Financial provisions – What it is, definition and concept

Financial provisions are those reserves made by banks or financial entities as a safeguard against the possible non-payment of a part of their client portfolio.

In other words, what these types of provisions do is to recognize a possible loss due to the lack of recovery of a percentage of the loans granted by the bank.

These provisions are usually established, by the regulator, as a percentage of the portfolio. This is the portion of the debt receivable that is estimated to be unlikely to be recoverable. The bank then goes ahead to recognize the possible loss.

Now, we must consider that in each country the legislation is different, so that some regulations will be more demanding than others, setting a higher percentage of provisions.

Another point to take into account is that the financial intermediation business is subject to credit risk, that is, of not recovering the borrowed money. Therefore, it is expected that a percentage of the loan portfolio becomes uncollectible, and this can only arouse concern when it exceeds a certain percentage.

Provisions that are increasing

Another issue to consider is that the percentage of provisions required is increasing. At least, to the extent that it is less likely to recover the debt. That is, the longer the delay or delay elapses.

We must say, then, that not all debts have the same credit risk. There are those categorized as normal, so they are expected to be charged, although a few days may have been late.

If 9 to 30 days are past due, the debt could be classified, for example, as “with potential problems.” Also, if there are 31 to 60 days past due, the debt can be considered deficient.

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Similarly, if the days of delay are between 61 and 120, the risk is doubtful, while if they exceed 120 days, the debt is already considered to be lost.

Each of these categories will be assigned, by the regulatory body, a percentage of provisions that will gradually increase.

For example:

Normal: 0.5% and -2% (greater than 0.5% and less than 2%).

With potential problems:> 2% and <10% (greater than 2% and less than 10%).

Poor:> 10% and <25%.

Doubtful:> 25% and <40%.

Loss:> 40%.

Now, within the loss, when exceeding 180 days of delay, a 50% of provisions may be required. Then, if the 270 days are exceeded, 75% must be provisioned. Finally, if the 360 ​​days past due are exceeded, the percentage of provisions will have to be 100%.

This is a fictitious case, but it shows how the requirement of provisions from financial institutions can be raised by the regulatory body.

Financial provisions in accounting

Financial provisions require that, in its accounting, the credit institution recognizes a provision account within the balance sheet or balance sheet. That is, within assets, as a provision for bad debts and with a negative sign.

As a counterpart, these reserves would also have to be recorded as an expense in the income statement. This, as an expense or loss due to the deterioration of financial assets.

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