So, you’ve been following Newslaundry’s series on the Reserve Bank of India’s Wilful Defaulters and Defaulting Borrowers List but is the jargon getting to you? Worry not. We bring you an explainer that will tell you everything (we mean it) you need to know about banks and bad loans. Yes, there’s more to it than Mallya’s good life. And you need to care about it because public money is at stake.

 Why do banks extend loans?

Taking deposits and lending are the two main activities a bank carries out. Depositors – individual and organisations – open accounts with banks for safely parking their money for any length of time, depending on their needs. Banks pay these depositors some interest for the period their money stays in that account. Depositors can also lock in their money for specified periods of time in ‘fixed’ or ‘term’ deposits that earn higher interest than that from money deposited in accounts.

On the other hand, individuals or organisations needing money typically borrow from banks and pay a certain interest, which is usually higher than what banks pay their depositors. Banks, therefore, earn money by lending at rates of interest higher than the rates they pay to depositors. Banks collect interest from their borrowers and in turn, pay interest to their depositors at a slightly lower rate. The difference between the two rates of interest is effectively the money the bank gets to keep as its profit.
Extending loans is therefore key to a bank actually remaining in business.

Banks also lend money to institutions and companies using instruments other than simple loans. They do so by buying bonds or debentures issued by the institution that requires money. Such borrowings are typically done for a specific period of time and at a specified rate of interest.

How do banks lend?

Typically after an individual or organisation applies for a loan, the bank checks for the borrower’s creditworthiness. In other words, the bank conducts a process of due diligence to see if the borrower would have the ability to repay the principal amount and interest. For individuals, Indian banks would typically check with a credit information company like the Credit Information Bureau (India) Ltd (Cibil), which gives each individual a so-called ‘credit score’ depending on his or her loan repayment history.

Similarly, for an organisation, a bank would look at its balance sheets to determine its profitability and indebtedness. If the company is profitable and has few liabilities on its books, it stands a greater chance of securing a loan at favourable terms. If, on the other hand, it is in loss or has significant liabilities on its books, the bank might still choose to loan it money, but on stringent terms and at a higher rate of interest. However, if the bank is convinced that the borrower cannot repay, it might choose not to extend a loan.

Why and how do loans go bad?

A borrower is said to ‘default’ on a loan when repayments on the interest or the principal amount are not made in accordance with the terms originally agreed upon with the bank that lent the money.
A loan is said to go ‘bad’ when the bank is convinced that it may never be repaid by the borrower. This usually happens when the borrower goes bankrupt or when the legal and other costs of pursuing the debtor to pay up might actually be more than the money that the bank can actually collect. In such cases, the loan becomes worthless and such ‘bad’ loans are listed as an expense on the bank’s balance sheet, effectively also reducing its net income by an equal amount. Although banks make allowances for a certain fraction of their lending going bad, it becomes a problem when the proportion of bad loans exceeds their estimates.

What does a bank do when a loan goes bad?

In an ideal world, banks would not want bad loans in their books. But bad loans are a reality with which every bank must grapple. When borrowers default on loan or interest repayments, willfully or otherwise, banks try and encash the underlying surety or collateral against which the loan was given, to recover as much of the money as possible. Banks often take legal action against defaulters in a bid to get them to pay up. Often, this results in no real recovery, although in some cases, banks do succeed, if only partially. In cases where it becomes apparent that the default is willful — which is to say the defaulter is not paying up despite having the option of liquidating some personal property — the banks can get law enforcement agencies to act against the defaulter, to try and recover the same.

What about the money that cannot be recovered?

As mentioned earlier, what cannot be recovered, must be written off. So, banks would typically write such bad loans off their books. Now, loans are assets on a bank’s book, and loans are what earn a bank income. So, a write-off does mean that your assets dwindle and your earnings take a hit, but too many bad loans or Non Performing Assets (NPAs) also don’t look good on your books. A write-off can also help pare the bank’s tax liability, which, if anything, is the proverbial silver lining.

How are NPAs classified in India?

Any asset that stops generating income for the bank is a Non Performing Asset (NPA). Typically, a loan is considered an NPA if an installment on the repayment of the interest or principal amount remains overdue for more than 90 days. NPAs are further sub-classified into the following categories:

1. Substandard asset – any loan that has remained an NPA for 12 months or less. In such cases, while banks are prepared to suffer some losses, they do try and recover some part of the outstanding amount.
2. Doubtful asset – any asset that has remained substandard for 12 months becomes a ‘doubtful’ asset. At this stage, recovery becomes extremely doubtful.
3. Loss asset – an asset that has been deemed uncollectable after an internal or external audit or an inspection by the RBI, but has not yet been written-off the books of the bank. Despite its inherent uselessness to the bank, the loan is not written-off outright because the bank may think that a part of it might still be salvaged.