What Is A Loan Loss Provision?
A loan loss provision is an amount of money a bank charges to its expenses on its income statement in anticipation that some of the loans it made will default. As a result, loan loss provisions reduce the bank's operating income.
In 2020, loan loss provisions have been much in the news as many of the world's banks have announced major loan loss provisions in expectation that many loans to businesses and consumers will become uncollectible, either in whole or in part, as a result of the economic dislocations from the coronavirus pandemic.
For example, JPMorgan Chase, the largest bank in the U.S. and one of the largest in the world, took a US$6.8 billion provision for bad loans in the first quarter. Wells Fargo, the fourth biggest, took a US$3 billion charge.
In Europe, Credit Suisse, Switzerland's second largest bank by assets, took a provision of 568 million Swiss francs (US$584 million) provision in the first quarter, a 600% increase compared to the same period a year earlier.
Why Banks Estimate Loan Losses?
Banks are required to estimate loan losses before they occur in order to provide their regulators, investors, depositors, borrowers and others with an accurate picture of their financial condition.
Since loan loss provisions are only estimates, it's possible that a bank was overly pessimistic in its expectations of losses. In the event that the losses don't turn out as bad as the bank anticipated, it can later reverse those provisions, in which case they would later be added to the bank's income, increasing future earnings.
Loan Loss Provisions In 2020
For example, in the third quarter of 2020, many banks sharply lowered their loan loss provisions compared to the first and second quarters after it began to appear that the economic fallout from the COVID-19 pandemic wouldn't be as bad as they first believed.
JPMorgan, for instance, set aside just US$611 million for potential future loan losses in the third quarter, down sharply from US$10.47 billion in the previous quarter and US$6.8 billion in the first three months of the year.
Of course, by the same token, banks may have underestimated their potential losses, in which case they will have to add more provisions later on.
While a loan loss provision appears as an expense on the bank's income statement, the amount of the provision is added to the bank's loan loss reserves, which appears on its balance sheet as a liability.
Loan loss reserves helps banks ensure that they have enough capital to cover loans that default.
A loan loss provision is an expense that banks record on their income statements that reflects their expectations of loans defaulting in the future. As a result, loan loss provisions reduce operating income. If these loans don't default to the degree that the bank first estimates, it can later reverse the provisions, which would add to future income.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…