A loan loss provision is an item on a bank's income statement that accounts for losses suffered when people or entities that borrow from the bank default on their loans. This is not a cash expense but rather a charge added to the bank's earnings to atone for such losses. By using a loan loss provision, a bank makes sure that it has enough capital to survive defaulted loans. The amount of the provision should be proportional to the riskiness of the loans that the bank has offered and the overall strength of the economy.
It is highly unlikely that a bank can offer a wide variety of loans to its customers without having some of those customers fail to repay either part or all of their loans. Banks understand that a small percentage of their customers will fail to pay them back or perhaps pay them back at a slower rate than first stipulated. To account for these circumstances, banks include on their income statement a loan loss provision, which is a negative charge against pre-tax earnings intended to simulate the financial hit of these defaulted loans.
Banks use the experience they have had in the market to determine how much of a loan loss provision they should include in their accounting. For example, Bank A is expecting to loan about $1,000,000 U.S. Dollars (USD) in a given year. Past experience has shown that, on average, about 2 percent of the loans the bank has previously offered in have not been repaid. In that case, the bank might include a provision of $20,000 USD, which is 2 percent of $1,000,000 USD, on the income statement to prepare for expected losses.
The above example is a simplified one, and most banks will have to take into account many other factors when determining their particular loan loss provision. If a bank is in the habit of handing out risky loans, then it should have a fairly high provision to keep its reserves replenished in case of multiple defaults. On the other hand, a bank that is particularly conservative about the types of loans it offers and the clientele those loans attract need not have a relatively high provision.
In addition, the pervading economic climate may also affect how much a bank needs for a loan loss provision. When a bank gives up on receiving its repayment for a loan, it is known as a charge-off. After a period of recession, banks often receive payments for these charged-off loans as the economy recovers and borrowers start to regain their financial footing. These recovered loans may be used to strengthen the bank's loan loss reserve and allow for more aggressive lending.