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

Loan accounting, transparency and disclosures (Contd)

General balance sheet disclosures

The following disclosures need to be made in relation to bank’s income, profits, etc.:

1. Complete breakdown of income to facilitate a meaningful assessment of the quality of income and inter-bank comparison.

2. Break-up of contribution of different activities and regions to financial performance to assess the diversification in the bank’s business and individual contribution of different businesses

3. Factors that impact current and next year’s profitability should be discussed explicitly in Management Discussions and Analysis.

4. Information detailing maturity and repricing structure of all assets and liabilities.

5. Cumulative provisions held against loan losses with the movement in provision accounts.

6. Full disclosures of off-balance sheet items with notional amounts and fair value of off-balance sheet transactions, commitments and contingent liabilities.

7. Details of risk weighted assets, leverage ratio, restrictions on distributions, including the impact on earnings, etc., need to be furnished uniformly.

8. Details of collateralised deposits or similar such liabilities or commitments wherever banks have resorted to them for managing their liquidity.

The ability of the accounting as well as internal control and management systems to support the growing size and diversity of business is the main operational risk faced by banks. Increasing frauds and deficiencies in follow-up are manifestations of the risk intensifying. A discussion in the management’s letter/Directors’ report on this issue along with a discussion on the sufficiency of the technology used by the bank and fall back positions in the event of their failure may be prescribed.

Disclosure by banks need to be made uniform in the following areas:

1. broad structure of board committees and membership, senior management structure with responsibilities and reporting lines and the basic organisational structure.

2. Information on qualifications and experience of the board and senior executives.

3. Information on incentive structure within a bank, remuneration policies, the use of performance bonuses and stock options.

4. Summary discussion of the philosophy and policy of executive and staff compensation and the role of the board in setting compensation.

5. Nature and extent of transactions with affiliates and related parties.

Credit risk disclosures are at present uniform and are not adapted to the size and nature of banks’ operations in accordance with the materiality concept.

1. qualitative information about the nature of credit risk and description of how credit risk arises in those activities.

2. Information on management, structure and organisation of banks’ credit risk management function.

3. Information on credit risk management and control policies and practices.

4. Information on techniques and methods for managing past due and impaired assets.

5. Details as to ageing schedule of past due loans and other assets, concentration of credit, aggregate exposures by counterparty credit quality, etc.

6. Information on use of credit scoring and portfolio credit risk measurement models.

7. Balances of credit exposures, including current exposure and, where applicable, future potential exposure, by major categories.

8. nformation about credit exposures by major categories of counterparties and by geographic areas

9. Information about significant concentrations of credit risk.

10. Effect of credit risk mitigation techniques, including collateral, guarantees, credit insurance and legally enforceable netting arrangements.

11. Information in respect of other credit mitigating instruments, such as securitisation, factoring and forfaiting, etc.

12. Summary of information about contractual obligations with respect to recourse arrangements and the expected losses under those arrangements.

13. Summary of information about the internal rating process and the internal credit ratings of its credit exposures.

Exposure to sensitive sectors such as real estate and capital markets are being disclosed. Banks also disclose the extent of lending to the priority sector. However, banks may also be advised to disclose business line-wise exposure which is not being done as of now.

While provisions made during the year are disclosed, these are not being classified by asset category. Information on cumulative provisions held against bad assets are also not being disclosed.

Management of Risks

More disclosures on risk management are essential. It should be possible for banks to begin providing these disclosures in two to three years time by when it can be made mandatory. Specifically, the disclosures related to risk management that need to be provided relate to the following:

1. Disclosures relating to management of risks by banks such as calculation of capital requirement for credit risks, capital requirements for market risks and data relating to broad value at risk, stress/back testing information. Alongside disclosures on capital allocation, details of future capital plans will also have to be made available.

2. Details about risk mitigating tools, which may include various limits, classification of exposures and information about the types of counterparties (exposure to banks, commercial and government entities, domestic and international exposures and subordinate assets)

3. Impact of interest rate risk on bank’s net interest margin or impact of foreign exchange risk on unhedged exposures.

4. Detailed information on interest rate risk and the extent of interest rate sensitive assets and liabilities and off-balance sheet exposures are not furnished since ALM and other bank risk management tools are still in their infancy in India. A beginning can be made by prescribing disclosure of quantitative information about the nature and extent of interest rate sensitive assets and liabilities.

5. Summarised data for significant concentrations of foreign exchange exposure by currency, broken down by hedged and unhedged exposures.

6. Detailed information on investments in foreign subsidiaries (translation risk) or foreign exchange transactions risk, the earnings impact of foreign exchange transactions and effectiveness of hedging strategies.

7. Disclosures on "Value at risk" and "Earnings at risk". To begin with, these may be prescribed in selected areas of activity, e.g., foreign exchange, treasury activities and investments.

8. Except for cash flow statement, detailed information on liquidity risk exposure is currently not being furnished. With the concept of ALM expected to stabilise in Indian banking in the ensuing years, detailed disclosures on liquidity risk exposure will be possible. A more detailed statement of cash flow than at present showing sources and uses of funds should be prescribed for disclosure.

Effective market discipline requires that the management’s letter/ directors’ report to the shareholders contain certain minimum levels of disclosure. Among other things, detailed discussions on operational, legal and strategic risks may be made mandatory in such letters/reports to the shareholders. Similarly, details about the diversity of funding options and contingency plan should form part of the management’s letter on managing liquidity risks.

Basic guidelines for classification of loans have been provided by RBI. In addition, banks have their own documented policies of loan classifications which are formulated with the RBI guidelines as the base. The policies are well documented and objectively followed. While the value of judgements in risk classification of loans is not denied, their role in the process is limited and not pronounced.

The exercise of accounting/classification of loans into four categories is carried out on an on-going basis and for the purpose of valuation, allowances (provisions) are created at the time of yearly closing of balance sheet. Banks also have proper internal control systems approved by the boards for recording, documentation, loan review procedures, etc.

The selection and application of accounting policies and procedures by Indian banks conform to fundamental accounting concepts. Banks identify and recognise impairment in a loan on an on-going basis primarily based on record of recovery. Availability of collateral is not considered while recognising impairment of loans since the legal system in India is at present not conducive for effective enforceability of lenders’ rights. However, banks have been given certain flexibilities in respect of loans which are restructured.

The present provisions are rule-based and as of now, not so much based on analytical and statistical methods. These, therefore, tend to be ad hoc and do not always bear close relationship with the realisable value of assets. RBI’s risk management guidelines require banks to set up a loan review mechanism for determining, inter alia, the adequacy of loan loss provisioning.

Banks in India are making standard disclosures as per the guidelines given by RBI. While the quality and extent of disclosures have been gradually improving, and the management note to the balance sheet is now expected to cover a number of areas about which disclosures have not been made in the past, generally qualitative changes in the portfolio including its credit quality do not yet form part of disclosures.

Banks disclose information on their accounting polices, practices and methods used to account for loans and determine specific and general allowances. An impaired loan is restored to accrual status only when it has returned to unimpaired status unless if it has been restructured. Through on-site inspection and off-site returns, RBI evaluates banks’ policies and practices for assessment of loan quality based on the regulations set by it. RBI also satisfies itself that the methods employed by banks to calculate provisions are as per its guidelines.

There are, however, no disclosures in respect of several key areas such as detailed breakup of income and the contribution of various regions and business lines to financial performance. In respect of credit, the gaps include information on concentrations of credit, recourse arrangements and expected losses from such arrangements, movement in provisions, impaired and past due loans by geographical regions and by major categories of borrowers and provisions against each category, and credit risk management and control policies and practices.

The progress in efforts on promoting high quality disclosure standards will have to be gradual but sustained. RBI has been adopting such an approach in moving towards international loan accounting, transparency and disclosure standards. While there will be some key disclosures which must find place in the balance sheets of all banks as prescribed by RBI, individual banks should be encouraged to make additional and innovative disclosures which they consider relevant to their business and balance sheet. It, however, needs to be ensured that a beginning is made with disclosures that are more relevant in our context than with those which are sophisticated and have relevance only in a very complex situation. A gradual process of increasing disclosures needs to be followed so that key elements always remain in focus.