As pandemics go, Covid-19 deserves a league of its own. Its devastating effects have sent the global business community running for cover amid widespread chaos and financial losses. Hundreds of prestigious brands, including family-owned veteran businesses in the U.S. and across the globe have declared bankruptcy. In an industry like BFSI that is already weighed down by performance issues involving bad debts and NPAs, the complications fuelled by the Coronavirus are taking on a dangerous form. This is especially true when considering they have lent to sectors like airlines, hospitality, and entertainment that are perhaps the worst hit.

In this context, the Expected Credit Loss (ECL) provisioning approach becomes more important than the actual incurred loss. Economists, governments, and international bodies in charge of restoring balance in the system need to know what ECL is going to be, so they can prepare ahead. Much-needed changes, like the ECL provisioning approach, will lend solid armour to financial institutions (FIs) in battling the lasting, long-term effects of economic downturn.

However, India’s lead up to Indian Accounting Standards 109 (Ind AS 109) implementation came to an unprecedented halt earlier this year. The country’s apex regulatory body, the Reserve Bank of India (RBI), deferred the implementation, hesitant to increase the burden on banks amid the ongoing macroeconomic challenges, it was reported. Although the delay comes as interim relief for many, Ind AS implementation is almost unequivocally seen as a much-needed move by the debt-laden industry.

Most of the Indian banks are preparing themselves for a possible Ind AS 109 implementation in FY21-FY23 to minimise transitional and operational difficulties. Ind AS 109 implementation seeks to do more than just improve the transparency of India’s present murky credit landscape, reduce risks, and alleviate complexities. It will raise the country’s profile, bringing it on par with countries that follow global accounting standards, like IFRS 9 or IAS.

Short- and long-term implications of Ind AS 109

Ind AS 109 will have definite long- and short-term impact on India’s financial services sector. As of now, the unavailability of real-time data makes it too early to comment with certainty on the severity of the impact. Other regions and countries that implemented IFRS 9 too saw variability in its impact on banks’ CET1 capital and impairment allowance. A transition arrangement from the RBI is expected to iron out any adverse or substantial impact over a period—as we have seen in the case of the U.K., Italy, and Spain.

Implications for Indian banks: During the transition period, banks would see an increase in impairment allowance, a stable impact on financial statements, and favourable CET1 ratio (which could vary, depending on a bank’s portfolio exposure). In the long term, the impairment allowance would normalise and become range bound as we have observed in other parts of the world.

Implications for NBFCs: According to the RBI’s 2019 guidelines, NBFCs are in the preparatory stage of full implementation of Ind AS 109. During this period, we can expect an increase in the loan allowance and provisioning. There will be some variability across FIs, mainly owing to differences in risk computation methodology; however, this is expected to normalise after full implementation.

An efficient automation system that requires advanced skills in terms of credit risk modelling is the core dependency of ECL computation. Obviously, the new regime of Ind AS 109 and ECL would throw operational challenges in the way of the existing infrastructure and resources of banks and NBFCs.

A simple, yet effective solution

In the wake of the Ind AS 109 announcement, fintech firms have been helping banks and financial institutions with ECL solutions that recognise the expected change in credit risk and provide a framework to manage forward-looking credit loss. For instance, many companies have ECL calculators embedded in their fintech product suites. These tools are exclusively designed, bearing in mind Indian regulatory requirements and the specific nuances of Indian financial institutions. With built-in, fully configurable algorithmic engines for efficient computation, today’s ECL calculators provide out-of-the-box compliance for RBI, IASB and ICAI guidelines, while accommodating India-specific macroeconomic factors—alleviating the worries for banks and financial institutions.

The road ahead

Despite the delays and minor setbacks, Indian banks are moving a step closer to implementing Ind AS 109. There is growing realisation among bankers and industry analysts alike that a systematic implementation plan should be put in place in the transition period. Such a plan should be founded on three key pillars: governance and control, ECL models and model validation, and effective model risk management.

The present global financial scenario we are in highlights the importance of inculcating an economic overlay in the computation of key risk components. ECL and risk models should be calibrated to the current market conditions, which can be done effectively through systematic model validation and calibration tools.

ECL computation, as it stands, involves parameters that vary across FIs and assets. Ind AS 109 does not mandate any methodology for calculating ECL. Definite guidelines on building a robust governance and control framework, validation of models, and model risk management will definitely help, as they alone can standardise the practices for ECL computation across FIs—up to an extent at least. Independent, local automation tools should be used to cover the large and diversified portfolios of Indian banks. Furthermore, transition guidelines from the regulator to spread out the impact of ECL implementation in phases would support FIs to adopt necessary technology tools, which in turn will smoothen the provision curve. All these practices will go a long way in enabling ECL to bring a semblance of certainty in the precarious market situation of today.

Views are personal. The author is CEO, BCT Digital.

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