Expected Credit Loss (ECL)

Expected Credit Loss (ECL) was implemented in different countries under IFRS9 standard in 2018. In U.S.A. also, the standard came in effect as part of ASC 326 – Current Expected Credit Loss (CECL) in 2022. In India, Reserve Bank of India (RBI) has deferred the implementation of the standard for banks, but any Non-Banking Financial Company (NBFC) which has transitioned to IndAS, the requirement to compute ECL is applicable as per IndAS109.

As ECL will impact Financial Statements of the FI, it is imperative that the framework is robust which adheres with applicable regulatory guidelines and industry best practices. Once ECL is implemented, FIs need to compute either 12-month or lifetime ECL for the facility from the day of loan disbursement. This will impact the financial statements of the FI including profitability, capital adequacy and other financial indicators.

In general, different ECL frameworks (IFRS9, IndAS109, ASC 326) are principal based and do not prescribe a single method that is to be used for ECL computation. As per ASC 326-20, “an entity may use discounted cash flow methods, loss-rate methods, roll-rate methods, probability-of-default methods, or methods that utilise an aging schedule to compute allowance for credit loss.

This paper discusses key components that are to be considered while formulating ECL framework within their organisations:

Definition of default
Segmentation
Significant Increase in Credit Risk (SICR)
Probability of Default (PD)
Loss Given Default (LGD)

Exposure At Default (EAD)
Effective Interest Rate (EIR)
Macroeconomic (MEV) Overlay and Weighted ECL
Post Model Adjustment (PMAs) and Overlays

In our experience, we have noticed different FIs globally face challenges in their journey of IFRS9/IndAS109/ASC 326 implementation which are on account of data availability, model methodology, process set-up, resource planning, information technology infrastructure, governance and controls, and management information system.

As per RBI guidelines, FIs should have independent three lines of defence to manage model risk and as per that, all ECL models should be independently validated before deployment as well as periodically monitored and validated as per MRM policy of the FI. Model validator to conduct comprehensive check on entire model development process and challenge model developer.

ECL implementation will not only impact complete credit lifecycle but also other functions and departments and thus it is imperative that different stakeholders understand the requirements and enhance process accordingly. Key areas that will be impacted by the ECL framework include pricing, liquidity, asset liability management, operations, ICAAP, regulatory compliance, reputation, risk appetite and limits, stress testing, and other fair value regulations.

As highlighted in this paper, ECL provisions requirements will not only impact credit department but all other aspects of business and risk management of the FIs. Thus, it is imperative that Fis should design Target Operating Model (TOM) in such a way that the framework is robust as well as optimise provision as a part of BAU process.