All companies need to make sure they have the money required to cover both eventual asset impairments and potential obligations that have still not materialized. These funds are commonly known as provisons. In the case of banks, due to the intrinsic structure of the business, default provisions are a key element with the potential to significantly affect results.
As we explained in the “What's a bank's balance sheet?, the main activity of a bank is financial intermediation. Financial institutions use the funds they raise through customers deposits (liabilities) to provide loans (assets) to these or other customers. But banks have no way of knowing whether they will back all the money they lend. Lenders are always exposed to the risk that a borrower may default or fall behind in their payment obligations. This is what is known as credit risk.
In some sectors, such as banking, the minimum provisions that incumbents are required to set up are established by law. Therefore, everytime a bank makes a loan, it has to set up the corresponding provision to cover the eventuality of that loan going into default; in other words, banking institutions’ P&L accounts include two types of provisions, recorded to cover credit risks: generic provisions, allocated at the time the loan is approved; and specific provisions, set up to cover loan defaults.
In short, the granting of a loan forces the lending bank to set up an allowance in its balance sheet to cover its potential writing off as an asset if its finally recognized as a non-performing loan (i.e., the reapyment of the loan becomes uncertain). Once recognized, this default fund or provision will be stated on the asset side of the balance sheet, under the “loans and customer advances” heading, with a negative sign. This way, the bank has a way of knowing, at all times, the volume of its gross and net loan portfolio (before and after deducting default provisions). If the loan is finally repaid, the corresponding fund will be derecognized in the balance sheet.
Besides deafult funds, banks, just as any other non-financial business, need to set up funds to cover eventual future obligations (such as pensions, early retirements, or legal proceedings). In a bank’s balance sheet, these funds are recognized under the “Provisions” heading, on the liability side.
The amounts recognized both at the time a loan is granted (generic provisions) and to cover the loans classified as non-performing over a certain period of time are accounted for under the “Impairment losses on financial assets” and are stated on the P&L Account with a negative sign, once the net operating income has been calculated. Provisions corresponding to future liabilities are accounted immediately afterwards, also with a negative sign, under the “Provisioning Expenses” heading. Therefore, both accounts can have a significant impact on the attributable result of a financial institution.