Gone are the days when the Indian financial sector suffered from inaccurate credit provisions. Now, with IFRS 9 in your books, you’re required to consider ECLs or Expected credit loss at the time financial instruments are originated or acquired. ECL has actually shaken up the way we think about the accounting world.
So, what exactly is ECL?
ECL is a forward-looking measure of credit risk that reflects the amount of credit losses an entity expects to incur over the expected life of its financial instruments. This includes loans, receivables, and investments.
In other words, ECL is an estimate of the potential losses an entity might face due to a borrower defaulting on a loan or failing to pay back an investment. Technically, ECL was launched in 2018, when it was first implemented under IAS 109, but like the internet in the 1990s, it was way ahead of its time and the financial sector was not prepared to implement it.
Why the shift to ECL?
Under previous accounting standards, we only recognized credit losses when their likelihood to defer was certain. This meant we were often playing catch-up, trying to address losses that had already occurred. ECL allows us to be proactive, identifying and addressing potential losses before they happen.
The adoption of IFRS 9 has had a significant impact on the financial statements of many entities. It’s resulted in an increase in the number of current expect credit losses recognized, particularly for instruments with longer maturities or for entities with higher credit risk.
But ECL is important for more than just lenders – it’s also important for investors and other users of financial statements. By understanding the ECL associated with a lender’s loans, investors can get a better sense of the risks associated with investing in that lender.
How do we calculate ECL?
In order to calculate the current expected credit losses, we need to review our estimates at each reporting date and adjust them as necessary to reflect changes in credit risk. If the credit risk of a financial instrument increases, so should our ECL estimate. On the other hand, if credit risk decreases, our ECL estimate should decrease as well.
To do this, the formula typically used in practice is:
ECL = EAD * PD * LGD
(Expected credit losses = exposure at default * probability of default * loss given default)
Exposure at default, or EAD, is the predicted amount of loss a lender may incur if a debtor defaults on their loan.
Probability of default, or PD, is a financial term describing the probability of a default over a particular period of time.
Loss given default, or LGD, is the share of losses, i.e., the amount which is expected to be irrecoverable from assets in case of bankruptcy.
How Contetra helped India’s third-largest bank save a whopping 7 crores?
With a portfolio size of Rs. 1300 crore, Bank of Baroda Financial Solutions Limited (BOB Cards) is thriving in the credit card market. In accordance with IFRS 9, the Company is required to determine the provision against a portfolio of assets (namely, credit card loans) using the Expected Credit Loss (ECL) method.
Earlier, the company created an ECL for every financial instrument with credit risk. Contetra concluded that since BOB was in the business of credit-card based lending which had a life span of more than 12 months, they would have to take the general approach instead of the simplified one.
Under the simplified approach, ECL is recognised for all financial instruments which has seen a significant increase in credit risk since origination but assets which have not undergone any significant deterioration will be recognized only for the past 12 months.
What was the financial impact of Contetra’s approach?
The change in methodology reduced the ECL provisions and resulted in the company saving a whopping Rs. 7 crores, which is equivalent to 0.52% of its asset portfolio.
What was the business impact of Contetra’s approach?
- Our detailed level segmental performance assessment helped the marketing team ascertain the most beneficial target group for the product sale.
- The customer-wise segmentation indicate that high amount of provision is required for Salaried and Self- Employee customers leading to the need for effective screening
- Our product-wise segments indicate high concentration of provision for Mass Market, Mass Affluent and Premium, resulting in the need to validate product features.
So, there you have it. ECL is the future of credit risk management, and it’s already making waves in the financial world. Who knows what the future will bring, but with ECL on your side, you’ll be prepared for whatever comes your way.
We hope that this article helped you revolutionize your approach to credit risk management.
IF YOU ARE KEEN TO EXPLORE “IMPLEMENTATION OF ECL MODEL FOR ACCURATE CREDIT PROVISIONING”, BOOK A 20-MINUTE FREE CALL WITH OUR TEAM OF EXPERTS!
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