Provisions for possible losses on loans: definition, formation, functions and calculation

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

There are five different categories of bank loans, distinguished by quality. And not all of them are returned on time for a variety of reasons. Therefore, reserves are needed for possible losses on loans. If the loans are not repaid, the bank needs to keep making payments. That's what a reserve is for. However, how is it formed, how is it regulated?

The creation of reserves for possible losses on loans is a mandatory action for all banks and organizations that carry out such operations. The main regulatory document for such work is Regulation No. 254-P of the Bank of Russia of 2004. There is an addendum to this document that is mandatory. This is Instruction of the Bank of Russia No. 2459-U of 2010, which concerns the risk assessment of debts.

Size guidelines

In order to determine the required amount of reserves for possible losses on loans, it is necessary to analyze the existing portfolio, and then classifyalready issued loans according to the quality criteria specified by the Bank of Russia. Of the five categories of this classification, depending on the criteria, there is its own level of risk. The first category - the risks are standard, there is no danger of non-return, and therefore in the calculation of the amount of the reserve there is zero. In the second category, risk situations are already non-standard, because the calculated risks of non-return range from 0.01 to 0.2. Therefore, reserves will have to be created up to 20% of the amount.

The third category - transactions are doubtful, the risk is 0.21-0.5, and the reserve should also be larger - from 21 to 50 percent. Problem loans fall into the fourth category, with the risk of default from 0.51 to 0.99, and reserves increase up to one hundred percent. In the last, fifth category, operations were carried out literally hopeless, most likely, the amount will not be returned. Therefore, reserves for possible losses on loans should be 100%. The assessment is made by bank specialists based on professional analysis.

Evaluation criteria

First of all, experts analyze all changes in the financial situation of the person who received the loan, as well as his conscientiousness or lack of it in servicing this debt. If the loan recipient is doing well both with the financial situation and debt servicing, then the risks of default are standard, you can only fear force majeure.

If, in a good financial situation, a bank client has interruptions in repaying money, that is, debt service is average, then the risks become non-standard. And it is already necessary to form reserves forpossible loan losses. If a financially successful person treats debt repayments very badly, then the operation is considered doubtful.

When a person has problems

Risks increase proportionally: with an average financial position and good debt service, the situation is still non-standard, and if this person also makes payments late, his credit history becomes doubtful. It also happens that a person with an average income stops repaying a debt, then the operation on his issue becomes problematic. The formation of reserves for possible losses on loans of such a plan should be in full swing.

Well, and the last option: the financial situation of the person to whom the bank issued a loan has become bad, but he is trying his best to pay his bills. All the same, the operation on his loan is considered doubtful. Who knows how soon he won't be able to pay at all? Provision for possible losses on loans is formed necessarily. If this loser does not contribute the planned parts and interest on the amount for a long time, this is a problematic operation. But when the client stops paying at all and nothing foreshadows an amendment to his financial situation, there is nothing to expect, this operation is hopeless.

Group

In order for the analysis and formation of RVPS (reserves for possible losses on loans) to be successful, similar criteria (mostly insignificant) are combined into a single portfolio. Its name is not difficult to guess. This is a group of homogeneous loans. In these cases, all calculations can be easily carried out inportfolio content.

Many people note that the process of creating a provision for possible losses on loans is very similar in terms of risk assessment criteria to the procedure for creating insurance reserves. The values of risks and reserves recommended by the Bank of Russia are determined by the method of mathematical statistics.

Norms and their application

A reserve for possible loan losses is created in accordance with the documents provided by the Bank of Russia, and there is also a single procedure for this purpose. This is a permanent process and should never be forgotten. Even yesterday's indicators of the value of the reserve today must be clarified and adjusted. This is because the main criteria that are taken into account are constantly changing.

Firstly, old loans are repaid and new ones are issued, and secondly, the situation of borrowers is changing, so transactions with their loans can move freely between categories - from one to another. For the same reason, the reserve rate is subject to adjustment, although it is specified and less frequently - quarterly.

Example of reserve formation

There are several rules for the process of creating and adjusting the reserve rate, but one of them is the main one, set out in Regulation No. 254-P (fourth chapter). If one borrower has several loans that accumulate debts with different estimated quality values, in this case all debts are assessed at the lowest value. Accordingly, the provision for possible losses on loans is also calculated.

For example, a borrower has two loans,which he repays in a timely manner, and they belonged to the category when both the financial situation and the attitude towards obligations of the client are conscientious, that is, both are “good”. However, the borrower burdened himself with yet another loan. And it became clear from the information provided that the financial situation worsened.

So, the new loan is rated "good-medium" in the risk category "non-standard", and the probability of default requires the creation of a provision for loan losses. Next step: two existing loans are moved to the same category. And they create a reserve. Although the borrower repaid the first two loans without problems and on time.

Other rules

If there are amounts not recovered from the debtor, bank guarantees are provided, but the same rules apply to the assessment of this operation as to other, ordinary borrowers, that is, it is necessary to form reserves for loan losses when risks arise. Amounts that are secured by mortgages are evaluated according to additional criteria, since an analysis of changes in the value of property that is under mortgage is necessary.

Finance transactions that are granted deferred payments or are allowed to transfer assets must be accompanied by the formation of additional reserves that will cover one hundred percent of the value of this financial asset. A syndicated loan (when there are several borrowers) requires the calculation of a reserve in relation to each member of this syndicate. These rules were enshrined in 2012 by the Bank of Russia(Instruction No. 139-I).

About insurance

The client's insurance (disability, he alth, life, etc.) is sometimes considered as a fact that affects the assessment of the reserve, and sometimes it is not taken into account. This is because the criterion here is only the amount of compensation in case of an insured event that will be due to the bank, as well as the level of coverage of the amount that the borrower needs in order for him to continue to service his debt normally.

If the amount owed to the bank in case of an insured event does not cover this debt of the client, the bank does not consider the presence of insurance at all as a factor contributing to the reduction of the reserve for possible losses on loans. Thus, the worst (fifth) category by default includes precisely those amounts that are issued to credit institutions, subsequently deprived of a license. As well as those for which there are no documents confirming the relationship with this loan. And for the fifth category, reserves for possible losses on loans are formed from capital. It's simple.

Formation of portfolio reserves

There are quite a few unpleasant nuances in these operations that need to be kept in mind, and most often they are associated with borrowers who are individuals. Correctly form reserves for loans to individuals based on two divisions. The first portfolio - ordinary individuals, and the second - entrepreneurs. Further, issued loans are classified into loans secured by collateral and unsecured. The pledge can be different: car, real estate, anyvaluable property. Any loans can be repaid in good faith, that is - on time, without delays, and in bad faith - with delays.

It is the criteria listed above that influence the formation of a portfolio of homogeneous loans. It is very convenient for use: the reserve is calculated entirely according to the contents of the portfolio, and each loan is not analyzed separately. Regulation No. 254-P establishes the amount of reserve deductions for choice: an option for ordinary individuals and two options for entrepreneurs.

Criteria for choosing a standard

You can choose the standard for creating a provision for possible losses on loans based on the criterion. Which is used by the bank to classify mortgage loans. For example, during the formation of portfolios, allocate low-risk loans into separate loans. But it depends on the policy of the bank - some do not allocate. The second criterion that is also not always used is when a whole group of loans with small delays, for example, up to thirty days, is placed in one portfolio. Some banks include them in the group of loans without delinquency at all.

The most important thing is that any applied procedure for creating a reserve must be fixed by local regulations. The bank also provides, at the first request of the Bank of Russia, all reporting on these issues, where the methods of forming a reserve fund for alleged losses on loans should be disclosed.

How to make a provision for loans: types

Credit institutions form a reserve based onchart of accounts approved by Regulation No. 385-P of the Bank of Russia in 2012. Thus, according to this plan, the bank reserves the estimated losses on the loan of the subaccount, which is opened for the same account and on which the loan itself is taken into account.

At the same time, analysis by type of loan is provided by using the account from the plan, plus debiting the bank's expense account. Purely technically, it turns out that through the formation of a reserve on the balance sheet, the amount of doubtful debt is reduced. And the difference is equally distributed over time to the financial result.

Provisioning for expected loan losses, the bank must also perform in order to evenly allocate loan losses to expenses directly in the process of risk assessment. Thus, the risks of non-repayment of loans can be managed.

Portfolio risk

Credit risk assessment is carried out in qualitative and quantitative terms, at the same time the analytical method of assessment, statistical and coefficient is used. The use of these methods helps to reduce and avoid the risks of the loan portfolio.

Analytical method assesses the risk level of the bank. This work is regulated by Regulation No. 254-P of the Bank of Russia of 2004, which refers to the formation of reserves and provides for the classification of loans issued. The credit risk of each loan portfolio is assessed directly by the bank according to approved criteria.

Evaluation criteria

The financial condition of the borrower is assessed with approaches thatare used in practice both in the international and in the Russian banking system. The client's ability to repay not only the principal debt, but also the interest due to this amount in favor of the bank, as indicated in the loan agreement, as well as all commissions and other payments, is assessed, which characterizes the quality of the borrower's servicing of its own debt. It is checked whether the client has highly liquid and high-quality collateral in the amount that is sufficient to compensate for the principal amount of the loan, the interest specified in the agreement, as well as the costs of exercising collateral rights. An analysis is made of the presence of overdue payments and their duration for the principal debt and for interest on this amount. The number of re-registrations of debt during the term of the contract is set.