Loan Loss Provision

A loan loss provision is an expense a bank records to cover expected losses from unpaid loans or defaults. It reduces reported operating profit and increases a reserve on the balance sheet so the bank’s financial statements more accurately reflect credit risk.

Key takeaways
* A loan loss provision is recorded on the income statement to cover expected credit losses.
* Provisions increase loan loss reserves (allowance for credit losses) on the balance sheet.
* Estimates are updated regularly using historical default rates, borrower profiles, and loss projections.
* Provisions help banks manage credit risk, maintain regulatory compliance, and present a transparent financial position.

Purpose and role
* Provide a buffer against future loan defaults and collection costs.
* Smooth the impact of credit losses over time so reported earnings are not suddenly depressed by charge-offs.
* Support accurate, conservative financial reporting for stakeholders and regulators.

How it works
* When a bank estimates future loan losses, it records a provision expense on the income statement.
* The corresponding credit increases the loan loss reserve (an allowance) on the balance sheet.
* When a loan is charged off (written off as uncollectible), the reserve is reduced by the charge-off amount.
* Provisions are recalculated regularly to reflect changes in loan performance, economic conditions, and borrower credit quality.

Estimating provisions
* Banks typically base estimates on historical default rates segmented by borrower type, loan product, and credit characteristics.
* Estimates incorporate anticipated collection costs and trends in late payments.
* Provisions are adjusted as actual losses (charge-offs) and new information change the expected loss outlook.

Regulatory and risk-management context
* Lending standards and reporting requirements tightened after the 2008 financial crisis, increasing focus on accurate provisioning and capital adequacy.
* Regular provisioning supports regulatory oversight, helps ensure sufficient capital buffers, and promotes prudent lending practices.

Impact on financial statements
* Income statement: provisions are recorded as an expense, lowering operating profit.
* Balance sheet: provisions increase the loan loss reserve (allowance for credit losses), reducing net loan carrying value.
* The interplay between provisions and charge-offs determines the reserve’s balance over time.

Bottom line
Loan loss provisions are a core credit-risk management and accounting practice for banks. By anticipating and reserving for expected loan losses, banks improve the reliability of their financial reporting, maintain regulatory compliance, and better absorb credit deterioration without sudden hits to earnings.