1
$\begingroup$

It is generally accepted that banks can create money by lending. If sb. wants to take a loan the bank simply extend the balance sheet by creating that loan. The bank has to adhere to reserve and capital requirements which limit the amount of money a bank can create by this process, although it is a multiple of the amount of money the bank has as reserve requirements.

In economics the ability to repay the bank with future revenue by the debitor is regarded as an asset, thus it is argued the bank does not create money but is engaging in liquidity transformation, transforming an illiquid asset (ability to repay) into a liquid asset. (loan)

Also If sb. want to take a loan to finance a business the banks will require a business plan. But ultimately what disincentives the bank not to approve as many loans as possible? (and thus charging interest which is a major source of income for banks) Since a bank does not mediate money it acquired through depositors what is the problem a bank faces if a debitor defaults on a loan, assumed that the debitor does not withdraw the money as hard cash, which would diminish the banks reserves?

$\endgroup$
7
  • $\begingroup$ The saying "If a tree falls in a forest and no one is around to hear it, does it make a sound?" comes to mind. "...a debitor defaults on a loan, assumed that the debitor does not withdraw the money as hard cash..." In this very unlikely case, the bank faces no problem. (Some work hours were wasted on the paperwork for the loan.) $\endgroup$
    – Giskard
    Commented Jun 28, 2022 at 14:28
  • $\begingroup$ Also, I would like to announce that I am opening Giskard Bank, where you can get a loan of \$1B at merely 0.01% interest, provided that you never withdraw any of the money. I will post the account number where you should send interest payments later. Defaulters will be prosecuted! $\endgroup$
    – Giskard
    Commented Jun 28, 2022 at 14:32
  • $\begingroup$ @Giskard I said withdraw in hard cash...I could still use that 1B to buy real estate or any other asset that accepts bank money right? $\endgroup$ Commented Jun 28, 2022 at 14:37
  • $\begingroup$ Is the money transferred out of bank A to bank B, so that bank A becomes liable to bank B? $\endgroup$
    – Giskard
    Commented Jun 28, 2022 at 14:44
  • $\begingroup$ Even if the seller of the property keeps the money received in bank A, the bank is liable to them. Suppose the buyer burns the property down, then declares bankruptcy. At this point, this penniless person is liable to the bank, while the bank is separately liable to the seller. There is no "chain of liability" here. $\endgroup$
    – Giskard
    Commented Jun 28, 2022 at 14:46

1 Answer 1

2
$\begingroup$

Banks earn profit on intermediation margin. If loans are not repaid bank won’t be profitable.

Private banks cannot themselves (individually) create reserves. They can get reserves by:

  • borrowing them from central bank
  • borrowing them from other banks that happen to have excess reserves
  • using deposits of people who put money in bank as reserves.

The way how bank earns profit is by charging consumers higher interest rate than the bank itself pays on one of the above.

If someone defaults on their loan bank not only looses the revenue from interest payments, but it still has to pay interest on reserves acquired to be compliant with capital/reserve requirements to issue the loan.

In addition to the profit motive being present as explained above there are further incentives created by banking regulation. Despite the above banks might decide to extend more credit than reasonable if they expect to be bailed out by taxpayers like during 2008 Great Recession.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.