Loan loss provisioning

CREDIT REVIEW:
LOAN LOSS PROVISIONING
With L Hanyire(MSU) and T Zimunhu(MSU)
sunbird.luckie@gmail.com

WHAT IS LOAN LOSS
PROVISIONING?
• A loan loss provision is an expense that is reserved for
defaulted loans or credits. It is an amount set aside in
the event that the loan defaults.
• It is said to be as a “shock absorber” to offset probable
future losses (Kendra, 2001).
• loan loss provision is a non-cash expense in
anticipation of possible loss in value of loan outstanding
both in principal and interest.

WHAT IS LOAN LOSS
PROVISIONING?
• A loan loss provision is the amount expensed
on the income & expenditure statement
deducted before the net income. The loan loss
provision represents the amount of principal
that is not expected to be recovered from
debtors. It is a negative asset on the balance
sheet.

WHY IS IT IMPORTANT ?
Since Loan loss provisions/reserves is a cost of
engaging in the business of lending, it forms the
basis for establishing a bank’s capacity to absorb
losses.
LLPs are important in their own way as are an indicator of a
bank’s ability not only to manage its credit costs but also as a
way to avoid problem assets/troubled loans.
Therefore, LLPs reflect a bank’s ability to manage its funding
costs, distinct from its ability to manage other expenses.sunbird.luckie@gmail.com

SETTING LOAN PROVISIONS/RESERVES
Asset classification (through credit scoring)provides a
basis for determining an adequate level of provisions for
possible loan losses.
The process of recognizing an uncollectable loan is
called a write-off. Loan losses are written off against
loan loss reserves & are also removed from the
outstanding portfolio. It means that they decrease the
reserve & the outstanding portfolio.
Loan loss or write offs occur only as an accounting
entries meaning that loan recovery should not be
stopped until total outstanding balance is recovered.

EXCESS LOAN LOSS OVER
PROVISIONED

SETTING LOAN
PROVISIONS/RESERVES
The LLP should not be less or should not be
more compared to expected future losses
because there is an opportunity cost between
lending and provisioning.
The LLP should be maintained at a level that is
believed to be sufficient to absorb the
estimated probable losses inherent in the
bank’s loan portfolio. Hence reviews are
necessary for representation of losses on a
balance sheet date.

FACTORS TO CONSIDER WHEN
EVALUATING A LOAN PORTFOLIO
Past loss experience – the trend of the past losses is
analysed to determine the amount of allowance that
must be set aside.
Quality of management in the lending area.
Loan collection and recovery practices.
Quality of credit policies and procedures.
Loan growth.

FACTORS TO CONSIDER WHEN
EVALUATING A LOAN PORTFOLIO
 Financial conditions of the borrower – the performance of the borrower
may fluctuate depending with the industry or other economic variables
such as inflation, disasters, droughts or other business drawbacks when
operating. Analysing the borrower’s condition gives a good overview of
estimating the borrower’s ability to repay the loan.
General economic trends.
Borrower’s industry e.g. Agriculture, Mining, Tourism
State of the economy e.g. when a country is in a recession the level of
problem loans might increase.

LOAN LOSS PROVISION
CALCULATION
What is important is to understand the basis of
making & calculating loan loss provisions.
For calculating loan loss provision for the
current period it is necessary to deduct current
loan loss reserve. Thus;
 LLP for the Current Period = LLP
Calculated as of day– Previous LLP

LOAN LOSS PROVISION RATE
Establishment of rate on loan
loss provisioning (% of loan
outstanding that need to be kept
aside)is determined by the
overdue tenor/maturity group,
based on risk attached to each
class.

LOAN LOSS PROVISION RATE:
(EXAMPLE)
Class Provision Percentage
On time loans 0%
Loans overdue for < 30 days 5%
Loans overdue between 31-60
days
10%
days
25%
days
50%
Loans overdue between 181-
365 days
75%
Loans overdue for above 365 100%

LOAN LOSS PROVISION
RATE: (EXAMPLE)
• After assigning provision rate for each class,
multiply the volume of loan outstanding in each
class with corresponding provisioning rate. This
will give the amount to be provisioned under each
risk class.
• Now add up all provision amounts under each age
class to get the overall provision amount .To get
the overall provision rate, divide the overall
provision amount by total outstanding portfolio.

LOAN LOSS PROVISION RATE: (EXAMPLE)
Class Outstanding
loan Portfolio
Provision Rate Loan loss
Provision
On time loans 500000 0% 0
Loans overdue for < 30 days 200000 5% 10000
Loans overdue between 31-60 days 100000 10% 10000
Loans overdue for above 365 days 10000 100% 10000
Total 1410000 72500
Provision Rate =72500/1410000=5.14%

LOAN LOSS PROVISION RATE:
(EXAMPLE)
• Thus, total Loan loss Provision will be $72
500.
• This loan loss provision indicates the total
provision required according to the aging
analysis for the outstanding portfolio as of
reporting date. In other words, this amount
should be the loan reserve.

LOAN LOSS PROVISION
COVERAGE RATIO
• This ratio shows the ability of the institution to
absorb any loan losses that maybe
encountered.
• The high the LLPC ratio, the greater the ability
of the institution to absorb the losses it will
face.
• LLPC= Pre tax income + loan loss Provision
Net off Charges
Where Net off Charges are the actual losses

LOAN LOSS RESERVES AND
REGULATORY CAPITAL
Loan loss reserves and supervisory capital requirements
based upon the level of risk in a bank’s financial positions
are directly linked.
In particular, for regulatory capital, loan loss reserves are
intended to cover losses that are expected to occur based
upon historical experience adjusted for changes in the
economic environment. Losses above this level are
“unexpected” and are covered by capital.

LOAN LOSS PROVISION AND
REGULATORY CAPITAL
Both the Basel I and Basel II capital regimes allow
loan loss reserves to be included in regulatory
capital, up to certain limits.
According to the Federal Administrator of National
Banks, the amount for LLP is about 2%-2.5% of the
outstanding loan receivables, depending on the
quality of the loans in the portfolio.
To encourage more forward-looking provisioning
methodologies (ie making provisions earlier in the
credit cycle) more robust levels of reserves are
encouraged.

CORPORATE VIEW ON L.L.P BY
BIS:
• The board and senior management are
responsible for understanding and determining
the nature and level of risk being taken by the
bank and how these risks relate to the level of
general and specific allowances.
• A bank’s board of directors should approve the
loan loss provision policies and procedures to
recognize, measure, monitor and control loan
impairment. The board should be informed
regularly of the loan loss provision and loan
impairment.

ZIMBABWEAN SCENARIO WITH
LLP:
 Non performing loans were seen as the major common
problem that was faced by several banks post
dollarization (2009). Cases in point according to
IMF(2012) include;
 Interfin Bank Limited-
It was placed under recuperative curatorship on June 11, 2012 after a
RBZ audit which revealed that the bank was operating in an unsound
and unsafe manner involving a high level of non performing,
aggressive insider and related party loan exposures ,amongst other
things. Interfin closed with a negative core capital of $92,9 million
against the provisioned $85 million.

ZIMBABWEAN SCENARIO WITH
LLP:
• Renaissance Merchant Bank-
In June 2011, this bank had a high level of non performing
and insider loans with persistent losses. Renaissance
understated their LLP as it had provisions of around
$418 000.00 set against regulatory requirements on
provisions of around $12,5 million resulting in it being
placed under curatorship. Curatorship was lifted in
March 2012, following a cash injection by the National
Social Security Authority and acquired 84% share, and
also installed new management.

SUBPRIME CRISIS

LOAN LOSS PROVISIONS AND
CHARGE OFFS

CONCLUSION
With the cited examples in mind on loan loss provisioning hand in
hand with capital adequacy, principle 8 of Core Principles for
Effective Banking Supervision by the BIS :
“banks establish and adhere to adequate policies,
practices and procedures for evaluating the quality of
assets and the adequacy of loan loss provisions and loan
loss reserves”
Hence this must be taken heed of to avoid troubled loans and
enable supervisors to obtain a true and fair value of the

THANK YOU

Loan loss provisioning

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