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Studying for a test? Prepare with these 8 lessons on Money, banking and central banks.
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I've talked a lot about what fractional reserve banking is, but I have kind of reserved making any commentary on it, and that's what I'm actually going to do in this video. So just as a bit of a review on the whole banking playlist, I started off with a very simple example of we're on an island. Let's say you had all of the gold on an island and you give it to me for safekeeping. So now, I have this asset called gold, and let's say it's 100 gold pieces that you gave me. And I also have a liability. This is my primitive island bank, and my liability is that you could demand this gold from me whenever you want, so this is my liability. If I were to draw your balance sheet, this would be your asset. So this would be an IOU to depositor. So at any point in time, I've told you, look, I have this nice safe, this vault there, but you can come to me any time and take as much of your gold as you want. And we, of course, know from the fractional reserve banking playlist that there's a slight discrepancy between what I told you, the depositor, and the reality of the situation, because the first thing that I'm going to do when you take this is, you know, I've taken your deposits and I could charge you for keeping your money with me, but I've come up with a slightly sneakier scheme, where I say, hey, I've seen your behavior. You never withdraw more than 10 gold pieces out at a time. So what I do is I lend out all but 10 of your gold pieces. So we end up with the situation. I have an IOU to you of 100 gold pieces like that, and I take the other 90 gold pieces and I lend it out to random entrepreneurs on our island. So loan to A and that is loan to B. And I think this is great, because I obviously collect interest from these guys, and assuming that these guys don't blow the money, I'll get all the money back, so you'll get all your money back and I'll get some interest, and I can say, hey, I'm keeping your money for free. You get safekeeping, and I collect the interest on it, and maybe that helps to fund making the vault nice, and everyone's happy. But clearly here, there is a discrepancy. What did I tell you? What did I tell you, the depositor? I told you that you can withdraw 100 gold pieces at any time. Now, what is the reality? The reality is you can withdraw 10 gold pieces at any time, and clearly, this is-- I don't know if you want to call this a lie or not, but this isn't completely true right here. And I know some of you might be saying, hey, Sal, this is kind of a very primitive example of gold pieces, but our current banking system doesn't work quite like this. And just to make sure that you understand that the analogy isn't completely off from our current baking system, our current banking system is more like this: You have 10 gold pieces that you give me. I'll draw it here. This is the modern banking system. What you do is you give me a deposit of 10 gold pieces like that, and so I say that, yeah, sure, I owe you 10 gold pieces. So this is my IOU to you. Everything looks nice and clean right now, but what I then do is then I issue checking deposits to other people, and my limit on how many checking deposits I can issue is based on the reserve requirements and all of that. But let's say I have to keep at least 10% reserves, just keep the math simple. So what I do in our modern system is I make a loan to B like that and I gave B a checking account that is equivalent to your checking account. So this is an IOU to B. So this is essentially a promise to B that, look, this is a checking account, and any time you can come and get this much. Maybe this was 40, maybe this is 50 gold pieces. This means that you can come at any time and get 40 gold pieces from me. But we know the reality that people actually don't actually get the gold pieces. In our modern system, we're not even dealing with gold. This will be reserve currency, but it's the same idea that people are getting money that really isn't necessarily in the reserves. And, of course, I'm going to make another loan to person A, and I'm just going to create a checking account deposit for them. I'm just going to create an IOU to A for 50, and the whole reason why this works is because people use these checking account deposits as a form of money. When I write you a check, notice what's happening. I'm just transferring one of these checking account deposits from me to you without any gold or without any reserve currency actually changing hands. So that's how it works. But if you look at these two balance sheets, one is kind of the primitive example. On my island where I had 100 gold pieces and I lent out 90, I owe 100. I've told people, maybe it's just one person, that hey, you can come to me at any time and get your 100 gold pieces, but the reality is I've lent all but 10 of it out to other people. Now what's the situation in the modern? Well, I've told people that there's 100 gold pieces that can come from me, right? 10 to the original depositor, 40 to this guy that I gave a loan to, and another 50 to that guy, but the reality is that I only have 10 gold pieces in my vault and my other assets are just loans to people. So if you look at these two balance sheets, you see that they are equivalent. I always like to start with this one because this one at least makes more sense. If you were to just walk up to a five-year-old and say, look, this is what fractional reserve banking is, this one starts to seem even a little bit even shadier, because you're creating these loans and you're creating these IOUs out of thin air, but your end result is that they're equally shady because they both have the same resulting balance sheet. So your next question is, hey Sal, what's wrong with this? And I could ask my son, once he learns to talk, what's wrong with this is that there's a discrepancy between what I told the depositor-- so in this case, I told the depositor you can withdraw 100 gold pieces at any time, when the reality is they can withdraw 10. Here, I'm telling the depositor, you can take your money whenever, where the reality in this modern system is that you can demand whenever-- and I would throw an asterisk there-- as long as no more than 10% ask for the money at the same time. Now, obviously, I think this is-- everyone already becomes a little uncomfortable when you say this, but you say, look, this is what our modern financial system is based on and what this allows is this guy, this bank, however you want to view it, is allowed to be an intermediary between the savers, the people who are giving their deposits, and the people who need to invest the capital in building new projects and whatever else. And the counterargument to that for someone who's against fractional banking is there's nothing to stop you from doing this. All you have to do is tell this guy the truth. What you do is, you do this exact same scenario. You don't tell him you can withdraw 100 gold pieces at any time. You tell him you can withdraw 10 gold pieces at any time and that maybe another 40 gold pieces will be available whenever this guy is supposed to pay back his loan, maybe in a year, and that the other 50 gold pieces would be available whenever this guy pays his loan back. Maybe it's in two years. So the question is why doesn't this happen? Well, the reality is because if you told the depositor that they can't have all of their money on demand, he'd say, OK, fine. One, assuming that you're giving these guys-- these are legitimate people to give your money to-- I want some of the interest that you're taking because you're just lending out my money. If you were to lock up your money for longer, people would want interest for this. But when the bank is allowed to kind of tell this half-truth, they don't have to give as much interest on it, because when people say, oh, I can get my money whenever I want, they say, well, then I don't need that much interest on it, because it's on demand. But the reality is they can't get all of their money at any time. They can only get some fraction of their money at any time. So the next thought might be, OK, you're being a little bit disingenuous when you tell the depositor that it's on demand and because you're being disingenuous, you're allowed to kind of not give them as much interest as you would have to give them if you told them that their money is locked up, but what's wrong as long as you are a good investor and that you put this money to good use? Doesn't the whole world benefit? And that might be true most of the time, assuming everything I just told you, but imagine a situation where we have multiple banks in our universe. Let me draw my multiple banks. So this is bank one, I have bank two, and then bank three. And bank one and bank two are very honest and good investors. And we all know it's very hard to know who's a good or a bad investor, especially when times are good, because then most loans tend to come out good. So they're good investors. But bank three takes on extra risk. Let me write it down. And what's their incentive for taking extra risk? Let's say that bank three is willing to lend to people that banks one and two weren't willing to lend to. So bank three's balance sheet here, these loans, are going to be riskier loans. Now why would they do that? Because when you give it to riskier people, you're able to take more interest from them. So they take extra risk, which leads to extra interest. And actually, if you were to look at these banks, you would say that this guy's the most profitable bank. Even worse, because he's getting extra interest, he can actually share more of that extra interest with their depositors. So you can give higher yielding checking accounts, I guess I could call it. Higher interest on deposits. So in this situation, the person who's taking the most risk is going to be the most profitable and they're going to give the higher interest and that might actually attract the most deposits, right? If all these guys look the same to me, and we all know it's very hard to know what banks are actually doing with their money, then I'll say, hey, I'm going to give my money to this guy right over there. But then what happens as soon as things go bad? As soon as the world gets a little bit of difficult, this extra risk actually starts rearing its ugly head and then this guy becomes insolvent. So this guy's-- let me see if I can draw his balance sheet. His balance sheet will look something like that. He has a bunch of loans out. He's got some reserves right there and then he's got a bunch of deposits that you or I might have given him. These are our IOUs to us. These are his loans out. As soon as things start going bad, some of these loans are going to go bad. As soon as one of those loans go bad, I'm going to hear about it on the news, and I'm going to run over to the bank, and I'm going to say, let me get my money back as quickly as possible. And let's say I'm the first one there and I get my money back. They promised it to me. So I withdraw my account right there, and I get all my money back, and I essentially deplete the reserves. Now the next guy's going to come along. This guy was a little bit of a slower runner than me. He comes to the bank, and he says give me back my reserves. And the bank says there are no reserves. And then this guy is mad. He has no reserves. And, of course, the whole time this guy's assets are just becoming worthless because he's loaned it to people who invested it badly. And so you have all of these people-- when he finds out that this guy didn't get his money, all of these people are going to go there and demand their money and the bank is going to be insolvent. It's going to be two things. It's going to be illiquid and insolvent. And I've explained the difference, but illiquid might mean the loans might be good-- and actually I'll reiterate it in this video-- but the loans might be good, it just doesn't have the cash. Insolvent means that these loans aren't good, that the value of these loans aren't equal to these deposits. So I'll say that this risky bank is insolvent. Now, you might say these guys right here deserve it. They guys deserve what they got because they were greedy. They invested in this risky bank that was doing shady things just to get a little bit higher interest on their deposits. But what happens when this happens? Well, you have these good banks over here that maybe did really conservative lending. So this is what their balance sheets-- maybe both of their balance sheets look like this. They have some reserves right there. They've made out some good loans to good entrepreneurs and then you have their depositors. But as soon as this guy finds out about what happened at that bank, he's like, things are really bad. Let me just be careful and go to my bank-- let's say it's this depositor right here-- and take my money out and put it into my mattress. So he goes to the bank and he's the first one there. He's the fastest runner of all of the depositors. So he claims his deposit. So his deposit, he withdraws, and he depletes all of the reserves. Now, he wasn't the only guy who was afraid. This guy was afraid as well. So he comes running to the bank, and the bank now says, gee, I know I made this promise to you that you have an on-demand account, but that guy you saw leaving the bank with the running shoes on, he actually just took all of the reserves, and I guess I have to admit now that I lied to you, that it isn't completely on demand. I actually loaned out the rest of your money. But I was a good banker. These are actually good loans. These loans are still worth what they want. If you just wait long enough, you'll get your money back. And, of course, this guy's going to be not so happy because he was lied to. And that's not going to be the only guy. Slightly slower runners are going to come there and also demand their money. And this is known as a bank run. Where because one maybe bad apple in the system actually is insolvent, everyone becomes afraid and comes and says, give me my money, and because we have this fractional reserve system, the money isn't there. It just will not be there because 90% of it is lent out. And so once this happens there, then you're going to have a run on bank two, and then everyone is going to take their money out of the banking system. So the whole banking system, this situation right here where the assets maybe still are worth the same or more than the liabilities, this guy's still solvent, but he doesn't have any money to pay these on-demand accounts, so this guy is running into a liquidity problem. He doesn't have the reserves, and that's why we have the whole Federal Reserve that's a lender of last resort. This guy can walk to the Federal Reserve and say, hey, I have some people knocking on my door. Give me some loans. The Federal Reserve will lend this guy some money, and, of course, then this guy's going to have another lender to it called the Federal Reserve and he can use this to pay off these guys. But that leaves another question: How does the Federal Reserve really know the difference between this guy-- he might say, OK, this guy's good. Let me just lend to him to make sure that he doesn't have a liquidity problem. How does the Federal Reserve really know the difference between this guy and this guy right here? This guy's going to also run to the Federal Reserve. Hey, Federal Reserve, these loans are still good. Just give me a loan so I can pay these people right there. So the Federal Reserve says, hey, you look good. You're a nice clean banker in a nice, fancy building wearing a Rolex on your arm. You must be good for it. So the Federal Reserve will also lend this guy, and now this guy also owes the Federal Reserve some money. We can already see that in this fractional reserve banking system, you have two problems. You have an unstable equilibrium, where one bad apple can lead to a run on the entire system. And I'll talk about what's been engineered to fix this problem: essentially banking insurance. I'll probably wait for that to the next video. So this is the first problem right here. And then the second problem is that it really becomes hard to differentiate between the good and bad banks. I mean, it's not so hard to differentiate at face-- well, it is hard to differentiate at first and becomes even harder to differentiate when you always have the Federal Reserve willing to be a lender of last resort. And when I talk about the Federal Reserve insurance, that makes it even harder to differentiate, and because it's harder to differentiate, there's a huge incentive for banks to take on risk. Because when times are good, they'll make more money than everyone else, and then when times are bad, it's really hard, that they'll all suffer equally. So in the video, I'll talk about some of what has been engineered to fix these problems and see if they actually make sense.