Fundamentals of Expected Credit Losses: Loan Classification and Provisioning under IFRS 9 in the Banking Sector of Bangladesh

Expected Credit Loss (ECL) based loan provisioning is an advanced approach to recognizing credit losses in banks and financial institutions. Unlike the traditional incurred loss model, which records losses only when they occur, the ECL model requires banks to estimate potential credit losses in advance, enhancing financial stability and transparency. In Bangladesh, loan classification and provisioning are governed by Bangladesh Bank (BB) through its regulatory circulars. However, the current system follows an incurred loss model rather than the expected credit loss (ECL) model outlined in IFRS 9. International organizations, including the IMF, have expressed concerns over loan classification practices in Bangladesh's banking sector, cited their tendency to understate Non-Performing Loan (NPL) ratios. In response, Bangladesh Bank issued a roadmap for the implementation of ECL-based loan classification and provisioning under IFRS 9, as outlined in BRPD Circular No. 03 dated January 23, 2025. This framework will replace the existing incurred-loss model for loan classification and provisioning by December 2027, with the goal of improving credit risk assessment and the accuracy of financial reporting. This article explores the current loan classification and provisioning practices, highlights their shortcomings, outlines the fundamentals of the Expected Credit Loss (ECL) approach for loan classification and provisioning, discusses potential challenges in implementing ECL-based practices in the Bangladesh banking sector, and suggests possible solutions moving forward.