A loan loss reserve is an accounting method used by banks to reflect the risk of potential losses from unpaid loans. The reserve is listed as an asset on balance sheets and is adjusted through charge-offs, recovered loans, provisions for credit losses, and adjustments based on the bank’s loan portfolio.
A loan loss reserve is an accounting method used to reflect the risk that not all loans made by a bank will be repaid. In each accounting period, a bank will list a certain amount, known as an allowance for credit losses, designed to reflect these potential losses as a notional expense. The relevant amount can be listed as an asset on balance sheets. This loan-loss reserve ensures that the bank has enough money on hand to cover defaults.
Although contributions to a reserve for credit losses are listed on the bank’s income statement, the contributions are not an actual cash expense. Instead, they simply reflect the necessary adjustments to the numbers to make sure the right money is set aside. Because the money is listed as an expense and as an addition to assets, the bank will act as if it had spent the money. Therefore, the money remains intact in the bank until it is needed.
Once a bank has established a loan loss reserve, there are four ways you can change the amount of the reserve. One is charge-offs, which occur when a bank stops trying to collect on an outstanding loan. This loss is counted as an expense on the income statement, and is then also deducted from the reserve figure on the balance sheet.
Another change occurs in the event that a loan that has been paid off in this way is actually recovered. This is relatively rare. If it happens, the reserve figure is increased accordingly.
The third change comes at the end of the accounting period. The bank will generally include a provision for credit losses designed to return the reserve for credit losses to its anticipated level. The amount indicated will be the total amount paid off during the accounting period, less previously paid off loans that have been recovered.
The fourth change is any adjustment the bank makes to the loan loss reserve to reflect its loan portfolio. The amount is based on a percentage of the outstanding loans, so the credit loss reserve will typically increase as the total loan amount increases, although the percentage used may change depending on how risky the bank believes overall. Therefore, it is technically possible for a bank to increase the total value of its loans while reducing the size of its loan loss reserve, or vice versa.
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