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Pittsburg, Kansas | In a single word, yes.
They set aside reserves that are supposed to be reflective of actual probability of default. In years past these reserve for loan loss accounts were sometimes used as slush funds to modify or shift income to avoid income taxes. In more recent times banking regulations tightened so that a bank has to be able to show auditors that a realistic methodology is used to reflect realistic loan loss potential.
A bank always hopes their actual losses are less thna their projected losses. Actually they hope for zero losses but if that happens it means they are not putting capital at much risk at all which likely means they are not generating a very good return on capital.
Them being on the hook for losses, as the very good article Zen Farm posted, is the main limitation to making loans. In other words finding borrowers that can pay the loan back.
Now lets expand that thought a little. Since banks create new money when they create a new loan, the only limitation to the expansion of the money supply (monetary inflation) is how many willing and credit worthy borrowers they can find AND how fast principal portion of old loans is being paid off (because money is destroyed as principal 8s paid back).
Thus the Boom/Bust credit cycle booms as credit expands till it is not supportable followed by the inevitable contraction bust. QE and ZIRP are just Band-Aid patches to temporarily keep the boom from busting. Zero interest supports a lot more debt than higher rates.
John
Edited by John Burns 1/12/2017 20:03
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why banks needd deposits
