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Assume a bank gives a loan to Mr X. for, say 100. The bank's assets (account "loans") increases by 100, and its liabilities (account "deposits") also goes up by 100 (which is the extra 100 added to the current account of Mr X. who asked for the loan).

Say Mr. X does not want to pay the loan + interest. The bank is, by law, entitled to them, so it can use the law to reclaim the money and interest (maybe possessing some material wealth like a house or other collateral used to secure the loan in the first place). However, can a bank, in theory, simply erase the loan and deposit? Can it simply eliminate the 100 from both assets and liabilities? Wouldn't this leave the bank exactly the same as in the beginning?

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    $\begingroup$ The deposit will usually be long gone, though, won't it? Mr. X borrowed the money to use it, not save it. $\endgroup$
    – 410 gone
    Nov 20, 2017 at 15:27
  • $\begingroup$ @EnergyNumbers Im confused. So, when Mr X uses the 100 to pay the money, it still owes 100 to the bank, which is recorded in the bank assets. Which is the counterpart to this asset then? $\endgroup$
    – chatGPT
    Nov 20, 2017 at 16:04
  • $\begingroup$ Say Mr. X spent his 100 at shop Y which banks at bank Z. When the payment clears, X's bank now has a liability to bank Z $\endgroup$
    – 410 gone
    Nov 20, 2017 at 16:53
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    $\begingroup$ @EnergyNumbers If X cashes all the money, and buy something at a store, which deposites in Bank Z, how does Bank X knows about Bank Z? What is the account that the liability takes in Bank X, in your example? Is it still as deposits (but in other banks?) Sounds VERY strange. $\endgroup$
    – chatGPT
    Nov 20, 2017 at 20:48

3 Answers 3

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If Mr. X hasn't used the money, so it's all still in a deposit account at the same bank, then the bank may be able to cancel the loan. Whether they can or not, will depend on the exact contract attached to the loan.

If Mr. X has withdrawn the money as cash, then that transaction represented a drop in the bank's liability to Mr. X of 100, and a drop in the bank's assets of cash-at-hand of 100.

If Mr. X has used the money in a digital transaction, then they can no longer cancel both at the same time, as the asset of the loan is with Mr. X, but its matching liability will be with another party.

In either of the last two cases, the bank can cancel the loan, reducing its assets by 100. The balancing transaction will be a reduction in the bank's equity of 100 - i.e. the bank records a net loss on the loan of 100, and the shareholders make a loss of 100 on the transaction as a result.

(because assets = liabilities + equity)

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  • $\begingroup$ With which party? In what form is it recorded in the balance sheet? Take the example of cash that I gave in the comments. Neither Mick nor your answer has dealt with this issue, which is interesting to me. THanks! $\endgroup$
    – chatGPT
    Nov 21, 2017 at 12:02
  • $\begingroup$ @user928172 I've updated the answer - does that clear up the cash issue? $\endgroup$
    – 410 gone
    Nov 21, 2017 at 12:47
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    $\begingroup$ Let me see if I understand. when the loan is aproved, credit account in asset goes up by 100, and bank deposits in liabilities go up by 100. If I get cash out, deposit fall by 100, and cash (asset) falls by 100. If bank were to erase the loan, it would eliminate 100 in the credit account, and then 100 as losses in equity? $\endgroup$
    – chatGPT
    Nov 21, 2017 at 12:54
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    $\begingroup$ @user928172 correct $\endgroup$
    – 410 gone
    Nov 21, 2017 at 13:00
  • $\begingroup$ This is the thing I don't understand. When granting the loan, the bank creates the money Ex Nihilo. So when the loan does not get redeemed, the bank just loses something it created 5mn ago, I don't really understand how this can be considered a "real" loss. $\endgroup$
    – Elouan Keryell-Even
    Nov 15, 2020 at 10:58
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Yes, it can eliminate a loan (an asset), but assets have to equal liabilities, so it would also need to eliminate a liability.

It can't just eliminate any liability. It couldn't eliminate any deposit liabilities, for example, because it still owes money to depositors. This doesn't change just because a loan is written down.

If the loan is worth 100, it would have to eliminate 100 from shareholder equity (a liability). Shareholders would take a loss as a result of the bank writing down the loan.

The end result wouldn't be the same as how the bank started out. In the most simple case the bank started out with:

Start: 100 shareholder equity (Liabilities) and 100 cash (Assets).

It made the loan from cash: 100 shareholder equity (Liabilities) and 100 loan (Assets).

After writing down the loan: 0 shareholder equity (Liabilities) 0 loan (Assets).

The bank blew 100 in cash, which ultimately came out of the shareholders' pockets.

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If Mr X has not spent the money yet and has not taken it out of the bank in the form of cash then in theory a bank cancelling both the assets and liabilities would bring it back to how it was before the loan took place.

If Mr X spent the money, buying something from person Y the situation can no longer be undone by simply cancelling assets/liabilities because the liabilities are now liabilities to Y.

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  • $\begingroup$ But how does the bank of Mr X knows where person Y deposits the money? If the shop is done by cash, they cannot know! Unless they trace the phisical money, which is very odd. What if Y keeps the money as cash? $\endgroup$
    – chatGPT
    Nov 20, 2017 at 20:50
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    $\begingroup$ If the purchase was made with cash then step one is that X withdraws the cash - which already makes the loan non-undoable. $\endgroup$
    – Mick
    Nov 20, 2017 at 23:27
  • $\begingroup$ Ok, so once the withdrawal occurs, what is recorded in the Bank accounts? How are liabilities and assets matched? $\endgroup$
    – chatGPT
    Nov 21, 2017 at 12:01
  • $\begingroup$ After the withdrawal the bank has paid out its liability to X and so has no further liability, i.e. its liabilities to X have gone to zero. The bank's capital has now been reduced by \$100. The bank still has the asset of the loan, i.e. it has a document that compels X to pay it \$100. $\endgroup$
    – Mick
    Nov 21, 2017 at 12:20
  • $\begingroup$ Capital?? Really? So every time I withdraw money from a bank I am depleting its capital? But if money was created out of nothing. How can capital be decreasing? How sure are you about this? Do you know of a book covering this? $\endgroup$
    – chatGPT
    Nov 21, 2017 at 12:38

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