Adjusted average provision

What Is Adjusted Average Provision?

Adjusted Average Provision is a concept integral to how financial institutions account for potential credit losses on their loan portfolios. It refers to the calculation of the provision for credit losses that incorporates adjustments to historical average loss rates to reflect current conditions and forward-looking information. This falls under the broader category of financial accounting and credit risk management. Its purpose is to ensure that a bank's financial statements accurately represent the expected losses from its lending activities. The calculation of the Adjusted Average Provision is a critical component in determining the allowance for credit losses which appears on a bank's balance sheet.

History and Origin

The evolution of how financial institutions account for potential loan losses has significantly shifted over time, moving from an "incurred loss" model to a more forward-looking "expected loss" model. Historically, banks would recognize losses only when evidence of a loss was apparent, such as a loan becoming past due or a borrower entering bankruptcy. This approach was largely governed by standards like the Allowance for Loan and Lease Losses (ALLL) in the United States. The Office of the Comptroller of the Currency (OCC) has provided guidance on the ALLL for decades, emphasizing the need for an adequate level to absorb expected loan losses based on management's knowledge of the loan portfolio.¹⁰

However, the 2008 financial crisis exposed weaknesses in this incurred loss methodology, as it often led to delayed recognition of credit losses, meaning allowances were "too little, too late".⁹ In response, accounting standard-setters aimed to improve the timeliness of loss recognition. In the U.S., the Financial Accounting Standards Board (FASB) introduced the Current Expected Credit Losses (CECL) methodology in June 2016 through Accounting Standards Update (ASU) No. 2016-13, Topic 326.⁸ CECL requires financial institutions to recognize lifetime expected credit losses for a wide range of financial assets, incorporating past events, current conditions, and reasonable and supportable forecasts.⁷ This significant shift mandated a more proactive and predictive approach to provisioning, leading to the development of calculations like the "Adjusted Average Provision" to meet these new forward-looking requirements. Internationally, the International Accounting Standards Board (IASB) issued International Financial Reporting Standard 9 (IFRS 9) in July 2014, which similarly introduced an "expected credit loss" (ECL) framework.⁶

Key Takeaways

• The Adjusted Average Provision is a key component of the Current Expected Credit Losses (CECL) methodology, requiring forward-looking estimates of loan losses.
• It reflects a shift from the older "incurred loss" model to a more proactive, "expected loss" approach in financial accounting.
• The calculation incorporates historical loss data, current economic conditions, and reasonable and supportable forecasts to estimate future credit losses.
• Its primary goal is to provide a more accurate and timely representation of a financial institution's true financial health and potential risks.
• Effective implementation requires robust data, sophisticated modeling, and significant management judgment.

Formula and Calculation

The Adjusted Average Provision, within the framework of modern accounting standards like CECL, does not have a single, universally prescribed formula. Instead, it represents an approach to calculating the allowance for credit losses that goes beyond simple historical averages. The core of its calculation involves:

• Historical Loss Experience: This serves as the baseline, often derived from a financial institution's past data on actual losses for similar loan portfolios. This historical average provides an initial estimate of potential future losses.
• Current Conditions Adjustments: This involves modifying the historical loss rates to reflect present economic realities, industry trends, and specific characteristics of the existing loan portfolio. Factors such as unemployment rates, interest rate changes, and commodity prices can influence these adjustments.
• Reasonable and Supportable Forecasts: This is the "forward-looking" aspect, requiring management to incorporate expectations about future economic conditions. These forecasts, while inherently uncertain, must be reasonable and supportable, meaning they are based on available information without undue cost or effort. This is a significant departure from the older "incurred loss" model, which did not explicitly consider future economic outlook.

The result of these considerations is an estimated expected credit loss over the lifetime of the financial assets, which then informs the Adjusted Average Provision.

Interpreting the Adjusted Average Provision

Interpreting the Adjusted Average Provision involves understanding its implications for a financial institution's financial statements and overall financial health. A higher Adjusted Average Provision typically indicates that the institution anticipates greater future credit risk within its loan portfolio. Conversely, a lower provision suggests an expectation of fewer loan losses. This figure directly impacts a bank's net income because the provision for credit losses is expensed, thereby reducing reported earnings. It also affects the allowance for credit losses on the balance sheet, acting as a contra-asset account that reduces the net carrying value of loans.

Analysts and regulators scrutinize the Adjusted Average Provision to assess the prudence of a bank's credit risk management practices and its preparedness for potential economic downturns. It is not just about the absolute number, but also the methodology and assumptions underpinning it, reflecting management's judgment about future collectability.

Hypothetical Example

Imagine "LendWell Bank" is calculating its Adjusted Average Provision for its consumer loan portfolio at the end of the fiscal year.

1. Historical Average: LendWell examines its data for the past 10 years and finds that its consumer loans have, on average, experienced a 0.5% loss rate annually. This is their historical average provision.
2. Current Conditions: The local economy is currently stable, but there has been a slight uptick in unemployment in a key industry in the region where many of LendWell's borrowers work. This suggests a potential increase in credit risk.
3. Forward-Looking Adjustment: Based on economic forecasts, LendWell's economists predict a mild recession in the next 12-18 months, which could lead to higher defaults.
4. Adjustment Calculation: Instead of simply applying the 0.5% historical rate, LendWell's management decides to adjust it upward. They estimate that the combination of current conditions and future forecasts warrants an additional 0.2% increase in their expected loss rate for the upcoming period.
5. Adjusted Average Provision: LendWell calculates its Adjusted Average Provision as 0.5% (historical) + 0.2% (adjustment) = 0.7%. If their consumer loan portfolio totals $500 million, the provision for credit losses for the period would be ( $500 \text{ million} \times 0.007 = $3.5 \text{ million} ). This expected credit loss amount would be recorded as an expense on their income statement and added to their allowance for credit losses on the balance sheet.

Practical Applications

The Adjusted Average Provision is a cornerstone of modern financial accounting for banks and other lenders, predominantly under the CECL standard in the U.S. and IFRS 9 internationally. Its practical applications span several critical areas:

• Financial Reporting: It directly influences the financial statements of institutions, particularly the income statement (as an expense) and the balance sheet (as part of the allowance for credit losses). This provides stakeholders with a more transparent view of potential future losses.⁵
• Regulatory Capital: Regulators, such as the Federal Reserve, closely monitor these provisions as they impact a bank's regulatory capital levels. Adequate provisioning ensures that institutions maintain sufficient capital to absorb potential losses, thereby promoting financial stability. The CECL standard requires institutions to recognize lifetime expected credit losses for a wide range of financial assets.⁴
• Risk Management: The process of calculating the Adjusted Average Provision compels financial institutions to engage in robust credit risk management, including sophisticated data analysis, scenario planning, and economic forecasting. It helps banks to proactively identify and manage risks within their loan portfolio.
• Investor Analysis: Investors use the provision for credit losses, informed by the Adjusted Average Provision, to evaluate a bank's asset quality, management's prudence, and potential future earnings per share. Earnings calls often discuss how provisioning impacts results, with analysts inquiring about the underlying economic factors and portfolio performance.³,²

Limitations and Criticisms

While the Adjusted Average Provision, particularly within the CECL framework, aims to improve the timeliness of loss recognition, it is not without limitations and criticisms. One significant challenge lies in the inherent subjectivity of forecasting future economic conditions. Critics argue that requiring banks to predict economic cycles can be difficult and may even introduce procyclicality, potentially leading to increased provisions during downturns when lending is most needed, and lower provisions during upturns. The American Bankers Association (ABA) has noted the difficulty experts face in accurately forecasting economic turns, highlighting concerns about the reliability of such predictions.

Another critique stems from the operational complexity and cost associated with implementing the models required for calculating the Adjusted Average Provision. Smaller financial institutions, in particular, may face significant burdens in gathering the necessary data, developing sophisticated models, and obtaining the expertise required for accurate expected credit loss estimations.¹ Furthermore, some argue that while CECL forces banks to recognize future losses immediately, it doesn't allow for the immediate recognition of higher future interest earnings that banks receive as compensation for risk, potentially distorting the full financial picture. The extensive judgment involved in adjusting historical data for current and future conditions can also lead to inconsistencies across institutions or make comparisons challenging, despite efforts by bodies like the Financial Accounting Standards Board to provide guidance. This means that while the intent is to enhance transparency, the complexity can sometimes obscure the underlying assumptions.

Adjusted Average Provision vs. Allowance for Loan and Lease Losses (ALLL)

The Adjusted Average Provision is a concept that directly relates to the methodology used to calculate the allowance for credit losses under current accounting standards like CECL. The Allowance for Loan and Lease Losses (ALLL) was the preceding accounting standard in the United States, based on an "incurred loss" model.

The key distinction lies in their forward-looking nature. Under ALLL, provisions for losses were recognized only when a loss was deemed "probable" and "incurred," meaning there was objective evidence that a loss event had already occurred. This often resulted in delayed recognition of losses on financial statements. In contrast, the Adjusted Average Provision, as part of the CECL framework, requires institutions to estimate and provide for expected credit losses over the entire lifetime of the financial asset from its origination. This necessitates proactive adjustments to historical loss averages based on current economic conditions and reasonable, supportable forecasts. Thus, while both ultimately contribute to reserves for potential loan defaults, the Adjusted Average Provision embodies a significantly more forward-looking and comprehensive approach to credit risk assessment than its predecessor.

FAQs

Q: What is the main goal of the Adjusted Average Provision?
A: The main goal is to ensure that a financial institution's financial statements reflect a more timely and accurate estimate of potential future losses from its loans, based on current conditions and future economic expectations, not just past events.

Q: How does it differ from older methods of calculating loan losses?
A: Older methods, like the Allowance for Loan and Lease Losses (ALLL), typically recognized losses only after they had already been "incurred" or when there was objective evidence of a loss. The Adjusted Average Provision, under newer standards like CECL, requires estimating expected credit losses over the lifetime of the loan, incorporating forward-looking information from the start.

Q: Why is forecasting important for the Adjusted Average Provision?
A: Forecasting is crucial because it allows banks to adjust their historical loss averages for anticipated changes in the economy or specific industry conditions. This proactive approach helps in setting a more appropriate allowance for credit losses and provides a more realistic view of the institution's credit risk.

Q: Does the Adjusted Average Provision affect a bank's profits?
A: Yes, the amount recognized as the Adjusted Average Provision directly impacts a bank's reported net income. It is recorded as an expense, reducing the bank's profitability for the period.