What is an Allowance for Loan Loss in Lending (ALLL)?

Jack Miller gives a little background on what a Loan Loss reserve or an Allowance for a loan loss reserve is in lending.

“Hi, this is Jack Miller. I want to make this a little video on what a loan loss reserve is, or accounting for a loan loss reserve, or allowance for a loan loss reserve. I’m making it from a real estate lending perspective, but it really is on any type of lending perspective. This can be a technical issue; I’m just going to try to keep it fairly simple, just to give people the basic understanding. Self-understood, they should speak to the regulator if they’re in a regulator industry – a related industry, their auditing firm if they get audited books, and their lenders if they borrow money because they’re probably going to want to make them keep an allowance reserve.
So, first of all, an allowance for loan losses is usually used in the accrual method of accounting, as opposed to the cash method of accounting. In, again, I don’t want to get too deep into it, but the cash method of accounting is cash in, cash out. Accrual method is when something happens. So, if you’re owed money, you would book it on the accrual basis; you would book it the day it’s owed, not the day the money comes in. If you contract for something or you incur a bill on a Monday, on the accrual method, you’d book that on a Monday, not when you paid the bill. Google “accrual in accounting” and you’ll get it. I don’t want to go into it now, but you can do an allowance for loan loss even if you’re in a cash method. I really want to focus on the allowance.

Effectively, an allowance for loan loss, what that effectively is, you as a lender are trying to predict what your losses are going to be on a loan, even before you anticipate the loss or before you even make the loan. And it’s traditionally booked when you close the loan, and then it’s updated periodically or as things happen. So, and it’s developed over time and depending on the risk of the loan. So, if you have a portfolio, for example, of unsecured loans, your loan loss allowance is going — on a percentage basis is going to be much bigger than secured loans. The more secured the deal is, the less likelihood the loss, the less you will encourage, and the less the allowance will be.

But I’ll start at the beginning. So again, what you’re trying to do in the pure sense is predict any losses that you’ll have on a deal or a portfolio and account for them as early as possible, really as soon as you book the loan, not when the loss is incurred. So, in a pure sense, and this is how I would explain it to someone non-technical: let’s say you own a local store and every day a kid comes in and you know he’s going to steal a Milky Way bar, and you know that sells for a dollar, whatever it is. Well, you know that in the beginning of the day, you know today that next Tuesday someone’s going to come in and steal that dollar item, so you have to prepare for it. You build that in into your profile and your accounting, and you raise the price of everything else by a penny or two pennies or whatever it is because you know that kid’s going to steal that candy bar. So, it’s the same thing with lending. You know, if you’re charging someone, let’s just say a 10% rate, and you know sooner or later you’re going to have a loss. You’re really not charging them a 10% rate; you’re grossly— your charging a ten percent rate, but the net effective rate to you may be nine and a half, maybe nine and three quarters, but less than ten. So, you want to account for that now.

So, give you a just a basic formula for it. Let’s say you’re going to say that you’re going to use a one percent loss ratio, and nothing changes, it’s just one percent. So, if you book a loan for a hundred thousand dollars, you’re gonna day one take a thousand dollar charge and build your loan loss reserve by a thousand dollars. And if nothing changes and you keep it that way, it stays at a thousand dollars. And when the loan pays off, you take that thousand dollars into income. Remember, you’re taking it as a loss day one, so really, you’re building up a cushion. In fact, when big banks do this all the time, the regulators make them do it, and they should be doing it. So, giving an example, when COVID hit, big banks, the huge, big banks, they took billions and billions, maybe hundreds of billions of dollars, a charge as soon as COVID hit. So, it negatively impacted their earnings. So had they had this reserve, and what happened is, in this particular case, a lot of the charges weren’t taken into reality because the loans performed better than expected. So, they released that money slowly into earnings. So, it really, it accelerated the losses, and it accelerated the earnings. That’s really not supposed to happen, and it’s really supposed to even out, and that’s the point of the accrual method. It evens out the highs and evens out the lows.

But let’s say, for example, you make a loan for a hundred thousand dollars, and let’s just say you come up with a one percent loan loss allowance. You take a hundred thousand dollars out of income, you put it in reserve. Remember, it’s a bookkeeping entry; it’s not tax; it’s not a tax deferral. You can’t use it for the IRS. Again, I’m not an accountant, speak to your accountant, but I’m pretty sure about that.”