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RBI releases discussion paper on dynamic provisioning framework
Proposals to strengthen balance sheets, but could impact near-term earnings
RBI's discussion paper on dynamic provisioning framework highlights the requirement of counter-cyclical provisioning to
reduce volatility in banks' earnings.
While dynamic provisioning will make banks' balance sheets structurally strong, some of the norms that RBI has proposed
will adversely impact their earnings and put strain on their capital in the near term.
Banks with superior technology that are already planning to move to IRB (internal rating based) approach might come out
with estimated loss assumption based on portfolio mix. Thus, 1.37% cannot be strictly taken as a benchmark for all banks.
Higher provisions will directly impact RoA (by 10-15bp) and RoE (by 100-200bp) of banks in the short-to-medium term.
Financials
3 April 2012
Update
RBI has released a discussion paper on dynamic
provisioning (DP), where it has highlighted the
requirement of counter-cyclical provisioning to reduce
volatility in banks’ earnings. It has requested views from
industry participants by 15 May 2012, post which it will
release draft guidelines.
Key highlights of discussion paper
Introduction of DP to strengthen balance sheets and
smoothen earnings: The discussion paper
emphasizes that it would be prudent for all banks to
create a counter-cyclical buffer during good times,
which could be utilized when asset quality pressure
emanates during an economic downturn, thus
reduce earnings volatility. Initial DP would be
outstanding provisions made on standard asset and
floating provision. However, it has an in built
assumption that banks have reached 70% PCR.
Incrementally RBI has suggested credit cost of 1.37%.
If actual specific provisions (SP) is lower than 1.37%
excess provisions will be transferred to DP and vicea-
versa subject to certain conditions.
Proforma credit cost estimated at 1.37%, but may
vary from bank to bank: Based on weighted average
estimated loss (EL) of nine individual banks, RBI has
arrived at a system-level loss given default (LGD) of
1.37% of loans during a downturn (a more
conservative approach which RBI has recommended)
and at an LGD of 0.84% of loans during normal times.
For the purpose of calculation, model portfolio with
corporate loans, retail loans, housing loans and other
loans was taken as 49%, 17%, 6% and 28%,
respectively. Thereby actual requirement would vary
from bank to bank. Further banks might come out
with estimated loss assumption based on their
internal rating method. Thus, 1.37% cannot be
strictly taken as a benchmark for all banks.
Treatment of DP: The suggested framework for
Indian banks is conservative (as credit cost suggested
is based on downturn LGD) and the DP framework
will include an element of general and specific
provisions. RBI has suggested that till the level of
normal LGD (0.84%), DP provisions should be
considered as specific provisions and can be utilized
to arrive at net NPA. Above normal LGD to actual
levels (1.37%-0.84%), DP provisions should be
considered as general provisions, and thus would
be consider for tier-II capital.
To strengthen bank balance sheets but transition to
impact near-term earnings
The suggested framework will strengthen the balance
sheet of the banks and smoothen the earnings which is
positive. However initially, banks would have to shore
up their provision coverage ratio (PCR) to 70%, which
may impact their profitability, especially in case of stateowned
banks, wherein the PCR has declined significantly
in the past one year. Further incrementally higher
provision requirement could cumulatively impact banks
PBT by 3-35% over FY13/14.
However, over the cycle, DP will considerably reduce
earnings volatility and will also make earnings
comparable among the banks. Higher provisions will
directly impact RoA (10-15bp) and RoE (100-200bp) of
banks in the short-to-medium term. These provisions
will need some enhancement in NIMs to ensure that
profitability remains intact. Banks with strong risk
management systems would gain over the rest, once
they convince RBI to lower provisioning norms for them.
Suggested DP framework: Aim is to create a buffer in times of uncertainty
The DP framework is based on the premise of average losses; average SP is equal to EL
over the cycle. Under this framework, in addition to SP (as per regulation), banks are
required to make provisions to extent of EL and the difference between EL and SP is
transferred to an account called DP. A positive difference between EL and SP will
increase DP and a negative value will lead to drawdown from DP (subject to certain
conditions). Thus, it will ensure that charge to P&L on account of credit cost will
remain the same irrespective of the cycle.
Outstanding standard asset and floating provisions to form initial DP
While shifting to the DP framework, in the beginning, total provision outstanding on
the balance sheet should be the addition of outstanding standard assets, floating
provisions and specific provisions (at least 70% of NPA). In the other words, the DP
initial balance will be the aggregation of standard and floating balance outstanding
on the balance sheet. RBI has also ensured that the balance in the DP account should
not go below 1/3rd of EL and has prescribed the floor limit below which banks cannot
draw down from the DP account. Under the framework, RBI has suggested that banks
take charge of 1/4th of the annual DP on a quarterly basis.
Incremental provision requirement in case of DP would be αCt – SP
Where α = average estimate of credit loss (1.37% of gross loans as calculated by a
sample of 9 banks),
Ct = outstanding loan portfolio, and
SP = specific provisions made during the year.
To strengthen banks’ balance sheets, but to impact RoA in near-term
The discussion paper appears to suggest that at the time of implementation of the DP
framework, banks would have already seen the worst of the credit cycle and would
have room to create DP in their balance sheets in the following years. Initially, banks
would have to shore up their provision coverage ratio (PCR) to 70%, which may impact
their profitability, especially in case of state-owned banks, wherein the PCR has
declined significantly in the past one year. However, in our view, even if the framework
is set up in the existing form, RBI would allow banks adequate time to reach the
stipulated PCR. Ambiguity in terms of whether technical write-off is included remains;
if disallowed, the impact could be higher.
Assuming amortization of 8 quarters and technical write-offs to be allowed while
calculating 70% PCR, the impact on banks’ PBT could be 0-10% over FY13/14 (see Table
1). Banks with superior technology and already planning to move to IRB (internal
rating based) approach might come out with estimated loss assumption based on
portfolio mix. Thus, 1.37% cannot be strictly taken as a benchmark for all banks.
Currently, we model credit cost of 60-140bp for FY13-14. If the DP framework based
on current suggested structure is implemented (at 1.37%), it will impact PBT by 3-30%
for FY13/14 (see Table 2).
If the DP framework is adopted as suggested in the discussion paper, overall it will
impact PBT (see Table 3) by 10-40% for FY13/14. However, over the cycle, DP will
considerably reduce earnings volatility and will also make earnings comparable among
the banks. Higher provisions will impact RoA (10-15bp) and RoE (100-200bp) of banks
in the short-to-medium term. These provisions will need some enhancement in NIMs
to ensure that profitability remains intact. Banks with strong risk management systems
would gain over the rest, once they convince RBI to lower provisioning norms for
them.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
RBI releases discussion paper on dynamic provisioning framework
Proposals to strengthen balance sheets, but could impact near-term earnings
RBI's discussion paper on dynamic provisioning framework highlights the requirement of counter-cyclical provisioning to
reduce volatility in banks' earnings.
While dynamic provisioning will make banks' balance sheets structurally strong, some of the norms that RBI has proposed
will adversely impact their earnings and put strain on their capital in the near term.
Banks with superior technology that are already planning to move to IRB (internal rating based) approach might come out
with estimated loss assumption based on portfolio mix. Thus, 1.37% cannot be strictly taken as a benchmark for all banks.
Higher provisions will directly impact RoA (by 10-15bp) and RoE (by 100-200bp) of banks in the short-to-medium term.
Financials
3 April 2012
Update
RBI has released a discussion paper on dynamic
provisioning (DP), where it has highlighted the
requirement of counter-cyclical provisioning to reduce
volatility in banks’ earnings. It has requested views from
industry participants by 15 May 2012, post which it will
release draft guidelines.
Key highlights of discussion paper
Introduction of DP to strengthen balance sheets and
smoothen earnings: The discussion paper
emphasizes that it would be prudent for all banks to
create a counter-cyclical buffer during good times,
which could be utilized when asset quality pressure
emanates during an economic downturn, thus
reduce earnings volatility. Initial DP would be
outstanding provisions made on standard asset and
floating provision. However, it has an in built
assumption that banks have reached 70% PCR.
Incrementally RBI has suggested credit cost of 1.37%.
If actual specific provisions (SP) is lower than 1.37%
excess provisions will be transferred to DP and vicea-
versa subject to certain conditions.
Proforma credit cost estimated at 1.37%, but may
vary from bank to bank: Based on weighted average
estimated loss (EL) of nine individual banks, RBI has
arrived at a system-level loss given default (LGD) of
1.37% of loans during a downturn (a more
conservative approach which RBI has recommended)
and at an LGD of 0.84% of loans during normal times.
For the purpose of calculation, model portfolio with
corporate loans, retail loans, housing loans and other
loans was taken as 49%, 17%, 6% and 28%,
respectively. Thereby actual requirement would vary
from bank to bank. Further banks might come out
with estimated loss assumption based on their
internal rating method. Thus, 1.37% cannot be
strictly taken as a benchmark for all banks.
Treatment of DP: The suggested framework for
Indian banks is conservative (as credit cost suggested
is based on downturn LGD) and the DP framework
will include an element of general and specific
provisions. RBI has suggested that till the level of
normal LGD (0.84%), DP provisions should be
considered as specific provisions and can be utilized
to arrive at net NPA. Above normal LGD to actual
levels (1.37%-0.84%), DP provisions should be
considered as general provisions, and thus would
be consider for tier-II capital.
To strengthen bank balance sheets but transition to
impact near-term earnings
The suggested framework will strengthen the balance
sheet of the banks and smoothen the earnings which is
positive. However initially, banks would have to shore
up their provision coverage ratio (PCR) to 70%, which
may impact their profitability, especially in case of stateowned
banks, wherein the PCR has declined significantly
in the past one year. Further incrementally higher
provision requirement could cumulatively impact banks
PBT by 3-35% over FY13/14.
However, over the cycle, DP will considerably reduce
earnings volatility and will also make earnings
comparable among the banks. Higher provisions will
directly impact RoA (10-15bp) and RoE (100-200bp) of
banks in the short-to-medium term. These provisions
will need some enhancement in NIMs to ensure that
profitability remains intact. Banks with strong risk
management systems would gain over the rest, once
they convince RBI to lower provisioning norms for them.
Suggested DP framework: Aim is to create a buffer in times of uncertainty
The DP framework is based on the premise of average losses; average SP is equal to EL
over the cycle. Under this framework, in addition to SP (as per regulation), banks are
required to make provisions to extent of EL and the difference between EL and SP is
transferred to an account called DP. A positive difference between EL and SP will
increase DP and a negative value will lead to drawdown from DP (subject to certain
conditions). Thus, it will ensure that charge to P&L on account of credit cost will
remain the same irrespective of the cycle.
Outstanding standard asset and floating provisions to form initial DP
While shifting to the DP framework, in the beginning, total provision outstanding on
the balance sheet should be the addition of outstanding standard assets, floating
provisions and specific provisions (at least 70% of NPA). In the other words, the DP
initial balance will be the aggregation of standard and floating balance outstanding
on the balance sheet. RBI has also ensured that the balance in the DP account should
not go below 1/3rd of EL and has prescribed the floor limit below which banks cannot
draw down from the DP account. Under the framework, RBI has suggested that banks
take charge of 1/4th of the annual DP on a quarterly basis.
Incremental provision requirement in case of DP would be αCt – SP
Where α = average estimate of credit loss (1.37% of gross loans as calculated by a
sample of 9 banks),
Ct = outstanding loan portfolio, and
SP = specific provisions made during the year.
To strengthen banks’ balance sheets, but to impact RoA in near-term
The discussion paper appears to suggest that at the time of implementation of the DP
framework, banks would have already seen the worst of the credit cycle and would
have room to create DP in their balance sheets in the following years. Initially, banks
would have to shore up their provision coverage ratio (PCR) to 70%, which may impact
their profitability, especially in case of state-owned banks, wherein the PCR has
declined significantly in the past one year. However, in our view, even if the framework
is set up in the existing form, RBI would allow banks adequate time to reach the
stipulated PCR. Ambiguity in terms of whether technical write-off is included remains;
if disallowed, the impact could be higher.
Assuming amortization of 8 quarters and technical write-offs to be allowed while
calculating 70% PCR, the impact on banks’ PBT could be 0-10% over FY13/14 (see Table
1). Banks with superior technology and already planning to move to IRB (internal
rating based) approach might come out with estimated loss assumption based on
portfolio mix. Thus, 1.37% cannot be strictly taken as a benchmark for all banks.
Currently, we model credit cost of 60-140bp for FY13-14. If the DP framework based
on current suggested structure is implemented (at 1.37%), it will impact PBT by 3-30%
for FY13/14 (see Table 2).
If the DP framework is adopted as suggested in the discussion paper, overall it will
impact PBT (see Table 3) by 10-40% for FY13/14. However, over the cycle, DP will
considerably reduce earnings volatility and will also make earnings comparable among
the banks. Higher provisions will impact RoA (10-15bp) and RoE (100-200bp) of banks
in the short-to-medium term. These provisions will need some enhancement in NIMs
to ensure that profitability remains intact. Banks with strong risk management systems
would gain over the rest, once they convince RBI to lower provisioning norms for
them.
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