Introduction:
A Loan provisioning is an expense that reserved for default/bad performing loans/credits. It is an amount set aside in the event of that loans defaults. or It is an expense set aside as an allowance for bad loans or credits. Loan loss provision is also known as the "Valuation Allowance" or "Valuation Reserve".
In any group of loans, banks expects there can be some loans that do not perform as expected. These loans may be delinquent on their repaymeStants or default of the entire loan. This can create a loss to the bank on expected income. Therefore, banks can set aside a portion of the expected repayments from all loans in its portfolio to cover all or a portion of the loss. In the event of loss or in critical situations banks can use the amount set aside to cover the loss instead of taking a loss in its cash flow. This loan loss reserve acts as an internal insurance fund.
Example:
Let's assume MFI/Bank ABC has made $ 100,000 of loans to different individuals and companies. Though ABC MFI/Bank works very hard to ensure that it lends to only those people who can repay the total amount on time, naturally some may default, some may fall behind and for some ABC MFI/Bank has to renegotiate.
MFI/Bank ABC estimates that 1% of loans amount that is $ 1000 will never comeback. So this $ 1000 is ABC MFI's/Bank's loan loss reserve and it records this amount as negative number on the asset portion of its balance sheet.If and when MFI/Bank ABC decides to write all or a portion of a loan off, it will remove the loan from its asset balance and also remove the amount of the write-off from the loan loss reserve. The amount deducted from the loan loss reserve may be tax deductible for MFI/Bank ABC.
How to define a Loan Provision:
Any loan can be categorized into 4.
- Standard Loan
- Sub-Standard Loan
- Doubtful Loan
- Loss Loan