Rethinking ECL: NBFCs And A Consumer-focused Path To Cheaper Cred

The RBI has been actively working on upgrading ECL norms to address evolving financial challenges and enhance systemic resilience. An announcement on the updated framework is expected soon, aiming to align provisions with the needs of a dynamic and consumer-focused financial ecosystem.

NBFCs with net worth of over Rs 250 crore are subjected to ECL norms, and there seems to be an opportunity to tweak some of those norms to make them aligned with banks, or lower standards. There is a market perception that these NBFCs seem to have unfair stringent norms, that make the loan pricing expensive.

The Expected Credit Loss (ECL) model marks a forward-looking advancement in financial risk management, addressing limitations of the previous “incurred loss” framework. By recognising potential credit losses over the life of a financial instrument from the outset, ECL aims to build resilience in financial institutions and strengthen systemic stability. This philosophy, embedded in global frameworks such as the International Financial Reporting Standard 9 (IFRS 9) and the Financial Accounting Standards Board’s (FASB) Current Expected Credit Loss (CECL) model, is a significant stride in improving risk assessment and aligning with international best practices.

NBFCs, already subject to stringent ECL requirements, must recognise credit stress earlier under the Indian Accounting Standards (Ind AS). However, certain aspects of the current ECL implementation for NBFCs present opportunities for refinement, ensuring the model achieves its full potential while benefiting consumers and supporting economic growth. ECL provisions currently focus exclusively on expected losses, without accounting for expected income from loan portfolios.

In a well-priced credit portfolio, expected income typically covers credit costs, operational expenses, and returns for stakeholders under normal circumstances. By omitting this consideration, the framework inadvertently inflates credit costs on a matching principle basis, resulting in suppressed profitability. This approach compels institutions to adjust their pricing models, which can increase borrowing costs for consumers.

Balancing this dynamic by factoring in expected income would present a truer reflection of financial health, reduce inflationary pressures on credit products, and improve affordability for borrowers. The credit cost charged to the P&L is often artificially inflated due to the exclusion of future income considerations, which disrupts the matching principle in accounting. This suppressed profitability prompts institutions to adjust their pricing models, passing on higher credit costs to borrowers.

Additionally, the ECL framework creates optical distortions across economic cycles. During growth phases, credit costs appear higher than they actually are, while in periods of economic slowdown, ECL provisions release, making credit costs seem artificially lower. This inconsistency can lead to misaligned pricing and financial planning, ultimately impacting affordability for consumers.

Another aspect requiring attention is the ECL model’s inflexibility during economic downturns. Unlike counter-cyclical buffers, ECL provisions cannot be released to absorb stress during challenging periods. Instead, these provisions further strain balance sheets, particularly when institutions are already grappling with heightened credit stress. Aligning ECL provisions more closely with counter-cyclical principles could enhance their utility as a buffer, allowing institutions to better navigate economic cycles without passing on undue costs to consumers.

The adequacy of the Capital to Risk-Weighted Assets Ratio (CRAR) as a safeguard against financial stress has long been a subject of debate. While CRAR provides a measure of resilience, its primary purpose is to ensure the continuity of financial institutions rather than fully absorb losses. To enhance prudence, a portion of the institution’s earnings could be set aside in the form of a reserve for counter cyclical reserves instead of routing ECL through P&L, which will achieve the similar result of it is not made available for dividends or capital allocation. Such a reserve would serve as a dedicated buffer, strengthening the institution’s capacity to withstand economic downturns without overly relying on CRAR. By aligning this reserve with ECL requirements, regulators can introduce an additional layer of stability to the financial ecosystem.

If ECL’s purpose is to absorb expected future losses, reclassifying it as a reserve rather than a provision could prove more effective. By maintaining ECL as a reserve on the balance sheet, institutions can ensure that these funds are earmarked for absorbing future shocks and are not available for dividend payouts. This approach reinforces the prudence of the ECL model while allowing institutions to better align their capital allocation strategies with risk management objectives. Such a reserve would create a more robust financial safety net without distorting the institution’s financial statements. Also, it shall reduce burden on consumer as pricing model will not account for full ECL impact which it does today.

In the Indian context, the current treatment of ECL as part of tier 2 capital introduces inconsistencies. While ECL is charged to the profit and loss statement, thereby reducing profitability, its inclusion in tier 2 capital allows institutions to deploy it for leveraging purposes. This dual treatment undermines the intent of ECL as a prudential buffer and dilutes its efficacy in stress scenarios. A clearer separation of ECL reserves from regulatory capital would ensure that these provisions remain a genuine safeguard rather than a tool for leveraging.

Furthermore, the lack of tax recognition for loss provisions which are not written off yet adds a permanent cash drag on institutions’ balance sheets. While companies account for loss provision which are not written off yet in their financial statements, the provisions are not deductible under the Income Tax Act, leading to additional cash outflows. This misalignment between regulatory and tax frameworks creates unnecessary strain on financial institutions and could be addressed through policy adjustments. Aligning tax treatment would provide much-needed relief, ensuring that institutions are not penalised for adopting forward-looking risk management practices.

To strengthen the ECL framework and enhance its effectiveness, regulators could consider a few key suggestions:

Firstly, ECL calculations should incorporate expected income alongside expected losses, reflecting the true financial position of an institution. This would align with the matching principle in accounting and reduce unnecessary inflationary impacts on credit pricing.

Secondly, stress-testing portfolios under various macroeconomic scenarios would ensure provisions are appropriately calibrated to reflect potential risks without overstating them under normal conditions.

An ideal solution for Expected Credit Loss (ECL) would combine its forward-looking approach with principles that balance financial stability and consumer affordability. While ECL is undoubtedly an improvement over rule-based provisioning, it can be refined to address its current limitations. For instance, if the ECL model predicts expected losses in stress scenarios exceeding expected income, only this excess should be charged to the P&L. This adjustment would reduce unnecessary pressure on the P&L, enabling institutions to offer more competitively priced loans to consumers while maintaining a true reflection of their financial health.

Additionally, establishing reserves for expected ECL, separate from the profit and loss statement, could provide an extra buffer over CRAR. These reserves would act as dedicated equity cushions, ensuring institutions have sufficient capital to navigate stress scenarios without compromising operational continuity or requiring additional regulatory intervention. Such a dual approach—aligning ECL with realistic financial scenarios and creating standalone reserves—would not only strengthen institutional resilience but also support economic growth by keeping credit affordable for borrowers. ECL is undoubtedly a significant improvement over past provisioning frameworks, and with thoughtful adjustments, it can deliver even greater value.