RBI Proposes To Bring Expected Credit Loss Accounting For Banks

The Reserve Bank of India on Monday proposed the first step in bringing domestic banks into the Indian Accounting Standards.

The regulator introduced a discussion paper discussing the nuances of the expected credit loss mechanism of account for stressed accounts for local banks.

Ind AS is the local version of the International Financial Reporting Standards. Expected credit loss approach for credit impairment is an integral part of the IFRS issued by International Accounting Standard Board and the U.S. Generally Accepted Accounting Principles issued by the Financial Accounting Standards Board of the United States.

The paper has proposed implementation of the expected credit loss mechanism across all scheduled commercial banks, except regional rural banks. Non-bank finance companies and housing finance companies already report figures under the expected credit loss mechanism.

Simply put, the expected credit loss mechanism monitors the estimated credit losses for the lifetime of an asset extended by a bank. On the reporting date, such estimates are compared with the actual credit losses from the asset.

Assets for Indian banks will comprise loans and advances including irrevocable loan commitments, lease receivables, irrevocable financial guarantee contracts, and investments classified as held-to-maturity or available-for-sale.

In case the risk of default on the asset increases significantly, banks will have to set aside a loss allowance, or provision, equivalent to the estimated lifetime credit losses.

"The adoption of an expected credit loss approach to loss provisioning will require a fundamental modification to the way financial assets and income from the assets are currently measured and accounted for by banks," the RBI said in its discussion paper.

Currently, Indian banks follow an incurred loss approach, where they provide for a loan after the borrower has remained in default for over 90 days. The current income recognition and asset classification norms of the RBI prescribe a time-based increment in provisions.

Three-Tiered Asset Classification

Under the expected credit loss mechanism, banks have to classify assets under three broad categories.

Stage 1: Includes financial assets that have not had significant increase in credit risk since initial recognition or that have low credit risk at the reporting date.

Stage 2: Includes financial instruments that have had a significant increase in credit risk since initial recognition, but that do not have objective evidence of impairment.

Stage 3: Includes financial assets that have objective evidence of impairment at the reporting date, or in other words, are in default.

In the event of a default being cured, the paper proposes that assets should not be immediately moved from Stage 3 to Stage 1.

Instead, the paper says, banks must keep a Stage 3 asset in Stage 2 for at least six months, after the defaults are rectified. Only after this period will the asset be allowed to move to Stage 1.

The regulator has also proposed a step-up prescription on loan loss provisioning against these assets. The provisioning requirement will be detailed in a draft paper, which will come after considering feedback to the discussion paper.

Avoiding A Capital Shock

Since the expected credit loss norms will likely have a large impact on provisions made by banks, the RBI in its discussion paper has proposed a transitional arrangement.

Under this arrangement, any difference between the provisions under expected credit loss and the existing asset classification norms, net of taxes, may be allowed to be added back to the common equity tier 1 capital of the bank.

The benefits of such an arrangement would be phased out over five years, the regulator has proposed.

"The primary objective of such a transitional arrangement is to avoid a “capital shock” by giving banks time to rebuild their capital resources following a probable negative impact arising from the introduction of ECL accounting," the RBI said.

The RBI has sought feedback on its discussion paper, which are expected to be submitted by Feb. 28.