Borrowing to get costly with tight dynamic loan loss provisions

Risks from unhedged foreign exchange exposures will also make borrowing expensive

The Reserve Bank of India's (RBI) move to revise dynamic loan loss provisions and increase risk weights and provisions for unhedged foreign exposures of companies may hit banks' profitability and capitalisation.

In all probability, banks may pass on the cost impact to customers. In its monetary and credit policy for 2013-14, RBI said it would issue the final norms (for dynamic loan loss provisioning), including their phased implementation, by the end of June 2013.

Besides concern over adequacy of loan loss provisions, RBI is also worried about the risks from unhedged foreign exchange exposures to themselves and the financial system. RBI has proposed to increase the risk weight and provisioning on such exposures.

The risks are more in times of currency volatility. RBI is unhappy with the current level of preparation to deal with such risks.

According to the top executive of a large public sector bank, the higher provisions and risk weight may increase costs. This will be passed on to the customers by way of increase in their borrowing cost.

Referring to dynamic loan loss provisioning, RBI said it had floated a discussion paper.

It is examining feedback from the stakeholders and is also re-calibrating the various parameters for proposed dynamic provisioning. Dynamic provisioning is a technique that allows banks to build up loan loss provisions when their profits are growing to draw on these provisions during an economic downturn.

The principle behind dynamic provisioning is that amounts should be set aside in line with estimates of long-run or through-the-cycle expected losses.

Banks are prone to business cycles. In good times, demand for credit goes up and banks tend to become aggressive with some easing of credit standards.

Borrowers service the loans in time. Loan loss rates are below the long-run average, and the need for loan loss provisions is less. The provisions are usually under-funded during a boom period, said RBI.

When the business cycle turns and economic conditions deteriorate, borrowers' credit quality tends to worsen.

There is an increase in defaults (in servicing interest and principal payment). Some loans become non-performing assets. Banks' profits go down, but they have to make higher loan loss provisions for bad loans.

On unhedged foreign exchange exposures of corporates, RBI said banks had a system to rigorously evaluate the risks from such exposure and price them in the credit risk premium. They should prescribe limit on the unhedged forex positions of companies. These steps should be strengthened by making corporates to frame risk management policy.

DYNAMICS OF DYNAMIC PROVISIONING

• Dynamic provisioning allows banks to build up loan loss provisions when their profits are up and draw on these provisions during an economic downturn
• RBI has floated a discussion paper on dynamic loan-loss provisioning
• After examining feedback from stakeholders, RBI to issue the final norms for dynamic loan loss provisioning by June
• RBI is worried about the risks from unhedged foreign exchange exposures to themselves and the financial system
• RBI has proposed to increase the risk weight and provisioning on such exposures
• This will make borrowing costly, as banks will pass on the cost impact to customers
• The provisions are usually under-funded during a boom period, said RBI
• On unhedged foreign exchange exposures of corporates, RBI said banks have a system to rigorously evaluate the risks from such exposure and price them in the credit risk premium