Loan Loss Provision

Banks know that some borrowers will default. Rather than waiting until losses actually happen, they set aside money in advance. The amount charged to the income statement in a period is the loan loss provision. It builds up the loan loss reserve on the balance sheet.

Modern accounting standards require banks to estimate expected credit losses, considering past experience, current conditions and forecasts of the economy. When the economic outlook worsens, banks usually increase provisions, even before many borrowers stop paying.

For example, if a bank expects losses on its loans to rise because of an approaching recession, it might increase its quarterly provision from 20 million to 60 million. That extra 40 million reduces its profit for the quarter.

Loan loss provisions are one of the biggest drivers of bank profits through the economic cycle. In good times, low provisions boost profits. In recessions, rising provisions can turn profits into losses. Investors watch them as a signal of how management sees the risks in the bank's loan book.