By Gregory J. Nolan, CEO, G J Nolan & Co.
gnolan@gjnolanco.com

Higher-risk customers are usually the bank’s most profitable customers, but a number of banks are understating their profitability internally and missing big opportunities. Many banks hammer high-risk customers with excessive internally reported loan loss provisions (LLP) that hide their true profitability.  They do this because they recognize that the higher risk may result in a default on the loan.

What is LLP?

LLP is a set aside of a portion of current period interest income for use in covering future defaults.  LLP is transferred to the asset side of the balance sheet and added to the Loan Loss Reserve.  If a customer defaults, the principal amount is deducted from the Reserve to cover the loss.

However, no customer can set aside enough LLP to protect its principal against default.  LLP is a “community event”, where numerous loans set aside LLP to protect a particular customer’s potential future default.  Adding excessive LLP to high-risk customers misstates profitability and does not add further protection to the bank.

How bad can it get?

We’ve seen banks that have set aside so much LLP for a particularly high-risk customer, that the LLP exceeded the customer’s interest income.  The amount in excess of interest income cannot be interest income.  It must be Capital.

We have also seen banks that have put the entire principal amount lost in a loan default into the customer’s P&L as LLP.  Their explanation was to punish the Loan Officer for the default.  There are numerous ways to punish Loan Officers without misstating profitability and mis-accounting for the loss.

Some banks deduct a significant amount of LLP in the first month a loan is on the books.  Once again if this amount exceeds interest income, then what are they adding to the Reserve?  It must be Capital since there isn’t enough Interest Income to set aside.  Capital, however, is there to protect the bank.  What is achieved by moving it from Capital to the Reserve?  These banks don’t usually move Capital.  They simply create an operating loss with the inflated LLP and leave it at that. 

External LLP’s vs. Internal LLP’s

Using expected losses as a basis to determine the adequacy of the Reserve is appropriate.  In fact, as of December 15, 2022, it is mandated for external reporting by The Financial Accounting Standards Board.  However, many banks use the externally reported provision for internal reporting of profitability by organizational unit, product, and customer.  This is not only unnecessary but also distorts internal reporting.  The externally reported provision is influenced by the regulators, the CEO, and the internal and external auditors.

The external LLP usually fluctuates from period to period which destroys trends and hides insights to profitability.  There is no regulatory requirement to use the externally reported provision for internal reporting.

Rational LLP’s

Our clients have been using expected losses to calculate internal LLP for years.  As a result, it’s only necessary to determine whether the Reserve is adequate to cover potential defaults.  This determination is usually based on an analysis of history, current economic conditions, and an assessment of the future.  Once the Reserve is determined to be adequate it’s not necessary to artificially adjust the LLP in an internal P&L for different risk classes.   Rather, it is much more informative to have a stable LLP period to period.  In that way, fluctuations in profitability can be attributed to specific causes such as manager behavior and/or customer behavior.

Profitable Higher-Risk Customers

The reason higher-risk customers are so profitable is that the higher risk results in higher interest rates and higher fees.  There is no reason to hammer them with high LLP’s and artificially depress their net income.  Understanding the characteristics of higher-risk customers, target marketing that group, pricing properly, and managing the Reserve can result in improved profitability.