A profit drag is coming for banks. What investors must know

Summary: A major change is coming to how banks deal with bad loans—one that could affect profits, valuations and the way investors look at banking stocks. The RBI’s new norms promise stronger safeguards, but not without short-term challenges. Here’s what’s changing and why it matters.

The Reserve Bank of India (RBI) has released a draft proposal that could significantly change how banks recognise and provide for bad loans. These new rules are not final yet, but if implemented, they will reshape how banks report profits, manage risk and necessitate investors to change the way they analyse banking stocks. To put it simply: banks will need to start preparing for losses much earlier than they do today.

Existing norms for loan provisioning

At the moment, banks generally make large provisions only after a loan becomes a non-performing asset (NPA)—meaning the borrower has stopped paying for more than 90 days. Until that point, provisioning tends to be relatively small and varies from bank to bank based on internal policies.

This means the current system is reactive. Banks wait for trouble to clearly surface before absorbing the impact. When loans finally turn bad, the financial hit can be sudden and large, often surprising both investors and depositors. We have seen this happen repeatedly in past credit crises where bad news arrived all at once.

The new norms and how they will work

To change this approach, the RBI has proposed a move to the Expected Credit Loss (ECL) framework. Under ECL, banks will need to estimate potential future losses based on risk models and begin providing for them in advance, even while loans are still performing.

To do this in a structured way, every loan will now be classified into one of three stages:

• Stage 1 covers loans that are completely healthy. Borrowers are paying on time, and there are no warning signs. Banks will still need to make a small provision here, based on the possibility that something could go wrong over the next 12 months. The important change is that provisioning begins from day one, not after trouble appears.
• Stage 2 includes loans where early signs of stress have emerged, for example, if payments have been delayed by 30–60 days, or the borrower’s financials are weakening. In this stage, provisioning rises sharply because banks must now provide for expected losses over the entire remaining life of the loan.
• Stage 3 consists of loans already in serious trouble, which we currently know as NPAs. These loans require very high provisions, sometimes close to full recognition of expected losses, similar to today, but more strictly calculated.

Put simply, the old approach opened the umbrella only after the rain started. The new one asks banks to carry it from the beginning. The new norms are expected to be implemented starting April 2027, with a phased rollout to ensure a smooth transition.

Likely impact on bank earnings

In the short term, the overall financial profile may take a hit. As banks start providing earlier, profitability will likely dip, returns on equity (ROE) could compress, and capital ratios may soften. Banks with weaker loan books could feel the impact more strongly, and their stocks could see greater volatility.

Over the long term, however, this is a positive change. Recognising problems early should lead to fewer unpleasant surprises like IL&FS, DHFL or Yes Bank. Losses will be absorbed gradually rather than in sudden shocks. Transparency improves, investor confidence strengthens, and the financial system becomes safer and more stable.

What should investors watch now?

The focus will shift from headline NPA numbers to the quality of the loan book before loans turn bad. Stage 2 movement—loans slipping into early stress—will become a key indicator of risk. Provision coverage and capital buffers will gain more importance than aggressive loan growth. And disciplined lenders will be rewarded over time.

The new ECL norms represent a shift from a reactive provisioning model to a proactive, forward-looking approach. The adjustment may cause short-term earnings pressure, but the long-term outcome is a banking system that is stronger, more reliable and more transparent. For long-term investors, that is a welcome direction and a reminder to stick with banks that prioritise quality and resilience over rapid expansion.

Which banks can weather the profit drag?

At Value Research Stock Advisor, our bank stock recommendations are carefully selected to weather changes like the new RBI provisioning norms. We focus on lenders with strong balance sheets, disciplined lending, and resilient earnings, so you can navigate profit pressures with confidence. Stay ahead of market surprises and invest in banks built to endure the next wave of changes.

Find them here