One of the ways banks make money is off the interest payments and expenses they receive from the loans they give out. If those loans aren’t repaid or the interest payments aren’t as high as expected, the banks’ earnings can take a hit. To mitigate those losses, banks will make loan loss provisions.
What’s a loan loss provision?
A loan loss provision refers to funds set aside by a bank to cover bad loans – the ones that don’t get fully repaid because the customer defaults or those that provide less interest income because the borrower negotiated a lower rate. They’re a bank’s best estimate of what percentage of a loan may not get paid back. Once made, the estimate will be included in a bank’s financial statement as an expense so investors to get a proper sense of a bank’s financial health. A loss on a loan is still a lost asset for the bank, but the goal of the loan loss provision is to ensure that the bank’s cash flow is protected so it still has the funds to provide services to other borrowers and depositors.
Loan loss provisions are different from loan loss reserves, which are a tally of all the loan loss provisions recorded over several years. And while a loan loss provision is estimated loss, the actual loss, when it comes, is called a net charge-off.
How does it work?
Banks will look at statistics around customer defaults (whether those customers are individuals, small businesses or large corporations) to work out loan loss provisions. Late payments and collection expenses are also included in these calculations.
Why are loan loss provisions needed?
Loan loss provisions can be good indicators not only of a bank’s health but also that of the overall economy. Loan loss provisions spiked during the 2008 crisis, for example, as well as with the COVID-19 outbreak in 2020, when big banks in both the U.S. and Canada had to set aside billions of dollars in reserves to cover bad loans and losses from consumer debt defaults as the global pandemic shut down majors segments of the economy.
For some banks, loan losses can be offset by strong performance on the capital markets side, if volatility means increased trading on the stock market or more bond deals. The big banks are generally believed to be in good shape when it comes to handling a financial crisis because of increased compliance, reporting and lending standards brought in after 2008, forcing banks to increase their capital reserve requirements and focus on higher quality borrowers – but these loan loss provisions are important because banks can still face loan defaults, especially in a crisis.