What Is Loan Loss Reserves?

Loan loss reserves (also called the allowance for loan and lease losses, or ALLL) are an accounting provision that banks maintain to absorb anticipated credit losses. Each quarter, bank management estimates how much of its loan portfolio may not be repaid and adjusts the reserve accordingly. The provision expense that builds this reserve is deducted from the bank's income.

Under current expected credit loss (CECL) accounting standards adopted in 2020, banks must estimate losses over the entire life of a loan at origination, rather than waiting for evidence of impairment. This front-loads recognition of potential losses and generally results in larger reserve balances, especially for banks with long-duration loan portfolios like mortgage lenders.

The adequacy of loan loss reserves is judged by comparing the reserve balance to the bank's nonperforming loans. A coverage ratio (reserves divided by NPLs) above 100% means the bank has set aside more than enough to cover its current problem loans. A coverage ratio below 50% suggests the bank may not have adequately provisioned for its credit risks. For depositors, strong loan loss reserves mean the bank has already acknowledged and prepared for potential losses, reducing the chance that a surprise wave of defaults will overwhelm its capital. Banks that "under-reserve" to boost short-term earnings may be taking risks that could surface later.