I am starting a series of blogs on IFRS9 'Expected Loss Provisioning'. In the next few days I will discuss how to model Expected Loss as per New accounting norms. I will be using Simple Excel spreadsheets for discussions. If anyone has any questions, feel free to contact at +91-9780564549
Why Expected Loss Provisions are required -
1. Pricing (Int. rates) is biased, int. rates are biased and driven by strategic concerns
2. Earlier RBI Provisions - Prescriptive guidelines for identification + provisioning New Expected Loss Provisions - Currently Impaired + Credit that may impair in future
- Eg 1. Suppose a loan is given to Telecom company, now there is some problems with 4G licence which will cause huge losses to company. So Expected Loss Provisions - are they forward-looking?
- Eg 2. Suppose loan is given to Tata Steel, now Tata is expected to face huge problems because of Steel dumping So again are my provisions - considering loss due to these macroeconomic factors. Current Provisioning is a) not Bank Specific b) no prescribed basis (just to meet regulatory objectives like promoting a certain loan) Provisioning is required to smoothen out profits of Bank in long-term rather than balance sheet taking a hit because of sudden losses
For which Instruments are provisions required
Provisions are not applicable to Financial assets measured at FVTPL
FVTPL - No ECL because losses are already going in PnL
Not FVTPL - ECL
How to calculate Provisions?
Step 1: Check whether ECL provisioning applies to the Co. & Instrument or not? Doubt Companies Companies on whom Ind AS applies - Have to do ECL Provisioning eg. Bank following Standardized approach + Ind AS applicable Companies adopted IRB approach - Have to do ECL Provisioning whether Ind AS followed or not Why ? To Compare Provisions already held vs Estimated ECL Provisions Instruments No FVTPL - ECL
Step 2: Identify the approach with which ECL provisioning needs to be done eg for Banks & FI - General approach, for NBFC - Specific approach, For Trade & Contract receivables etc.
Step 3: Define strict criteria for identifying an asset as Stage 1 or Stage 2 or Stage 3 because calculations of ECL depends on it. What are these stages ?
- Stage 1 - Performing Asset - Low Credit Risk What is 'low' - Depends on banks definition of low eg rating AA ++, PD<=0.25% i.e. should be an absolute (not relative) & clear benchmark Que - Can a credit with PD=0.35% be stage 1 - YES, it can be Then Whats the use of Benchmark - We don’t have to check for Significant Increase in Credit Risk (Stage 2) if PD <=0.25%, so it simplifies the classification process.
- Stage 2 - Underperforming - i.e. Significant increase in Credit Risk eg. The relative increase in PD by 10pc or more Eg a loan 30 days past due can be SICR unless rebuttable (i.e. bank can explain that there is no SICR if the person doesn’t pay in 30 days)
- Stage 3 - Impaired - Loan is certainly a default Eg. 90 days past due unless rebuttable, 180 days past due in case of SME (unless rebuttable)
Why are these Stages important?
- Determines quantum of Provisioning Stage 1 - 12 Months ECL, PD low Stage 2 - Lifetime ECL, PD High Stage 3 - Lifetime ECL, 100pc PD So for Stage 2 & 3 we calculate multiple PDs, LGDs & EADs
- How will you recognize interest income.
Points to be Noted-
- Deciding the stage is done only on the basis of ability to pay without the ability to recover. However, Expected loss provisioning is done on basis of ability to pay + ability to recover.
- The classification above has to be done continuously for every reporting date i.e. say every quarter
- Assessment can be done on a standalone basis - Loan by loan or Collective assessment for say Retail Housing Loans. The advantage of collective assessment is that it is more forward-looking
- On the date of Origination, all assets are classified as performing even if a poor rated Bond but that doesn’t mean Provisions will be low, it only means we have 12 months ECL After the date of origination, even next day only we can make it Stage 2
- As we move from Stage 1 to Stage 3, EL will obviously increase until Bank is more active on Collateral Side.
- A stage 2 or 3 loans can come to stage 1 if repayment is established
- Its possible in the new framework that one facility to Borrower A is in stage 3 while another facility to the same borrower is in Stage 1 (eg. Disputed loan etc.) Earlier a person defaulter in one facility was a defaulter everywhere However if a person has defaulted on a loan from Bank. A and paying to us, there is still an objective evidence of SICR, so he should be most probably S2 or S3 unless rebuttable.
Step 4: Forecast Real World PD, Economic LGD & EAD
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