Chapter 8 · Part 8 — Accounting Policies, NFRS and NAS
The three stages, PD, LGD, EAD and the higher-of rule
Two cliff-edges, the components of expected credit loss, and how NFRS 9 and NRB provisioning are reconciled.
Stage 1 — 12-month ECL
The report's description:
What "12-month ECL" actually means — a common misunderstanding.
! 12-month ECL is NOT "the losses expected in the next 12 months."
It IS: the LIFETIME losses that would result from default
events occurring in the next 12 months.
┌──────────────────────────────────────────────────────────────┐
│ A 10-year loan defaults in month 8. │
│ The loss is NOT limited to months 1-12 — it is the FULL │
│ loss on the loan. │
│ │
│ 12-month ECL = P(default in next 12 months) │
│ × full lifetime loss if that happens │
└──────────────────────────────────────────────────────────────┘Every loan enters at Stage 1 on origination — so a bank booking a large volume of new lending immediately recognises a Stage 1 allowance. This is the "day one loss" feature of ECL.
Stage 2 — Lifetime ECL
The report's description:
The financial impact of the transfer. Illustrative.
A 7-year term loan, EAD NPR 50,000,000
STAGE 1: 12-month PD 1.5%, LGD 25%
ECL = 1.5% × 25% × 50,000,000 = NPR 187,500
STAGE 2: Lifetime PD 12%, LGD 25%
ECL = 12% × 25% × 50,000,000 = NPR 1,500,000
─────────────
INCREASE on transfer = NPR 1,312,500
(8× the Stage 1 allowance)
⇒ A single loan moving to Stage 2 costs NPR 1.3m of profit,
with NO payment missed and NO default.Interest still accrues at Stage 2 — the borrower is underperforming, not defaulted.
Nepal-specific mapping. Watchlist under NRB classification broadly corresponds to Stage 2 thinking — an early-warning bucket short of non-performing. But the two systems are not identical and a loan can be Stage 2 without being Watchlist, or vice versa [R].
Stage 3 — Lifetime ECL, credit impaired
The report's description:
The double hit, quantified. Illustrative, continuing the NPR 50m loan at 11%.
BEFORE (Stage 2):
Allowance held NPR 1,500,000
Annual interest recognised (accrual) NPR 5,500,000
AFTER moving to Stage 3 (lifetime PD ≈ 100%, LGD 40%):
Allowance required = 100% × 40% × 50m NPR 20,000,000
Incremental impairment charge NPR 18,500,000
Annual interest recognised (cash basis) NPR 0
──────────────
TOTAL P&L impact in the year of transfer:
Impairment charge NPR 18,500,000
Interest income forgone NPR 5,500,000
──────────────
NPR 24,000,000Related terms. Credit impaired · Cash basis interest recognition · Part 2.1 · Part 6.2
Significant Increase in Credit Risk (SICR)
Simple definition. The trigger that moves a loan from Stage 1 to Stage 2.
Technical definition. A significant increase in the risk of a default occurring over the expected life of a financial instrument since initial recognition, assessed by comparing the risk of default at the reporting date with that at initial recognition.
Typical SICR indicators used by banks:
QUANTITATIVE • A specified increase in PD since origination • Internal credit rating downgrade by a set number of notches • BACKSTOP: 30 days past due (a rebuttable presumption under NFRS 9 — a loan more than 30 days overdue is presumed to have suffered SICR) QUALITATIVE • Borrower placed on a watchlist • Covenant breach • Significant adverse change in the borrower's industry • Restructuring or forbearance granted • Loss of a major customer or contract
Analyst use. The SICR criteria are a policy choice disclosed in the annual report. A bank with loose SICR criteria keeps more exposure in Stage 1 and reports lower ECL. Compare criteria across banks before comparing ECL.
Probability of Default (PD)
Simple definition. The chance the borrower fails to pay.
Technical definition. The likelihood of a default event over a specified time horizon — 12 months for Stage 1, the remaining lifetime for Stages 2 and 3.
Two horizons.
12-MONTH PD probability of default within the next 12 months
→ used for Stage 1
LIFETIME PD cumulative probability of default over the
remaining life of the instrument
→ used for Stages 2 and 3
Note the report's refinement: "For those financial assets with a
remaining maturity of less than 12 months, a Probability of
Default (PD) is used that corresponds to the remaining maturity."
You cannot apply a 12-month PD to an instrument maturing in
3 months.How PD is estimated. From historical default experience by rating grade or segment, adjusted for current conditions and forward-looking macroeconomic forecasts.
Loss Given Default (LGD)
Simple definition. How much of the money you lose when a borrower defaults.
Technical definition. The proportion of exposure that is not recovered following default, expressed as a percentage of EAD, after taking account of collateral realisation, guarantees, recovery costs and the time value of money.
Formula.
Present value of expected recoveries
LGD = 1 − ────────────────────────────────────────────────
Exposure at Default
equivalently
LGD = (EAD − PV of recoveries) ÷ EADWorked example. Illustrative — the collateral timing effect most people miss.
Exposure at Default NPR 20,000,000
Collateral: commercial land, forced-sale
value NPR 18,000,000
Legal and enforcement costs NPR 1,500,000
Expected time to realise (Nepal, with
court process) 3 years
Discount rate (EIR) 11%
Net expected recovery = 18,000,000 − 1,500,000
= NPR 16,500,000
Present value = 16,500,000 ÷ (1.11)³
= 16,500,000 ÷ 1.36763
= NPR 12,065,000
LGD = (20,000,000 − 12,065,000) ÷ 20,000,000
= 39.7%Nepali context. Most Nepali bank lending is collateral-backed, typically by land and buildings. That gives structurally lower LGDs than unsecured lending — but it makes LGD highly sensitive to (a) property valuations and (b) enforcement timelines. A property-price correction would raise LGD across the entire system simultaneously.
Exposure at Default (EAD)
Simple definition. How much the borrower will owe when they default.
Technical definition. The expected gross carrying amount of the financial instrument at the time of default, including expected drawdowns of undrawn commitments.
Formula.
EAD = Current drawn balance
+ (Undrawn commitment × Credit Conversion Factor)
+ Accrued interest expected at default
− Expected repayments before defaultWhy undrawn limits matter — the counter-intuitive part.
┌──────────────────────────────────────────────────────────────┐ │ A distressed borrower DRAWS DOWN their remaining limits │ │ before defaulting. This is empirically consistent and │ │ intuitive: a company heading for trouble takes all the │ │ cash it can get. │ │ │ │ ⇒ EAD is typically HIGHER than the current balance │ │ ⇒ Overdrafts and revolving facilities carry higher EAD │ │ uncertainty than term loans │ │ ⇒ ECL must be recognised on UNDRAWN commitments too, │ │ even though they are off balance sheet │ └──────────────────────────────────────────────────────────────┘
Worked example. Illustrative.
Overdraft limit NPR 30,000,000 Currently drawn NPR 18,000,000 Undrawn NPR 12,000,000 Credit Conversion Factor (bank's estimate) 60% EAD = 18,000,000 + (12,000,000 × 60%) = NPR 25,200,000 ⇒ ECL is computed on NPR 25.2 million, not NPR 18 million — 40% more than the drawn balance.
Nepali relevance. Overdrafts, working-capital limits and trade-finance facilities are widespread in Nepali corporate and SME lending, so EAD modelling on undrawn limits materially affects reported ECL.
Gross carrying amount
The amortised cost of a financial asset before deducting the loss allowance.
Gross carrying amount − Loss allowance = Net carrying amount
(what appears on the
balance sheet)Its role in ECL. Interest at Stages 1 and 2 is recognised on the gross carrying amount — i.e. on the full balance, ignoring the allowance. Only at Stage 3 does the basis change (to cash basis, under NRB's guidelines).
Credit impaired
Technical definition. A financial asset is credit-impaired when one or more events have occurred that have a detrimental impact on the estimated future cash flows.
Indicators: significant financial difficulty of the borrower; a breach of contract such as default or past-due event; a concession granted for economic or contractual reasons relating to the borrower's financial difficulty; probable bankruptcy or financial reorganisation; disappearance of an active market for the asset.
Performing / Underperforming / Non-performing
The report's plain-language labels for the three stages:
Stage 1 → PERFORMING Stage 2 → UNDERPERFORMING Stage 3 → NON-PERFORMING
! Do not equate Stage 3 with NRB's NPL. They overlap heavily but are defined under different rulebooks with different triggers [R]. NRB's NPL = Substandard + Doubtful + Loss, driven by overdue-day thresholds. Stage 3 is driven by credit-impairment evidence.
Effective interest on gross carrying amount
The interest recognition basis at Stages 1 and 2 — EIR applied to the gross carrying amount (before the allowance). See 8.D.12 and Part 2.1.
Cash basis interest recognition
The Stage 3 basis — interest recognised only when actually received. Applied per NRB's Interest Income Recognition Guidelines, and described in the report as "based on cash basis approach (incremental) for FY 82/83."
Fully worked in Part 2.1 and 8.D.7.
Accrual basis / Incremental cash basis
Simple definition. The two bases on which a Nepali bank recognises interest, depending on the loan's stage.
Technical definition. Accrual basis — income recognised as it is earned over time regardless of receipt. Incremental cash basis — income recognised only to the extent of amounts actually received during the period, applied to Stage 3 exposures.
The report's exact wording:
┌──────────────────────────────────────────────────────────────────┐ │ ACCRUAL BASIS INCREMENTAL CASH BASIS │ │ ───────────── ────────────────────── │ │ Stages 1 and 2 Stage 3 │ │ │ │ Coupon rate × principal Only what is RECEIVED │ │ outstanding, recognised over in the period │ │ time whether or not received │ │ │ │ Creates INTEREST RECEIVABLE Creates NO receivable │ │ → which NRB then strips out │ │ of distributable profit │ │ (Part 7.9) │ └──────────────────────────────────────────────────────────────────┘
Why "incremental." The word signals that only the movement in the period is recognised — each period's income is limited to the cash actually collected in that period, not a recalculation of cumulative entitlement.
Related terms. 8.D.15, 8.D.16 · Part 2.1 Interest income · Part 4.1 Interest received · Part 7.9
Credit exposures
The aggregate of on- and off-balance-sheet amounts subject to credit risk — loans, advances, placements, debt securities, undrawn commitments, guarantees and letters of credit.
The report: "the Bank has recognized impairment on credit exposures based on the higher of total ECL calculated as per NFRS 9 and existing regulatory provisions in the Unified Directives."
Regulatory provisions, the higher-of rule, and reconciliation
The three governing instruments, all named in the report:
| Instrument | Issuer | What it does |
|---|---|---|
| **NFRS 9 Expected Credit Loss (ECL) Related Guidelines, 2024** | NRB | Establishes the higher-of rule |
| **Unified Directives** | NRB | Prescribes loan classification grades and provisioning rates [R] |
| **NRB Interest Recognition Guidelines (with amendments)** | NRB | Governs interest recognition by stage and the EIR transition |
The higher-of rule, stated by the report:
Reconciling accounting ECL to regulatory provisions
╔═══════════════════════════════════════════════════════════════════╗
║ THE RECONCILIATION AN ANALYST SHOULD BUILD ║
╠═══════════════════════════════════════════════════════════════════╣
║ ║
║ NFRS 9 ECL (Stages 1+2+3) A ║
║ NRB regulatory provision (by grade) [R] B ║
║ ───── ║
║ Impairment recognised = MAX(A, B) C ║
║ ║
║ IF B > A: ║
║ the excess (B − A) is a "regulatory provision ║
║ shortfall" in NFRS terms — but it IS booked, ║
║ so the Part 7.10 line stays NIL ║
║ ║
║ IF A > B: ║
║ accounting is more conservative; the regulatory ║
║ minimum is comfortably met ║
║ ║
║ IF the bank books only A when B > A: ║
║ ⇒ SHORTFALL appears in Part 7.10 as a deduction ║
║ from distributable profit — and is a compliance ║
║ and audit issue ║
╚═══════════════════════════════════════════════════════════════════╝
NMB: Part 7.10 is NIL in both years
⇒ the higher-of rule is being applied correctlyWhy the two regimes disagree — the structural reasons.
| Dimension | NFRS 9 ECL | NRB Unified Directives |
|---|---|---|
| **Purpose** | Faithful economic representation | Prudential depositor protection |
| **Basis** | Expected loss, forward-looking, probability-weighted | Rules-based by overdue days and grade [R] |
| **Collateral** | Reduces LGD, hence reduces ECL | Prescribed rates largely regardless of collateral [R] |
| **New lending** | Day-one Stage 1 ECL | Pass-grade provision from day one [R] |
| **Judgement** | Extensive (PD, LGD, EAD, scenarios) | Minimal — rules-driven |
| **Comparability** | Low (model-dependent) | High (same rules for all banks) |
| **Cyclicality** | Forward-looking, potentially pro-cyclical | Stable, backward-looking |
Related terms. All of §8.D · Part 1.7 · Part 2.11 · Part 6.2–6.4 · Part 7.10 · Part 15
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