What Is Loan Loss Reserve?
Loan loss reserves (LLRs) are types of insurance and credit enhancement that help banks and lenders mitigate estimated losses on loans in the event of defaults or nonpayments. Should borrowers default on their loan, banks might use loan loss reserve funds to alleviate these losses.
How Often Are Loan Loss Reserves Calculated?
Loan loss reserves are revised quarterly. Should an increase in the balance occur, it is called a loan loss provision. A decrease in the balance, however, is referred to as a net charge-off.
Loan Loss Reserve Accounting Example
Bank XYZ has made $10,000,000 of loans to various companies and individuals. Bank XYZ works very hard to ensure that it lends only to people who are able to repay their loans in full and on time. However, some will inevitably default, fall behind, or even need to renegotiate their loan payments.
Bank XYZ knows this and estimates that 1% of its loans (i.e. $100,000) will probably never be paid. This $100,000 estimate is recorded as Bank XYZ’s reserve for loan losses and is entered a negative number on the asset portion of its balance sheet.
If Bank XYZ decides to write all (or a portion) of a loan off, it will remove the loan from its asset balance while also removing the amount of the write-off from its loan loss reserve. The amount deducted from the loan loss reserve may be tax-deductible for Bank XYZ.
Why Are Loan Loss Reserves Important?
To analysts and investors, loan loss reserves are useful because they indicate a bank's sense of how stable its lending base is. Obviously, loan losses aren’t always the result of bad lending decisions or risky lending decisions. For example, changes in macroeconomic factors can hit even the most responsible borrowers hard.
It’s important to note that each bank decides how much of a loan to write off (and when). This can make LLR comparisons between banks tricky.
