his may be understandable as loans are illiquid and there is always some risk of default on loans. Prudent banks try to limit their loan portfolio (and ration credit/ loaning out only to reputable companies rather than new and small businesses) not to take on the risk of non-performing loans/ loan losses and possibility of an erosion in their net worth. Of course, this type of bank behavior may reduce the overall profitability as loans pay out more in terms of interest returns, say, as compared to government bonds. One major rule in finance: Higher the risk, higher the expected return.An aggressive bank, on the other hand, keeps little or almost no excess reserves over and beyond the required reserves and rather than investing a sizeable part of the deposit funds in government bonds, it chooses to lend out almost all of its deposits (after satisfying the reserve requirements). Each loan carries a risk of default and sometimes, loans are simply non-performing as firms dont make timely payments on the principal amount borrowed as well as the interest owed to the bank. If a majority of the loans made out by a bank becomes non-performing, then the bank has to consider those as losses. The value of the loan portfolio drops and those losses erode the banks net worth (capital placed on the bank by the shareholders/owners) as loan losses are ultimately subtracted from the net worth of the bank. When a bank has a net worth which is insufficient to cover its liabilities, then it is insolvent and goes bankrupt. It has a negative net worth when loan losses accumulated over time erodes the owners capital. To prevent such dire cases, the CB closely monitors (or should monitor) the activities of banks and imposes capital requirements as a % of total assets to build confidence in the banking sector. This is because higher the capital requirements, less risks the owners/bank managers are willing to take in terms of loans and they become more selec...
