What is a Loan Loss Provision?
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.