Arjun Singh Rathore
The concept of Expected Credit Loss (ECL) is not new. It was floated in April 2018 as a part of Indian Accounting Standard (Ind-AS). But Ind-AS was deferred, mainly on account of the fact that the banking system was not prepared to implement it at that point of time. The ECL framework also suffers from a weakness. It aims to reckon the loss (on account of a particular loan) by finding the probability of default (PD) based on historical behaviour, whereas in reality the servicing pattern of a loan is not uniform throughout its currency and is bound to move for better or worse depending upon the borrower’s cash flow.
On January 16, 2023, the RBI released the ‘Discussion Paper (DP) on Introduction of ECL Framework for Provisioning by Banks’. The DP proposes adoption of an expected loss framework. As per RBI guidelines on Ind-AS 109, it is worthwhile to move towards a robust Expected Credit Loss (ECL) provisioning methodology from the existing Incurred Loss Provisioning method.The global financial crisis (GFC) in 2008 exemplified the weaknesses in the current accounting standards and practice (IAS 39 Financial Instruments), which adopts the incurred loss model for impairment of financial assets. The challenge with the incurred loss model is that impairment losses and the resulting write-downs in the reported value of financial assets can only be recognized when there is evidence that they exist (i.e. have been incurred). Post GFC 2008, at the request of the G20 and the Financial Stability Board, the International Accounting Standard Board (IASB) stepped up its work to replace IAS 39. In July 2014, the IASB introduced the International Financial Reporting Standard (IFRS) 9.
The Indian Accounting Standard (Ind-AS) is converged with the IFRS. It is the accounting standard adopted by companies in India and issued under the supervision of the Accounting Standard Board (ASB). Accordingly, Ind-AS 109 is converged with IFRS9.
Ind-AS 109 lays out the guidelines for accounting based on the expected credit loss model. The objective of this standard is to establish reporting principles that will present relevant and useful information to users of financial statements for the assessment of the amount, timings and uncertainty of the entity’s future cash flows. This standard will have an impact on the measuring and accounting of credit losses, which means that the risk and finance team of an organization needs to collaborate with the IT department for implementation and complying with Ind-AS 109 standards.
To ascertain the applicability of the impairment calculation, an entity needs to classify its financial instruments into amortized cost, fair value through other comprehensive income (FVOCI) and fair value through P&L (FVTPL). Instruments classified as amortized cost and FVOCI are subject to the Ind-AS 109 impairment calculation. The standard requires banks to assess credit risk on the financial instruments to ascertain if there is an increase in risk on the reporting date as compared to the date of initial recognition. The standard also requires banks to assess their portfolio and determine the criteria for stage determination depending on the portfolio risk characteristics. There are certain rebuttable presumptions provided by the standard such as, 30 days past due (DPD) for classifying an asset into Stage-2 and default should not occur later than when a financial asset is 90 days past due. Per Ind-AS 109 standards, an entity can refute this presumption if it has reasonable information that is available without undue cost or effort, and demonstrates that risk has not increased significantly since initial recognition.
The 12-month or lifetime Expected Credit Loss (ECL) is computed and accounted for based on whether the financial instrument is classified as Stage 1 or 2/3. The components that are crucial to calculate ECL include – Exposure at Default (EAD), Probability of Default (PD), Loss Given Default (LGD), and discount rate. These models are expected to be validated at least once in a year or at a more frequent interval; if required.
ECLs are further classified into (i) lifetime ECLs and (ii) 12-month ECL. The former are those that result from all possible default events over the expected life of a financial instrument. The latter are those that result from default events that are possible within 12 months after the reporting date.
Once the three functions (EAD, PD and LGD) are determined, the ECL is calculated as EAD x PD x LGD. The calculation can be either for 12 months or based on the lifetime of the financial asset.
Setting aside the pluses/minuses of this concept (as it is too early to discuss at this stage), the moot question is: Does the RBI think that our banks are geared up for moving to the ECL framework?
Curiously enough, as per the extant guidelines of the RBI, banks are now required to make provision for non-performing assets at 15-100 per cent of the outstanding balances depending upon the status of overdue position – that is, sub-standard/doubtful or loss, besides 0.15-1 per cent for all “standard assets”. In a way, this provision made by banks for these performing assets is also meant to meet the ‘deemed credit loss’.
Coming to the decision with regard to ECL, it is to be borne in mind that only now banks are showing an uptrend in their business growth after the ravage caused by the pandemic.
Bank credit grew by 15 per cent year-on-year in the fiscal ended March 2023 due to low base of last year and higher demand for funds as economic activity picked up. Bank advances rose to Rs 136.75 lakh crore as on March 24, 2023 from Rs 118.91 lakh crore as on March 25, 2022, according to the provisional data released by the Reserve Bank of India (RBI) on Wednesday. Bank advances grew at 9.6 per cent in FY 2021-22; 5.6 per cent in FY 2020-21 and 6.1 per cent in FY 2019-20. Business enterprises, particularly MSMEs which reached a nadir during Covid times, are now showing significant signs of revival thanks to the huge funding by banks. The economy is back on the rails now, and it is the right time for banks to ensure steady credit growth, making use of the flourishing business opportunities.
At this juncture, introduction of ECL, which will be complex in structure, will not only divert the focus of banks on rapidly redeeming their business but will also affect their bottom-line, which is becoming steady now.
The RBI’s Financial Stability Report (FSR), of December 2022, reveals that the RBI will not have any apprehension over the adequacy of the existing provisioning norms or of any capital erosion in banks in the long run. The Risk Management Department of all banks is proactively undertaking stress tests of their loan books under different scenarios to check how far their CRAR (capital to risk weighted assets ratio) gets impaired.
Also, credit sensitivity analysis is also being done by the RBI on a different scale. The recent FSR says that a severe stress test of the credit portfolio of 46 select banks (where perhaps the GNPA ratios are not comfortable), by applying 2 SD (standard deviation) shock, showed that the GNPA ratio moved up from 6 per cent to 11.5 per cent and the CRAR declined from 16.5 per cent to 12.6 per cent, that is still a solid 3.6 per cent over the prescribed level of 9 per cent.
Further, real time marking of NPAs is being religiously done by all banks subsequent to the RBI circular issued in September 2021. To spot the stress in loans before they actually become bad, the status of overdue position is captured under three levels, Special Mention Account (SMA) 0, SMA 1 and SMA 2 and timely steps are taken by banks to put them on the right track.
At a time when we are witnessing an uptick in the performance of banks after the Covid disaster, it is a bold step to change the existing provisioning framework, a crucial factor which will determine the net profit of banks.
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