Regulation of banks is increasingly becoming inter-temporal in spirit with increasing emphasis on through-the-cycle approach as against the point-in-time approach. Provisioning is one of the regulatory tools available at the disposal of the regulators. Globally, efforts are underway to adopt a forward-looking framework for the application of provisioning. The Reserve Bank had issued a Discussion Paper on dynamic provisioning in March 2012, proposing a methodology for the conduct of dynamic provisions in India (http://rbi.org.in/Scripts/PublicationReportDetails.aspx?ID=660).
Basically, there are two generic models for dynamic provisioning viz., banking models employing banking data; and macro-economic models involving GDP data. This paper belongs to the latter genre. The advantages associated with relying on GDP rather than on credit are: it is empirically found that credit trails GDP. Hence, targeting GDP could tend to be more countercyclical than targeting credit. Further, from an EME’s perspective in general and Indian perspective in particular, credit growth per se need not signal emerging financial imbalances due to structural factors. The paper uses quarterly data for the period of Q1:1996-97 to Q3:2013-14. Based on detailed analysis of Indian business cycles, the paper proposes a model capable of identifying various phases of growth of real output, warranting activation/deactivation of dynamic provisions. For this purpose, a threshold based on average potential output growth rate is determined. Employing the simplest and the most popular method for estimation of potential output, the paper empirically estimates such potential output threshold at 7 per cent.
In back testing the model, the paper finds evidence that the model-based signals for the activation/deactivation of dynamic provisions by and large supported the timing of judgment-based increase or decrease in risk weight(RW)/provisions on the standard assets of certain identified sensitive sectors introduced by the Reserve Bank since December 2004.
* The Reserve Bank of India introduced the RBI Working Papers series in March 2011. These papers present research in progress of the staff members of the Reserve Bank and are disseminated to elicit comments and further debate. The views expressed in these papers are those of authors and not of the Reserve Bank of India. Comments and observations may kindly be forwarded to authors. Citation and use of such papers should take into account its provisional character.