What Is Loan Provision Expense?
Banks are key to a country's economy because the availability of credit is pivotal to the growth of companies. Despite the banks' best efforts to find clients who will pay back their loan in full, not all loans get paid back and the banks have to estimate what percentage of loans this will be. Once they get this number, also referred to as the loan provision expense, they then make an accounting entry on the income statement and balance sheet so investors know the expected loan losses.
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How Banks Work
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The most basic definition of a bank is an organization that profits on the spread between how much they pay for capital and how much they loan it out for. They can get capital in a number of ways including: simple savings/checking deposits; certificates of deposit; and issuing debt/equity. They then have to go out and find people and companies to loan it to make the spread. Things they look for in clients include stability of cash flows, purpose for the loan, credit score and business they are in. The better the customers' stats, the lower the rate offered to them.
Transaction-Based Income
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Most banks now also earn money from fee-based services, including 401k accounts, brokerage services, financial advising, safe-deposit boxes and credit cards. This gives them the ability to be more of a banking supermarket and a one-stop shop for everything, as well as more stable income to please their shareholders.
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Loan Provision Expense
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Loan provision expense is the entry banks make to communicate to investors what kind of losses they expect on their loan portfolio. There are many different reasons why a bank's ratio may be high or low. For example, one bank may specialize in high-risk high-interest loans that will default at a higher rate. Another bank may focus on real estate loans in a market with a very strong economy and bright prospects; this bank may have a lower provision expense because the prospects of payback are quite high.
Profit From Discrepanices
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As an investor, one way you can profit in a bank investment is seeing if they are being too conservative or aggressive with their loan provision expense. For example, if a company's loan provision expense is 5 percent of loans while the industry average is 10 percent, that may be a sign the company is being overly aggressive with their accounting and overstating their earnings.
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References
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