Chapter 8 · Part 8 — Accounting Policies, NFRS and NAS
Fair value, the hierarchy, and the ECL model
Where management judgement hides in a balance sheet, and the forward-looking impairment model that replaced incurred loss.
Solely payments of principal and interest
Simple definition. The test asking whether a loan behaves like a plain loan.
Technical definition. Contractual cash flows that are solely payments of principal and interest on the principal amount outstanding, where interest is consideration for the time value of money, credit risk, other basic lending risks and costs, and a profit margin.
What passes and what fails.
PASSES SPPI FAILS SPPI
─────────── ──────────
Fixed-rate term loan Loan with returns linked to
Floating-rate loan (benchmark + the borrower's PROFITS or to
spread) a commodity/equity index
Government bond Convertible bond (the equity
Overdraft conversion feature)
Loan with ordinary prepayment Loan with leverage that
option at par magnifies cash flow variability
→ MUST be FVTPLWhy it matters in Nepal. Most Nepali bank lending is plain vanilla and passes SPPI easily. The test bites on structured products, profit-sharing arrangements and instruments with embedded equity features.
Related terms. 8.C.1, 8.C.3
Statement of Financial Position (SoFP)
The formal NFRS name for the balance sheet, used in the report's policy notes (e.g. "presented as a line item on the face of consolidated Statement of Financial Position (SoFP)").
Fully covered in Part 1.
Determination of fair value
The process of arriving at fair value: quoted price where available; otherwise valuation techniques using observable market data where possible; otherwise models with unobservable inputs. This ordering is the fair value hierarchy.
Fair value hierarchy
Simple definition. A three-level ranking of how reliable a fair value measurement is.
Technical definition. The hierarchy under NFRS 13 categorising the inputs to fair value measurement, giving highest priority to quoted prices in active markets and lowest priority to unobservable inputs.
The report's definitions, reproduced:
╔═══════════════════════════════════════════════════════════════════╗ ║ LEVEL 1 — most reliable ║ ║ "Quoted market prices (unadjusted) in an active market for ║ ║ identical instruments." ║ ║ ║ ║ In Nepal: NEPSE-listed shares with genuine trading volume; ║ ║ actively traded government securities ║ ║ Reliability: HIGH — an observable price for the exact thing ║ ╠═══════════════════════════════════════════════════════════════════╣ ║ LEVEL 2 ║ ║ "Valuation techniques based on observable inputs, either ║ ║ directly (i.e. as prices) or indirectly (i.e. derived from ║ ║ prices). This category includes instruments valued using: ║ ║ quoted market prices in active markets for SIMILAR ║ ║ instruments, quoted prices for identical or similar ║ ║ instruments in markets that are considered less active or ║ ║ other valuation techniques where all significant inputs are ║ ║ directly or indirectly observable from market data." ║ ║ ║ ║ In Nepal: FX FORWARDS and SWAPS (valued from observable ║ ║ forward points) ← where NMB's derivatives sit ║ ║ Thinly-traded listed shares ║ ║ Reliability: MEDIUM — a model, but fed by real market data ║ ╠═══════════════════════════════════════════════════════════════════╣ ║ LEVEL 3 — least reliable ║ ║ "Valuation techniques using significant unobservable inputs. ║ ║ This category includes all instruments where the valuation ║ ║ technique includes inputs not based on observable data and ║ ║ where the unobservable inputs have a significant effect on ║ ║ the instrument's valuation. This category includes ║ ║ instruments that are valued based on quoted prices for ║ ║ similar instruments where significant unobservable ║ ║ adjustments or assumptions are required to reflect ║ ║ differences between the instruments." ║ ║ ║ ║ In Nepal: UNLISTED equity investments; non-banking assets ║ ║ (foreclosed property) — valued by appraisal ║ ║ Reliability: LOW — management's model and assumptions ║ ╚═══════════════════════════════════════════════════════════════════╝
Why an analyst must check the level.
A large Level 3 balance means a large part of the balance
sheet is valued by MANAGEMENT JUDGEMENT, not by the market.
│
▼
Level 3 assets are where valuation optimism hides.
In a Nepali bank the classic Level 3 items are:
• Unlisted equity stakes
• Non-banking assets (foreclosed land and buildings)
│
▼
⇒ The NBA balance (NPR 1.96bn, Part 1.12) is a Level 3
measurement AND a credit-quality signal AND subject to
NRB provisioning [R]. Three reasons to read the note.Disclosure. NFRS 13 requires the hierarchy level for each class, transfers between levels, and for Level 3 a reconciliation of opening to closing balances and sensitivity to reasonably possible alternative assumptions. These tables are in the annual report, not the quarterly.
Related terms. Part 1.4 (Level 2 derivatives) · Part 1.8 · Part 1.12 (Level 3 NBA) · Fair value
Level 1
Quoted, unadjusted prices in an active market for identical instruments. See 8.C.10.
Level 2
Valuation using observable inputs, directly or indirectly. NMB's FX derivatives sit here. See 8.C.10.
Level 3
Valuation using significant unobservable inputs. Unlisted equity and non-banking assets sit here. See 8.C.10.
Recognition and de-recognition of financial instruments
The report's policy:
The two dates.
TRADE DATE the date the entity COMMITS to buy or sell SETTLEMENT DATE the date the asset is DELIVERED ┌─────────────────────────────────────────────────────────────┐ │ NMB's policy: │ │ Everything → SETTLEMENT DATE │ │ Derivatives → TRADE DATE ← the exception │ │ │ │ WHY the exception: a derivative HAS no meaningful │ │ settlement at inception (little or no initial net │ │ investment). Its economic exposure starts the moment │ │ the contract is struck. Waiting for settlement would │ │ leave the exposure unrecognised. │ └─────────────────────────────────────────────────────────────┘
De-recognition of a financial asset — when contractual rights to cash flows expire, or when the asset is transferred and substantially all risks and rewards pass. A loan sold with recourse generally stays on balance sheet.
Loan write-off is a de-recognition event — and, as established in Part 1.7, it has no P&L effect where the allowance is already in place.
Related terms. Part 1.4 · Part 1.7 · Settlement/Trade date basis
Settlement date basis / Trade date basis
The two recognition conventions above. NMB: settlement date generally, trade date for derivatives.
Offsetting
The report's policy:
Two cumulative conditions under NAS 32 — a legally enforceable right to set off and an intention to settle net or realise and settle simultaneously. Both, not either.
The consequence in NMB's accounts.
Derivative assets 19,021,033 Derivative liabilities 19,140,536 → shown GROSS: conditions not met Current tax assets 155,706 (Group) Current tax liabilities 99,341 (Group) → shown GROSS: different entities in the Group Deferred tax assets 482,627 (Group) Deferred tax liabilities 12,883 (Group) → shown GROSS: same reason
Related terms. 8.A.6 · Part 1.4 · Part 1.9 · Part 1.15
Derivative assets and derivative liabilities
The report's definition:
Fully covered in Part 1.4 — recognition on trade date, FVTPL measurement, gross presentation, Level 2 valuation, RWA treatment, and the near-matched asset/liability position that indicates hedging rather than speculation.
Underlying primary financial instrument
The instrument or variable from which a derivative derives its value — for a Nepali bank's FX forward, the underlying is the foreign currency itself.
Cash and cash equivalents
Fully covered in Part 1.1. The report's policy: "Cash and cash equivalents comprise monetary assets and placements with original maturities of three months or less, calculated from the date the acquisition and placements were made. Cash and cash equivalents are classified as financial asset and are measured at amortized cost in SoFP."
Restricted deposits
The report's policy:
Why the exclusion matters. A restricted balance cannot be used to meet obligations, so including it would overstate liquidity. Typical Nepali examples: margin held against LCs and guarantees, court-attached accounts, statutory balances, and balances pledged as collateral.
Related terms. Part 1.1, 1.2 · Part 6.16 Liquidity Ratio (NLA)
— IMPAIRMENT: EXPECTED CREDIT LOSS (18 terms)
Expected Credit Loss (ECL) Model of Impairment
Simple definition. Setting aside money for loans you expect to go bad in future, rather than waiting until they actually do.
Technical definition. The forward-looking impairment model in NFRS 9 requiring recognition of a loss allowance for expected credit losses, measured as an unbiased, probability-weighted estimate determined by evaluating a range of possible outcomes, reflecting the time value of money and reasonable and supportable information about past events, current conditions and forecasts of future economic conditions.
The report's statement:
Why ECL replaced the old model
┌──────────────────────────────────────────────────────────────────┐
│ THE OLD "INCURRED LOSS" MODEL (NAS 39 / IAS 39) │
│ │
│ Provide only when there is OBJECTIVE EVIDENCE that a loss │
│ has ALREADY been incurred — a missed payment, a bankruptcy. │
│ │ │
│ ▼ │
│ PROBLEM exposed by the 2008 global financial crisis: │
│ provisions arrived TOO LATE and TOO SUDDENLY. Banks │
│ reported healthy profits right up to the moment they │
│ reported catastrophic losses. "Too little, too late." │
└──────────────────────────────────────────────────────────────────┘
│
▼
┌──────────────────────────────────────────────────────────────────┐
│ THE ECL MODEL (NFRS 9 / IFRS 9) │
│ │
│ Provide from DAY ONE, based on EXPECTED losses. │
│ Increase the provision as credit risk increases — │
│ BEFORE default occurs. │
│ │ │
│ ▼ │
│ RESULT: earlier, smoother, more forward-looking provisioning. │
│ Also: more judgement, more volatility, more model risk. │
└──────────────────────────────────────────────────────────────────┘The core ECL formula
ECL = PD × LGD × EAD × Discount factor
summed across scenarios, weighted by probability:
ECL = Σ [ Pᵢ × (PDᵢ × LGDᵢ × EADᵢ × DFᵢ) ]
i
where i = each macroeconomic scenario and Pᵢ its probabilityComponent explanation.
| Component | Meaning | Nepali example |
|---|---|---|
| **PD** — Probability of Default | The likelihood the borrower defaults over the relevant horizon | A Pass-grade SME borrower might carry a 12-month PD of 1.5% |
| **LGD** — Loss Given Default | The proportion of exposure lost if default occurs, after recoveries and collateral | A loan secured by land at 150% cover might have an LGD of 30% |
| **EAD** — Exposure at Default | The expected outstanding balance at the time of default, including expected drawdowns on undrawn limits | An overdraft with a NPR 10m limit and NPR 6m drawn might have an EAD of NPR 8m |
| **Discount factor** | Brings the expected loss back to present value at the effective interest rate | 1 ÷ (1+EIR)ⁿ |
Worked ECL calculation. Illustrative — HCBL, single Stage 1 exposure.
Loan outstanding NPR 10,000,000 Undrawn commitment NPR 2,000,000 Credit conversion factor on undrawn 50% EAD = 10,000,000 + (2,000,000 × 50%) = NPR 11,000,000 12-month PD 1.5% Collateral: land valued NPR 15,000,000 Expected realisation after costs and delay NPR 9,900,000 LGD = (11,000,000 − 9,900,000) ÷ 11,000,000 = 10% Undiscounted 12-month ECL = 1.5% × 10% × 11,000,000 = NPR 16,500 Discount at EIR 11% over an average default timing of 0.5 years: 1 ÷ (1.11)^0.5 = 0.9492 12-month ECL = NPR 15,662
Now the probability-weighted, multi-scenario version.
Prob. PD LGD ECL contribution
Base case 60% 1.5% 10% 0.60 × 16,500 = 9,900
Upside 15% 0.8% 8% 0.15 × 7,040 = 1,056
Downside 25% 4.0% 18% 0.25 × 79,200 = 19,800
────────────────────────
Probability-weighted 12-month ECL NPR 30,756
⇒ MORE THAN DOUBLE the base-case-only figure.
This is the effect of probability weighting: because loss
is CONVEX in a downturn (PD and LGD both worsen together),
the weighted average exceeds the "most likely" case.Related terms. 8.D.2–8.D.18 · Part 1.7 · Part 2.11 · Part 15
Forward-looking model
The requirement that ECL incorporate reasonable and supportable forecasts of future economic conditions, not merely historical loss experience.
In the Nepali context, relevant forward-looking factors would include:
- GDP growth and remittance inflows (which drive household repayment capacity)
- Interest rate direction
- Real estate prices (collateral values)
- Tourism and hydropower sector outlook
- Monsoon and agricultural performance
- Political and policy stability
Probability-weighted estimate
The requirement that ECL reflect an unbiased, probability-weighted amount determined by evaluating a range of possible outcomes — not a single best estimate and not a worst case.
Demonstrated numerically at 8.D.1 — the weighted figure was NPR 30,756 against a base case of NPR 16,500.
Three-stage approach
The staging model, with the report's own descriptions.
┌───────────────────────────────────────────────────────────────────────┐ │ CREDIT EXPOSURE │ │ │ │ │ Has credit risk increased │ │ SIGNIFICANTLY since initial │ │ recognition? │ │ │ │ │ ┌─────────────────────┼─────────────────────┐ │ │ NO YES YES + credit │ │ │ │ impaired │ │ ▼ ▼ ▼ │ │ ┌───────────┐ ┌────────────┐ ┌─────────────┐ │ │ │ STAGE 1 │ │ STAGE 2 │ │ STAGE 3 │ │ │ ├───────────┤ ├────────────┤ ├─────────────┤ │ │ │ 12-month │ │ Lifetime │ │ Lifetime │ │ │ │ ECL │ │ ECL │ │ ECL │ │ │ ├───────────┤ ├────────────┤ ├─────────────┤ │ │ │Performing │ │Under- │ │ Non- │ │ │ │ │ │performing │ │ performing │ │ │ ├───────────┤ ├────────────┤ ├─────────────┤ │ │ │ Interest │ │ Interest │ │ Interest │ │ │ │ on GROSS │ │ on GROSS │ │ on CASH │ │ │ │ carrying │ │ carrying │ │ BASIS │ │ │ │ amount │ │ amount │ │ │ │ │ │ (accrual) │ │ (accrual) │ │ │ │ │ └───────────┘ └────────────┘ └─────────────┘ │ │ │ │ │ │ │ └──── movement is BIDIRECTIONAL ────────────┘ │ │ (loans can cure and move back) │ └───────────────────────────────────────────────────────────────────────┘
The report's own table, reproduced:
| Stage 1 | Stage 2 | Stage 3 | |
|---|---|---|---|
| **Nature** | 12 month expected credit loss | Lifetime expected credit loss | Lifetime expected credit loss |
| **Risk** | No significant risk since initial recognition | Significant credit risk since initial recognition | Credit impaired (with objective evidence of impairment) |
| **Nature** | Performing | Underperforming | Non-performing |
| **Interest Revenue** | Effective interest on gross carrying amount | Effective interest on gross carrying amount | On Cash Basis |
The two cliff-edges that matter financially.
STAGE 1 → STAGE 2: the allowance jumps from 12-month ECL to
LIFETIME ECL. For a 10-year loan this can be
a 5-10× increase in provision, with NO default
having occurred.
STAGE 2 → STAGE 3: interest accrual STOPS. The bank now takes
a double hit — a bigger provision AND lost
income.Related terms. 8.D.5–8.D.7 · SICR · Part 1.7 · Part 2.11
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