What is RBI Expected Credit Loss (ECL) Model for Indian Banks?

In a major reform move, the Reserve Bank of India (RBI) has proposed adopting the Expected Credit Loss (ECL) framework for loan provisioning — marking a significant shift from the long-followed incurred loss model. This change will apply to Scheduled Commercial Banks (except Small Finance Banks, Payments Banks, and Regional Rural Banks) and All India Financial Institutions.

The objective is to align India’s banking system with international standards such as the US Federal Reserve’s SR 11-7 and the UK’s PRA SS1/23. So far, Indian banks have only been preparing pro-forma ECL statements, but not implementing them in full. The new framework aims to bring a more analytical and forward-looking approach to provisioning. The draft guidelines will be released soon, and the implementation will begin in April 2027, with a gradual transition until March 2031.

The basic idea of banking and why this matters

Banking fundamentally works on a simple model: banks borrow money from depositors by paying them interest and lend it to borrowers at a higher interest rate. The difference forms their profit. However, this profit can quickly disappear when borrowers fail to repay loans. These bad loans, or Non-Performing Assets (NPAs), come with a credit cost, meaning banks have to set aside a portion of their income as a cushion against potential losses. This process is called provisioning. The way banks calculate and record these provisions is crucial — because it affects not only their profits but also their financial stability and investors’ trust.

How provisioning works today: The incurred loss model

Under the current incurred loss system, banks start making provisions only after a loan shows signs of distress. In other words, they wait until the loss actually occurs. Loans are categorized in stages of delay called Special Mention Accounts (SMAs):

• SMA-0: Payment overdue by 0–30 days
• SMA-1: Overdue by 31–60 days
• SMA-2: Overdue by 61–90 days

If a loan remains unpaid for more than 90 days, it is classified as an NPA. At that point, banks make larger provisions. Before that, provisions are minimal — often less than 0.5%. This approach has a key weakness: it is reactive, not predictive. By the time a loan officially turns bad, the bank may already face significant risk. This is why the incurred loss model is often described as “too little, too late.”

The new approach: Expected Credit Loss (ECL)

The proposed ECL framework changes this logic completely. Instead of waiting for a default, banks will now have to anticipate potential losses in advance using statistical and analytical models. The ECL model is built on three key factors:

1. Probability of Default (PD): The likelihood that the borrower will fail to repay.
2. Loss Given Default (LGD): The percentage of the loan likely to be lost if the borrower defaults.
3. Exposure at Default (EAD): The total amount outstanding when the default occurs.

Together, these give the Expected Loss through a simple formula:
Expected Loss = PD × LGD × EAD

This means that even loans currently being repaid on time will have a small provision made against them, depending on the borrower’s risk profile. If a borrower’s credit risk increases, provisions must increase immediately — without waiting for an actual default.

Three stages of risk under ECL

Under the new framework, loans will be classified into three stages based on credit risk:

• Stage 1: Loans performing well, with no significant increase in risk. Banks will provide for 12 months of expected losses.
• Stage 2: Loans that have shown a significant increase in credit risk, even if they are not yet in default. Banks must provide for expected lifetime losses.
• Stage 3: Loans that are already in default or credit-impaired — similar to current NPAs.

This is a major change. Under the old model, loans in early trouble (like SMA-1 or SMA-2) required very small provisions, often below 0.4%. Under ECL, a similar loan might need around 5% provisioning, which is nearly ten times higher.

The challenge: Subjectivity and discretion

While the ECL model strengthens risk recognition, it also brings subjectivity. In the old system, provisioning was formula-based and uniform. Under ECL, each bank will develop its own risk models, estimate default probabilities, and use forward-looking data such as GDP growth, inflation, or sectoral stress.

This gives management more room for judgment — and potentially, manipulation. For example, a bank could assume unrealistically low default probabilities to reduce its provisioning and show higher profits. To counter this, the RBI plans to introduce regulatory backstops — minimum provisioning levels that banks must maintain regardless of their internal estimates. For example, Stage 2 loans must have at least 5% provisions even if a bank’s model suggests lower losses. This ensures consistency and prevents banks from being overly optimistic.

Global experience and significance

Globally, after the 2008 financial crisis, regulators realized that the incurred loss model delayed recognition of problems. This led to the introduction of the IFRS 9 standard internationally and the Current Expected Credit Loss (CECL) model in the United States. Both require early and forward-looking provisioning.

India is now following this global best practice. The timing is right — banks have already cleaned up much of their bad loan burden from previous years and are financially stronger to absorb the initial impact. However, estimates suggest the shift to ECL may cause a one-time hit of around ₹60,000 crore across the Indian banking sector due to higher provisions.

Impact on different stakeholders

• For banks: The ECL model will make banks more resilient and transparent but could temporarily reduce profits as provisions increase.
• For borrowers: Banks may adopt a more cautious approach in lending or slightly raise interest rates to offset the higher risk cost.
• For investors: Financial statements will become more comparable to global peers. This transparency could increase investor confidence and attract more foreign investment into Indian banks.

The bigger picture

The RBI’s move towards ECL marks a major evolution in India’s banking regulation. It represents a shift from reactive to proactive risk management — identifying potential problems before they grow into crises. Implementation, however, will be the real test. Banks will need to strengthen their data systems, modeling capabilities, and internal governance to make this transition successful.

While it may bring short-term challenges, the long-term outcome will likely be a stronger, more transparent, and globally aligned banking system — one that protects both depositors and investors better than before.