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October 2020

PROVISIONING FOR EXPECTED CREDIT LOSSES FOR FINANCIAL INSTITUTIONS AND NBFCs POST-COVID-19

By Zubin F. Billimoria
Chartered Accountant
Reading Time 20 mins

INTRODUCTION

The Covid-19 outbreak which surfaced in
China towards the end of 2019 was declared a global pandemic by the WHO in
March, 2020. It has affected economic and financial markets, and virtually all
industries are facing challenges associated with the economic conditions
resulting from efforts to address it. As the pandemic increases both in magnitude
and duration, entities are experiencing conditions often associated with a
general economic downturn. The continuation of these circumstances could result
in an even broader economic downturn that could have a prolonged negative
impact on an entity’s financial results. In response thereto, the RBI announced
a series of regulatory measures and relief packages dealing with rescheduling
of loans and credit facilities, providing moratorium, asset classification and
provisioning for the entire financial services sector which comprises of banks,
financial institutions and NBFCs.

 

Since the purpose of this article is to
highlight some of the key issues that emanate from the Covid pandemic to be
considered by financial institutions and NBFCs, in particular, in applying the
expected credit loss model (ECL) for provisioning in their Ind AS financial
statements, the discussion of the regulatory aspects will only be limited to
the extent it impacts the ECL. Whilst the focus of this article is for lenders,
much of it would apply to measurement of ECL in industries other than financial
services.

 

For the purpose of this article, it is
assumed that the readers have reasonable working knowledge of the various
technical requirements and guidance under Ind AS on ECL and related matters.

 

OVERVIEW OF THE ECL
MODEL AND ITS INTERPLAY WITH OTHER TECHNICAL AND REGULATORY REQUIREMENTS IN THE
COVID ENVIRONMENT

 

ECL model as per Ind AS 109

Ind AS 109 on
Financial Instruments sets out a framework for determining the amount of
ECL that should be recognised. It requires that lifetime ECLs be
recognised when there is a significant increase in credit risk (SICR) on a
financial instrument
. However, it does not set bright lines or a mechanical
approach to determining when lifetime losses are required to be recognised, nor
does it dictate the exact basis on which entities should determine
forward-looking scenarios to consider when estimating ECLs.

 

Ind AS 109 requires entities to measure
expected losses and consider forward-looking information by reflecting ‘an
unbiased and probability-weighted amount that is determined by evaluating a
range of possible outcomes’
and taking into account ‘reasonable
and supportable information that is available without undue cost or effort at
that date about past events, current conditions and forecasts of future
economic conditions’.
Whilst it always required entities to consider
multiple scenarios, entities may not have done so because it did not make a
material difference to the outcome in a benign / static economic environment.
However, such an approach may no longer be appropriate in the current Covid
scenario. Further, Ind AS 109 requires the application of judgement and
permits entities to adjust their approach to determining ECLs in different
circumstances. A number of assumptions and linkages underlying the way ECLs
have been implemented to date may no longer hold in the current Covid
environment and therefore entities will have to revisit the ECL approach /
methodology and should not continue to apply their existing ECL methodology
mechanically.

 

PRESENTATION AND
DISCLOSURES

In line with the requirements of Ind AS
107
on Financial Instruments – Disclosures and Ind AS 1 on Presentation
of Financial Statements
, entities would be required to provide more
additional information to enable users of financial statements to understand
the overall impact of Covid-19 on their financial position and performance.
This is particularly important for areas in which Ind AS requires that
significant judgement is applied, which might also include other areas of
financial reporting. Similarly, the auditors would also need to consider
whether reporting on Covid-related matters needs to be reported as a key audit
matter in terms of the Auditing Standards.

 

Finally, distinguishing between adjusting
and non-adjusting events requires significant judgement,
particularly in the current environment for those entities where the economic
severity of the pandemic became apparent very shortly after the end of their
reporting period. The Guidance issued by the ICAI in connection therewith
should be referred to.

 

Impact of regulatory measures

The government and the RBI have been
announcing various relief measures / packages to enable entities to tide over
the adverse impact of Covid on their operations and financial position.
However, it may be difficult to initially incorporate the specific effects of
Covid and government support measures on a reasonable and supportable basis. The
changes in economic conditions should be reflected in macro-economic scenarios
applied by entities and in their weightings. If the effects of Covid are
difficult to be reflected in models considering the timing of Covid and
implications on Internal Financial Controls over Financial Reporting (IFCoFR),
post-model overlays or adjustments duly considering the portfolio segmentation
having shared credit risk characteristics and staging criteria (Stages 1, 2 and
3) may need to be considered as a pragmatic approach.

 

Further, entities should carefully assess
the impact of the economic support and relief measures on recognised financial
instruments and their conditions. This includes the assessment of whether such
measures result in modification of the financial assets and whether
modifications lead to their de-recognition. If it is concluded that the
support measures provide temporary relief to borrowers affected by the Covid
outbreak and the net economic value of the loan is not significantly affected,
the modification would be unlikely to be considered as substantial.

 

Finally, measures taken in the context of
the Covid outbreak that permit, require or encourage suspension or delays in
payments, should not be regarded as automatically having a one-to-one impact on
the assessment of whether loans have suffered an SICR.
Therefore, a
moratorium under these circumstances should not in itself be considered as an
automatic trigger of SICR. Assessing whether there is an SICR is a holistic
assessment of a number of quantitative and qualitative indicators. Furthermore,
when relief (forbearance) measures are provided to borrowers by issuers, these
measures should be analysed taking into account all the facts and circumstances
in order to distinguish, for example, whether the credit risk on the financial
instrument has significantly increased or whether the borrower is only
experiencing a temporary liquidity constraint and there has not been a
significant increase in credit risk and consequential impact on the ECL to be considered.

 

These and some other specific considerations
arising out of Covid-19 on the assessment of ECL are examined later in this
article.

 

SPECIFIC CONSIDERATIONS


The following are some of the specific
considerations which need to be kept in mind whilst determining the adequacy
and appropriateness of the ECL provisions in the post-Covid scenario.

 

Reassessing the business model

As per Ind AS 109, the classification and
measurement of financial assets is dependent on the contractual cash flows
of the asset and the business model within which the asset is held,
which
in turn determines the basis of valuation of the financial assets and
the provisioning thereof. An entity’s business model is determined at a
level that reflects how groups of financial assets are managed together
to achieve a particular business objective. Going forward, entities may need to
revisit their business model to determine whether it (the business model) has
changed due to the Covid implications, as the entity may decide to sell its
‘hold to collect’ portfolio as part of its revised strategy to manage liquidity
and credit risks.

 

Revisiting overall portfolio
segmentation

In accordance with Ind AS 109, financial
instruments
should be grouped on the basis of shared credit
risk characteristics.
Due to the disruptions in the business
operations, entities might witness an impact on the credit quality of their
portfolio across certain industries, geographies, customer segments, etc., that
may require them to revisit their portfolio segmentation and revise the ECL
assessment as appropriate. This may result in new portfolios being created or
assets moving to an existing portfolio that better reflects the similar credit
risk characteristics of that group of assets.

 

Further, forward-looking information might
need to be tailored for each portfolio. How much weight to give that
information depends on the specific credit risk drivers relevant to the
entities’ portfolios.

 

To illustrate, entities may lend across a
broad customer base resulting in concentration of risk exposure because of the
sectors and geographic areas in which customers are based or work. An entity’s
expectations over future unemployment in a particular sector may only be
relevant to borrowers who work in that sector.

 

At a broader level the portfolios can be
segregated between corporate and retail customer base which can be further
segregated based on the representative shared credit risk characteristics,

as considered relevant. Examples of shared credit risk characteristics may
include, but are not limited to, the following:

(a)   instrument type;

(b)   credit risk ratings;

(c)   collateral type;

(d)   date of initial recognition;

(e)   remaining term to maturity;

(f)    industry;

(g)   geographical location of the borrower; and

(h)   the value and liquidity of collateral
relative to the financial asset if it has an impact on the probability of a
default occurring (for example, loan-to-value ratios).

           

Assessment of SICR vis-à-vis
moratorium

When an entity grants an extension of terms
to a counter-party, the management should assess whether or not this indicates
that there has been a significant increase in credit risk. Measures taken in
the context of the Covid outbreak that permit, require or encourage suspension
or delays in payments should not be regarded as automatically having a
one-to-one impact on the assessment of whether loans have suffered an SICR.
Determining whether a change in the timing of contractual cash flows is an
SICR, or evidence of a credit-impaired financial asset, requires careful
consideration of the specific facts and circumstances.

 

Within the population of customers that
apply for a moratorium, separating those that are in financial difficulty
(borrowers with a solvency issue) from those that are not (borrowers with a
temporary liquidity issue), will be an operational challenge.
Consideration
will need to be given to the payment status and history of the borrower
on the date when he applies for a moratorium. Therefore, an assessment will be
needed as to whether the moratorium is providing a short-term liquidity benefit
or addressing a deterioration in the borrower’s ability to meet its obligation
when due which, if it is a significant increase in lifetime Probability of
Default (PD), is an SICR.

 

An illustrative list of factors which can be
considered in making the aforesaid evaluations is as under:

 

1.   ‘Days Past Due’ metrics could reflect
the impact of the payment moratorium where borrowers take advantage of a
payment holiday and so instalments due on or after 1st March, 2020 may
no longer be ‘past due’.

2.   Payment history: Has the customer made
regular payments over, say, the last year on the loan in question and its other
credit obligations?

3.   Collateral: Has the valuation of the
underlying collaterals been significantly depleted?

4.   Leverage: Has the customer seen a
recent increase in leverage or indebtedness?

5.   Repeat forbearance: Has the customer
been granted prior / subsequent (post-balance sheet) forbearance treatments?

6.   Changes to credit risk policy: Do the
previous qualitative indicators of SICR need a reconsideration?

7.   Breach of the covenants of a credit
contract is a possible indication of unlikeliness to pay under the definition
of default. However, a covenant breach does not automatically trigger a
default. Rather, it is important to assess covenant breaches on a case-by-case
basis and determine whether they indicate unwillingness to pay.

8.   Sector in which the customer is
employed or operates, including its representative income profiles.

9.   Reference may also be drawn from various credit
agency reports
which detail the sectors which have had a significant
impact, e.g., travel, aviation, tourism, etc.

10. In case of wholesale customers, factors
including current cash position, gearing status, future payments (including
loan repayments, expenses), future cash inflows and likely covenant breaches
can be evaluated.

 

Paragraph B5.5.17 of Ind AS 109 also provides a non-exhaustive list of information that may be
relevant and considered by entities in assessing and evaluating changes in
credit risk.

 

The entity should have a clearly defined
policy
based on its portfolio to detail its evaluation of SICR and
how it will be applied across various portfolios and it should be approved by
the Board. (Refer to discussion under Governance process for further
details).

 

Assessing management overlays

This is an important consideration in the
context of the current unprecedented situation. The speed and timing of the
economic impact of Covid would require entities to include Post-Model
Adjustments (PMAs)
to cater for the inadequacies of their ECL
models
that are not designed to cater for the extreme economic
circumstances and government support measures that currently exist and to
reflect risks and other uncertainties that are not included in the underlying
ECL measurement models. Some of the macro-economic factors which could
be considered for making the assessment include, but are not limited to, GDP
growth rates, bank credit growth, wholesale price index, consumer price index,
Index of Industrial Production, unemployment rate, crude oil price, exchange
rates
, etc., depending upon the nature of the portfolio. Considering the
timing, availability of information and uncertainties involved, a pragmatic
approach needs to be considered depending on the facts and circumstances in doing the overlay on Probability of Default (PD)
scenarios at the identified segmented portfolio levels.
This would result
in additional downside scenarios in their year-end results, which topped
up the amount of their ECL allowances to specifically address economic
uncertainty.

 

Such PMAs should be well-controlled,
authorised, documented and need to be disclosed in accordance with the
governance framework for ECL as laid down by the entity.
It is recommended
that entities disclose an explanation for each material post-model
adjustment or overlay made,
along with the reason for the adjustment,
how the amount is determined, the approach used for the estimation and the
amount of each material post-model adjustment.

 

Probability weightage of various
scenarios

Paragraph 5.5.17(a) of Ind AS 109 requires the estimate of ECL to reflect an unbiased and
probability-weighted amount that is determined by evaluating a range of
possible outcomes.
In practice, this may not need to be a complex analysis,
and relatively simple modelling may be sufficient without the need for a large
number of detailed simulations of scenarios.

 

However, currently there is little
visibility on how long the pandemic would last and the economic impact could
range from a mild downturn (where growth slows for a quarter or two, and the
economy bounces back immediately) to a severe slowdown (where growth slows for
more than a year followed by a tenuous recovery). Accordingly, ECL computation
needs to be done based on a range of possible scenarios, presenting a varying
degree of the economic and financial crisis and predict corresponding outcomes
such as:

 

(i)   an optimistic scenario, considering a
temporary impact of Covid-19 and a V-shaped recovery,

(ii)  a scenario, considering a severe and extended
impact of Covid-19 and a U-shaped recovery; and

(iii) a pessimistic scenario, with a prolonged severe
downturn, leading to a new low-level normal.

 

An unbiased estimate is one that is neither
overly optimistic nor overly pessimistic. For this purpose, entities will need
to develop an estimate based on the best available data about past events,
current conditions and forecasts of future economic conditions. Adjustments to
expected loss rates in provision matrices and overlays to formal models (where
used) will be needed. Updated facts and circumstances should continue to be
monitored for any new information relevant to assessing the conditions at the
reporting date. The probabilities assigned to these multiple economic scenarios
will often be a significant judgement warranting disclosure, which is a
critical component of ECL reporting, given the level of measurement uncertainty
resulting from Covid.

 

Forward-looking
information

The use of forward-looking information is a
key component of the ECL impairment approach. But this is not straight-forward
and involves judgement. No one can predict the future with certainty so the
incorporation of forward-looking information introduces considerable volatility
into entities’ results.

 

The economic forecasts that entities use to
estimate lifetime losses should not only be consistent with internal
managements’ forward-looking views, but also supportable with sound
quantitative data and methods. It is recommended that lenders consider official
economic forecasts issued by RBI and internal economists in assessing the
severity and duration of the macro-economic deterioration. Economic forecasts
generated by research agencies or professional forecasters could also be used.
However, over-reliance on these sources may become problematic as market prices
for debt and derivatives might reflect factors other than the borrower’s risk
of default (such as market liquidity) and the credit ratings could be a lagging
indicator of credit risk. But so long as the forecasts are defensible and
consistent with the institution’s own views, these could also be used where
relevant for the particular financial instrument or group of financial
instruments, and not at the entity level, to which the impairment requirements
are being applied. Different factors may be relevant to different financial instruments
and, accordingly, the relevance of particular items of information may vary
between financial instruments, depending on the specific drivers of credit
risk. Some examples in respect thereof are as under:

 

(A)  For corporate lending, forward-looking information
includes the future prospects of the industries in which the group’s
counter-parties operate, obtained from economic expert reports, financial
analysts, governmental bodies, relevant think-tanks and other similar
organisations, as well as consideration of various internal and external
sources of actual and forecast economic information.

(B)  For retail lending forward-looking information
includes the same economic forecasts as corporate lending with additional
forecasts of local economic indicators, particularly for regions with a
concentration of certain industries, as well as internally generated
information of customer payment behaviour.

 

As required by paragraph 35G (b) of Ind
AS 107
, financial statements should disclose how forward-looking information
has been incorporated into the determination of expected credit losses,
including the use of macro-economic information.
Further, paragraph
35G(c)
requires disclosure on changes in the estimation techniques or
significant assumptions made during the reporting period and the reasons for
those changes.

 

Events after the reporting period

Ind AS 10 on Events
after the Reporting Period
distinguishes between adjusting and non-adjusting
events, with adjusting events being those that provide further evidence of
conditions that existed at the end of the reporting period and therefore need
to be reflected in the measurement of balances in the reporting period. Non-adjusting
events are those that are indicative of
a condition that arose after the end of the reporting period.

 

Entities will need to update their forward-looking
information to reflect expectations at the reporting date. Entities will need
to distinguish between those events that arose after the end of the reporting
period that reflect new events, as opposed to those that were reasonably
expected at the reporting period end and so would have been reasonably assessed
as being included in the forward-looking assessment made at the end of the
reporting period. This assessment might include, for example, assessing the
status and extent of the Covid-19 pandemic in geographies relevant to the
entity’s credit risk exposures at the reporting period end and considering the
path and extent of the increase in infection rates in other areas that were affected
earlier.

 

An entity may consider it reasonable at the
reporting period end to forecast particular macro-economic inputs used in ECL
modelling. If those macro-economic inputs end up not occurring or changing
after the reporting date, this should not be used as evidence to adjust the
entity’s expectation at the period end. Doing so would represent inappropriate
use of hindsight and would not reflect the conditions that existed at the
reporting period end. Distinguishing between adjusting and non-adjusting events
requires significant judgement, particularly in the current environment for
those entities where the economic severity of the pandemic became apparent very
shortly after the end of their reporting period.

 

The severity of the economic impact of Covid
after the end of the reporting period will require consideration even if those
economic impacts are non-adjusting events. When non-adjusting events after the
reporting period are material, an entity is required to disclose the nature of
the event and an estimate of its financial effect, or a statement that such an
estimate cannot be made.

 

Governance process

An entity’s Board of Directors (or
equivalent) and senior management are responsible for ensuring that it has
appropriate credit risk practices, including an effective system of internal
control, to consistently determine adequate allowances in accordance with its
stated policies and procedures, the applicable accounting framework and
relevant supervisory guidance.

 

As per the RBI circular dated 13th
March, 2020
on Implementation of Indian Accounting Standards, for
Non-Banking Financial Companies and Asset Reconstruction Companies,
the
RBI expects the Board of Directors to approve sound methodologies for
computation of ECL that address policies, procedures and controls for assessing
and measuring credit risk on all lending exposures, commensurate with the size,
complexity and risk profile specific to the NBFC / ARC.
These matters
become more critical in the context of the Covid-19-induced environment.
It would not be out of place for entities to set up a separate sub-committee
of the Board to monitor the impact on various aspects of the business due to
Covid, which could also cover the above referred matters.

 

The following are some of the specific matters
which need to be documented and approved by the Board and / or the Audit
Committee of the Board (ACB):

 

(I)    The parameters and assumptions considered
as well as their sensitivity to the ECL output.

(II)   NBFCs / ARCs are advised to not make
changes in the parameters, assumptions and other aspects of their ECL model for
the purposes of profit smoothening.

(III)  The rationale and justification for any
change in the ECL model.

(IV)  Any adjustments to the model output (i.e.,
a management overlay)
which are necessitated due to Covid-19 should be approved
by the ACB
together with its rationale and basis.

(V)  ACB should also approve the
classification of accounts that are past due beyond 90 days but not treated as
impaired, together with the rationale for the same.

 

CONCLUSION

Covid-19 is likely to be the new normal and
will continue to pose several challenges which will require quick responses on
a real-time basis, which may make it difficult to incorporate the specific
effects of the regulatory support measures on a reasonable and supportable
basis. However, changes in economic conditions should be reflected in
macro-economic scenarios applied by entities and in their weightings. If the
effects of Covid-19 cannot be reflected in models, post-model overlays or adjustments
will need to be considered. Although the current circumstances are difficult
and create high levels of uncertainty, ECL estimates can still be made if
monitored under the appropriate supervision and governance framework laid down
by the entities, based on reasonable and supportable information supplemented
by adequate disclosures for transparency in the entity’s financial statements.

 

(The author
would like to acknowledge the contribution of CA Rukshad Daruvala and CA
Neville Daruwalla for their inputs in preparing this article.)

 

 

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