Expected credit losses on loans: Guide for NBFCs

– Vinod Kothari | finserv@vinodkothari.com

One of the most important, and often the most complicated issues in applying IndAS 109 to financial assets, particularly loan portfolios, is to the computation of expected credit losses (ECL). The following points need to be noted about ECL computation:

• ECL is not relevant for assets which are subject to FVTPL. Hence, ECL computation is relevant for assets subject to amortised cost and FVOCI. This means, practically, all loan assets of NBFCs will be covered.
• ECL is not a provision – it is a loss allowance. Therefore, ECL is debited to P/L account.
• ECL is to be measured and re-measured every reporting period.
• ECL is a present value measure. Therefore, even if there is no change in the estimates of the delays or defaults, there will still be a change in the ECL estimates, due to unwinding of the discount. The unwinding of the discount results in reduction of the ECL allowance.
• The assessment of ECL has to be done even if the loan is perfectly performing. In fact, ECL computation has to be done at the very inception of the loan, when the question of monitoring its performance does not arise. As to why ECL is relevant for a performing loan, see discussion below.

Why and how is ECL measured?

Stage 1 assets

ECL is applicable even if the loan is fully standard, and in fact, its assessment is required even for a recently originated loan. All these loans, which are fully performing and have not shown any evidence of SICR, are treated as Stage 1 assets. For these assets, ECL is computed by applying the probability of default or delays as perceived over the next 12 months to the loan cashflows. That is to say, even if the loan does not default but delays payments, the present value of the contractual cashflows will be computed by delaying the contractual cashflows by so much delay, as is estimated based on a 12-month probability. Therefore, ECL is essentially a present value loss due to delays or defaults.

The rationale for ECL for fully performing assets is that there is a degree of expected loss which is priced into the spread of the credit asset. Stage 1 ECL tries to capture at least the immediately perceived expected credit loss and knock that off from the income from the asset, on the assumption that so much of income was always believed to be liable to losses.

How do we estimate the probability of default for a newly originated asset? Practically, ECL for Stage 1 may be assessed on a pool basis, based on historical performance of similar loans. [Para B. 5.5.42] For example, if we have a portfolio of car loans of 5 years’ maturity, we may assign probability of default within the first 12 months of origination for similar loans in the past. 

Instead of using a single probability, the computation will be more scientific if range of probable scenarios (say 3 or 5 scenarios), and the default probabilities in each with the weights assigned to the scenarios, are taken. The scenario approach is closer to the expectation of the Standard [see para 5.5.17 (a)]

Stage 2 assets

The asset moves from Stage 1 to Stage 2, when it shows any SICR. While there may be many subjective indications of SICR too, the most practical indication, particularly for retail assets, is when the cashflows are trailing by 30 days or more.  [Para 5.5.11]

In the case of Stage 2 assets, the estimation of probability of defaults/delays is based on lifetime losses. The difference between 12 month loss, and lifetime loss is that the probability of default usually scales up over time. Therefore, lifetime losses are computed by applying the higher probability of default or delay. It is not necessarily  a probability curve, but the higher probability as forecasted over the life (or the remaining life) of the asset.

Is Stage 2 slotting applicable to assets on individual basis, or on pool basis? While the Standard talks about pool-based Stage 2 degradation [B 5.5.1 onwards], these paras should be relevant only where individual performance details are not available, and the assets in a pool may be expected to perform similarly. For example, a lender gets into a new business of fintech lending, initially assessing a default rate of 2%. After 6 months into business, lots of these loans are already 90 DPD. In such a case, performance of individual loans does not matter, and the entire pool may be said to have demonstrated SICR. Barring such cases, SICR may be based on performance of each individual loan in the pool. 

Stage 3 assets

A stage 3 asset is already credit impaired. In regulatory parlance, the asset has become a non-performing asset already. As the asset is already non-performing, there is no question of any probability of default – hence, the focus shifts to the recovery rate for determining expected losses. Note, expected loss = Exposure * PD * (1-Recovery rate). 

At this stage, the ECL is deducted from the carrying value of the asset. An important difference between regulatory accounting and IndAS principles is that there is no cessation of income recognition under IndAS for financial assets. The income will be recognised at the effective interest rate, but on the reduced value of the asset net after the loss allowance. The underlying rationale seems to be that once the loss allowance has already been knocked off from the asset value, the remaining value should be good for the purpose of income accrual.

Restructuring or loan modification

A modification or restructuring of a financial asset results in 2 implications. First, a modification gain/loss has to computed. This is done by discounting the revised contractual cashflows at the original IRR of the unmodified loan, and accordingly, write down a modification loss (or gain). Secondly, a modification is treated as an indication of SICR. [Para B 5.5.2]. Therefore, there will also be a need to compute lifetime losses.

IRAC provisions and ECL

The following table compares IRAC provisions and ECL requirements:

	IRAC provision	ECL allowance
Asset is originated; perfectly standards	0.40% in case of standard assets	Based on a 12-month probability of default.
Asset is between 30 DPD and 89 DPD	Asset is standard; hence provision is 0.40%	Based on a lifetime probability of default
Asset is >89 DPD	Different for different levels of substandard assets, but starting from 10% of the exposure	Since default has already occurred, ECL will be based on loss given default. Hence, (1-Recovery rate)
Asset is > 89 DPD	Reversal of income already accrued and not paid; cessation of income recognition	Income recognition to continue on the net asset after the loss allowance as above

As may be noted, ECL allowance will generally be higher than the IRAC provision.

In those rare cases where ECL is lower than IRAC provision, the difference between IRAC and ECL will be an appropriation item, that is, a reserve will be created called Impairment Reserve. However, this comparison between IRAC and ECL will have to be done entity-wide, and not on asset-by-asset or categories of assets. Hence, the changes of such impairment reserve seem low.

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