A bad loan refers to a loan that is unlikely to be repaid by the borrower, either because they are facing financial difficulties or because they are simply unwilling to pay.
When a loan becomes “bad,” the bank may face financial losses and must take legal action to recover the funds, sometimes writing off the remaining amount as a loss if the borrower declares bankruptcy.
In the banking industry, bad loans are formally managed under the category of Non-Performing Assets (NPA).
1. Categorization of Bad Loans (NPAs)
An asset becomes non-performing when it stops generating income for the bank. According to the RBI, a loan is classified as an NPA if interest or principal installments remain overdue for more than 90 days. These are further classified into three categories based on how long they remain unpaid:
- Substandard Assets: Loans that have remained NPAs for 12 months or less.
- Doubtful Assets: Loans that have stayed in the substandard category for more than 12 months.
- Loss Assets: These are assets where the loss has been identified by the bank or the RBI, but the loan has not been completely written off because some residual value might remain.
2. Key Terms in Managing Bad Loans
- Slippage: This occurs when a standard (healthy) loan “slips” and becomes an NPA because the borrower has missed payments for over 90 days.
- NPA Provisioning: Banks must set aside a portion of their profits to cover potential losses from bad assets. This helps maintain a healthy book of accounts and is known as the Provisioning Coverage Ratio.
- Subprime Borrowers: These are high-risk individuals with poor credit histories. Granting “teaser loans” (low initial interest rates) to subprime borrowers was a primary cause of the 2007-08 Global Financial Crisis.
3. Write-off vs. Waive-off
It is important to distinguish between how a bank cleans its books and how a debt is forgiven:
| Feature | Loan Write-off | Loan Waive-off |
|---|---|---|
| Purpose | A tool to clean the balance sheet and minimize tax liabilities. | A facility to help borrowers (often farmers) during natural calamities. |
| Recovery | The debt is not forgiven; the bank continues legal action to recover the money. | The borrower is free from the burden of repayment. |
| Collateral | Collateral is confiscated and auctioned by the bank. | Collateral is given back to the borrower. |
4. Recovery Mechanisms in India
To tackle the “NPA Crisis”—which peaked around 2016 when many public sector banks reported massive losses—India introduced several tools:
- SARFAESI Act, 2002: Allows banks to take possession of and sell securities (like property) for secured loans without court intervention.
- Asset Reconstruction Companies (ARC): These entities buy bad loans from banks to clear the banks’ balance sheets.
- The “Bad Bank” (NARCL-IDRCL): A new structure where the NARCL acquires stressed assets and the IDRCL handles their sale in the market.
- Insolvency and Bankruptcy Code (IBC) 2016: Provides a time-bound process for resolving insolvent businesses or liquidating their assets.
To understand a Bad Loan: Think of a Library (the Bank) that lends out Books (Loans).
- Standard Loan: The borrower returns the book on time.
- NPA (Bad Loan): The borrower is 90 days late. The library now marks that book as “missing” (NPA) and stops counting it in their active inventory.
- Provisioning: Because the book is missing, the library sets aside some money from its “Late Fee Fund” to eventually buy a replacement book so the library doesn’t go empty.
- Write-off: The library removes the book from its public catalog to make the inventory look clean, but they still have the borrower’s name on a “Blacklist” and will try to get the book back if they see the person again.
- Waive-off: The library tells the borrower, “It’s okay, you don’t have to return it or pay the fine,” and wipes the record clean entirely.