What Is a Loan Loss Provision and How Does It Work?
Explore how banks anticipate and account for future loan defaults, a key metric that reveals their approach to risk and their economic outlook.
A loan loss provision is an expense a financial institution records to account for the estimated losses from loans that are not expected to be repaid in full. This figure, reported on a bank’s income statement, serves as a signal of the institution’s financial health and its perception of economic risk. When a bank anticipates that borrowers may default on their loans, it increases its loan loss provision, which directly reduces the bank’s reported profits for the period.
The practice of setting aside provisions is an aspect of prudent bank management and regulatory compliance. It ensures that a bank’s financial statements present an accurate picture of its assets by acknowledging potential future losses today. A change in the loan loss provision can indicate management’s outlook on the quality of its loan portfolio and the broader economy, as it is a forward-looking measure intended to protect the institution from credit losses.
The Mechanics of Loan Loss Accounting
The loan loss provision is an expense on the income statement that reduces a bank’s net income for a reporting period. When recorded, the provision increases a balance sheet account known as the Allowance for Credit Losses (ACL). The ACL is a contra-asset account paired with and reduces the gross value of the bank’s loans, resulting in the net loan value presented on the balance sheet.
Think of the ACL as a reserve fund built to absorb future loan losses. The provision for credit losses is the periodic contribution to this fund, based on the bank’s estimate of expected future defaults. The provision is the expense taken in one period, while the allowance is the cumulative total of these provisions, adjusted for actual losses over time.
When a bank determines that a loan is uncollectible, it performs a “charge-off.” This action involves removing the defaulted loan from its assets and reducing the ACL by the same amount. A charge-off does not directly impact the income statement in the period it occurs because the expense was already recognized through prior loan loss provisions.
If a bank recovers money from a loan that was previously charged off, it records a “recovery.” The recovered amount is added back to the Allowance for Credit Losses, increasing the reserve. Recoveries directly adjust the allowance account on the balance sheet and do not affect the loan loss provision expense for the current period.
Estimating Credit Losses Under CECL
The methodology for estimating loan loss provisions is governed by the Financial Accounting Standards Board’s (FASB) standard known as Current Expected Credit Loss (CECL). CECL requires financial institutions to be more forward-looking, replacing the previous “incurred loss” model. The model requires estimating and reserving for expected losses over the entire life of the loans from the moment they are originated.
Calculating the provision under CECL involves an analysis that combines several inputs. The first is historical loss experience, where banks analyze their own data on loan defaults for different types of loans under various economic conditions. This historical perspective provides a baseline for understanding how a loan portfolio has performed.
The second input is current conditions. The historical data is adjusted to reflect the present economic environment and the current state of the loan portfolio. This can include factors like current unemployment rates, changes in property values, and the credit scores of current borrowers. For example, if unemployment is rising, the historical loss rate might be adjusted upward to reflect the increased risk of default.
A final component of the CECL model is the use of “reasonable and supportable forecasts.” Banks must develop forecasts of future economic conditions and model how those forecasts will impact loan performance, such as projecting Gross Domestic Product (GDP) growth or interest rate changes. For the period beyond which a bank can make reasonable forecasts, it reverts to historical loss information.
Financial Statement Reporting and Analysis
The loan loss provision is located on the income statement, listed as a non-interest expense. Because it is an expense, a higher provision directly reduces a bank’s pre-tax income and, consequently, its net income and earnings per share.
The Allowance for Credit Losses (ACL) is found on the asset side of the balance sheet. It is presented as a deduction from the gross loans and leases, resulting in the “net loans and leases” figure. The footnotes to the financial statements provide a detailed reconciliation of the ACL, showing the beginning balance, the provision for credit losses added, charge-offs deducted, and recoveries added back.
Analysts use these figures to calculate ratios to gauge a bank’s risk profile and provisioning adequacy. One common ratio is the Allowance for Credit Losses to Total Loans. This percentage indicates how much of the total loan portfolio is covered by the existing reserve. A higher ratio suggests a more conservative approach to reserving for potential losses.
Another metric is the Allowance for Credit Losses to Nonperforming Loans. Nonperforming loans are those that are in or near default. This ratio, often called the “coverage ratio,” shows how many dollars of reserves the bank has for every dollar of troubled loans. A rising loan loss provision can signal that management expects economic conditions to worsen, while a falling provision may suggest an improved outlook.