Loan Loss Provisions

What is Loan Loss Provisions?

Loan loss provisions are the portion of the loan repayments set aside by banks to cover the portions of the loss on defaulted loan payments as it helps the bank to balance the income and survive during bad times and is recorded in the income statement as a non-cash expense.

How does it Work?

Lending and borrowing are the main businesses of the banking industry.  They borrow money from customers, called deposits, and lend these to needy people. Interest out of these lending is the main source of revenue for the banks.  According to the conservatism principle, for a business, all losses should be accounted, whether it is materialized or not. So the banks anticipate loan default payments and provide a portion of loan repayments to balance the loss of default payments.

Loan Loss Provisions

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Loan Loss Provisions (wallstreetmojo.com)

How to Calculate?

Many factors affect the calculation of loan loss provisions. The provision needs to be adjusted frequently as per the available estimates and calculations on customer loan repayment reports.

  1. Historical Data on Repayments and Default: The bank has to refer and collect the record on default and repayments of loans by customers.
  2. Loan Collection Expenses: Loan collection expenses affect the calculation of provisions.
  3. Credit Losses: The credit loss for late payments.
  4. Economic Conditions: The prevailing economic recession affects the calculations.
  5. Business Cycle: The movement of GDP is also a factor.
  6. Interest Rate: The change in interest rate influence its calculation.
  7. Tax Policy: The changes in the tax rate.

The Loan Loss Provisions Example

  • Loan unpaid more than 2 months=100000,  provision 10%
  • Loan unpaid between 2and 6 months =250000, provision 12%
  • If, Loan unpaid more than 6 months =400000, provision 15%
Loan Loss Provision Example 1-1

This Ratio is a ratio that indicates the capacity of the bank to bear the loss on loans. A higher rate means a greater ability of the banks to face the loan losses.

Loan Loss Provision Coverage Ratio = Pre-Tax Income + Loan Loss Provision / Net Charge Offs

Net charges = Actual Losses

Loan Loss Provision Example 1
  • =2,000,000 + 300,000 / 500,000
  • = 4.6

Loan Loss Reserves vs. Loan Loss Provisions

Impact

These are expected losses of the bank due to credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, charged against the profits, recorded as an expense in the income statement. It affects the regulatory capital of the bank through a profit and loss account.

Conclusion

Recommended Articles

This has been a guide to What is Loan Loss Provisions & its Definition. Here we discuss its calculations along with examples, impact, and how it works. You can learn more about from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *