The question now remains, "What happens when "loans" go bad?"

If First Bank owned a note on which the signer defaulted, who would bear that loss? Would the depositors suffer a loss? Would some sort of adjustment be made to the bank reserves? (You may have heard the term loan loss reserves and confused it with the reserve balance at of the Federal Reserve.) Or, do the owner’s of First Bank have to absorb any loss in their capital account?

Let’s first look at the effect of a moderate loss (moderate means a loss smaller than the $80,000 depicted in the diagram above)…