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.