[Seungseop Song's Financial Light] What Is the Difference Between Allowance for Bad Debts and Provision for Bad Debts?

If Banks Accumulate Provisions After Accounting Standard Valuation, It's 'Allowance for Bad Debts'
If Allowance for Bad Debts Falls Short of FSC Standards, It's 'Bad Debt Reserve'

Finance is difficult. It is filled with confusing terms and complex backstories intertwined. Sometimes, you need to learn dozens of concepts just to understand a single word. Yet, finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Therefore, Asia Economy selects one financial issue each week and explains it in very simple terms. Even if you know nothing about finance, you can immediately understand these ‘light’ stories that turn on the bright ‘light’ of finance for you.

[Asia Economy Reporter Song Seungseop] Recently, as the domestic and international financial market environment has become unstable, voices have emerged saying banks must prepare for shocks. There are various ways to do this, but the most certain way is for banks to secure ample funds. What do we call the money accumulated like this?

“The Financial Services Commission plans to continuously encourage sufficient ‘allowance for loan losses’ accumulation assuming various crisis situations such as the expansion of potential non-performing loans in the financial sector and delays in business improvement for small and medium enterprises and small merchants.”

“The Financial Supervisory Service recently recommended additional accumulation of ‘allowance for loan losses’ to banks as a part of preemptive supervision in response to uncertainties in the domestic and international economy such as the resurgence of COVID-19 and the Ukraine situation.”

Looking at recent messages from financial authorities, the money banks have accumulated is sometimes called ‘daeson chungdanggeum’ and sometimes ‘daeson junbigeum.’ The names sound similar and their uses seem hardly different. Sometimes the media even uses them interchangeably, making them appear as the same concept, but in fact, daeson chungdanggeum and daeson junbigeum are distinctly different.

First, daeson chungdanggeum (allowance for loan losses) is money that banks set aside by evaluating themselves according to the International Financial Reporting Standards (IFRS) and reserving a portion of their profits. For example, if you lent 100 million KRW to a friend (loan) and expect that half of it will not be repaid (evaluation), you prepare 50 million KRW in advance (allowance for loan losses) to cover the loss. Banks also classify loans they have extended to you by risk into categories such as ‘normal, precautionary, substandard, doubtful, estimated loss.’ The closer to estimated loss, the harder it is to recover the money, and the more allowance they accumulate.

Daeson chungdanggeum is classified as an ‘expense’ in accounting. In other words, an increase in allowance for loan losses affects the bank’s ‘profit’ indicators. Saying that the allowance for loan losses has increased means expenses have increased. When expenses increase, the bank’s profit indicators deteriorate.

No bank would welcome a decrease in profits due to setting aside allowance for loan losses. Even if the financial environment becomes risky, banks might not accumulate enough allowance for loan losses. Therefore, the Financial Supervisory Service sets minimum standards for allowance for loan losses by asset type in the bank supervision regulations. For normal loans, 0.85% is set aside as allowance for loan losses, and for others, depending on risk, 7%, 20%, 50%, and 100% are set aside respectively. There are differences depending on whether the borrower is an individual or a company, and the industry.

Allowance for loan losses is an 'expense', allowance for loan loss reserves is 'capital'

What if a bank, after evaluating itself according to IFRS and setting aside money, has less than the amount required by the Financial Supervisory Service? Since the minimum standard is not met, the bank must set aside additional money equal to the difference. This additional money is called daeson junbigeum (allowance for loan loss reserves).

Daeson junbigeum is classified as ‘capital,’ not an expense. When setting aside allowance for loan losses, expenses increased, right? But allowance for loan loss reserves increase capital even though it is the same money set aside. Financial institutions are evaluated as safer when they have more capital, so this raises their capital ratio, which is an advantage. However, since it belongs to statutory reserves within capital, it cannot be used for dividends.

There are also similarities. Both allowance for loan losses and allowance for loan loss reserves fluctuate constantly depending on the situation. They are not money set aside once and for all. If a loan product was safe and the allowance was low, but then delinquency starts and it becomes non-performing, more allowance must be accumulated. Conversely, if a risky loan product becomes safe and its soundness improves, the allowance can be reduced or recovered.

There is a difference in how the money is recovered. When the accumulated allowance for loan losses is recovered, it is classified as ‘non-operating income.’ It was an expense when set aside, but recovering it increases profits. When allowance for loan loss reserves is recovered, it is calculated as ‘retained earnings’ belonging to capital.

However, just because allowance for loan losses or allowance for loan loss reserves are low does not mean banks have not prepared for risks. When a crisis approaches, banks sometimes accept losses and sell or write off non-performing loans. In such cases, even if allowance or reserves decrease, the actual safety of the bank improves.

Loan loss provisions and allowance for doubtful accounts accumulated by domestic banks. Data provided by the Financial Supervisory Service.

So, how much money have domestic banks currently set aside as allowance for loan losses and allowance for loan loss reserves? As of the end of last year, it is about 37.6 trillion KRW (provisional). Allowance for loan losses decreased from 19.3 trillion KRW a year ago to 19.5 trillion KRW. Allowance for loan loss reserves increased from 16.6 trillion KRW to 18.1 trillion KRW.

Financial authorities say that although the overall loss absorption capacity (allowance for loan losses + allowance for loan loss reserves) has increased, it cannot be considered safe. They cite reasons such as increased uncertainty due to long-term deferment of loan maturity and interest payments for small and medium enterprises and small merchants, the global tightening trend with countries raising interest rates, and the extremely unstable external financial market environment due to the Russia-Ukraine situation. Accordingly, the Financial Supervisory Service recommended domestic banks to additionally accumulate about 876 billion KRW in allowance for loan loss reserves.