Impairment and Derecognition

1. Impairment and Derecognition Ind AS 109 Financial Instruments

2. Agenda 1. Impairment : Financial Instruments 2. Expected Credit Loss Model 3. Derecognition of Financial Assets 4. Derecognition of Financial Liabilities 5. Modification of Terms

3. Scope * With Ind AS 115 being deferred, the words “contract assets” have been substituted by “contractual rights”.

4. Scope and Variation of Expected Credit Loss Model * Ind AS 115 : Revenue from Contracts with Customers has been deferred.

5. General Approach Start Here Loss allowance updated at each reporting date Stage 1 Stage 2 Stage 3 12-month expected credit losses Lifetime expected credit losses Lifetime expected credit losses Credit risk has increased significantly since initial recognition (individual or collective basis) Lifetime expected credit losses criterion + Credit-impaired Interest revenue calculated based on Effective interest rate on gross carrying amount Effective interest rate on gross carrying amount Effective interest rate on amortised cost • Change in credit risk since initial recognition • ImprovementDeterioration

6. What is significant increase in Credit Risk Interpretation of ‘significant’ Original credit risk at initial recognition Expected life or term structure • Change in absolute probability of default (PD) occurring is more significant for financial instruments with lower initial credit risk as compared to financial instrument with higher initial risk of default occurring • Risk of a default occurring increases with the expected life of the financial instrument • PD will decrease less quickly over time for instrument with significant payments obligations close to maturity

7. Factors or indicators of change in the risk of a default occurring Operating results Credit spread (e.g., credit default swap) Business, financial or economic conditions Credit rating (internal or external) Regulatory, economic or technological environment Factors or indicators of change in the risk of a default occurring Rates or terms (e.g., covenants, collateral) Collateral, guarantee or financial support, if this impacts the risk of a default occurring Credit risk management approach Payment status and behaviour

8. Significant increase in credit riskWhat this means in practice? 1. Yes Primary drivers Stage 2 • Change in forward-looking marginal lifetime PDs, guided by credit scores, ratings, risk categories and collective assessment of effects of forward-looking information (most sophisticated approach) • It may be possible to use changes in 12-month PDs for certain loans • Challenge to define significance thresholds No Quantitative Yes 2. Secondary drivers Stage 2 No Yes Qualitative • Watch lists (Wholesale) • Ratings / credit scores • Changes in behaviour • Death, divorce, unemployment or bankruptcy • Expectations of forbearance • Market indicators, e.g., credit spreads, bond spreads • Business environment, technological changes, market prices 3. Stage 2 Backstops No Backstops • > 30 days past due presumption • Forbearance • Covenant breaches Stage1 Stage1

9. Significant increase in credit riskKey attention points • Key concept that triggers the switch from 12 Months ECL to lifetime ECL • Must be based on the change in the risk of a default occurring (PD) • Collateral is not taken into account • Must be identified before default occurs or the asset becomes credit-impaired • Standard not prescriptive: • Usually involves a multifactor analysis, based on all reasonable and supportable information that is available without undue cost or effort and that is relevant • Significant disclosure area: Parameters, approaches, judgment, triggers

10. Operational simplifications in assessing significant increase in credit risk • Low credit risk • More than 30 days past due (DPD) • For financial instruments that are equivalent to ‘investment grade’ quality, an entity would continue to recognise 12-month ECL • Rebuttable presumption that there is a significant increase in credit risk when contractual payments are more than 30 DPD • An entity can assume that a financial instrument has not significantly increased in credit risk if it has low credit risk at the reporting date • Low credit risk notion is not a bright-line trigger and financial instruments are not required to be externally rated • More than 30 DPD rebuttable presumption is intended to serve as a backstop and should identify significant increases in credit risk before default or objective evidence of impairment. • An entity can rebut this presumption. However, it can do so only when it has reasonable and supportable information available that demonstrates that even if contractual payments become more than 30 DPD, this does not represent a significant increase in the credit risk of a financial instrument.

11. Initial Low credit risk

12. Assessment of Significant Increase in Credit Risk: Illustration Question Response • Bank B uses an internal credit grading system of 1 to 10 with one denoting the lowest credit risk and 10 denoting the highest credit risk. • A increase of 2 rating grades represents a significant increase in credit risk. • It considers Grades 3 and lower to be ‘low credit risk’. • Bank B has two loans: • Loan 1: Graded 2 at initial recognition, Graded 5 at the reporting date. • Loan 2: Graded 4 at initial recognition, Graded 5 at the reporting date. • Q: At the reporting date, would each loan attract a 12-month or lifetime expected credit loss allowance? • Loan 1: Loss allowance = lifetime expected credit losses • Loan 2: Loss allowance = 12-month expected credit losses • The credit loss model in Ind AS 109 is a relative model rather than an absolute model which means that it focuses on the relative size of increase in credit risk.

13. Loss Allowance Recognition: Illustration Question Response • On 15 March 2016 Bank B grants a loan to a borrower with low credit standing, but still at an acceptable level for B. • The price of the loan does not reflect incurred credit losses. • Q: What loss allowance should B recognise in the statement of financial position at 31 March 2016? • None. • 12-month expected credit losses. • Lifetime expected credit losses. • 12-month expected credit losses • Under the general model of Ind AS 109, all assets need to have a loss allowance. • Allowance covers either 12-month or lifetime expected credit losses depending on whether the asset’s credit risk has increased significantly. • Since the loan has just been granted and there has not been a significant increase in credit risk, an allowance equal to 12-month expected credit losses is appropriate.

14. Lifetime expected credit losses of a collateralised loan Question Response • Bank A holds a collateralised loan. A determines that the credit risk of the loan has increased significantly since initial recognition – i.e. the risk of default has increased significantly. • However, as the value of the collateral is significantly higher than the amount due from the loan, the loss given default is very small. • Will the bank recognise lifetime expected credit losses on the same? • Although Bank A does not believe that it is probable that it will suffer a credit loss if a default occurs, it recognises lifetime expected credit losses for the asset. This is because a significant increase in credit is assessed with reference to the risk of default rather than to the loss given default. • However, the amount of the loss would be very small, because the asset is expected to be fully recoverable through the collateral held under almost all possible scenarios. • However, the collateral should be valued based on a stressed sale scenario.

15. Loan commitments and financial guarantee • For loan commitments, an entity considers changes in the risk of a default occurring on the loan to which a loan commitment relates. • For financial guarantee contracts, an entity considers the changes in the risk that the specified debtor will default on the contract. Assessment of Significant increase in Credit Risk Measured from the date on which the entity becomes a party to the irrevocable commitment

16. Collective Assessment

17. Collective Assessment (Contd…) The standard gives the following examples of shared credit risk characteristics: Credit risk ratings Instrument type Date of initial recognition Collateral type Remaining term to maturity Shared credit risk characteristics Value of collateral relative to the financial asset if it has an impact on PD. Geographical locationof Industry the borrower As groupings are required to be amended over time, banks need to put in place processes to reassess whether loans continue to share similar credit risk characteristics. In practice

18. Collective assessment: Illustration Reasonable and supportable information • Past due status • Industry / source of income (e.g., coal mining) Decline in coal exports ‘Bottom-up’ approach Sub-portfolios Lifetime expected credit losses • Existing mortgages to coal miners • Existing mortgages more than 30 DPD 12-month expected credit losses • New mortgages to coal miners • Other remaining mortgages (e.g., mortgages to lumber jacks)

19. Significant increase in credit risk - Reclassification FVTPL Amortised Cost FVTPL FVOCI Amortised Cost FVOCI FVOCI Amortised Cost

20. Significant increase in credit risk - Reclassification Amortised Cost FVTPL FVOCI FVTPL

21. Exceptions to general model • Financial assets that are credit-impaired on initial recognition • Simplified approach for trade receivables, contract assets and lease receivables • An entity shall always measure loss allowance at an amount equal to lifetime expected credit losses • At each reporting date, an entity shall recognise in profit or loss amount of change in lifetime expected credit losses as an impairment gain or loss • Modified financial assets • Modified assets that are not derecognised, an entity shall assess whether there has been significant increase in credit risk (i.e. for making loss allowance for lifetime expected credit losses) by comparing credit risk at reporting date (based on modified contractual terms) to credit risk at initial recognition (based on original contractual terms)

22. Simplified Approach: Provision Matrix

23. Credit Impaired Financial Asset • A financial asset is credit-impaired when one or more events that have detrimental impact on estimated future cash flows of that financial asset have occurred like: • significant financial difficulty of issuer or borrower; • breach of contract, such as a default or past due event; • lender(s) of the borrower, for economic or contractual reasons relating to borrower's financial difficulty, having granted to borrower a concession(s) that the lender(s) would not otherwise consider; • it is becoming probable that borrower will enter bankruptcy or other financial reorganisation; • disappearance of an active market for that financial asset because of financial difficulties; or • purchase or origination of financial asset at a deep discount that reflects the incurred credit losses. • It may not be possible to identify a single discrete event—instead, combined effect of several events may have caused financial assets to become credit-impaired.

24. POCI Assets - Initial Recognition and Subsequent Measurement

25. Example – Initial Recognition • Bank Y buys a portfolio of amortising loans with a remaining life of four years for 800, which is the fair value at that date.The remaining contractual cash flows at the time of purchase are 1,000 and the expected cash flows are as follows. Assume that all cash flows are expected to be paid at the year end. • The EIR of 3.925% p.a. is calculated as the IRR of the initial purchase price — i.e. 800 — and the cash flows expected to be collected. • On initial recognition, following journal entries are to be passed:

26. Example – Subsequent Measurement – No changes • Continuing the above example, assume that Y's expectation about future cash flows from the portfolio at the end of Year 1 has not changed since initial recognition. • At the end of year 1, Y calculates interest revenue of 31 by applying the EIR — i.e. 3.925% p.a. — to the amortised cost of the loan of 800. • In addition, Y receives a cash payment of 220. • Experience and expectations about the collectibility of cash flows are unchanged from expectations at initial recognition and no impairment allowance is recognised. • Y records the following entries in Year 1.

27. Example – Subsequent Measurement – Positive changes • Alternatively, assume that the creditworthiness of the borrowers in the portfolio has improved and at the end oear 1,Y expects the following cash flows to be collected. • At the end of year 1, Y calculates interest income of 31 by applying the EIR — i.e. 3.925% p.a. — to the loan of 800, and records the same entries for recognition of revenue and cash received. • In addition, the revised expected cash flows are discounted using the original EIR, and the resulting favourable change in lifetime expected credit losses of 83 is recognised as an impairment gain at the end of year 1, as follows:

28. Measurement of Expected Credit Losses

29. Definition of 12 Month and Lifetime Expected Credit Losses Lifetime expected credit losses Expected credit losses that result from all possible default events over the expected life of a financial instrument. 12-month expected credit losses The portion of lifetime expected credit losses that result from default events on a financial instrument that are possible within the 12 months after the reporting date. ‘Default’ Default is not defined by the standard and there is a 90 days past due rebuttable presumption. In practice Although 12-month horizon may be consistent with regulatory capital requirements (e.g., Basel), the computation of expected credit losses under Ind AS 109 will differ from regulatory capital calculation.

30. Expected Credit Loss Calculation

31. Measurement of Expected Credit Losses Expected credit losses Numerator: cash shortfalls • The period over which to estimate ECL: maximum contractual period (for revolving credit facilities, this extends beyond contractual period) • Probability-weighted outcomes: possibility that a credit loss occurs, no matter how low the possibility • Reasonable and supportable information: information available without undue cost or effort about the past, current and future forecasts • Present value of all cash shortfalls over the remaining life, discounted at the original effective interest rate (EIR) • Cash shortfalls- • Difference between all contractual cash flows that are due to an entity in accordance with contract and all cash flows that entity expects to receive Denominator: discount rate • Discounting period: from cash flows date to reporting date • Assets: rate that approximates EIR of the assetor if credit-impaired on initial recognition, then use credit-adjusted EIRof the asset • Commitments and guarantees: current rate representing risk of the cash flows (for commitments, use EIR of resulting asset if this is determinable)

32. Discount Rate Type of Instrument Discount Rate Financial assets other than POCI assets and lease receivables The EIR determined at initial recognition or an approximation thereof (the current EIR for floating rate financial assets) The credit adjusted EIR determined at initial recognition POCI assets Lease receivables Discount rate used in measuring lease receivable as per Ind AS 17 Undrawn loan commitments EIR or approximation used to discount the financial asset arising from loan commitment Undrawn loan commitments for which the EIR cannot be determined and financial guarantee contracts The discount rate that reflects the current market assessment of the time value of money and the risks that are specific to the cash flows (but only if, and to the extent that, the risks are taken into account by adjusting the discount rates instead of adjusting the cash shortfalls being discounted

33. Cash Flows EIR • An entity shall estimate cash flows by considering all contractual terms of financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument. • Cash flows that are considered shall include cash flows from sale of collateral held or other credit enhancements that are integral to contractual terms Credit adjusted EIR • An entity shall estimate cash flows by considering all contractual terms of financial instrument (for example, prepayment, extension, call and similar options) through the expected life of that financial instrument and expected credit losses • Calculation includes all fees and points paid or received between parties to the contract that are an integral part of EIR, transaction costs, and all other premiums or discounts.

34. Measurement of expected credit losses: implementation changes • Defining default • Determining 12-month and lifetime ECL • Unbiased and probability-weighted estimate • No prescribed approaches • Not best estimate Best available information Past Current • Future • Area of judgement • Availability of data • Reliability of forecasts + + • The time value of money • Choice of discount rate

35. Interpretation and implementation issues in measuring expected credit losses In practice • Reasonable and supportable information • Interpreting the term ‘undue cost or effort’ • Adjusting historical information to reflect current conditions and forecasts of future conditions (e.g., use of econometric model, base-case model, data used for budgeting and capital planning) • Translating macroeconomic factors into expected credit losses • Leveraging on calculation, stress testing and information used for provisioning as per the RBI Prudential Norms.

36. Interpretation and implementation issues in measuring expected credit losses (contd…) In practice • Discounting • Interpreting the term ‘approximation’ of the effective interest rate • Calculating the effect of discounting • Collateral • Including cash flows from the realisation of the collateral and other credit enhancements only if they are part of the contractual terms and not recognised separately

37. Cash Shortfalls Financial assets measured at amortised cost or at fair value through other comprehensive income Cash shortfalls between cash flows that are due to entity in accordance with contract and cash flows that entity expects to receive Loan Commitment Cash shortfalls between contractual cash flows that are due to entity if holder of loan commitment draws down the loan and cash flows that entity expects to receive if the loan is drawn down Cash shortfalls are expected payments to reimburse the holder for a credit loss that it incurs less any amounts that entity (issuer) expects to receive from holder, debtor or any other party Financial Guarantee

38. Illustration: 12 Months ECL Calculation Question Response • ABC Bank originates a 10 year loan for INR 1 million. The interest is paid annually. • Loan’s coupon and EIR are 5%, interest being payable at the beginning of the next year. • ABC estimates PD of 0.5% over the next 12 months. • It further determines that 25% of the gross carrying amount would be the loss if the loan were to default i.e. the LGD is 25%. • Q: Calculate the impairment allowance for 12 months ECL at the balance sheet date. At the Balance Sheet date, the loss allowance for the 12-month ECL is INR 1,250 which is calculated as follows: Present Value of (Cash Flow Receivable for Principal & Interest * LGD * PD) i.e. PV of (10,50,000 * 25% * 0.5%) @ EIR of 5% for one year = 1,312 * 0.9524 = INR 1,250

39. On December 31, 2015, Bank ‘Q’ purchases a debt instrument with fair value of INR 1,000 and classifies it as measured at FVOCI. The instrument is not credit-impaired. Q estimates 12 month expected credit losses for the instrument of INR 10. On initial recognition of the instrument, Q makes the following entries: At the end of the next reporting period, the fair value of the debt instrument decreases to 950. Q concludes that there has not been a significant increase in credit risk since initial recognition & that the 12 month expected credit losses on December 31, 2016 are INR 30. Example: Estimating expected credit losses – FVOCI (1/2)

40. Accordingly, Q makes the following entries at that date: Notes: Calculated as 1000-950, being the amount needed to state the debt security at fair value as at reporting date. Calculated as 30-10, being the change in expected credit losses since initial recognition. Balancing amount. Q also provides disclosures about accumulated impairment of 30 Example: Estimating expected credit losses – FVOCI (2/2)

41. Presentation • An entity shall recognise in P&L, as an impairment loss or gain, the amount of expected credit losses (or reversal) that is required to adjust the loss allowance at the reporting date to the amount that is required to be recognised in accordance with this Standard. • An entity should recognize ECL in statement of financial position as: • a loss allowance for financial assets measured at amortized cost and lease receivables; and • a provision (that is, a liability) for loan commitments and financial guarantee contracts. • the loss allowance shall be recognised in other comprehensive income and shall not reduce the carrying amount of the financial asset in the balance sheet.

42. ECL on Modified Financial Asset Does the modification result in derecognition?` Yes No Assessment made for the old asset Assessment made for the new asset A lender cannot automatically assume that a modified asset has lower credit risk than the original unmodified asset, just because the loan is no longer past due.

43. Illustration: Assessment of Modified Financial Assets Question Response • Bank L has a portfolio of retail loans for which it applies the presumption that the credit risk increases significantly if the loan is more than 30 days past due. • One of the borrowers (Borrower B) is experiencing some difficulty in meeting the contractual payments, and so L modifies the contract by extending the maturity of the loan and reducing the monthly payments. • The modification does not result in derecognition. • At the time of the modification, the loan is 60 days in arrears. • Q. Will the loan to Borrower B be assessed as low credit risk? • Following the modification, B is meeting the new contractual payments. • L will have to exercise judgement taking into account all reasonable and supportable information (eg. historical experience on forbearance activities) to determine whether the modified loan continues to meet the ‘significant increase in credit risk’ criterion.

44. Thank You