Coming to terms | Loan-loss provision

Last week, Washington Mutual reported a $3.3 billion loss in the second quarter; one big reason was the $5.9 billion loan-loss provision the bank recorded. What is a loan-loss provision, and how does it affect a bank's financial results?

When a bank loans money, it records as income the interest payments as they come due; even if the borrower misses a payment or two, the bank still expects to get those installments.

But the bank knows, or can estimate, that some percentage of borrowers won't repay their loans in full. So the bank sets aside a chunk each quarter representing the loans it thinks will eventually go bad; that chunk is the loan-loss provision.

Each quarter's provision is added to the bank's total allowance for loan losses, which sits on the asset side of its balance sheet. When the bank concludes it's not likely to be fully repaid, the loan is charged off, or subtracted from the allowance.

Accounting rules give management much leeway in deciding how much to set aside. Because the loan-loss provisions directly reduce reported profits, there may be a temptation to skimp on them. But if more loans go bad than the allowance can absorb, the bank may have to raise additional capital from investors — as WaMu did earlier this year.

Seattle Times business reporter Drew DeSilver