Formation of allowances means recognizing that part of the assets will not be fully recovered. An allowance reduces a bank's profit and is reflected in financial statements as an expense, even if actual losses have not yet occurred.
The size depends on asset quality: the higher the estimated probability of non-repayment, the larger the allowance. Deterioration in borrower payment discipline leads to additional allowance charges and, accordingly, to reduced profit.
For bank analysis, this is one of the most informative indicators. The dynamics of allowances and the share of problem loans in the portfolio indicate the quality of risk management better than current profit: a bank can show good results by under-provisioning and recognize losses later.
The ratio of allowances to problem assets shows a safety margin. Insufficient coverage means that loss recognition is still ahead. Systemic problems of this kind can lead to violations of regulatory standards and, in extreme cases, to license revocation.