Loan Loss Provision
Categories: Credit
Banks hope they get paid back the full amount of every loan. Every deal starts with the best of intentions. The bank has policies to weed out deadbeats, and does its best due diligence to make sure every deal has a good chance of paying off.
But...stuff happens. Businesses fail. People declare bankruptcy. Borrowers run off to Guatamala with their yoga instructors.
The bank, therefore, has to be prepared to suffer some defaults. Despite their best intentions, bank managers know that some percentage of the loans they issue will go bad.
The loan loss provision takes this into account. It's like a pile of money set aside for those loans that default. Like a rainy day fund, it's in place to cover the potential loan losses that occur. To calculate what it needs to set aside, a bank will look at previous default patterns and apply that to the loans it has outstanding.
In the same way that life insurance companies can guess death rates in a population, the bank will determine the likely rate of defaults in its loan portfolio. From there, it can set the appropriate loan loss provision.