RBI's ECL move may hit capital position of smaller private banks

The Reserve Bank of India’s (RBI’s) discussion paper suggesting banks migrate to an expected credit loss (ECL) approach for provisioning of bad assets is likely to have a bearing on the capital position of smaller banks, analysts have said. 

According to them, while large private banks, such as HDFC Bank, ICICI Bank, and Axis Bank, are well placed and could see release of provisions, smaller lenders, including City Union Bank, DCB Bank, and Equitas Small Finance Bank, may have to accelerate provision buffers and raise capital faster than intended.

The RBI’s discussion paper, released on Monday, proposed an ECL-based approach used in International Financial Rep­o­rting Standards (IFRS) 9 for recognition of provisions by banks. According to the appr­oach, banks have to make provisions on the basis of self-desi­gned models that are app­roved by the RBI and that capture the regulatory guidance.

Banks are required to measure the ECL of a financial instrument by classifying the loans in three stages — 1, 2, and 3. The stages are to be classified on the overdue position of the asset and provisions have to be made determining the probability of default, loss given default, and exposure at default.

The RBI will give at least a year’s time to the banks to put in place the necessary systems and procedures, including the development and validation of ECL models, from the date of final guidelines on ECL approach for loss provisioning.

Also, the increase in provisioning requirement on common equity tier-I (CET1) capital for loan loss, which will be incurred by scheduled commercial banks due to transition to expected credit loss (ECL) model, will be phased out in five years, the RBI has said. This is because the RBI itself has estimated that the potential initial impact of application of ECL approach on banks’ capital could be significant.

“The impact could be felt in FY26 accounts and banks would have to start preparing in FY25 to raise capital, in our view,” said analysts at Macquarie Research in their report on Tuesday. Since the probability of default for public sector banks over the past several years has been much higher and they usually don’t make many contingent provisions, the impact could be far more severe on them, they said.

Over the past 5-10 years, the probability of default would have been very high for the banking sector and that’s why eventual ECL provisions could be higher. Plus, ECL rules also include interest lost over the lifecycle of loan, which compounds the problem. However, at this point in time, the impact cannot be quantified due to paucity of data and rules, Macquarie Report said.

“Overall, we believe the potential impact on banks will be manageable based on our current asset quality expectations, unlike significant implications 3-4 years back,” said Morgan Stanley in a report.

Analysts at Emkay Research said ECL-based norms could release provisioning for some large banks, such as ICICI Bank, Axis Bank, HDFC Bank, which have strong buffers, while some small banks may have to accelerate provision buffers and even replenish capital levels faster than planned.

According to analysts at Kotak Institutional Equities, the RBI probably wanted banks to complete their provisions from the previous corporate non-performing assets (NPA) cycle before migrating into a new regime. And, a five-year transitioning period of the initial migration costs should make it comfortable for most banks.

They, however, feel a key challenge to move to the ECL approach is the data that goes behind these assumptions. “Estimating defa­ult probabilities or losses requires rich data sets that capture various cycles. While ECL is the best way forward, we need to acknowledge that we are also moving with less quality of data as well,” analysts at Kotak Institutional Equities said in their report.

Analysts, however, agree that this is the best time to implement the ECL approach as India’s banking sector is in a purple patch, wherein profits are soaring and bad assets ratios are declining, resulting in reduced credit costs.

“The ECL framework, though tough on the balance sheet and profit and loss of banks initially, strengthens the banking system in the long run. The RBI is doing so at a time when the health of the banking system is the best,” said Suresh Ganapathy, associate director, Macquarie Capital.