Definition:

Loan Loss Provision is an expense set aside by banks and financial institutions to cover potential losses from defaulted loans. It acts as a buffer to protect the institution's financial health against bad debts.

Examples

A bank estimates that 2% of its loan portfolio might default. If the total loan portfolio is $100 million, the bank would set aside $2 million as a loan loss provision. Another example is during an economic downturn, a bank might increase its loan loss provisions in anticipation of higher default rates.

Formula:

Loan Loss Provision = Expected Default Rate x Total Loan Portfolio

How to use the metric:

Financial analysts and bank managers use the loan loss provision to assess the risk level of a bank's loan portfolio. It helps in understanding the bank's preparedness for potential loan defaults and is a critical component in evaluating the bank's financial stability.

Limitations:

Loan loss provisions are based on estimates and assumptions, which can be inaccurate. If the provision is too high, it can unnecessarily reduce profits. Conversely, if it's too low, it may not adequately cover actual loan losses, potentially jeopardizing the bank's financial health.

Applies to:

Loan loss provisions are primarily applicable in the banking and financial services industry, where institutions extend credit and need to manage the risk of loan defaults.

Doesn't apply to:

Industries that do not engage in lending activities, such as manufacturing or retail, do not typically use loan loss provisions. These industries do not face the same credit risk exposure as financial institutions.

Summary:

Loan loss provision is a critical financial metric for banks and financial institutions, allowing them to prepare for potential loan defaults by setting aside funds. While it provides a measure of risk management, its effectiveness depends on accurate estimation and forecasting of default rates.