Banking 8: Reserve Ratios How reserve requirements limit how much lending a bank can do.
Banking 8: Reserve Ratios
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- In the last video
- I gave the example of this bank that I keep using
- And in this example
- as opposed to giving the gold out to make loans
- and be used for projects that gold gets redeposited
- and then re-lent out
- What we did in this examples is that the bank
- every time it made a loan,
- it just made a loan and that created an asset
- and then it had a corresponding liability
- where the liability was either a checking account
- that the entrepreneur could use or bank notes
- which are essentially cash
- that the entrepreneur could use to pay their laborers
- or to buy their land or whatever they needed to do.
- So an obvious question was,
- how much could a bank do it?
- When does this stop?
- Can a bank just keep increasing the left
- and right hand sides of the balance sheet?
- And to answer this question,
- we'll introduce the idea of a reserve ratio.
- So just, I guess, a bit of a review, just to make sure
- we're clearly reading this balance sheet.
- Let me label things a little bit more
- because sometimes I assume too much.
- Remember, these are the assets.
- The assets are all of these.
- Let me make a bold line here.
- All of these is the assets of this bank,
- including its building,
- so its vault down there.
- And then the liabilities.
- I'll do that in this red.
- I like this red color,
- But these are the liabilities
- over here, in this red color, that I am coloring right now
- And the equity - whoever owns the bank,
- whether it's stockholders or maybe
- it's owned by an individual.
- Maybe it's owned by me - is what's left over.
- I'll do it in a nice neutral color.
- This is the equity.
- So the question is, how much can the bank... [continued later]
- - let me do this, all of these are liabilities -
- So the question is,
- how much can the bank continue to issue out more loans
- and increase its assets and its liabilities?
- Remember, every time it'd issue a loan,
- like for right here,
- it issued a 100 gold piece equivalent loan to D -
- and instead of giving D 100 gold pieces from, say, right here,
- it just created a checking account for D,
- which later D paid to A
- and that's why it's labeled A right here.
- Let me relabel another thing
- because the gold is a different color
- just so you see the gold.
- This is the gold part of the assets.
- Let me make that very clear,
- that all of these right here is gold.
- Maybe I'll color it a little bit
- That's all gold and there's 500 gold pieces
- So let's introduce the concept of a reserve ratio
- Let's think a little bit about what even a reserve is.
- A reserve is something that you keep aside
- because you might need it one day.
- And in this situation, all of these liabilities -
- - whether they're these bank notes outstanding in this example
- or whether they're these checking accounts,
- these demand accounts - these are all liabilities that
- someone can come back to the bank on any given day
- and say, hey, I want my gold now, for whatever reason.
- Maybe I'm leaving town.
- Maybe I don't trust the bank anymore.
- For whatever reason,
- maybe they just want to make some jewelry.
- For whatever reason, that person wants their gold back.
- These are demand accounts.
- These checking accounts are demand accounts
- and these notes are things that
- can be exchanged for gold at any point in time
- And we talked a little bit about this earlier
- when we started the whole banking discussion,
- but you have to leave aside a little bit of gold
- just in case someone wants their gold back.
- So this amount of the gold that
- you have to leave aside as a reserve,
- relative to the total amount of demands you have on that gold,
- that's the reserve ratio.
- And in this situation, this world that we've created,
- The reserve store value is gold.
- Later on we're going to get ourselves off of this gold system
- and then that reserve store of value
- is actually going to turn into cash,
- but for right now and
- I think it's easier actually to conceptualize gold.
- Let's stick with gold.
- The reserve ratio for this bank is the amount of gold assets
- you won't see this formal definition anywhere
- because most people are off the gold standard right now
- but it's the amount of gold assets divided by total
- I don't want to say total liabilities
- because the bank could take out loans
- that aren't demand loans.
- Everything on the liabilities right now is on demand loans,
- which means whoever has that liability can come back
- and exchange it for gold at any moment in time,
- but the bank could've taken just a regular loan
- And a regular loan might not be on demand.
- A regular loan might be a loan that
- the bank doesn't have to pay back for 10 years,
- in which case there's no reason why the bank
- would have to set aside some gold to pay that back.
- So let's make our definition not total liabilities,
- but total demand liabilities.
- So what would be total demand liabilities?
- That would be total bank notes in this case
- and bank notes are also something we'll later leave
- a world where every bank is issuing bank notes,
- but I just wanted to give you that kind of historical context,
- how bank notes even started off.
- Total bank notes and demand accounts,
- demand or checking accounts.
- So let's see what it is for this bank that we have here.
- So our total gold assets are 500
- and what's our total demand accounts?
- 100 plus 100 plus 100
- - 100, 200, 300, 400 - 600 -
- and I think this is another 100 here - 700.
- The total demand liabilities, I just figured out, was 700
- and the gold assets in this bank are 500.
- So right now the reserve ratio of this bank
- is pretty high - 5/7. So I don't know what 5/7 is.
- If I'm doing my mental math right, it's about 62% -
- 7 goes into 50 - no, no, 7 goes into 50, 7 times
- - it's like 71%. Right. 7 times 7 is 49-- 71%.
- So that's its reserve ratio.
- And what keeps banks from just keep issuing more assets
- and debts to expand its balance sheet
- is a reserve ratio requirement.
- So right now in the United States –
- although we're not on the gold standard,
- but you could imagine it in this world
- our bank regulators might say that your reserve ratio
- on demand accounts, so the amount of gold
- you have to set aside for checking accounts
- - so reserve requirement, we'll call it.
- Let me change colors just to ease the monotony.
- The reserve requirement
- They might say the reserve requirement is equal to -
- let's say they want to be safe.
- Let's say they want to make it 20%.
- In the U.S. right now, it's 10%,
- although the reserve commodity isn't gold anymore.
- Let's say your reserve requirement is 20%.
- That means as long as - at any given moment in time,
- more than 20% of these people
- don't demand their money back,
- the bank's going to have liquidity.
- The bank is going to be able to fulfill its promise.
- Because all of these people think at any given moment
- They can go to the bank and get their gold.
- In order for this system to work,
- there has to be confidence
- and in order for there to be confidence,
- the bank has to be good for it
- every time someone asks for their money.
- So the bank has to stay liquidate
- So essentially this reserve ratio is
- what the regulators think that a bank needs to maintain,
- in order to maintain, be liquid
- Our bank as it is right now, it has a reserve ratio of 71%.
- So as long as no more than 71% of these people
- some of these loans, they might be out for a year or two.
- So as long as -
- - in that year or two that these loans are out -
- as long as no more than 71% of these people don't come asking for their gold
- we should be OK.
- If all of a sudden for whatever weird reason, I don't know,
- 80% of these people who have demand deposits or
- bank notes come and want to switch their money for gold,
- this bank is going to run out of gold
- and that's a bank run.
- And there's a couple of reasons why that's really bad.
- One is, all of a sudden these demand deposit accounts
- all of a sudden don't seem to be that great
- because you're not really getting your gold on demand
- because more people are asking for gold than there is gold.
- And the other problem is, all of a sudden,
- everyone will lose confidence in the system
- and everyone's going to think,
- oh boy, these banks that have these nice vault-looking buidlings
- maybe they're not as safe as I thought.
- So everyone is going to start pulling their money out.
- And that's called a bank run.
- So in this example, if I assume,
- that this loan is really worth 300 gold pieces
- and it's really going to be paid back
- and this loan right here is really worth 100 gold pieces
- and it really will be paid back,
- this bank is solvent.
- It has more assets than it does liabilities.
- So if it has enough time,
- it will be able to pay back all of its liabilities.
- But if all of these people, all of a sudden, come in and
- want not just 500 gold pieces, if they want 600 gold pieces,
- right, they're owed actually 700 - so if they want 600 gold pieces
- all of a sudden
- everyone's going to lose confidence in the system
- These people probably - if they're not able to get that,
- they're probably going to want all their money back
- so then all of these liabilities are going to come due.
- And then maybe the bank is going to have to try to sell its assets
- these loans to someone else
- or maybe try to collect from someone,
- but as you can imagine, it's a whole... big mess and
- the whole system which is dependent on confidence
- will just start to crumble.
- But anyway, the initial question is, what is the limit to how much
- you can expand the asset and the liability side of the balance sheet
- just by creating these loans and these deposit accounts?
- And that limit is driven by the reserve ratio,
- whatever the regulators set.
- Anyway, I'll see you in the next video.
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