-The test of a Financial Crisis-driven model in times of Global Crisis
By Rahul Maharshi, Financial Services Team , (firstname.lastname@example.org, email@example.com)
The disruption throughout the globe due to the COVID-19 disease has caused tremendous uncertainty and difficulty in the financial sector. The Expected Credit Loss (ECL) model was introduced in the aftermath of the 2008 global financial crisis, to curb the loopholes of the incurred loss model and to provide a forward looking approach in the accounting of loan loss provisioning by inclusion of various credit measures. The current global COVID-19 disruption is an event when the ECL model should provide transparency to users of financial statements.
This write-up is an attempt to shed light on the factors to be considered in accounting for ECL in the light of the current uncertainty resulting from the COVID-19 disruptions.
The approach of ECL at time of COVID-19 disruption
The ECL model requires application of judgement and differs from entity to entity. Such application of judgement and approaches are considered based on the industrial practices as well as the business environment in which the entity operates. For example, a financial institution may not have an aggressive approach in determination of ECL for the portfolios serving to the affluent sections of the economy as compared to the low credit-score portfolios.
However, conventional assumptions taken in the ECL model may not hold well in the current environment we are going through. The assumptions of significant increase in credit risk (SICR), at times when there is extension in the repayment structure may be a classical example of SICR which would result in stage-shifting of the credit exposure. But the same would not hold well, in times of such a disruption, where the financial sector regulator has proposed to extend a three month moratorium for repayment of term loans, considering the disruption to the economy.
We arrive at ECL estimates with the help of three primary data points [B5.5.49] –
- Best available information about the past events;
- Best available information about the current conditions; and
- Forecast of economic conditions
In the current COVID-19 disruptions, the entities should actively consider the effects of the COVID-19 disruption as well as the measures taken by the government and regulators in the current situation as well as the prospective measures which would affect the forecast. Such measures should be considered as forward looking “macro-economic information” [B5.5.4] and accordingly be considered by the entities.
However, it is easier said than done, considering the rapid changes and updates in the current stressed environment. But if the ECL estimates are arrived at, after proper consideration of reasonable and supportable information, the same can provide better transparency to the financial statements and aid in providing assurance to the stakeholders.
The major component in ECL computation is the probability of default (PD). To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.
Effect of the moratorium grant on loan repayments on ECL
To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI to mitigate the burden on debt-servicing caused due to the disruption. These measures include moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. The lending institutions have been permitted to allow a moratorium of three months on payment of all instalments falling due between March 1, 2020 and May 31, 2020. The below explanation specifies effect of the moratorium.
Effect on credit risk and stage shifting
Since the moratorium is to be considered as a repayment holiday where the borrower is granted an option to not pay during the moratorium period, the same cannot be considered as a factor in determining change in the credit risk complexion of the borrower. The provisions of para 5.5.12 of Ind AS 109 are self-explanatory on the point that if there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a SICR, the entity shall compare the credit risk before the modification, and the credit risk after the modification. Sure enough, the restructuring under the disruption scenario is not indicative of any increase in the probability of default.
Accordingly, the same should ideally not be considered as a factor for considering SICR and in turn, should not result in shifting of the financial instruments from one stage to another.
Effect on rebuttable presumption about credit deterioration
The moratorium granted by the RBI seeks to amend the payment schedule without resulting in a restructuring. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. However, the rebuttal may be offered in case the payments are more than 30 days past due. The very meaning of “past due” is something which is not paid when due. The moratorium amends the payment schedule. What is not due cannot be past due.
Effect on Effective interest rate (EIR) for the loan and income during the moratorium
The whole idea of the modification is to compute the interest for the deferment of EMIs due to moratorium, and to compensate the lender fully for the same. The IRR for the loan after restructuring should, in principle, be the same as that before restructuring. Hence, there should be no impact on the EIR.
As the EIR remains constant, there will be recognition of income for the entire Holiday period. For example, for the month of March, 2020, interest will be accrued. The carrying value of the asset (POS) will stand increased to the extent of such interest recognised. In essence, the P/L will not be impacted
Also, there will not arise any modification gain or loss as per para 5.4.3 of Ind AS 109 since the EIR remains constant.
Requirement of Impairment-testing of financial asset
The revision in the payment schedule does not result in a modification of the financial asset, which could have resulted in an impairment testing of the financial asset. Since the contractual modification in case of the moratorium is not a result of a credit event, the question of any impairment for this reason does not arise.
The concept of ECL being a fallout of the Global Financial Crisis, it will be interesting to see how fairly the model lives up in providing transparency to the users of financial statements at this time of global disruption. The current situation is difficult, creating high levels of uncertainty but certain measures may be adopted by entities in curbing the situation to some extent, such as:
- Developing more than one scenarios for the potential impact of the COVID-19 disruptions treated as macro-economic information as per para B5.5.4 of Ind AS 109
- Effect of measures taken by the government and the regulators in the true spirit with which the same is implemented.