60 biws bank credit loss accounting

Bank Credit Loss Accounting – Quick Reference

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Credit Loss Accounting Overview Unlike normal companies, banks and financial institutions expect to lose money on their assets. Specifically, when they issue loans to businesses and consumers, they expect that a certain percentage will default and be unable to repay the loans. If this happened to a normal company, they might record it as an asset write-down on the balance sheet, and then make it flow through the income statement and cash flow statement. But since it’s an expected event for banks, accounting for these credit losses is a critical part of their financial reporting and is “built-in” to all 3 financial statements. How It Works

Beginning Reserve Balance: 10$

Net Charge-Offs Calculation:Less: Gross Charge-Offs: (10) Plus: Recoveries: 5

Net Charge-Offs: (5)

Plus: Additions to Provisions: 10

Ending Reserve Balance: 15$

1. Banks have a beginning reserve balance (also called a beginning allowance for loan losses or beginning loan loss reserve) that says how much they expect to lose over the year.

2. Then, they subtract gross charge-offs from this balance. This represents the value of the loans that borrowers default on over the year.

3. Next, they add recoveries to this number. Recoveries represent loans that were previously charged off but where some value can be recovered by selling collateral.

4. Finally, they add provisions for credit losses – how much they expect to lose over the next year – to arrive at the ending reserve balance.

This part makes intuitive sense. To project these items – gross charge-offs, recoveries, and additional provisions (sometimes just listed as provisions for credit losses) – here’s what you do:

• Provisions for Credit Losses: % of Average Gross Loan Balances • Gross Charge-Offs: % of Average Gross Loan Balances (Or individual loans if you have them) • Recoveries: % of Average Gross Loan Balances (Or individual loans if you have them)

Sometimes in models you assume a “dip” or “bump” in the initial years followed by a return to normalcy, as we do with the JP Morgan operating model.



Credit Loss Accounting & The 3 Financial Statements Let’s continue with the assumptions above and also assume that we’re adding $100 in loans over the course of the next year, and that our tax rate is 40%:

Assumptions & LLR Calculation

Tax Rate: 40.0%Loan Additions: 100$






Commercial Bank - Income Statement

Net Revenue: 100$ Provisions for Credit Losses: 10 Non-Interest Expenses: 50

Pre-Tax Income: 40 Net Income: 24$

Yes, that’s correct – only the provisions for credit losses flow into the income statement. Even if the bank charges off $10 billion worth of loans, charge-offs themselves do not show up on the IS.

And here’s what happens on the cash flow statement:








Commercial Bank - Cash Flow Statement

Net Income: 24$ Provisions for Credit Losses: 10 Loan Additions: (100) Changes in Deposits: - Changes in Debt: - Changes in Borrowings: - Preferred Issuances: - Common Stock Issuances: -

Net Change in Cash: (66)$

Just like a normal company, an asset going up (loans) reduces cash flow. We add back provisions for credit losses because it’s a non-cash expense – just like depreciation.



The trickiest part is what happens on the balance sheet:








Commercial Bank - Balance SheetAssets: Beginning Ending

Cash: 100$ 34$

Gross Loans: 1,000 1,095 Allowance for Loan Losses: (10) (15)

Net Loans: 990 1,080

Total Assets: 1,090$ 1,114$

Liabilities & Shareholders' Equity:Liabilities:

Deposits: 700$ 700$ Debt: 50 50 Borrowings: 50 50

Total Liabilities: 800$ 800$

Preferred Stock: 50 50 Common Stockholders' Equity: 240 264

Total Liabilities & SE: 1,090$ 1,114$

• Gross Loans: On the balance sheet, you always list gross loans net of charge-offs – so that’s why we’re adding the loan additions and then subtracting the net charge-offs to get to the final number.

• Allowance for Loan Losses: Flows in from the Loan Loss Reserve calculations; the Beginning Reserve Balance is the Beginning Allowance and the Ending Reserve Balance is the Ending Allowance.

• Everything Else: Exactly the same as how a normal company works – cash from the bottom of the cash flow statement, shareholders’ equity based on net income, dividends, and stock issuances, and so on.

The $50 Million Question: Wait a minute, don’t we have to take into account the net charge-offs on the cash flow statement? Why are we only taking into the provisions for credit losses and the loan additions? The Answer: There’s no simple 2-word explanation, but here’s how you can think about it:

• On the balance sheet, the Gross Loans number increases by (Loan Additions – Net Charge-Offs). • On the balance sheet, the Allowance for Loan Losses number increases by (Net Charge-Offs –

Provisions for Credit Losses) – because it is a contra-asset. Otherwise, the signs would be flipped. So let’s think about the net changes here for a second…



New Net Loans = Old Net Loans + (Loan Additions – Net Charge-Offs) + (Net Charge-Offs – Provisions for Credit Losses) Remember your algebra: the negative Net Charge-Offs and positive Net Charge-Offs cancel each other out. So we’re left with: New Net Loans = Old Net Loans + Loan Additions – Provisions for Credit Losses That’s how much Net Loans is increasing by – and we know that an asset going up decreases cash flow – so on the cash flow statement, we only need to reflect the Loan Additions and Provisions for Credit Losses. So, the short answer: the net charge-offs number reduces gross loans and increases allowance for loan losses, so it cancels itself out and we don’t need it on the cash flow statement. The $100 Million Question: Wait a minute, if actual loan charge-offs don’t affect the income statement or cash flow statement, couldn’t a company lose billions of dollars in loans and never have it affect their earnings? The Answer: Theoretically, yes – but if a company has a lot of charge-offs, it has to increase its Provisions for Credit Losses. All of these numbers must be disclosed in a bank’s filings – you can’t just issue an annual report and say, “By the way, we charged off $10 billion of loans but our Provisions for Credit Losses for next year is only $500 million due to the miraculous economic recovery!” Instead, banks must adjust their Provisions for Credit Losses based on what’s happening in the current year – or shareholders and research analysts would notice in about 5 seconds. Key Metrics & Ratios There are dozens of metrics and ratios related to credit losses for banks, but here are the most important ones that you will actually use in models:

Metric Name How to Calculate It* What It Tells You NCO Ratio Net Charge-Offs / Average Gross Loan Balances How bad are the defaults? NCO / Reserves Net Charge-Offs / Loan Loss Allowance Did we cover our losses? Reserve Ratio Loan Loss Allowance / Gross Loan Balance What % of our loans will go bad? NCO / Prior Year Provisions

Net Charge-Offs / Prior Year Provisions for Credit Losses

Were our predictions for charge-offs in line with real charge-offs?

* Numbers should always be positive, so flip signs if necessary. Use ending balances unless otherwise noted.

60 biws bank credit loss accounting

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