Banks make money by taking in deposits and lending them out at higher rates than it pays. They don't lend it all out - what they keep is called the capital ratio and it is typically around 10 percent of what they have lent.
For example, say a bank has $1,000 in outstanding loans. It keeps 10% or $100 in cash. That's $100 it won't lend because to do so would put its capital ratio below 10%.
Now say just 1% of the $1,000 in outstanding loans go bad, which is $10 of bad loans. The bank has to pay the $10 out of cash since the loan has to be repaid by someone. Now the bank only has $90 in cash; the maximum amount it can lend is $900. But it has $990 left in outstanding loans. Ooops, the capital ratio just went down to 9.1%.
The bank would need to reduce its lending another $90 to get back to a 10% capital ratio. That's a total reduction of $100 in lending: $10 for the bad loan and $90 to keep the 10% capital ratio.
The bottom line? A bank needs to reduce its loan balance by $10 for every $1 in losses.
Goldman's chief U.S. economist estimates that because of sub-prime mortgage losses, lending may be reduced by as much as $2 trillion, 7% of US non-financial debt, raising the likelihood of recession.
Now there’s a depressing thought.