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What happens to your outstanding loans if the bank falls?

Parag NarangParag Narang | Updated: 30-11-2019 19:53 IST | Created: 30-11-2019 19:44 IST
What happens to your outstanding loans if the bank falls?
Contrary to many arguments, the loans neither get waived off nor the depositors are required to pay the full amount upfront.

Fears of a global recession are looming in different parts of the world and with it comes the horrors of the 2008 financial crisis, when it seemed like at least one bank is falling every Friday for a few months. There has been a lot of discussions about how people can lose their life savings when a bank falls, the deposits are insured to a certain amount and depositors might just lose anything above that. The amount varies widely from country to country, with standard insurance amount in India set at only about USD 1,400 (Rs 1,00,000) while in the United States it is set at USD 250,000 (Rs 1,75,00,000).

But what people don't usually talk about is what happens to the money, like home loans, personal loans, and student loans, that are owed to the bank. And the answer is not as simple as one might think.

Interesting Fact: Most banks fail on Fridays and experts believe the trend goes back to when banks were not online and used to be closed on Saturday and Sunday. It was done so that the authorities had the weekend to sort things out before the business day.

What happens to the loans owed to a bank when it falls?

Banks are large institutions with many of them being systemically important to the economy, and falling of a bank is almost always a major event because the ripple effects are visible in the stock market and ultimately the economy. But the world has still witnessed many such events during the great recession when as much as a total of 489 banks and thrifts failed from 2008 to 2013 in the US alone, according to Federal Deposit Insurance Corporation (FDIC).

When a bank fails, depositors get their money back although only up to a certain insured amount. But what happens to loans owed to the bank?

Contrary to many arguments, the loans neither get waived off nor the depositors are required to pay the full amount upfront. But the loans are just transferred or sold to a different entity and the agreement remains mostly the same.

To understand this better you must understand that loans are negotiable instruments that are routinely sold in the financial markets. When a loan is sold, the borrower retains all the rights and obligations associated with the loan note or loan agreement. The borrower will usually be notified by the new holder of the note and given payment instructions.

The laws might vary slightly from country to country. In some cases, the entity who has acquired the failed bank will automatically be entitled to recover borrowed loans while in other countries the loan-selling process must go through the regulator. But one thing is for sure, there is no such thing as free lunch in this situation.

What has happened in the past?

Thousands of banks have failed if looked at the world collectively and the 2008 financial crisis was arguably the bloodiest time for banks and financial institutions. In the US, the Emergency Economic Stabilization Act was brought in during October 2008. This temporarily raised the basic limit of federal deposit insurance coverage from USD 100,000 to USD 250,000 per depositor. It was earlier planned that the basic deposit insurance limit will return to USD 100,000 but new legislation passed in July 2010 made the USD 250,000 figure permanent.

Depositors with uninsured deposits in a failed bank may also recover some or all of their money but it depends on the recoveries made from selling the assets of failed institutions. There is usually no time limit on these recoveries, and it can take years for a bank to liquidate its assets.

As far as outstanding loans owed to the bank go, FDIC either sold them at the closing of the bank or retained it temporarily but the obligation to pay didn't change.

The story is a little different in India, which is among the countries that have the lowest standard deposit insurance coverage, it boasts a strength that many other countries can't. No scheduled commercial bank has been allowed to go under in India since liberalization policies were announced in 1991, according to a report in Economic Times. The country faired well even during the 2008 crisis and the Reserve Bank of India along with the government has always made sure that a failing bank gets acquired before it drowns.

Although struggling scheduled commercial banks have been merged or acquired which saves the deposits, the co-operative banks haven't been so fortunate. Dozens of co-operative banks have failed and the outstanding loans have been transferred to other lenders. But thousands have also lost their life-savings in such events.

One such case is of Ahmedabad's Madhavpura Mercantile Cooperative Bank, which failed in 2001 due to a large-scale scam. Deposits up to Rs 1,00,000 were returned to depositors while the fight to recover money continued and only after 17 years, in 2018, it was announced that deposits up to Rs 2,00,000 will be returned.


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