Page 80 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

Loan Loss Provisions READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS
The credit quality of loans and loss provisions are critical
in evaluating the bank’s financial position and performance.
MODULE 17.2: CAPITAL ADEQUACY AND ASSET QUALITY

Allowance for loan losses is a contra asset account to loans and is the result of provision for loan losses, an expense subject to management
discretion. Analysts need to evaluate the bank’s policy of setting aside adequate provisions relative to actual loan performance. Actual losses (net
of recoveries) are then written off against these provisions. Key ratios:
1. Ratio of allowance for loan losses to nonperforming loans.
2. Ratio of allowance for loan losses to net loan charge-offs.
3. Ratio of provision for loan losses to net loan charge-offs.

Each ratio compares a discretionary metric (i.e., allowance or provision) to a more objective measure.

The allowance for loan losses to nonperforming
loans ratio has declined from 1.02 to 0.56,
indicating that the bank has not made sufficient
provisions for loan losses (i.e., possible
aggressive accounting).

This aggressive accounting is also evidenced
by the provision for loan losses to net loan
charge-offs ratio, which is also declining from
0.68 to 0.65. In other words, for 20X8, the
expense recorded for loan losses was only
65% of actual losses during that year.

The allowance for loan losses to net loan
charge-offs ratio has decreased for 20X8,
indicating that the rate of increase in allowance
for loan losses is significantly below the growth
rate of actual write-offs.