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Difficulties with the Non-Performing Assets
Owners do not obtain a market return on their capital. In the worst case, if the bank fails, owners lose their assets, in modern times; this may affect a broad pool of shareholders.
Depositors do not obtain a market return on savings. In the most horrible case if the bank fails, depositors lose their assets or uninsured balance. Banks also reallocate losses to other borrowers by charging higher interest rates. Lower deposit rates and higher lending rates repress savings and financial markets, which hampers economic development.
Non performing loans epitomize bad investment; they misallocate credit from good projects, which do not receive funding, to failed projects. Bad investment ends up in misallocation of capital and, by expansion, labour and natural resources. The economy performs lower its production potential.
Non performing loans may fall over the banking system and contract the money stock, which may lead to economic contraction. This effect can channelize through illiquidity or bank insolvency; (a) when numerous borrowers fail to pay interest, banks may experience liquidity shortages. These shortages can squash payments throughout the country, (b) illiquidity constraints bank in paying depositors, example, cashing their paychecks, banking panic follows. A run on banks by depositors as part of the national money stock become out of action. The money stock agreement and economic contraction follows (c) undercapitalized banks exceeds the banks capital base.