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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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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.