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When a bank receives payments towards repayment of the principal of a loan, it is called "Repaid Principal". What does a bank do with this amount?

Does "Repaid Principal" add up to their pool of funds or reserves which they lend again in form of new loans, or do they utilize it in some other ways?

Where exactly does the "Repaid Principal" end up?

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When you repay principal of 90 USD, the bank makes two accounting entries in its computerized books.

One is called a debit and it goes like this. If you pay by check drawn on another bank, their reserves at the Fed are increased by 90 USD. If you paid in currency, their vault cash asset account, which is also an asset of the bank, increases by 90 USD and the cash is dumped into the vault with all the other cash. If you pay out of your checking account at the same bank, their "deposits" book entry, which is a liability of the bank, is decreased by 90 USD.

The other entry is called a credit. Your loan balance, which is an asset to the bank, is decreased by the 90 USD.

You asked what they do with "it", meaning the principal paid. As you can see above, when the currency was dumped into the vault and mixed with all the other dollar bills, or a computerized balance was increased or decreased by 90 USD, "it" ceased to exist. The 90 USD are no longer distinguishable from any other dollars. So it is a meaningless question. A lot of people don't understand this!

But if you are asking what the bank does with its reserves (vault cash plus reserve account at the Fed), in general: in normal times, they keep them as low as allowed by the Fed. As their reserves increase higher than required, they reduce them by lending money to customers and other banks, purchasing securities, or paying their expenses. Transactions that make their reserves increase are things like (a) loan principal is repaid, (b) currency or checks drawn on other banks is deposited, (c) paying their expenses, (d) loan interest is paid by their debtors.

At present, banks are holding on to more than they are required to, because they are relatively afraid to lend. The extra is called "excess reserves".

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  • $\begingroup$ The reason banks are holding high reserves in the USA at the moment is 1) the extra reserve money pushed into the system by TARP, and 2) the federal reserve paying interest on those reserves. In the US banking system reserves have a negligible effect on actual lending since they only apply to part of the bank's total liability deposits - lending is effectively regulated primarily by demand for loans, and Basel capital requirements. $\endgroup$ – Lumi Jun 19 '15 at 22:13
  • $\begingroup$ Good comment. I was actually referring to the fact that banks until around 2007 always kept excess reserves at about zero, and in the 8 years since have increased them to 1.8 trillion dollars. They've not approached their capital requirement limits, if I remember my facts well. research.stlouisfed.org/fred2/series/EXCRESNS $\endgroup$ – user2781942 Jun 21 '15 at 0:00
  • $\begingroup$ The capital requirement limit is a tricky one - since they can increase capital from profits, absent evidence to the contrary, I suspect it's more of a throttle than a hard limit. My strong suspicion is that the US system has been essentially free wheeling since Bretton Woods - but not so sure about the European banks. They do have a fairly firm reserve requirement. $\endgroup$ – Lumi Jun 21 '15 at 0:17
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Just as when a loan is made, a matching liability deposit is created by the underlying double entry book keeping operations, when a loan is repaid that money is effectively removed from the system. i.e.

Loan creation:

[debit loan, credit customer account]

Loan repayment of principal

[credit loan, debit customer account]

The regulatory and accounting framework within which these operations occur, then allow the bank to re-create the repaid money, by making a new loan.

Essentially modern banking systems exist in a state where money is continuously being destroyed and re-recreated as loan principal is repaid or written off. As there is typically a slight excess of new lending over loan repayment, most banking systems expand the money supply (their customer's liability deposits) over time, but if there is less new lending than repayment, then the system can also contract.

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  • $\begingroup$ Can you throw some light on this, say for example, I took a secured interest only loan against a CD of mine at 90 % LTV, means against USD 100 CD took USD 90 loan for which I serviced the interest for the term of loan & upon its maturity out of total USD 100 CD, I repaid the principal part of the payment which is USD 90 & took home USD 10 out of total CD. NOW THE QUESTION IS THAT THIS USD 90 WHICH THE BANK RECEIVED AS "REPAID PRINCIPAL", WHAT WILL IT DO WITH IT? WHERE WILL IT END UP, BECAUSE FOR SURE I DIDN'T TOOK IT HOME? $\endgroup$ – AndyFlip Jun 18 '15 at 20:22
  • $\begingroup$ Yes, that's the principal. You borrowed 100, repaid it - it doesn't matter how, and paid some extra interest on top of it. $\endgroup$ – Lumi Jun 18 '15 at 21:02

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