The Provision to Loans and Leases Ratio

Provision is a critical line item on a bank's income statement as it fluctuates significantly with the business cycle. It rises when the business cycle is in a recessionary period and is lower otherwise. Acting as an expense, it exacerbates difficulties for a bank's bottom line when the economy is at its worst.

Provision Over Loans and Leases Ratio

In short, provision taken at the discretion of a bank for anticipated losses. If the bank has given a loan to a client and the client is no longer expected to repay the loan, provision will be taken ahead of time and act as a loss on the bank's income statement in the current quarter.

Loans and leases then, represent a theoretical maximum for provision. If a bank has a thousand clients that each have a million-dollar loan making total loans a billion dollars, then they are on the hook for a billion in losses if all of those thousand clients decide not to pay anything back.

Of course, that is an extreme example and one would not expect every client to default. However, given a large number of clients, some would be expected to default. And, during bad economic times, more would be expected to default.

So, the ratio of provision to loans and leases provides a simple metric for determining the amount of a loan book a bank expects to default at any given point. It works well as an indicator because provision is anticipatory. So, if a recession is imminent, the ratio would be expected to increase.

As of now, things have been relatively flat. With the business cycle continuing to age, an early blip in the provision to loans and leases ratio may give an early heads up for economic trouble in the near future.

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