Unlocking New Possibilities: The Power of ECL Adoption for NBFCs

By Durgesh Jaiswal & Niharika Gupta

In today’s fast-evolving financial landscape, the ability to anticipate and mitigate risks is crucial for the survival and success of Non-Banking Financial Companies (NBFCs). The adoption of the Expected Credit Loss (ECL) framework under Ind AS 109 is proving to be a transformative step for NBFCs, enabling them to shift from a reactive to a proactive approach to managing credit risk. This change allows institutions to predict and prepare for potential credit losses, enhancing financial stability while aligning with global standards. More than just a regulatory compliance measure, ECL adoption equips NBFCs to thrive in a world marked by increasing economic volatility.

The ECL framework offers a range of features that significantly improve risk modelling and asset quality for NBFCs. It shifts credit risk management from a backward-looking incurred loss model, which recognises losses only after they materialise, to a forward-looking approach that anticipates potential losses. The methodology incorporates key predictive factors such as Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD). These tools enable institutions to better estimate credit losses, strengthening financial stability while bringing Indian NBFCs in line with global best practices.

The Regulatory Importance of ECL for NBFCs

The Reserve Bank of India (RBI) has mandated that NBFCs with a net worth of Rs 500 crore or more to adopt the ECL framework. This aligns Indian financial institutions with international regulatory standards and ensures that credit risk provisioning is timely and accurate.

The central bank is likely to release a draft circular on expected credit loss and the onus of implementation across the financial industry shall lie with the new RBI Governor. The circular is expected to throw light on issues like phrased adoption of revised Basel III guidelines; issuance of guidelines for ECL; liquidity coverage ratio (LCR); and prudential framework for financing of project loans. At a recently concluded Global Leadership Summit, the ex-Governor of RBI, Shaktikanta Das had said that the central bank’s overall approach would be “consultative”.

While larger NBFCs have embraced ECL, smaller institutions are working to upgrade their data systems and risk management frameworks to meet these compliance requirements. The transition to ECL not only satisfies regulatory needs but also sets the stage for stronger credit risk management across the sector. ECL is forward-looking in nature and helps the organisation to classify the borrower portfolio based on credit deterioration. Classification of borrowers can be made on leading indicators such as rating down gradation, imperfect security, etc, which helps the lender monitor the portfolio of borrowers and create adequate or sufficient provisions against anticipated losses.

Challenges in ECL Implementation

The shift to ECL comes with several roadblocks, particularly for smaller NBFCs. The accuracy of ECL modelling relies heavily on the availability and quality of historical data. Storage and maintenance of data require setting up of a well-constructed process framework. Smaller institutions may struggle to maintain the granularity required for robust risk assessment. Moreover, the forward-looking nature of ECL necessitates scenario analysis and stress testing, which means the computations and policies have to be dynamic to adapt to the changing landscape of macroeconomic variables (MEVs). Compliance with regulatory guidelines and ensuring transparency in reporting to internal and external stakeholders further add to the complexity of this transition.

Economic Factors and Their Impact on ECL

Economic conditions play a vital role in shaping ECL estimates. The impact of different MEVs on shock computations plays a crucial role in predicting forward-looking PD and a lender’s Gross Non-Performing Assets (GNPA%) under various economic scenarios. Key variables like GDP growth, inflation, unemployment, and interest rates influence asset quality differently. In a best-case scenario, strong economic growth and controlled inflation typically improve borrower creditworthiness and reduce PDs, thus reducing ECL. Conversely, in a worst-case scenario, it is marked by a recession or high inflation, leading to higher default probabilities, thus increasing ECL. As ECL computations evolve under different scenarios, they directly impact the lender’s profitability and capital reserves. These insights help financial institutions adjust to changing economic conditions and better manage their risk exposure.

?Sectoral Insights and Emerging Trends

The adoption of ECL has brought notable improvements in credit risk management for lending to sectors like MSMEs, retail, and infrastructure, all of which have seen reductions in GNPA. Government support measures, including liquidity infusions and regulatory relief, have further boosted recovery in these areas. Upper- and middle-layer NBFCs, in particular, have demonstrated a greater capacity to absorb shocks and recover quickly, highlighting the effectiveness of ECL adoption in improving resilience across the sector.

The Path Forward for NBFCs

The NBFC sector has shown remarkable resilience, reflected in improved asset quality and steady credit growth. With a growing emphasis on retail lending, especially in the MSME segment, the sector is well-positioned for sustainable growth. However, NBFCs must continue to remain vigilant, particularly in managing risks associated with unsecured lending. Refining ECL models and regular external validation to account for evolving market conditions will be critical to for future success and abiding by regulatory guidelines.

Looking ahead, the role of technology and data analytics will be pivotal in enhancing risk management frameworks and ensuring regulatory compliance. As NBFCs continue to refine their credit risk models and adopt advanced data analytics, they are set to play an even larger role in India’s financial system. While the journey to full ECL adoption may present challenges, the long-term benefits of this proactive risk management tool are undeniable. It is not merely a regulatory requirement but a catalyst for fostering financial stability and economic resilience.

Durgesh Jaiswal, Vice President, Risk Management Services, ICRA Analytics & Niharika Gupta, Manager, Risk Management Services, ICRA Analytics

Please explore our article on https://www.financialexpress.com/business/banking-finance-unlocking-new-possibilities-the-power-of-ecl-adoption-for-nbfcs-3715672/