The implementation of Ind-AS, the Indian version of the International Financial Reporting Standards (IFRS), will remain a challenge for some banks due to higher capital requirements, lack of adequate systems, processes and data.
This is because banks would have to contend with the impact of an increase in provisioning on their overall loss-absorption buffers.
Experts are wary that banks may end up reducing their capital ratios as a response to higher provisioning under Ind-AS. This will dent the ability of these entities to absorb unexpected asset quality stress. Here, state-owned banks face a bigger challenge than private banks due to their more modest capital buffers relative to their risk appetite.
“The transition to ECL is a fairly cumbersome process for which you need a significant amount of data that all banks may not have. Banks having poorer asset quality and processes could get negatively impacted by the transition to Ind-AS,” says Bhavik Hathi, managing director, Alvarez & Marsal. “Any negative impact may have serious implications on capital adequacy which would result in additional capital requirements. Having adequate depth in markets to be able to support capital requirements of banks once they make transition to Ind-AS is a concern.”
In a step towards transitioning to the Ind-AS accounting system, the Reserve Bank of India (RBI) in January issued a discussion paper on the implementation of the expected credit loss (ECL)-based provisioning by banks. The RBI has sought feedback from stakeholders, prior to the issuance of the actual guidelines. It has stated in its recent annual report that the guidelines will likely be issued in the current fiscal.
While the likes of ICRA and Fitch Ratings expect ECL to be implemented from April 2025, there is no formal communication from the RBI in this regard.
“The movement of Indian banks to IFRS-9 or Ind-AS is subject to approval from the RBI, which in turn would also require approval from Parliament. So, none of the banks has moved to Ind-AS as of now,” Anil Gupta, senior vice president, co group head – financial sector ratings, ICRA, said. “The delay could partly be explained by asset quality issues the banking sector faced and consequently its impact on their capital position.”
The transition to Ind-AS will impact banks’ balance sheets, capital adequacy and ability to raise funds. Hence, experts say the delay in transition is not an issue of intent, but instead one of “practicality”. Also, banks may have to face the ire of analysts and other stakeholders if there is a sudden movement in their profitability as a result of the transition to ECL.
Under the ECL model, ‘financial assets’ must be classified as Stage 1, 2 or 3, depending on their credit risk profile, with Stage 2 and 3 loans having higher provisions based on historical credit-loss patterns. This runs contrary to the existing approach of incurred loss provisioning, wherein step-up provisions are made based on the time that the account has remained in the non-performing asset category.
Hence, shifting to ECL-based provisioning would entail a one-time provisioning requirement on such Stage 2 and 3 exposures apart from other off-balance sheet exposures.
While the RBI has proposed a maximum time frame of five years after the date of implementation for spreading out these provisions. ICRA expects some banks to raise external capital sooner to manage the impact of the transition in a better manner. ICRA expects capital requirements of banks to rise by 300-400 bps as a result of the transition to ECL.
The transition will likely have a negative impact on banks’ capital levels, as more impairment charges are front-loaded. But, it should bring qualitative benefits in credit risk management over longer term, say experts.
“The ECL framework primarily addresses the problem of procyclical provisions, as banks are required to estimate ECL ahead of adverse credit events, instead of making provisions after loans have become impaired, as is the current norm,” Fitch Ratings said in a recent report.
After Q4 results, State Bank of India chairman Dinesh Kumar Khara said the lender was well equipped to weather the transition to ECL.
But, the journey is unlikely to be smooth for some other banks given the issues related to upgrading accounting systems, training teams and potential impact on the financial statements.
“It is expected that banks having better corporate governance, robust processes and consequently stronger underlying asset quality may benefit from the transition to Ind-AS. However, banks having poorer asset quality and processes could get negatively impacted,” Hathi said.