How Should Banks Estimate Their Expected Loan Loss Provisions to Survive in Difficult Times?

As part of its continuous efforts to improve financial stability as well as to ensure uniform practices of accounting globally, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) issued a guidance on how to recognise and measure financial instruments. Required in more than 100 countries, all financial entities must incorporate a new expected credit loss model and adhere to new accounting standards within the next few years. The new acc­ounting standards aim to simplify and strengthen risk measurement and the reporting of financial instruments in an efficient and forward-looking manner. To address the “too little, too late” problem arising from the incurred loss model, the new accounting standards necessitate a “forward-looking” impairment model for the estimation of loss provision by commercial banks.

This forward-looking approach requires banks to update and recognise expected credit loss (ECL) for financial assets from the initial acquisition or origination date. In the view of rising stress on banks due to poor-quality loans and falling profitability, the Reserve Bank of India (RBI) has postponed the adoption of the standards by Indian banks. However, sooner or later the banks have to mandatorily adopt this standard to better deal with the uncertainty. Banks that have better data management systems and a prudent risk internal risk culture have been using these three risk drivers as per internal estimation models to measure loss provisions as well as capital requirement for credit risk.