This is a fantastic video. I have worked in a medium sized Financial Institution for the past 7 years and nobody explained this in such great detail and in a comprehensive manner. Totally recommend this course to anybody interested in Banking, Finance or into Fintech. I am about 80% sure I will sign up for this course
Thank you. This is so helpful it 'hurts'. Thanks for doing that. You mentioned we could get the spreadsheet by clicking a link but I can't seem to get it.
Are there any prerequisite courses that you can recommend to me before understanding this one? I am particularly lost why there's a beginning and ending assets and how come change in provision in income statement affects the balance sheet. Should I just look at it as two consecutive quarters' financial statements? Or banks update their financial statements before publicly releasing them?
Before learning bank accounting/valuation, you should really learn accounting and valuation for normal companies to have a strong knowledge base. We have generalist courses on these topics, but plenty of books and other courses also cover them. If you want to understand the flow of these items for banks, maybe find a smaller regional bank with simple statements and see if you can find a breakout of changes in the Allowance for Loan Losses there.
I'm not really sure what you mean. Net Income for a bank = Net Interest Income + Other Revenue Sources Such as Fees - Provision for Credit Losses - Non-Interest Expenses - Taxes, exactly what's shown on screen and in the file here.
"Provisions" is where I thought the COVID crisis would affect the banking and financial institutions the most. It would be interesting to apply Monte Carlo or Var to this analysis. I think that the Basel requirements made sure that the financial institutions had enough of a buffer or reserve assets on hand. Very clean model- I have a pretty sophisticated one just like it.
Banks did initially increase their Provisions if you look at Q1 and Q2 of 2020. But then the government bailed out big companies, so the higher Provisions ended up not being necessary.
I'm a bit confused - Can you please help me understand why there is no impact on cash? Or where cash comes into play? I would logically think that at some point the bank would be on the hook for some of the loan losses and would face liquidity concerns as a result. This seems to not be the case though? In fact, seems like provision for credit losses actually boosts the cash balance due to being an add-back on the CFS. I'd think at some point the bank would face insolvency issues and real cash losses if all their outstanding loans went to 0 (as an extreme illustration of this example)?
The more relevant question for banks is not cash, but regulatory capital and specifically having enough Common Equity Tier 1 (CET 1) on hand to cover potential unexpected losses in the future. The main issue with recording a Provision for Credit Losses is that doing so reduces the bank's Net Income, and therefore reduces its CET 1 as well. This is a big problem because if CET 1 falls low enough, the bank will have to cut dividends, halt stock repurchases, and possibly raise additional capital, diluting existing shareholders. By themselves, loan defaults do not reduce a bank's cash balance because the loans are not in cash on the Balance Sheet... they're a separate line item. A falling cash balance is more of an issue for the Liquidity Coverage Ratio (LCR) and related metrics.
@@financialmodeling Got it, thanks for getting back to me on this and see what you are saying regarding regulatory capital and common equity tier 1 being reduced over time as the bank has to keep taking net income losses as they set aside provisions for loss - But as a follow up, there is ultimately some relation to cash balance correct? Here is my accounting logic below, but maybe I'm confused: Bank loans out $100, this is presumably an outflow of cash for (100) and an increase of 100 in loan receivables. Then they take make an addition to provision for loan losses of 50 and net charge off of (50), which reduces their net income, equity, and also reduces the net loan amount outstanding by (50) so the net loan balance is now 50. Lastly, when the bank gets paid back $50, their cash increases by $50 and net loan amount is written down to $0. Presumably, since they had cash outflow of $100 when they issued loan and cash inflow of $50 when they received the loan (or net loan amount), there is a net cash loss of ($50). Is my logic correct there? Thanks again for getting back to me on this - You guys are great!
@@benfrieden1921 No. An initial loan issuance for a bank just means that Gross Loans increases on the Assets side, and some L&E line item increases to balance the change on the other side. Banks issue Loans first, and then back them up with funding sources on the L&E side. It's not like letting a friend borrow cash from you. It really is all about Equity and CET 1 for a bank. If the bank receives back $50 of the loan, it may sit in cash temporarily, but the bank will then put the proceeds into another loan or some other interest-earning asset.
but, when someone "suddenly appears" and repays some of its debt, USD2 in the example at about min 13, how come that increases gross loans? if a debtor pays its debts, then they no longer owe you anything, and so you dont own a loan anymore. I am missing something!
Eventually, the Gross Loan balance will be reduced. This is just what happens immediately after the repayment of the Debt when the bank is required to record the change on its statements. If the debt is repaid, it must be viewed now as a valid Gross Loan just like all the other loans the bank has issued.
@Mergers & Inquisitions / Breaking Into Wall Street Should we consider any tax effect from recoveries? How are recoveries reflected in the CF statement? It is clear from your video that recoveries are not included in the P/L but how do we translate the fact that we recovered a loan into the CF with is corresponding tax effect? Thanks in advance
??? Are you asking about what happens if the Allowance for Loan Losses decreases? There would be a Cash impact, but that's not the best way to think about it. The company's Provision for Credit Losses would change and that, in turn, would affect Pre-Tax Income, Net Income, Cash, Equity, the Allowance for Loan Losses, etc.
No. I‘m talking about scenario 4 at 12:15. You booked $2 increase in loans and another $2 in loss allowance (contra). However I believe the $2 should've been booked in cash instead of loans in that case.
Recoveries shouldn't affect the Net Loans number. The only way that happens is if there are offsetting changes to the Allowance and to the Gross Loans number. Also, if there's a Recovery, that doesn't mean the bank gets cash from borrowers; it could just mean the borrowers have started repaying the loan again, in which case Gross Loans needs to increase to reflect that.
I see. You used upgrades and recoveries interchangeably here. I'm not sure if written-off loans would be entirely booked back on BS in that case though. Thanks for your response.
Superb explanation and thanks for the video. Can you actually do a video on how IFRS 9 changes will affect banking when it comes to impairment compared to IAS 39?
Thanks for the suggestion, but that one is probably a bit too obscure to cover here (we get virtually no interest in anything Bank Modeling-related, so I don't even know why we created any of this material).
Very helpful, thanks a lot! I have this perhaps beginner question: If I assume some loan will not pay 5% of the total outstanding, but the loan has a, let's say, 3 year maturity; is it equivalent to say that each year I expect to charge-off a 5%/3= 1.67% of the loan? And if, for example, the first year I just lost 1% of the loan, as it is less than 1.67%, I could be able to reduce provisions?? Thanks a lot.
Principal repayments of loans are not the same as charge-offs. Charge-offs are unexpected events that also affect the Provision for Credit Losses because banks tend to adjust provisions upward as a result. Mechanically, yes, repaying a loan and charging it off both reduce Gross Loans on the Balance Sheet, but their impact on Provisions is different, as is the potential for reversing the event (possible with a charge-off, but not with principal repayment).
thank you for the video and the excel file..it is really helpful as i am writting my thesis on loan loss reserves in banking industry..The think i want to ask you is why in the excel file you have limited the loan loss allowance in tier 2 to 50%???i mean i dont find anything in basel iii that limiths the amount of loan loss reserve in tier2..i will much appreciate it if you could support me with an answer!thank u!!
There are always limitations around the Allowance that can be counted toward regulatory capital so that banks can't "game the system" by setting their provisions too high. The 50% number here is arbitrary, but there are usually limitations based on the RWAs or other items... www.fdic.gov/regulations/resources/call/crinst/999rc-r.pdf "This adjusted gross risk-weighted-assets figure multiplied by 1.25 percent is the bank's Tier 2 capital limit on the allowance for loan and lease losses"
It is not necessarily a "regulatory requirement," as a bank just has to have enough equity capital on-hand to meet the requirements (and the same for the net stable funding and liquidity requirements), but it is a standard part of a bank's business to estimate the potential losses for each loan over its lifecycle, allocate them in the Allowance for Loan Losses, and change it over time as the loss expectations change.
I'm not sure what you're referring to. Recoveries change the Net Charge-Off number and the Allowance for Loan Losses, but not the Provision for Credit Losses (at least, not directly). Indirectly, if Recoveries are higher than expected, a bank may reduce its Provision for CLs if it expects lower losses in the future.
Mergers & Inquisitions / Breaking Into Wall Street alright thanks man. I dint really get much understanding from wiki and investopedia so thought you might know. Thanks anyway.
@@financialmodeling your videos are very informative thanks for such nice work I never seen such a video with illustrative examples in excel Kudos to such hard and nice work
This is a fantastic video. I have worked in a medium sized Financial Institution for the past 7 years and nobody explained this in such great detail and in a comprehensive manner. Totally recommend this course to anybody interested in Banking, Finance or into Fintech. I am about 80% sure I will sign up for this course
Thanks, glad to hear it!
Man this is brilliant! Makes me want to sign up to your courses right away! Thanks a lot!
Thanks for watching!
This is fantastic material. Very well explained and thought out - straight forward examples make for excellent conceptual understanding. Thank you!
Thanks!
Thoroughly discussed the concept.Very helpful video....Thank You....
Thanks for watching!
Thanks a lot. This has been very helpful
Thank you, it helped me understand me much more on banking
Thanks for watching!
This video was very helpful- thanks
Thanks for watching!
Cant thank you enough, so very helpful
Thanks for watching!
Thank you. This is so helpful it 'hurts'. Thanks for doing that. You mentioned we could get the spreadsheet by clicking a link but I can't seem to get it.
Click "Show More". Scroll to the bottom. Click the links.
Are there any prerequisite courses that you can recommend to me before understanding this one? I am particularly lost why there's a beginning and ending assets and how come change in provision in income statement affects the balance sheet. Should I just look at it as two consecutive quarters' financial statements? Or banks update their financial statements before publicly releasing them?
Before learning bank accounting/valuation, you should really learn accounting and valuation for normal companies to have a strong knowledge base. We have generalist courses on these topics, but plenty of books and other courses also cover them. If you want to understand the flow of these items for banks, maybe find a smaller regional bank with simple statements and see if you can find a breakout of changes in the Allowance for Loan Losses there.
@ thanks. I actually went to your website and found some more courses which were really helpful.
Can you please tell how are you calculating the net income?
I'm not really sure what you mean. Net Income for a bank = Net Interest Income + Other Revenue Sources Such as Fees - Provision for Credit Losses - Non-Interest Expenses - Taxes, exactly what's shown on screen and in the file here.
"Provisions" is where I thought the COVID crisis would affect the banking and financial institutions the most. It would be interesting to apply Monte Carlo or Var to this analysis. I think that the Basel requirements made sure that the financial institutions had enough of a buffer or reserve assets on hand. Very clean model- I have a pretty sophisticated one just like it.
Banks did initially increase their Provisions if you look at Q1 and Q2 of 2020. But then the government bailed out big companies, so the higher Provisions ended up not being necessary.
I'm a bit confused - Can you please help me understand why there is no impact on cash? Or where cash comes into play? I would logically think that at some point the bank would be on the hook for some of the loan losses and would face liquidity concerns as a result. This seems to not be the case though? In fact, seems like provision for credit losses actually boosts the cash balance due to being an add-back on the CFS. I'd think at some point the bank would face insolvency issues and real cash losses if all their outstanding loans went to 0 (as an extreme illustration of this example)?
The more relevant question for banks is not cash, but regulatory capital and specifically having enough Common Equity Tier 1 (CET 1) on hand to cover potential unexpected losses in the future. The main issue with recording a Provision for Credit Losses is that doing so reduces the bank's Net Income, and therefore reduces its CET 1 as well. This is a big problem because if CET 1 falls low enough, the bank will have to cut dividends, halt stock repurchases, and possibly raise additional capital, diluting existing shareholders. By themselves, loan defaults do not reduce a bank's cash balance because the loans are not in cash on the Balance Sheet... they're a separate line item. A falling cash balance is more of an issue for the Liquidity Coverage Ratio (LCR) and related metrics.
@@financialmodeling Got it, thanks for getting back to me on this and see what you are saying regarding regulatory capital and common equity tier 1 being reduced over time as the bank has to keep taking net income losses as they set aside provisions for loss - But as a follow up, there is ultimately some relation to cash balance correct? Here is my accounting logic below, but maybe I'm confused: Bank loans out $100, this is presumably an outflow of cash for (100) and an increase of 100 in loan receivables. Then they take make an addition to provision for loan losses of 50 and net charge off of (50), which reduces their net income, equity, and also reduces the net loan amount outstanding by (50) so the net loan balance is now 50. Lastly, when the bank gets paid back $50, their cash increases by $50 and net loan amount is written down to $0. Presumably, since they had cash outflow of $100 when they issued loan and cash inflow of $50 when they received the loan (or net loan amount), there is a net cash loss of ($50). Is my logic correct there? Thanks again for getting back to me on this - You guys are great!
@@benfrieden1921 No. An initial loan issuance for a bank just means that Gross Loans increases on the Assets side, and some L&E line item increases to balance the change on the other side. Banks issue Loans first, and then back them up with funding sources on the L&E side. It's not like letting a friend borrow cash from you. It really is all about Equity and CET 1 for a bank. If the bank receives back $50 of the loan, it may sit in cash temporarily, but the bank will then put the proceeds into another loan or some other interest-earning asset.
Can you give link to the full course?
breakingintowallstreet.com/biws/bank-modeling/
Do you know how I can download the excel spreadsheet that was used in this excellent tutorial?
Click "Show More" and scroll to the links under "Resources" at the bottom.
Superb.. thnk you sir :)
but, when someone "suddenly appears" and repays some of its debt, USD2 in the example at about min 13, how come that increases gross loans? if a debtor pays its debts, then they no longer owe you anything, and so you dont own a loan anymore. I am missing something!
Eventually, the Gross Loan balance will be reduced. This is just what happens immediately after the repayment of the Debt when the bank is required to record the change on its statements. If the debt is repaid, it must be viewed now as a valid Gross Loan just like all the other loans the bank has issued.
@@financialmodeling Thank you very much for the answer. Greatly appreciated :-)
@Mergers & Inquisitions / Breaking Into Wall Street
Should we consider any tax effect from recoveries? How are recoveries reflected in the CF statement? It is clear from your video that recoveries are not included in the P/L but how do we translate the fact that we recovered a loan into the CF with is corresponding tax effect? Thanks in advance
When a recovery happens, in my opinion the increase on the asset side be attributable to cash balance instead of gross loans.
What do you think?
??? Are you asking about what happens if the Allowance for Loan Losses decreases? There would be a Cash impact, but that's not the best way to think about it. The company's Provision for Credit Losses would change and that, in turn, would affect Pre-Tax Income, Net Income, Cash, Equity, the Allowance for Loan Losses, etc.
No. I‘m talking about scenario 4 at 12:15. You booked $2 increase in loans and another $2 in loss allowance (contra). However I believe the $2 should've been booked in cash instead of loans in that case.
Recoveries shouldn't affect the Net Loans number. The only way that happens is if there are offsetting changes to the Allowance and to the Gross Loans number. Also, if there's a Recovery, that doesn't mean the bank gets cash from borrowers; it could just mean the borrowers have started repaying the loan again, in which case Gross Loans needs to increase to reflect that.
I see. You used upgrades and recoveries interchangeably here. I'm not sure if written-off loans would be entirely booked back on BS in that case though. Thanks for your response.
Superb explanation and thanks for the video. Can you actually do a video on how IFRS 9 changes will affect banking when it comes to impairment compared to IAS 39?
Thanks for the suggestion, but that one is probably a bit too obscure to cover here (we get virtually no interest in anything Bank Modeling-related, so I don't even know why we created any of this material).
Very helpful, thanks a lot! I have this perhaps beginner question: If I assume some loan will not pay 5% of the total outstanding, but the loan has a, let's say, 3 year maturity; is it equivalent to say that each year I expect to charge-off a 5%/3= 1.67% of the loan? And if, for example, the first year I just lost 1% of the loan, as it is less than 1.67%, I could be able to reduce provisions?? Thanks a lot.
Principal repayments of loans are not the same as charge-offs. Charge-offs are unexpected events that also affect the Provision for Credit Losses because banks tend to adjust provisions upward as a result. Mechanically, yes, repaying a loan and charging it off both reduce Gross Loans on the Balance Sheet, but their impact on Provisions is different, as is the potential for reversing the event (possible with a charge-off, but not with principal repayment).
thank you for the video and the excel file..it is really helpful as i am writting my thesis on loan loss reserves in banking industry..The think i want to ask you is why in the excel file you have limited the loan loss allowance in tier 2 to 50%???i mean i dont find anything in basel iii that limiths the amount of loan loss reserve in tier2..i will much appreciate it if you could support me with an answer!thank u!!
There are always limitations around the Allowance that can be counted toward regulatory capital so that banks can't "game the system" by setting their provisions too high. The 50% number here is arbitrary, but there are usually limitations based on the RWAs or other items...
www.fdic.gov/regulations/resources/call/crinst/999rc-r.pdf
"This adjusted gross risk-weighted-assets figure multiplied by 1.25 percent is the bank's Tier 2 capital limit on the allowance for loan and lease losses"
i know about the limitation of 1.25%..thank you very much for your reply!!!keep up the good work!!
Is it a regulatory requirement to create provisions for EACH loan that the bank has provided?
It is not necessarily a "regulatory requirement," as a bank just has to have enough equity capital on-hand to meet the requirements (and the same for the net stable funding and liquidity requirements), but it is a standard part of a bank's business to estimate the potential losses for each loan over its lifecycle, allocate them in the Allowance for Loan Losses, and change it over time as the loss expectations change.
@@financialmodeling thank you very much!
Could you please include a link to down the example excel sheet you use in your video. U say the link is provided below but could not find it!
Click on "Show More." Scroll to the bottom under "Resources." Click the links.
get stuff! but where can I get this excel doc? you said you were going to link it, but I dont see it!
Click "Show More". Scroll to the bottom. Click the links under "Resources."
thanks!!
I still didn't get why recoveries would increase provision for credit losses ??
I'm not sure what you're referring to. Recoveries change the Net Charge-Off number and the Allowance for Loan Losses, but not the Provision for Credit Losses (at least, not directly). Indirectly, if Recoveries are higher than expected, a bank may reduce its Provision for CLs if it expects lower losses in the future.
is the allowance recovery equivalent to allowance write back?
Yes sometimes it is called that.
Can you please explain interest suspense account of a bank to me? And why it comes under other liabilities?
Not familiar with it, but it looks like Investopedia, Wikipedia, etc. have decent explanations.
Mergers & Inquisitions / Breaking Into Wall Street alright thanks man. I dint really get much understanding from wiki and investopedia so thought you might know. Thanks anyway.
Can you share this excel to my email
Click "Show More" and scroll to the links at the bottom.
@@financialmodeling your videos are very informative thanks for such nice work
I never seen such a video with illustrative examples in excel
Kudos to such hard and nice work