Loan loss provisions are financial safety precautions designed to protect lenders and other financial institutions from monetary losses from delinquent and defaulted customers. A loan loss provision usually comes in the form of money or credit set aside in a loan loss reserve.
But how does a loan loss provision affect you as a borrower? The lending industry can be confusing at times, especially when you are not familiar with the financial terms regularly used by banks and other financial institutions. Although there is a significant amount of knowledge to absorb, educating yourself on various aspects of the banking industry can empower you as a customer and borrower.
What Is a Loan Loss Provision?
Within the banking and lending industry, a loan loss provision is a particular type of income statement expense. This expense is set aside to be an allowance for loans that go uncollected and loan payments that go unpaid. Put plainly, the bank or other financial institution sets aside money to account for loan losses that occur when customers default, declare bankruptcy, or renegotiate loans.
Loan loss provisions are added to the loan loss reserves, which is a balance sheet representing the total amount of loan losses minus the bank or company’s overall loans. Loan loss provisions can help cover banks and lenders when anticipated funds are missing because borrowers are delinquent on their loans or unable to pay them back.
How Do Loan Loss Provisions Work?
The lending industry brings in revenue to sustain its business through interest and other costs associated with lending products. When consumers, small businesses, or large corporations miss loan payments or default on their loans, the bank or lender’s revenue takes a major hit.
A loan loss provision can be thought of as an internal insurance fund to protect lending companies from the financial damage that credit losses can cause. Every bank or corporation that deals with lending products has a certain amount of expected credit loss. Being equipped with sufficient loan loss provisions minimizes the negative impact those credit losses might have on a lender’s revenue.
Loan loss provisions are calculated based on the expected credit loss. The goal is to have a loan loss provision as close as possible to the anticipated loan loss. However, lenders can’t always accurately predict the expected credit losses, so there are bound to be discrepancies on the balance sheet occasionally.
When trying to predict the size of their loan loss provisions ought to be, lenders seek to determine future expected losses through:
- Loan defaults
- Late payments
- Collection expenses, etc.
The company will typically attempt to calculate an estimate using previous loss history and competitive analysis of the industry standard. Some banks or lenders choose to divide their loan loss reserves into categories allowing them to flag riskier loans for a more extensive loan loss provision.
What is the Texas Ratio?
The Texas Ratio is a calculation used to measure the bank or lender’s non-performing loans compared to the loan loss reserves. A company’s Texas Ratio is found by dividing the amount of the non-performing loan loss by the total tangible equity capital plus the loan loss reserves. If the amount of loan loss expenses exceeds the available capital in the loan loss provision, the bank or lending company could be in financial trouble.
Loan Loss Reserves and the 2008 Financial Crisis
A notable aspect of the 2008 financial crisis is that many banks did not have enough loan loss provisions to account for the actual losses that occurred. According to Federal Reserve History, the 2008 financial crisis marked the deepest recession since World War II.1 This big blow to the banking and lending industry made a significant difference in the typical loan loss provisions allocated for potential loan defaults. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 made grants available to increase loan loss reserve funds.2
The onset of the 2020 recession has also caused banks to review their loan loss provisions and loan loss reserves to ensure they are prepared for any further economic decline. Banks and other lenders are doing all that they can do to avoid finding themselves in a similar situation to the 2008 financial crisis by being overly cautious in their bulking up of loan loss reserves.
Obtaining a Loan With Poor Credit
Since loan repayment, interest, and other associated fees are how lenders and banks generate revenue, most of these financial institutions care about a borrower’s creditworthiness. A borrower with bad credit is more likely to pose a severe risk of financial loss to a bank or other lender.
The inability to obtain funding can be incredibly aggravating for consumers with a less than perfect credit score. It can be challenging to be approved for loans with poor credit scores, but there are some reliable options that subprime borrowers can turn to in times of need, such as:
- Subprime lenders
- Online tools and resources for improving credit
Subprime Lending
While most loans have particular standards when it comes to the borrower’s credit report, there are some loans that are designed specifically for subprime consumers. Loans for people with bad credit include auto title loans, payday loans, online no credit check loans, bad credit loans, and other quick cash loans. These loans tend to be short-term and high-interest, which can make them costly, but they can be a convenient last resort option when you are in a pinch.
Lending options made for individuals with bad credit are at-risk for predatory lending, so it is important to do research on the online lenders you are considering. You will want to make sure that they are trustworthy. Before signing any contract, look into the repayment schedule and what you can realistically afford because missing payments can lead to detrimental consequences on your credit report.
Credit-Building Tools
Some banks and financial institutions offer lending products that can be used by customers with poor or minimal credit history to build a better credit score. Products like a credit-builder loan and a secured credit card allow consumers to place a cash deposit for a secured loan or credit line. The lender will then report the payments to the credit bureaus as if it was a standard loan or credit card to improve the borrower’s payment history and credit mix.
These credit-building lending products are excellent recovery options for people who have recently filed for bankruptcy or experienced some other credit-damaging financial crisis. A secured credit card or credit-builder loan is perfect for working your way up to normal credit cards and other mainstream lending products.
Tips For Improving Your Credit
If you wish to improve your overall chances of being approved for loans and other various forms of credit, it is a good idea to put effort into cleaning up your credit report. Our consumer credit report plays an incredibly impactful role in our day to day lives, from funding approval to renting apartments.
Luckily, you are not stuck with a bad credit score, as there are many actions you can take to improve it over time. Here are a few ways in which you can make your credit report far more appealing to lenders who are keeping their loan loss provisions in mind:
- Lower your credit utilization ratio.
- Make your due payments on or before their due date.
- Know your credit score most likely won’t change overnight, and improving it will require responsible financial behavior consistently.
Decrease Credit Utilization
One of the ways to improve your credit with nearly immediate results is to decrease your overall credit utilization ratio. The credit utilization ratio is the amount of debt you have compared to the available credit you have left unused. Your credit utilization rate is heavily relied upon by lenders as a marker for your overall credit health.
Most financial experts advise that your credit utilization ratio should remain at 30% or below. If you are able to pay off a significant portion of your debt so that your credit utilization drops below 30%, you will likely see a major difference in your credit score.
Make On-Time Payments
Never miss payments or make them late for any of your loans or credit cards. Your payment history makes up the most considerable percentage of your credit score calculation. Late or missed payments bring down your creditworthiness and harm your credit score. Making on-time payments consistently will improve your payment history and boost your score.
Paying more than the minimum payment on your credit cards and making extra payments on your loans without prepayment penalties will not only improve your credit but also help you pay off your debt faster and save you money.
Have Patience
One of the most important things to keep in mind when it comes to your credit score is that you are unlikely to see results overnight. You can’t expect to make one change and have your score jump one hundred points overnight. The key to improving your credit report is to be consistent and patient.
Keep up with your on-time payments and debt repayment strategies. Don’t give up, and keep making positive changes that will be good for your overall financial health. Include new types of credit or have yourself added as an authorized user on a family member’s credit card. Be creative and be patient.
Loan Loss Provision vs. Loan Loss Reserve
| Loan Loss Provision | |
| Definition | A loan loss provision refers to an income statement expense that a bank or financial institution sets aside in anticipation of potential future loan losses. It’s essentially an estimation of future uncollectible amounts from borrowers. |
| Function | It acts as an “expense” for the bank, recognizing that some of their loans may not be repaid in the future. By setting aside this provision, the bank prepares for potential bad loans or defaults. |
| Variability | The amount set aside can vary each financial period based on the bank’s assessment of potential risks in its loan portfolio. |
| Loan Loss Reserve | |
| Definition | Loan loss reserves are a contra-asset account on a bank’s balance sheet that accumulates the total amounts set aside for anticipated loan losses. It represents the cumulative sum of all loan loss provisions over time, adjusted for loans that have actually been written off as uncollectible. |
| Function | Loan loss reserves acts as a “buffer” or “cushion” on the balance sheet, reducing the bank’s total assets by the expected uncollectible amount. Essentially, loan loss reserves show how much money the bank has set aside in total to cover potential loan losses. |
| Adjustments | When a loan is deemed uncollectable and is written off, the loan loss reserves are decreased by that amount. Likewise, when recoveries are made on previously written-off loans, loan loss reserves can be increased. |
FAQ: Loan Loss Provisions
One of the primary risks is underestimating the amount needed, which can jeopardize a bank’s financial stability in the face of future financial crises. If the provisions for loan losses are not reflective of the bank’s non-performing loans, it could lead to significant financial challenges.
Regularly analyzing the bank’s historical losses, monitoring current economic conditions, and assessing the bank’s non-performing loans are crucial. It’s also essential to routinely review financial reports to ensure accurate estimates.
It’s essential to be aware of the total loan loss reserves compared to the bank’s overall loan portfolio. An imbalanced ratio might indicate inadequate preparation for defaulted loans or over-conservatism that might hamper profitability.
Most banks review and adjust their loan loss provisions quarterly when they prepare their financial reports. However, in rapidly changing economic conditions, banks might review these provisions more frequently.
Changes in loan loss provisions directly impact a bank’s earnings. If a bank increases its provisions, it reduces its current earnings. Conversely, releasing provisions for loan losses can boost earnings. It’s a balance of ensuring financial stability while maximizing profitability.
The bank’s finance and risk management teams are typically responsible for calculating provisions for loan losses. They analyze the bank’s historical losses, non-performing loans, and future loan prospects to come up with an estimate.
The bank’s credit and risk management departments usually determine whether an account qualifies as a defaulted loan.
Regulatory bodies often set general guidelines, but within those parameters, the bank’s board and risk management team set specific criteria, based on what the bank expects given its unique circumstances, loan loss reserves, etc.
Typically, the bank’s board of directors or a designated committee approves the final amount for a loan loss provision based on the bank estimates and recommendations from the risk and finance departments.
The main benefit of a loan loss provision is ensuring that the bank has a cash reserve to cover losses from defaulted loans. This provides both financial stability and confidence to investors and stakeholders that the bank is prepared for future loans that might go bad.
Overestimating can unnecessarily tie up capital when it comes to a loan loss provision, which could have been used profitably elsewhere. On the other hand, underestimating might leave the bank vulnerable if a larger-than-expected number of loans default.
Loan loss provisions are usually found in a bank’s financial statements, specifically on the income statement as an expense, and as a contra-asset reducing loan balances on the balance sheet. The income statement helps stakeholders understand what the bank expects in terms of potential future losses.
CreditNinja’s Thoughts on Provisions for Loan Losses
While loan loss reserves and provisions exist to protect financial institutions from economic loss, it’s important that borrowers for loans and lines of credit take actions to protect themselves as well. CreditNinja suggests all consumers take the following precautions before applying for any kind of financial product:
- Research lenders and financial products
- Look at online reviews to see what kind of experience other borrowers had
- Review your finances (debts, expenses, etc.) and consider the pros and cons of personal loans to determine whether applying for a loan is the right choice for you
You can also find more free tools and resources about budgeting, online loans, and more at the CreditNinja blog dojo!
References:
1. The Great Recession and Its Aftermath | Federal Reserve History
2. Text – H.R.4173 – 111th Congress (2009-2010): Dodd-Frank Wall Street Reform and Consumer Protection Act | U.S. Congress
3. Loan loss provisions – Financial Pipeline
