IndAS switch to impact banks' earnings, return on equity

All of them will have to report their financial statements from next year under the new rules

The loan loss provisioning as required by the new Indian Accounting Standards (IndAS) is expected to have a significant impact on banks' earnings and return on equity.

Financial year 2018-19 will be the first one where they will be required to report their financial statements under IndAS. The requirements are in line with the global International Financial Reporting Standards (IFRS)-9.

Till now, banks calculated the loss provisions on their loan portfolios based on the guidelines issued by Reserve Bank of India (RBI). These prescribe a percentage-based provisioning methodology, after an asset is overdue for a minimum number of days. However, under IndAS, the impairment provisions need to be computed on the expected credit loss (ECL) methodology, by categorising the loans in three stages. Apart from borrower-specific factors, these also considers forward-looking, macro economic factors that have a bearing on recoverability of the loans.

"The existing provisioning required by the RBI was based on the incurred loss model. Provisions were required to be made only when a loan was due for 90 days or more. However, the ECL method would require provisioning on Day 1 of the exposure taken by financial institutions. The guiding principle of ECL is to reflect the general pattern of deterioration or improvement in the credit quality of financial instruments," said Charanjit Attra, partner in an Indian member-firm of consultancy EY Global.

He says the parameters to determine a reasonable ECL provision would be based on methods used to compute exposures, default frequencies, loss rates, collateral values and actual recoveries in the past. "This would involve historic information, which would serve to build the forward-looking, customer-specific and macro economic factors in each of these parameters."

Changes in each of these factors could impact the amount of impairment provision. For example, ignoring the expected fall in exposure due to prepayment of the loan amount would lead to measurement of ECL on the higher side. Similarly, ignoring the drawdowns on a loan facility within the agreed limit on the revolving facility would result in a lower ECL provision.

Apart from financial reporting, the way banks manage and do business could be impacted. "The new model requires banks to make assessments of future losses expected to emerge over the next 12 months or, in certain cases, lifetime of the asset. This will impact the bank as a whole in terms of credit risk management processes, pricing of products, and IT (information technology) systems for operationalising the new model," said Sai Venkateshwaran, partner at consultancy KPMG India.

The higher provisioning under ECL would directly impact capital adequacy ratios. "The extent to which provisions created on loans categorised as stage-1 or stage-2 would be allowed to be treated as tier-II capital is still not clear. In case it is not allowed, the entire provisioning would have an impact on the profitability and, accordingly, on the net worth of the bank," said Attra.

Analysts believe the transition to IndAS would require a change in ESOP (employee stock option plan) accounting. Currently, accounting for ESOPs is done on the intrinsic value method. After transition to IndAS, banks will have to account for ESOPs based on the fair-value method. "HDFC Bank would see the biggest hit, followed by ICICI Bank. There are no implications for publci sector banks, as they have no ESOPs. Based on the disclosures by banks, the average impact will be four per cent on earnings and 58 basis points on the RoE (return in equity). Currently, the impact cost due to the intrinsic method is minimal, as most stock options are issued with exercise prices close to current market prices," said Suresh Ganapathy, banking analyst, Macquarie Capital.

He says HDFC Bank is likely to see a 10 per cent impact on earnings, followed by ICICI at four per cent, with the rest in the one to two per cent range. "Our conversations with finance headss of some banks reveal the impact will be a recurring one and the cost can be brought down only if they change their policy on grant of options," he added.

"We have US GAAP accounts which follows fair-value accounting. The annual impact on the profit and loss on account of ESOPs is already available. We had a much more extensive ESOP programme earlier, which has come off a bit in terms of grants. You can't look at that in isolation because the bank is reducing other costs. The overall cost to revenue will determine the EPS (earnings per share) and RoE impact of this transition. There will be some impact, which might not be meaningful," said Paresh Sukhtankar, deputy managing director, HDFC Bank.

Impact on Banks

The higher provisioning under IndAS is expected to impact profitability, RoE, net worth and capital adequacy ratios of banks. Lenders with lower coverage ratios under the existing guidelines would be more impacted as compared to banks with higher coverage ratios.
 

• Now: Guidelines prescribe a 
• percentage-based provisioning methodology after an asset is overdue for a minimum number of days 
• After transition to IndAS: Impairment provisions need to be computed based on the expected credit loss (ECL) methodology by categorising loan dues in three stages
• Now: Existing provisioning required by RBI is required to be made only when a loan is due for 90 days or more 
• After transition: Needs provisioning on Day 1 of the exposure taken by financial institutions 
• Now: Provisions are made generally on  loan dues 
• After transition: ECL provisions to be made on the entire exposure 
• Now: NPAs sold to asset reconstruction companies (ARCs) no longer considered under gross NPAs 
• After transition: Sale of NPAs to ARCs will remain in a bank’s books and will be considered part of gross NPAs