Allowance for Loan and Lease Losses: ALLL
This is often thought of as a reserve, a set-aside for the fact that some borrower is not going to pay. Which borrower? We don’t know, otherwise we would not have lent to them.
The Allowance increases in one of two ways:
The financial institution recognizes an expense, the Provision for Loan and Lease Losses, to build the Allowance to the ‘best guess’ required to prepare for loans that will not be collected. This guess is based on a rather complicated, and extensive process of
- identifying loans that are at risk (impaired) and determining the likely amount that might be received, and
- applying a historical loss rate, modified for today’s environment, to the remaining loans on the books.
Recoveries outpace charge-offs. This is the least painful way to build (or rebuild) the allowance and results when the financial institution recovers previously charged-off loans faster than the decision to charge-off other loans.
This may happen when a recession truly turns the corner into recovery and loans perform better than expected.
The impact of an increasing ALLL
If it goes up as a result of booking the expense, the increase reduces profits and the resulting addition to capital for that period. Shareholders may not be as happy, but examiners and auditors likely will be.
If it goes up as a result of improving recoveries, everyone is likely to be happy.
Either way, if the guess as to the ALLL is a good one, the balance sheet more accurately reflects the loans receivable. Anyone trying to understand how well (or not) the bank or credit union is doing should appreciate that.