Is a loan loss provision an expense?

The charge that creates or increases it is an expense in the income statement, usually called the impairment charge or credit loss expense. The provision itself is the balance built up, shown as a reduction of the loan book. If a bank later concludes it provided too much, the excess is released and adds to profit. So profit moves with the change in the provision in each period, not with the size of the total.

Does a provision mean the bank has given up on the loan?

No. A provision says the bank expects, on balance, to recover less than it is owed, and the debt stays fully due. On a healthy loan it is a small statistical amount. On a troubled loan the bank may be working hard on recovery while holding a large provision. A provision is generally not visible to the borrower and does not reduce the balance; only a later agreement or release can do that.

What is the difference between Stage 2 and Stage 3?

Both carry lifetime expected credit loss. A Stage 2 loan has had a significant rise in its risk of default since it was made, but is not credit-impaired, and may be fully up to date. A Stage 3 loan has objective evidence of impairment, often default. The further differences are in the amount, which is usually much larger at Stage 3, and in interest, which is recognised on the net balance rather than the gross.

Why do bank provisions rise before a recession?

Because the model is meant to look ahead. A bank includes forward-looking economic scenarios when estimating expected losses, so a worse outlook raises the probability of default and with it the provision, sometimes before many borrowers have missed a payment. The result can be a sharp increase early in a downturn and releases if it turns out milder than feared. Investors read those movements as a statement of how the bank sees its book.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Loan Loss Provision: a Worked Example

The charge arrives early. The final figure arrives late.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

A bank's profit can fall because of a loan that has not missed a payment. The provision is why: an accounting charge that brings the estimated credit loss into the accounts as risk rises, well before the final result is known. Under IFRS 9 and its local versions, a US$6m loan to a diving contractor might carry US$28,800 when it is healthy, US$336,000 once its risk has risen significantly and US$1.98m once it is credit-impaired. Those amounts are the bank's estimates, and the charge changes nothing about what the borrower must repay.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

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PART OF When Your Loan Goes to the Workout Team

// 01 — WHY THE CHARGE COMES BEFORE THE LOSS

A bank knows that some of the loans it makes will not be repaid in full, though not which ones. Older accounting waited for evidence that a loss had happened. After the financial crisis that approach was criticised for recognising losses too little and too late, and IFRS 9 replaced it with a model that looks forward from the day a loan is written. New Zealand and Australia apply it through NZ IFRS 9 and AASB 9, and UK banks reporting under UK-adopted international standards apply it too.

Not every lender is on that model. FRS 102, used by many smaller UK entities, has its own impairment rules based on objective evidence of a loss, unless the entity chooses the recognition and measurement requirements of IFRS 9. The Financial Reporting Council deferred a decision on aligning the two in its 2024 review. The rest of this page describes the expected loss model.

// 02 — HOW IT IS MEASURED

Stage 1 no significant rise in risk 12-month expected credit loss

Stage 2 significant rise in risk lifetime expected credit loss

Stage 3 credit-impaired lifetime expected credit loss,

interest on the net balance

Expected credit loss ≈ probability of default × loss given default × exposure

weighted across scenarios and discounted

Twelve-month expected loss is often misread. It is the lifetime loss that would follow a default in the next twelve months, weighted by the chance of that default, and not the loss expected to be suffered in the coming year. The move to Stage 2 compares the risk of default now with the risk when the loan was made, so a sound borrower that has weakened can move while a weaker borrower priced for its risk stays put. Payments more than 30 days past due are presumed to be a significant rise, and that presumption can be rebutted. Loans can also move back.

Smaller loans are usually measured in groups, using models. Larger or troubled exposures are more often assessed individually, and in Australia APRA requires material non-performing exposures to be assessed that way.

// 03 — THE EXAMPLE

A commercial diving contractor, constructed for this page like every figure in it, owes its bank US$6.0m on a term loan at 9% with four years to run. The bank's estimate of loss given default is 40%. For simplicity, discounting in the first two stages is ignored. Every probability is the example's and is not offered as a market norm.

Stage 1 at origination (12-month): 6.0 × 1.2% × 40% = 0.0288

Stage 2, contract lost (lifetime): 6.0 × 14% × 40% = 0.3360

Stage 3, in default, assessed individually (present values):

Plan succeeds 40% × 5.0 = 2.00

Business sold 40% × 3.8 = 1.52

Break-up 20% × 2.5 = 0.50

Weighted recovery = 4.02

Provision: 6.0 − 4.02 = 1.98

Each step is a charge to profit for the difference only: US$28,800, then US$307,200, then US$1.644m. The contractor still owes US$6.0m, but the bank now carries the loan at US$4.02m and, at Stage 3, books interest on that net figure: about US$0.36m a year in place of US$0.54m. A credit-impaired loan keeps accruing on the contract, and the income the bank recognises is smaller.

Eighteen months later the business is sold and the bank nets US$3.8m. Leaving aside the interest accrued and the discount unwound in those months, it writes off US$2.2m. The provision of US$1.98m absorbs most of that, and a further US$0.22m goes through profit. Had the net recovery been US$4.4m, the write-off would have been US$1.6m and US$0.38m would have been released back to profit. The estimate was a judgment, and the sale settled it.

// 04 — PROVISION, WRITE-OFF AND CAPITAL

A write-off is the later event: the removal of the amount from the balance sheet once recovery has run its course. A provision is an estimate that can be raised or released. Capital is a separate layer again, held for losses beyond what provisions expect. Banks using internal models must also compare their total provisions with regulatory expected loss, and a shortfall reduces their capital, which ties the accounting estimate to the capital position.

Expected loss in pricing uses the same three factors with a different purpose and often a different horizon. A borrower's own doubtful debts provision is a separate thing altogether: an allowance against money owed to the business, in the business's accounts.

DEFINED IN ONE PARAGRAPH → · PROVISION COVERAGE, WORKED → · HOW BANKS MANAGE CREDIT RISK →

// 05 — WHERE IT DECIDES A FILE

A provision changes the bank's incentives, and it can reach the borrower through them. The jump from Stage 1 to Stage 2 costs the bank a multiple of its original charge with no missed payment, which is why a watch-list file gets attention from credit and finance as well as from its banker. Across a book, a worsening outlook raises provisions on loans nobody has yet looked at individually, and banks sometimes add a management overlay when models lag events. That is why cost of risk can rise before defaults do.

In a workout the provision already taken shapes what a settlement costs. In the example, a bank holding the loan at US$4.02m takes no further charge on any recovery at or above that figure, so an offer that would have looked like a large loss at the outset may cost nothing further against profit. A haircut is still argued on what the plan will recover, but a bank's room to agree is partly set by what it has already booked.

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Financial Stability Institute (Bank for International Settlements), FSI Summaries: IFRS 9 and expected loss provisioning — Sets out the three stages, 12-month and lifetime expected credit loss, and the basis on which interest is calculated at each stage — section 02.
Basel Committee on Banking Supervision, Basel Framework CAP30 — paragraph 30.13, with CRE35.8 — Requires banks using the internal ratings-based approach to compare total eligible provisions with total expected loss and to deduct any shortfall from Common Equity Tier 1 — section 04.
Financial Reporting Council (UK), Periodic Review 2024 Feedback Statement — Question 4 — Records the FRC's decision to defer its conclusion on aligning FRS 102 with the IFRS 9 expected credit loss model — section 01.

// QUESTIONS PEOPLE ASK

Is a loan loss provision an expense?: The charge that creates or increases it is an expense in the income statement, usually called the impairment charge or credit loss expense. The provision itself is the balance built up, shown as a reduction of the loan book. If a bank later concludes it provided too much, the excess is released and adds to profit. So profit moves with the change in the provision in each period, not with the size of the total.
Does a provision mean the bank has given up on the loan?: No. A provision says the bank expects, on balance, to recover less than it is owed, and the debt stays fully due. On a healthy loan it is a small statistical amount. On a troubled loan the bank may be working hard on recovery while holding a large provision. A provision is generally not visible to the borrower and does not reduce the balance; only a later agreement or release can do that.
What is the difference between Stage 2 and Stage 3?: Both carry lifetime expected credit loss. A Stage 2 loan has had a significant rise in its risk of default since it was made, but is not credit-impaired, and may be fully up to date. A Stage 3 loan has objective evidence of impairment, often default. The further differences are in the amount, which is usually much larger at Stage 3, and in interest, which is recognised on the net balance rather than the gross.
Why do bank provisions rise before a recession?: Because the model is meant to look ahead. A bank includes forward-looking economic scenarios when estimating expected losses, so a worse outlook raises the probability of default and with it the provision, sometimes before many borrowers have missed a payment. The result can be a sharp increase early in a downturn and releases if it turns out milder than feared. Investors read those movements as a statement of how the bank sees its book.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit risk analystSets and monitors the standard the lending line works to — policy, appetite, ratings and the models underneath them.
Portfolio managerOwns the credit on a book after the money is out — reviews, covenants, ratings and early warning.
Model validatorIndependently checks that the bank's models do what they claim, before anyone relies on them.

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THE READING ROOMIN ONE PARAGRAPHLoan loss provision What is a loan loss provision?