Bank Loan-Loss Provisioning: Methodology and Application

by Jean Dermine of INSEAD, and
Cristina Neto de Carvalho of the Universidade Catolica Portuguesa

January 5, 2006

Abstract: A fair level of provisions on bad and doubtful loans is an essential input in mark-to-market accounting, and in the calculation of bank profitability, capital and solvency. Surprisingly, recent micro studies on loan loss-given-default have not been exploited to derive provisioning schedules. Two methodologies to calculate a fair level of loan-loss provisions, at the time of default and after the default date, are developed in the paper. To illustrate, the methodology is applied to a private data set of non-performing loans. The estimated dynamic provisioning schedule is then compared to a regulatory schedule imposed by a central bank.

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