The RBI, on April 27, released final directions related to how banks classify assets, how lenders provision for it as well as the income recognition part.
Until now, banks were following the incurred loss approach in recognition of bad loans.
The Reserve Bank of India on April 27 released final directions related to how banks classify assets, how do the lenders provision for it as well as the income recognition part. The RBI had first issued draft norms on it back in October 2025. Following the feedback received on the draft directions, it has now come out with its final directions.
What are the key directives?
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The extant norms for classification of non-performing assets (NPAs) have been retained. However, now a new expected credit loss (ECL) approach has been introduced. So, the central bank is now adopting a forward-looking provisioning approach under the ECL framework.
Furthermore, a staging framework has now been introduced for asset classification. An effective interest rate (EIR) method will also be part of the new directives. EIR is the rate that exactly discounts estimated future cash flows through the expected life of the instrument to the gross carrying amount of a financial asset.
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Why have the new norms been introduced?
These directions are intended to further strengthen credit risk management practices, improve comparability across regulated entities, and align the regulatory framework more closely with internationally accepted financial reporting principles.
These new directions bring transparency on how a lender is recognising bad loans. This could also lead to banks anticipating stress earlier, rather than waiting for a default to happen.
Expected Credit Loss approach and how it’s different from existing norms
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Expected credit loss means the weighted average of credit losses under different scenarios with the respective probability of the various scenarios as the weights.
Until now, banks have been following the incurred loss approach in recognition of bad loans. In a way, losses were being recognised only when a default happened. Under the new ECL approach, a lender must basically now look at the future to estimate what the losses could be. A bank will have to build enough buffers looking at the likely losses that the asset is likely to incur.
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Staging process
A bank shall recognise loss allowance under the ECL framework using a three-stage approach, based on changes in credit risk since initial recognition, and on whether the asset is credit-impaired at the reporting date.
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A financial instrument shall be classified under Stage 1, where it has not experienced a significant increase in credit risk since initial recognition or where it is determined to have low credit risk.
A financial instrument shall be classified under Stage 2, in case it has experienced a significant increase in credit risk since initial recognition, but it is not yet considered to be credit impaired.
A financial instrument shall be classified under Stage 3, where it is considered to be credit impaired as at the reporting date.
At each reporting date, a lender will have to assess whether the credit risk on the financial instrument has increased significantly since initial recognition.
Will it impact bank’s balance sheet?
Banking stocks were under pressure on Tuesday, with several banks such as Union Bank, Axis Bank, Bank of Baroda, Canara Bank, IDFC First Bank, Punjab National and State Bank of India among others declining 2-3%, while the broader market was down about 0.5%.
“The decline followed the RBI’s confirmation of its expected credit loss framework and final asset classification norms, which raised concerns regarding higher provisioning requirements,” said analysts at Bajaj Broking.
Implementation of the ECL norms will result in higher upfront provisioning, especially in unsecured retail, micro, small and medium enterprises and corporate exposures. The impact on public sector and mid-tier banks will be higher, said analysts at Nomura.
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The large private sector banks are likely to be better placed as the transaction impact would be lower, given provision buffers of 2-4% of net worth, they added.
PSU banks generally hold lower additional provisions and they will have to increase that, say analysts.
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