CFA Level II Exam · Analysis of Financial Institutions

Bank Asset Quality, Provisioning and Earnings Analysis

Updated 7 October 2026 · Fact-checked

Asset quality analysis checks how likely a bank's loans are to be repaid. You measure non-performing loans, loan loss reserves and provisions against total loans. Then you test earnings with net interest margin, efficiency ratio and the share of income that is recurring. Compare each ratio over time and with peers.

Understand Asset Quality, Provisioning and Earnings Analysis

A bank earns money by lending at a higher rate than it pays on deposits. The risk is that some borrowers do not repay. So the first question about any bank is: how good are its loans?

Non-performing loans (NPLs) are loans where the borrower has stopped paying, usually for 90 days or more, or where payment is doubtful. The NPL ratio divides NPLs by gross loans. A rising ratio signals trouble. Loans that are restructured or renegotiated may hide the problem, so read the disclosures on forbearance.

Banks set aside money for expected losses. The loan loss allowance (or reserve) is a balance sheet account that reduces loans to their net carrying amount. The provision for loan losses is the income statement expense that tops up the allowance. Under IFRS 9, banks use an expected credit loss model with three stages, so provisions are recognised earlier than under old incurred-loss rules. Write-offs remove a loan and cut the allowance, but they do not hit the income statement again.

Provisions need judgment, so they are a tool for earnings management. A bank can under-provide to lift profit, or over-provide in good years to build a cushion and release it in bad years to smooth earnings. Coverage ratios (allowance ÷ NPLs) and provision relative to NPL growth help you spot this.

Then look at earnings. Net interest margin (NIM) shows the spread earned on assets that produce interest. The efficiency ratio shows how much cost it takes to earn a unit of revenue. Quality earnings come mainly from recurring net interest and fee income, not from one-off gains, securities sales or reserve releases.

Key formulas to remember

NPL ratio: NPL ratio = Non-performing loans ÷ Gross loans; Higher means weaker asset quality. Use gross loans unless told otherwise.
Allowance (coverage) ratio: Coverage ratio = Loan loss allowance ÷ Non-performing loans; Below 100% means the allowance does not cover all NPLs, though collateral may cover the gap.
Allowance to loans: Allowance ratio = Loan loss allowance ÷ Gross loans; Shows the cushion against the whole book.
Allowance roll-forward: Ending allowance = Beginning allowance + Provision − Write-offs + Recoveries; Use it to find a missing item. Write-offs reduce the allowance. Recoveries add to it.
Net charge-offs: Net charge-offs = Write-offs − Recoveries; Often expressed as a percentage of average loans.
Net interest margin: NIM = Net interest income ÷ Average interest-earning assets; Net interest income = interest income − interest expense. Use average earning assets, not total assets.
Efficiency ratio: Efficiency ratio = Non-interest expense ÷ (Net interest income + Non-interest income); Lower is better. Definitions vary, so use the one the vignette gives.
Pre-provision profit: Pre-provision profit = Net interest income + Non-interest income − Non-interest expense; Shows earnings power before credit-cost judgments.

How to solve Asset Quality, Provisioning and Earnings Analysis questions

Use this order for any vignette on bank asset quality or earnings.

1Read the question first and note which ratio or judgment is asked for, such as NPL ratio, NIM or earnings quality.
2Find the data in the exhibits. Separate gross loans, net loans, allowance, provision and write-offs, because they are easy to confuse.
3Pick the formula and check the denominator: gross loans, NPLs, average earning assets or total revenue.
4If an item is missing, use the allowance roll-forward to solve for it.
5Calculate to enough decimals and compare with the prior year or the peer figure given.
6Interpret the direction. Ask whether the change is driven by credit costs, margin, costs or one-off items.
7Check for earnings management: provisions falling while NPLs rise, reserve releases, or large securities gains.
8Choose the option that matches both your number and your reasoning.

Quickest way: Three-check shortcut

When to use it: Use when time is short and the question asks for a judgment on a bank's credit or earnings.

Check 1: Is NPL growth outpacing loan growth? If yes, asset quality is weakening.
Check 2: Is the provision falling or the coverage ratio dropping while NPLs rise? If yes, suspect under-provisioning and lower earnings quality.
Check 3: Is profit growth coming from net interest and fees, or from reserve releases and one-off gains? Only the first is sustainable.
For any calculation, write the formula with its denominator before you plug in numbers.

Common mistakes in Asset Quality, Provisioning and Earnings Analysis

Treating the provision and the allowance as the same thing.
Both relate to loan losses and the names sound alike.
Fix: The provision is an income statement expense for the period. The allowance is a balance sheet stock. Link them with the roll-forward.
Subtracting write-offs from the provision expense in the roll-forward.
Students think write-offs are an expense.
Fix: Write-offs reduce the allowance directly and do not touch the income statement. Only the provision is expensed.
Using total assets as the NIM denominator.
Total assets is the more familiar base.
Fix: NIM uses average interest-earning assets. Exclude cash that earns nothing, fixed assets and other non-earning items if the exhibit separates them.
Reading a lower provision as better credit quality without checking NPLs.
Lower expense raises profit, so it looks good.
Fix: Compare the provision with NPL trends and coverage. A cut while NPLs rise is a red flag.
Thinking a higher efficiency ratio is better.
Most other ratios in finance reward higher values.
Fix: The efficiency ratio is cost per unit of revenue, so lower is better.
Ignoring restructured loans when judging asset quality.
The reported NPL ratio looks like the whole story.
Fix: Restructured loans that are not classified as non-performing can mask problems. Look for forbearance disclosures and adjust your view.

Worked examples

Example 1

Vignette: Bank Alder reports for the year (in millions): beginning loan loss allowance 400; provision for loan losses 150; write-offs 120; recoveries 20. Gross loans at year-end are 20,000 and non-performing loans are 800. Q1: What is the ending allowance? Q2: What is the coverage ratio? Q3: What is the NPL ratio?

Show the solution

Q1: Ending allowance = 400 + 150 − 120 + 20 = 450.
Q2: Coverage ratio = 450 ÷ 800 = 0.5625, or 56.25%.
Q3: NPL ratio = 800 ÷ 20,000 = 0.04, or 4.0%.
Interpretation: The allowance covers about 56% of NPLs, so the bank relies on collateral or expected recoveries for the rest.

Answer: Q1: 450 million. Q2: 56.25%. Q3: 4.0%.

Example 2

Vignette: Bank Brandt reports (in millions): interest income 900; interest expense 400; non-interest income 200; non-interest expense 330; provision for loan losses 60. Average interest-earning assets are 12,500. Last year, NPLs rose 30% while the provision fell 25%. Q1: What is NIM? Q2: What is the efficiency ratio? Q3: What does the provision trend suggest about earnings quality?

Show the solution

Q1: Net interest income = 900 − 400 = 500. NIM = 500 ÷ 12,500 = 0.04, or 4.0%.
Q2: Revenue = 500 + 200 = 700. Efficiency ratio = 330 ÷ 700 = 0.4714, or 47.1%.
Q3: NPLs rose sharply while the provision fell. That pattern suggests under-provisioning, which lifts current profit but is not sustainable.
So reported earnings are of lower quality than the margin and efficiency figures alone suggest.

Answer: Q1: 4.0%. Q2: about 47.1%. Q3: Provisions look too low relative to NPL growth, so earnings quality is lower and profit may be overstated.

Exam tips

Always write the denominator out. Many wrong options are right numbers divided by the wrong base.
Expect a roll-forward question. Learn the signs: provision adds, write-offs subtract, recoveries add.
When asked about earnings quality, link the direction of provisions to the direction of NPLs before commenting on profit.
Look for one-off items in the vignette, such as gains on securities or reserve releases. They usually signal lower-quality earnings.
Use the efficiency ratio definition in the vignette if one is given. Do not impose your own.

Asset Quality, Provisioning and Earnings Analysis: frequently asked questions

How do you calculate net interest margin?

Subtract interest expense from interest income to get net interest income. Divide that by average interest-earning assets. For example, 500 ÷ 12,500 gives a NIM of 4.0%.

What is the difference between loan loss provision and loan loss reserve?

The provision is the expense recorded in the income statement for the period. The reserve, or allowance, is the balance sheet account that builds up from provisions and falls with write-offs.

Is a high NPL ratio always bad?

A high or rising ratio signals weak asset quality and potential future losses. Judge it with the coverage ratio, collateral and the trend. A bank with a high NPL ratio but strong coverage is in a better position than one with weak coverage.

How can provisions be used to manage earnings?

A bank can under-provide to raise profit or over-provide in strong years and release reserves later to smooth results. Watch for provisions moving opposite to NPLs and for profit that depends on reserve releases.