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Banking 8: Reserve ratios

How reserve requirements limit how much lending a bank can do. Created by Sal Khan.

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  • winston default style avatar for user Chris K
    So what's the penalty for a bank that drops below the lowest legal reserve ratio? No more new bank notes?
    (28 votes)
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  • blobby green style avatar for user bugmobile
    if bank notes represent gold in the bank, why there is a different between value of money eg. us dollar vs uk pound? Tq
    (11 votes)
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    • blobby green style avatar for user salvatorej1
      A fiat system means that the banknote is only backed with the purchasing power of the currency instead of gold. The purchasing power of the currency is the value that the banknote has when purchasing goods e.g. with a $1 I buy an egg today, but tomorrow an egg costs $2, my $1 has lost purchasing power because I have to pay more for the same things. That is called inflation. Inflation takes place when there is being a lot of money printed into the economy (by the Federal Reserve) so people can pay back the interests from the loans. Basically, it is a cycle where somebody always looses all its money, a bit unfair, isn't?
      (19 votes)
  • leaf blue style avatar for user Ali
    Wikipedia says that Canada doesn't have a reserve ratio.

    So a bank here can infinitely produce money and infinetly collect interest casuing inflation and other problems?

    So how is our banking system considered one of the world's best and safest??????
    (7 votes)
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    • leaf green style avatar for user Robert
      A number of countries do not have regulated reserve ratios. In those cases, it is up to the individual bank to set their own ratio based on their corporate risk tollerance. Remember that banks have an economic self interest to ensure they are not endangering their business continuity by engaging in high risk lending. In Canada this form of self regulation has proved to be ballance-positive and by extention has lead to the Canadian system being one that is stable and safe. I hope that helps :)
      (18 votes)
  • leaf blue style avatar for user zhuyan79
    How could a loan be considered as liability of bank? Bank actually lend out this money....I didn't get it
    (3 votes)
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  • purple pi purple style avatar for user Al-Qaid Akbar
    At , what function does the reserve ratio serve? How does it relate to the reserve requirement? I understand that value of the reserve requirement is arbitrary and dependent on the bank. The reserve ratio determines how much gold is required in order to pay of the total demand liabilities?

    In addition, what is "total demand liabilities" and how does it relate to liabilities?

    (1 vote)
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    • blobby green style avatar for user killandcath
      The reserve ratio is essentially the proportion or % of your assets you need to keep aside to meet the demand requirements of your demand liabilities. It's the concept, essentially, of someone coming knocking on your door to demand their money back, well, if you promised to pay them when they ask, then you have to make sure you have that money to pay them that money back. So, the reserve ratio and reserve requirement are essentially the same thing, just different units of measurement for the same thing, e.g. the reserve requirement might be (let's say) $400, this is essentially $400 worth of assets you must keep at the bank (in easily transferable format, e.g. it's no good having $400 worth of a building!). This $400 might represent say 15% of your demand liabilities (i.e. you don't have to keep every single penny of assets aside for what is payable right now, you figure this out based on statistics and analyses of customer behaviour. If you have your own checking account, you probably don't go into the bank and take out all your cash at one go? So, think about all the customers a bank has with checking accounts - how likely is it that you AND every single one of those other checking account holders will go into the bank at the same time (or in one day) and say I want (i.e. I am demanding) my money back right now? Statistically, relatively low, so you then only need to keep a smaller percentage (your reserve ratio) aside to meet these demands for immediate cash).

      Your demand liabilities are a sub-set/piece of your total liabilities. If in the banking example above the Bank had borrowed money from somewhere for 10 years (i.e. it pays that loan off over 10 years) and say that long-term loan was for $1,000, they also, let's say, have $200 of checking accounts and $300 of bank notes outstanding. Well, in this case their total liabilities are $1,500 and their demand liabilities are $500, i.e. their demand liabilities are the $500 portion of the total $1,500 liabilities. The reason this is important is the $1,000 does not have to be paid right now (i.e. on demand) as the people who gave you that money only need back after 10 years, so you do not have to set any assets aside to pay that amount NOW, but you will need to ensure you have sufficient assets to cover it when it is due for payment. Whereas the $500 is payable immediately.
      (7 votes)
  • duskpin ultimate style avatar for user ogiekim
    Couple of things to clarify... so in the example at , if we assume all the loans will be paid back, a bank's solvency will always be time-dependent? And the reason why a bank sets up a reserve ratio instead of printing more money to stay liquid is because of inflation?
    (1 vote)
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    • leaf green style avatar for user Ryan
      Solvency just means assets are greater than liabilities. It is the ability to meet long term expenses. So, if assets are higher than liabilities, you could liquidate all your assets and pay off all your long term liabilities. It is not time dependent in the sense that the bank cannot do anything with their assets until the customer pays back their loans. A loan is an asset to a bank like any other kind of asset and they can always sell a loan to another lender if they have to.

      A bank does not determine the reserve ratio. Authorities regulating the banks are responsible for determining the reserve ratio. It is something banks have to comply with in order to stay in business.
      (4 votes)
  • hopper cool style avatar for user Bentastic
    Why wouldn't someone trust the bank of Sal??
    (3 votes)
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  • blobby green style avatar for user petejs926
    lets say that i have have a peach farm and i sell one of the people who got banknotes from the bank a peach and they give me a one dollar banknote. i do this 50 times and then i have all these banknotes that i want to keep safe, so i go to the bank and start an account and give the bank the banknotes which creates a new $50 liability for the bank. unlike the check that transfers the gold pieces from account to account, the bank has increasing liabilities. How does that work?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      When you gave the bank the banknotes, that liability went away, and it was replaced by a liability that is recorded in your deposit book. Now they still have a $50 liability, but it is to you instead of a holder of the banknote, because there is no holder of the banknote anymore.
      (3 votes)
  • male robot hal style avatar for user berfle
    what is demand liabilities in greater explanation?
    (1 vote)
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    • blobby green style avatar for user jimdetry
      It is how much people could try to take out of the bank. If everyone tried to empty their accounts at once they are "demanding" you pay off your "liabilities." You could also have liabilities that CAN'T be demanded on the spot, such as a loan from another bank which you only have to pay off when it comes due.
      (3 votes)
  • blobby green style avatar for user omar.nadim11
    According to the example, the bank has 500 gold pieces , they gave loans of 400GP to C and D , we still have 500GP in Assets , the loans are backed up by gold , if we say 900 gp of assets we count the same asset twice. NO ??
    (2 votes)
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Video transcript

In the last video, I gave the example of this bank that I keep using. In this example, as opposed to giving the gold out to make loans and be used for projects that gold gets redeposited and then re-lent out. What we did in this examples 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, which are essentially cash that the entrepreneur could use to pay their laborers or to buy their land or whatever they needed to do. So an obvious question was, how much could a bank do it? When does this stop? Can a bank just keep increasing the left and right hand sides of the balance sheet? And to answer this question, we'll introduce the idea of a reserve ratio. So just, I guess, a bit of a review, just to make sure we're clearly reading this balance sheet. Let me label things a little bit more because sometimes I assume too much. Remember, these are the assets. The assets are all of these. Let me make a bold line here. All of this is the assets of this bank, including its building, so its vault down there. And then the liabilities. I'll do that in this red. I don't like this red color, but these are the liabilities. And the equity-- whoever owns the bank, whether it's stockholders or maybe it's owned by an individual. Maybe it's owned by me-- is what's left over. I'll do it in a nice neutral color. This is the equity. So the question is, how much can the bank continue to issue out more loans and increase its assets and its liabilities? Remember, every time it'd issue a loan, like for right here, it issued a 100 gold piece equivalent loan to D-- 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. Let me relabel another thing because the gold is different colors so you see the gold. This is the gold part of the assets. Let me make that very clear, that all of this right here is gold. That's all gold and there's 500 gold pieces. So let's introduce the concept of a reserve ratio. Let's think a little bit about what even a reserve is. A reserve is something that you keep aside because you might need it one day. And in this situation, all of these liabilities-- whether they're these bank notes 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 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 gold at 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 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. And in this situation, this world that we've created, the reserve store value is gold. Later on we're going to get ourselves off of this gold system and then that reserve store of value is actually going to turn into cash, but for right now-- and I think it's easier actually to conceptualize gold. Let's stick with gold. The reserve ratio for this bank is the amount of gold assets-- you won't see this formal definition anywhere because 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 the bank could've 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 10 years, in which case there's no reason why the bank would have to set aside some gold to pay that back. So let's make our definition not total liabilities, but total demand liabilities. So what would be total demand liabilities? That would be total bank notes in this case-- and bank notes are also something-- we'll later leave a world where every bank is issuing bank notes, but I just wanted to give you that kind of historical context, how bank notes even started off. Total bank notes and demand accounts, demand or 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's our total demand accounts? 100 plus 100 plus 100-- 100, 200, 300, 400-- 600-- and I think this is another 100 here-- 700. The total demand liabilities, I just figured out, was 700 and the gold assets in this bank are 500. So right now the reserve ratio of this bank is pretty high-- 5/7. So I don't know what 5/7 is. If I'm doing my mental math right, it's about 62%-- 7 goes into 50-- no, no, 7 goes into 57 times-- it's like 71%. Right. 7 times 7 is 49-- 71%. So that's its 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 it in this world-- our bank regulators 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. They might say the reserve requirement is equal to-- let's say they want to be safe. Let's say they want to make it 20%. In the U.S. right now, it's 10% although the reserve commodity isn't gold anymore. Let's say your reserve requirement is 20%. That means as long as-- 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 bank 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. In order for this system to work, there has to be confidence-- and in order for there to be confidence, 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 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-- some of these loans, they 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 don't come asking for their gold, we should be OK. 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 there's a couple of reasons why that's really bad. One is, all of a sudden 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 than there is gold. And 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 300 gold pieces and it's really going to be paid back and this loan right here 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 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 600 gold pieces, right, they're owed actually 700-- so if they want 600 gold pieces, all of a sudden everyone's going to lose confidence in the system. These people probably-- if they're not able to get that, they're probably going to 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 loans to someone else or maybe try to collect from someone, but as you can imagine, it's a big mess and the whole system which is dependent on confidence will just start to crumble. But anyway, 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 regulators set. Anyway, I'll see you in the next video.