Case 073Retail and portfolio creditCore
A microfinance lender has Rs 800 crore in stage 1 at a 2% twelve-month PD, Rs 150 crore in stage 2 at an 18% lifetime PD and Rs 50 crore in stage 3, all at 65% LGD. Compute the expected credit loss provision and the extra charge if Rs 100 crore moves from stage 1 to stage 2.
1The situation
Nilvarna Microfinance lends small group loans in rural districts and reports under the expected credit loss approach. Its Rs 1,000 crore book is split by stage. Stage 1, performing loans, is Rs 800 crore with a twelve-month default probability of 2%. Stage 2, loans whose credit risk has risen significantly, is Rs 150 crore with a lifetime default probability of 18%. Stage 3, loans already in default, is Rs 50 crore. Loss given default is 65% throughout.
Heavy rains have hit two districts, and the risk team expects Rs 100 crore of stage 1 loans there to show a significant rise in credit risk next quarter.
2Your task
Compute the provision by stage and in total, then the extra charge if Rs 100 crore moves from stage 1 to stage 2, and explain why the jump is so large.
Quick check
Moving Rs 100 crore from stage 1 to stage 2 raises the provision by roughly how much?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The provision is Rs 60.45 crore today and rises by about Rs 10.4 crore to Rs 70.85 crore if Rs 100 crore moves to stage 2. Stage 1 needs Rs 10.4 crore, stage 2 Rs 17.55 crore and stage 3 Rs 32.5 crore. The moved loans go from 1.3% cover to 11.7%, nine times more, because stage 2 switches the horizon from twelve months to the whole life of the loan.
Step 1How is the provision built, stage by stage?
Each stage asks a different question about the same formula, exposure x PD x LGD. Stage 1 provides for defaults expected in the next twelve months; stage 2 for defaults expected over the loan's whole remaining life; stage 3 for loans already in default, so the PD is 100%. For Nilvarna that is 800 x 2% x 65% = Rs 10.4 crore, 150 x 18% x 65% = Rs 17.55 crore and 50 x 100% x 65% = Rs 32.5 crore, a total of Rs 60.45 crore, 6.0% of the book.
| Stage | Exposure | PD | LGD | ECL today | ECL after move |
|---|---|---|---|---|---|
| 1: twelve-month | 800 then 700 | 2% | 65% | 10.40 | 9.10 |
| 2: lifetime | 150 then 250 | 18% | 65% | 17.55 | 29.25 |
| 3: defaulted | 50 | 100% | 65% | 32.50 | 32.50 |
| Total | 1,000 | 60.45 | 70.85 |
Step 2Why does the move multiply the provision?
Insuring a car for one year and insuring it for the rest of its life cost very different amounts, even for the same driver. Moving a loan to stage 2 does not change the borrower overnight; it changes the horizon the provision must cover, from twelve months to lifetime, and that is what multiplies it. The Rs 100 crore needed 2% x 65% = Rs 1.3 crore in stage 1; in stage 2 it needs 18% x 65% = Rs 11.7 crore. The net extra charge is Rs 10.4 crore, which for a lender earning perhaps Rs 30 to 40 crore a quarter is a large share of the quarter's profit, from a weather event that has not yet caused a single default.
Step 3What would you check before booking the charge?
Test the staging decision, because it drives the number. What evidence says credit risk has risen significantly: days past due, restructuring requests, or only the rainfall? A significant increase in credit riskThe test that moves a loan from stage 1 to stage 2, based on how much its default risk has risen since the loan was made. can be judged forward-looking, which is right here, but the rule should be written down, not decided in the quarter. Then test the 18% lifetime PD: microfinance loans are short, often a year or two, so lifetime is not much longer than twelve months and 18% implies a sharp deterioration. If the loans have a year left, lifetime and twelve-month horizons nearly coincide, and the jump should be driven by a higher PD, not by the horizon. The accounting standard and the RBI's current guidance for NBFCs set the framework; confirm both before finalising.
Where candidates lose it
The usual miss is computing the stage 2 charge, Rs 11.7 crore, and forgetting the Rs 1.3 crore released from stage 1. The net extra charge is Rs 10.4 crore.
The second is saying stage 2 loans are more likely to default, full stop. The mechanical reason for the jump is the horizon: twelve months against lifetime, and interviewers want that sentence.
What the interviewer asks next
- Half the moved loans recover next quarter and return to stage 1. What happens to the provision?
- How would you build a forward-looking overlay for the rains before any loan falls overdue?
- Why might a microfinance lender's lifetime PD be close to its twelve-month PD?
Company names and figures are illustrative.