ECL approach will help banks address risk factors pragmatically

In a sound decision, the Reserve Bank of India (RBI) issued a discussion paper themed “Introduction of Expected Credit Loss Framework for Provisioning by Banks” on January 16. It sought feedback from banks on various questions raised therein.

Banks are always exposed to credit risks and market risks with the former being of primal importance, which stem from default risk.

The standard approaches to regulate capital require banks to classify their credit risks into two categories- expected losses and unexpected losses. While expected losses are taken into account at the time of sanctioning loans, in the case of the latter, the loan provisioning would not have taken into account such unexpected credit loss, which can adversely impact the bank’s capital.

Currently, all banks are required to make prudential provisions in accordance with the income recognition norms as prescribed by RBI on the ‘incurred loss’ approach with the loan asset becoming an NPA. This means that banks are required to make specific provisions towards such assets when the loss in terms of non-performing has already happened and the amounts are overdue for more than 90 days. It is also possible that the concerned loan asset has been showing irregularities or delays in payment or signs of sickness for some time. It will be considered as non-performing only when the due amount has remained pending for more than 90 days. Ideally, as a precautionary measure, banks should consider providing provisions when the borrowers face financial difficulties.

Special Mention Accounts are those assets that show symptoms of bad asset quality in the period of 90 days before it is classified NPA. The classification of Special Mention Accounts (SMA) was introduced by the RBI in 2014, to identify those accounts that are potential NPAs or ‘Stressed Asset’.

RBI’s discussion paper aims to provide for expected Credit Loss based on forward looking estimates rather than wait for suffering credit losses before making any corresponding provisions. In periods of financial crisis like global financial crisis in 2007-09 or severe economic downward periods affecting the real economy, when credit defaults increase substantially and the loan provisions made on loss incurred approach will not be sufficient to meet such unexpected severe credit defaults. They will dent the bank’s capital and they will not be able to raise capital due to the severe market situation.

It is therefore felt by G20 and Basel Committee on Banking Supervision to recommend standard accounting setters to modify the provisioning practices by incorporating a more forward looking approach rather than to require the losses to happen before recognising the same.

According to RBI “to further enhance the resilience of the banking system, RBI proposes to amend the prudential regulations governing loan loss provisioning by banks to incorporate the more forward looking expected credit losses approach as against the extant “incurred loss” approach”.

Expected Credit Loss approach dovetails the probability of weighted estimates of the present value of all cash shortfalls from an instrument. The cash shortfalls are discounted cash flows for this purpose. Any delay in payment, even if not an actual shortfall in amount of payment, will also give rise to expected credit losses.

Currently, global uncertainties are much in terms of economic growth due to inflation control and geopolitical reasons.

In the Indian context, even though our economy is better placed than others, the risks to economy cannot be totally avoided and we have to vigilant and take proactive steps to avoid such economic crises. Thanks to the government’s pro-active measures, India could sustain the growth momentum while the future looks brighter than other countries. It is also glad to note that Indian financial system is strong and resilient with adequate capital cushion, low gross NPA and net NPA ratios and substantial provisions coverage. This is the right time for the regulator to introduce Expected Credit Approach. Banks are better equipped to absorb the impact of incremental loan losses with buffer capital. Banks should continuously aim at raising capital whenever an opportunity presents itself than waiting for the actual need for capital. Currently, bank’s credit growth started to show growth of 16 /17 per cent and it is expected that in view of the low credit to GDP ratio of India, there is a need for further deepening of credit and in view of strong infrastructure growth of the government, the need for bank credit will grow. While focusing on enhancing resources growth I mean deposits growth, capital enhancements will be the need of the hour. The RBI has made applicable Expected Credit Loss approach for NBFCs and it now proposes to go in for the ECL approach for prescribing guidelines for loss provisioning by banks.

Expected Credit Loss approach for credit impairment is an integral part of IFRS. In the case of IFRS, the guidelines pertaining to impairment in financial instruments are dealt with IFRS 9 (Financial instruments). In the case of US GAAP, the modification related to impairment in financial instruments is dealt with in Topic 326 Financial Instruments- Credit Losses.

Looking into the applicability of the above two IASB and USGAAP and FASB, the RBI feels that IFRS 9 adopts a more principle-based approach towards estimation of expected credit losses. It is also the widely accepted framework internationally.

Considering the vitality of adequate loan loss provisions from a prudential perspective, management discretion for making such estimates cannot be unfettered. Therefore, the proposed approach for introducing expected credit loss based provisioning by banks would be to formulate principle based guidelines supplemented by regulatory backstops wherever felt necessary, RBI adds.

There are reports that the ECL approach when implemented will necessarily require banks to make large provisions would necessitate raising capital requirements.

All banks I hope would have already assessed their inherent strength and need to strengthen their risk models to make futuristic loan loss provisioning under ECL approach. Even though RBI is expected to provide a cushion period to absorb the incremental provisioning, each bank, depending on their current position of strength, can opt for full implementation without a transitional arrangement. Under the ECL approach, the onus will be on the Board of Directors and senior managers to ensure robust credit risk management and an effective internal control.

In fact, banks have in the recent past have worked well in this area and strengthened their risk policies, risk practices and internal control and monitoring. This will come in handy while handling the ECL approach as per the regulator’s guidelines and expectations.

(The author is former Chairman & Managing Director of Indian Overseas Bank)