Definition of loan-loss provision

The money a bank sets aside to cover potential losses on loans. [1]

For instance, a bank gives a out a loan of €100, and the interest rate is five per cent, so the income is €5 every year.  Let us assume that the bank will get its money back in 12 months.

If after six months the bank thinks that the borrower will default, then it can create a provision for the estimated loss.

Let us assume that €40 is set aside as a provision as the bank is expecting to get €60 back, so it would increase its losses by €40.  If the bank recovers €65, then a profit is made.

Example

Imagine you are the accountant of a bank which has provided a loan of €1m to an employee of a company so that s/he can buy a house of an estimated value of €1 m based on recent transactions.  The house is used as collateral for the loan.

After several months without any transactions, the owner of a similar house loses his job. Desperate to secure cash, he puts his property up for sale.  A buyer pays € 0.5 m. for this house.

The question you face as an accountant is, what is the economic value of the first house, €1 m, €0.5m or something in the middle? If you say €0.5m, then you may need to make a provision of €0.5m.

This is how accounting is related to judgments on provision.  The key question, is whether this transaction offers enough to go on to assess the economic price of a similar asset.  As there are no clear rules, there is plenty of room for subjective assessment.

A conservative bank may create an allowance for €0.5m, a more aggressive bank may not provide one at all. This creates uncertainty surrounding the financial health of some banks during the downturn as large and complex balance sheets make it very difficult for anyone to estimate the fair value of many loans. [2]