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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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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.