KARACHI: The method that banks use for calculating their expected credit cost will change under the revised set of accounting standards that may lead to a higher exp­ense for commercial lenders in the medium term.

Speaking to Dawn on Thursday, JS Global Capital Ltd Head of Research Amreen Soorani said banks will start reporting their loss expectations on investments and loans under the new accounting requirements of the International Financial Reporting Standards (IFRS)-9 from the first quarter of 2023.

In non-technical terms, the credit cost represents the increase or decrease in the stock of a bank’s non-performing loans (NPLs) as a percentage of its loan book.

For example, the credit cost of a bank would be two per cent (200 basis points) if NPLs increased from Rs10 to Rs12 on a yearly basis for total loans of Rs100.

Rising NPLs reduce a bank’s interest income and lowers its profitability. “In our base-case estimates (for bank earnings), we’ve incorporated a higher credit cost this year,” said Ms Soorani.

Under the current accounting practices, a bank takes provisions on its bad loans. But the new accounting standards require every bank to come up with probabilities for its entire loan book.

“In the most likely case, banks’ credit cost will go up. But nothing can be said for sure until we see the next quarterly accounts,” she said. With the implementation of IFRS-9 from this year, banks will classify their loss expectations under different categories. They’ll assign a probability to compute the expected credit loss (ECL) based on “forward-looking scenarios”.

Each bank will be required to build and use statistical models for the Probability of Default (PD), Loss Given Default (LGD) and Exposure At Default (EAD) based on forward-looking assumptions. These models will also incorporate evolving economic factors.

In a recent research note issued to clients, Ms Soorani noted that banks may need to assess and assign ratings to sectors and obligors separately. They’ll create three categories — to be called “Stages” — and classify loans from the least risky to the most risky. The existing NPL stock will directly fall under Stage-3. Its provisions will also be higher than others as per the ECL model.

“We keep our credit cost estimates at 100 basis points annually for 2023 and 2024,” she said, noting that the average credit cost of the last 15 years amounts to 110 basis points a year. The average drops to 48 basis points a year by excluding the tumultuous 2008-2010 phase that saw a sharp increase in NPLs owing to the financial crisis.

Even though the stock of NPLs increased in 2022, their share in the total loan portfolio decreased by 80 basis points year-on-year to 5.8pc.

Ms Soorani said the overall economic situation is the chief reason for her expectation of a higher credit cost in the medium term. “Interest rates are high, growth in large-scale manufacturing is negative, ports are nearly closed and the rupee has sharply depreciated. All these factors have hurt cash flows of businesses, which are finding their debt-paying capacity impaired.”

Published in Dawn, March 31st, 2023