loan loss provisioning
TRANSCRIPT
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 [email protected]
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 [email protected]
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 PORTFOLIOPast 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. [email protected]
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 [email protected]
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 PercentageOn time loans 0%Loans overdue for < 30 days 5%Loans overdue between 31-60 days
10%
Loans overdue between 61-90 days
25%
Loans overdue between 91-180 days
50%
Loans overdue between 181-365 days
75%
Loans overdue for above 365 days
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 between 61-90 days 50000 25% 12500
Loans overdue between 91-180 days 30000 50% 15000
Loans overdue between 181-365 days 20000 75% 15000
Loans overdue for above 365 days 10000 100% 10000
Total 1410000 72500
Provision Rate =72500/1410000=5.14%[email protected]
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 ChargesWhere Net off Charges are the actual [email protected]
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 [email protected]
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.
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 financial condition of the bank and the profitability of its business.
