Loan Loss Provision

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Context:

• The Reserve Bank of India (RBI) published a discussion paper on “loan loss provision”.

Background:

• The global financial crisis (GFC) has drawn attention to the pro-cyclicality in banks’ operations. In the aftermath of the GFC, there has been a renewed interest in the accounting practices followed by banks.
• One such area is the loan loss provisions, the amount which banks set aside to offset future loan losses on outstanding loans.

What is Loan-Loss provision?

• The RBI defines a loan loss provision as an expense that banks set aside for defaulted loans.
• Banks set aside a portion of the expected loan repayments from all loans in their portfolio to cover the losses either completely or partially.
• In the event of a loss, instead of taking a loss in its cash flows, the bank can use its loan loss reserves to cover the loss.
• Since the bank does not expect all loans to become impaired, there is usually enough in the loan loss reserves to cover the full loss for any one or a small number of loans when needed.
• An increase in the balance of reserves is called loan loss provision. The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.

Description:

• During an upswing the financial conditions of firms improve with reduced likelihood of loan defaults, whereas downswings have the opposite effect. However, apparently favourable conditions during the boom period can lead to an excessive increase in credit growth and a less critical assessment of creditworthiness of borrowers as loan defaults are low.
• Hence, loan loss provisions also decline as they are generally backward-looking in nature. This leads to build-up of risk and financial imbalances during the upswing that increases the likelihood of economic contraction in future. On the other hand, during downswing phase, when credit growth is low and loan defaults increase, loan loss provisioning also rises.
• As provisions have to be carved out of the bank profits, it negatively affects bank capital during these bad times which in turn leads to lower credit growth, thus reinforcing the downturn. Thus a pro-cyclicality is witnessed in loan loss provisioning, however, it is negatively related to growth cycles and credit cycles. Recognising this cyclical pattern, an efficient loan loss provision management entails that banks should build up loan loss reserves during good times, to provide a cushion when the economy is experiencing a cyclical downturn.
• In the aftermath of the GFC, the merits of having forward looking provisioning practices have been recognised. Availability of adequate loan loss provisioning helps in buttressing the dent which the mounting losses may make on banks’ earnings and capital.

Significance of Loan Loss Provisions:

• It is generally assumed that unexpected losses by banks would be covered by bank capital, whereas expected losses would be covered by loan loss provisions.
• In reality, however, the distinction may be blurred. Whereas specific provisions are linked to impaired loans, general provisions are often based on a broad assessment of possible future losses on the entire portfolio.
• Besides, when loan loss reserves and future margin income are inadequate to cover expected losses due to downturn or some other issues, these losses eat into the capital reserves.
• Prudential reserve management practices result in higher provisioning ahead of a crisis so that banks build up reserves prior to actual losses.
• This results in income smoothing as it reduces the negative impact of asset volatility on bank capital. It may also lead to a reduction in pro-cyclicality in banks’ lending operations since loan loss provisioning potentially creates a feedback mechanism between the financial and real sectors of the economy.

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