The bank has a loan loss reserve for such shortfalls.

Loan loss provision is an expense set aside as an allowance for uncollected loans and loan payments. This provision is used to cover a number of factors associated with potential loan losses including bad loans, customer defaults and renegotiated terms of a loan that incur lower than previously estimated payments. Loan loss provisions are an adjustment to loan loss reserves and can also be known as valuation allowances

BREAKING DOWN 'Loan Loss Provision'

Banking industry lenders generate revenue from the interest and expenses they receive from lending products. Banks lend to a wide range of customers including consumers, small businesses and large corporations. Lending standards and reporting requirements are constantly changing, and constraints have been rigorously tightening since the height of the 2008 financial crisis. Improved regulations for banks resulting from the Dodd-Frank Act have been focused on increasing the standards for lending, which have required higher credit quality borrowers and also increased the capital liquidity requirements for bank.

Despite these improvements, banks still have to account for loan defaults and expenses that occur as a result of lending. Loan loss provisions are a standard accounting adjustment made to a bank’s loan loss reserves included in the financial statements of banks. Loan loss provisions are consistently made to incorporate changing projections for losses from the bank’s lending products. While standards for lending have greatly improved, banks still experience late loan payments and loan defaults.

Bank's Cash Flow Statement

Loan loss reserves are typically accounted for on a bank’s cash flow statement and reduce a company’s total cash and cash equivalents by the reserve amount. The line item on the cash flow statement is adjusted according to loan loss estimates. It is increased when new loans are added. It also decreases when estimates are lowered, funds are collected or collateral held against a loan is used to cover a borrower’s outstanding debt.

Loan loss provisions are constantly made to update estimates and calculations based on statistics for the bank’s customer defaults. These estimates are calculated based on average historical default rates by different levels of borrowers. Credit losses for late payments and collection expenses are also included in loan loss provision estimates and are calculated using a similar methodology, which takes into account the previous payment statistics of a bank’s credit clients. The industry standard for loan loss reserves is an average 2 to 2.5% of a bank’s total outstanding loan receivables.

Overall, by setting aside loan loss reserves and constantly updating estimates through loan loss provisions, banks can ensure they are presenting an accurate assessment of their overall financial position. This financial position is often released publicly through the bank’s quarterly financial statements.