What happens to a bank when many of their loan customers default?

Question

What happens TO THE BANK when MANY...default and the cost of the item (farms, land, houses) aren't valued as much as the loan was for?

Unspoken: The bank loans money (gives money to other businesses) based on the money they receive from their other loan payments. What happens to the bank if that circle is broken?

Answer 1

I'll answer your question from a balance sheet perspective and try to keep it simple. The ratios for the following numbers are realistic even if the absolute amounts are not.

Before a bank can take deposits it must find investors willing to put up their own money as equity for the bank (this is sometimes referred to as capital). Regulators specifiy the minimum amount of capital that a bank must hold for a given deposit base (the number is actually calculated by looking at the riskiness of is assets the mix of securities and loans held but lets skim over that).

Lets say that the bank has $50m in capital and takes $950m in deposits and that the regulator says it must have capital of at least $30m to support this deposit base. It spends $50m on its headoffice and technology etc, This leaves it $950m to lend out.

In practice it can not lend all of this out because it must keep some of its assets in the form of liquid government securities and short term deposits with other banks and even a bit of cash in its branches and ATMs. Lets assume that $450m is in liquid assets and $500m in loans.

Lets assume that 20% of these loans ($100m) become non-performing, customer can't pay interest or repay principal. After foreclosure, sale of assets and possibly bankruptcy procedures the bank gets back (say) 60 cents for every dollar it has lent. It has therefore made a loss of $40m on these loans. These losses come directly from the bank's capital reducing it from $50m to $10m.

At this stage the bank is no longer meeting the regulatory requirement for the minimum amount of capital to be held. It must then try to raise sufficient capital ($20m) to meet these requirements. Exisiting shareholders may put up more money themselves or new investors could be brought in diluting the existing shareholder's ownership of the bank.

If management are unable to raise new capital then the regulator has the option of issuing a cease and desist order which prohibits the bank from taking new deposits. In theory the bank could have its licence to take deposits removed and the regulator force a liquidation of the bank (in practice this happens rarely).

If the losses had been greater - say it got back only 40 cents in the dollar its losses of $60m would have wiped out the bank's capital. The bank would then be insolvent. In the liquidation process small depositors (less than $100,000) would be protected (in the US) by a federal bank deposit insurance scheme but larger depositors would not get all of their funds back.

Banks are rarely allowed to actually fail because of the risk of one failure causing another - it is not unknown for a larger bank to take over a failing smaller bank for a token amount. Banks are more prone to fail as a result of a deposit run than as a result of insolvency as such. Loans are inherently illiquid and if this bank lost half its deposit base it would be unable to meet depositor withdrawal requests and would have to close.

Answer 2

It partially depends on the type of loan involved, but in general the bank will attempt to salvage at least some of their investment. If there is collateral involved, there will be a seizure of the securing property, say for example a stock or bond. If it's a mortgage or automobile loan, then the property in question will be repossessed. In these cases, the property is most likely to be put up for auction where they hope that they'll get a large part of their loan back.

For unsecured loans such as credit cards, lines of credit, and personal loans, the likely avenue that a bank will take is to sell the debt to a collection agency, usually for a small fraction of the debt. The collection agency then owns the loan and the bank is done with it. Of course, if bankruptcy is declared on a obligation, all bets are off.

Banks usually take into account the expected rate of defaults when they calculate interest rates. This is one reason that higher credit scores often have lower rates--less risk of default. If an usually high number of defaults occur, most banks will have some level of insurance for that, which is another aspect of FDIC.

Answer 3

The bank seizes whatever was put up for collateral and sells it to get their money back.

Answer 4

They will foreclose on the home, and then eventually sell it to gain all or most of the amount they are owed.

Answer 5

The bank will chease the property...