Dynamic Provisioning: The Basel II Framework is approaching dynamic provisioning by clearly requiring banks to separately measure EL(Expected Loss) and UL(Unexpected Loss). EL-based provisioning has forward-looking element as it is capable of incorporating through the cycle view of probability of default. The recent financial crisis has provided a still further fillip to the search for a forward-looking provisioning approach due to pro-cyclical considerations.
Inadequacy of the Current Provisioning Policy in India: In normal provisioning policies, specific provisions are made ex-post based on some estimation of the level of impairment. The general provisions are normally made ex-ante as determined by regulatory authorities or bank management based on their subjective judgment. While such a policy for making specific provisions is pro-cyclical, that for general provisions does not lay down objective rules for utilization thereof. Indian banks make the following types of loan loss provisions at present:
- General provisions for standard assets,
- Specific provisions for NPAs,
- Floating provisions,
- Provisions against the diminution in the fair value of a restructured asset.
The present provisioning policy has the following drawbacks:
- The rate of standard asset provisions has not been determined based on any scientific analysis or credit loss history of Indian banks.
- Banks make floating provisions at their own will without any pre-determined rules and not all banks make floating provisions. It makes inter-bank comparison difficult.
- This provisioning framework does not have countercyclical or cycle smoothening elements. Though RBI has been following a policy of countercyclical variation of standard asset provisioning rates, the methodology has been largely based on current available data and judgment, rather than on an analysis of credit cycles and loss history.
- Provisioning is done based on the NPA recognition and not on the expected loss principle.
Thus banks profitability factors actual credit losses and not the expected loss. As a result, in boom time banks profits are higher both due to better business as well as lower credit losses. However during recession, banks profitability get affected both on account of lower business activity and higher credit losses. This phenomenon is called ‘Procyclicality”.
The Role of Dynamic Provisioning
- In view of the above, there is a need for introducing a comprehensive provisioning framework for banks in India with dynamic and countercyclical elements. The fundamental principle underpinning dynamic provisioning is that provisions are set against loans outstanding in each financial year in line with an estimate of long-run, expected loss. Thus the banks’ income would no longer be measured net of actual losses, but net of contributions to the expected loss provision.
- Dynamic provisioning would build up a buffer (reserve) to cover expected credit loss from the time a loan is taken on. The reserve would build up in any year in which actual losses fell short of expected losses, while in years in which losses exceeded the expected level, the reserve would be drawn down. However, if a bank made a credit loss that was greater than the accumulated dynamic provision, then the excess would be charged directly to the profit and loss account
- Dynamic Provisions are cumulative buffers to handle counter-cyclical impacts during recession when banks profitability get affected both on account of lower business activity and higher credit losses and there is difficulty in raising additional capital during recession to support high credit losses.
- During good times — DP is positive as EL is > SP
- During bad times — DP is negative as EL is < SP
- DP = Expected loss provision — Specific provision(incurred losses)
Thus, Dynamic Provisioning is created when SP(Specific Provision) is less than EL(Expected Loss) and vice versa. Created at good times or boom to be utilized during bad times or bursts in an economic cycle.