Breaking down RBI’s Move to Expected Credit Loss

Editor – Munmun Bose

Framework: What is it & why it matters?

If you read the news, you might have seen the headline stating the Reserve Bank of India’s (RBI’s) plan to draw up a road map for Expected Credit Loss (ECL) adoption. In this article, I will break down the ECL framework, the existing method, and why RBI is planning to move to the ECL framework.

Introduction

In case you do not know already, on Thursday, November 14, at CNBC-TV18’s Global Leadership Summit, RBI Governor Shaktikanta Das announced that the RBI will soon issue a draft circular on the Expected Credit Loss (ECL) framework, a new approach to provisioning for potential future loan defaults.

RBI first talked about the ECL provisioning for NBFCs (Non-Banking Financial Companies) in March 2020 when it rolled out the regulatory guidelines for Ind AS. Ind AS, Indian Accounting Standards are the set of guidelines that regulate how companies record their current financial transactions. Ind AS mandates NBFCs to follow the ECL framework to maintain transparency and for better risk management.

What is ECL?

It is a method for accounting for credit risk and estimating the potential losses on a loan or a portfolio of loans. Under this method, financial assets are classified into 3 major categories which are based on the potential credit risk and expected deterioration. The three categories are:

1)Performing Assets

2)Underperforming Assets

3)Credit-Impaired Assets

As fancy as this might sound, they are pretty easy to understand by the name itself, but before that let me remind you that for banks the loans they sanction are assets to them and the deposits they receive are liabilities because there is a burden to pay back the deposited money as and when demanded whereas they are yet to receive the money from the loans they sanction.

Banks continuously monitor borrowers’ financial health and loan performance. Based on the risk assessment the banks take collateral, use guarantees from third parties, and make provisions; provisions are funds that banks set aside from their profits to cover potential losses from loans that might not be repaid. If this is clear let’s talk about the three stages of the ECL framework.

Stage 1: Performing assets

These are the assets to banks that have the lowest risk of defaulting, and the credit risk has been significantly low since the initial recognition; in simpler words, borrowers are meeting their obligations as expected. Provisions are calculated based on the Expected Credit Loss (ECL) for the next 12 months rather than the entire life of the loan. This is because the chances for default within the next year are deemed low for these assets.

For example, if the chance of default is calculated to be 1% and the potential loss on default is ₹10 lakh, the provision would be ₹10,000 (1% of ₹10 lakh).

Stage 2: Underperforming Assets

These are the assets where there has been a significant increase in the credit risk since the initial recognition but there hasn’t been any default. Here the expected credit loss is calculated over the lifetime of the asset. The provisions are higher in stage 2 compared to stage 1 since the risk of default is higher here.

Stage 3: Credit-Impaired Assets

These are the assets to the bank or the loan accounts that have defaulted. NPA (non-performing assets) comes under credit impaired assets, there are loan accounts where the borrower fails to pay back either the principal amount or the interest amount in a period of 90 days (in India). Expected credit losses are calculated over the lifetime of the asset, and interest revenue is recognized on the net carrying amount; the Net Carrying Amount of a loan is its book value after deducting provisions for expected credit losses (ECL) or any impairment losses.

Net Carrying Amount = Original Loan Amount − Provisions for Expected Credit Losses

The provisions are the highest here since the probability of a credit risk is highest in stage 3.

So, when RBI says that it is going to draw up a road map for the ECL framework it means it will outline the steps, guidelines, and timelines to transition from the current provisioning system (Incurred Loss Model) to the forward-looking ECL model. Then this poses the question of how ECL framework different from the existing method is i.e. Incurred Loss Model.

How is ECL different from Incurred Loss Model

In one sentence it is a movement from a reactive (Incurred Loss Model) to a proactive (ECL) approach. In the incurred loss model banks wait for an actual event or a clear signal of credit loss. Provisions are made only when the borrower defaults, i.e. misses a payment for a certain period e.g. 90 days (non-performing assets).

In the existing method the losses are recognized too late, in some cases the loan has already turned bad. Since the bank does not account for future risk, it tends to underestimate the provisions for bad loans. This method also delays the provisioning which becomes a nightmare for banks during economic downturns. This pretty much gives you the idea why RBI has future plans to adopt ECL approach for provisioning for credit risk.

Why is the ECL Framework Better?

Does ECL enable banks to recognize credit risks at an earlier stage?

Does the ECL framework smoothen the provisioning process reducing the volatility of the financial statement?Does ECL give banks an upper hand during unstable economic conditions?

The simple answer to all these questions is yes. ECL framework is better because it helps banks manage credit risks proactively, aligns with global best practices, ensures financial stability and fosters trust. It represents a more resilient and forward-looking way to safeguard the banking system against loan defaults. It fills in the gap that exists in the current method i.e. incurred loss model.

Conclusion

The RBI’s move to shift to the Expected Credit Loss model from the Incurred Loss Model will be a pivotal shift in the Indian banking sector. As students of business school understanding its implications will help in making informed decisions when working with budgets, forecasts, and strategic planning. ECL approach underscores the evolving regulatory environment in India, apprehending such shifts equips us to navigate policy changes and their implications for business and the economy. I hope this article has been able to comprehend the ECL framework, its key features, and how it is better than the existing method.