic provisioning would be the difference between the long-run average expected loss (EL) of the portfolio for one year and the incremental specific provisions made during the year.
EL = EAD*PD*LGD, where EAD = exposure at default, PD = probability of default, and LGD = loss given default.
The RBI has calibrated PD and LGD based on data from nine banks over 5-10 years. However, this period may not capture the probable losses in a cycle if there is a downturn. Hence, the RBI uses downturn LGD. For EAD, a relative proportion of corporate, retail, housing and other loans have been taken at 49 per cent, 17 per cent, 6 per cent and 28 per cent respectively.
According to the RBI, the calibrated EL comes to 1.37 per cent, which would mean taking the annual provision charge to profit-and-loss at 1.37 per cent of gross advances, while it has remained at around 1.04 per cent during 2003-10. To avoid excessive provisioning and maintain a minimum balance of dynamic provisioning, the RBI has also proposed a cap and a floor. Also, the RBI should specifically approve the draw-down from dynamic provisioning to absorb losses.
Banks capable of calibrating their own parameters have been allowed to introduce dynamic provisioning using the prescribed model with prior approval of the RBI, while other banks have to use the standardised calibration.
The introduction of dynamic provisioning is a step towards financial stability of banks in India, as it would reduce profit-and-loss volatility. However, data availability is a challenge. Henceforth, banks have to devise systems to collect the data required for calibration. In the long term, systematic and robust implementation of dynamic provisioning would help Indian banks maintain healthy balance sheets sustainably.
Shrenik Baid is Partner, Price Waterhouse & Co