What is a loan loss provision?
A loan loss provision (allowance for credit losses) is an expense a lender recognises to cover expected defaults in its loan book. It reduces the net carrying amount of loans on the balance sheet and absorbs losses when borrowers fail to repay. Under IFRS 9 and US CECL, provisions are forward-looking — based on expected credit losses rather than waiting for actual default events.
How is expected credit loss (ECL) calculated?
The standard formula is ECL = EAD × PD × LGD. EAD (exposure at default) is the amount outstanding if the borrower defaults; PD (probability of default) is the likelihood of default over the measurement horizon; LGD (loss given default) is the share of the exposure lost after collateral and recoveries. Example: a $1,000,000 loan with a 2.5% PD and 45% LGD carries an ECL of $11,250.
What are the three stages of IFRS 9?
Stage 1 (performing): no significant credit deterioration — recognise 12-month ECL; interest on gross amount. Stage 2 (underperforming): significant increase in credit risk (e.g. 30+ days past due) — recognise lifetime ECL. Stage 3 (credit-impaired): objective evidence of default (typically 90+ days past due) — lifetime ECL with PD near 100%, and interest is recognised on the net amount.
What is a good provision coverage ratio?
The coverage ratio = total provisions ÷ gross loans (or ÷ non-performing loans for NPL coverage). Healthy banks typically hold total provisions of 1–3% of gross loans, and NPL coverage of 50–150% depending on collateral quality and jurisdiction. Rising coverage signals deteriorating credit expectations; falling coverage can flag under-provisioning. Regulators and auditors scrutinise both the models and the macro-economic scenarios behind these numbers.
How is a provision different from a write-off?
A provision is an estimate of losses expected across a portfolio, recognised while the loans are still on the books and still being collected. A write-off removes a specific exposure once recovery is judged unlikely, and is charged against the provision already held rather than hitting profit again. So provisions are forward-looking and reversible if conditions improve, while write-offs are the recognition of a particular failure. A bank with rising provisions is signalling expected deterioration; one with rising write-offs is realising losses it already anticipated.
Why do provisions swing so sharply from year to year?
Because expected credit loss under IFRS 9 and CECL is forward-looking and rests on macroeconomic scenarios. When the outlook deteriorates, lifetime losses must be recognised immediately on exposures that have not yet missed a payment, so charges can jump well before any actual default. When the outlook improves, provisions can be released back into profit. This makes reported earnings more volatile and somewhat procyclical, and it is why comparing provision levels between banks means checking the scenario assumptions behind them.