As per RBI guidelines on Ind-AS 109, it is worthwhile to move towards a robust Expected Credit Loss (ECL) provisioning methodology from the existing Incurred Loss Provisioning method. Through this paper, the author explains the ECL implementation process at three hypothetical banks. These banks are diverse in nature with reference to their risk appetite, turnover, portfolios, vintage, and business prospects.
The global financial crisis (GFC) in 2008 exemplified the weaknesses in the current accounting standards & practice (IAS 39 Financial Instruments), which adopts the incurred loss model for impairment of financial assets. The challenge with the incurred loss model is that impairment losses and the resulting write-downs in the reported value of financial assets can only be recognized when there is evidence that they exist (i.e. have been incurred). Post GFC 2008, at the request of the G20 and the Financial Stability Board, the International Accounting Standard Board (IASB) stepped up its work to replace IAS 39. In July 2014, the IASB introduced the International Financial Reporting Standard (IFRS) 9.
The Indian Accounting Standard (Ind-AS) is converged with the IFRS. It is the accounting standard adopted by companies in India and issued under the supervision of the Accounting Standard Board (ASB). Accordingly, Ind-AS 109 is converged with IFRS9.
Ind-AS 109 lays out the guidelines for accounting based on the expected credit loss model. The objective of this standard is to establish reporting principles that will present relevant and useful information to users of financial statements for the assessment of the amount, timings and uncertainty of the entity’s future cash flows. This standard will have an impact on the measuring and accounting of credit losses, which means that the risk and finance team of an organization needs to collaborate with the IT department for implementation and complying with Ind-AS 109 standards.
Overview: Key components of the Ind-AS 109 requirements for banks
To ascertain the applicability of the impairment calculation, an entity needs to classify its financial instruments into amortized cost, fair value through other comprehensive income (FVOCI) and fair value through P&L (FVTPL). Instruments classified as amortized cost and FVOCI are subject to the Ind-AS 109 impairment calculation. The standard requires banks to assess credit risk on the financial instruments to ascertain if there is an increase in risk on the reporting date as compared to the date of initial recognition. The standard also requires banks to assess their portfolio and determine the criteria for stage determination depending on the portfolio risk characteristics. There are certain rebuttable presumptions provided by the standard such as - 30 days past due (DPD) for classifying an asset into Stage-2 and default should not occur later than when a financial asset is 90 days past due. Per Ind-AS 109 standards, an entity can refute this presumption if it has reasonable information that is available without undue cost or effort, and demonstrates that risk has not increased significantly since initial recognition.
The 12-month or lifetime Expected Credit Loss (ECL) is computed and accounted for based on whether the financial instrument is classified as Stage 1 or 2/3. The components that are crucial to calculate ECL include - Exposure at Default (EAD), Probability of Default (PD), Loss Given Default (LGD), and discount rate. These models are expected to be validated at least once in a year or at a more frequent interval; if required.
Case Study: ECL deployment for 3 banks
Based on experience and industry inputs, we have presented practical aspects of the Ind-AS 109 (ECL) implementation through case studies of three hypothetical banks to elucidate the best feasible approach. These banks are quite diverse in nature with reference to their risk appetite, turnover, portfolios, vintage, and business prospects.