Expected Credit Loss (ECL): Highlights from the latest RBI Discussion paper
Deep Adhvaryu
Treasury Management | Liquidity Management | Credit Risk Management | Credit Analysis | Risk Management | Fixed Income Investing | Leadership
RBI released a discussion paper on 13 Jan formulating guidelines to adopt the Expected Credit loss (ECL) framework for determining provisioning requirements and move away from the current incurred loss approach. This will bring Indian Banks in line with the global reporting standards such US GAAP (CECL) and IFRS9 (ECL). RBI’s own guidelines mention IFRS9 as the inspiration.
What is the Expected Credit Loss (ECL) approach?
The ECL model formulates a forward-looking approach to credit losses. The expected credit losses are modelled based on various macro-economic scenarios and calculates a probability-weighted provisioning requirement. These requirements are then carried on the balance sheet at amortized cost or at Fair Value through Other Comprehensive Income.
In simpler terms: ECL = Exposure x Probability of Default x Loss Given Default
Why do we need it?
Like most recent changes in regulations, the origins of ECL too can be traced back to the Global Financial crisis of 2008-09. In the aftermath of the Global financial crisis, regulators realized that the financial reporting and regulatory system was broken and there was a need for a more timely and prudent approach to risk management across Financial Institutions.
As such, the Basel Committee for Banking Supervision (BCBS) came up with multiple new enhancements to Liquidity Risk management (enforcing ratios such as LCR, NSFR, etc.), credit risk management (ECL) and increased capital requirements.
The ECL approach was subsequently adopted by International Accounting Standards Board (IASB) in IFRS9 standards (effective 2018) and the US Financial Accounting Standards Board (FASB) as CECL (Current Expected Credit Loss, effective 2020).
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Why is ECL better than the current incurred loss approach?
While the incurred loss approach was the global standard till the global financial crisis, the limitations became readily apparent in 2008. Given that credit losses are recognized only when they are actually incurred, the value of the loans / securities that the banks carried were overstated, provisions understated, and banks’ capital ratios looked healthier than they actually were. As systemic credit losses increased, banks were required to hold more and more provisions which ate into their capital at a time when they most needed it.
If the ECL approach was adopted before that, Banks would have had to reserve for losses earlier – on the day the asset was recognized on the balance sheet and on every subsequent reporting date, which would have allowed provisions to be phased in over time allowing banks to plan capital requirements in an orderly fashion.
What is the expected impact on banks?
Once the rules come into force, there will be an increase in bank’s provisioning requirements which will lead to a decrease in Banks’ CET1 ratios and hence increase in capital requirements.
Though regional rural banks and co-operative banks will be kept out of the ambit given the complexity of the modeling requirement, RBI has asked for suggestions from the public on whether co-operative banks over certain size should also be included.
TLDR
Private Credit | MBA: NMIMS | B-Tech: NIT Surat
2 年Guess that banks would need to raise more capital after the implementation. With PSBs seeing a re-rating of thier valuation, the framework has come at a good time!