A loan loss provision is an expense that a bank or other lender charges to its income statement to cover loans it expects will not be repaid in full. The expense builds up a reserve, called the allowance for loan losses or allowance for credit losses, which is shown on the balance sheet as a deduction from gross loans. Provisions exist so that a lender's reported profit reflects the credit risk it has taken on, not only the interest it has earned.
The provision is the flow and the allowance is the stock: each period's provision tops up (or, if released, reduces) the allowance, and write-offs of bad loans draw it down. Since 2018 most banks outside the US calculate provisions under IFRS 9's expected credit loss model, while US lenders use the FASB's CECL standard (ASC 326).
Loan loss provision in plain terms
Think of a shop that sells on credit to regular customers. The owner knows from experience that a few customers each year will never settle their tab. Rather than waiting to be surprised, the owner puts aside a little money every month in a jar marked "bad debts", sized to what past years suggest will go unpaid.
When a customer finally disappears without paying, the owner takes the loss from the jar instead of from that month's earnings. A loan loss provision is the bank's version of putting money in the jar, and the allowance is the jar itself. If the economy looks worse, the bank puts more in; if things improve, it can take some back out.
How provisioning works in the accounts
The mechanics follow double-entry accounting. When the lender books a provision, it debits provision expense and credits the allowance, which lowers net income and the carrying value of loans at the same time. When a loan is judged uncollectible, the lender writes it off by debiting the allowance and crediting the loan, which has no further effect on profit because the loss was already provided for. Later recoveries are credited back to the allowance.
The size of the provision each period is the amount needed to bring the allowance to the level the accounting model requires:
Here net write-offs are gross write-offs less recoveries. For example, a bank starts the year with an allowance of $50 million, writes off $20 million of loans, recovers $4 million, and calculates that it needs an allowance of $60 million at year end. Its provision for the year is , or $26 million.
From incurred loss to expected loss
Before IFRS 9, banks used the incurred-loss model of IAS 39 and old US GAAP, which allowed a provision only once there was objective evidence that a loss had occurred. Regulators and the G20 criticised this after the 2008 financial crisis as "too little, too late". The replacement standards look forward:
- IFRS 9 (effective 2018). Lenders provide for 12 months of expected losses on healthy loans and for lifetime losses once credit risk has increased significantly, using a three-stage model.
- CECL, ASC 326 (issued 2016, effective for large SEC filers in 2020). Lenders provide for lifetime expected losses on all loans from the day they are made.
Both models are built from inputs such as probability of default and loss given default, adjusted for economic forecasts. Some countries also set minimum prudential provisions by asset class; India's income recognition and asset classification (IRAC) norms and the State Bank of Pakistan's prudential regulations are examples.
Ratios analysts watch
Provisions are a key line in bank analysis because they are large, partly judgemental and highly cyclical. Common measures include:
- Cost of risk. Annual provision expense divided by average gross loans, usually quoted in basis points.
- Coverage ratio. The allowance divided by the stock of non-performing loans, showing how much of the bad book is already reserved.
- Allowance to total loans. A broad measure of how conservatively the whole book is reserved.
The coverage ratio is calculated as:
A bank with a $60 million allowance and $80 million of non-performing loans has a coverage ratio of , or 75%. A falling coverage ratio while bad loans rise can suggest under-provisioning, though collateral levels also matter.
Regulation and capital
Provisions interact with regulatory capital. A higher provision lowers retained earnings and therefore Common Equity Tier 1 under Basel III. Under the standardised approach, general provisions may count towards Tier 2 capital up to a limit, and under internal-ratings approaches any shortfall of provisions against regulatory expected loss is deducted. Many supervisors allowed transitional arrangements to phase in the capital hit when IFRS 9 and CECL were adopted.
Criticism and limitations
Because the provision depends on management forecasts, it can be used to smooth earnings: building reserves in good years and releasing them to flatter weak ones. Expected-loss models can also be procyclical, since provisions jump when forecasts turn negative, as happened in early 2020, which may push banks to cut lending exactly when borrowers need it. Comparisons across banks are difficult because IFRS 9 and CECL produce different allowances for the same loan.