Indian Banks

Sector outlook
Aashish Agarwal
aashish.agarwal@clsa.com 91-22-66505075

Transition to IFRS
While transition from Indian GAAP to IFRS will make financial statements globally more comparable, it will be challenging for Indian banks to meet the FY12 deadline. Clarity on regulatory aspects, upgrade of IT systems and staff training and development are imperative to this transition. IFRS puts more onus on management judgement and differs considerably from Indian GAAP in valuation and accounting of investments and recognition and provisioning on impaired assets. Though banks are yet to quantify the likely impact of the transition, we believe that those with lower NPL provisions could see a negative impact.

Prakhar Sharma
(91) 22 66505058

15 December 2009

Key difference #1: Investment valuation and accounting

As per Indian GAAP, banks need to value available for sale (AFS) and held for trading (HFT) investments at cost or market value whichever is lower; held to maturity (HTM) investments are valued to amortised cost. IFRS recommends two important changes: (1) Banks can recognise MTM gains while valuing investments held in AFS and HFT categories and (2) MTM impact (gains and losses) on AFS portfolio will be routed through reserves and surplus (HFT through P&L). While recognition of unrealised gains on investments can boost reported book values, routing of MTM changes in AFS investment through shareholders reserves will make quarterly earnings less volatile.

India
Financial services

IFRS impact on key sectors

Key difference #2: Asset impairment

Presently, banks classify assets as performing and non-performing based on RBI guidelines. IFRS will replace the concept of NPAs with impaired assets which will be based on managements judgement and historical trends in conjunction with the overall economic scenario to determine the likely credit losses (after recoveries) on loans and investments. IFRS also sets new rules for accounting, provisioning and income recognition on impaired assets. We believe that while banks with higher NPL coverage may see only a limited (or even positive) impact from this transition, those with lower coverage levels may need to make additional provisions. However, if by FY11 banks step-op NPL coverage to 70% (RBIs proposal), earnings impact may be lower.

Others: Income and expense, securitisation and derivatives

Under IFRS, interest income will be recognised based on management estimates that factor NPV of cash flows from these assets. Income and expenses directly related to loans and deposits will be amortised over their expected life, as against being recognised in the first year under Indian GAAP and profit on securitisation of assets will need to be recognised in the same year. But IFRS has stricter rules on securitisation of assets and many transactions that comply RBI guidelines may fail IFRS tests, resulting in larger balance sheets and fall in capital adequacy ratios. Under IFRS all derivatives are recognized on the balance sheet at fair values with changes being recognized in the income statement, other than in the case of a qualifying cash flow hedge.

Key challenges- Regulatory gaps, IT and staff bottlenecks

Presently, there are various gaps in the accounting principles set out by IFRS, RBI guidelines and SEBI disclosure standards. Banks are awaiting clarity on their harmonisation and will accordingly commit financial and man-power resources to upgrade of IT systems and training and development of employees. Therefore, the Indian Banks Association (IBA) has requested RBI to push the transition to IFRS for Indian banks by one year.
www.clsa.com
Find CLSA research on Bloomberg (CLSA <go>), Thomson First Call, Reuters Knowledge - and profit from our powerful CLSA evalu@tor database at clsa.com

Transition to IFRS

Indian banks

Figure 1

Key differences between Indian GAAP and IFRS for banking and financial sector Aspect Valuation of investments Indian GAAP AFS and HFT: Valued at cost or realisable value, whichever is lower MTM impact taken through P&L HTM: Valued at amortised cost Banks can not recognise MTM gains on AFS and HFT investments Banks follow RBI guidelines on recognition, accounting and provisioning for NPAs Income on NPAs is recognised on receipt basis Income recognition Interest income is recognised on accrual basis Fee income is recognised upfront Profit on securitisation of assets is distributed over term of assets; loss charged in the first year Direct origination expenses related to assets and liabilities are recognised upfront Securitised assets with credit enhancements do not form part of originators balance sheet No specific guideline IFRS AFS and HFT: Accounted at fair value MTM impact: On HFT through P&L and on AFS through reserves HTM: Valued at amortised cost Banks can recognise MTM gains on AFS and HFT investments Asset impairment is based on management judgement, past trends and economic cycle Income on impaired assets is recognised on accrual basis Interest income is recognised on accrual basis (based on management judgement on NPV of cash flows) Fee income is distributed over expected term of asset Profit and loss on securitisation of asset is recognised in the first year Direct origination expenses are amortised over term of assets and liabilities Securitised assets with credit enhancements will be part of originators balance sheet This may lower capital adequacy ratio Accounted at fair value

Asset impairment

Expense recognition De-recognition of financial assets Derivative

Source: CLSA Asia-Pacific Markets, News reports

Detailed discussion on key issues

Investment valuation and accounting Differences in valuation and accounting of investments are highlighted below:
Indian GAAP does not permit recognition of MTM gains MTM changes in AFS through P&L IFRS permits recognition of MTM gains MTM changes in AFS through P&L

Indian GAAP: Investments held as HFT and AFS are valued as cost or market value whichever is lower and any MTM losses/ write-back of losses are taken through the P&L account. Investments classified as HTM as valued at amortised costs. Banks can not recognise unrealised gains on investments. IFRS: The two important changes that IFRS proposes are (1) Banks can recognise MTM gains while valuing investments held in AFS and HFT categories and (2) MTM impact (gains and losses) on AFS portfolio will be routed through reserves and surplus (HFT through P&L). IFRS has stringent guidelines for recognition of assets as HTMif banks sell HTM securities earlier than their maturity then for that year and two following years they will not be permitted to classify any security as HTM; but there are some exceptions to this rule. Impact: Under IFRS quarterly earnings will be less volatile as changes in the value of AFS investments will be routed though reserves under a new line termed as other comprehensive income (OCI). Permission to recognise unrealised gains on investments will increase reported book values.

Transition impact: 1. P&L will be less volatile 2. MTM gains will boost book value

aashish.agarwal@clsa.com

15 December 2009

Transition to IFRS

Indian banks

Asset impairment IFRS will replace the concept of NPAs with impaired assets which will be based on managements judgements and past trends. IFRS also sets new rules for accounting, provisioning and income recognition on impaired assets.
Presently, NPAs are based on RBI guidelines

Indian GAAP: Presently banks classify assets as performing and nonperforming based on RBI guidelines. Provisioning is based on the age of the NPA and realisable value of security and banks recognise income on these assets only upon receipt. IFRS: IRFS requires management to use its judgement and historical trends in conjunction with the overall economic scenarios to determine the likely credit losses (after recoveries) on loans and investments. Banks need to provide for the difference between assets carrying value and present value of estimated future cash flows discounted at assets effective interest rate. However, banks are permitted to follow the accrual principal to recognise income on impaired assets. Impact: IFRS requires extensive use of management judgement, historical trends and assumptions for classification and provisioning for impaired assets. Under IFRS, banks will not carry any general provisions or provision for standard assets. We believe that while banks with higher NPL coverage may see only a limited (or even positive) impact from this transition, those with lower coverage levels may need to make additional provisions. However, if by FY11 banks step-op NPL coverage to 70% (RBIs proposal), earnings impact may be lower.

IFRS links impairment to management judgement and past trends

Transition could be negative for banks with low NPA coverage

Income recognition The differences in income recognition under the two accounting standards are highlighted below:
Fee income is booked upfront, profit on securitisation is amortised

Indian GAAP: Interest is credited to income statement on an accrual basis (except in the case of NPAs); fee income (like loan processing fee) is recognised upfront. As per RBI guidelines, profit/ premium on securitisation of assets is recognised over the term of the assets securitised and losses/ discounts are recognised immediately. IFRS: Interest income will be recognised based on management estimates that factor the NPV of cash flows from these assets. Fee income will be recognised over the expected duration of the loan (not the contractual duration). Profit or loss on securitisation of assets is to be recognised in the same year.

Fee income to be amortised, profit on securitisation to be booked upfront

Expense recognition Under the two sets of accounting standards, there is a timing difference in recognition of direct expenses related to acquisition of assets and liabilities.
Direct origination expense booked upfront

Indian GAAP: Direct expenses related to origination of loans or deposits (like commission paid to agents for originating loans or public deposits) are charged to P&L in the year of acquisition/ origination. IFRS: Expenses directly related to such loans and deposits will be amortised over the expected duration of the loan/ liability (not the contractual duration).

Direct origination expense to be amortised

15 December 2009

aashish.agarwal@clsa.com

Transition to IFRS

Indian banks

De-recognition of financial assets Under IFRS, de-recognition of financial assets is a complex, multi-layered area that depends largely on whether there has been a transfer of risks and rewards or an assessment of control and the extent of involvement.
Securitised assets with credit enhancements do not form part of originators balance sheet

Indian GAAP: As per RBI guidelines, if the obligation of the originator of securitised assets to the investors is limited to value of credit enhancement/ liquidity facility offered then such assets will not be part of originators balance sheet. IFRS: Securitization transactions where credit collateral or guarantee is provided to cover credit losses in excess of the losses inherent in the portfolio may not meet the de-recognition criteria under IFRS. Impact: IFRS norms could lead to transfers failing the de-recognition criteria and thereby resulting in larger balance sheets, fall in capital adequacy ratios and lower return ratios.

but will be part of originators balance sheet under IFRS Capital adequacy ratio could fall under IFRS

Derivatives The differences in valuation and accounting of derivatives under the two accounting standards are highlighted below:
No specific guideline on embedded derivatives

Indian GAAP: There is no guidance available and consequently, such derivatives are not accounted for and may be disclosed as part of notes to accounts. IFRS: Under IFRS all derivatives are recognized on the balance sheet at fair values with changes being recognized in the income statement other than in the case of a qualifying cash flow hedge. IFRS defines embedded derivatives as rights/ obligations linked to the principal contract like a debt asset (loan/ bond) with a right to convert into equity, prepayment options in loans/ bonds, interest caps and floors in loans/ bonds etc. Wherever possible embedded derivatives are separated from principal contracts and accounted at fair value. Changes in fair value are recognised in the P&L.

Derivatives to be accounted on fair value

Key to CLSA investment rankings: BUY = Expected to outperform the local market by >10%; O-PF = Expected to outperform the local market by 0-10%; U-PF = Expected to underperform the local market by 0-10%; SELL = Expected to underperform the local market by >10%. Performance is defined as 12-month total return (including dividends). 2009 CLSA Asia-Pacific Markets (CLSA). Note: In the interests of timeliness, this document has not been edited.

The analyst/s who compiled this publication/communication hereby state/s and confirm/s that the contents hereof truly reflect his/her/their views and opinions on the subject matter and that the analyst/s has/have not been placed under any undue influence, intervention or pressure by any person/s in compiling such publication/ communication. The CLSA Group, CLSA's analysts and/or their associates do and from time to time seek to establish business or financial relationships with companies covered in their research reports. As a result, investors should be aware that CLSA and/or such individuals may have one or more conflicts of interests that could affect the objectivity of this report. The Hong Kong Securities and Futures Commission requires disclosure of certain relationships and interests with respect to companies covered in CLSA's research reports and the securities of which are listed on The Stock Exchange of Hong Kong Limited and such details are available at www.clsa.com/member/research_disclosures/. Disclosures therein include the position of the CLSA Group only and do not reflect those of Calyon and/or its affiliates. If investors have any difficulty accessing this website, please contact webadmin@clsa.com on (852) 2600 8111. If you require disclosure information on previous dates, please contact compliance_hk@clsa.com IMPORTANT: The content of this report is subject to CLSA's Legal and Regulatory Notices as set out at www.clsa.com/disclaimer.html, a hard copy of which may be obtained on request from CLSA Publications or CLSA Compliance Group, 18/F, One Pacific Place, 88 Queensway, Hong Kong, telephone (852) 2600 8888. 05/03/2009

aashish.agarwal@clsa.com

15 December 2009