Main content
Finance and capital markets
Course: Finance and capital markets > Unit 8
Lesson 1: Banking and money- 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
- LIBOR
© 2023 Khan AcademyTerms of usePrivacy PolicyCookie Notice
Banking 2: A bank's income statement
Introduction to the income statement of a bank (and to income statements in general). Created by Sal Khan.
Want to join the conversation?
- How is cash reserve ( the portion of the depositors' money kept separate from investment capital ) considered an asset rather than a liability?(3 votes)
- When someone makes a deposit, there are two entries on the banks books, not one. Cash comes in, and that's an asset, so assets increase. But that money is owed to the depositor, and that's a liability, so liabilities increase. BOTH assets and liabilities go up when you take in a deposit. The net effect on equity is of course zero.(4 votes)
- Do banks take more money out of the economy than they put into it? It seems like bank profits are out of control or is that not a problem. I keep getting told the economy isn't a zero sum game, but I think it's more complicated than that.(3 votes)
- As any existing bussines, banks are trying to profit from a fundamental activity: risk taking. And of course there are juicy profits for risking in the money business, however as lucrative or selfish as it looks it is really a fundamental activity for the society. Why? because there must be someone that be able to take idle resources and lend them to productive ideas, the risk for bearing such activity is charged by the banks as interests or intermediary fees. As additional interesting facts, moneylending was crucial in the development of the Reinassance since financial intermediaries are rather a synergic participant in the system. Other examples are the Dutch empire prevailing over the Hapsburg empire thanks in part to having the first modern stock exchange in the world :)(1 vote)
- At, Sal begins to explain what he means by capital. What's the distinction between this and an asset? I'm thinking that capital is a claim on assets, yet a claim itself is an asset. Both capital and an asset is something that can be used to create additional value. 2:45(1 vote)
- There really isn't a big difference between them, but technically: an asset is something that has the ability to produce future cash flows. An asset, therefore, is valued based on the expected future cash flows that it will produce. If, for any reason, the amount or timing of those future cash flows changes, then the value of the asset should change with it (either "writing it down" if impaired or "writing it up" if enhanced). Capital is a general term to capture all ownership claims on the assets of an entity. Capital is not valued in the same way that assets are, instead it reflects who has claims on the existing assets. On a Balance Sheet, you will only see assets on the Assets side of the equation and you will only see "Capital" on the Liabilities and Stockholder Equity side.(3 votes)
- what would happen if the bank got robbed? what would happen to all the money people gave him and what would they do?(2 votes)
- In the primitive setting that Sal illustrated the money would essentially be lost. The people would lose their money. However, in most modern banking systems the accounts are insured. In the United States the primary insurer is the FDIC which is a government corporation that was established during the great depression (most European and many Asian countries have equivalent programs). In the event that something happens (e.g. the bank is robbed, the economy collapses, the bank explodes etc..) and the bank is unable to give the depositors their money back the FDIC will give each account holder up to $250,000 of their accounts worth.
This is good because it give people piece of mind and encourages people to keep their money in banks, which in turn makes it easier to loan out money to worthy investments.(6 votes)
- -- what's usually considered a "good" return on equity? 11:13(1 vote)
- It depends on the riskiness of the company. If it is a super stable business that has absolutely no chance of changing the amount it pays you then it would be around 5%. A normal company would have a return on equity around 10%, because normal businesses have more variation in their income. This number will also tend to depend on interest rates and a bunch of other factors.(2 votes)
- if you spend your equity on real estate,()then how are you getting 1,200,000 in the first year?( 1:05) 9:15(1 vote)
- The bank uses addition liabilities to invest in all sorts of things (projects, loans ect.) to generate profits. This profit is partly paid out to the customers saving money on the bank. The rest of the profit the is added to the equity. As the bank now has more value.(1 vote)
- Is it just me or does any one else notice that the subtitle move around maybe too fast. The only time they don't bounce back in forward is if you can watch the video in a higher quality setting if it has that option but 240p is not good enough I think so that the subtitle don't move back and forth so much.(1 vote)
- What would happen if every person who put their money in the bank decides that they want their money back? Would the bank have to get a loan from a bigger bank? What would happen if that bank did not have enough money either? Would the people ever get their money back? Would the bank just have a bad 'credit score'?(1 vote)
- The Federal Reserve is always available as a "lender of last resort".
Federal deposit insurance guarantees deposits in the US. No US depositor has ever lost any money since deposit insurance has been in place. Bank runs have become virtually non-existent because depositors know they need not panic.(1 vote)
- I dont think youcan pull all your moneyout at once only how much the bank has for you.(1 vote)
- If you read the fine print in your bank book or account agreement, you'll see if there are any restrictions on the amount you can withdraw at one time. The bank will do what they can, generally, to accommodate withdrawals in order to serve customers well. However, if the amount is very large or a withdrawal is being made against a very recent deposit the bank will sometimes invoke the terms of its written account agreement. In any case it's always a good idea to read the fine print.(2 votes)
- What if people take all the money out and then the bank is left with none(1 vote)
- That is considered a run on the bank. Sal discusses the majority of the questions throughout the video series. It may interest you to watch the next video which discusses Fractional Reserve Banking.(1 vote)
Video transcript
Let's go over that example, that
I gave in the last video, where I'm in this village and
I start a bank to match up savers with investment
opportunities. And I actually want to do it,
one, to hit the point home a little bit more about how
a bank makes money. And I actually think this
example is a very good instrument to teach you about a
new financial statement that I don't think I've covered
at all much. And that's the income
statement. So far, you're familiar with the
balance sheets, hopefully. And now, we'll learn what
an income statement is. So let's say that this is my
balance sheet at the beginning of my first year of operation,
the beginning of year one. And let me see if I
can recreate it. I think I had said that I had
originally capitalized this company with $1 million. That was coming from
my savings. Or maybe I went to 10 of my
friends and they gave me $100,000 each. But we don't care about how
that equity was raised. All we know is that
we had $1 million. And then, I had bought a
building that I could put money in, that looks
really safe. And people would feel secure
giving that money, putting that money into that building. So let's say I had $1 million
of real estate. And then, the rest of the
village saw this nice big fortress I had constructed. And so they gave me
at least part of their savings as deposits. Saying that, wow, that's a safer
place to put my money than in my mattress or buried
in my backyard. And, this bank of Sal says that
he's going to give me some interest. And he seems to
be a fairly reputable fellow in our village. So let's deposit some of
our savings with him. So I get $10 million
of deposits. And, of course, I told them,
look, this isn't a loan. Although, it kind of is. I'm not borrowing this
money from you. You guys can use this money
whenever you need it. And because of that, I need to
set some of these deposits aside, in case someone comes the
next day and says, I gave you that dollar yesterday. I actually need that dollar
now to pay for my teeth cleaning or something. So I need to set aside
some of it. And I figure, well, if I set
aside 10% of it, that's the most that anyone would ever
come in one day, unless there's some type of strange
run on the bank. So I'm going to set aside
10% of it as reserves. So it's cash reserves. So let's say, $1 million
of cash. If I thought, for some reason,
that there's a higher likelihood of everyone coming at
once for their money, or a large percentage of the people
coming at once, I'd want larger reserves. And then, finally, I'm
left with $9 million. They gave me 10, I had
to put one aside. I'm left with $9 million
to loan out. This is productive capital. And when I say, capital,
that's just a claim on someone's goods and services
that can be used to construct or perform something that adds
value, that creates more value than was used. So that's $9 million of loans. And I know I always keep talking
in those terms. And I do that because I think, in our
society today, we get so fixated with the points, and
that's money, or the dollar bills, that we often forget
what the points represent. The points, or the money,
represents claims on goods and services. I've actually met people who
become obsessed with-- Well actually, like on
[? Connicet, ?] I get emails from people who
want to get extra points on their account. And they're obsessed with it. And it's just a number. But what's important is, what
does a point system really do for you? And in money, those points
represent future claims on goods and services. So this is how my balance sheet
looked at the beginning of year one. And I said, well, I'm going
to be getting in 10% on these loans. And let's say that I'm very good
and none of them default. And I really do get my 10%. And I said that I'm going to
pay these people out 5%. So what happens over the
course of that year? So how much interest income
am I going to get? I'll call that interest, Int
Inc. So 9 million times 10%. I'm going to get $900,000. And then, what's my
interest expense? I probably should have
done this in green. Well, I have to pay out
5% on the $10 million. So it's $500,000. I'll put it as a negative
number, just so you know it's an expense. Although, since I said it's an
expense, you might want to put it as a positive number. But that's just an accounting
convention. But I think you get the idea. Let me put it as
minus $500,000. And then to operate this bank--
I had this building. it had to be cleaned. It has to be maintained. I had to hire bank tellers
and security guards. And I had to buy my security
guards machine guns. I have expenses, above and
beyond just this little interest transaction
that's going on. So let's say that
I have salaries. So I have some other expenses. Let's say it's minus 50K
a year in salaries that I have to pay. And let's say, upkeep of the
building-- you have to paint it every now and then. Have to install new marble
tiles every now and then. Because I have to project this
impression of the shining, impenetrable fortress. So upkeep is actually a
big expense for me. So I spend 50K on upkeep. And so, what am I left with? Let's see, 900 minus 500 is
400, minus another 100. So I'm left with 300,000. But even though this is a
primitive village that I live in, it's not so primitive that
it does not have taxes. And so, this is my
pre-tax income. [PHONE RINGS] My cellphone is ringing,
but I'll ignore it. Actually, it's very
hard to ignore. But anyway, this is
my pre-tax income. But my local village government
says, well, you have to pay for the army and all
of the other services that we provide. So they take 30%. So income taxes. Let's say they take one third. So they take 100K. And so, what am I going
to be left with? What is my net income? 300 minus 100, I'm
left with 200K. Fair enough. And, just so you know, this
is the income statement. And I'm going to talk a little
bit about how all of these match up. So let me let me draw big,
nice box around it. So it looks like a proper
statement of something. So what is my balance sheet
going to look like at the end of the year, given that this
is how much money I made? Well, let's say those loans
haven't been paid off, just people paid the 10%
interest on them. So I still have those loans
on my balance sheet. Let me draw the loans. So I still have $9 million of
assets, which are those loans. They haven't paid them off. I still have the building. And actually since I spent
50,000 on upkeep, all of the wear and tear was made up
for, with my upkeep. So it's still worth
a million dollars. So I still have a million dollar
building, 9 million of loans outstanding. I had a million dollars
of cash. And now, how much
cash do I have? Well, I had that million
dollars before. And I'm assuming that my overall
level of deposits do not change over the course
of the year. So I had a million dollars of
cash, and nothing dramatic happens with the deposits. Over the course of the
year, I show right here, I made $200,000. And this 200,000 is,
essentially, going to be cash now. So now, I have 1.2
million of cash. My deposits haven't changed. I still have 10 million
of deposits. Those are liabilities, because
I owe them to the people who've deposited their
money with me. I owe them money. And so what am I left with? What is my equity? My equity was 1 million. What is my equity now? Well, equity is just total
assets minus total liability. So what are my total
assets now? 9 plus 1 is 10, plus 1.2. I have 11.2 million
of total assets. Minus my total liabilities,
minus 10. So I have 1.2 million,
now, of equity. Now, something interesting
has happened. What has been my change
in equity? I had $1 million of equity. Now I have $1.2 million
of equity. So my change in equity-- so $1
million to $1.2 million. So we could call it, if you're
used to the math notation, you could use that delta notation. Triangle just means change. My change in equity is
equal to $200,000. And that is the same thing
as your net income. So what is an income
statement? Well, first of all, this
is an income statement. But how does it connect with
the balance sheet? And later, we'll talk about
the cash flow statement. Well, a balance sheet is just
a snapshot of what you have and what you owe at any
given point in time. This is the balance sheet at
the beginning of the year. This is the balance sheet
at the end of the year. This is a snapshot of what
you have and what you owe at the beginning. This is a snapshot of what you
have and what you owe at the end of the year. The income statement tells you
what happened over the course of this year. So it essentially tells you
how did you get from this balance sheet to this
balance sheet. Another way to think about it,
the income statement, at the end, it'll tell you all
of your inputs. What money came in. What money came out in
the form of expenses and taxes, et cetera. And then, you get a
net income number. And that net income number is
actually the change in equity. So if you have a positive net
income in a year, the balance sheet's equity will increase
by that amount in a year. And if you have a negative net
income, your balance sheet's equity will decrease
in a year. So you could actually call your
net income is the same thing as your change
in equity. And, another thing you want
to talk about, what's your return on equity? Well, your initial equity
was $1 million. How much money did we make? Well, it grew by $200,000. So 200,000 over 1 million. Well, we could call that
1,000 thousands. That equals a 20%. That was our return on equity. We put in a million, and we
got 20% more than that. That was our return on equity. Equals ROE. And notice, the return on equity
is really-- that's the same thing. That's change of equity divided
by starting equity, which is the same thing as
net income in the period. Well, I'm defining it
as starting equity. Sometimes people talk
about it as average equity, and all of that. Anyway, I thought that this was
a good tool to at least introduce you to the notion of
an income statement, and show you how to all connects. Because that's the beauty
of accounting. It's that you have these
different financial statements that are very intertwined
with each other. You give me two balance
sheets. And then, I can actually
construct the income statement that must have happened
in between them. Anyway, see you in
the next video.