Mr Hans Hoogervorst International Accounting Standards Board 1st Floor 30 Cannon Street London Dear Mr Hoogervorst and Technical Director, We appreciate the Board s effort in trying to develop a robust model for Credit loss recognition and measurement. HDFC Bank Limited (the Bank) is one of the leading banks in India. The proposals in the ED will impact the Bank significantly. We thank the IASB for giving us the opportunity to comment on the exposure draft (ED) on credit losses. Thanks and Regards, Mehul Nagda
Question 1(a) Do you agree that an approach that recognises a loss allowance (or provision) at an amount equal to a portion of expected credit losses initially, and lifetime expected credit losses only after significant deterioration in credit quality, will reflect: (i) the economic link between the pricing of financial instruments and the credit quality at initial recognition; and (ii) the effects of changes in the credit quality subsequent to initial recognition? If not, why not and how do you believe the proposed model should be revised? At the stage of pricing of a financial asset, it is expected that credit losses are dovetailed in the pricing, thereby not requiring institutions to recognize expected credit losses at the time of initial recognition. However, in developing economies like India, it is generally observed that institutions, whilst lending, take into account PDs of shorter duration rather than the estimated life of the financial asset. This is primarily on account of lack of available information and the capabilities to compute long term PDs. This economic link between the pricing of financial instruments and the credit quality at initial recognition deserves to be appropriately presented in the financial statements. We therefore believe that the approach proposed in the ED of recognizing a loss allowance (or provision) at an amount equal to a portion of expected credit losses initially and lifetime credit losses only after significant deterioration in credit quality, is an operationally feasible method that aims to achieve a balance between timely recognition of credit losses and matching principle so that losses get recognised in line with the income generated from that asset. Question 1(b) Do you agree that recognising a loss allowance or provision from initial recognition at an amount equal to lifetime expected credit losses, discounted using the original effective interest rate, does not faithfully represent the underlying economics of financial instruments? If not, why not? We agree that recognising a loss allowance or provision from initial recognition at an amount equal to lifetime expected credit losses, discounted using the original effective interest rate, does not faithfully represent underlying economics of financial instruments. This is because pricing methodologies should consider credit losses expected to occur over the expected life of the financial asset. Thus on day one, the amount disbursed to the borrower is the best estimate of the present value of the cash flows expected to be realized and the loan should be presented at this value on day one i.e without any credit loss allowance or minimal expected credit losses like 12-month expected losses. Moreover, the full lifetime expected loss model leads to front loading of credit losses and violates the matching principle.
Question 2(a) Do you agree that recognising a loss allowance (or provision) at an amount equal to 12-month expected credit losses and at an amount equal to lifetime expected credit losses after significant deterioration in credit quality achieves an appropriate balance between the faithful representation of the underlying economics and the costs of implementation? If not, why not? What alternative would you prefer and why? As stated in our response to Question 1(a) above, we do not disagree with the believe that recognising a loss allowance (or provision) at an amount equal to 12-month expected credit losses and at an amount equal to lifetime expected credit losses after significant deterioration in credit quality achieves an appropriate balance between the faithful representation of the underlying economics and the costs of implementation. Alternate approach: The Board may however consider the following suggested approach especially in relation to developing economies which face difficulties in arriving at a reasonable estimate of long term PDs: Recognise a loss allowance at an amount equivalent to 12-month credit losses on initial recognition of the financial asset Subsequent measurement of loss allowance should there be a significant deterioration in the credit quality would also be recognised at an amount equivalent to 12-month credit losses based on a revised estimate of PDs We expect the cost of implementation of the suggested alternate approach would be minimalistic and institutions could reap the following benefits: Accounting principle of matching the credit loss recognition with revenue recognition would be better presented in the financial statements for financial asset that may have witnessed a significant deterioration in credit quality but without any objective evidence of impairment. Need for assumptions (which may not be consistent across preparers), requirement of estimates and long term forecasts for computing of long term PDs would be done away with thereby increasing the level of transparency and comparability of financial statements across entities. We believe that estimating expected credit losses weighted with the revised probability of a default occurring in the next 12 months given a significant deterioration in credit quality, would be an operationally less burdening and cost effective method of achieving a balance between the faithful representation of the underlying economics compared to the model that was proposed in the SD (without the foreseeable future floor)
Question 2(b) Do you agree that the approach for accounting for expected credit losses proposed in this Exposure Draft achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than the approaches in the 2009 ED and the SD (without the foreseeable future floor)? Yes we agree that the model proposed in this ED achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than the time proportionate approach excluding foreseeable future floor that was proposed earlier. We believe that the reference to 30 DPD should be removed and the standard should allow entities to set their own DPD parameters. Entities can base their assessment of increase in credit risk basis the DPD benchmark and can accordingly determine the level of DPD at which full life time loss should be recognised for each category of assets. In developing economies like India, a 30 DPD benchmark is more likely to be rebutted than not. Question 2(c) Do you think that recognising a loss allowance at an amount equal to the lifetime expected credit losses from initial recognition, discounted using the original effective interest rate, achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than this Exposure Draft? No, we do not think that recognising a loss allowance at an amount equal to the lifetime expected credit losses from initial recognition, discounted using the original effective interest rate, achieves a better balance between the faithful representation of the underlying economics and the cost of implementation than this Exposure Draft. As stated in our response to Question 1(b), this would lead to front loading of credit losses. Question 3(a) Do you agree with the proposed scope of this Exposure Draft? If not, why not? We agree with the scope of this ED. We feel it is correct to exclude the assets carried at fair value through profit and loss (P&L) from the scope of this ED since the fair valuation techniques should factor in the credit loss expectations. Some observers might argue that during the financial crisis the fair value of loans carried at fair value through P&L did not correctly represent the credit losses incurred on such loans. However, this problem should be addressed in the fair valuation techniques being used by the entities and hence the credit loss model should correctly exclude such financial assets within its scope.
Question 3(b) Do you agree that, for financial assets that are mandatorily measured at FVOCI in accordance with the Classification and Measurement ED, the accounting for expected credit losses should be as proposed in this Exposure Draft? Why or why not? We believe that, for financial assets that are mandatorily measured at FVOCI in accordance with the Classification and Measurement ED, the accounting for expected credit losses should not be different from accounting for credit losses for other financial assets within the scope of this ED. Question 4 Is measuring the loss allowance (or a provision) at an amount equal to 12-month expected credit losses operational? If not, why not and how do you believe the portion recognised from initial recognition should be determined? We believe that such a model should be operational. Question 5(a) Do you agree with the proposed requirement to recognise a loss allowance (or a provision) at an amount equal to lifetime expected credit losses on the basis of a significant increase in credit risk since initial recognition? If not, why not and what alternative would you prefer? Whilst we do not dispute the proposed requirements to recognise a loss allowance at an amount equal to entire lifetime expected credit losses on the basis of a significant increase in credit risk since initial recognition, we recommend that the Board consider the alternative approach suggested in our response to Question 2(a). Question 5(b) Do the proposals provide sufficient guidance on when to recognise lifetime expected credit losses? If not, what additional guidance would you suggest? We believe that the proposals in the ED provide sufficient guidance on when to recognise lifetime expected credit losses. We believe that the reference to 30 DPD should be removed and the standard should allow entities to set their own DPD parameters. Entities can base their assessment of increase in credit risk basis the DPD benchmark and can accordingly determine the level of DPD at which full life time loss should be recognised for each category of assets.
Question 5(c) Do you agree that the assessment of when to recognise lifetime expected credit losses should consider only changes in the probability of a default occurring, rather than changes in expected credit losses (or credit loss given default ( LGD ))? If not, why not and what would you prefer? We agree that the assessment of when to recognise lifetime expected credit losses should consider only changes in PD and not LGD. The risk of the asset is correctly represented by its PD and not LGD. Any increase in LGD will result in a higher recognition of losses since 12-month expected losses would consider the increased LGD. However, an increase in LGD does not by itself indicate higher credit risk on the asset and hence should not require entities to recognise full lifetime expected losses. Question 5(d) Do you agree with the proposed operational simplifications, and do they contribute to an appropriate balance between faithful representation and the cost of implementation? We agree with the proposed operational simplifications with regard to assessment of significant increase in credit risk. However, the standard should remove rebuttable presumption of 30 day DPD and should allow entities to set up their own DPDs for assets as stated in our response to Question 5(b). Question 5(e) Do you agree with the proposal that the model shall allow the re-establishment of a loss allowance (or a provision) at an amount equal to 12-month expected credit losses if the criteria for the recognition of lifetime expected credit losses are no longer met? If not, why not, and what would you prefer? We agree with the proposal to allow the re-establishment of a loss allowance equal to 12-month expected losses if the criteria for recognition of full lifetime expected credit losses are no longer met. We also recommend that the Board consider the alternative approach suggested in our response to Question 2(a).
Question 6(a) Do you agree that there are circumstances when interest revenue calculated on a net carrying amount (amortised cost) rather than on a gross carrying amount can provide more useful information? If not, why not, and what would you prefer? We believe that for financial assets, there should be a practical exemption to allow suspension of recognition of interest income after the credit risk crosses a certain limit instead of requiring income to be recognised on net basis on such financial assets. Question 6(b) Do you agree with the proposal to change how interest revenue is calculated for assets that have objective evidence of impairment subsequent to initial recognition? Why or why not? If not, for what population of assets should the interest revenue calculation change? We do not agree with the proposal to change how interest revenue is calculated for financial assets that have objective evidence of impairment subsequent to initial recognition. Please refer our response to Question 6(a). Question 6(c) Do you agree with the proposal that the interest revenue approach shall be symmetrical (ie that the calculation can revert back to a calculation on the gross carrying amount)? Why or why not? If not, what approach would you prefer? We agree with the proposal that the interest revenue approach shall be symmetrical. In line with our recommendation in our response to Question 6(a), we recommend that interest accrual be resumed once the financial asset witnesses a significant favourable movement in its credit risk (ie that the financial asset moves from Stage 3 to Stage 2). However, we would like the Board to clarify with an illustration as to when would a financial asset move from Stage 3 to Stage 2.
Question 7 (a) Do you agree with the proposed disclosure requirements? Why or why not? If not, what changes do you recommend and why? (b) Do you foresee any specific operational challenges when implementing the proposed disclosure requirements? If so, please explain. (c) What other disclosures do you believe would provide useful information (whether in addition to, or instead of, the proposed disclosures) and why? We agree with the proposed disclosure requirements. The proposed model involves use of lot of assumptions and estimates and hence it is critical that adequate disclosure requirements are laid down. There will be operational challenges in implementing the proposed disclosures especially with respect to large pool of homogenous financial assets. However, we believe that entities can overcome these operational difficulties to comply with the proposed disclosures which we believe are reasonable. We believe that entities should be required to disclose the PD and LGD considered across various credit risk grades. In addition the entities should also give details of the manner in which financial assets have been grouped under various credit risk grades. This is especially important for homogenous financial assets which are assessed collectively. The manner of grading these financial assets in to various risk categories for arriving at the PD and LGD and PD / LGD applied should be disclosed by entities applying the proposed standard. Question 8 Do you agree with the proposed treatment of financial assets on which contractual cash flows are modified, and do you believe that it provides useful information? If not, why not and what alternative would you prefer? We believe that accounting for assets that have been modified should be as follows- An assessment should be made by entities if such modification constitutes a restructuring due to financial difficulty of the borrower. If the modification is assessed as a restructuring due to financial difficulty of the borrower, then an impairment loss should be recognized to the extent of difference between the present value of future expected cash flows as per the revised terms at the original EIR and current gross carrying amount of the financial asset. Where such modification does not constitute a restructuring due to financial difficulty of the borrower, the proposed approach in the ED should be followed.
Question 9(a) Do you agree with the proposals on the application of the general model to loan commitment and financial guarantee contracts? Why or why not? If not, what approach would you prefer? We agree with the proposals on the application of the general model to loan commitments and financial guarantee contracts. This is because the loan commitment exposure duly adjusted with the credit conversion factor (CCF), are no different from outstanding loans. Hence the CCF applied exposure of loan commitments should be subject to impairment measurement like any other loans. Financial guarantee contracts are subject to credit risk in the same manner as any other loans. Hence the general impairment model should be applicable for financial guarantee contracts as well. It should be noted that financial guarantee contracts are required to be carried at fair value. It should be clarified that the liability recognised in respect of financial guarantee contracts should be higher of a. fair value of such contracts or b. credit loss arrived as per the ED The standard should clarify the application of the proposed credit loss model for other non-fund based financial instruments such as letters of credit (LCs). Question 9(b) Do you foresee any significant operational challenges that may arise from the proposal to present expected credit losses on financial guarantee contracts or loan commitments as a provision in the statement of financial position? If yes, please explain. We do not foresee any significant operational challenges that may arise from the proposal to present expected credit losses on financial guarantee contracts or loan commitments as a provision in the statement of financial position. The provision owing to loan commitments and financial guarantees can be disclosed separately if required. We recommend that the Board consider incorporating its basis for conclusion BC179 as an integral part of the accounting standard.
Question 10 (a) Do you agree with the proposed simplified approach for trade receivables and lease receivables? Why or why not? If not, what changes do you recommend and why? (b) Do you agree with the proposed amendments to the measurement on initial recognition of trade receivables with no significant financing component? If not, why not and what would you propose instead? We agree with the proposed simplified approach for all trade receivables and lease receivables. We also agree with the proposal to provide an accounting policy choice for trade receivables with an embedded funding element, to either recognize full lifetime expected losses or recognize impairment as per normal model. Question 11 Do you agree with the proposals for financial assets that are credit-impaired on initial recognition? Why or why not? If not, what approach would you prefer? We do not agree with the proposal to include expectations of credit losses in the calculation of Effective Interest Rate (EIR) for financial assets that are credit impaired on initial recognition. This creates deviation from the general principles of initial recognition for financial assets and also from the general principles of measuring impairment. The amount of impairment charge is an important and one of the best parameter for judging the extent of credit risk undertaken by an entity in its operations. With the adoption of credit adjusted effective interest rate for measuring revenue, the amount of impairment charge does not truly reflect the extent of risk undertaken by an entity. Any losses incurred on account of credit loss should be presented as an impairment charge in the P&L and not as an adjustment to revenue. This reflects the underlying economics of the transaction too. For instance, let us assume there are two entities A and B. Entity A sources a loan which is not credit impaired, at the rate of 10% per annum. Entity B sources a loan which has objective evidence of impairment, at the rate of 15% per annum, for which credit adjusted effective rate works out to 10% per annum. Assuming, Entity B experiences the losses as estimated, under the proposed model, both entities would end up recognising the same amount of revenue and zero credit loss. This would lead to a conclusion that risk profiles of both the entities are the same, which is not the case. Accounting for financial assets should reflect the credit risk profile of the entities, which is not achieved in the proposed model. We believe that for financial assets that are credit impaired upon initial recognition, the transaction value best represents the estimate of PV of cash flows estimated to be collected. The measurement of impairment for such financial assets should be no different from measurement of impairment for other financial assets, which should be 12 month expected credit losses with suspension of interest accrual as suggested in our response to Question 6(a). Thereafter, such
financial assets should be monitored for further deterioration in credit risk basis which it should be decided whether full lifetime losses should be provided or not. Currently under Para 59 of IAS 39, decrease in cash flows evidenced by historical data is treated as an objective evidence of impairment. Thus for homogenous pool of financial assets, there was always some evidence of objective evidence of impairment upon initial recognition. The said para has been deleted (refer pg 56 of the ED) in the proposed ED. Such evidence from historical data has not been included in the definition of objective evidence under the ED (refer pg 33 of the ED). We believe that such historical data will not be considered as an indicator of objective evidence of impairment in case of homogenous pool of financial assets. It would be better if this is clarified somewhere in the Implementation Guidance to the standard. In case, the Board decides to go ahead with the proposals in the ED, then we seek clarification as to how this proposal would apply for purchase of a pool of homogenous assets in which some portion which are not individually significant have an objective evidence of impairment. For instance, an entity purchases 1 million mortgage receivables out of which there is an objective evidence of impairment in 5000 cases. How should credit adjusted effective interest rate be applied in this case? Question 12(a) What lead time would you require to implement the proposed requirements? Please explain the assumptions that you have used in making this assessment. As a consequence, what do you believe is an appropriate mandatory effective date for IFRS 9? Please explain. The implementation date of IFRS in India has not been finalised till date. Hence, we would not be able to comment on the lead time required for implementation of the proposed requirements. Question 12(b) Do you agree with the proposed transition requirements? Why or why not? If not, what changes do you recommend and why? We agree with most of the proposed transition requirements since we believe that the entities have been provided a practical expedient for homogenous pool of assets where DPD can be used as an indicator of credit risk (subject to change in 30 DPD rebuttable presumption as suggested in our response to Question 5(b)). Entities have also been provided a practical exemption of recognising entire lifetime expected losses when it is not possible to determine whether there has been a significant increase in credit risk. In our view, should the Board go ahead with the guidance proposed in ED for accounting for credit impaired assets upon initial recognition, there should be an exemption given to entities from applying credit adjusted effective interest rates for all assets sourced prior to the date of adoption of the proposed standard. The proposed guidance on assets that are credit impaired
upon initial recognition should be grandfathered for all assets that are sourced prior to the date of adoption of the proposed standard. Question 12(c) Do you agree with the proposed relief from restating comparative information on transition? If not, why? We agree with the proposed relief from restatement. Question 13 Do you agree with the IASB s assessment of the effects of the proposals? Why or why not? We do not fully agree with IASB s assessment of the effects of the proposals. We appreciate the concerns raised by the Board that the current standards do not adequately address the concern of timely recognition of credit losses. Whereas this may be partially true, we believe that failure to recognise credit losses on a timely basis has more to do with the application of the existing standard. The credit loss recognition models of the entities are not adequately addressing the issue of timely loss recognition. This issue would continue to remain even if the proposals of the ED are adopted. We believe it is very critical for both the Boards (FASB and IASB) to reach one common measurement approach. The Board has not factored in the effect of having different credit loss models under US GAAP and IFRS. This has the potential of entities maintaining multiple models under both GAAPs and having to reconcile both the models which would be operationally strenuous and financially draining. That is why it is very important to achieve a common credit loss model under US GAAP and IFRS. Another issue that we feel, the Board should addressed is the regulatory requirements with respect to recognition of credit losses. In India, for instance credit loss measurements of banks are guided by guidelines issued by the banking regulators. It is highly likely that for accounting, credit loss norms would be as per the guidance issued by regulators. The loss recognition models of regulators are set considering the macro economic scenario and are generally not entity specific. This vitiates the comparability of the financial statements amongst entities. How does IASB plan to achieve the endorsement of regulators around the world? We feel IASB should interact with regulators across the globe in its outreach and come out with measures to address regulators concerns.