Opinion

Assessing credit risk

Mohan R Lavi | Updated on: Jun 23, 2022
‘Expected credit loss’ is a forward-looking approach that will result in more timely recognition of credit losses

‘Expected credit loss’ is a forward-looking approach that will result in more timely recognition of credit losses | Photo Credit: sakhorn38

‘Expected credit loss’ model will serve banks well

In a recent statement, a Deputy Governor of Reserve Bank of India stated that the central bank is contemplating mandating that banks transition to the expected credit loss (ECL) model for loan-loss provisioning instead of the incurred credit loss (ICL) model currently being followed.

The ECL model is one of the requirements of Ind AS (Indian Accounting Standards) that banks are yet to adopt. If banks move to the ECL impairment framework, they will be required to recognise ECLs at all times, taking into account past events, current conditions and forecast information, and update the amount of ECLs recognised at each reporting date to reflect changes in an asset’s credit risk.

Forward looking

ECL is a forward-looking approach and will result in more timely recognition of credit losses — the amount of losses recognised are also expected to be higher. As a next step, the RBI is expected to issue a discussion paper on this. As far back as 2015, the RBI had set up a working group to discuss the impact of Ind AS on provisioning. The main recommendation of the group was that the prudential norms issued by the RBI should be the bare minimum that banks should provide for. In case banks are of the opinion that a provisioning higher than the prudential norms is required, they can fall back on the ECL model.

Since nothing significant has changed between 2015 and today in terms of the accounting standard on financial instruments, it is expected that the discussion paper would toe the line of recommendations made by the working group. Implementation of Ind AS would impact the core of the financial statements of any bank or financial institution — loan-loss provisioning and accounting for most of their treasury operations at fair value. Globally, banks have implemented ECL models taking into account forward looking economic scenarios and their likelihoods, customer risk ratings (CRRs), and probability of defaults and the recoverability of credit impaired wholesale exposures. The modelling methodologies are developed using historical experience, which can result in limitations in their reliability to appropriately estimate ECL. These are often addressed with adjustments, which are inherently judgmental and subject to estimation uncertainty.

Covid-19 has impacted economic factors such as GDP and unemployment, and consequently the extent and timing of customer defaults. These factors have increased the uncertainty around judgments made in determining the severity and likelihood of macroeconomic variable forecasts used in ECL models.

Managements have made significant adjustments to ECL to address these limitations through ‘management overrides’, which are mathematical estimates. The determination of CRRs is based on quantitative scorecards, with qualitative adjustments for relevant factors.

The RBI did not mandate banks to transition to Ind AS since amendments had to be made to the Banking Regulation Act (including the format of the Ind AS financial statements). In addition, the RBI wanted to give banks some breathing time to beef up their balance-sheets so that they are prepared for the impact of Ind AS.

However, the pandemic has derailed all plans, forcing the RBI to announce moratoriums and restructuring packages. Instead of pushing Ind AS upon banks and financial institutions in instalments, the RBI should mandate outright transition to Ind AS. Banks will face some impact on transition, but it cannot be worse than it has been for smaller listed companies. The impact of Ind AS may also hasten consolidation in the banking sector.

The writer is a chartered accountant

Published on June 23, 2022
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