Why do banks write off bad debt?

Banks prefer to never have to write off bad debt since their loan portfolios are their primary assets and source of future revenue. However, toxic loans—loans that cannot be collected or are unreasonably difficult to collect—reflect very poorly on a bank's financial statements and can divert resources from more productive activity. Banks use write-offs, which are sometimes called "charge-offs," to remove loans from their balance sheets and reduce their overall tax liability.

Banks never assume they will collect all of the loans they make. This is why generally accepted accounting principles (GAAP) require lending institutions to hold a reserve against expected future bad loans. This is otherwise known as the allowance for bad debts.

For example, a firm that makes $100,000 in loans might have an allowance for 5%, or $5,000, in bad debts. Once the loans are made, this $5,000 is immediately taken as an expense as the bank does not wait until an actual default occurs. The remaining $95,000 is recorded as net assets on the balance sheet.

If it turns out more borrowers default than expected, the bank writes off the receivables and takes the additional expense. So if our example bank actually has $8,000 worth of loans default, it writes off the entire amount and takes an additional $3,000 as an expense.

When a nonperforming loan is written off, the lender receives a tax deduction from the loan value. Not only do banks get a deduction, but they are still allowed to pursue the debts and generate revenue from them. Another common option is for banks to sell off bad debts to third-party collection agencies.

(For related reading, see: What is the difference between a write-off and write-down?)