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RBI recently released a discussion paper on dynamic provisioning framework to be followed by banks. The move, aimed at introducing counter-cyclical element to provisioning against the current practice of pro-cyclical provisioning, will reduce earnings volatility and lead to re-rating of valuation multiples. However, implementation of the proposed mechanism could have teething problems such as: 1) Lack of sufficient data and 2) significant earnings impact – conservative measure used by RBI.
To reduce cyclicality in earnings
The proposed framework of dynamic provisioning will focus on the concept of long-term expected loss (probability of default * loss given default) against the current system of incurred loss model (specific provisions). The proposed approach does away with the concept of “standard provisions and floating provisions”, replacing it with a more scientific method of covering loss. The approach will certainly aid in reducing the volatility in earnings due to credit cost (a key concern for SOE banks) as it smoothens the impact of provisioning across the cycles.
Issues with the framework
Though in concept, the framework is positive, it is riddled with following issues:
1) Expected loss is calculated on downturn LGD (which is about 1.6x of normal over the cycle LGD), reflecting a significantly conservative stance. Banks have been asked to provide a dynamic provisioning of 1.4% (based on the suggested mix), annually higher than the average of 1.04%, which will put significant strain on profits.
2) Lack of sufficient data (sample size of 9 banks)/systems and use of judgment of banks officials has brought in lot of subjectivity in estimating the most important metrics – Expected Loss (EL).
3) At the time of implementation of the framework, banks have been asked to carry coverage to the tune of 70% - another uphill task for some of the SOE banks which have dropped coverage levels.
4) Guidelines for drawdown of the dynamic provisioning balance.
5) Banks with adequate data/history can approach RBI to use their own internal expected loss parameters. However, considering that RBI will approve the IRB (please expand this in the start) approach for banks not before 31st March, 2014, it would suggest that they would need to provide as per the framework suggested by RBI.
Impact:
Near term impact on earnings could be significant, specifically for banks short on 70% provisioning coverage (SBI and Union Bank). The earnings impact could specifically reduce internal generation capability of banks, leading to approaching capital markets/GOI more frequently.
Private banks based on standardized approach may be required to make higher provisioning considering higher LGD for retail loans upto FY14. However, with prior approval of RBI (post FY14), these banks having capability to calibrate their own parameters may introduce dynamic provisioning using theoretical model based on historical experience which may require lower than suggested provisioning.
Though not explicitly recommended by RBI, market will over period of time give benefit of conservative dynamic provision build up by adding to the adjusted book value.
A constant over the cycle credit cost will ensure that banks follow a disciplined approach in pricing loans across cycles.
Despite the near term hiccups, we believe the framework will be beneficial for state-owned banks reducing volatility in earnings and consequently will lead to re-rating in trading multiples.
Regards,
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