Financial Standards and Codes: Report of Advisory Group on Banking Supervision

Loan accounting, transparency and disclosures

Introduction

Public disclosure of information and resultant market discipline constitute key elements of an effectively supervised, safe and sound banking system. On the other hand, lack of transparency tends to negatively distort risk perceptions in the market and increases the intrinsic fragility of individual banking institutions apart from bearing seeds of systemic disturbances. Practices followed by banks with regard to loan accounting and disclosures relating thereto affect the overall quality of financial reporting and transparency. Towards improving market discipline over banks through better transparency and disclosures, BCBS has brought out three papers laying down sound practices in respect of loan accounting, bank transparency and credit risk disclosures. These are discussed in the following paragraphs.

The Group has examined the present system of loan accounting in Indian banks vis-à-vis the sound practices as laid down in the paper on Sound Practices for Loan Accounting and Disclosure (July 1999) prepared by the BCBS. The important suggestions made in this regard are described below.

The basis of loan classification in India is currently objective. It is based on record of recovery of interest and principal coupled with current assessment about their realisability. Although, internationally, in most banking systems, an asset is classified as sub-standard after 90 days of payment delinquency, Indian banks have not yet adopted this practice. This is, however, being introduced from the year ending 31 March 2004. The present practice is largely due to the current trade/business practices followed in the country, which permit a long payment cycle. Further, the basis of classification in India is conservative in as much as the value of collaterals is not taken into account for risk classification of loans. However, while creating allowances for doubtful assets, the value of collateral is reckoned at a progressive discount up to three years beyond which there is no further discounting of the value of collaterals. The difficulty with this approach, however, is that if the loan does not migrate to loss category (for which 100 per cent provision is required to be made), the accounts remain under-provided as, up to the end of the third year, on the secured portion of a debt in the doubtful category, the maximum provision created is 50 per cent. This may result in under-provisioning in some cases, a loophole that needs to be plugged in view of the limitations in the legal system in the country for realisation of collateral.

The extant rule-based provisioning requirements need to be tightened and gradually brought at par with the internationally accepted standards in this regard. Within a given timeframe of, say, 3-5 years, the level of provisions on standard assets should be gradually raised to international standards. Similarly, even on the secured portion of doubtful debts, provision beyond 50 per cent will have to be stipulated if the condition and realisabilty of collaterals so demand. Over a period of time, the formulae-based system of classification and provisioning will have to give way to a more closer to reality assessment of the realisabilty of assets, relying on a risk assessment-based system. This changeover will be facilitated as the changes in the legal system reduce delays and make it more efficacious

While, at present, a formulae-based system for provisioning on impaired loans is being followed, the extent of provisioning is not being determined scientifically based on analysis of arrears, ageing of balances, migration analysis or use of various statistical methodologies. While some small private sector banks have made a recent move in this direction, public sector banks constituting more than 80 per cent of the system continue to base their provisioning on the general guidelines given by Reserve Bank of India. Banks should be asked and encouraged to place their system of provisioning on more scientific lines, closer to their own specific actual situation. Now that they have already put a credit risk management system in place, it should not be difficult for them to adopt analytical and statistical methods. Reserve Bank of India should also consider issuing suitable guidelines. Migration to a suitable provisioning system can be achieved in the next two financial years, i.e., by the end of March 2003 and Reserve Bank of India should attempt to lead banks towards that

At present, all banks irrespective of their size, scope and complexity of operations, are required to make the same credit risk disclosures. Reserve Bank of India may take early steps to introduce the concept of materiality in the matter of disclosures. Among other things, banks should be asked to disclose qualitative information on their credit risk management and control policies and practices in the Management’s Note to the Balance Sheet. Banks should also be advised to disclose information about significant concentrations of credit risks, business segment-wise general and specific provisions and movement in provisions.

The Group has made an assessment of the current position in regard to bank transparency in India against benchmarks/ principles enunciated in the BCBS paper on Enhancing Bank Transparency (September 1998). While compliance with the Core Principles for Effective Banking Supervision under the harmonised assessment methodology has been separately dealt with, this assessment essentially focuses on further elaboration of the Core Principles relating to bank transparency suggested in the September 1998 paper.

Information on the extent of credit risk faced by banks and the methods used to keep such risks under control are important to market participants to arrive at a judgement on the overall soundness of banks. Disclosures regarding credit risk assume importance in view of this and because of the role of credit risk in bank failures. The BCBS had brought out a paper on Best Practices for Credit Risk Disclosure (September 2000) "to encourage banks to provide market participants and the public with the information they need to make meaningful assessments of a bank’s credit risk profile". The Group’s views on the Indian position vis-à-vis these best practices are given in Annex 9. Some of the important observations made in the above two annexes are summarised below.

Considering the growing complexities in product risk profiles and activities of banks, the BCBS has recognised that the minimum standards or guidelines for public disclosure set out in its paper do not necessarily assure a sufficient level of transparency in the market for all institutions. The effectiveness of the public disclosure measures would require that information disclosed results in adequate transparency. The market should be able to reward the better managed banks. Further, having regard to the competitive and legal issues involved in public disclosures and the need to strike a balance between transparency and confidentiality obligations, the Group has made its assessments on the basis of observed disclosure practices as well as legal and regulatory stipulations in this regard.

In India, banks’ financial reporting broadly encompasses financial performance and financial position (excluding liquidity) and accounting policies. As regards information on basic business management and corporate governance, wide range of practices are prevalent ranging from very little information to elaborate disclosures. Irrespective of the size and nature of a bank’s operations, the scope and content of information provided tend to be more or less standardised with limited disaggregation and detail.

The levels of disclosure in the balance sheets of Indian banks need to be improved further. Efforts have to be made to come close to internationally followed standards of disclosure within the next two to three years. Reserve Bank of India may take the Institute of Chartered Accountants of India (ICAI) into confidence and consider issuing comprehensive guidelines on necessary disclosures in a bank’s balance sheet. Since disclosures in India are still in an evolutionary stage, and additional disclosures are getting added to the disclosure requirements, it would also be desirable for RBI to undertake from time to time comprehensive reviews and update the guidelines regularly until the Indian disclosures fully match the international standards in this regard. Initially, updating of these guidelines may be undertaken at shorter, say, biennial intervals. A coordinated approach between the ICAI and RBI may be adopted for this purpose.

The Group, on examination of the current practices as against the standards suggested by BCBS, feels that several changes need to be made in disclosure practices. The areas in which more disclosures are considered desirable are the following:

1. Balance sheet presentation,

2. Internal control and management system,

3. Management of credit risk and

4. Management of risks in general.

The four items listed above are discssed in detail in the next page