RBI’s ECL & risk-weight norms will help banks avoid capital shock

The RBI has released two draft circulars, including Expected Credit Loss provisioning norms, effective FY28 and risk weight modification across asset classes. These guidelines will ensure smooth transition for banks.

The ECL implementation is gradual, with negligible impact on capital ratios, but some upfront earnings impact. Experts have marginally revised estimates upward. The capital framework provides a marginal release in residential real estate and MSME loans while tightening commercial real estate.

Kotak expects a smooth transition on ECL, ending a decade of anticipation on the impact of these guidelines.

The first guideline mandates a standardized approach for credit risk, detailing risk weights for various asset classes and credit risk mitigation techniques. The second guideline replaces incurred-loss provisioning with ECL, requiring banks to assess credit risk in three stages and provision based on probability-weighted scenarios.

There is likely to be thenegligible impact on capital adequacy ratios as the shortfall is not being observed as a charge to CET-1 (gradual phasing). However, it does appear that banks would have to take the impact upfront on earnings. Lenders have been given adequate time to transition, as it will be fully effective from FY31.

The overall impact would still be 10-60 bps of loans and 1-5 per cent on net worth, which means a negligible increase over analysts’ earlier assumptions. In fact, their estimates have been revised upward marginally for the floor on select subcategories, while they have not released higher provisions made in other segments even where the floor of these provisions is lower than their current estimates.

During transition, banks can release existing provisions, including Stage 3, which may allow reversals for public banks with high coverage ratios. This has been an area of concern for investors, but there is clarity in the draft guidelines.

The guidelines prescribe floors across retail, agriculture and corporate loans. The floors for Stage 1 and 2 provisions appear to be lower than desired, as they may not fully capture the risk of ECL requirements for short-duration assets. To reduce pro-cyclicality and ensure adequate credit flow during downturns, experts would ideally prefer lenders having significantly higher Stage 1 and 2 provisions. The lookback period of five years reduces uncertainty.

The draft guidelines on risk weights have a few key differences. First, residential mortgages now have more granular risk weights based on loan-to-value and loan count, say 20-60 per cent, with higher weights for third and subsequent loans, compared to the earlier 35-75 per cent range. Risk weights on BBB-rated corporates are reduced to 75 per cent from the currently existing mark of 100 per cent. Commercial real estate exposures see higher risk weights for riskier segments, which may go up to 150 per cent.

The five-year transition period is intended to help banks avoid any sudden capital shock for lenders.

Besides. the step is set to provide a multi-year glide path for implementation, balancing prudential strengthening with financial stability.