In recent times several banks locally recorded losses on their books, sparking debates among people from all walks of life. Everyone seemed to have an opinion on what should have been done and why losses were recorded.
The sad reality is that not many people are informed about the reasons why banks, in particular, continue to record losses over a consistent period of time. It is very important that everyone pays attention to what goes on with our banks but one should not panic because of mere public perception. Panic can cause chaos and make things more complicated for a bank. The purpose of this article is to highlight a few ways in which banks record losses and become insolvent.
We must first establish where a bank’s stream of income and its profits are generated from.A company’s profit is all the revenue left over after all the expenses the business incurs have been deducted from the income received. Banks derive most of their income from fees, interest income on investments and loans. Profits are recorded when the bank pays all its operational costs and interest on your savings. If a bank is unable to pay its debts, and ultimately the interest on your deposits, it will eventually become insolvent. The first course of action for a bank making losses is to evaluate its operational costs, interest paid to you, the depositor, and finally, its loan portfolio.
One needs to be aware that when a bank gives loans to its customers, it records this as an asset. If the banks are owing to other parties more than it is owed, its assets (especially loans) are worth less than its liabilities i.e. depositor funds, shareholders capital etc. As mentioned earlier, one of the main sources of income for a bank is interest on loans provided. In reality, not all loans given will be properly serviced. When loans are classified as non-performing, the bank must incur the expense and write it off as a bad debt. Banking regulations require that a bank holds a certain percentage of its capital as a provision for bad loans. This enables the bank to give a more accurate picture of its financial position.
There is no need to panic when it is reported in the news that a bank is making losses or is being taken over by other banks. Normally, this is done to ensure that depositor funds are protected and the livelihood and jobs of its employees are safeguarded. No economy can afford to have any of its commercial banks fail, especially if most of its shares are owned by the public purse. Banks must ensure that they implement proper credit risk policies and investment practices so that they can continue to make profits and remain solvent.
However, what happens when that provision is not adequate and a bank is forced to write off more than it was supposed to? It means that its capital will eventually erode. The value of its shares will decrease (capital erosion) and the shareholders will not get paid dividends. As a result, a bank has to reevaluate its lending policies, try to recover non-performing loans and look for capital injection.