Loading the player...

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 can also be known as valuation allowances.

BREAKING DOWN 'Loan Loss Provision'

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 have been 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.

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 chargeoffs 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. The industry standard for loan loss reserves is an average 2 to 2.5% of a bank’s total outstanding loan receivables.

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.

RELATED TERMS
  1. Technical Default

    A technical default is a deficiency in a loan agreement that ...
  2. Term Loan

    A term loan is a loan from a bank for a specific amount that ...
  3. Loan Servicing

    Loan servicing refers to maintaining the records, processing ...
  4. Allowance For Bad Debt

    An allowance for bad debt is a valuation account used to estimate ...
  5. End Loan

    A permanent, long-term loan used to pay off a short-term construction ...
  6. Problem Loan

    A problem loan is a loan in which the borrowers cannot or are ...
Related Articles
  1. Insights

    An Introduction to Government Loans

    Government loans further policymakers' efforts to create positive social outcomes by offering timely access to capital for qualified candidates.
  2. Personal Finance

    Different needs, different loans

    When it comes to loans, there are many different types according to your needs. Find out what options are available when it comes to borrowing money.
  3. Personal Finance

    Getting a loan without your parents

    Do you want to receive a loan without the help of your parents? Use these five tips to finance your dreams without banking on a second signature.
  4. Personal Finance

    College Loans: Private vs. Federal

    Not all student loans are the same. Learn the difference between federal vs private student loans.
  5. Investing

    Analyzing a bank's financial statements

    In this article, you'll get an overview of how to analyze a bank's financial statements and the key areas of focus for investors who are looking to invest in bank stocks.
  6. Financial Advisor

    The 6 Best Peer-To-Peer Lending Websites (LC)

    A look at some of the most well-known and reputable peer-to-peer lending websites, their business models and successes to date.
  7. Retirement

    10 Ways to Borrow in Retirement

    Before you take money from your nest egg, consider these 10 other ways to borrow in retirement.
  8. Personal Finance

    Home Improvement Loans: What Are Your Best Options?

    If you plan on taking out a home improvement loan, you should know what your options are and which ones might be best for your situation.
  9. Personal Finance

    Time To Consolidate Your Student Loans?

    Use these strategies to decide whether consolidating your student loans makes sense for you – and what to do next if it does.
  10. Personal Finance

    Student Loan Asset-Backed Securities: Safe or Subprime?

    Similar to the mortgage-backed securities that caused the 2008 recession, student loan asset-backed securities could lead to the next financial crisis.
Trading Center