COMMENTARY
assets in this difficult time posed by the
How Should Banks Estimate
Their Expected Loan Loss
Provisions to Survive in
Difficult Times?
Arindam Bandyopadhyay
This article explains how banks
can use their forward-looking
internal credit risk estimates and
apply on loan cash flows over
different time horizons and assess
the impact on loss provisions.
Such an estimate based on
longer historical data will enable
the banks to better foresee
the uncertainty pertaining to
repayment status of their loans
and make loss provisions in a
more proactive manner.
Arindam Bandyopadhyay (arindam@
nibmindia.org) is an associate professor at the
National Institute of Bank Management, Pune.
Economic & Political Weekly EPW MAy 28, 2022
A
s 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 rec-
ognise 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 account-
ing standards necessitate a “forward-look-
ing” 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 profita-
bility, 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 uncer-
tainty. Banks that have better data man-
agement systems and a prudent risk in-
ternal risk culture have been using these
three risk drivers as per internal estima-
tion models to measure loss provisions as
well as capital requirement for credit risk.
The purpose of this article is to explain
how ECL-based provisioning would benefit
the banks to manage the impairment of
vol lVii no 22
COVID-19 pandemic situation. A longer
historical data on delinquency rates can
be used for this purpose. Since the loan
assets on initial recognition have to be
classified into three stages depending on
their credit-quality maintaining data as
per days past due buckets would facili-
tate better estimations and forecasting
of probability of default (PD) of a loan for
each stage. This will enable the banks to
accurately estimate their future credit
provisioning requirements while con-
ducting credit planning.
Impairment Model
The International Financial Reporting
Standards (IFRS) 9 introduces a new
impairment model that requires the rec-
ognition of expected credit losses on all
financial assets at an amortised cost or
at a fair value through other comprehen-
sive income (other than equity instru-
ments), lease receivables, certain loan
commitments, and financial guarantee
contracts. The expected credit loss must
also consider forward-looking informa-
tion to recognise impairment allowan-
ces earlier in the lifecycle of a product.
The IFRS 9 recommends a three-stage
approach to impairment as follows:
Stage 1—the recognition of a 12-month
ECL, that is, the portion of lifetime ECLs
from default events that are expected
within 12 months of the reporting date,
if credit risk has not increased signifi-
cantly since initial recognition;
Stage 2—lifetime ECLs for financial in-
struments for which credit risk has in-
creased significantly since initial recog-
nition; and
Stage 3—lifetime ECLs for financial in-
struments that are credit impaired.
Twelve-month ECLs are the portion of
the lifetime ECLs that results from default
events that are possible within the next
12 months weighted by the probability of
that default occurring. At initial recogni-
tion, a 12-month ECL is provided for. At
the next reporting date, ECL will be clas-
sified into the lifetime category, that is,
the losses that might occur in the whole
life of the asset if there is a significant
increase in the credit risk of the account.
13
COMMENTARY

Finally, if the account becomes impaired and 30 days past due for retail exposure with the definition used for internal credit
or non-performing, it is categorised as on the reporting date for SICR. risk management purpose.
stage 3 and lifetime ECL is calculated for it. It can be estimated in many ways: inc- Table 1 presents an example of the re-
The IFRS 9 defines lifetime ECLs as rease in cumulative probability of default payment schedule of a term loan with
those that result from all possible default above a threshold, movement of rating the corresponding conditional PDs, the
events over the expected life of a finan- from super grade low investment grade, 12-month and lifetime ECLs.
cial instrument (that is, an entity needs worsening of rating or behavioural score Effective interest rate (EIR) is the rate
to estimate the risk of a default occur- changes can be considered as triggers. that exactly discounts estimated future
ring on the financial instrument during For example, statistically significant cha- cash payments or receipts through the
its expected life). They would be esti- nge in PD, benchmark relative change in expected life, or when appropriate, a
mated based on the present value of all PD (say a 20% increase), etc. shorter period of the financial asset or
cash shortfalls over the remaining expe- financial liability to the gross carrying
cted life of the financial asset, that is, the Expected Credit Loss Estimation amount of a financial asset or to the
difference between the contractual cash The ECL calculation method for both amortised cost of a financial liability.
flows that are due to an entity under the stages 1 and 2 accounts is based on de- The calculation of EIR includes all fees,
contract and the cash flows that the rived PD, loss given default (LGD), and transaction costs, and all other premi-
holder expects to receive. exposure at default (EAD). ums or discounts that are directly rela-
Significant increase in credit risk Expected credit loss at the borrower level ted to the acquisition of financial assets
(SICR) is another concept introduced in is calculated by using the following formula: on the book of an entity.
the standards. This is the basis on which ELi = PDi × LGDi × EADi … (1) The cumulative PDs are obtained from
accounts are classified into either of the where EL is expected loss. The term PD is marginal probability of default (MPDs) that
three stages. SICR is not defined by the the probability of default over the life- are derived from a yearly rating migra-
standard; banks will have to use their time of the asset (cumulative probability tion study (transition matrix). In this
own knowledge and experience in judg- of default) if lifetime ECL is calculated. exercise, this has been estimated using
ing what will be a significant increase in For the 12-month ECL, PD will the proba- historical data through a static cohort
credit risk. Otherwise, they can apply bility that the account defaults within analysis, which is followed by leading
the RBI’s backstop measure that uses 60 next 12 months. EAD is the adjusted exp- credit rating agencies (CRAs).
days past due to non-retail exposures osure at default. It shows the total Table 2 provides estimates for condi-
Table 1: Calculation of Expected Credit Loss amount that the bank has lent to the tional PD, which has been used in esti-
Panel 1A borrower adjusted for some haircut. LGD mation of ECL using EAD cash flows report-
Interest rate 10% is the loss given default of the asset, ed in Table 1 Panel C.
Upfront fees 0.0% which is the amount the bank might not The conditional PD for each period is
Limit $1,000 recover out of the entire exposure. conditioned on the fact that the borrow-
Tenor 5 years
Each entity should define their own er has not defaulted in the previous pe-
Current drawdown 70% p a UGD 1 year 60%
definition of default (for example, 90 days riod and defaults in the current period.
UGD 1 is a one-year usage given default for the loan exposure.
Source: Compiled by the author. past due), which should be consistent Thus, in the second year, conditional
marginal PD is estimated as:
Panel 1B: Original Loan Schedule
Original Loan Schedule =1.59% × (1-1.27%) = 1.57%.
Year Loan Cash Flows Principal Repayment Principal Balance O/S Begin Interest Repayment Exposure at Default Similarly, in the third year, conditional
0 -700.0 marginal PD for the same BBB borrower
1 70 0 700.0 70 770.00 would be: = 2.76% × (1-1.59%) = 2.72%.
2 88 0 880.0 88 968.00
The survival benefit is passed to the
3 95.2 0 952.0 95.2 1,047.20
borrower to derive credit risk for each
4 98.08 0 980.8 98.08 1,078.88
yearly cash flow.
5 1,091.6 992.3 992.3 99.232 1,091.55
Effective interest rate = 10%. Table 2: Conditional PD, Marginal PD, and
Source: Compiled by the author. Cumulative PD (%)
Rating: BBB
Panel 1C: Expected Loss Estimation Details Using Cash Flows Time Horizon Marginal One-year PD MPD CPD
If Default EAD = Year-wise Marginal One-year LGD (= PV of Cash Year-wise PV of Net Year-wise Prob PV of Year-wise Prob Conditioned on Previous Survival
Takes Place in PV of Gross Loss Conditional PD Rec/ EAD) Loss = EAD*LGD Weighted Net Loss Weighted Net Loss
1 1.27 1.27 1.27
Year (CNPD) Up to Year of Default
2 1.57 1.59 2.84
1 770.00 1.27% 40% 308.00 3.91 3.56
3 2.72 2.76 5.52
2 968.00 1.57% 40% 387.20 6.08 5.02 4 1.24 1.27 6.72
3 1,047.20 2.72% 40% 418.88 11.37 8.54 5 1.25 1.27 7.90
4 1,078.88 1.24% 40% 431.55 5.33 3.64 Source: The author’s own compilation.
5 1,091.55 1.25% 40% 436.62 5.46 3.39
The cumulative PD is estimated from
24.15
historically obtained marginal PDs (MPDs)
Note that the Borrower’s Credit Rating = BBB.
Source: Compiled by the author. using the following expression:
14 MAy 28, 2022 vol lVii no 22 EPW Economic & Political Weekly
 COMMENTARY

CPD(n)=d (1)+d(2)×(1-d(1))+d(3) Ultimately, we obtain lifetime ECL (for provision. Portfolio segmentation into
×(1-d(1))×(1-d(2))+….+d(n)(1-d(n)) … (2) stage 2) using conditional PDs estimated accounts which will be assessed at indi-
For example, cumulative probability as $24.15. For stage 1, one-year ECL is es- vidual level and accounts that will be as-
of default in the second year (CPD2) is es- timated as $3.56. This has been further sessed as part of a homogeneous credit
timated as: summarised in Table 3. risk group also provides more risk-sensitive
= 1.27%+(1-1.27%)*1.59%=2.84% In Table 3, it is important to note that and granular ECL estimates.
In the same manner, CPD in the third the discounting for ECL based on amor-
year (CPD3) can be obtained by using the tising EAD is crucial in the analysis of ECL Estimation for Marketable
expression: loan loss provisioning, which should also Instruments—Corporate Bonds
=2.84%+(1-1.27%)*(1-1.59%)*2.76% be applied for the exposure of each bor- In Table 4, we have demonstrated the
Similarly, CPD in the fourth year rower, especially those in stage 2. This ECL estimation based on cash flow obt-
(CPD4) is estimated as: will lead to a reduction in the lifetime ained from a portfolio of bond instru-
=5.52%+(1-1.27%)*(1-1.59%)*(1-2.76%)* ECL provisioning amounts and will actu- ments. A CDS spread method has been
1.27% =6.72% ally benefit the banks. used to estimate the 12-month as well as
In this case, we have used equation 2 The difference between the 12-month lifetime PDs and based on that, stage 1
which is used by CRAs. and lifetime ECLs depends on many fac- and stage 2 ECLs in dollar amount have
It is interesting to note that in many tors, including the loan’s contractual ma- been estimated.
default study reports, CRAs publish their turity and “lifetime” as well as how de- The risk-neutral default probability is
cumulative PDs for different time hori- fault risks (PDs), recovery values (LGDs) implied from the CDS spread using the
zons. From these CPDs, one can obtain and exposures (EADs) are expected to following expression:
forward-looking conditional marginal PDs evolve over the life of a loan.
CPDt = 1-e^(-S × t/(1-R)) … (4)
directly using the following expression. Annual cash flow projections can be
Conditional marginal PDn constructed from the principal and inte- where S is the flat credit default swap
= 1-{(1-CPDn)/(1-CPDn-1)} … (3) rest repayment schedules provided by (CDS) spread and R is the recovery rate.
where n is the number of years. the bank (since PD is annual). It has been Similarly, 1-R is the LGD. The expression t
This forward-looking PD is a pure his- observed that bank can save ECL provi- represents time. In India, instead of a CDS
torical view. However, one can adjust sion mainly for stage 2 accounts if they spread, a bond market spread can be used
macroeconomic factors through regres- are able to track year-wise cash flows and to estimate PDs for corporate borrowers.
sions or by using the Z-index approach to apply conditional PDs instead of simply Accordingly, using the above expre-
link PD with macroeconomic scenarios. using cumulative PDs on current outstand- ssion, one can estimate cumulative PD for
It is important to note that, alternatively, ing for estimation of their ECL-based the first year, which is also the 12-month
one can use the matrix multiplication Table 3: Estimate ECL Comparison—Stage 1 PD = 1-EXP ((-0.50%×1)/(60%)).
method to derive cumulative PDs and con- versus Stage 2 (in $ amount) Similarly, for the second year also,
ditional PDs for the estimation of ECL. One Year ECL (3.56) CPD2 can be estimated using figures
In the Ind AS 109 prescribed method- Lifetime ECL provision amount (24.15) reported in Table 4.
Figures are in parenthesis since this will be used for loss
ology for ECL computation, the 12-month provision.
One can use forward rates by tracking
ECL for stage 1 accounts multiplies the Source: The author’s own compilation. bond spreads from the yield curve to
estimated EAD with the one-year PD and
Table 4: ECL Estimation for Bond Instrument Based on CDS Spread
LGD. We have assumed 40% LGD for the Bond Instrument Units in thousand $
loan pool. The estimated EAD is the sum Time (Years) 1 2 3 4 5
of the principal balance outstanding and Coupon 50 50 50 50 50
interest accrued if the customer defaults Capital repayment 1,000
on that loan account at the end of the year. Cash flows 50 50 50 50 1,050
Effective interest rate (EIR) 5% 5% 5% 5% 5%
This has been shown in Table 1 Panel C.
DF (EIR) 0.95 0.91 0.86 0.82 0.78
The lifetime ECL for stage 2 accounts EAD 1,050 1,050 1,050 1,050 1,050
first estimates the expected loss on the CDS spread 0.50% 0.60% 0.70% 0.80% 0.90%
account for each future year of potential LGD (estimated from market value calculation) 60% 60% 60% 60% 60%
default during the loan lifetime by mul- Cumulative default prob 0.83% 1.98% 3.44% 5.19% 7.23%
tiplying each future year’s EAD with the Cumulative survival prob 99.17% 98.02% 96.56% 94.81% 92.77%
one-year marginal conditional PD and Periodic PD (conditional marginal PDs) 0.83% 1.150% 1.459% 1.754% 2.032%
LGD. Each future year’s EAD is estimated PD×LGD 0.50% 0.69% 0.88% 1.05% 1.22%
EAD 1,050 1,050 1,050 1,050 1,050
as the sum of principal balance out-
Expected loss per period 5.25 7.25 9.19 11.05 12.80
standing and interest accrued if the cus-
Expected loss per period (discounted at EIR) 5.00 6.57 7.94 9.09 10.03
tomer defaults on the loan in the middle Lifetime expected loss (discounted) 38.64
of that year. Each future year’s expected 12M expected loss 5.00
loss is then discounted using the EIR. Source: The author’s own compilation.

Economic & Political Weekly EPW MAy 28, 2022 vol lVii no 22 15
COMMENTARY
estimate the 12-month PD as well as life-
time PD for different maturities.
One can clearly check the difference
between the lifetime ECL and 12-month
ECL as reported in Table 4. The diffe-
rence is quite significant. However, if we
do not consider five-year cash flow and
directly estimate ECL from by multiply-
ing one-year EAD with five-year cumula-
tive PD, the lifetime expected loss amo-
unt will be greater (without discount-
ing). Hence, cash flow-based ECL is a
better method.
Concluding Discussions
For the purpose of Ind AS 109 ECL com-
putation for loan portfolios, banks should
actually follow the discounted proba-
bility weighted cash flow-based EAD
method and multiply with the derived
12-month PD for stage 1 and lifetime PD
for stage 2 accounts to more precisely es-
timate their loan provisions. For this,
loan-level cash flow data associated with
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16
the bank’s term loans need to be culled
out. For non-fund-based exposures, app-
ropriate credit conversion factors need
to be applied. For stage 2 classification
loans, banks can choose the criteria that
if days past due is more than 60 days,
then the term loan is in stage 2, else in
stage 1. Banks can also choose other in-
ternally set criteria.
Early detection of a significant increase
in credit risk may incentivise the bank to
bring back those accounts to standard
category and shred their further non-
performing asset burdens. Banks may
consider classifying restructured ac-
counts as stage 2 for a certain number of
reporting periods (say for one or two
quarters) post restructuring and hold
lifetime ECL provisions for such accounts.
Banks will have to take an internal policy
decision with regard to when they will re-
vert a restructured exposure in stage 2
to stage 1 classification. This can be
based on monitoring the repayments on
MAy 28, 2022
restructured exposure, and if there have
been no overdue in the last two to three
quarters, the account can be upgraded
to stage 1. Such risk-based analysis will
enable the banks to maintain their risk
appetite and sustain their lending busi-
ness even in difficult times.
References
Bandyopadhyay, A (2019): “The Accuracy of Agency
Ratings,” Economic & Political Weekly, Vol LIV,
No 36, pp 15–17.
Hamilton, D H (2002): “Historical Corporate Rat-
ing Migration, Default and Recovery Rates,”
Credit Ratings: Methodologies, Rationale and
Default Risk, Michael K Ong (ed), Chapter 2,
London: Risk Publisher.
Mukherjee, S and S Maji (2017): “Credit Risk Mod-
elling Challenges in IFRS 9,” Prajnan, Vol XLV,
No 4, pp 383–404.
Moodys (2006): “Measuring Corporate Default
Rates,” November.
Roy, S (2018): “Expected Credit Loss Estimation:
Embedding the Forecasts of Future Economic
Conditions as per IFRS 9 Guideline,” Prajnan,
Vol 46, No 2, pp 185–94.
Saunders, A and M M Cornett (2008): Financial
Institutions Management: A Risk Management
Approach, New York: McGraw-Hill/Irwin.
Features
Data is from 1954
onwards based on
availability.
Structured in six
major sections :
• Demography
• Health Status
• Infrastructure
• Health Manpower
• Education Facilities
• Health Finance
vol lVii no 22 EPW Economic & Political Weekly