How Bad Loans Affect Banks. To understand the credit-making decision, we have to understand what happens when downside risk has been underestimated and the loan goes bad. For a lending institution, according to the Basel III accord, which were reforms put in place after the 2008 crash, common equity tier one capital must be greater than 4.5% of the bank's risk weighted assets. Which for a traditional bank, are the sum of the loans in the loan portfolio. If 10% of the high risk loans were to go bad, for example, the following happens. The loans are written off of equity, so equity goes down to 35. The maximum risk weighted assets goes down to 777.8 or 35 divided by the 4.5% threshold. This means our new balance sheet requires us to dump a portion of the loan portfolio, thereby reducing it to excess cash on the balance sheet. That excess cash is no longer generating the return that the loans had previously made. Post adjustment, the balance sheet looks like this. 777.8 of loans, 232.3 of excess cash. Customer deposits have not changed. Tier one capital has decreased to 35. The result is a loan portfolio bringing in less return. In the old portfolio, the loans were generating net interest income on the loans of 55, paying interest on the deposits of 9.8 for a net interest income of 45.3. In the new portfolio, the bank is only generating income of 38.9, but still paying out interest of 9.8, for net interest income of 29.1. A loss of 10, that's 1% of the total risk weighted assets because of the bad debt, has resulted in a reduction in net income of 16.1 or 35.6% of profits.