When Banks Write Off Massive Loan Amounts

Should We Be Bothered?

Newsreel Asia Insight #66
Dec. 7, 2023

Recently, the Indian government revealed in the Lok Sabha that Scheduled Commercial Banks (SCBs) have written off 10.6 trillion rupees in loans over the last five years, as reported by Business Line. This practice of loan write-offs, while not directly funded by the government, has far-reaching consequences for both the economy and the general public.

Notably, half of this amount is linked to big industrial groups. To put 10.6 trillion rupees into perspective, if we were to divide it among India’s 1.4 billion people, each person would get about 7,500 rupees. And what are SCBs, which erased this amount? They include a variety of banks we have our accounts with, like the State Bank of India, Punjab National Bank, HDFC Bank, ICICI Bank, and even international banks like Citibank and HSBC.

Before delving into the consequences of banks writing off substantial loans, let’s understand how this process unfolds within the Indian banking context. A loan write-off in banking doesn’t mean the debt is forgiven or the loss absorbed by the government or bank immediately.

Instead, when a bank writes off a loan, it’s removing that loan from its financial statements. This is a standard accounting move to keep the bank’s books in order. A loan usually gets written off when it becomes a Non-Performing Asset (NPA), which happens when the borrower hasn’t paid the interest or principal for a long time.

Before writing off a loan, banks must set aside funds to cover possible losses. These funds, taken from the bank’s earnings, help cushion the financial blow if the loan goes bad. This practice is essential for maintaining a bank’s financial health, even when some loans don’t pan out. Thus, while the government doesn’t directly bear the cost of these write-offs, the profitability of banks, especially public sector ones where the government is a major shareholder, is affected.

It's important to note that writing off a loan doesn’t halt recovery efforts. Banks still try to get back their money by selling bad loans, taking legal action, or seizing and auctioning collateral.

In this whole process, the government doesn’t directly spend money to write off these loans. However, if a public sector bank needs more capital due to a high number of NPAs, the government might step in to recapitalise it, ensuring its stability and ongoing operations.

The Reserve Bank of India sets strict rules for loan write-offs and recovery, ensuring these actions are not random and align with the banks’ financial health.

Now, let’s consider the broader impact.

Banks’ health is vital for everyone, as it affects the safety of deposits and the availability of banking services. Big loan write-offs can strain banks, possibly leading to stricter loan conditions and higher interest rates. This makes it harder for people to get loans for homes, education, or personal needs.

Public trust in the banking system is crucial. When big borrowers get their loans written off, it can create a sense of unfairness and distrust. This might push people to seek riskier investment options instead of bank deposits.

Though the government claims it doesn’t spend on corporate loan write-offs, the indirect effects on the economy and public funds are substantial. If public sector banks need recapitalisation due to write-offs, it could mean using taxpayer money, reducing funds available for healthcare, education and infrastructure.

Large loan write-offs can ripple through the economy. A weaker banking sector might lend less, affecting credit availability for small and medium businesses, key for jobs and growth. This impacts employment and economic stability, directly affecting people’s lives.

These write-offs can also influence inflation and interest rates. If the government has to pump money into banks, it might lead to more government borrowing, affecting inflation and interest rates. Higher inflation reduces people’s buying power, and higher interest rates make loans costlier.

There’s also the risk of moral hazard. If big borrowers seem to get off easily, it might encourage risky borrowing and lending, destabilising the financial system. This instability affects the economic environment for everyone.

Finally, this issue raises questions of social fairness. Ordinary people, often diligent in repaying smaller loans, might see the system as biased towards big borrowers and corporations. This perception can undermine trust in the financial and judicial systems.

The government must take measures to mitigate the issue of bad loans. Among them could be enhancing the regulatory framework to ensure more rigorous assessment and monitoring of loan applications, especially of corporates. This involves setting stricter criteria for loan approvals and continuous monitoring of the financial health of borrowers.