{"id":21765,"date":"2020-01-08T18:44:42","date_gmt":"2020-01-08T23:44:42","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&#038;p=21765"},"modified":"2024-08-07T22:52:30","modified_gmt":"2024-08-08T03:52:30","slug":"allowance-for-loan-losses-for-banks-fig","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/bank-modeling\/allowance-for-loan-losses-for-banks-fig\/","title":{"rendered":"The Allowance for Loan Losses for Banks (FIG) (22:17)"},"content":{"rendered":"<style>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">\u201cThe<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/bank-modeling\/allowance-for-loan-losses-for-banks-fig\/#The_Business_Model_of_Commercial_Banks\">The Business Model of Commercial Banks<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/bank-modeling\/allowance-for-loan-losses-for-banks-fig\/#Loan_Loss_Accounting_Illustrated_in_Different_Scenarios\">Loan Loss Accounting, Illustrated in Different Scenarios<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/bank-modeling\/allowance-for-loan-losses-for-banks-fig\/#How_Regulatory_Capital_and_the_Allowance_for_Loan_Losses_Are_Linked\">How Regulatory Capital and the Allowance for Loan Losses Are Linked<\/a><\/li><\/ul><\/nav><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"The_Business_Model_of_Commercial_Banks\"><\/span>The Business Model of Commercial Banks<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Banks collect money from customers (deposits), and then lend I to people who need to borrow money (loans).<\/p>\n<p>They *expect* to lose something on these loans because some people and companies default and become unable to pay back their loans.<\/p>\n<p>But there are two categories: *expected losses* and * unexpected losses*.<\/p>\n<p>The Allowance for Loan Losses corresponds to *expected losses*, while <a href=\"https:\/\/breakingintowallstreet.com\/kb\/bank-modeling\/bank-regulatory-capital\/\" target=\"_blank\" rel=\"noopener\">Regulatory Capital<\/a> corresponds to *unexpected losses*.<br \/>\nLoan Loss Accounting on the Three Financial Statements<\/p>\n<p><strong>Balance Sheet:<\/strong> The Allowance is a contra-asset that\u2019s netted against Gross Loans to calculate Net Loans.<\/p>\n<p><strong>Additions:<\/strong> The Provision for Credit Losses will increase this reserve, making the contra-asset more negative. This Provision represents the *additional* amount, above and beyond the existing Allowance, that the bank expects to lose.<\/p>\n<p><strong>Subtractions:<\/strong> Net Charge-Offs (actual defaults) will reduce this Allowance, making the contra-asset less negative.<\/p>\n<p><strong>Income Statement:<\/strong> The Provision for Credit Losses is an expense that reduces Pre-Tax Income and Net Income, but Net Charge-Offs do not appear on the IS&#8230; not directly, anyway.<\/p>\n<p><strong>Cash Flow Statement:<\/strong> The Provision for CLs is a non-cash add-back; you also record Loan Additions here. Just as with the Income Statement, Net Charge-Offs do NOT show up here.<\/p>\n<div class='code-block code-block-3' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/mergersandinquisitions.com\/wp-content\/uploads\/2024\/04\/Bank-Financial-Institution-Modeling.png\" alt=\"Bank Modeling\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Bank and Financial Institution Valuation and Financial Modeling<\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Master financial institution modeling and valuation<\/h4>\n              <p>Build operating models, perform valuations, and analyze M&A deals with 4 global case studies<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Dominate interviews and excel on the job<\/h4>\n            <p>Create professional deliverables like stock pitches, equity research reports, and IB pitch books<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Explore private equity and growth equity scenarios<\/h4>\n            <p>Study buyouts and minority-stake deals in the financial services sector\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/bank-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Bank-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div>\n<\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"Loan_Loss_Accounting_Illustrated_in_Different_Scenarios\"><\/span>Loan Loss Accounting, Illustrated in Different Scenarios<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<h3>Scenario #1: The Bank expects to lose an ADDITIONAL $10 on its Loans<\/h3>\n<p>It simply records $10 for the Provision for Credit Losses. Gross Loans stays the same, but the Allowance becomes $10 more negative, and Net Loans declines by $10 as a result.<\/p>\n<h3>Scenario #2: Bank adds $100 in Loans, and expects to lose $5 on them<\/h3>\n<p>It records $5 for the Provision for Credit Losses. Gross Loans increases by $100, the Allowance becomes $5 more negative, and the Net Loans figure increases by $95.<\/p>\n<h3>Scenario #3: Now the bank actually loses $5 and records the charge-off<\/h3>\n<p>The Gross Loans figure declines by $5 and the Allowance for Loan Losses becomes $5 more positive. Those changes cancel each other out, and so the Net Loans figure stays the same. There\u2019s no Income Statement impact.<\/p>\n<h3>Scenario #4: \u2026but now, there\u2019s a recovery of $2! Due to collateral, or the borrowers suddenly repaying some of the loan<\/h3>\n<p>Now, the Gross Loans figure increases by $2, but the Allowance also becomes $2 more negative \u2013 so the changes cancel each other out once again, and Net Loans stays the same. There\u2019s no Income Statement impact.<\/p>\n<h3>Scenario #5: The Allowance is $10, but there\u2019s a Gross Charge-Off of $20 \u2013 what happens? How can this possibly work?<\/h3>\n<p>In this case, the bank simply has to *increase* its Allowance for Loan Losses to cover this unexpected loss. So the bank might set aside, say, an additional $20, and therefore record a $20 Provision for Credit Losses, which results in a higher Allowance to cover this loss.<\/p>\n<p>The Net Loans figure ends up declining because the Gross Loans figure will fall and the Allowance will eventually return to its original level.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_Regulatory_Capital_and_the_Allowance_for_Loan_Losses_Are_Linked\"><\/span>How Regulatory Capital and the Allowance for Loan Losses Are Linked<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>So how exactly does Regulatory Capital (mostly Common Equity or Equity) \u201cabsorb\u201d losses?<\/p>\n<p>Because when an unexpected loss occurs, banks have to increase their Allowance for Loan Losses.<\/p>\n<p>They do this by increasing the Provision for CLs, which reduces Net Income since it appears on the Income Statement.<\/p>\n<p>That reduced Net Income, in turn, reduces Shareholders\u2019 Equity.<\/p>\n<p>So Regulatory Capital \u201cabsorbs losses\u201d by ensuring that Equity stays above a certain level, even if Net Income falls\u2026 since a dramatic drop in Net Income would come, most likely, from unexpected losses.<\/p>\n<p>The capital ratios fall when this happens, as they should.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you\u2019ll learn all about the Allowance for Loan Losses and the Provision for Credit Losses for commercial banks, which are important topics related to accounting and valuation for financial institutions (FIG). These topics are extremely likely to come up in interviews with these groups, and will come up on the job day in and day out.<\/p>\n","protected":false},"featured_media":21772,"template":"","class_list":["post-21765","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-bank-modeling"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/21765","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/21772"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=21765"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}