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Video transcript

in this video we're going to talk about balance sheets and in particular balance sheets for banks and a fractional reserve lending system now it's not just banks that have balance sheets all corporations have a balance sheet you can even have your own individual balance sheet that is a snapshot of what do you have a value and what do you owe to other people now the things that you have a value if we're talking about a bank the things that the bank has of value those are called assets and that could be cash that the bank has in its vaults it might be property that the bank owns and the things that the bank owes to other people are liabilities liabilities and this might be money that the bank owes to someone else some future lobbie obligation now there's this other notion of equity and when we're talking about a corporation like a bank equity is what's left over if you take your assets and you subtract your liabilities equity is you could view it as the net worth how much net value is owned by the shareholders and to make this tangible you can look at an analogy to your everyday life if you're thinking about your own personal balance sheet let's say the only asset you owned was a car that was worth $10,000 $10,000 car so that is your asset and let's say that you only have one liability you had to borrow $8,000 in order to buy that $10,000 car so this is something that you owe to other folks so that is your liability what would be your equity here what would be your net worth well if you own something worth $10,000 if all of your assets are 10,000 but you owe 8,000 what you have left over that's going to be $2,000 and so this would be your equity in everyday language is often times the net worth and so assets minus liabilities is equal to equity or if you add liabilities to both sides of that you could say that assets are equal to liabilities plus plus equity and so when you see many balance sheets it's typical to see it in two columns on the left hand side you have assets and on the right hand side you have liabilities plus equity and these two things should add up to the same amount so whatever assets our liabilities plus equity should add up to that same amount so now let's use this framework to start ourselves a bank and so let's say we immediately go and buy a building and some equipment worth a million dollars just to even have a place to run the bank and so we immediately have assets of building building plus equipment plus equipment of $1,000,000 now I just said whatever our total assets are that would be our liabilities plus our equity so in this situation what are our liabilities so far remember the balance sheet gives us a snapshot at any moment in time well so far I don't owe anything to anyone I'll just assume that I had that million dollars I didn't have to borrow from anyone to to get that million so I have zero dollars in liabilities and so what would the equity be pause the video and think about that well liabilities plus equity needs to be 1 million dollars if liabilities is zero then our equity is 1 million dollars so if I'm the owner of the bank this tells me that the value of what I own is 1 million dollars but as we know banks don't exist just to be a building they take deposits from people and then they make loans to people so let's say someone's walking down the street and they see our bank and say hey that looks like a good place to deposit their money it looks like a safe place maybe they'll get some interest on it and so they come and they give a million dollar cash deposit they have a suitcase with a million dollars of cash in it so how would that be reflected on this balance sheet well it would actually get categorized as reserves reserves you can view as the Federal Reserve notes the cash that it has on hand it could be money that's in its vaults it could be an account that it has with the central bank although that gets a little bit more sophisticated but you should just you can visualize it as it's one way to to simplify it and so in this situation your reserves are now going to be $1,000,000 where did that come from it came from that suitcase of cash that that person gave now what happens on the right hand side of this balance sheet they didn't just give us the money at some future point in time they might withdraw some or all of that money our liabilities now so we now have a demand deposit let me write it this way demand deposit for 1 million dollars and this is a good time to pause this video and really understand this because this is essential for understanding banks is that yes we got that cash but it's offset by a liability because at some point in the future we have to give that million dollars back to that person who made that deposit and they can come on demand now you might be saying alright this is all nice but how am I as a bank going to make money and the main way that banks make money is by making loans but how do they loan out the money if all of this is on demand deposit well in a fractional reserve system you don't have to keep all of your demand deposits on hand as reserves you can actually lend out a good chunk of it and it's dictated by what the required reserve ratios are so let's say in the country we're in or the jurisdiction we're in the required reserve ratio so required required reserve ratio is 10% of demand deposits that means that we can look whatever our demand deposits are we have to keep 10% of that in reserves and then the excess reserves we can loan out and so I can now group my reserves and say instead of saying a million dollars of just total reserves I could sub categorize it as required reserves required reserves and excess reserves now what do you think are going to be the required and excess reserves in this scenario pause this video and figure it out well required in excess are going to add up to my total million dollars of reserves the required reserves are 10% of the my demand deposits so I have to keep 10% of this million dollars which is $100,000 and then the rest is excess reserves of $900,000 and so this model is based on the idea that statistically especially if these demand deposits are coming from many different people it's unlikely that more than 10% will be will be withdrawn at any moment in time and we can talk about runs on banks where this tends to break down and so banks will then lend out this other 90% of the demand deposits or up to 90% of the demand deposits and they lend them out to people they think are likely to pay back the money with interest and that interest is how banks make the money and so this bank could say hey I have nine hundred thousand of excess reserves which okay which I can use to make loans to other people and so let's say a bunch of people come by and they have some good ideas and we think that they're going to pay us back so what we do is we can take those excess reserves up to nine hundred thousand dollars of them and instead of having it as excess reserves we can put them out as loans so we can make loans of nine hundred thousand dollars now one thing that might be counterintuitive to some of you is say wait I'm used to alone being something like a liability here we just said we owed people money and so that was an obligation to other people why is it an asset here well it depends if you are the lender or you're the person borrowing the money here as the bank we're the lender the loan is an asset because someone is going to pay us money back in the future this has value if we owed money to someone else well then that would be a liability and so now notice here the whole time that we were doing this the assets were equal to the liabilities plus equity assets right now are two million dollars 1 million plus one hundred thousand plus nine hundred thousand and our liabilities plus equity are two million dollars 1 million and liabilities 1 million in equity
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