Loan losses

What Are Loan Losses?

Loan losses represent the portion of a loan or credit portfolio that a lender, typically a financial institution, expects to be uncollectible. These anticipated or actual losses arise when borrowers fail to repay their debts according to the agreed-upon terms, often due to default, bankruptcy, or renegotiation of loan terms. In the realm of financial accounting, accounting for loan losses is crucial for banks and other lenders to accurately reflect their financial health and manage credit risk. These losses are an essential consideration for assessing a bank's asset quality and overall financial stability, impacting both the income statement as an expense and the balance sheet as a reduction in the value of outstanding loans.

History and Origin

The accounting for loan losses has evolved significantly, particularly in response to major financial crises. Historically, banks recognized loan losses primarily using an "incurred loss" model. Under this approach, a loss was only recognized when it was probable that a loss event had occurred. Critics argued that this method led to a "too little, too late" problem, where losses were acknowledged only after a downturn was well underway, exacerbating economic cycles and potentially contributing to a credit crunch.³⁰, ³¹

The shortcomings of the incurred loss model became particularly evident during the 2008 global financial crisis. During this period, large U.S. and European banks experienced over $1 trillion in losses from toxic assets and bad loans, leading to widespread solvency concerns and a significant tightening of credit markets. In the wake of the crisis, global policymakers and accounting standard-setters, including the Financial Stability Forum (now the Financial Stability Board), called for more forward-looking provisioning for loan losses.²⁸, ²⁹

This global push culminated in significant reforms. In the United States, the Financial Accounting Standards Board (FASB) responded by issuing Accounting Standards Update (ASU) 2016-13, Topic 326, which introduced the Current Expected Credit Loss (CECL) methodology.²⁶, ²⁷ Effective for large public companies in January 2020 and other entities later, CECL requires entities to estimate and provision for expected credit losses over the entire contractual life of financial assets, rather than waiting for an actual loss event to occur.²³, ²⁴, ²⁵

Key Takeaways

• Loan losses represent the estimated or actual portion of a loan portfolio that will not be repaid.
• They are recognized by financial institutions as an expense on the income statement, contributing to an allowance for uncollectible amounts on the balance sheet.
• The accounting for loan losses shifted from an "incurred loss" model to the "Current Expected Credit Loss" (CECL) model after the 2008 financial crisis, mandating a more forward-looking assessment.
• Accurate assessment of loan losses is vital for a bank's financial stability, regulatory compliance, and investor confidence.
• Factors influencing loan losses include economic conditions, industry-specific risks, and the creditworthiness of individual borrowers.

Formula and Calculation

Under the Current Expected Credit Loss (CECL) model (ASC 326), there is no single prescribed formula for calculating loan losses. Instead, the standard provides flexibility, allowing financial reporting entities to use various measurement approaches based on the type of financial asset and available information.²² The objective is to estimate the net amount an entity expects to collect over the contractual life of a financial asset. This estimate considers:

• Historical Loss Experience: Past events and actual losses on financial assets with similar credit risk characteristics serve as a starting point.
• Current Conditions: Factors existing at the reporting date, such as changes in borrower risk profiles or collateral values, are incorporated.
• Reasonable and Supportable Forecasts: Future economic conditions that are expected to affect collectability over the loan's contractual term, such as unemployment rates, GDP growth, or industry outlooks, must be considered.²⁰, ²¹

The calculation generally involves:

Where:

• Probability of Default (PD): The likelihood that a borrower will fail to meet their repayment obligations.
• Loss Given Default (LGD): The percentage of the exposure that a lender is expected to lose if a default occurs, after accounting for any recoveries.
• Exposure at Default (EAD): The total amount a borrower is expected to owe at the time of default.

This estimated amount is then recorded as a "provision for loan losses" on the income statement and contributes to the allowance for credit losses (ACL) on the balance sheet.

Interpreting Loan Losses

Interpreting loan losses requires a nuanced understanding of their context. For banks, rising loan losses can signal deteriorating asset quality within their loan portfolio or a worsening economic outlook. Conversely, declining loan losses may indicate improving credit conditions or a de-risking of the loan book.

Analysts and investors often compare a bank's loan losses to its total loan balances or its net interest income to gauge the impact on profitability. High loan losses directly reduce a bank's earnings and can impair its regulatory capital. Regulators closely monitor loan loss trends as an indicator of systemic risk and the health of the banking sector. The Federal Reserve, for instance, in its supervision reports, examines how banks are boosting their allowance for credit losses in anticipation of potential deterioration in asset quality.¹⁸, ¹⁹ Similarly, the Federal Deposit Insurance Corporation (FDIC) includes data on loan loss provisions and asset quality in its "Quarterly Banking Profile," providing a comprehensive summary of the aggregate financial condition of U.S. insured institutions.¹⁷

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution. At the end of Q3, Horizon Bank's lending department reviews its various loan portfolios. Their commercial real estate (CRE) portfolio, totaling $500 million, has been flagged for increased risk due to rising vacancies in office buildings in their lending region.

Based on historical data, current market conditions, and their forward-looking economic forecasts, Horizon Bank's credit risk model estimates that 1.5% of its CRE loans, or $7.5 million, are expected to become uncollectible over the remaining life of the loans.

To account for this, Horizon Bank makes a "provision for loan losses" of $7.5 million on its income statement for Q3. This provision reduces their reported earnings for the quarter. Simultaneously, the bank increases its allowance for credit losses (ACL) on its balance sheet by the same $7.5 million. This allowance acts as a contra-asset account, reducing the net carrying value of the CRE loans on the balance sheet to reflect the expected uncollectible portion. If, in a later quarter, $2 million of these anticipated losses materialize as actual write-offs (charge-offs), the ACL would be reduced by $2 million, and the specific loans would be removed from the bank's books.

Practical Applications

Loan losses are a critical metric for various stakeholders in the financial system:

• Bank Management: Banks use robust models to estimate loan losses for internal budgeting, capital planning, and risk management. This helps them determine appropriate pricing for loans, set aside sufficient regulatory capital, and identify concentrations of credit risk within their loan portfolio.
• Investors and Analysts: Investors analyze loan loss trends to assess a bank's profitability, future earnings potential, and resilience to economic downturns. Elevated or rapidly increasing loan losses can signal financial distress. For example, during the 2008 financial crisis and the COVID-19 pandemic in 2020, loan loss provisions spiked significantly as banks prepared for a surge in defaults.¹⁶
• Regulators and Supervisors: Agencies like the Federal Reserve and the FDIC closely monitor loan loss levels across the banking system. They use this data to evaluate the overall health and financial stability of individual banks and the financial system as a whole. The FDIC's "Quarterly Banking Profile" provides detailed insights into loan performance, including delinquency and charge-off rates, helping regulators identify emerging risks.¹⁵ This oversight is essential for maintaining confidence in the banking sector and preventing systemic failures.
• Auditors: External auditors meticulously review a bank's loan loss estimates to ensure compliance with Generally Accepted Accounting Principles (GAAP) and to provide assurance to investors that the financial statements present a true and fair view.

Limitations and Criticisms

Despite the shift to the Current Expected Credit Loss (CECL) model, the accounting for loan losses still faces limitations and criticisms. A primary concern is the potential for increased "procyclicality," meaning that CECL might amplify rather than dampen economic cycles. Critics argue that because CECL requires forward-looking estimates, banks might increase loan loss provisions significantly during downturns (when forecasts are grim), which could further reduce their regulatory capital and limit their ability to lend, thus deepening a recession.¹², ¹³, ¹⁴

Conversely, during economic expansions, optimistic forecasts could lead to lower provisions, potentially encouraging excessive lending and contributing to asset bubbles. While proponents of CECL argued it would lead to more timely recognition of losses and better prepare banks, some research suggests it may indeed exacerbate lending procyclicality, particularly for newly originated loans during recessions.¹⁰, ¹¹

Another criticism revolves around the increased complexity and subjectivity introduced by CECL. Estimating expected credit losses over a loan's lifetime requires considerable judgment and reliance on complex models and economic forecasts. This can lead to increased costs for financial institutions and potentially reduce the comparability of financial statements across different banks, as they may use varying assumptions and methodologies.⁹ Additionally, the reliance on management judgment introduces a higher risk of bias in reported loan losses.⁸

Loan Losses vs. Loan Loss Reserves

While closely related, "loan losses" and "loan loss reserves" (also known as the allowance for credit losses (ACL)) represent distinct concepts in financial accounting.

Loan losses refer to the estimated or actual amount of uncollectible debt from a lender's outstanding loans. When a bank anticipates that a portion of its loans will not be repaid, it records a "provision for loan losses" as an expense on its income statement. This provision directly reduces the bank's current period earnings.⁷ It is the "flow" component, representing the expense recognized in a specific accounting period for expected or actual losses.

Loan loss reserves, or the allowance for credit losses (ACL), is a contra-asset account on a bank's balance sheet. It represents the cumulative amount of funds that a bank has set aside to cover potential loan losses. The provision for loan losses increases this reserve account. When actual loans are determined to be uncollectible and are "charged off," the loan loss reserve account is reduced.⁴, ⁵, ⁶ Therefore, the loan loss reserve is the "stock" component, a pool of money accumulated over time to absorb future or current loan losses. It acts as a buffer against defaults, ensuring that the bank can absorb potential losses without jeopardizing its capital adequacy or ability to lend.³

FAQs

Why do banks set aside money for loan losses?

Banks set aside money for loan losses to prepare for future defaults and non-payments on the loans they issue. This practice ensures that their financial statements accurately reflect their true financial condition and helps maintain financial stability by providing a buffer against unexpected credit events. It's a fundamental part of managing credit risk.

How do loan losses affect a bank's profitability?

Loan losses reduce a bank's profitability because the provision for loan losses is recognized as an expense on the income statement. This expense lowers the bank's net income and can negatively impact key performance indicators like return on assets (ROA).

What is the Current Expected Credit Loss (CECL) model?

The Current Expected Credit Loss (CECL) model is an accounting standard (ASC 326) that requires financial institutions to estimate and provision for expected credit losses over the entire contractual life of their financial assets. Unlike the previous "incurred loss" model, CECL incorporates historical data, current conditions, and reasonable forward-looking forecasts to determine the allowance for credit losses (ACL) at the time a loan is originated or purchased.¹, ²