Background

The Reserve Bank of India (RBI) prescribes prudential standards to regulate the activities of commercial and other banks. To prescribe a uniform and consistent approach for classification of assets by banks and to ensure an adequate level of provisioning on those assets on the basis of an objective criteria, on 1 July 2015, RBI updated the Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances (the Master Circular).                               

As part of its supervisory processes, RBI also assesses the extent of compliance by banks with prudential norms on income recognition, asset classification and provisioning.

New developments

On 18 April 2017, RBI issued three important circulars. They deal with the following topics:

• Additional provisions for standard advances at higher than the prescribed rates
  To enhance the stability of the financial sector, RBI issued a circular advising banks to ensure that they have adequate provisions for loans and advances at all times. It encouraged banks to consider higher provisioning rates for standard assets (as compared to the minimum rates prescribed in the Master Circular) and review the provisions made for advances to stressed sectors of the economy.
• Disclosure in the ‘Notes to Accounts’ to the financial statements-Divergence in the asset classification and provisioning
  In its fourth bi-monthly monetary policy statement, 2015-16 dated 29 September 2015, RBI announced that it had observed material divergences by banks on compliance with extant prudential norms on Income Recognition, Assets Classification and Provisioning (IRACP). Accordingly, to bring in greater transparency and better discipline with respect to compliance with IRACP norms, RBI would mandate disclosures in the notes to accounts to financial statements of banks, where such divergences exceeded a specified threshold. Accordingly, on 18 April 2017, RBI issued a circular specifying the threshold of divergence, beyond which a disclosure would be mandated in the notes to accounts to financial statements of banks.
• Guidelines on compliance with Accounting Standard (AS) 11
  The RBI also issued guidelines clarifying the treatment of the foreign currency translation reserve (FCTR) relating to non-integral foreign operations, as per Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates.

This issue of First Notes provides an overview of these circulars issued by RBI.

Overview of the circulars issued by RBI

Additional provisions for standard advances at higher than the prescribed rates

With a view to ensure that banks have adequate provisions for loans and advances at all times, RBI, through its circular, requires banks to:

• Put in place a board approved policy for making provisions for standard assets based on evaluation of risk and stress in various sectors. The RBI encouraged banks to adopt a higher provisioning rate for the standard assets as compared to the regulatory minimum prescribed in the Master Circular.
• Review the board approved policy (as explained above), at least on a quarterly basis, on the basis of the performance of various sectors of the economy to which the bank is exposed and evaluate the present and emerging trends of the economy and stress therein. The review should include quantitative and qualitative aspects (for example, industry performance and issues, financial ratios, credit ratings, non-performing assets, etc.) and may include sector specific parameters.
• Specifically, RBI requires the Board of Directors of banks to review the provisioning for standard assets of the telecom sector and consider making a higher provision thereon by 30 June 2017. The RBI observed that the telecom sector was currently reporting stressed financial conditions and presently, the interest coverage ratio for the sector was less than one.

Disclosure in the ‘Notes to Accounts’ to the financial statements - Divergence in the asset classification and provisioning

The Master Circular specifies the criteria for classification of Non-Performing Assets (NPAs) and the minimum provision rates for each class of NPA. It also prescribes that banks may make additional provision for expected losses on the NPAs.

The RBI, as part of its supervisory processes has assessed compliance by banks with the above prudential norms and observed instances of material divergences in the asset classification and provisioning levels. The RBI has indicated that these divergences have led to the published financial statements not depicting a true and fair view of the financial position of the concerned banks. Accordingly, in order to ensure transparency, banks would be required to make suitable disclosures in the Notes to Accounts in the ensuing annual financial statements published immediately following communication of such divergences by RBI to the bank, where:   

• The additional provision requirements assessed by RBI exceed 15 per cent of the published net profits after tax for the reference period, or
• The additional gross NPAs identified by RBI exceed 15 per cent of the published incremental gross NPAs for the reference period, or both.

Disclosure requirements

• The disclosures would be included under the sub-head ‘Asset Quality (Non-Performing Assets)’ 
• The first such disclosure with respect to the divergences observed by RBI for financial year 2015-16 would be made in the notes to accounts of financial statements for the year ended 31 March 2017
• The RBI has also notified the format in which such disclosure should be made by the banks.              

Guidelines on compliance with Accounting Standard (AS) 11

AS 11 requires entities to recognise exchange differences arising on translation of non-integral foreign operations in the FCTR account. The amounts in this reserve are transferred to or recognised in the statement of profit and loss on full or partial disposal of the foreign operation. AS 11 observes that such disposal may be through sale, liquidation, repayment of share capital or abandonment of all or part of that operation. Further, payment of a dividend is considered to form part of a disposal only when it constitutes a return of the investment.

The RBI observed that banks have been recognising gains in the statement of profit and loss from FCTR on repatriation of accumulated profits/retained earnings from overseas branches. The RBI clarified that such repatriation of accumulated profits/retained earnings should not be considered as disposal or partial disposal of interests in non-integral foreign operations as per AS 11 and banks should not recognise a proportionate amount of exchange gains or losses held in the FCTR in the statement of profit and loss.

Our comments

The RBI’s notifications relating to enhanced provisioning requirements for assets advanced to stressed sectors and disclosure of divergence in provisioning levels are intended to build resilience in the banks’ balance sheets towards any future deterioration in asset quality. The direction of these norms is also consistent with the requirements under Ind AS where banks will have to consider expected credit losses for the purposes of determining loan provisions.

With disclosures on divergence from the IRACP norms, RBI is expected to be stringent with reference to accountability on the part of the banks towards its stakeholders for non-compliance with the classification and provisioning norms. This is likely to encourage banks to be compliant with the norms or provide reasons for not adhering to the same. We note that this is a significant departure from the long standing practice of ensuring that regulatory inspections and their outcomes are confidential between RBI and the inspected/supervised institution. In addition, the comments of RBI on whether the financial statements are ‘true and fair’ also pose some complex questions on who determines and when does an auditor/bank determine if financial statements are ‘true and fair’ and what should be the implication on previously issued financial statements and auditor’s reports if there is a significant divergence between the published financial statements and the RBI’s report/assessment.

The guidelines provided to clarify accounting under AS 11 reiterate that dividends would form part of a disposal only when they constitute a return of the investment. This may have an adverse impact on profits of banks that have recognised exchange gains on repatriation of funds by their overseas branches. Additionally, it would appear that the guidance, while potentially driven with a view to be prudent, could result in a treatment that is inconsistent with the intent of AS 11 in situations where there is an ‘in substance’ disposal/wind down of operations in a foreign operation/branch of a bank. Given that this circular has been worded as a clarification, it is also unclear as to the position that is to be followed for past transactions that have been subject to a review/audit.

Next steps

Banks are required to ensure compliance with the notifications (above) in their financial statements from the year ended 31 March 2017 onwards.

To access the text of the RBI circulars on

• Additional provisions for standard advances at higher than the prescribed rates, please click here.
• Disclosure in the ‘Notes to Accounts’ to the financial statements-Divergence in the asset classification and provisioning, please click here.
• Guidelines on compliance with Accounting Standard (AS) 11, please click here.