Allowance for loan losses: is it lower the better or the opposite?

[sleepybird]

I am analyzing a auto financing company. Balance sheet shows that "allowances for loan losses" has been declining while "consumer loan balance" has been increasing. Is this a good thing?

I think it is a good thing because "allowance for loan losses" = reserve = expected losses ~= cost of goods sold. Since EL is a function of EAD, PD and LGD, decreasing EL must mean the company is underwriting more good loans (i.e., lending to customers with high FICO scores, PD down) and/or better recovery experience. Is this correct?

However, on the flipside of the coin, one can argue that there's increasing probability that the company is under-reserving for its loans.
What do you guys think?
Thanks!

 

[Bryon]

I think it would be a good idea to check the management discussion part in the annual report to see if there is any comment.
It could be real improvement, could be just aggressive management assumption.
Bryon

 

[ShaktiRathore]

@sleepybird
EL= ExpectedExposure@Defalut*PD*LGD; Now for Expected loss to decrease and Exposure to increase that means PD*LGD should decrease so PD is decreasing that means more good quality and high rating customers are granted loan. LGD is increasing that means that due to good collateral(the auto itself for which the loan was granted as its a auto financing company) can be recollected and loss arising out of default is less.So in the end product has good effect to decrease the EL.
"allowances for loan losses" means the company is taking a precautionary approach to the loan losses that can happen i the future just like we keep allowance for bad debts in balance sheet to cover the losses for the debts that go bad. Its decreasing that means company either has a lot of confidence in the loans it is granting which means it is granting loans to high rating customers backed with enough collateral so that even if loans go bad it can recover the losses and since its an auto financing company that means that auto can be kept as collateral at the time of granting loan.
"consumer loan balance" is increasing that means company has enough confidence to recover the loan once it has granted it. Company has full faith in the customers to whom it is lending the loan and in the case of default on part of customer auto company can recover substantial part of the loan. While granting the loan many factors like income level, collateral quality, bad loan experience, credit risk etc are considered.So naturally if all or some of the tenets improve than allowances could decrease.

thanks

 

[Hend Abuenein]

I would make your same conclusions Sleepybird, but I'd go a step farther and ASK how the reserve or allowance for loan losses is computed, and the reasons it dropped. You can't assume the measures are all taken correctly. I mean that you should check if their accountants are assigning the allowance the same way you're accounting for it.

Also, I'd check when and how much was the last bad debt write off. (I'm not sure if this can occur during a financial year, not at the end only)
If recent, that might explain the drop in the allowance when compared to increase in the loans granted.

 

[sleepybird]

Thanks for all the inputs and thoughts. Great example of applying what we learned from FRM to real world situation. This is such a great forum. I wish there could be a specific session for us to discuss practical topics such as real life work related.

 

[MariusE]

Hello everyone,

i think that is best to present my opinion illustrating an example:

Let’s assume we have on the Asset side of the balance sheet a loan of 5 mln. This loan has a collateral or other type of guarantee of 4 mln. This means that we are left with a 1 mln unreserved part of the loan. Now, what happens is that we charge an expense to the income statement of 1 mln as a loan loss provision (credit risk charge). This 1 mln charge will mean an increase of 1 mln in the allowance for loan losses (loan loss reserves).
So, now the structure in the Asset side is Gross Loan of 5 mln, composed by Net Loan of 4 mln and 1 mln in allowance for loan losses.
In the moment that the loan will become impaired and will be written down (charged off), allowance for loan losses will be reduced by the amount. This does not have immediate impact on loan loss provisions (already charged by 1 mln). The same goes for any recovery from the impaired loans, that will increase the allowance for loan losses.

Now, in my opinion, it is best that we have high allowance for loan losses, because this is the way that we cover the impaired loans. If allowance for loan losses do not cover 100% of the impaired loans, the unreserved part of the impairments will have a potential impact on the equity. So it is important to check the impaired loans and the potential impact of the unreserved impaired loans on equity

In conclusion, on my opinion, high allowance for loan losses (LLRs), butt correlated to the amount of impaired loans, and low loan loss provisions (credit risk charges).

Marius

 

[sleepybird]

Hi Marius
Thanks for the illustration. I see where you’re coming from. I think either over-reserving (not efficient) or under-reserving is not good – and it is difficult to find the right balance. But in general, as an investor, I would like to see declining loan loss provisions because it is MOST likely an indication of better loan quality/business management or at least management’s confidence in the loans they underwrite. But we also have to be careful that the company is not under-reserving. Company is more likely to under-reserve than over-reserving.

So if I see decreasing loan loss reserves, I would like to see OTHER evidences/indications that show the loan quality is improving (what we learned from finance class is that never rely on a single ratio). I look at Net Charge Off ratios, delinquency ratios, loss severity or frequency if such information is available. If these ratios indicate otherwise, we should be cautious.

To make sure the company is not under-reserving, I look at loan loss reserves/nonperforming (or delinquent or other measures that measure trouble loans). The reserve should adequately cover the nonperforming loans (at least 100% but I think best to compare to industry or peers).

Sleepybird

 

[sleepybird]

To add to above:
Frequent “adverse prior year reserve developments” is an indication of Company’s poor reserving practice. On the other hand, “favorable prior year reserve developments” indicates sound/conservative reserving practice. So I’ll look at those too.

Also, if I see increasing loan loss reserve trend, although it could be possible that the company is conservatively adding reserve, but as an investor, I tend to associate the increase reserve with declining portfolio quality rather than conservative reserving practice – as stated above, I think company is more likely to under-reserve than over-reserving.

 

[troubleshooter]

EL is the reasonable starting point and the main driver for the general allowance reserves. But the management exercises some level of discretion and make adjustments based on their assessment of the general economy, regional, industrial expectations for the time the GA is being set up. As someone suggested earlier, you should pay attention to management discussions released with the financial statements. This might shed some light on why reserves were cut while the book increased. We can make all sorts of guesses, but only way to get to the bottom of this is to ask the management...