Lending business of banks carries an inherent risk – not every loan amount disbursed may be repaid. To protect banks against such risk, central banks globally have stipulated provisioning requirements, thereby creating a financial cushion for such losses. In India, banks are currently required to create provisions only after stress became visible (i.e., usually when there is a default in repayment). This leaves the banks vulnerable to materialization of unexpected losses and decrease in income, which ultimately carries a negative impact on the banking system. Therefore, a need was felt to change this regime and create a forward-looking approach, requiring banks to create preventive provisions before the stress becomes visible.
As a stride in this direction, the Reserve Bank of India (“RBI”), vide its notification dated April 27, 2026 titled Reserve Bank of India (Commercial Banks – Asset Classification, Provisioning and Income Recognition) Directions, 2026 (“New IRACP Directions”), introduced the framework for ‘Expected Credit Loss’ (“ECL Framework”), which is a forward-looking provisioning framework for commercial banks. This is a major regime shift from the extant framework (“Existing IRACP Directions”), whereunder a bank was required to make higher provisions only after a loan exhibited signs of stress. The ECL Framework requires banks to measure financial assets at amortised cost using the effective interest rate (“EIR”) method. The New IRACP Directions (including the ECL Framework) will be effective from April 1, 2027, with an exception for legacy loans, which are required to be brought under the EIR regime by no later than March 31, 2030.
The Existing IRACP Directions classify loans as standard asset or non-performing asset (“NPA”). Further, non-performing loans are categorised as substandard, doubtful and loss assets. Standard assets attract low provisioning requirements, ranging between 0.25% to 1%, depending upon the type of loan. However, once an account has been classified as substandard, the provisioning requirement rises to 15% for secured loans and 25% for unsecured loans.
The ECL Framework has introduced a change in the timing and rationale for provisioning. Banks will be required to estimate the credit losses that may arise in the future rather than waiting for a loss event to occur. The New IRACP Directions also define expected credit loss as the weighted average of credit losses under different scenarios, using the respective probability of those scenarios as weights. Therefore, ECL Framework directs a bank to ascertain the loss expected on a particular loan considering several factors such as the behaviour of the borrower, the underlying collateral, macroeconomic conditions, probability of default and recoveries.
The ECL Framework recognise loss allowance using a three-stage model, which is as under:
(a) Stage 1: It includes those assets which have not experienced a significant increase in credit risk since initial recognition, or it is determined to have low credit risk as per the New ICARP Directions. ECL is calculated based on the outlook of 12-month for such assets.
(b) Stage 2: It includes those assets which have experienced a significant increase in credit risk but is not yet credit impaired. For such assets, ECL is calculated on the outlook of the loan for its entire lifetime.
(c) Stage 3: It includes those assets which are credit impaired. For such assets too, ECL is recognised based on the entire lifetime of the loan.
The ECL Framework makes provisioning more sensitive to early stress warning signals such as deteriorating financials, rating downgrades, sectoral stress, weakening collateral coverage, adverse macroeconomic conditions, delayed payments or classification into internal watch-list categories. Therefore, a loan may be classified as Stage 2 under the ECL Framework (thereby requiring higher provisioning) even before it becomes an NPA (as per the Existing IRACP Directions).
RBI has prescribed product-wise and stage-wise prudential floors (minimum provisioning requirements), which are required to be adhered to by banks. Such floor ranges between 0.25% to 1% for Stage 1, 0.40% to 5% for Stage 2 and 25% to 100% for Stage 3. However, if expected credit losses assessed by the bank’s ECL model are higher than the above floors, then the bank will be required to maintain higher provision.
To ensure that the banks are adhering to the new requirements, the New IRACP Directions require banks to have internal policy and governance frameworks covering all material aspects of the ECL lifecycle. A bank is required to ensure that implementation of the ECL Framework is overseen by its board or any other committee approved by the board comprising of the chief financial officer and chief risk officer of the bank. In addition, banks are required to provide detailed disclosures on credit risk management, assumptions, estimation techniques, changes in ECL allowances and credit-risk concentrations.
In practical terms, the ECL Framework is expected to require banks to monitor loan accounts closely to determine any stress. A borrower with weakening cash flows, repeated delays, rating pressure or adverse sectoral exposure may face tighter covenants, higher pricing, additional collateral demands or earlier restructuring conversations even before they become NPAs.
For implementing the ECL Framework, banks will require better data systems, stronger risk teams and defensible credit models. This is also likely to improve transparency and financial stability within the bank.
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*This article has been co-authored by Nand Gopal Anand, Partner; Harshit Dusad, Partner and Vrindesh Patel, Principal Associate at JSA Advocates & Solicitors.
