In this tutorial, you’ll learn all about the Allowance for Loan Losses and the Provision for Credit Losses for commercial banks, which are important topics related to accounting and valuation for financial institutions (FIG). These topics are extremely likely to come up in interviews with these groups, and will come up on the job day in and day out.
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Table of Contents:
3:03 Part 1: Allowance for Loan Losses vs. Regulatory Capital
4:24 Part 2: Loan Loss Accounting on the Financial Statements
8:18 Part 3: Example Scenarios to Illustrate the Mechanics
16:45 Part 4: How Regulatory Capital and the Allowance for Loan Losses Are Linked
19:50 Recap and Summary
The Business Model of Commercial Banks
Banks collect money from customers (deposits), and then lend I to people who need to borrow money (loans).
They *expect* to lose something on these loans because some people and companies default and become unable to pay back their loans.
But there are two categories: *expected losses* and * unexpected losses*.
The Allowance for Loan Losses corresponds to *expected losses*, while Regulatory Capital corresponds to *unexpected losses*.
Loan Loss Accounting on the Three Financial Statements
Balance Sheet: The Allowance is a contra-asset that’s netted against Gross Loans to calculate Net Loans.
Additions: The Provision for Credit Losses will increase this reserve, making the contra-asset more negative. This Provision represents the *additional* amount, above and beyond the existing Allowance, that the bank expects to lose.
Subtractions: Net Charge-Offs (actual defaults) will reduce this Allowance, making the contra-asset less negative.
Income Statement: The Provision for Credit Losses is an expense that reduces Pre-Tax Income and Net Income, but Net Charge-Offs do not appear on the IS… not directly, anyway.
Cash Flow Statement: The Provision for CLs is a non-cash add-back; you also record Loan Additions here. Just as with the Income Statement, Net Charge-Offs do NOT show up here.
Loan Loss Accounting, Illustrated in Different Scenarios
Scenario #1: The Bank expects to lose an ADDITIONAL $10 on its Loans
It simply records $10 for the Provision for Credit Losses. Gross Loans stays the same, but the Allowance becomes $10 more negative, and Net Loans declines by $10 as a result.
Scenario #2: Bank adds $100 in Loans, and expects to lose $5 on them
It records $5 for the Provision for Credit Losses. Gross Loans increases by $100, the Allowance becomes $5 more negative, and the Net Loans figure increases by $95.
Scenario #3: Now the bank actually loses $5 and records the charge-off
The Gross Loans figure declines by $5 and the Allowance for Loan Losses becomes $5 more positive. Those changes cancel each other out, and so the Net Loans figure stays the same. There’s no Income Statement impact.
Scenario #4: …but now, there’s a recovery of $2! Due to collateral, or the borrowers suddenly repaying some of the loan
Now, the Gross Loans figure increases by $2, but the Allowance also becomes $2 more negative – so the changes cancel each other out once again, and Net Loans stays the same. There’s no Income Statement impact.
Scenario #5: The Allowance is $10, but there’s a Gross Charge-Off of $20 – what happens? How can this possibly work?
In this case, the bank simply has to *increase* its Allowance for Loan Losses to cover this unexpected loss. So the bank might set aside, say, an additional $20, and therefore record a $20 Provision for Credit Losses, which results in a higher Allowance to cover this loss.
The Net Loans figure ends up declining because the Gross Loans figure will fall and the Allowance will eventually return to its original level.
How Regulatory Capital and the Allowance for Loan Losses Are Linked
So how exactly does Regulatory Capital (mostly Common Equity or Equity) “absorb” losses?
Because when an unexpected loss occurs, banks have to increase their Allowance for Loan Losses.
They do this by increasing the Provision for CLs, which reduces Net Income since it appears on the Income Statement.
That reduced Net Income, in turn, reduces Shareholders’ Equity.
So Regulatory Capital “absorbs losses” by ensuring that Equity stays above a certain level, even if Net Income falls… since a dramatic drop in Net Income would come, most likely, from unexpected losses.
The capital ratios fall when this happens, as they should.