What time is it?? It’s metric time!! This month we’re talking about the Provision for Loan Losses. If you have clients in the banking industry, you no doubt hear this term repeatedly – but how is it really measured and why is it meaningful? Read on….
This Month’s Metric – Provision for Loan Losses Who uses it? Primarily banks, including commercial banks, savings institutions, and credit unions. The provision for loan losses is also commonly referred to as the provision for credit losses.
How is it measured? As we do with many other financial metrics, the provision for loan losses is measured as a percentage of total income, or what’s also called revenue. This enables comparison over time and relative to competitors and industry norms. For example, a bank with $1 billion in total income and $50 million set aside in the loan loss provision will record a 5% loan loss provision as a percentage of total income ($50 ÷ $1,000).
What’s in it? It’s money that a bank or financial services firm sets aside as an allowance for uncollected loans and expected losses from delinquent loans and bad debt, which includes installment loans such as mortgages, car loans, or student loans; revolving credit balances; and leases. It’s an estimated amount based on historical statistics, the quality of the loan portfolio, and other circumstances such as market factors and the economic environment.
Why is it important? The provision for loan losses is actually a non-cash expense that banks will write to their loan loss reserve; this allows them to maintain a reserve for bad debt to which they’ll charge off the actual bad debt if and when it occurs, rather than taking it as a hit to earnings. While it’s a non-cash expense, it appears as an expense on the income statement and will impact profit margins. It’s fairly well-known that banks will tend to use the provision for loan losses as a way to manage earnings – lessening the contribution to the reserve in less profitable years and adding more than needed in years when earnings are strong.
What drives it? One of the key drivers of the provision for loan losses is the mix of loans in the portfolio and the type of borrower. Business, construction, and commercial loans require a different provision and amount in reserve than residential mortgages, auto loans, revolving debt, or student loans. Companies that specialize in making loans to riskier borrowers will tend to carry a higher loan loss provision than more traditional lenders. However, those riskier loans typically come with higher interest rates to the borrower, meaning that there’s a bit of an offset to the higher provision for loan losses in the form of income to the bank from the higher rate. Another significant factor is the economic environment; when the economy deteriorates - as it did in the 2008 to 2010 time frame due to the financial crisis - borrowers have more trouble making payments on loans and credit cards, and banks will adjust the loan loss provision to absorb the anticipated higher levels of defaults and bad debt. For example, in the case of U.S. bank Wells Fargo, the loan loss provision rose to almost 31% during the worst of the financial crisis in 2008, making it very difficult for them to manage profit margins.
However, if you were to analyze their lines of business, you’d see that their line of business that provides services to consumers and small businesses had a much higher loan loss provision in 2008 (41.3%) than other lines of business; it also fell back to historical norms at a much slower rate. The other effect is that if a bank’s reserve isn’t enough to absorb losses, they’ll have to increase provisioning, which could limit lending and further prolong recovery. Additionally, regulators play a big role in dictating the level of a bank’s reserves; Basel III regulations that are currently being phased in are expected to make loan loss provisioning more forward-looking than it has been in the past.
What's the Goal?Usually, the lower the provision for loan losses, the better; however, as is the case with many other metrics, it’s always a balancing act between risk and return. This is typically done through better management of risk – enterprise, operational, and financial – and compliance, audit, and fraud.
So HOW do you translate this into conversation about value with your clients? We’ll follow this up on Thursday with The KPI Connection, connecting this month’s metric to key business processes and ultimately measurable impact on your clients’ business, so check back for that.
For a deeper discussion on Financial Metrics, Operational KPIs and how they drive sales, see our previous blog post at http://www.finlistics.com/blog.
This blog was originally posted on June 10, 2014.