RBI’s expected credit loss approach may impact capital positions of banks

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The Reserve Bank of India (RBI)’s discussion paper suggesting banks move to an expected credit loss (ECL) approach for provisioning of bad assets from the current incurred loss approach is likely to have a bearing on the capital position of some banks, if not all, analysts reckon.

RBI released a discussion paper earlier this week, wherein it proposed the ECL-based approach used in IFRS-9 for recognition of provisions by banks. According to the ECL approach, banks have to make provisions on the basis of self-designed models that are approved by the regulator and that capture the regulatory guidance.

Under this approach, banks would have to measure the ECL of a financial instrument by classifying the loans in three stages — 1, 2, and 3. The stages are to be classified on the basis of the overdue position of the asset and subsequently, provisions have to be made determining the probability of default, loss given default, and exposure at default.

RBI has said it will give at least a year’s time to the banks to put in place the necessary systems and procedures required, including the development and validation of ECL models, from the date of final guidelines on the ECL approach for loss provisioning.

Also, the increase in provisioning requirement on common equity tier-I (CET1) capital for loan loss, which will be incurred by scheduled commercial banks due to the transition, to the expected credit loss (ECL) model, will be phased out in five years, RBI has said. This is because the RBI itself has estimated that the potential initial impact of the application of the ECL approach on banks’ capital could be significant.

“The impact could be felt in FY26 accounts and banks would have to start preparing in FY25 to raise capital, in our view”, said analysts at Macquarie Research in their report on Tuesday. Since the probability of default for public sector banks over the last several years has been higher and they usually don’t make many contingent provisions, the impact could be far more severe on them, they said.

“The problem here is that over the last 5-10 years, the probability of default would have been very high for the banking sector and that’s why eventual ECL provisions could be higher. Plus, ECL rules also include interest lost over the lifecycle of loans, which compounds the problem. However, at this point in time, the impact cannot be quantified due to paucity/clarity of data/rules, Macquarie Report added.

“Overall, we believe the potential impact on banks will be manageable based on our current asset quality expectations,unlike significant implications 3- 4 years back.Large private banks are much better placed given significant higher floating/contingency provisions, we believe”, Morgan Stanley said in a research report.

Analysts at Emkay Research said, ECL-based norms could release provisioning for some large banks such as ICICI Bank, Axis Bank, HDFC Bank, etc, which have strong buffers, while some small private sector banks may have to accelerate provision buffers and even replenish capital levels faster than planned.

According to analysts at Kotak Institutional Equities, RBI, probably, wanted banks to complete their provisions from the previous corporate non-performing assets (NPA) cycle before migrating into a new regime. And a five-year transitioning period of the initial migration costs should make it comfortable for most banks.

However, they feel a key challenge of moving to the ECL approach is the data that goes behind these assumptions. “Estimating default probabilities or losses requires rich data sets that capture various cycles. While ECL is the best way forward, we need to acknowledge that we are also moving with less quality of data as well.”, analysts at Kotak Institutional Equities said in their report.

Having said that, analysts seem to have a consensus on the fact that this is the best time to implement the ECL approach to provisioning for bad assets as India’s banking sector is in a purple patch, wherein profits are soaring and bad assets ratios are declining, resulting in reduced credit costs.

“Given that the Covid shock is largely behind and with banks sitting on healthy provision buffers, we believe that now is an opportune time to introduce ECL norms for banks and strengthen their provision buffers, before the next asset-quality shock”, analysts at Emkay Research said.

“The ECL framework initially, though tough on the balance sheet and profit and loss of banks, in the long run, strengthens the banking system. And RBI is doing so at a time when the health of the banking system is the best. So, it is certainly a welcome move,” said Suresh Ganapathy, Associate Director, Macquarie Capital.

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