Are RBI circulars relevant for ECL computation as per Ind AS 109?
The Reserve Bank of India (RBI) vide its notification dated 12th Nov 2021, has prescribed a revised criteria for classifying NPAs. The question is whether the Reserve Bank of India circulars that prescribe the criteria for classification of loans as non performing should be considered for computation of expected credit loss according to Ind AS 109?
Short answer to this question is ‘NO’, with a caveat as mentioned below.
Expected credit loss (ECL) allowance computed as per Ind AS 109, is principle based. Provisioning as per the regulatory norms (IRACP) are computed as per the Reserve Bank of India circulars giving the methodology for such a computation. This is rule based.
The revised NPA classification criteria does not alter the credit risk of the underlying instrument. ECL is computed based on the impact of credit risk on the collectability of a loan portfolio. The principle-based Ind AS 109 prescribes the guidelines to compute the key components of ECL viz., the probability of default, loss given default and the exposure at default. None of these components change due to the revised NPA classification prescribed by RBI.
However, the regulator has decided to implement the stringent NPA classification criteria due to its wisdom; and perhaps is apprehensive of a larger systemic risk that may be brewing?
Hence in our view, the impact of the revised classification criteria should be considered as a possible ‘outcome’ and appropriate weight should be assigned for this outcome to determine the probability weighted outcome of computing the ECL. In other words one more outcome for ECL should be constructed based on the revised NPA classification criteria and an appropriate weightage should be assigned for this outcome in addition to the regular ECL computation as per the extant model of computing ECL.
NPA classification as per the RBI notification dated 12-Nov-2021
Let us first understand the operative part of the Reserve Bank of India (RBI) notification dated 12th Nov 2021 for the purpose of our discussion.
Upgradation of accounts classified as NPAs
Compliance date: Immediately with effect from 12-Nov-2021
- Some lending institutions upgrade accounts classified as NPAs to ‘standard’ asset category upon payment of only interest overdues, partial overdues, etc.
- Loan accounts classified as NPAs may be upgraded as ‘standard’ asset only if entire arrears of interest and principal are paid by the borrower.
The key takeaway from this notification is that with immediate effect, the provisioning based on IRACP should consider the above paragraph. This means that once a loan account becomes NPA then it will be treated as ‘standard’ only when the entire amount of interest and principal are paid. Drawing an analogy with Ind AS perspective this would mean that once a loan account moves into Stage 3 then it can move only to Stage 1 (zero days dpd), and cannot move back to Stage 2, even when the ‘days past due’ (dpd) falls below 90 days. It is assumed that the classification into Stage 3 is based on the rebuttable presumption of 90 days dpd.
Let us the understand the key points for computation of expected credit loss as per Ind AS 109.
Expected credit losses as per Ind AS 109 (ECL)
ECL is the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (cash shortfalls), discounted at the original effective interest rate.
An entity shall measure expected credit losses of a financial instrument in a way that reflects:
- an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes
- the time value of money
- reasonable and supportable information that is available without undue cost or effort at the reporting date about past events, current conditions and forecasts of future economic conditions
Expected Credit Loss is defined as the weighted average of credit losses with the respective risks of a default occurring as the weights. 12-month expected credit losses is defined as the portion of lifetime expected credit losses that represent the expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date.
Recognition of expected credit losses
General approach for loss allowance
As per Ind AS 109 at each reporting date, an entity shall measure the loss allowance for a financial instrument at an amount equal to the lifetime expected credit losses if the credit risk on that financial instrument has increased significantly since initial recognition.
The objective of the impairment requirements is to recognise lifetime expected credit losses for all financial instruments for which there have been significant increases in credit risk since initial recognition – whether assessed on an individual or collective basis – considering all reasonable and supportable information, including that which is forward-looking.
At the reporting date, if the credit risk on a financial instrument has not increased significantly since initial recognition, an entity shall measure the loss allowance for that financial instrument at an amount equal to 12-month expected credit losses.
An entity shall recognise in profit or loss, as an impairment gain or loss, the amount of expected credit losses or reversals that is required to be recognised as per Ind AS 109.
Determining significant increases in credit risk
At each reporting date, an entity shall assess whether the credit risk on a financial instrument has increased significantly since initial recognition.
If reasonable forward-looking information is available without undue cost or effort, an entity should not rely solely on past due information to determine whether credit risk has increased significantly since initial recognition.
An entity may use past due information to determine whether there have been significant increases in credit risk since initial recognition when forward-looking information is not available without undue cost or effort.
There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due.
An entity can rebut this presumption if the entity has available information that demonstrates that the credit risk has not increased significantly since initial recognition even though the contractual payments are more than 30 days past due.
Definition of default
An entity shall apply a consistent default definition that is used for internal credit risk management purposes and also consider qualitative indicators like financial covenants etc., when appropriate.
There is also a rebuttable presumption that default does not occur later than when a financial asset is 90 days past due unless an entity has information to demonstrate that a more lagging default criterion is more appropriate.
The definition of default used for these purposes shall be applied consistently to all financial instruments unless information becomes available that demonstrates that another default definition is more appropriate for a particular financial instrument.
The purpose of estimating expected credit losses is neither to estimate a worst-case scenario nor to estimate the best-case scenario. Instead, an estimate of expected Credit losses shall always reflect the possibility that a credit loss occurs and the possibility that no credit loss occurs even if the most likely outcome is no credit loss.
The estimate of expected credit losses should reflect an unbiased and probability-weighted amount that is determined by evaluating a range of possible outcomes.
In some situations, the identification of scenarios that specify the amount and timing of the cash flows for particular outcomes and the estimated probability of those outcomes will probably be needed. In those situations, the expected credit losses shall reflect at least two outcomes.
Relevance of RBI circulars/guidelines
The RBI comes out with periodic circulars/notifications/guidelines to regulate the way the provisioning for credit losses are to be computed. The following table also needs to be considered:
ECL computation at a high level as per Ind AS 109:
ECL represents the present value of cash short falls:
- EIR is effective interest rate as per Ind AS 109
- Cash short falls = Contractual cash flows less expected cash flows
- Exposure at Default = Principal outstanding plus interest outstanding
- Probability of default = multiple ways to calculate the same
- Loss Given Default = (1- recovery rate)
- Recovery rate = (Collateral – haircut) / Exposure
ECL as per Model Scenarios are calculated as follows:
ECL as per COVID Scenarios are calculated as follows:
The probability weighted outcome of regular and COVID scenarios are as follows:
The probability weighted outcome of (regular + COVID scenarios) and RBI adjusted scenarios are as follows: