Fortune India Explainer: Time for India’s banks to be battle-ready under ECL norms

India’s banking sector is at the threshold of a significant structural change on the assessment of credit risk. The Reserve Bank of India (RBI) has finalised the Expected Credit Loss (ECL) guidelines for scheduled commercial banks which will be implemented from April 1, 2027. The new “forward looking” guidelines will replace the existing “incurred loss” model to calculate and provision for non-performing assets (NPAs). Small finance banks, regional rural banks and payments banks have been excluded from adopting ECL guidelines.

Why was the previous model changed?

The truth is that—despite historic gross NPAs at a low of 2.15% and net NPAs at a low of 0.5%—the current model to calculate NPAs was not seen to be the perfect approach. In the current structure banks and NBFCs would recognise and provide for a bad loan only after a default, which would mean the loan being overdue for 90 days. So even though a company or borrower showed signs of a financial distress, in the form of weak earnings data or rising debt, fresh provisions were not made until the borrower defaults on the loan. Banks have followed the ‘issuer-based’ provisioning rather than a ‘loan-based’ provisioning.

But where ECL scores over the current model is that, by its very nature, it is forward looking and would meet global standards. The ECL framework is being aligned to the IFRS 9, which is the International Financial Reporting Standard, starting from January 1, 2018, which sets out accounting requirements for financial assets and liabilities.

How is ECL calculated?

In the ECL model, the bank anticipates an estimate on which loans will turn delinquent. It will, beforehand, make provisions for it, so that it is prepared for something that may happen. Loans will be classified under Stage 1, Stage 2 and Stage 3. Stage 1 is a low credit risk where loans are performing normally, there is no deterioration in credit quality, and the provision is based on 12-months probability of default (PD). The minimum prudential floor for Stage 1 loans is 0.40%.

Stage 2 is increased credit risk where credit quality has deteriorated since initial recognition. The minimum prudential floor for Stage 2 loans is 5% (500 basis points provisioning). Stage 3 is where the loan has been defaulted upon, where it needs the highest level of provisioning ranging on the duration of the loan.

The existing norm to identify non-performing assets (NPAs) will remain unchanged, where a loan is classified as a bad loan if the repayments are overdue for more than 90 days.

There are three main components: probability of default (PD), loan given default (LGD), which is the percentage of loan the bank could lose after accounting for recoveries and EAD (exposure at default), which refers to the total exposure of the bank at the time of default. The formula to be considered is ECL = PD x LGD x EAD.

Experts believe this could be the best time for the introduction of ECL norms, as banks’ asset quality, profitability and capital adequacy levels are better than a decade ago. Making more provisioning at this stage would be most prudent.

What is the pressure on banks due to the ECL model?

This will be a better way of determining credit risk in the ecosystem. But even as banks align themselves with the new model, there will be inconsistencies, which is why the transition period of one year has been given. Most of the private sector banks are better prepared, having better provisioning, advanced risk models and early warning signals already in place.

Some banks will face pressure on their capital adequacy due to a possible provision shortfall in the ECL model. Kotak Institutional Equities has in a latest calculation, says the magnitude of provision shortfall for PSU banks and large private banks seems limited. The provision shortfall amount for some of the banks is calculated as: for ICICI Bank (₹1,900 crore), IndusInd Bank (₹1,900 crore), State Bank of India (₹20,400) and Bank of Baroda (₹5,700).

Crisil assesses that there could be a one-time net impact of up to 120 basis points on their Common Equity Tier 1 (CET-1) ratio. But banks will be allowed to spread the impact over four years. RBI has said that all loans must transition to an effective interest rate -based accounting to calculate ECL by March 31, 2030.

If prescribed, how will NBFCs cope with a floor under ECL norms?

Currently, RBI has prescribed the ECL norms only for scheduled commercial banks. But NBFCs have migrated to Ind-AS norms from FY18 and adopted ECL about ten years ahead of banks. But the RBI has not prescribed any floor/minimum requirement under the ECL model, for NBFCs.

Kotak Institutional Equities says most NBFCs are “well placed” to comply with floor requirements, in a hypothetical scenario of ECL floors being prescribed for NBFCs too.