Debt write-off signals the end of a bad asset in the balance sheet of a bank. It is replaced by equivalent fund. The financial statement of the bank will indicate that the written off loans are compensated through some other way. This is needed to cleanse the balance sheet of the bank. Cleaning of the balance sheet means bad assets are replaced.
From the banking angle, the term “write-off” is just an accounting term. It means the bank or lender doesn’t count the money borrower owes to it. Write-off for a defaulter doesn’t mean he is pardoned; rather legal actions against him will continue.
You can analyze write-off from three angles:
The bank – its balance sheet will improve.
The defaulter – has to face consequences including legal actions.
General public – get a notion that taking loans and not repaying it is profitable.
The best way is to understand the term from the angle of the bank because, it is the bank that must bear the burden, initiate process and has the responsibility to replace the bad assets. Bad asset problem is the survival issue for the bank. Replacing bad assets through write-offs is the way out.
When write-off will happen?
When a debtor fails to repay the loan for a considerable time and the bank counts the loan as a ‘loss asset’, write-off process is initiated. Here, there is a defaulter.
When the government declares a debt waiver scheme for specific categories like farmers (agricultural loans) and students (educational loans), banks can waive the loan and it will be equivalent to write off. But here, the government pays loans to the bank on behalf of the debtor. There is no case of default here.
How written off loans should be compensated?
Securitization – here the bank can sell the underlying assets (building, machineries etc.) of the defaulter to an asset reconstruction company. Even in this process only a part (sometimes- major part) of the loan can be reclaimed. The remaining should be compensated by the bank from its own profit or from capital.
Provisioning – here, the bank uses profits and other money to compensate for the written off assets.
Capital – here, the bank uses contributions of its shareholders (in the form of new capital) to compensate the written off assets. The recent recapitalization is an example for this format.
Implication of debt write-off on the economy
Debt write-off relieves banks as it reclaims its blocked funds for doing business. Bank is the most important beneficiary if write-off is done in the desirable way. Too much money blocked for too long time will reduce bank’s lending capacity.
For the economy, once banks are made strong, they can finance more economic activities and in this way, write-off will benefit the economy.
For the defaulter, the legal action will put him under pressure and his financial activities are curtailed.