Expected Credit Loss Framework: Reform or Reckoning for Banks?

The Reserve Bank of India released a series of circulars earlier this week, the most important impactful of those being on provisioning norms. It ushers in the Expected Credit Loss regime. This circular converts a draft proposal floated six months ago into regulation. With four-fifths of Indian banks’ capital invested in lending related activity, it shifts the way Indian banks recognise and prepare themselves on losses in lending activity.

Higher-Risk Loans Treatment
In the initial proposal, loan overdue status of days past due was seen as a credit risk indicator and measure thereof. That stood to contradict the main theme of the G20 backed ECL reform. The core idea of ECL is to anticipate credit losses and not wait until loans become overdue and non-performing. This central idea of ECL could not have been compromised. I had also pointed to the need for resolving this weakness in one of my previous articles. 

This issue has been fixed in the final circular, thereby eliminating a major convergence roadblock with international standards and practices on ECL as well as Credit Risk Management. Higher-risk loans must now be recognised by banks early through their internal risk identification mechanisms.

For loans that are well overdue, they would anyway be classified in higher-risk category. In this manner, the older pre-ECL days past due approach gets absorbed within the ECL framework. In other words, days past due based measures act as backstop.

Anticipating Losses
Estimation of expected losses requires risk on loans to be anticipated and quantified. This applies to all risk categories, low or higher. Therefore, in this context qualitative judgement must give way to quantitative models. The most important component for quantification of credit risk is the default probability  – the likelihood that a borrower will fail to repay in time.

That requires default probability to be anticipative. This hasn’t always been the actual practice at lenders, leading to late recognition of loans. This directive aims to plug that hole by requiring banks to harmonise default probabilities with core internal credit risk assessment capabilities. Banks already evaluate their borrowers through quantitative method(s) involving default probability, at the time of granting loans. They would henceforth be required to extend the capability to ongoing assessment.

For lenders that have not yet commenced granting of loans via quantification processes, they will have good ground to cover in limited time. The challenge would however come not from investment and efforts in getting there. The battle will be to change the risk culture within.

Supervised and the Supervisor
Banks in other regions of the world achieved this about a decade earlier. We must play catch up. Therefore, the time for discovery is little. However, there are immense benefits.

The benefits depend on how well these risk-based next generation reforms are implemented in India. And the quality of implementation ultimately depends upon how well lenders absorb the ECL framework and succeed in applying it for anticipative ‘forward looking’ loss recognition.

The next most important player is the regulatory supervision. It is the quality of supervision that is instrumental in ensuring effective implementation. The burden of pointing out of inconsistencies and non-compliances largely falls on banking supervision teams worldwide. The better the supervision, higher the quality of implementation. The skillsets have improved markedly in recent years and will need robust augmentation especially in area of quantification of risks.

The quality of implementation and final output depends a great deal also on the quality of regulations. Ambiguous regulations seldom act as foundation for a well-regulated ecosystem. This is also an area where I see improvement, with the RBI now clarifying key implementation elements such as: methods for estimating default probability, its expectations on risk management capabilities at regulated banks, governance benchmarks, etc.

The RBI should also consider refreshing the ECL circulars that are already applicable to NBFC lenders, to converge with the principles and mechanisms just laid down for banks. 

Road Ahead
Globally, internal credit rating systems have long formed the backbone of modern banking. With this circular India has the chance to create convergence with international risk management framework and use risk management best practices to move ahead. The circular is just the beginning. The real work will have to begin now.