Banking 7: Giving out loans without giving out gold

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 a kind of ad hoc configuration. So it might not sound as good as it normally does, but let's just try to keep learning. So let's start off the way I start off every video, but maybe I'll do it a little different this time. So I want to start a bank. So I use 300 gold pieces, 100 to actually build a bank. So this is my vault. The actual physical structure-- that took 100 gold pieces and I'm actually going to initially capitalize this bank with 200 gold pieces. You want to show people what it looks like for gold to be sitting in the vault to get the idea. So my initial equity is 300 gold pieces. Like 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 100 gold pieces. This is just all gold. And then 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 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 B comes. He's a little bit richer, gives 200 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. And then half of it, he wants in terms of bank notes. So this liability would be bank notes outstanding, 400 gold pieces. This is 100 right here. And I'll print up some bank notes. Maybe he wants five 20s. So I'll give him five times-- each of the bank notes might look something like this-- 20 gold piece denomination, have a picture of a handsome bank founder. It'll say Bank of Sal at the bottom. I'll give it to him and then he could use that for transactions with people who maybe don't like to leave a paper trail. But anyway-- 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, they 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 at 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 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 would redeposit it back in the bank and that process would continue. What we're going to do now is try to think about, how could we do this without the bank 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. If someone wants to sell something worth half a gold piece, do they cut it? If someone wants to sell something worth 1,000 gold pieces, it's a security risk and it weighs a lot. So what can we do? So let's say entrepreneur-- let's see. We did A, B-- so let's do Entrepreneur C. He has an idea. Let's say it's the irrigation ditch again. And he needs 300 gold pieces. So what we do is, we lend him 300 gold pieces. So I have an asset-- 300 gold piece loan to Entrepreneur C. And instead of actually taking it out of my assets here and then waiting maybe for his laborers to redeposit it, I can just create a checking account for Entrepreneur C. In fact, it can be maybe part checking, maybe part cash. What I could do is maybe 100 of it, I can make a checking account and then the other 200, I could put some more bank notes outstanding. So maybe I do 20, maybe he wants it in 10s. And I give him a bunch of these things that I've printed out from the Bank of Sal. And maybe he could use this to pay his laborers. And if the laborers later on, they don't want to just hold these pieces of 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. So I have a loan-- 100 loan. That's my asset. 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 nowhere. 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 issued the gold. It's just that we had to wait for the gold to come back to the bank. This is essentially a 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 the person who actually builds the factory. Person D can write Person A a check. He could write 100-- You know what a check looks like. He'll sign it. Person D-- He'll say it's for a factory. He'll write out 100 here and he'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. And then when A takes this check that he got from D, brings it back to the bank, then the bank says, OK, well, D is going to take all this money out of his account and we have to transfer it to A. So I could move that down or I could just change it to A's color. And I think you get the point. All this 100 gold pieces is now A's. And once again, we did not have to change anything. 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 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 take on arbitrary amounts of risk-- and there are regulations, although I think a bank would do it on their own to some degree, but there are regulations called reserve requirements that tell us how much lending can a bank do relative to its actual reserves. In this case, it's reserves of gold. Actually, even a better definition-- 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 leaving. In the next video, we'll actually talk about reserve requirements and think about why reserve requirements are what they are and what happens in extreme circumstances. See you in the next video.