Debt: Debt is the sum of money borrowed from one party (the lender) to another (the borrower). The primary function of a bank is to deposit and lend money (debts), they classify these debts as an asset and these assets bring income to the bank- in the form of interest payments, which in turn helps banks to increase their business. Debt given to customers can be in the form of a loan or a credit card. Deposits are in fact liabilities for the bank, since it is the amount of money they owe back to their customers.
When does the Debt become bad? Debts are said to be bad when they fail to generate income for the bank (i.e. the customer is not able to pay back the instalments or defaults on the loan) which means that the bank ends up making losses from these assets.
Banks also maintain a provision for these debts given out called the ‘Provision for Bad debts’ in order to protect continuity of the business if such cases do occur.
Banks need to write-off such debts that are declared as non-collectable (i.e. no further payment can be collected from the customer on the loan or a credit-card) – thus it needs to be removed from the balance sheet. Since debt is an asset for the bank, a non-collectable debt signifies a reduction in the asset’s value by the expense incurred or loss.
How does a bank Write-off a debt? Let’s understand this with a simple example:
Suppose Mr.A takes Rs.10,00,000 loan from XYZ bank.
The bank maintains 5% provision for bad debts for all the loans given out. Hence setting sets aside Rs.50,000 in the form of a provision (or expense) by the bank and the remaining Rs.9,50,000 is recorded as the net assets in the balance sheet.
The customer is able to pay Rs.7,00,000 back to the bank, but is unable to make any further payments (i.e. defaults on the remaining amount). If beyond a point there is no income coming from the asset- the bank will first provide for the loss of an asset and then remove it completely from the balance sheet. This process of declassifying the loan as an ‘asset’ in the books is what is termed as write-off.
XYZ bank has a defaulted loan for Rs.3,00,000, it write-off’s the entire amount and takes extra Rs.2,50,000 (Rs.50,000 comes from the provision made by the bank, when the loan was issued) as an additional expense.
What does it means for the bank? This additional expense taken by the bank is the loss incurred, which reduces the bank’s profits. The bank also gets a tax relief due to the reduced profit. Thus, by giving a true and fair picture of its assets that is making money the bank gets a tax-break on the loss incurred.
Further still, banks also have the option to pursue the loan and generate the revenue. Some banks sell the write-off book to a third party to recover the loans or might hire a third party on commission basis for the recovery of the write-off amount.
It is important to note here that the loan amount comprises of two components- Principle amount + Interest amount, the loss in interest amount for the bank is reduction in their income, while a loss in principle amount is the loss in the value of an asset.
Does it affect other depositors? Banks that have a high level of non-performing asset tend to have low deposit rates and keep lending rates high in order to recover the losses on these assets.