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Banks will be allowed to design own credit loss models and spread the higher provisions over a five-year period under a newer system of setting aside money for lending, the RBI proposed on Monday.

The Reserve Bank of India will issue “broad guidance” required to be considered while designing the credit risk models, the RBI said in the paper which is now open for public comments.

“Banks would be allowed to design and implement their own models for measuring expected credit losses for the purpose of estimating loss provisions in line with the proposed principles,” the paper suggests.

At present, banks use the “incurred loss” model for loan provisioning, wherein banks are required to set aside money much later. In September last year, Governor Shaktikanta Das announced that the regulator is mulling a shift to the newer system calling it a “more prudent and forward-looking approach”.

The discussion paper said banks will have to classify financial assets, including primary loans, irrevocable loan commitments, and investments classified as held-to-maturity or available-for-sale, into one of the three categories—Stage 1, Stage 2, and Stage 3, depending upon the assessed credit losses on them.

It adds that the classification will have to be done at the time of initial recognition as well as on each subsequent reporting date, and banks will have to make necessary provisions.

While the RBI proposes to leave it to banks to design the model, there is a list of mitigants concerns relating to model risk and considering the significant variability that may arise, as per the paper.

This will include RBI issuing a “broad guidance” required to be considered while designing the credit risk models, an independent validation to verify whether the models follow the guidance issued by RBI and also a non-exhaustive list of disclosures to be made by banks, the paper said.

In order to enable a seamless transition, as permitted under the Basel guidelines, banks shall be provided an option to phase out the effect of increased provisions on Common Equity Tier I capital, over a maximum period of five years, it proposes.

There have been concerns about the drain on the capital base because of the transition to the newer system.

It is also proposed to implement an expected credit loss approach for loss provisioning to all scheduled commercial banks, excluding regional rural banks.

However, in the case of cooperative banks, it said that a threshold will be decided based on comments.

Apart from that, the discussion paper flagged more critical issues on which a final view shall be taken based on the feedback received as well as comprehensive data analysis. It has asked the public to respond with comments on the proposals by February 28.