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Thursday, November 17, 2016

What is a Loan Write Off?

Even before the dust has settled from the Demonetisation of the 500 and 1000 rupee notes bombshell dropped by the Indian government last week, yet another topic has become the most widespread shared & criticised subject. What is it?

“Loan Write off by Banks” is that hot topic and everyone is talking about this subject but based on what is being spoken, it looks like; the ones doing the talking don’t understand what a Write Off is. The purpose of this article is to help you understand that is a Loan Write Off, why banks do it and what happens after the write off.

Before we begin: This is not a politically motivated article. The purpose of this article is to help you understand what a Write off is, that’s all. Please refrain from posting politically affiliated comments in the post. Thank you.

Why this Article?

Ever since news broke out over the fact that SBI has written off some of Vijay Mallya’s Loans, there are tons of forwards going around in whatsapp and social media. In my school friends whatsapp group, this topic is under heavy discussion and one of my friends (Albert) wanted me to help clarify to the group on what exactly is a Write off and is it the same as Waiving off loans. So, here we go…

What Exactly is a Loan Write Off?

Let us assume you have taken a loan of Rs 1,00,000 from a bank but are unable to repay. From the bank’s point of view, the loan is an ‘asset’ and the interest that you repay is an ‘income’. As long as you continue to make the EMI payments, it is considered a normal and the loan features in the asset column of the Bank’s Balance Sheet.

Lets say you stop repaying your EMI, the bank will generate lower revenue due to your missed payments – right? The bank is going to make attempts at contacting you to resume your loan payments and this usually goes on for a few weeks/months and until this is happening, your loan will remain in the “Assets” column in spite of the fact that the bank isn’t generating any revenue from it.
But, beyond a point, as per the norms set forth by the Reserve Bank of India, if there is no Income coming from an asset (in this case Interest & EMI) the bank will have to first provide for the loss of that asset and then remove it from its Balance sheet.

This process is what is called a “Write-off”.


What Happens to the Asset ?

From the actual definition of the Write Off, you may have gotten an impression that the bank is just giving up and isn’t going to ask you (the borrower) for payment. Am I right?

Actually, a Write Off does not mean that the bank is not going to try to recover money from you. They may either try to continue to recover the money themselves or sell your loan to a recovery company who will continue to push you for repayment.

A loan that has been written off only disappears from the banks balance sheet for the current financial year. They DO NOT forget about the loan and you will continue to Owe the Bank Money.

To Be Very Specific to the SBI Kingfisher scenario, SBI Bank will continue to pressure Kingfisher and its owner Mr. Mallya to repay the amounts that they owe the bank. There are some legal proceedings going on which will continue to happen until a decision is arrived at through the system. This write off is only for the banks financial statements and DOES NOT mean that Kingfisher doesn’t need to repay the loan.

Why Does the Bank Do this?

Now that you know that a write off doesn’t mean loan waiver, you may be wondering why a Bank would do something like this – right?

There must be some benefit for the bank in writing off your loan otherwise why do it at all?

Firstly, after the write off, the bank can distinguish between loans that are still actual “Assets” and those that aren’t. More importantly, writing off loans help Banks get some tax breaks because these write offs are considered as “Losses” for that financial/tax assessment year and hence reduce the banks tax liability for the year.

Who Pays for this Loss?

As the loan borrower hasn’t repaid the loan, the bank has written off the loan which means someone is going to incur some losses. The bank will bear some portion of the losses but not all because the government is allowing them some tax offset due to the loss.

So, I would say eventually it is the Government that is making the loss. If the loan was properly repaid, the bank would have earned its share of income and paid a % of it as taxes. Now, neither has happened and the Government has lost tax revenue.


Why are Banks Allowed to Write Off Loans?

Now, you may be wondering, if the Government is losing Tax Revenue, why are they allowing Banks to Write Off Loans? Am I right?

According to the rules set forth by the RBI, Banks can only lend so much % of their deposits as loans. Up until a few years bank, Banks did not have this habit of write off’s and continued to keep even bad loans as “Assets” on their books. As the amount of loans was already close to the threshold, banks would stop lending to other customers who actually need funds. This type of paused lending activity by banks causes a lot of negative effects on the markets and the country’s economy as a whole. That is why the RBI intervened and instructed banks to write off loans that are not in a position to be recovered immediately so that they can continue to lend to other customers who need the money.

In fact, banks these days are forced to clean up their balance sheets on a regular basis to flush out such toxic loans and continue lending to deserving customers.

Does this Loan Write Off Affect Others?

As banks give loans using the money they collect from us as Deposits, the natural question now would be whether these write off impact other customers of the Bank – right?

Yes, Write offs will have impact on other customers of the bank – both deposit customers as well as loan customers. As part of our deposit agreement banks are bound to give us back our principal amount so, we aren’t losing out on the capital. However, if there are too many loans being written off by a bank, it will have a negative impact on the interest rates they are able to offer to their deposit customers. Similarly, they may increase the interest rates on other borrowers to try to recover their lost interest income.

Does this Loan Write Off Affect the Defaulter?

Of course, Yes. First and foremost the bank will initiate legal proceedings and try to recover as much money as possible from the Defaulter. On top of this, banks these days are maintaining a centralized list of such defaulters so, it will be very difficult for such individuals to borrow money from the banking system in India, in future.

Some last words:

As you can see a loan write off is more of an accounting procedure to allow the banks to clear up some space for new loans and avail some tax benefits. It does not mean that the bank has forgiven the defaulter and he/she doesn’t need to repay the loan.
Hope I was able to help you understand about the Write Off concept. If you have any questions on this topic, please feel free to leave a comment and I would be more than happy to answer them.
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