What are Loan Loss Reserves?
How Do Loan Loss Reserves Work?
Let's assume Bank XYZ has made $10,000,000 of loans to various companies and individuals. Though Bank XYZ works very hard to ensure that it lends only to people who can repay their loans (and repay them on time), inevitably some will default, some will fall behind, and some will have to be renegotiated.
Bank XYZ knows this and estimates that 1% of its loans, or $100,000, will probably never come back to it. This $100,000 estimate is Bank XYZ's loan loss reserve, and it records this reserve as a negative number on the asset portion of its balance sheet.
If and when Bank XYZ decides to write all or a portion of a loan off, it will remove the loan from its asset balance and also remove the amount of the write-off from the loan loss reserve. The amount deducted from the loan loss reserve may be tax deductible for Bank XYZ.
Why Do Loan Loss Reserves Matter?
Loan loss reserves are useful information for analysts and investors because they indicate a bank's sense of how stable its lending base is. It is important to note that banks vary when it comes to deciding how much of a loan to write off and when, which makes comparisons among banks tricky sometimes.
Loan loss reserves are revised quarterly. An increase in the balance is called a loan loss provision. A decrease in the balance is called a net charge-off.
Clearly, loan losses are not always the result of bad lending decisions or risky lending decisions. Changes in macroeconomic factors, for example, can hit responsible borrowers hard.