Loan Loss Provision

Written By
Paul Tracy
Updated November 4, 2020

What is a Loan Loss Provision?

A loan loss provision is an expense that is reserved for defaulted loans or credits.  It is an amount set aside in the event that the loan defaults.

How Does a Loan Loss Provision Work?

Generally, banks conduct their business by taking deposits and making loans using those deposits.  It is a bit more complicated (e.g. investments, securitization, etc,), however, this is the basic banking model.  Banks must balance their loan receivables (i.e. the principal and interest repayments from borrowers), with the demand for deposits (i.e. the requests from depositors for all or a portion of their deposits.)  In any group of loans, banks expect there to be some loans that do not perform as expected.  These loans may be delinquent on their repayments or in default of the loan entirely, creating a loss for the bank on expected income.  

Therefore, banks set aside a portion of the expected loan repayments from all loans in its portfolio to cover all, or a portion, of the loss. In the event of a loss, instead of taking a loss in its cash flows, the bank can use the amount set aside to cover the loss.   Since the bank does not expect all loans to be late, there is usually enough in the loan loss reserve to cover the full loss for any one or small number of loans when needed.  The loan loss reserve acts as an internal insurance fund.

To establish the loan loss provision amounts, bank regulators require regular screening of bank loan portfolios, ranking each asset (i.e. loan) or group of assets by market conditions, collateral condition, and other business risk factors.   According to the Federal Administrator of National Banks, the amount set aside for loan losses is about 2%-2.5% of the outstanding loan receivables, depending on the quality of the loans in the portfolio.

Why Does a Loan Loss Provision Matter?

From a balance sheet perspective, a loss on a loan is still a loss of an asset.  However, on an operating basis, because of the loan loss provision, cash flow remains available.  The loan loss provision ensures that banks will have sufficient funds to provide services to its depositors.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Loan Loss Provision.
Be the first to ask a question

If you have a question about Loan Loss Provision, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Loan Loss Provision, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Loan Loss Provision

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms