How do banks resolve "bad debt"?

Question

If we simplify this argument we call "fractional reserve banking" we could say that for every $1 or so the bank has in capital or seed-funds, they can generate loans of $10.  Making a $1million loan means the bank presumably has about $100k to support it. 

If this $1mill loan goes bad right away and they can't recover any of it, how do they handle it?  My understanding is that they have a ledger account in debit for $1mill that would gradually be zeroed out as payments of principle were made over the life of the loan.  At the end of the day, the $1mill created would become $0 once more (not considering the interest).  When the loan defaults, the bank still has its $100k reserve and hasn't really lost anything at all that it can't recreate at will.
Does the Central Bank deem that the $1mill still exists in the economy even though the bank can no longer recover it from the person they lent it to?  If so, how does the bank zero out a $1mill account when they never had more than $100k of it in the first place?  It seems improbable to me that the bank would throw $1mill of capital at a bad loan to get it off the books.  Yet I keep seeing bank press releases saying they are "making provisions" for so many hundreds of millions of dollars in bad debt.  What does that mean?

Ams · Accepted Answer

The answer can be as complicated as you want. There are a lot of advanced financial instruments used to package a loan book. Here is a simple and fundamental answer:
Banks maintain a balanced loan book and most of its loan book consists of secured debts. If the borrower is unable to pay the loan, banks can recover it by selling the asset that was used as security. For secured debts that are highly geared, banks have Insurance, in case the asset is no longer worth enough to clear the loan. Over the years banks have realized their appetite of bad debt at any given time and that determines the ratio of various debts in their loan book.
The obvious exception to the above is the recent GFC, where all the measures set against a loan default failed, mainly because the asset wasn't worth enough to pay back the loan and the insurance companies couldn't handle the volume of claims that came in a very short period of time.
But other than the GFC, banks have been recovering their debts for over a century now by selling assets.
Yes the central bank considers the $1mill is in existence. In case the bank is unable to recover the loan (mostly in case of unsecured loans), bank will consider it under loss for the financial year. Making provisions would mean introducing a financial instrument to cover the losses, similar to an insurance policy.

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lafayette · Answer

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How do banks resolve "bad debt"?

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