Finance and capital markets
- Banking 1
- Banking 2: A bank's income statement
- Banking 3: Fractional reserve banking
- Banking 4: Multiplier effect and the money supply
- Banking 5: Introduction to bank notes
- Banking 6: Bank notes and checks
- Banking 7: Giving out loans without giving out gold
- Banking 8: Reserve ratios
- Banking 9: More on reserve ratios (bad sound)
- Banking 10: Introduction to leverage (bad sound)
- Banking 11: A reserve bank
- Banking 12: Treasuries (government debt)
- Banking 13: Open market operations
- Banking 14: Fed funds rate
- Banking 15: More on the Fed funds rate
- Banking 16: Why target rates vs. money supply
- Banking 17: What happened to the gold?
- Banking 18: Big picture discussion
- The discount rate
- Repurchase agreements (repo transactions)
- Federal Reserve balance sheet
- Fractional Reserve banking commentary 1
- FRB commentary 2: Deposit insurance
- FRB commentary 3: Big picture
What leverage is. Why it is is good or bad. Leverage and insolvency. Created by Sal Khan.
Want to join the conversation?
- I am typing this is again as I did not see it on the site. To me the bank is not loaning out real money; they are only making accounting entries. If you are not losing real money, how can you have become insolvent. A bank run can be a problem but if there is no bank run, it should be no problem to have bad loans. JUST MAKE NEW ONES.(2 votes)
- You can't lend out money that you don't have.
Even though you say it is just accounting entries, that's not really true, because the bank has to finance every loan it makes, and it eventually has to pay back all that financing. The financing is in the form of deposits and other borrowings.(4 votes)
- In a scenario where gold std. doesnt exist, does this concept work? If yes, can we assume that instead of Gold Pieces the banks would have Dollar Bills as the common currency.(2 votes)
- Of course it works because in reality the gold standard is not used anymore. Also the banks in the United States do use dollar bills as the currency. Sal is just using gold pieces as an example.(3 votes)
- The examples are confusing. Could someone correct me if I'm wrong? So in the no-leverage-situation (at4:15), and the with-leverage-situation (at6:40) they both started with 300 Gold Pieces (GP) in equity.
The difference is that, in no-leverage-situation there was no liability (only equity) because the bank DIDN'T acquire any assets from other people. So it means the bank invested whatever ownership that IT had in this project, and took equal amount of loss as the amount that the project had lost. And in a worst case scenario, the bank would have been left with 0 GP.
In the case of with-leverage-situation, the bank had liabilities, and it used other people's money to invest in certain projects that unfortunately resulted in unrecoverable loss. And in this (worst case) scenario, the bank lost everything AND it ended with negative equity.
Is this right?
The part I had most difficulty understanding was how could a bank possibly operate with no leverage. Because, a bank will always use someone else's money to invest in potentially profitable projects to increase its assets, so there's ALWAYS going to be a leverage right? :S(2 votes)
- How is the leverage ratio (assets: equity) any different from reserve ratio? Shouldn't the leverage ratio be assets: liabilities?(1 vote)
- The reserve ratio looks at how much cash you have to satisfy your liabilities. You could have low leverage but still not have much cash on hand.
Leverage is assets/equity, not assets/liabilities. The idea is to understand how big the balance sheet is compared to what the owners actually have on the line.(3 votes)
- how do you find out about a particular bank's solvency or leverage?(2 votes)
- Usually in their financial statements that are given out after their fiscal year end if they are publicly traded. Sal uses the balance sheet in this video and in the financial statements of a publicly traded bank, they are required to produce a balance sheet also. Once you have the bank's balance sheet, you can look at their assets to equity ratio and their debt to equity ratios.(1 vote)
- how the equity becomes minus 200??? I cannot understand please help me....(1 vote)
- As shown in the video your assets are only worth 500(50 + 50 + 100g + 200g + 100 building), amounting to total assets of $500. The Total Liabilities are $700. So the equity is -200 (500-700). If your question is why the assets are lowers - its because two parties who borrowed $300 each paid back only $50 leading to losses of $500. The losses are also known as non performing assets or bad debts. Hope this clarifies your doubt.(2 votes)
- It's been a fairely smooth ride up to the introduction of misterious checking accounts. I do not really understand how Sal conjured up 300 gp out of thin air just by creating a checking account for the person he had already borrowed money (exatcly the same 300 gp).:(
It just goes against common sense. You have to get this money from someone who owns it and then lend it out to one of the clients who needs it to finance their business or whatever. A person A doesn't have this money in the first place, nor does the bank and yet the money is borrowed but what's even more weird is that it's the person's A account that offsets the loan he receives from the bank. How crazy is that?(1 vote)
- It's not that crazy. It's just accounting, until someone actually withdraws the gold piece. I say that there's money in your account and you owe me money. I didn't actually give you the money yet, so it doesn't matter whether I have it or don't have it. When you withdraw it, though, I better have it to give to you. I will, because someone else will have deposited their gold with me, and I will lend out less than I take in.(2 votes)
- At7:00, Sal says that if assets drop below liabilities, the bank is "broke," and thus insolvent. However, if one customer (A for example) can't pay back even 1 Gold of his 300 Gold loan, assets are less than liabilities. Does that mean that this 1 Gold deficit is enough to consider the bank insolvent? Of course, the bank can make up the difference by borrowing from its equity, making it only truly broke once the deficit passes the equity, but then his example at7:30is WRONG, because he states that with total demand liabilities of 700 Gold, and total remaining assets of 500 Gold, the bank is insolvent, even though it had 300 Gold in equity to cover the difference if needed.
Where is the mistake here?(1 vote)
- The equity doesn't count toward liabilities. As a result, the bank currently has 1000 in assets and 700 in liabilities. If a borrower fails to pay back a single gold piece, then the bank's assets goes from 1000 to 999 and so assets are still greater than liabilities. If a borrower fails to pay back 300 gold pieces, then assets become 700 and liabilities would remain at 700 which would mean that the bank has no equity, and so it is right at the tipping point. In Sal's example, the bank lost 500 gold pieces, which means its assets were down to 500 while its liabilities were still at 700. At that point, liabilities were greater than assets and so the bank was insolvent.(2 votes)
- To come out of insolvency, can a bank use the 50 (down from 300) to perhaps invest somewhere or trade in stocks to increase that 50 to, say 300? I guess this is assuming the bank moves out of its core business to solve its insolvency mess, but was wondering if that is a possible scenario.(1 vote)
- The regulators would not allow a bank to try that. You can see why: what if they make a loss rather than a gain?(2 votes)
- I have often heard the phrases "leveraged buyout" and "leveraged to the hilt." Are the mechanics that Sal is talking about related to these and similar phrases?(1 vote)
- Leveraged buyout is a method people use to takeover a company.
Leveraged to the hilt would be when a person or company has a lot of leverage. When something is highly leveraged it usually means there is either a high level of fixed expenses (expenses you can't avoid), or a high level of assets combined with a low level of equity.(2 votes)
I now want to introduce you to the concept of leverage. And then in future videos, we'll talk about this more in terms of what leverage does and when it's good and when it's bad. We'll talk about it in a lot of different contexts. Right now, I'll talk about a little bit more in the context of a bank. So let's say I start off my bank again and I have 300 gold pieces of equity and let's say I use that for my building. That was 100 gold pieces. And then I have 200 gold pieces that I just put into my building just to start it off. Let's say I take a 100 gold piece deposit, and of course I have an offsetting checking account that those people can at any point use-- either to write checks or at some point they can come back and demand their money back. Let's say I make out some loans for different projects. Let's say 300 gold pieces loan A-- and I do that just by giving Person A or Entrepreneur A or whoever took this loan out a 300 gold piece checking account. Let me just do one more loan. Let's say I make another loan for 300. Loan B-- and I can give that. I could have also issued notes and all of that, but let's say I just give them a checking account. And we have explored reserve requirements and all that. Let's think a little bit about leverage. And leverage is essentially, how much assets do you control with a certain amount of equity? So in our example right now, what is our equity? Our equity is equal to 300 gold pieces. Let me do it in a different color just so the equity stands out from the liabilities. And how many assets are we controlling with that 300 gold pieces of equity? So I have 300, 400, 700, 1,000. So, assets are equal to 1,000 gold pieces. So a lot of times people-- when they talk about leverage, you might hear someone say, 2:1 leverage. Well, that means the ratio of the assets to the equity is 2:1. In this case, the ratio of our assets to equity-- so we have assets to equity leverage, is what people say-- in this case, it's 1,000 to 300-- or what is it? 10:3. You seldom hear 10:3 leverage. You'll hear people talking in terms of 10:1 or 2:1, or something to one, but 10:3 is a fair leverage ratio. It tells you just how many assets we're controlling with a certain amount of equity. I guess a very good reason why a bank wants to do this, because if it's making more money on its assets than it's paying on its liabilities, in theory, a bank will want to take on as much leverage as possible, right? Because with this original 300 investment, every time it adds some assets and some liabilities, it's going to make a difference. It's going to make the spread on that money and so it wants to keep doing that. But there's a downside to leverage because what if the bank-- what if some of these loans aren't so good? your What if some of these loans just don't turn out to be so good? So leverage, when things are good, when they go on the upside, it kind of multiplies how much money you're going to make. But as you're going to see in about a second, on the down side, leverage also multiplies the loss you would take. So in this situation, what happens if I had a 30% loss-- let's say I have a 50% loss on these loans that I made. In a world without leverage-- so if I didn't have all this leverage, if I just had the same amount of assets and equity-- so in an example like this where my assets are equal to my equity-- if my assets go down by 50%-- notice here I have no liability. So this is all equity and this is all assets. In this example, if my assets-- for whatever reason, I take a loss. If they go down by 50%, my new balance sheet looks like this. Let me scroll down a little bit. My new balance you will look like this-- 150 and 150. So my equity also went down by 50%. I took a 50% loss because maybe I made some bad investments. But now that I have leverage, what happens if the value of my assets get written down by-- at some point, I determine that Loan B-- they're probably not going to pay up and Loan A maybe won't pay up. So the value of my assets go down by 50%. So I have 1,000 of assets-- so essentially I'm writing down my assets by 500. So let's say that I think Loan B is only worth 50 and I think that this is only worth 50-- because for whatever reason, maybe I give these loans out to build real estate or these were loans to sub-prime individuals. Who knows? Whatever loans these were, they just weren't good loans and I realize I'm not going to get 300 gold pieces back. I'm only going to get 50 gold pieces back. But in this situation, what does my balance sheet now look like? Now that I had leverage, my balance sheet looks like this. I have 100 in terms of the building itself. Then I have 300 of gold deposits. And then that first loan shrinks to 50 only and then that second loan shrinks to 50. So now, what are my total assets? This is 50 and this is 50. So I have 100 plus 300 plus 250-- so it's 100. So I have 500 of assets, which is consistent with what I said. Our assets go down by 50% because I had 1,000 of assets before. And then what are my liabilities? Well, I owe this 300 checking account, this 300 checking account-- because he might have written checks to other people so it's not necessarily the same person that I lent it to initially. But I have-- let's see-- 700 of liabilities. So notice, I now have negative equity, right? Because assets are equal to liabilities plus equity. Well, if my assets are 500 and my liabilities are 700, then what is my equity? Well, my equity's going to be minus 200. So essentially I'm broke. This bank is out of business. And in this situation, there's a very good reason for people to want to get their money back. There's a very good reason to have a run on this bank because frankly, even if you gave this bank all the time in the world, this bank is not going to be able to pay back its money. Even if it were able to offload these loans, it still does not have enough money to satisfy all of the demand deposits or all of the liabilities. And this situation is called insolvency. Let me do that in another color. And that just means you don't have the money. You're not good for it. Remember, when we talked about the reserve ratio, that dealt with illiquidity. You wanted to make sure you had enough gold left aside that when people came and said, I want my gold back, that you had gold to give it to them. But if by chance, people ask for more gold than you had, it doesn't mean you're out of business. You just essentially have to tell them, oh well, can you wait a little while while I deal with my assets and wait for those loans to get paid back? You're still solvent. Insolvency is when you actually, because of bad investments, you actually end up with less assets then do have liabilities and then there's nothing left over in the equity column. And that's what leverage is a measure of, because if you have really high leverage, then you-- notice, when we had no leverage, you could take a 50% loss really easy, but now that we had even 10:3 leverage, even a 50% loss wiped us out. And if you had 10:1 leverage, then even a 10% loss would wipe you out. So leverage really is a measure of how much cushion do you have to take losses in the future. Anyway, before I run out of time-- and in the next video, I'll actually talk about how leverage is regulated within banks, but just to give you another measure of leverage-- because this measure I gave you-- if someone says 10:3 leverage, it's assets to equity-- another one that people often use, often in the investing world, is debt to equity. But it's really a measure of the same thing. Because if someone tells you debt to equity, you can figure out the assets to equity, but in this case, the debt to equity ratio before I took any losses-- it was what? My liabilities are-- this, you can view that as debt because I owe these people that money-- is 700 and my equity is 300. So it's 7:3 is my debt to equity ratio. Anyway, see you in the next video.