Optimising Credit Risk Management: An In-Depth Exploration of the Expected Credit Loss Framework for Effective Credit Loss Provisioning

Abstract

The banking sector in India currently relies on the incurred loss approach (ILA) for provisioning non-performing assets (NPAs), wherein credit losses are recognised only upon the occurrence of a loss event. While widely adopted, this reactive approach suffers from significant limitations, including delayed recognition of losses, inadequate early warning indicators, procyclicality, and the absence of forward-looking insights. These shortcomings impede effective risk management and highlight disparities with globally accepted standards. To address these gaps, the Reserve Bank of India (RBI) has proposed a transformative shift to the expected credit loss (ECL) framework, as outlined in its discussion paper. The ECL approach introduces a forward-looking, proactive provisioning methodology based on a three-stage model for categorising loans and advances. By emphasising early loss recognition and aligning with international best practices, this framework aims to enhance the resilience and stability of the banking system. This paper critically examines the limitations of the ILA and provides a comprehensive analysis of the ECL framework. It underscores the potential of the ECL approach to revolutionise credit risk management (CRM) in India, offering insights into its benefits, implementation challenges, and implications for the financial ecosystem.

Keywords: Banking Resilience, Credit Risk Management, Expected Credit Loss (ECL) Framework, Incurred Loss Approach (ILA), Non-Performing Assets (NPAS), Proactive Provisioning

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