Final answer:
Banks factor in an expected small percentage of loan defaults when estimating bad debt expenses. However, if actual defaults exceed these estimates because of unforeseen events like a recession, it can significantly impact the bank's financial stability and assets, potentially resulting in negative net worth.
Step-by-step explanation:
When estimating future bad debt expense, a well-run bank will account for the likelihood that a small percentage of borrowers will fail to repay their loans. In their annual expense calculations, banks include a provision for the loans they anticipate will not be repaid. This accounting practice acknowledges that some level of risk is inherent in the bank's loan portfolio based on the expectation that some loans will become bad debts.
However, if the actual number of loan defaults exceeds the expected amount, as can occur during an economic downturn, the bank's financial health can be affected adversely. Taking the hypothetical example of the Safe and Secure Bank, should there be a wave of unexpected defaults reducing the value of loans from $5 million to $3 million, the bank's assets would shrink, potentially leading to a negative net worth situation.