A loan loss provision is a statement of income set aside as an allowance for loan payments. These loss provisions are often used to cover a variety of loan losses such as customer bankruptcy, renegotiated loans, non-performing loans, and any loan that incurs lower-than-estimated payments.
Loan provisions are known as loan loss reserves, and are an item on a balance sheet that represents the overall amount of loan losses taken from a company’s loans.
How Does Loan Loss Provision Work?
Lenders within the banking industry generate a vast amount of revenue from expenses and interest that has been received from lending products. Banks tend to lend a large range of customers including large corporations, consumers, and small businesses.
Reporting requirements and lending standards are consistently changing and the constraints have been tightening intensely since the financial crisis in 2008. Improved regulations now focus on increasing the standard for lending, which requires a higher quality of borrower while increasing the capital liquidity requirements for banks.
In spite of any improvements that have been implemented, banks are still required to account for any loan expenses and defaults that occur from lending. Thus, loan loss provisions have become a standard adjustment that is made to the bank’s loan loss reserves. Loan loss provisions are made in order to incorporate any change in projections for losses incurred through lending. While the standard of lending has drastically improved, most banks are still experiencing loan defaults and late repayments. As the loan loss provision is stated on the income statement as an expense, it also lowers operating profits.
Loan Loss Reserves (Accounting)
Loan loss reserves are normally accounted for on the balance sheet of the bank, which increases by the amount of provision and decreases by the number of charge-offs that occur each quarter. Provisions for loan losses are consistently made in order to update calculations that are based on the bank’s customers defaulting on their loans. These calculations are based on different levels of borrowers and historical rates of default.
Any credit losses for late payments and expenses are incorporated into loan loss provision estimates and are also calculated using the same or a similar method. This takes into account the previous statistics related to the payments made by a bank’s credit clients.
Thus, setting aside reserves for loan losses and making loan loss provisions involves continually updating estimates via these provisions. This way, banks can make sure that they are presenting accurate statistics and conclusive assessments of their financial position. This position is often publicly released through the quarterly statements issued by the banks.
In a lot of ways, a loan loss provision is like an internal insurance fund for the bank. This is because it protects the bank in the event that a credit client has defaulted on their entire loan. In order to defend the bank, a loan loss provision offers coverage of any losses that have been incurred.
On a balance sheet, a loan loss provision ideally highlights the exact funds that have been used in order to cover loan losses. Banks can always predict when loans are not going to be repaid. Thus, they assess their loan profiles in order to correctly estimate any losses, which informs them of the size of their loan loss provision. In this sense, a loan loss provision forecasts the future losses of the bank.
Previously, banks have used numerous methods to indicate the size of their loan provisions and these methods include the following:
1) Loan history – a bank predicts losses on future loans by assessing its history of previous loan losses.
2) Competitive analysis – a bank can also use financial reports from other banks in order to estimate the standard of loan losses across the industry. While this may not include historical losses for the bank itself, it does help banks to ascertain whether loan loss reserves are an industry standard or specific to the bank.
Some banks choose to divide loan loss reserves into two key categories: general and specific. After they have assessed their current clients, a bank can flag specific loans or groups of loans that have a higher risk of default. The funds in their loan reserves are then allocated to cover these losses in the event that they default. General reserves are used to address those loans that do not require as much attention.
During the financial crisis in 2008, a number of banks did not have sufficient loan loss reserves in order to account for the losses that they incurred. In the years thereafter, banks started to allocate their resources in order to enhance the size of their loan reserves to defend against defaulting loans.
Congress then passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The main goal was to enhance the financial stability of the country. Grants were also made available in order to develop financial institutions and help them to enhance their loan loss reserves to manage any losses on defaulting loans.
The recession in 2020 has caused numerous banks to assess their loan loss reserves again in order to assess and address economic declines. Many banks have doubled their reserves in order to make these loan loss provisions.
To conclude, loan loss provisions are listed on income statements to state the number of reserves that are set aside to deal with defaulting loans. They are used as a means of protecting banks in the event of financial crashes. This is because recessions and financial instability can result in numerous people defaulting on loans that they have taken from the bank. Thus, these provisions ensure that the bank is able to access reserves in order to cover these losses accordingly.
Due to the financial instability of the last few years, banks have often revisited these provisions in order to make sure that they are fully covered in the event that loan losses drastically increase. I hope that you have found this article to be insightful and informative. Thank you for reading.