Credit Loss or Operational Loss?

Banks face potential losses from an array of relationships, and when the sad day arrives and a certain loss must be recognized, a frequent question arises-is it a credit loss or an operational loss? The question is not merely academic.  Banks establish reserves for credit losses and the recording of a specific loss may not have an immediate dollar for dollar impact on net earnings.  On the other hand, credit losses become part of the bank's loss history and will have a lingering future effect on the analysis of the allowance for loan losses.  Also, loan losses are a metric that is watched closely by bank regulators, analysts and investors. 

Before making a decision of how to classify a loss we must understand the definition of each type of loss.

Credit Loss

Losses that arise from a contractual relationship between a creditor and a borrower.  A credit loss will need two elements-a borrower and credit relationship. 

Case Example:

Bank extends credit to a borrower, secured by collateral.  Borrower pays off loan with a bad check drawn on another institution.  Upon release of the collateral, the borrower liquidates it and transfers the funds out of the reach of the bank.  When the check fails to clear, the bank peruses the borrower, but has no expectation of collection.

This loss would be recorded through the ALLL even though the loss was caused by the fraudulent actions of the borrower because the case has the two required elements of a credit loss.

Operational Loss

Losses that arise outside of a relationship between a creditor and a borrower.  

Case Example:

Loan officer at a bank creates a loan application and loan file for a straw borrower.  The loan is approved and funded in the regular course of business.  When the loan becomes delinquent, the scheme is discovered, but the prospect of recovery is unlikely. 

This loss would be classified as an operational loss as there was no real borrower and no real credit relationship. 

Whether either of these losses would be covered by a bank's insurance carrier would be based on the terms of the policy and should be explored with legal counsel.  If it is determined the bank has a covered loss, the question arises, when should a receivable from the insurance carrier be recorded?  This topic is addressed in the article "Recievables-Troubled Debt Restructuring."