RAL4 - IndAs 109 GUIDELINES AND ECL COMPUTATION

1.0 Introduction :
BASEL reforms were introduced basically to strengthen the Capital base of Banks so that they can
withstand any financial storm. The timely recognition of and provision for, credit losses promote safe
and sound banking system. In response to the lessons learnt from the financial crisis, the international
accounting standard setting bodies (International Accounting Standards Board – IASB, and US Financial
Accounting Standards Board – FASB) have modified provisioning standards to incorporate forward
looking assessments in the estimation of credit losses i. e. Expected Credit Loss (ECL). This entails
making provisions based on “expected credit loss” instead of current practice based on “incurred
loss”. Thus, Internal Financial Reporting Standards (IFRS – 9) came into being.
The Indian counter part to international body viz. Institute of Chartered Accounts of India (ICAI) came
out with a set of guidelines for convergence of “Indian Generally Accepted Accounting Principles” (I
GAAP) with that of IFRS – 9 in the form of Ind AS 109. Whereas, Ministry of Corporate Affairs (MCA)
had notified the Companies Rules 2015, which stipulated the adoption and applicability Ind AS in a
phased manner commencing from the accounting period 2016-17. It has been made mandatary to all
companies from 1st April, 2016, provided : 1. It is a listed or unlisted company, 2. Its Net Worth is
more than or equal to Rs. 500 crore. It was made applicable to companies having Net Worth
of more than Rs. 250 crore w e f 01.04.2017. The applicability of Ind AS for Banks ought to have been
w e f 01.04.2018. The same ha been postponed by one year by Reserve Bank of India and will be
implemented w e f 01.04.2019.
2.0 Expected Credit Loss (ECL) framework :
In terms of Ind AS, the delinquency is a lagging indicator of significant increase in credit risk. Banks
are therefore expected to have credit risk assessment and measurement process in place to ensure
that credit risk increase are detected ahead of exposure becoming past due or Non Performing.
The credit assets are divided into 3 stages based on performance of repayment as per sanction terms,
as follows and accordingly ECL is arrived at :
a) Stage 1 - Performing : When loans first come onto bank balance sheets, banks shall recognize
the 12 month ECL for these loans. This is the probability in the next 12 months of a loan
defaulting (Probability of Default – PD) multiplied by the amount of money a bank would lose
on the default (Loss Given Default – LGD). Stage 1 assets include financial instruments that
have not had a significant increase in credit risk since initial recognition or that have low
credit risk at the reporting date. For these assets, 12 – month ECL are recognized and interest
revenue is calculated on the gross carrying amount of the asset.
b) Stage 2 – Underperforming : Where a loan or other financial instrument begins to show signs
of stress, or where deterioration in the macroeconomic environment suggests that the
probability of default is on the rise, i.e. loans and other financial instruments that have had
a Significant Increase in Credit Risk (SICR) since initial recognition (unless they have low credit
risk at the reporting date) but do not have objective evidence of impairment. For these assets
bank will have to recognize lifetime ECL (i.e. based on the lifetime PD), but interest revenue
is still calculated on the gross carrying amount of the asset.
c) Stage 3 – Non Performing : Includes financial assets that have objective evidence of
impairment at the reporting date. For these assets, lifetime ECL are recognized and interest
revenue is calculated on the net carrying amount (i.e. net of credit allowance).

3.0 Mapping of Asset Classification Rules under IRAC and Ind AS 109 :

IRAC Norms ‘Standard’ Special Mention Substandard Doubtful Loss

IRAC Norms Un-impaired Impaired
Ind AS 109 Stage 1 Stage 2 Stage 3
4.0 Provisioning - IRAC vs. Ind AS 109 :

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 Accounting Norms – Stage 1 Stage 2 Stage 3
Basis of recognition
IRAC – Performing loans Underperforming loans Nonperforming loans
Incurred loses Impairments: none Impairments: minimal Impairments:
Yes, 'incurred’
Ind AS 109 – Performing loans Underperforming loans Nonperforming loans
Expected losses Impairments: Impairments: Lifetime Impairments:
12 month expected expected loss Lifetime expected loss
loss
Note : IRAC – Income Recognition and Asset Classification Norms.
5.0 Overview of Ind AS 109 Expected Credit Loss Model :

Stage 1 Stage 2 Stage 3

• Upon credit origination,
12 month expected credit
losses established and
recognised in P&L
• 12 month ECL= 12 month
PD x LGD
• If credit risk of loan increases
significantly and the resulting
credit quality is not considered to
be low credit risk, lifetime ECL
are recognised in P&L
• 30 day rebuttable presumption
• Lifetime ECL = lifetime PD x LGD
• Credit impaired or incurred loss
has occurred
• Similar to IAS 39 impairment
model
• Lifetime ECL = lifetime PD x LGD

• Analogous to performing • Analogous to ‘underperforming’ • Analogous to ‘non-performing’;

loans loans but not yet impaired and current incurred loss model
under IAS 39

• Interest income • Interest income recognised on • Interest income recognised on

recognised on gross basis gross basis net basis (net of provisions)

Note : 1. ECL – Expected Credit Loss.

2. PD – Probability of Default.
3. LGD – Loss Given Default.
4. IAS 39 – International Accounting Standard 39.

6.0 Criteria for movement from Stage 1 to Stage 2:

1. Significant changes in internal price indicators of credit risk
2. Changes in the rates or terms of an existing financial instrument
3. Significant changes in external market indicators of credit risk
4. Actual or expected change in external ratings
5. An actual or expected internal credit rating downgrade for the borrower
6. Existing or forecast adverse changes in business, financial or economic conditions
7. An actual or expected significant change in the operating results of the borrower
8. Significant increases in credit risk on other financial instruments
9. Actual or expected significant adverse change in the regulatory, economic, or technological
environment
10. Significant changes in the value of the collateral
11. Significant change in the quality of the guarantee provided by a shareholder
12. Significant changes, such as reductions, in financial support from a parent entity
13. Expected changes in the loan documentation (i.e., changes/breach of contract terms)
14. Significant changes in the expected performance and behavior of the borrower
15. Changes in the entity’s credit management approach in relation to the financial instrument

16. Past due information

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(Non-exhaustive list of information given in IndAs 109 guidelines which may be relevant in assessing
changes in credit risk.)
7.0 Computation Methodology:
7.1 Term Loan:
 Stage 1: ECL = Exposure at Default (EAD) * 12m PD * LGD
 Stage 2:
o Step 1: Computation of lifetime PD for different tenors
o Step 2: Cash flow projections for different tenors
o Step 3: Computation of ECL = Cash flow * corresponding Tenor PD * LGD
o Step 4: Discounting of ECL to Computation Date
 Stage 3: ECL = Outstanding * 100% PD * LGD

1.2 CC / OD:

 Stage 1: ECL = EAD * 12m PD * LGD

 Stage 2: ECL = EAD * Lifetime PD * LGD
 Stage 3: ECL = Outstanding * 100% PD * LGD

1.3 Non-fund:

 Stage 1: ECL = EAD * 12m PD * LGD

 Stage 2: ECL = EAD * Lifetime PD * LGD
 Stage 3: ECL = Outstanding * 100% PD * LGD

EAD = Outstanding + Unavailed * CCF

8.0 Probability of Default:

Probability of default (PD) is a financial term describing the likelihood of a default over a particular
time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its
debt obligations.
Banks which have an internal rating methodology use the same to differentiate the corporate
borrowers into different rating grades corresponding to varying credit risk profile. The borrowers in
different rating grades will have different likelihood of default.
Bank would need to compute its internal rating wise PD for the corporate portfolio. PD may be
estimated based on the historical default data. The observed PD is computed as the count of
borrowers that defaulted over the year dividing by total numbers of non-default borrowers at the
beginning of the year.
e. g. There are 137 borrowers at the start of the year in as particular rating grade (say CB3), out of
which 3 borrowers are migrated to the default during the year. The one year observed PD of rating
grade CB3 is given as 3/137 i.e. 0.0219 or 2.19%.
Similarly, the observed PD for all rating grades can be arrived using the following transition matrix:

Total no of Migration of the borrowers during the year

borrowers at One year
the beginning observed
Rating of the year Default PD
Grades (T) CB1 CB2 CB3 CB4 CB5 CB6 CB7 (D) (D/T)*100
CB1 9 8 1 0 0.00%
CB2 58 1 53 3 1 0 0.00%
CB3 137 1 6 108 13 3 2 1 3 2.19%
CB4 175 1 13 136 12 4 9 5.14%
CB5 122 1 5 95 9 2 10 8.20%
CB6 87 4 5 39 2 37 42.53%
CB7 31 2 1 12 16 51.61%

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 CB8 7 7 100.00%
Total 626 10 60 125 159 118 55 17 82

The PD estimate arrived using the above method (after suitable macroeconomic adjustment) is used
for 12 months ECL computation. For Life time ECL, LIFE Time PD is required to be estimated from 12
months PD using matrix multiplication method.
9.0 Loss Given Default:
Loss Given Default (LGD) is net loss incurred by the bank after taking into consideration total recovery
when an account turns to NPA, calculated based on the historical recovery from the NPA accounts.
It is indicative percentage that depicts the Loss in case of default. LGD mainly depends upon the
quality of the collateral linked to the account and robustness in the recovery mechanism of the Bank.
LGD is the Bank’s economic loss upon the default of a borrower.
It is computed as shown below:
• LGD = (Outstanding at the time of default – Present Value of Net Recovery) / Outstanding at the
time of default.
LGD is expressed in percentage terms. It depends primarily on the type of collateral, value of
collateral and security coverage ratio. LGD is facility specific and different facilities to the same
borrower may have different LGDs. The LGD may be floored to zero (RBI floored at min 20%) and
capped at 100%.
Requirements of LGD for Corporate and Retail Borrowers:

Approach LGD for Corporates LGD for Retail

Standardised Approach Given by RBI Given by RBI
Internal Rating Based- Given by RBI Internally derived LGD
Foundation
Internal Rating Based- Internally derived LGD Internally derived LGD
Advanced

Under (Indian Accounting Standards) Ind AS 109 Expected Credit Loss (ECL) is computed to arrive at
the provisioning requirement for loans and advances. LGD is one of the key inputs for ECL
computation.
9.1 Types of LGD
1. Downturn LGD: The LGD for a facility that aims to reflect economic downturn conditions to
capture the relevant risks is called downturn LGD.

2. Long-run default-weighted average LGD: The LGD computed for the observation period is
default-weighted to arrive at average long-run default-weighted average LGD.

3. Lower of downturn LGD and long-run default-weighted average LGD is used for IRB
computation. Default-weighted average LGD is used for ECL computation.

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