What are Loan Loss Provisions?

How does it Work?

Lending and borrowing are the main businesses of the banking industry.  They borrow money from customers, called deposits, and lend these to needy people. Interest out of these lending is the main source of revenue for the banks.  According to the conservatism principleConservatism PrincipleThe conservatism principle of accounting guides the accounting, according to which there is any uncertainty. All the expenses and liabilities should be recognized. In contrast, all the revenues and gains should not be recorded, and such revenues and profits should be recognized only when there is reasonable certainty of its actual receipt.read more, for a business, all losses should be accounted for, whether it is materialized or not. So the banks anticipate loan default payments and provide a portion of loan repayments to balance the loss of default payments.

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How to Calculate?

Many factors affect the calculation of loan loss provisions. The provision needs to be adjusted frequently as per the available estimates and calculations on customer loan repayment reports.

  • Historical Data on Repayments and Default: The bank has to refer to and collect the record of customers’ defaults and repayments of loans.Loan Collection Expenses: Loan collection expenses affect the calculation of provisions.Credit Losses: The credit loss for late payments.Economic Conditions: The prevailing economic recession affects the calculations.Business Cycle: The movement of GDP is also a factor.Interest Rate: The change in interest rate influence its calculation.Tax Policy: The changes in the tax rate.

The Loan Loss Provisions Example

  • Loan unpaid more than 2 months=100000,  provision 10%Loan unpaid between 2and 6 months =250000, provision 12%If, Loan unpaid more than 6 months =400000, provision 15%

This Ratio is a ratio that indicates the capacity of the bank to bear the loss on loans. A higher rate means a greater ability for the banks to face loan losses.

Loan Loss Provision Coverage Ratio = Pre-Tax Income + Loan Loss Provision / Net Charge Offs

Net charges = Actual Losses

  • Suppose a bank provides Rs. 1,000,000 loan to a construction company to purchase machinery. After one year, due to the recession in the economy, the company is not able to make full repayment of the loan.  The bank expects 70% of the repayment, and it records a provision of Rs.300,000.But the bank can collect only Rs.500,000 from the company, and the net charge off is Rs.500,000. Suppose the bank’s recorded pre-tax incomePre-tax IncomePretax income is a company’s net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more is Rs.2,000,000

  • =2,000,000 + 300,000 / 500,000= 4.6

Loan Loss Reserves vs. Loan Loss Provisions

  • At the time of the loan issue, the bank estimates a loan loss reserve to cover the default, which is shown in the asset side of the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more deducted from total loans. It is a contra asset, which reduces the amount of loan that needs to be paid back. If the bank thinks it needs to raise the reserve due to some factors, the bank charges an amount from its current earnings to increase the loan loss reserve. It is the loan loss provisions.Loan loss reserve is shown on the asset side of the balance sheet as a contra asset accountContra Asset AccountA contra asset account is an asset account with a credit balance related to one of the assets with a debit balance. When we add the balances of these two assets, we will get the net book value or carrying value of the assets having a debit balance.read more, deducted from the loan. Whereas, Loan loss provision is recorded as a non-cash expense in the income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more.Loan Loss provision is an adjustment to loan loss reserve.The loan loss reserve is an appropriation of profit. Loan loss provision is a charge against profit.The loan loss reserve is created at the time of providing a loan. Whereas, Loan loss provision is charged if there is a need for an increased reserve.Loan loss reserve refers to withholding the amount. The loan loss provision is the amount set aside to meet the default loan payments

Impact

These are expected losses of the bank due to credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, charged against the profits, recorded as an expense in the income statement. It affects the regulatory capital of the bank through a profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more.

Conclusion

  • Loan Loss Provision is the amount set aside to meet the expected credit loss. It is a systematic way used by the banks to cover the risk. The calculation of provision is based on estimations and calculations.The information about loan loss reserves and provisions is useful for investors as it provides insights into the bank’s stability in lending and how the bank manages the credit. The bank can also decide the amount of provision that needs to be set aside based on the incomeAnd it can manage the earningsManage The EarningsEarnings Management refers to producing “fabricated” financial statements by the company managers to display its monetary success in front of the stakeholders.read more by creating large provisions in case of high returns and small provisions during low returns. The bank can withstand the changing economic conditions by providing ample provisions to cover the losses and expenses

This has been a guide to What is Loan Loss Provisions & its Definition. Here we discuss its calculations, examples, impact, and how it works. You can learn more about it from the following articles –

  • Provision for Income TaxBad Debt ProvisionAccrual vs. ProvisionRevaluation Reserve