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:10:49

Video transcript

in the last video I gave the example of this Bank that I keep using and in this example as opposed to giving the gold out to make loans and be used for projects and that gold get redeposited and then relent out what we did in this example is that the bank every time it made a loan it just made a loan and that created an asset and then it had a corresponding liability where the liability was either a checking account that the entrepreneur could use or bank notes or which are essentially cash that the entrepreneur could use to pay their labourers or to buy their land or whatever they needed to do so an obvious question was how much could a bank do it when when does this stop can a bank just keep increasing the left and right hand sides of the balance sheets and to answer this question we'll introduce the idea of a reserve ratio so just a I guess a bit of a review and just make sure we're clearly reading this balance sheet and let me label things a little bit more because sometimes I assume too much remember this is these are the assets the assets are all of these me make a bold line here all of this is the assets of this Bank including its building so it's vault down there and then the liabilities I'll do that in this yielded in round like this red colors little blight but these are the liabilities over here in this red color that I'm coloring in right now and the equity whoever owns the bank whether stockholders or maybe it's owned by an individual maybe it's owned by me is what's left over this is the I call doing a nice neutral color this is the equity so the question is how much can the bank and of course this let me do all of this for liabilities liabilities so the question is how much can the bank continue to issue out more loans and increase its assets and liabilities remember every time it is you're alone like for here right right here is issued a 100 gold piece 2d and instead of giving D 100 gold pieces from say right here it just created a checking account for D which later D paid to a and that's why it's labeled a right here and let me real able another thing because the gold is different colors just so you see the gold this is all this is the gold part of the assets let me make that very clear that all of this right here is gold maybe I'll colored in a little bit that's all golden there's 500 gold pieces 500 gold pieces so let's introduce the concept of a reserve ratio reserve ratio now let's think a little bit about what what even though reserve is a reserve is something that you keep aside because you might need it one day all right and in this situation all of these liabilities whether they're these banknotes outstanding in this example or whether they're these checking accounts these demand accounts these are all liabilities that someone can come back to the bank on any given day and say hey I want my gold now for whatever reason maybe I'm leaving town maybe I don't trust the bank anymore for whatever reason maybe they just want to build some make some jewelry for whatever reason that person wants their gold back these are demand accounts these checking accounts are demand accounts and these notes are things that can be exchanged for goal any point in time and we talked a little bit about this earlier when we started the whole banking discussion but you have to leave aside a little bit of gold just in case someone someone wants their gold back so this amount of the gold that you have to leave aside as a reserve relative to the total amount of demands you have on that gold that's the reserve ratio so the reserve ratio and in this situation this world that we've created the the reserve the reserve store value is gold later on we're going to get ourselves off of this gold system and then that reserve that reserve for value is actually going to turn into to cash but for right now and I think it's easier actually to conceptualize gold let's stick with gold the reserve ratio is for this bank is the amount of gold assets you won't see this formal definition anywhere because no one most people are off the gold standard right now but it's the amount of gold assets divided by total I don't want to say total liabilities because the bank could take out loans that aren't demand loans everything on the liabilities right now are on demand loans which means whoever has that liability can come back and exchange it for gold at any moment in time but we could the bank could have taken just a regular loan and a regular loan might not be on demand a regular loan might be a loan that the bank doesn't have to pay back for ten years and in which case there's there's no reason why the bank would have to set aside some gold to pay that back so let's let's make our definition not total liabilities but total demand liabilities total demand liabilities look but liabilities whoops liabilities so what would be total demand liabilities that would be total total bank notes in this case and banknotes are also something will you know what will later leave a world where every bank is issuing banknotes but I just wanted to give you that kind of historical context how banknotes even started off total banknotes and demand accounts demand or checking accounts demand checking accounts so let's see what it is for this Bank that we have here so our total gold assets are 500 and what star total demand accounts this ISA a hundred plus 100 plus 100 plus one is let's see one two three four hundred six hundred and I think this was another hundred year seven hundred so it equals see the total demand liabilities I just figured out was seven hundred and the gold assets in this Bank are five hundred 500 so right now the reserve ratio of this Bank is is pretty high five seven so I don't know what five seven is five seven seas I don't know seven goes into five how many times sixty positive I'm doing my mental math right it's about 62% seven goes into 50 no no 7 goes into 50 seven times seven times so it's like seventy-one percent right 7 times 7 is 49 71% so that's this reserve ratio and what keeps banks from just keep issuing more assets and debts to expand its balance sheet is a reserve ratio requirement so right now in the United States although we're not on the gold standard but you could imagine in this world our bank regulators might might say that your reserve ratio on demand accounts so the amount of gold you have to set aside for checking accounts so reserve requirement we'll call it let me change colors just to ease the monotony reserve requirement they might say the reserve requirement is equal to let's say they want to be safe let's say they want to be they want to make it 20% in the US right now it's 10% although the reserve commodity isn't gold anymore let's say 20% that means as long as in on any given at any given moment in time more than 20% of these people don't demand their money back the bank's going to have liquidity the banks bill is going to be able to fulfill its promise because all of these people think at any given moment they can go to the bank and get their gold and in order for this system to work there has to be confidence and in order for them to be confident the bank has to be good for it every time someone asks for their money so the bank has to stay liquid so essentially this reserve ratio is what the regulators think that a bank needs to maintain in order to maintain be liquid our bank as it is right now it has a reserve ratio of 71% so as long as no more than 71% of these people because some of these loans these might be out for a year or two so as long as in that year or two that these loans are out as long as no more than 71% of these people come asking for don't come asking for their gold we should be okay if all of a sudden for whatever weird reason I don't know 80% of these people who have demand deposits or bank notes come and want to switch their money for gold this bank is going to run out of gold and that's a bank run and and and there's there's a couple of reasons why that's really bad what is all of a sudden these these demand deposit accounts all of a sudden don't seem to be that great because you're not really getting your gold on demand because more people are asking for gold then there is gold and then the other problem is all of a sudden everyone will lose confidence in the system and everyone's going to think boy these banks that have these nice vault looking buildings maybe they're not as safe as I thought so everyone is going to start pulling their money out and that's called a bank run so in this example if I assume that this loan is really worth three hundred gold pieces and it's really going to be paid back and this loan right is really worth 100 gold pieces and it really will be paid back this Bank is solvent it has more assets than it does liabilities so it has if it has enough time it will be able to pay back all of its liabilities but if all of these people all of a sudden come in and want not just 500 gold pieces if they want if they want 600 gold pieces right there oh actually 700 so if they want 600 gold pieces all of a sudden everyone is going to lose confidence in the system these people probably have been unable to get that they're probably gonna want all their money back so then all of these liabilities are going to come due and then maybe the bank is going to have to try to sell these asset this these loans to someone else or maybe try to collect from someone but as you can imagine it's a whole it's a big mess and the whole system that which is depending on confidence will just start to crumble but anyway the the initial question is what is the limit to how much you can expand the asset and the liability side of the balance sheet just by creating these loans and these deposit accounts and that limit is driven by the reserve ratio whatever the regulator's set anyway I'll see you in the next video