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A loan loss reserve is an accounting method used to reflect the risk that not all loans made by a bank will be repaid. In each accounting period, a bank will list a certain amount, known as a provision for loan losses, designed to reflect these potential losses as a hypothetical expense. The relevant amount can then be listed as an asset on balance sheets. This loan loss reserve ensures the bank has enough money on hand to cover defaults.
Although contributions to a loan loss reserve are listed on a bank's income statement, the contributions are not an actual cash expense. Instead they simply reflect the necessary adjustments to the figures to make sure adequate money is set aside. Because the money is listed both as an expense and an addition to assets, the bank will act as if it has spent the money. Therefore the money remains untouched in the bank until it is needed.
Once a bank has set up a loan loss reserve, there are four ways in which the amount of the reserve can change. One is charge-offs, which occur when a bank gives up on trying to collect an outstanding loan. This loss is counted as an expense on the income statement, and then also deducted from the reserve figure on the balance sheet.
Another change happens in the event that a loan that has been charged off in this way is actually recovered. This is relatively rare. If it happens, the figure for the reserve is increased appropriately.
The third change comes at the end of the accounting period. The bank will usually list a provision for loan losses designed to bring the loan loss reserve back to its intended level. The amount listed will thus match the total amount charged off during the accounting period, minus any previously charged off loans that have been recovered.
The fourth change is any adjustment the bank makes to the loan loss reserve in order to reflect its loan portfolio. The amount is based on a percentage of the outstanding loans, so the loan loss reserve will usually increase as the total loan amount increases, although the percentage used may change depending on how risky the bank believes the loans are overall. It is therefore technically possible that a bank might increase the total value of its lending while cutting the size of its loan loss reserve, or vice versa.