Fractional Reserve banking commentary 1

I've talked a lot about what fractional reserve banking is fractional reserve banking 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 when 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 you draw it like this Gold and let's say it's a hundred gold pieces that you gave me 100 gold and I also have a liability so this is my primitive Island Bank and my liability is that you could demand this gold from me from 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 a you know an IOU IOU to depositor to depositor so at any point in time I've told you look I have this nice safe this vault here but you can come to me anytime 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 deposit and I could charge you for keeping your money with me but I've come up with a slightly sneakier scheme slightly sneakier scheme where I say hey I've seen your behavior you never withdraw more than ten gold pieces out at a time so what I do is I lend out all but ten of your gold pieces so we end up with this situation ten gold pieces you I have an IOU to you of 100 gold pieces right like that 100 gold IOU and I take the other 90 gold pieces and I lend it out to random entrepreneurs on our island I lend it out to these are loans to random entrepreneurs so loan to a and that is loaned 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 could say hey I'm keeping your money for free you get safekeeping and I collect the interest on it and maybe that helps you know to fund making the vault nice and everyone's happy but clearly here there's there is a discrepancy what did I tell you what did I tell you the depositor so what did I tell you I told you that you can withdraw 100 gold pieces at any time you can withdraw 100 gold pieces at any time any time now what is the reality what is the reality the reality is you can withdraw 10 gold pieces 10 gold pieces at any time and clearly this is you know you know 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 know you might be saying hey Sal but isn't this you know this is kind of a very primitive example with gold pieces but our current banking system doesn't work quite like this and let's just to make the make sure that the you understand that the analogy isn't completely off from our current banking system the current banking system is more like this you have 10 gold pieces that you give me you have 10 gold pieces I'll draw it here this is this is the modern right here the modern banking system what you do is you give me a deposit of 10 gold pieces like that 10 gold pieces and so I say that yeah sure I owe you 10 gold pieces so this is my IOU to you everything looks nice and and clean right now but what I then do is and 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 can I have to keep at least 10 percent reserves just to keep the math simple so what I do in our modern system is I make a loan to B I make a loan to be loan to be like that and I give B a checking account I give be a checking account that is equivalent to your checking account so this is an IOU to be IOU to B so this is essentially a promise to be that look this is a checking account at any time you can come and get this much you know maybe this was maybe this was 40 and 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 and 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 the person a 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 another checking an IOU to a or 50 and the whole reason why this works is because people use 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 I'm just transferring some of these rights from me to you without any gold or without any reserve currency actually changing hand 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 ninety I owe 100 I've told people maybe it's just one person that lei you can come to me at any time and get your hundred gold pieces but the reality is I've lent all but ten of it out to other people now what's the situation in the modern well I have I've told people that there's a hundred gold pieces they can come from me right ten to the original depositor 40 to this guy that I gave a loan to another 50 to that guy but the reality is is that I only have ten 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 and I always like to start with this one because this one at least makes more sense if you were to just you know 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 creating these IOUs out of thin air but their end result is that they're equally shady because they both have the same resulting balance sheet so your next question is in hey Sal when you know what's wrong with this and I think you could ask you know 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 what I told the depositor so in this case I told the deposit you can withdraw 100 gold pieces any time when the reality they can withdraw 10 here I'm telling the depositor here you can done telling the depositor you can take your money whenever demand money whenever whatever where the reality in this modern system is that you can demand whenever and I would throw an asterisks there as long as as long as no more than 10% no more than 10% ask for the money at the same time ask for money at the same time now you know obviously I think this is it everyone already becomes a little uncomfortable when you say this but you say look you know 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 counter-argument 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 such an it scenario but you don't tell this guy you can withdraw ten huh you don't tell them you can withdraw a hundred gold pieces at any time you tell them you can withdraw ten gold pieces at any time and that the other and that may be there another 40 gold pieces will be available available in whenever this guy is supposed to pay back his loan maybe in a year and that the other 50 gold pieces would be available in 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 is because if you told if you told the depositor this if you told the depositor that they can't have all of their money on demand you'd say okay fine one assuming that you're giving these guys you know 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 so this if you were to lock up your money for longer right this money is being locked up locked up locked up 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 some fraction of their money at any time so the next thought might be okay 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 your money is locked up but what's wrong as long as you are a good investor and that you put these 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 we have multiple banks so let me draw my multiple banks so this is Bank Bank one I have Bank bank two and then bank three and Bank One and bank two are very honest and good investors good investors and we all know it's very hard to see know who's a good or a bad investors especially when times are good because though then most loans Tum tend to come out good so they're good investors but bank three takes on extra risk let me write it down extra risk and what's their incentive for taking extra risk let's say that Bank 3 is willing to lend to people that banks 1 & 2 wasn't weren't willing to lend - 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 from there extra interest and actually if you were to look at these banks you would say that this guy is more the most profitable Bank the most profitable most profitable 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 higher yielding checking accounts I guess I could call it higher interest on deposits so in this situation the person is taking the most risk is going to be the most profitable and they're and they're going to give the higher interest and that might actually attract the most deposits right if I could find if all of 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 if this guy's let me see if I can draw his balance sheet his balance sheet will look something like this he has a bunch of loans out he has got some reserves right there and then he's got a bunch of deposits that URI might have given him these are our io u--'s 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 it about on I'm gonna hear about it on the news and I'm gonna run over to the bank and I'm gonna say let me get my money back as quickly as possible and I let's say I'm the first one there and I get my money back they promised it to me so I so I would draw my account right there and I get all my money back and I essentially deplete the reserves now the next guy is going to come along this guy owes a little bit of a slower than me he comes to the bank 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 this bank's assets are just becoming worthless because he had 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 well it's going to be two things it's going to be a liquid and insolvent and I've explained the difference but a liquid might mean it might have the loans might be good and actually I'll explain it I'll reiterate it in this video but the loans might be good it just doesn't have the cash and solvent means that these loans aren't even good that the value of these loans aren't equal to these deposits so I'll say that this risky Bank is insolvent is insolvent now that you might say these guys right here deserve it these 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 deposit but what happens when this happens well you have these good banks over here these good banks over here that maybe did really conservative lending they did really conservative lending so this is what their balance sheets may be both of their balance sheets look like this they have some reserves right there and then they've made out some good loans - good - good entrepreneurs and then you have their depositors these are their depositors right there 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 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 he depletes all 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 you know gee I know I promised you I know I made this promise to you that you have an on-demand account but that guy you lease all leaving the bank with the running shoes on he actually just took all of the reserves and I 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 you know I 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 is going to be not so happy because he would lie too and that's not going to be the only guy there's slightly slower runners are going to come there and also demand their money and this is known as a bank run this is a bank run where because one maybe bad apple in the system actually did 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 here then you're gonna have a run on bank too and then everyone 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 this guy is running into a liquidity problem liquidity problem he doesn't have the reserves and that's why we have the hole we have the hole Federal Reserve that's a lender of last resort this guy can go 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 will lend this guy some money and of course then this guy is going to have another depositor called or 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 you might say okay this guy is 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 is going to also run to the Federal Reserve hey you know Federal Reserve these loans are still good just give me a loan so I can pay these people right there so the Federal Reserve said hey you look good you you're a nice clean banker and a nice fancy building wearing have you have a 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 you can already see that in this fractional reserve banking system you have two problems you have an unstable equilibrium unstable equilibrium where one bad apple can lead to a run on the entire system one bad bank bad bank leads to a run on the entire system entire system and I'll talk about what's been engineered to fix this problem essentially the 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 bank's hard to differentiate I mean it's not so hard to differentiate at face well it is hard to differentiate at first it becomes even harder to differentiate when you always have the Federal Reserve be willing to be a lender of last resort and when I talk about the Federal Reserve insurance that makes it even harder to differentiate it because it's hard 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 when times are bad it's really hard that they'll all suffer equally so in the next video I'll talk about some of what has been engineered to fix these problems and see if they actually make sense