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Current time:0:00Total duration:17:19

Video transcript

in the last video I touched on the core weakness of fractional reserve banking and that's the idea of the bank run where if you have a bunch of banks and they've all lend out 90% of their reserves so let's say that here's all my bank bank 1 bank to bank 3 and you could have a ton of banks I mean you could imagine you go all the way to bank 100 the problem with the bank run is if just even one bank all of a sudden isn't able to give its depositors its money so it is illiquid in a liquid and will reserve judgment as to whether it is truly insolvent but it really just doesn't have the money to give its depositors then all of the depositors of all of the other banks get scared and run over to the banks and ask for their money back and by definition in a fractional reserve banking system these guys only have 10% of their 10% of their of their deposits as reserves 10% reserves so if more than 10% of the people ask for their money they're all going to be a liquid you're all going to be illiquid and then you're going to have just an all-out panic you're going to have an all-out panic of the financial system people as soon as any of these guys loans come due so let me draw one of their balance sheets let's assume that they were actually good investors which is a big assumption but let's just say let's say that their balance sheets look like this here's all of the deposits that they owe to people to me and you that their liabilities they have 10% of their assets as actual currency reserves looks like that that's the reserves right there and then the rest is loans out loans out to businesses and whatever else their loans out to random businesses so these are loans and that's an asset because businesses oh them something then what's going to happen as soon as they're a panic everyone wants their money out the reserves are depleted very quickly so you have the reserves you see if I can you have the reserves get depleted very quickly and then these guys sit there waiting for their money essentially it shuts down the bank as soon as these loans as soon as these loans mature May this guy owed his money in a year then they're going to say just give me the money back I'm not going to renew the loan even though you have a good business and so everyone's going to want their money back and the whole financial system is going to break down and credit is going to freeze panic and then you're going to have a freezing of credit freezing of credit and this is a huge problem remember this could be just caused by one bad actor who couldn't manage their liquidity properly even worse it could be managed it could be caused just by one panicky withdraw it doesn't even have to be a bad actor it could just be some fear that enters the system and even for a completely legitimate bank and I'll use legitimate in quotations because we're assuming legitimate because some would debate whether fractional reserve banking is legitimate but even if this is a completely up-and-up Bank if for whatever reason more than ten percent of their deposits get scared then of a sudden they'll be illiquid and you'll be in this all-out panic condition now I talked in the last video some of the things that have been engineered to fix this problem so these are the fixes the first one is to have a banker of last resort ender of last resort lender of last resort and that's our central bank or the Federal Reserve Bank the Federal Reserve Bank and they'll never run out of reserves because these these reserves can be lent borrowed from them and all these are are IOUs IOUs from the Federal Reserve so what the Federal Reserve does and I've talked about this in the past is let's say that their balance sheet currently looks like this let's say that this is their current liabilities these are their current assets and their current liabilities are essentially going to be IOUs these are going to be these reserve notes but let's say someone else comes and says hey Federal Reserve lend me some money lend me some money so what they're going to do is that they're going to print some so these are Federal Reserve notes Federal Reserve notes that are like that and then they're going to just create an offsetting liability and they have no they have no reserved limits let me make it a new color just to ease the monotony so they'll have this corresponding notes outstanding liability and then they're going to give those notes to you they're going to give those notes to the bank that's in a desperate situation if it couldn't lend it borrow from any other bank and so the Federal Reserve balance sheet will now look like this this is what it would look like before it has these new notes outstanding notes outstanding and now this will say instead of Federal Reserve notes and it's and it's in its vaults it'll now have this little thing on its books called loan to to the bank loan to this guy right here which is an asset because he owes him something and the federal there's no limit to which the Federal Reserve could do this obviously there might be some kind of implicit limits if they keep doing this arbitrarily people might not accept these Federal Reserve notes as actually carrying value so that's probably the main limiting concern and I'll probably talk more in future videos on other things that are kind of keeping the Federal Reserve from just doing this willy-nilly but the general idea is that they never run out so this is one idea lender of last resort but not even the Federal Reserve wants to keep doing this because what if this guy what if this guy is essentially insolvent if these loans are actually going bad if these loans are actually getting stinky right here they're starting to smell then there's no reason that even the central bank should actually be lending to this guy you shouldn't be lending to this guy so let's say the Federal Reserve looks at this guy's books and say you know what these loans are really worthless I'm not going to lend more money to you what I'm going to do is take you into receivership and I haven't even talked about what that is that's the second fix the second fix is to have this notion this notion of insurance of Federal Deposit Insurance Deposit Insurance so if a bank is just has a liquidity problem it's a good Bank and I'll put good in quotation marks too good Bank good Bank it just ran out of reserves and no other Bank is willing to lend to it which might you might debate whether it's even a good bank if the other banks aren't willing to lend to it then it go to the it can go to the discount window at the Federal Reserve and borrow some reserve notes now in the situation where even that's not good enough and the bank is essentially out of business it had been paying the FDIC a little bit of money the Federal Deposit Insurance Corporation Insurance Corporation a little bit of money I mean probably a lot of money by an individual's point of view but a little bit of money from a banks point of view and it's it's a fraction of a percent a little bit of money every year so that it could tell us depositors look even in the situation that our bank goes bust the Federal Reserve is going to pay you directly if these are FDIC bank accounts the Federal Reserve will make you whole completely regardless of what happens to the banks now this this to me is a big fix I mean I'll tell you right now all of my savings right now are in Federal Deposit Insurance Ord FDIC insured bank accounts now this might sound great to the depositor but what's the side effect on the banking system well let me draw all of my banks again so I have bank one I have bank 2 i have bank three I have bank four now they are all FDIC insured they are all FDIC insured they pay some small fraction of a percentage every year so that they can tell their depositors look if we ever go bust if we ever blow up for whatever reason your deposits are a hundred percent safe are 100 percent safe now what's going to happen this will solve the bank run problem right let's say for whatever reason this guy runs out of reserves or he goes bankrupt let's say that this guy goes bankrupt in the old situation before the insurance everyone else is going to get scared and you're going to have a bank run and they're going to ask for their money there's just not going to be enough reserves because they only keep a fraction of the reserves that's what fractional reserve banking is but now everyone's going to feel comfortable like you know what everything is backed by the Federal Reserve which can print as many notes as it wants so I'm just going to sit pretty so this does solve the bank run problem solve the bank run problem you might say hey you know this doesn't make it an unstable equilibrium anymore which is kind of true but what does this do all of these guys are now FDIC insured I'm equally willing to give my money to eat any of these guys so I'm essentially going to give my money to the guy with who gives me the highest interest giv deposit to the highest interest highest interest and I've actually done that with my personal accounts I've gone and I've seen which bank provides the highest interest and I've ignored how they're investing their money I mean otherwise I'd be pretty suspicious about a bank offering more interest because they're probably doing something risky but now I don't care because I know it's FDIC insured and even if that Bank blows up I'm gonna get all my money back so I might as well give my deposit to the bank with the highest interest now based on what you saw in that last video which is the bank that's going to be giving the highest interest what's going to be the bank that's taking on the most risk that is taking on the most risk so once again when you give this relatively cheap insurance cheap insurance to all of these banks and all of these banks can attract money much easier by paying this insurance if they didn't have this insurance they would have to pay much more let's say this insurance is you know let's say it's point one percent per year if they didn't have this insurance they would have to pay much more than point one percent per year to the depositor and interest to make up for the risk that they're taking on that they're not being backed by the government so it's a really good deal for the depositor they pay point one let's put it this way when you give a deposit to a bank you're lending money to the bank so you're you're checking deposit rate so let me write this down you're checking deposit interest rate interest rate is the same thing as the bank's borrowing cost right when I go to some bank and they're paying me 2% a year that's the bank's borrowing cost banks borrowing cost they're the same thing now if the bank didn't have FDIC insurance it wouldn't to pay point one percent a year but it would have to give me more interest it would have to pay me three or four percent probably more because I'd say this is a risky Bank or it's more risky any bank will be more risky than the than someone who can print out the notes so it would have to pay more but now it can just pay 0.1% a year now it can just pay 0.1% a year pay 0.1% or whatever the Fed the Federal Deposit Insurance Corporation pays it but it's going to lower to FDIC it pays that to the FDIC but the main side effect like of this is this going to lower what it has to pay the depositors because the positive say oh this is a lot safer than what I thought so it's going to lower borrowing costs borrowing costs buy much more buy much more than 0.1% so it's a really good deal for the bank and so it's a especially good deal for the for the ultra risky banks who might have to pay a little bit more but because they can now do SuperDuper risky things and you say hey but you know this is insurance the Federal Deposit Insurance Corporation isn't stupid it should just charge more for riskier banks but my I guess the the rebuttal to that is that's easier said than done because when times are good when times are good like in the 20s or in the it or during the housing bubble times are good you get hidden risk risk it gets hidden so you don't risk gets hidden so you don't know who's taking on the risk it's usually the person who's getting the highest returns but if they're if they if they're always good for it you don't see it and that person just looks like a genius that person just looks like a genius when times are good and then when times are bad that guy blows up but guess what he's not on the line for it it's the Federal Deposit Insurance Corporation who all along was probably under charging for that insurance I want to make one last point about this you know it's called insurance it's a Federal Deposit Insurance Corporation Insurance Corporation and I want to point out the difference between financial insurance and you could watch my video on credit default swaps which is another form of financial insurance between financial insurance and what we normally associate with insurance if I have car insurance so I am a car insurance person and I agree you know let's say that they are driver one let's say have a bunch of drivers so driver one driver two driver three driver four and I know that in any given year they each have a 10% chance ten percent chance of an accident that's a lot higher than reality but will make the numbers easy and if there is an accident it will cost me $10,000 $10,000 so I could go to driver one and say look there's a 10% chance you're going to have an accident it would cost $10,000 if you do so I'm going to charge you the fair price would be a thousand I'll charge you $1,100 so I'll charge 1,100 just so I can make a little bit of a profit right what you would charge is a thousand if you wanted to break even but I'll charge eleven hundred and I might do this more than just for drivers I might do with four thousand drivers so on average in any given year in any given year let's say I have let's say I have one let's have a 1 million drivers 1 million drivers in any given year how much am I going to bring I'm going to bring in a million times $1,100 which is I'm going to get 1.1 billion in input or in revenue from people paying their premiums and how much am I going to have to pay out what's going to be my pay out my pay out well roughly 10 percent if you believe these statistics are going to have an accident so that means that 100,000 are going to have an accident each of those 100,000 actions are going to cost me ten thousand dollars ten thousand times 100,000 I'm gonna have to pay out 1 billion for the accidents so I will net every year for my statistics of my actuaries did their job I will net a hundred million every year and this works out pretty good assuming these statistics are right and people are willing to pay the premium because if you have enough drivers like a million drivers the statistics really hold in any given year the chance of 20% of the drivers having an accident is very very very almost infinitesimally small it's almost zero and one driver having an accident doesn't make it more or less likely than another we'll have an accent when you're talking about on the order of a million drivers and that's true of health insurance and everything else it's just purely probabilistic and if you have enough people insured the statistics can actually hold up now with financial insurance you have a different situation you might say look in any given year you know three on average you're on average so on an average year the FDIC a might say look you know only I don't know one out of you know one out of a thousand banks fail so there's a point one percent chance of failure and of course it'll capture back some money because it'll have some assets on average but the reality is is that when times go bad the bank failures tend to be correlated because they're all interlinked and I've done a lot you know what they might one might be lending to some business that's dependent on some business that this guy is lending to the whole financial system is all linked up so the failures aren't aren't they all correlate with each other they're not independent events so if one bank fails it's more much more likely that other banks are going to fail all at the same time and we're experiencing that right now so you can't really call you can't really follow the insurance model because the statistics really don't apply you can do this insurance model when each of the events that you're insuring are uncorrelated but when all of the events that you're insuring are likely to all happen at the same time what you're going to have is when times are good you're going to have a much lower you're going to see much lower kind of loss rate and then when times are bad all of your guys are going to blow up and you're essentially on the hook for all of these people and we see that right now and the FDIC is actually you know it's going to have to go back to Congress I'm 100% sure and ask for more money and it's us the type we the taxpayers that are going to be on the line for this type of thing