Banks create a loan loss provision to set aside funds for default or problem loans. It is an income statement expense banks can tap into when borrowers are delinquent on their payments and are unlikely to repay their loans.
Definition and Examples of a Loan Loss Provision
A loan loss provision is a cash reserve a bank creates to cover problem loans that are unlikely to see repayment. When a bank expects that a borrower will default on their loans, the loan loss provision can cover a portion of or the entire outstanding balance. When a bank establishes or contributes funds to maintain the provision, the charge appears as an income statement expense.
- Alternate names: Loan loss reserves, valuation allowance, valuation reserve, allowance for loan loss
Consider this example: Let’s say a bank has issued $100,000 total in loans and has a loan loss provision of $10,000. On one of their defaulted loans, the borrower repaid only $500 of the outstanding $1,000. To cover the $500 loss from the defaulted loan, the bank would deduct $500 from the loan loss provision.
How Does a Loan Loss Provision Work?
In many ways, a loan loss provision serves like an internal insurance fund. It protects the bank in the event that a borrower is delinquent on their payments or defaults on the entire loan. To defend the bank, a loan loss provision can offer coverage of these incurred losses.
Banks rely on loan loss provisions to prepare against problem loans that can arise during declining economic conditions.
The Community Bank of the Bay, for example, increased its loan loss provision in response to the 2020 recession. The bank increased its loan loss provision by $250,000 in 2020 Q3 to help defend against potential loan losses, even though the bank has a fairly low level of net charge-offs.
On a balance sheet, the loan loss provision ideally would reflect the exact funds used to cover loan losses. Banks, however, can not always accurately predict which loans would not be repaid. Therefore, banks analyze their loan profile to estimate potential losses, which would then inform the size of a loan loss provision. In other words, a loan loss provision represents a bank’s forecast of future loan losses.
In the past, banks have used several methods to determine the size of their loan provisions, including:
- Loss history: A bank uses its history of loan losses to predict losses on future loans.
- Competitive analysis: A bank can use the financial reports of other banks to estimate an “industry standard” for loan loss reserves. While it may not factor in a bank’s historical losses, it can help a bank assess whether its loan loss reserves are comparable to another bank’s reserves.
When a bank first establishes a loan loss reserve or has to replenish funds that were previously exhausted, the charge appears as an expense on the income statement. The expense category is typically labeled “Provision for loan losses.”
Some banks may choose to divide their loan loss reserves into two categories: specific and general. After assessing their current loans, a bank may flag a specific loan or group of loans with higher risk profiles. The funds in the specific reserves are allocated to covering those loans in the event of a default. General reserves address any loans that don’t require as much special attention.
The number of a bank’s non-performing loans compared to its loan loss reserves is measured with the Texas Ratio. The Texas Ratio is calculated by dividing the amount of a bank’s non-performing loans by the total of its tangible equity capital plus its loan loss reserves.
When the amount of problem loans exceeds the available capital to handle losses, it signals that the bank is in trouble. A ratio of 1:1, or 100%, typically predicts the failure of that bank.
During the 2008 financial crisis, many banks did not have enough loan loss reserves to account for actual losses. In the following years, banks began allocating resources to increase the size of their loan loss reserves to defend against the increase of defaulting loans.
When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act of 2010, one of its goals was to improve the financial stability of the United States. Under the Dodd-Frank Act, grants were made available to help community development financial institutions create their own loan loss reserve funds to help manage losses on nonperforming loans.
As a result of the 2020 recession, many banks have revisited their loan loss reserves to address economic declines. Some banks have even more than doubled their reserves. In 2020 Q2, bank loan loss provisions, in aggregate, totaled $242.79 billion—slightly down from $263.11 billion in 2010 Q1 following the Great Recession.
- A loan loss provision is a cash reserve that banks set aside to cover losses incurred from defaulted loans.
- Some methods that banks have used to determine the size of their loan loss reserves are to rely on historical losses or to use the reserves of other banks within the industry as a guideline.
- The Texas Ratio measures the value of a bank’s non-performing loans to its total loan loss reserves and is calculated by dividing the dollar amount of a bank’s non-performing loans by the total of its tangible equity capital plus its loan loss reserves.