If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:8:29

Banking 7: Giving out loans without giving out gold

Video transcript

welcome back and I just want to apologize ahead of time because I'm actually in a hotel right now because my wife is at a medical conference and I'm using my laptop with kind of ad-hoc configuration so it might not sound as good as it normally does but let's just try to to keep learning so let's start off the way I start off every video but maybe a little different this time so I want to start a bank so I use three hundred gold pieces one hundred to actually build a bank one hundred to build a bank so this is more of my vault the actual physical structure that took 100 gold pieces and then I'm actually going to initially capitalize this bank with two hundred gold pieces you actually want to show people what it looks like for gold to be sitting in the vault look at the idea so my initial equity is three hundred gold pieces three hundred gold pieces that's my equity or whatever the investors were that initially invested in this Bank unlike all of the other examples I start off by taking deposits the villagers trust me so villager a comes and gives me let me just do villager a in green he comes and gives me his hundred gold pieces one hundred gold pieces this is a stall gold and then my that's an asset sitting in my vault and then the offsetting liability for me although this would be an asset for him is a checking account so account account for person a and he can write checks against that and we know how that can be used as actual currency or actually be used to make payments and then person becomes he's a little bit richer gives two hundred gold pieces two hundred gold pieces and he wants half of that in his checking account and he wants the other half essentially in cash or in bank notes as we've learned so this is this is the account of be account of villager B and then half of it he wants in terms of banknotes so this is the sly bility would be bank notes outstanding bank notes outstanding for 100 gold pieces this is 100 right here this is 100 and I'll print up some Bank notes maybe he wants 5 20s so I'll give him 5 times and each of the bank notes might look something like this 20 gold piece denomination have a picture of the handsome bank founder and we'll say Bank of Sal at the bottom and I'll give it to him and then he can use that for transactions with people who maybe don't like to leave a paper trail but anyway or or whatever buying a newspaper whatever he needs to do but he can use these and then whoever he hands these to if they have one of these 20 gold piece bills that can come back to the Bank of Sal and actually redeem 20 gold pieces so it's kind of like a checking account but you don't know who actually has rights to it any given moment in time but anyway we've done that in the last couple of videos and we've shown how you can change hands and how when someone writes a check say between a and B you're just kind of you're just changing what happens in the books and the gold never has to leave but let's think about what happens now when we actually start to lend some money so in the old example if someone had a project that required let's say 300 gold pieces we would actually give them the 300 gold pieces we would actually take it out of our vaults they would use that 300 gold pieces to hire the people or buy whatever supplies they needed to actually do their project and then those people maybe will redeposit it back in the bank that process would continue what we're going to do now is try to think of how could we do this without the bank with ever having to give the gold out one it's just a safety concern and then the gold is just not an easy thing to transact with you don't if someone you know wants to sell something worth half a gold piece do they cut it if someone wants to sell something with a thousand gold pieces so security is gonna is a lot so so what can we do so let's say entrepreneur see we did Abyan so let's do entrepreneur see he has an idealist it's the irrigation ditch again and he needs three hundred gold pieces so what we do is we lend him three hundred gold pieces so I have an asset 300 gold piece loan to entrepreneur see and instead of actually taking it out of my assets here and then waiting for it maybe for his laborers to redeposit it I can just create a checking account for entrepreneur see in fact it can be made in part checking maybe part cash what I could do is maybe a hundred of it I can make a checking account one hundred so it's an account for see that's a checking account and then the other 200 I could put some more banknotes outstanding is two hundred banknotes outstanding so maybe I do twenty maybe he wants it in tens 20 times and I give him a bunch of these things that I printed out from the Bank of Sal and then maybe he could pay use this to pay his laborers and if the labor is later on they don't want to just hold these pieces paper they can come back to the Bank of Sal and get gold in exchange for it and then let's say another entrepreneur comes and he wants to build a factory he needs 100 gold pieces I can do is say he needs 100 gold pieces so I have a loan 100 loan that's my asset loan to entrepreneur D and then I can create a checking account for him so this is account for D and I know what you're thinking it looks like I'm making money out of out of nowhere I can just I'm just increasing both the left and the right hand side of the balance sheet for every new loan I make and if you think about this was actually not that different when we act when we issued the gold it's just that we had to wait for the gold to come back to the bank this is essentially way of keeping the gold here and we just use these checking accounts and these bank notes as a way of transacting instead of the gold itself so for example let's say this entrepreneur D he wants to build a factory let's say that person a is is the person who actually builds the factory so what let's see is a person D and half person a person D can write person a a check you know you could write 100 you know what a check looks like he'll sign it person D he'll say it's for a factory and he'll write out 100 here and I'll write it out in words however a check is just something that shows it has to be authenticated so that when a takes it back to the bank the bank believes that D actually wrote it in his checkbook as opposed to somehow a forging it and in return a is going to build D a factory a is going to build D a factory and then when a takes this check that he got from D brings it back to the bank and the bank's they say ok well D is going to take all this money out of his account we have to transfer it to a so I could move that down or I could just change it to a sculler and I think you get the point all this hundred gold pieces is now a z' and once again we did not have to change anything or we didn't have to deal with any gold now the natural question is how far can this process continue can a bank just continue issuing loans and checking accounts indefinitely and and essentially collecting the difference in the interest between the interest it gets on the loan and the interest it gives on the checking account well no because then a bank would take on arbitrary amounts of risk and there are regulations although I think a bank would do it on their its own to some degree but there are regulations called reserve requirements that tell us how much how much lending can a bank do relative to its actual reserves in this case its reserves of gold actually even a better definition how much how much checking accounts and bank notes it can issue relative to its reserves and in the next video the point of this video was showing you how this loan process can occur with the gold never leave and the next video will actually talk about reserve requirements and think about why reserve requirements are what they are and what happens if in extreme circumstances see in the next video