Banking 11: A reserve bank

Everything we've covered so far dealt in a world of only one bank and we all know that there are more than one bank in this world. Let's see what happens in that example. So I've drawn the balance sheets for three hypothetical banks in a world where gold is the reserve currency and let's see what happens in that world. So let me show you all of the-- so that's the first one and that's the last one. They all didn't fit on the screen, but just so you understand and a bit of review of what we covered in the last several videos, in these balance sheets, of course the left side are the assets, the right-hand side, up until here, is liability. So from here to here, that's liabilities. And what's left over is the equity. So in every balance sheet, just to be consistent, I made this blue color equal to the equity. Let me write that down. And just to be consistent, I made this little orange color the building, brown for building. And this yellow or this gold color-- that's actually the gold reserves of that bank. And each of these lines, these divide the various other assets of the bank. In this case, they're just loans, maybe to different entrepreneurs. And then these green lines separate the different demand deposits or checking accounts that are with that bank and then the green-- this filled in green, for example, in this middle bank-- that shows its notes outstanding. Remember, there's two ways that you could essentially give someone an IOU from this bank. One is to say, oh, you have a checking account and you can write checks against it. The other way is to issue this bank note and someone can come back later with this bank note and you should have to give them an equivalent amount of gold. So in this middle bank, this green area, that shows its bank notes outstanding. This purple area in this bank, that's its bank notes outstanding. And then down here, this off-white color is its bank notes outstanding. Fair enough. We've created a world with three banks Now what is the problem here or, are there any problems? Well, there are a couple that I see immediately. The first is, all of them might have different reserve ratios. In the last video, I kind of talked about a world with regulation, but let's say in this world, since every bank is kind of a separate entrepreneur, maybe it was originally the goldsmith, they all just made their own rule of thumb that if I have this amount of demand deposits based on how my customers act or whatever or based on my liabilities or however it works, I'm going to keep this amount of gold. So maybe this guy's reserve ratio-- I don't know what the ratio of this to this is, but maybe his reserve ratio is 8%. So for every 100 gold pieces of demand deposits and bank notes, he keeps eight gold pieces on reserve. Maybe this guy is 10%. Looks a little bit better. Maybe this guy up here is keeping a 12% reserve ratio. So there's no consistent reserve ratio. So let me write that down. And there's a couple things that that might lead to. Maybe this guy right here, he was the first bank to start-- or maybe this guy. This guy had a 12% reserve ratio-- and people really trusted it for a long time. Every time they deposited money and then they came back later, they were able to find it. He really lent money really well. So that there was never any scare on this bank. No one ever felt afraid to keep their deposit there. But as the banking business got more and more profitable, more and more risky people showed up and this guy only has an 8% reserve ratio. And maybe one day, 9% of their checking accounts want their money back and this guy's not good for it. This guy up here, the 12% guy, he knew that 9% could happen. That on any given day 9% of your demand deposits might want their gold back. So that's why he kept 12%. But this guy kept an 8% so he could get extra interest on more loans. So one day, he can't give his gold back and that scares everyone. So everyone comes and you have a run on this bank, but he's not the only bank. Everyone starts having less trust in the banking system as a whole and so there are runs on all of these banks. And that's unfortunate for two reasons. One, these guys were safe to begin with. They kept enough reserve ratio so that people could get their gold. And then the other sad thing about it is, if this guy just needed another 1%-- I keep going off the video screen-- if this guy just needed another 1% of gold, he could have borrowed it from that top guy and then you would have prevented this whole banking crisis. He could have borrowed it from either this guy or that guy, right? If this guy's gold gets depleted and more people still want money, this guy would clearly rather lend the money to this guy as long as he's still solvent than have a systemic run on all banks. Bank runs affect everyone. So in this world that we're dealing with right now, just one weak link in the chain can break the whole chain. If you just have one irresponsible bank, it'll create a bank run on all of them even though some of the more capital rich banks could have lent to the other ones. And then finally-- and I did this here and this is a situation that we're not familiar with today, but it's a situation that's happened many times in history. It happened in the colonies before we had our independence. Is that you had a bunch of different banks each issuing their own bank notes as a form of currency. So this one up here issues the purple bill, this bank here issues a green bill, and this bank here issues this off-white bill. Besides the confusion, you're always going to have all these exchange rate differences, et cetera, et cetera. You don't know ahead of time-- this guy's the riskiest bank so maybe his bills should be worth a little bit less than this guy up here. But you don't have-- it really just becomes a big mess to the economy for someone in a cash register to keep track of. In this case, I only have three banks, but imagine if all 13 colonies each had their own banks that were each issuing their bank notes and you always had to translate between them. And then one bank defaults and their bank notes are worth nothing and you have to worry about that. So you have another problem; inconsistent currency. Inconsistent paper currency. And I think you know where I'm going with this. So what's the solution to all of this? Well, what if there were a way-- and I guess you could do this without any extra institutions. You could just regulate reserve ratios. So that's easy to do. That's just government intervention. Just say, if you want to be a bank in our world, you have to keep at least 10% reserve ratios. But we have to think about who regulates that and who sets that reserve ratio, but it's fair enough that we need someone to regulate it. We don't need a separate institution. But how could we do this mechanism where we can prevent bank runs? Especially when there's money to lend from one bank to the other. And if we could use a mechanism that prevents this and provides a consistent currency, then we're all set. Well, the only way you can provide a consistent currency is if you only had one bank issuing currency. So let's call that bank a reserve bank. There you go. So let's say these three banks get together-- all the banks in this world get together and say, let's start a new institution where we all keep our gold reserves there. So what happens is, this guy, this guy, this guy, they all keep their gold reserves at this central bank. And now with these guys, instead of having gold reserves here, what do they have? They have checking accounts with the reserve bank. Let me write that down. Let me erase the top of that balance sheet just because I don't want to make things confusing. So that's the balance sheet that our reserve bank now has. Now what does this do? Well, it definitely solves that bank run problem because now in this world-- and of course we're regulating it now-- and I kind of threw that out there because this guy will be the regulator. This central bank will be the regulator, but what you could say now-- is if for some reason-- let's say 11% of these demand deposits come due, 11% of these people want their money all of a sudden-- this guy, he just has to go to his reserve bank account and he can borrow from one of the other players. The gold is all centrally in one place. Now the notes issue-- how do we solve that? Well, what if by government law, from now on only one bank can issue bank notes and that's this central bank. Let's say this middle guy-- instead of having just a checking account, maybe he took half of it as a checking account and half of his gold deposits, he gets in these bank notes of this reserve bank. So now these turn into bank notes of the reserve bank and these bank notes of the reserve bank are the only currency that's allowable. So we've already solved two problems. We've solved an inconsistent currency. And now think about what starts to happen. The reserves of these banks no longer become gold. The reserves at the banks that people actually interact with now become these bank notes, the bank notes of this central reserve bank. And this gold is just sitting in some big vault someplace in this world right now. So let's just-- I know it's a little bit disjointed-- so reserve ratios. Now you have a central banking authority where they all chipped in a little bit of money, created this big vault, and this central bank dictates reserve ratios. It prevents bank runs because if for whatever reason-- let's say on some day all of this bank's customers get scared and want their gold back, this bank can just go to its checking account and borrow gold from the other banks and it'll get transferred to it. But if you think about it, in a world where people get used to enough of this one central bank note, then people probably won't even want that gold back. They'll probably start viewing this one currency as the equivalent of gold. So when people actually want their money back, they don't even have to give gold. They can just give bank notes, but there's this one consistent bank note now from this central reserve bank. Anyway, I think I said the word central and reserve too much, but I will see you in the next video. Hopefully it wasn't too complicated and I think you see where this is going. We'll slowly extend this to getting off the gold standard and how this relates to the Federal Reserve or central banks as we know them today. See you soon.