Three-Stage Asset Classification

The Reserve Bank of India (RBI) has issued new Master Directions, effective 1st April 2027, to tighten the rules governing the classification and recovery of bad loans, to strengthen credit risk management and align the framework with globally accepted standards. 

• Borrower-Level NPA Classification: The most significant change is that if one loan of a borrower with multiple loans is classified as a Non-Performing Asset (NPA), all their loans will now be considered NPAs.
  • The fundamental criterion for NPA classification remains at 90 days overdue.
• Stringent Upgradation Norms: An NPA borrower will only be upgraded to a “standard asset” upon the repayment of the entire arrears of interest and principal across all credit facilities, not just the defaulting one.
• Mandatory Automated Identification: The RBI has directed banks to implement automated systems to identify NPAs, phasing out the older manual tagging processes to ensure accuracy and prevent human intervention.
• Shift to Expected Credit Loss (ECL) Framework: The RBI is replacing the older ‘Incurred Loss’ method with a stricter Expected Credit Loss (ECL) framework.
  • ECL calculates loss allowance across three stages: no/low credit risk, significant increase in credit risk, and credit impaired. This requires banks to provision for potential losses before a loan is 90 days overdue.
• Adoption of Effective Interest Rate (EIR): The RBI has mandated the use of the effective interest rate (EIR) to calculate ECL, replacing the contractual interest rate.
  • EIR estimations will be based on expected cash flows, considering all contractual terms except potential credit loss.

Non-Performing Asset (NPA)

• A NPA is a loan or advance that has stopped generating income for a bank, typically when interest or principal payments remain overdue for more than 90 days.
  • Gross NPAs represent the total value of such defaulted loans, while Net NPAs are the actual burden after deducting provisions made by banks.
  • RBI’s Trends and Progress report shows banks’ asset quality improved, with gross NPAs down to 2.1% by September 2025 and net NPAs at 0.5%.
• A Bad Bank is a specialized financial institution created to purchase these NPAs from banks, thereby reducing their financial stress and enabling them to resume normal lending.
  • It may later restructure or sell these bad loans to investors, with the primary aim of cleaning bank balance sheets rather than making profits.