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If the bank was taking deposits and actually lending these deposits out for loans I can see how loan defaults could send them bankrupt.

However banks don't use deposits to create loans, loans are actually created out of thin air. If loans are created out of thin air, why does a loan default cause bank insolvency. The bank has lent the borrower nothing and therefore surely nothing can be lost.

Example: If a bank gives someone a mortgage and that mortgage loan is created out of thin air. When the borrowers default the bank gets a free house which they can just sell and make a massive profit.

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    $\begingroup$ What does "out of thin air" mean to you? $\endgroup$
    – ThisIsNoZaku
    May 15 at 23:01
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    $\begingroup$ How is what the banks do different from your example? $\endgroup$
    – ThisIsNoZaku
    May 15 at 23:18
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    $\begingroup$ I think the author of the question read an explanation that banks create new money when they make loans and got confused because of that. There are really lots of half-truths around modern banking, I think someone can provide a decent explanation that would reconcile all those half-truths, but I am not very knowledgeable to say something authoritative about it. $\endgroup$
    – LudwigNagasena
    May 16 at 13:02
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    $\begingroup$ @troybeckett Understanding what you don't understand is important to explaining it. When a bank gives you \$100 the bank still loses \$100. It's true the bank doesn't lose any money if it puts \$100 in your account, because your account is just an item in a spreadsheet on the bank's servers, but, when you go to the ATM and you take out \$100, the bank has to give you a real \$100 bill so the bank loses a \$100 bill. If the bank doen't have a \$100 bill to give you, then it's bankrupt. $\endgroup$
    – user253751
    May 16 at 14:22
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    $\begingroup$ The question may sound simple but the answer is actually quite complex because our monetary system is quite complex. I doubt that you will get a good answer here because it would take too much space. My recommendation is that you read this -> bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/… . If that doesn't answer your question then at least you will be in a better position to understand any answers put forward here. $\endgroup$
    – Mick
    May 17 at 12:32

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Oversimplistic explanation: Banks don’t create loans out of thin air , they create them versus deposits. Thus, they have an asset and a liability which net to zero. If the loan defaults , they can sell the house , but then they have to repay the deposit so there’s no magic profit.

Is that what you are asking ?

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    $\begingroup$ Thank you for your commenting. I was reading something by the bank of england where it said when banks originate loans they create new money. They are not redirecting saver deposits like I thought. So all I'm asking is how loan defaults can cause bank insolvency, if no money was needed to create them. Logically the bank hasn't lost anything. $\endgroup$
    – troy beckett
    May 16 at 14:20
  • $\begingroup$ Both deposits and reserves play a role, don't they? $\endgroup$
    – user253751
    May 16 at 14:22
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    $\begingroup$ Important to understand : The Bank of England is not saying that loans can be created without any offsetting liability. They are saying they can create simultaneously a loan and a deposit , without waiting for someone to deposit anything. (The deposit will be owned by the person taking out the loan ). $\endgroup$
    – dm63
    May 16 at 18:04
  • $\begingroup$ @dm63 Is it possible for you to just explain how the bank physically loses money on a loan default, so I can understand how too many will eventually lead to bank insolvency. Your comment is great but it's just too advanced for me. $\endgroup$
    – troy beckett
    May 17 at 4:48
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    $\begingroup$ If a loan defaults, the bank realizes that an asset on its books is worth less than it thought. If this happens to a lot of assets then the value of assets could drop below what the bank owes to people. That is insolvency. $\endgroup$
    – dm63
    May 19 at 9:14
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Loaned money is not created out of thin air, they represent liquidity transformation of illiquid future cash streams of creditor into liquid deposit (Rendahl & Freund, 2019).

In addition to the above, every time bank issues a loan it is by law required to hold some liquid assets like bonds or excess reserves. Most of these are nowadays borrowed from central banks but deposits can be used as well. These are also moved between banks as banks settle various transactions between themselves. If the financial outflows (e.g. people withdrawing money) exceed financial inflows (e.g. people repaying their loans) then bank will need to start getting into its buffer and once that is exhausted bank becomes illiquid and eventually insolvent.

Example: If a bank gives someone a mortgage and that mortgage loan is created out of thin air. When the borrowers default the bank gets a free house which they can just sell and make a massive profit.

Nope, they can't make massive profit. They can only make profit if they somehow manage to sell that house at higher value than was the mortgage. When banks creates loan which is asset for a bank there is matching liability in deposit that the creditor has at its disposal. If the creditor defaults on a mortgage bank still has that loan as an asset deposit as a liability. Repossessing and selling the house just reverses this process and basically 'cancels' the asset and liability. If the bank sells the house for less than mortgage value they actually record a loss if more they record profit if for the same value they have neither loss or profit.

If there would be no collateral like house with mortgage bank would have to write off the whole unrecoverable value of the debt as loss.

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    $\begingroup$ Thanks for your comment. I must say that though, I can't understand any of it. If anything I'm more confused. $\endgroup$
    – troy beckett
    May 15 at 22:44
  • $\begingroup$ @troybeckett what part of the answer you do not understand? $\endgroup$
    – 1muflon1 ♦
    May 15 at 22:53
  • $\begingroup$ The whole thing is not clear. I'm going to keep re reading to hopefully understand, but I'm struggling $\endgroup$
    – troy beckett
    May 15 at 22:57
  • $\begingroup$ That link is also very confusing, its like the author has purposedly wrote it in a difficult way to try and create the excuse that "you just don't get it". $\endgroup$
    – troy beckett
    May 15 at 23:11
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    $\begingroup$ I don't understand anything you wrote. What you've wrote is not suitable for a layman like myself. $\endgroup$
    – troy beckett
    May 16 at 5:10

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