Let's talk a little bit more
about reserve ratio requirements and then if I have
time, I want to introduce another, almost related and
often confused, topic, and that is leverage. So let's do reserve ratio
requirement and let's say in whatever jurisdiction or world
that I live in, that requirement is 10%. So that means that for every
dollar of checking account liabilities or notes libraries
that I have outstanding, that I have to keep at least 10% of
that in actual whatever the reserve currency is. In our world we've been dealing
so far it's been gold. In the current world,
it's not gold. It's actually dollar bills. But anyway, we'll stay in the
gold world and later on we'll get ourselves off the
gold standard and see how that works. But let's just do the example
from scratch again and just see how big I can get my balance
sheet and see exactly how this stops me from
getting too big. So I have my bank like
I always did. Let's say my building is worth
100 gold pieces and then I capitalize it with another
200 gold pieces. This is the building. And this is my equity that
I start off with. So I start off with
300 equity. I should always do the equity
in a different color because sometimes it gets confused with
the liabilities because they're both on the
right-hand side. So this is my equity. And then I might take
some deposits. Let's just-- I don't want to
make this too large of a diagram, so let's just say I
take another 100 gold pieces in deposits. And then I have checking
accounts for these people who deposited them. I'll do that in purple. These are checking accounts
or notes deposit accounts for people. These are my liabilities. So my question is, if these are
all the deposits I have, or this is all of the
reserves I have, how much can I lend out. Or, how much can I expand
my balance sheet? Well, the reserve ratio
requirement says that my reserves over my total checking
accounts that I have on my liabilities and the notes
that I issue, that my reserves can be no more--
or have to be at least 10% of that. So right now I only
have 100-- whoops. I pressed the wrong button. Right now I only have 100
gold pieces of on demand checking accounts. And I'm not going to worry
too much about the notes outstanding right now. They're really the same thing,
at least from a balance sheet point of view. And I have 300 gold pieces. So I actually have more reserves
than I have on demand accounts because I've actually
pre-capitalized it with some of my initial equity. So how much lending can I do? Well, this requirement says that
I can only expand these on demand accounts so that this
is at least 10% of it, this 300 gold pieces is at
least 10% of it, right? These are my actual reserves. So let's think of it this way. 10% has to equal my reserves. I have 300 gold pieces
of reserves. 100 from actual deposits, 200
that I actually put in ahead of time to start up my bank. That was my own gold-- over
the total amount of-- I'll just say demand deposits. I won't worry-- it's demand
deposits plus bank notes, but we'll keep it simple
right now. I think you get the idea. So we can do a little
bit of math. Let's see. Multiply so we get 10% of the
demand deposits have to equal 300-- or divide both sides by
0.1 and then you say, well, I could have up to 3,000 gold
pieces of demand deposits. So how much could I expand
my balance sheet? Well, I could keep making loans
until I have 3,000 gold pieces of demand deposits. Let me start making loans out. So someone has a project where,
say, 900 gold pieces. They need to build a factory
of some kind. I say, sure, here you go. 900 gold pieces-- I'll draw it a
little bit less high than it should be if it would be
proportional to that. So 900 loan. And I don't hand that
person gold. I just give them a
checking account. So it's a 900 checking
account. Of course they're going to use
this maybe to write checks to their laborers or their
contractors, whoever needs to build a factory. And so let's see. How much do I have outstanding
right now in terms of demand deposits? I have 900 plus 100. I have 1,000. So I have 2,000 left. So let's say someone has
a really big project. They want to build a bridge
over the local river or whatever and they'll charge a
toll and I think that's a pretty good idea because people
are very likely to use that bridge. So I'll give out a loan
to that person. So I'll give out a 2,000 gold
piece loan to that person. And then instead of giving them
actual gold, I'll just create a checking account
for them. I could've actually issued
bank notes, same idea. So 2,000 checking account. And then I'm done, right? Because are my total
demand deposits? 2,000 plus 900 plus 100. I have 300 in total demand
deposits-- and actually all of my liabilities at this point
are demand deposits. I could have borrowed money in
some other way, but I won't worry about right now. So the ratio of my reserves--
300 to my demand deposits, which is this part right here,
which is essentially all of my liabilities right
now-- is 10%. And what this allows-- because
of this requirement, one, it kept me from keep making
loans out. I've essentially maxed out what
I can do under this type of reserve ratio requirement. And what it says is, it allows
10%-- essentially it makes sure that I'm liquid enough. It makes sure that when these
people, who I've said, at any point in time, you can come and
ask for your money, that if people actually do want their
money in terms of gold-- remember, they can transact
with this money. They can write checks or if
these were bank notes, they could exchange those
bank notes. But if whoever has access to
this checking account at some point in time actually wants
their gold, I need to keep at least 10% aside, assuming
that no more than 10% need it at one time. So that's what these reserve
requirements are. It keeps me liquid. Liquid means when someone
actually asks for their gold, I have the gold to
give it to them. Now a separate question
is, am I solvent? Solvent means, am I good
for the money? And solvent is just an issue
of, are your assets larger than your liabilities? So right now in this world,
my assets are what? I have 3,000 plus my
initial equity. This was 100 down here. So my assets are 3,300. So I'm also solvent. As long as my assets-- which are
this entire left-hand side of the balance sheet-- as long
as my assets are bigger than my liabilities, I'm solvent. Which means that even if in a
world-- let's say in a world where for whatever reason,
people wanted gold again, they'd come to me and
let's say they wanted 400 gold pieces. I would not be liquid in that
situation because I do not have 400 gold pieces to
immediately give them. So I would have a liquidity
problem. Maybe I would have to borrow
gold from someone else, but I would be solvent assuming
that these two loans are still good. And if someone gave me enough
time, either these loans would be paid back or maybe I could
sell these assets, which these loans are, to somebody else and
get 900 gold pieces for them, in which case I could pay
these people with the gold that they need. So anyway, I just wanted to
show you that difference between liquidity
and solvency. And actually, I realize that I
almost used up all my time. So in the next video,
I'm going to show you about leverage. And leverage and leverage
requirements have a lot more to do with solvency
than liquidity. And just to give you a little
bit of a preview, it essentially says, how much of a
cushion do you need to have before you're insolvent-- before
your liabilities are greater than your assets? So how much loss can you
take here before you're out of business? Anyway, I'll see you
in the next video. It ended up being just on
reserve ratios, this one. The next one, I'll
do leverage.