A[U]n Expected Injury: ECL is here, likely to hurt bank profits and retained earnings in FY28
Team Finserv | finserv@vinodkothari.com
Additionally, upfront fair valuation may also deplete retained earnings
The new ECL framework marks a major regulatory shift for India’s banking sector; it has been long overdue, and therefore, there was no case that the RBI could have deferred it further; pleadings to defer the implementation were rejected by the regulator. It comes coupled with regulatory floors for provisions, which would cause a major increase in provisioning requirements over the earlier requirements. Our assessment, on a very conservative basis, is that the first hit to Bank P/Ls will be at least Rs 60000 crores in the aggregate.
This is in addition to fair valuation requirement on upfront adoption, as on 1st April, 2027. While a vaguely worded part in para 19 was inserted on suggestions of the stakeholders, if interest rates have moved up since the date of the original loan, there will be almost a sure case of upfront valuation loss, which will eat up retained earnings.
RBI had come up with a draft framework on ECL pursuant to the Statement on Developmental and Regulatory Policies, wherein it indicated its intention to replace the extant framework based on incurred loss with an ECL approach. The final regulations were notified on 26th April and are applicable w.e.f 1.04.2027 i.e., for FY 27-28. The manner of implementation will be that all loans as on 1st April 2027 will be fair valued, and all new loans/financial instruments originated or acquired on or after 1st April 2027 will be subject to ECL provisions.
A major impact that the directions will have on the Banking sector is the need to maintain increased provisioning pursuant to a shift from an incurred loss framework to the ECL framework. Under the earlier framework, banks made provisions only after a loss has incurred, i.e., when loans actually turn non-performing. The newECL model, however, requires banks to anticipate potential credit losses and set aside provisions for such anticipated losses.
Banks presently classify an asset as SMA1 when it hits 30 DPD, and SMA2 when it turns 60. Both these, however, are standard assets, which currently call for 0.4% provision. Under ECL norms, both these will be treated as Stage 2 assets, which calls for a lifetime probability of loss, with a regulatory floor of 5%. Thus, the differential provision here becomes 4.6%.
Once an asset turns NPA, the present regulatory requirement is a 15% provision; the ECL framework puts these assets under Stage 3, where the regulatory minimum provision, depending on the collateral and ageing, may range from 25% to 100%. Our Table below gives a more granular comparison.
| Type of asset | Asset classification | Existing requirement | New requirement w.e.f 1.04.2027 | Difference |
|---|---|---|---|---|
| Farm Credit, Loan to Small and Micro Enterprises | SMA 0 | 0.25% | 0.25% | – |
| SMA 1 | 0.25% | 5% | 4.75% | |
| SMA 2 | 0.25% | 5% | 4.75% | |
| NPA | 15% | 25%-100% based on Vintage | 10%-85% based on Vintage | |
| Commercial real estate loans | SMA 0 | 1% | Construction Phase -1.25% Operational Phase – 1% | Construction Phase -0.25% Operational Phase – Nil |
| SMA 1 | 1% | Construction Phase -1.8125% Operational Phase – 1.5625% | Construction Phase -0.8125% Operational Phase – 0.5625% | |
| SMA 2 | 1% | Construction Phase -1.8125% Operational Phase – 1.5625% | Construction Phase -0.8125% Operational Phase – 0.5625% | |
| NPA | 15% | 25%-100% based on Vintage | 10%-85% based on Vintage | |
| Secured retail loans, Corporate Loan, Loan to Medium Enterprises | SMA 0 | 0.4% | 0.4% | – |
| SMA 1 | 0.4% | 5% (0.4% for loans against FD, NSC, LIC and KVP) (2.5% for direct exposures to/guaranteed by State Governments) | 4.6% No change for loans against FD, NSC, LIC and KVP | |
| SMA 2 | 0.4% | 5%(0.4% for loans against FD, NSC, LIC and KVP) (2.5% for direct exposures to/guaranteed by State Governments) | 4.6% No change for loans against FD, NSC, LIC and KVP | |
| NPA | 15% | 25%-100% based on Vintage 10%-100% for loans against FD, NSC, LIC and KVP and for direct exposures to/guaranteed by State Government) | 10%-85% based on Vintage | |
| Exposures under various schemes of Credit Guarantee Fund Trust for Micro andSmall Enterprises (CGTMSE), Credit Risk Guarantee Fund Trust for Low IncomeHousing (CRGFTLIH) and National Credit Guarantee Trustee Company Ltd (NCGTC) | SMA 0 | 0.4% | 0.25% | 0.15% |
| SMA 1 | 0.4% | 0.25% | 0.15% | |
| SMA 2 | 0.4% | 0.25% | 0.15% | |
| NPA | No provision for the guaranteed portion. NPA provisioning as per extant guidelines for the portion outstanding in excess of the guarantee (Only when the Governmentrepudiates its guarantee when invoked) | 10%-100% based on vintage for secured and guaranteed portion 25%-100% based on vintage for unsecured and unguaranteed portion (Only if the claims are not settled with ninety datesfrom the due date of the loan) | ||
| Home Loans | SMA 0 | 0.25% | 0.25% | 0.15% |
| SMA 1 | 0.25% | 1.5% | 1.25% | |
| SMA 2 | 0.25% | 1.5% | 1.25% | |
| NPA | 15% | 10%-100% based on Vintage | (-)5% – 85% based on Vintage | |
| LAP | SMA 0 | 0.4% | 0.4% | – |
| SMA 1 | 0.4% | 1.5% | 1.1% | |
| SMA 2 | 0.4% | 1.5% | 1.1% | |
| NPA | 15% | 10%-100% based on Vintage | (-)5% – 85% based on Vintage | |
| Unsecured Retail loan | SMA 0 | 0.4% | 1% | 0.6% |
| SMA 1 | 0.4% | 5% | 4.6% | |
| SMA 2 | 0.4% | 5% | 4.6% | |
| NPA | 25% | 25%-100% based on Vintage | 0%-75% based on Vintage |
The actual impact of such additional provisioning will be a hit of more than 3% to the profit of banks. Based on the RBI Financial Stability Report of FY 24-25, the current level of SMA and NPA is estimated to be ₹3,78,000 crores (2%) and ₹4,28,000 crores (2.3%), respectively.
Accordingly, an additional provision of approximately ₹ 18,000 crores (4.6% of SMA volume) and ₹ 42,000 crores (10% of NPA volume) will be required for SMA and NPA respectively, leading to a total impact of at least ₹60,000 crores. This estimate has been arrived at by considering the % of NPAs and SMA-1 & SMA-2 portfolios of banks. The actual impact may be higher, as lot of loans may be unsecured, and may have ageing exceeding 1 year, in which case the differential provision may be higher.
It may be noted that while the draft directions allow Banks to add back the excess ECL provisioning to the CET 1 capital, it does not neutralize the immediate profitability impact, as the additional provisions would still flow through the profit and loss account.
How do we expect banks to smoothen this hit that may affect the FY 27-28 P/L statements? We hold the view that it will be prudent for banks, who have system capabilities, to estimate their ECL differential, and create an additional provision in FY 25-26, or do technical write-offs.
Effective Interest Rate requirement applies to all loans effective 1st April, 2027
ECL does not come alone; it comes along with the Ind AS 109 companion – the requirement to compute effective interest rate (EIR) for all financial assets and financial instruments. How does EIR requirement differ from the existing rate of interest/internal rate of return approach? Because EIR has the impact of amortising loan acquisition costs or upfront fees. Currently, banks could have taken the upfront earnings such as processing or origination fees/costs directly to revenue – these will now have to part of the EIR computation. More than impacting the profit number, EIR creates a significant impact on loan management systems, as it results in dual computations – the accounting balances and the customer LMS balances are likely to be different.
Upfront recognition of fair value changes
Para 19 requires that on 1st April, 2027, that is, the date of first adoption, all financial assets and instruments will be fair valued, and the fair value changes (gains or losses) will be adjusted against retained earnings. This is consistent with the principles of first time adoption of Ind AS.
On stakeholder representation, the RBI added this part to Para 19:
Where facts and circumstances indicate that the transaction has been undertaken on terms such that the fair value of the financial asset is not materially different from its carrying cost, the same shall be presumed to be the best evidence of fair value.
What does this imply? If the terms of the financial facility have remained the same, does it mean no fair valuation has to be done? Surely no, at least in our opinion. Any fair value change in fixed rate instruments happens for two reasons: change in credit spreads (rating changes, credit quality changes, etc), or change in rate of interest. If there is a facility extended, say at a rate of interest of 8%, whereas the prevailing rate of interest for a borrower of similar credit standing has moved up to 10%, will there be a fair value decrease? Surely yes.
There are lots of loans which were extended during Covid or periods of low interest rates, which are still continuing. In all such cases, fair value losses are imminent.
The meaning of the para above can only be that if the terms of the original facility are similar to what they would currently be, then the fair value will not have to be computed.
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