What Is a Loan Loss Provision?

A loan loss provision is an expense set aside as an allowance for uncollected loans and loan payments. This provision is used to cover a number of factors associated with potential loan losses, including bad loans, customer defaults, and renegotiated terms of a loan that incur lower-than-previously-estimated payments. Loan loss provisions are an adjustment to loan loss reserves and are also known as valuation allowances.

Key Takeaways

  • A loan loss provision is an expense set aside to allow for uncollected loans and loan payments.
  • Banks are required to account for potential loan defaults and expenses to ensure they are presenting an accurate assessment of their overall financial health.
  • Loan loss provisions, also known as valuation allowances, are included in a bank’s financial statements.

Loan Loss Provision

How a Loan Loss Provision Works

Banking industry lenders generate revenue from the interest and expenses they receive from lending products. Banks lend to a wide range of customers, including consumers, small businesses, and large corporations.

Lending standards and reporting requirements are constantly changing, and constraints have been rigorously tightening since the height of the 2008 financial crisis. Improved regulations for banks resulting from the Dodd-Frank Act focused on increasing the standards for lending, which have required higher credit quality borrowers and also increased the capital liquidity requirements for the bank.

Despite these improvements, banks still have to account for loan defaults and expenses that occur as a result of lending. Loan loss provisions are a standard accounting adjustment made to a bank’s loan loss reserves included in the financial statements of banks. Loan loss provisions are consistently made to incorporate changing projections for losses from the bank’s lending products. While standards for lending have greatly improved, banks still experience late loan payments and loan defaults.

Because the loan loss provision appears on the income statement as an expense, it will lower operating profits.

Loan Loss Reserves in Accounting

Loan loss reserves are typically accounted for on a bank’s balance sheet, which can increase by the amount of the loan loss provision or decrease by the amount of net charge-offs each quarter.

Loan loss provisions are constantly made to update estimates and calculations based on statistics for the bank’s customer defaults. These estimates are calculated based on average historical default rates by different levels of borrowers. Credit losses for late payments and collection expenses are also included in loan loss provision estimates and are calculated using a similar methodology, which takes into account the previous payment statistics of a bank’s credit clients.

Overall, by setting aside loan loss reserves and constantly updating estimates through loan loss provisions, banks can ensure they are presenting an accurate assessment of their overall financial position. This financial position is often released publicly through the bank’s quarterly financial statements.

Example of Loan Loss Provisions

Some of the biggest banks in the U.S. added sizable loan loss provisions in the first quarter of 2020 due to the coronavirus pandemic and the dramatic economic downturn it has caused. Combined, the five biggest lenders in the U.S. built a war chest of $24 billion in loan loss provisions. For example, JPMorgan Chase & Co.—the largest U.S. bank—set aside almost $7 billion in reserves for possible losses from consumer debt defaults in 2020.