Management of loan loss reserves by commercial bankers--part 1

Journal of Bank Cost & Management Accounting, The, 1996 by Joyce, William B

The loan loss reserve account represents loan losses both from loans the bank can currently identify as bad loans but has not yet written off and from some apparently good loans that will later prove to be uncollectible. Banks make additions to the allowance account in three circumstances: first, when it becomes apparent that current reserves understate the expected losses of a loan or group of loans; two, when an unanticipated charge-off has occurred for which the bank did not set aside adequate reserves; or three, the amount of bad loans in the bank's portfolio has increased.

The amount actually charged against earnings ($500 below) each pedod is called the provision for loan losses, and it is equivalent to the increase (change) in loan loss reserve (net of charge-offs, write-downs and recoveries) as shown below:

Loan Loss Reserves, beginning of 1994 $ 1,300 Less: Charge-Offs & Write-Downs During 1994 Plus: Recoveries During 1994 250 Plus: Loan Loss Provisions, 1994 500 Loan Loss Reserves, end of 1994 $ 2,000 The loan loss reserve account is established and maintained by periodic charges against earnings. The appropriate journal entry for year-end 1994 would be as follows: Loan Loss Provision (expense) $500 Loan Loss Reserve (contra-asset) $500

The loan loss provision is reflected in the income statement as an expense, as presented below (a complete illustrative income statement is available in appendix 2): Net Interest Income $ 7,500 Less Loan Loss Provision 500 Net Interest Income After Provision $ 7,000

Determining the Loan Loss Reserve

Various methods or techniques are available for banks to employ in determining the appropriate level of loan loss reserves. The most common and theoretically best method is the "allowance method." It involves determining the appropriate size of the allowance or loan loss reserve. The appropriate loan loss provision for the income statement is then determined by the required change in the loan loss reserve.

"Loan analysis" represents the primary technique in determining the loan loss reserves. Regulators, in their efforts to promote more accurate reporting of banks' income and net worth, have been encouraging banks to use careful loan analysis in the determination of reserve levels since the mid-1 980's. When a bank sets its loan loss reserves equal to its estimate (based on analysis of each loan or loan category) of the loss inherent in the loan portfolio, it determines its reserves using the loan analysis method. While there is considerable variation among banks in the specifics of the analysis, the basic procedures are similar.

Banks generally divide loans into categories and then apply separate and distinct analyses to each category to estimate the reserves needed for each category. These reserve estimates are summed across categories to arrive at a total for the loan portfolio, as shown next. Loan Category Principal Estimated Amount Reserve Large Classified Loans Potentially Weak $ 400 $ 20 Substandard 600 60 Doubtful 5,000 1,000 Loss 500 500