Banking 9: More on Reserve Ratios (Bad sound) Seeing how reserve ratios limit how much lending I can do.
Banking 9: More on Reserve Ratios (Bad sound)
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- Let's talk a little bit more about reserve ratio requirements
- And then if I have time, I want to introduce another,
- almost related and often confused topic
- and that is "leverage."
- So let's do reserve ratio requirement.
- And let's say in whatever jurisdiction or world that I live in,
- that requirement is 10%. So that means that
- for every dollar of checking account liabilities
- or notes liabilities that I have outstanding,
- that I have to keep at least 10% of that in actual
- whatever the reserve currency is.
- In our world we've been dealing so far it's been gold.
- In the current world, it's not gold.
- It's actually dollar bills.
- But anyway, we'll stay in the gold world
- and later on we'll get ourselves off the gold standard
- and see how that works.
- But let's just do the example from scratch again
- and just see how big I can get my balance sheet
- and see exactly how this stops me from getting too big.
- So I have my bank like I always did.
- Let's say my building is worth 100 gold pieces
- and then I capitalize it with another 200 gold pieces.
- This is the building.
- And this is my equity that I start off with.
- So I start off with 300 equity - 300 gold pieces of equity.
- I should always do the equity in a different color
- because sometimes it gets confused with the liabilities -
- - because they're both on the right-hand side.
- So this is my equity.
- And then I might take some deposits.
- Let's just - I don't want to make this too large of a diagram.
- So let's just say I take another 100 gold pieces in deposits,
- 100 gold pieces of actual deposits.
- And then I have checking accounts
- for these people who deposited them.
- Let me do that - I'll do that in purple.
- These are checking accounts
- or notes deposit accounts for people.
- These are my liabilities.
- So my question is, if these are all the deposits I have,
- or these are all of the reserves I have,
- how much can I lend out.
- Or, how much can I expand my balance sheet?
- Well, the reserve ratio requirement says that
- my reserves over my total checking accounts
- that I have on my liabilities and the notes that I issue,
- that my reserves can be no more -
- - or have to be at least 10% of that.
- So right now I only have 100.
- Oops... I pressed the wrong button.
- Right now I only have 100 gold pieces
- of on-demand checking accounts.
- And I'm not going to worry too much
- about the notes outstanding right now.
- They're really the same thing -
- - at least from a balance sheet point of view.
- And I have 300 gold pieces.
- So I actually have more reserves
- than I have on demand account
- because I've actually pre-capitalized it
- with some of my initial equity.
- So how much lending can I do?
- Well, this requirement says that
- I can only expand these on demand accounts
- so that this is at least 10% of it,
- this 300 gold pieces is at least 10% of it, right?
- These are my actual reserves.
- So let's think of it this way.
- 10% has to equal my reserves -
- - I have 300 gold pieces of reserves:
- 100 from actual deposits,
- 200 that I actually put in ahead of time
- to start up my bank, that was my own gold -
- - over the total amount of -
- - I'll just say demand deposits, I won't worry
- it's demand deposits plus bank notes,
- but we'll keep it simple right now, I think you get the idea -
- So we can do a little bit of math.
- Let's see. Multiply -
- so we get 10% of the demand deposits have to equal 300 -
- or divide both sides by 0.1 and then you say, well,
- I could have up to 3,000 gold pieces of demand deposits.
- So how much could I expand my balance sheet?
- Well, I could keep making loans
- until I have 3,000 gold pieces of demand deposits.
- Let me start making loans out.
- So someone has a project where, say, 900 gold pieces
- they need to build a factory of some kind.
- I say, sure, here you go. 900 gold pieces -
- - I'll draw it a little bit less high than it should be,
- then it would be proportional to that.
- So 900 loan.
- And I don't hand that person gold.
- I just give them a checking account.
- So it's a 900 checking account.
- Of course they're going to use this, maybe to write checks
- to their laborers or their contractors,
- - whoever needs to build a factory.
- And so let's see
- how much do I have outstanding right now
- in terms of demand deposits?
- I have 900 plus 100.
- I have 1,000.
- So I have 2,000 left.
- So let's say someone has a really big project.
- They want to build a bridge over the local river or whatever
- and they'll charge a toll
- and I think that's a pretty good idea
- because people are very likely to use that bridge.
- So I'll give out a loan to that person.
- So I'll give out a 2,000-gold-piece loan to that person.
- 2,000 loan.
- And then instead of giving them actual gold,
- I'll just create a checking account for them.
- I could've actually issued bank notes, same idea.
- So 2,000 checking account.
- And then I'm done, right?
- Because what are my total demand deposits?
- 2,000 plus 900 plus 100.
- I have 300 in total demand deposits. And actually
- all of my liabilities at this point are demand deposits.
- I could have borrowed money in some other way,
- but I won't worry about that right now.
- So the ratio of my reserves, 300,
- to my demand deposits, which is this part right here,
- which is essentially all of my liabilities right now,
- is 10%. And what this allows -
- because of this requirement,
- one, it kept me from keep making loans out -
- - I've essentially maxed out what I can do
- under this type of reserve ratio requirement.
- And what it says is, it allows 10% -
- - essentially it makes sure that I'm liquid enough,
- it makes sure that when these people, who I've said,
- at any point in time, you can come and ask for your money,
- and that if people actually do want their money
- in terms of gold.
- Remember, they can transact with this money.
- They can write checks, or if these were bank notes,
- they could exchange those bank notes.
- But if someone,
- whoever has access to this checking account
- at some point of time actually wants their gold,
- I need to keep at least 10% aside,
- assuming that no more than 10% need it at one time.
- So that's what these reserve requirements are.
- It keeps me liquid.
- Liquid means when someone actually asks for their gold,
- I have the gold to give it to them.
- Now a separate question is, am I solvent?
- Solvent means, am I good for the money?
- And solvent is just an issue of,
- are your assets larger than your liabilities?
- So right now in this world, my assets are what?
- I have 3,000 plus my initial equity.
- This was 100 down here.
- So my assets are 3,300.
- So I'm also solvent.
- As long as my assets,
- which are this entire left-hand side of the balance sheet,
- as long as my assets are bigger than my liabilities,
- I'm solvent,
- which means that even if in a world -
- - let's say in a world, where for whatever reason,
- people wanted gold again, they'd come to me
- and let's say they wanted 400 gold pieces.
- I would not be liquid in that situation
- because I do not have 400 gold pieces
- to immediately give them.
- So I would have a liquidity problem.
- Maybe I would have to borrow gold from someone else.
- But I would be solvent, assuming that
- these two loans are still good.
- And if someone gave me enough time,
- either these loans would be paid back,
- or maybe I could sell these assets, which these loans are,
- to somebody else and get 900 gold pieces for them,
- in which case I could pay these people
- with the gold that they need.
- So anyway, I just wanted to show you that difference
- between liquidity and solvency.
- And actually, I realize that I almost used up all my time.
- So in the next video,
- I'm going to show you about leverage.
- And leverage and leverage requirements have a lot more
- to do with solvency than liquidity.
- And just to give you a little bit of a preview,
- it essentially says, how much of a cushion
- do you need to have, before you're insolvent -
- - before your liabilities are greater than your assets?
- So how much loss can you take here
- before you're out of business?
- Anyway, I'll see you in the next video.
- It ended up being just on reserve ratios, this one.
- The next one, I'll do leverage.
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