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FRB commentary 3: Big picture

Summary of thoughts in last two videos. Discussion of why Fractional Reserve Banking is a subsidy to banks and allows them to arbitrage the yield curve. Created by Sal Khan.

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  • male robot hal style avatar for user Collin McCloud
    What are the requirements to be insured be the FDIC?
    (I'm only 14, lol)
    (6 votes)
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    • leaf grey style avatar for user CasualJames
      As a bank:
      1) Be a state or nationally chartered bank.
      2) File appropriate reports with the FDIC periodically.
      3) Pay your FDIC membership dues.

      As a consumer:
      1) Open an account at a covered bank. All deposit accounts are automatically covered for at least $250,000. Your savings account is fine, and so will the checking account that you can (legally) have when you turn 16.
      (6 votes)
  • mr pants teal style avatar for user William Coffman
    If I understand this lecture:
    1) FDIC is provided by taxpayers, &
    2) FDIC is necessary to prevent bank runs, &
    3) Preventing bank runs permits Fractional Reserve Banking &
    4) Fractional Reserve Banking permits Banks to arbitrage yield curve &
    5) Arbitraging yield curve creates tremendous profits for Banks
    6) Which have incentive to take on more risk because of FDIC
    7) Because greater risk means higher interest rates & greater demand.
    Question: If these premises are accurate, then the government is creating the rent exploited by the financial system. Are we really a capitalist system in any sense at all? If so, in what sense? If not, on what principled basis does the financial system object to regulation (of virtually any nature) by the government which creates its ability to make money?
    (4 votes)
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    • leaf green style avatar for user Ryan
      Couple of things:

      1. Be careful with the term "arbitrage." An arbitrage is a guaranteed risk free profit. When a bank borrows at a low interest rate and lends at a high interest rate, that is not an arbitrage because there is no guarantee that the money they lent will be paid back.

      2. I think it's a stretch to say that the only reason why fractional reserve banking exists is because the FDIC prevents bank runs. Financial system stability is contingent on many different factors. For example, banks competing against each other to offer loans to borrowers creates a certain level of stability due to credit always being available (credit that could pay depositors). The central bank also plays a large role in allowing the financial system to exist because they are the lender of last resort, meaning a solvent bank can always access money to pay depositors. The FDIC plays a role in this, but not the only role.

      3. You are certainly on the right track. There is and always will be many inherent conflicts of interest within the financial system. It's a result of the special status we've given banks in exchange for them financing nearly every business on the planet.
      (5 votes)
  • blobby green style avatar for user Lauren Berns
    This certainly provides a good argument that the government backstop of FDIC insurance distorts the market substantially. I wonder if you might elaborate on the causes of the boom and bust cycle that predated the advent of the Fed and FRB.
    (5 votes)
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  • leaf blue style avatar for user glacierice16
    Wait a sec...so if you deposit $10 in the bank at 5% interest, you will get a $0.50 return in a years time.

    During that same year, if the bank is getting a 10% return, they will be getting a 10% return on not just $10, but $90 (10x10 - 10), for a total of $9 interest.

    So they will basically make $8.50 in profit on a $10 deposit in a years time. Am I correct here?
    (4 votes)
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    • male robot hal style avatar for user Andrew M
      Yes, banks make money on the interest rate spread between what they can lend for and what they can borrow for. If they can borrow at 1% and lend at 5%, they make 4%, but keep in mind that out of that 4% they have to pay all of their operating expenses to run the branches and the back office and the marketing.

      But generally speaking, you have made the correct observation that deposits are the source of a bank's profitability.
      (2 votes)
  • blobby green style avatar for user T.B.Taylor005
    At , Sal explains how taxpayers are essentially subsidizing banks to arbitrage the yield curve--which is a great deal for them because they can borrow low and lend high. My question is this--since we are pretty much stuck with the fractional system, couldn't we at least, as taxpayers, demand some of those profits that the banks are making in the form of higher returns on our deposits? For example, say we lend to a bank at 0.5% via a deposit account. If the bank gets great returns that year, say 6.00%, shouldn't we be entitled to at a least a fraction of some of those profits? What obstacles exist that prevent taxpayers/depositors from getting a bigger piece of the pie?
    (3 votes)
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  • blobby green style avatar for user Benjamin De Menil
    The lecturer (Mr. Khan?) says several times at the end that VC, PE, and Hedge Fund 'Financial Intermediaries' share in the downside risk of their investments - unlike bankers. How is that so? In all cases the 'Financial Intermediary' is investing primarily other people's money. The FIs stand to lose their jobs and have their careers tarnished, but ultimately have no direct liability for the money they lose. Aren't PE and hedge fund managers as incentivised as bankers to take unhealthy risks?
    (2 votes)
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    • piceratops ultimate style avatar for user ppietraski
      The difference is the FDIC.... FDIC takes away the downside of risky behavior while allowing for all the upside. If their risky loans to projects fail and they can't pay their on-demand account holders, FDIC protects them.
      Take banks out of the picture for a moment. Now let's say that the government told you that no matter how you invested your money, it would make sure you did not lose it. Would you invest in very safe things that retuned 1%, things more risky that returned 10% even after the probability of failure is accounted for? (remember - you now don't lose when an investment fails) Most would choose the 10% return of course. But the average return on those risky investments is actually much lower (and could be very negative) because some of those risky investments could lose everything. You only get that 10% return because because of the FDIC.
      (3 votes)
  • male robot donald style avatar for user typhoon#flame
    Doesn't the FDIC lower the value of the government in general? Why doesn't the Government do something about this?
    (2 votes)
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  • leaf green style avatar for user Jon Dough
    How do credit unions fit into all this, and why not go with them over a bank?

    Does anyone know any banks in the US that are not FDIC insured? I found this link http://www.npr.org/blogs/money/2009/04/do_banks_need_the_fdic.html but was curious as to what interest rates these non-FDIC banks pay out.
    (2 votes)
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    • male robot hal style avatar for user davis
      Credit Unions operate like a bank.
      Yes, there are accounts at banks that are not FDIC insured. The FDIC does not insure mutual funds because they are deemed too risky. Mutual funds are similiar (from the customer's point of view) to money market accounts, but get slightly better returns because of the risks involved.
      (2 votes)
  • male robot hal style avatar for user Tanak Nandu
    Hi Sal, in terms of the fractional banking reserve system not adding value to society, as opposed to the private equity, venture capitalists etc. and merely exploiting the arbitrage of the yield curve...Couldn't we think about it as enabling entrepreneurs to undertake projects (most likely increasing the factors of production) by a factor of x=(100/reserve ratio requirement), essentially proving to be a multiplier to the GDP of society, and hence providing a massive service to society?
    (2 votes)
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  • female robot grace style avatar for user Daniel Tabakman
    It would seem to me that if the FDIC where better at estimating insurance, all the problems would go away. is this correct?
    (2 votes)
    Default Khan Academy avatar avatar for user

Video transcript

My motivation for doing this series of three or four videos on the fractional reserve banking system isn't because I expect some type of revolutionary change or I think that the world is going to end if we keep fractional reserve banking. The whole reason why I want to do it is just to kind of clarify our collective thoughts on what it is and what are its weaknesses. I mean, it is the system that we're in and by the way that it's often talked about, it's kind of viewed as the only system because banks around the world now use the system. But we have to realize this is a system, a structure, that's been in a place and its modern form for on the order of a hundred years. And it isn't the only way to do banking and this has some very obvious flaws that I've gone over in the last couple of videos. And just to kind of highlight them-- the first one-- and this is one that would strike anyone as, at least it would make them uncomfortable, is just this disingenuous nature of fractional reserve. Look, you tell someone you can get your deposits anytime you want, but the reality is you can get your deposits anytime you want as long as no more than 10% of people want their money at that same time. And obviously that by itself might make you a little uncomfortable, but that by itself isn't a whole reason to say a system is bad, but the more severe problem is that this kind of half-lie leads to the notion of a bank run. Everyone has the right to get all of their money back on-- essentially on a day's notice or an hour's notice, but the reality is that everyone can't get all of their money back on an hour's notice so that leads to an inconsistency and some people aren't going to get what they expected and this leads to a panic, this leads to a generalized panic-- which is, of course, a very unstable situation for your entire financial system. You don't want an unstable financial system. So to fix this problem of bank runs and panics, there have been kind of two fixes here. You have your lender of last resort in the Federal reserve and then probably more importantly, you have the notion of FDIC insurance. And in the last video, I talk about the idea that FDIC insurance-- the main negative I see-- it essentially gives all banks the same access to capital because they all say, hey, look give me your money. It's insured. So essentially it's a Federal subsidy for all banks. By definition the fact that the FDIC is about to be insolvent and will have to go back to Congress to ask for more money-- that means that it was undercharging for the insurance. So it was subsidizing these banks and since all of these banks have the same as the FDIC insurance and they're paying a slight different amount for them, what it leads to is, it encourages risk taking to essentially get more profits because all of the banks' borrowing costs are the same because when they take on more risk, people don't say, hey, you're a riskier bank. I need more money from you to give me your deposits. They'll say, no, I might be a riskier bank, but I'm FDIC insured just like that more conservative bank down the street. So I should be able to-- I'll just pay you a slightly higher deposit, just for giving me your business, but then I can go take big risks and it's essentially subsidized by the Federal government. But even here, you might say, hey, look, we've been-- the U.S. runs on a fractional reserve banking system and is clearly kind of the financial or the economic powerhouse of the world and those are both true. And obviously other modern countries are all based on on fractional reserve banking, so what's wrong with it? Maybe we have these weaknesses, but we've engineered away the problem. And the main-- I guess the best way to answer that question-- and I really don't want to-- I guess I want to make it very clear that when I started off thinking about this problem-- because I've gotten a lot of requests from people to think about the problem, I came at it from as neutral a position as possible. I said, I don't want to just say it's bad and be kind of this reactionary radical person, but the more you think about it, the more that you realize that there is something that just doesn't fit right here. For example, when you talk about any financial intermediary, what's it's purpose? Let me draw a financial intermediary right here. You have savers who like to put their money in a nice big vault someplace or maybe they would like it invested someplace, but they just don't know how to invest it or they don't have-- their money doesn't have the scale so it can be invested properly. And what the financial intermediary says is, hey savers, give me all of your money and I'll hire some really smart people to invest your money properly in good investments. So you have your savers on this side and then you have your projects or your investments on this side. They might loan out the money-- I'm speaking in very general terms. We're talking about a commercial bank or lending out the money. If you're talking about a venture capital fund, they're making direct investments in actual startup companies, but the idea for any financial intermediary is the same. For them to create value, they're taking the saver's money and they're putting it in investments that should generate some positive yield. So it'll generate some positive return if they invested right. And they'll give some fraction of that return back to the savers. And they'll keep some of that for themselves-- which you might say is reasonable. If they're doing this work and they're allocating this capital, they're providing a useful function for society. These people deserve to be wearing their Armani suits and and have their Rolex watches. I'll put deserve in quotation marks. But you can say they are adding value to our economy. Is fractional reserve banking a requirement to have financial intermediaries like this? And the simple answer is, no. You don't need fractional reserve banking to do this. In fact, many financial intermediaries in no way participate in a fractional reserve lending system. I guess the most obvious one is venture capitalists and regardless of what you think of them, they are not-- there's not some kind of-- they tell their investors, which are the equivalent of the depositors for a bank-- they tell them, look, you're going to have your money locked up for X years. Or they'll say, look, we'll take your money as we need it. Once we take our money, it's going to be locked up. That's also true of private equity funds. Some people consider venture capital a subset of private equity, but private equity more invests in companies that already exist. They do that-- and hedge funds, maybe they don't have a lockup for the most part. Some of them might actually tell you, look, we're going to lock your money up. So they're being very upfront with their investors. I don't want to defend them, but the ones that don't have a lockup, they'll invest in liquid instruments. Hedge funds-- this is a big group of people. Some of them are adding some value to society. Some of them aren't. Probably the great majority of them are just trading funds between each other in some type of a game, but I won't go into that debate. I won't try to defend all of the hedge fund world, but that the notion is that to be a financial intermediary, you're not dependent on fractional reserve banking-- even if you wanted to run a commercial bank. I could take deposits. So let's say you come to me. Let's say a bunch of people come to me. Let's say this is your deposit right here. This is your money. Let's say you have $100 right here. I could tell you, look, if you want money on demand, I'm not going to pay you any interest on that. For the service of you having access to it on your ATM and for it to be secure and all of that, I'm actually going to maybe charge you a little bit of money for on demand money and everything-- and if you want interest on your money, you have to give me your money for a certain period of time. So what you do is-- so you've given me your $100-- and you say, I would like to get some interest on my money. I'm a sophisticated investor. I'd like to participate in the miracles of capitalism. So let me tell you what. Out of this $100, I only need $10 on a daily basis to run my business or my household so I'm going to make this a demand account. So that would be just a checking account-- and for that I'll get no interest. I might even have to pay some money. Now the other part-- the longer you're willing to lock up your money for, I'm going to give you more interest in it. So this is $10 right here. Let'sw say, well, I might need some of my money in a year. So let me put the rest of it in for one year. We'll call that a one year CD, which exists already. For this, the bank will pay you 2% or maybe 3%. And then you said, the rest of the money-- this is long term retirement money and I'll put it in a 10 year CD and because I've locked it up longer, I'm going to get more interest. Maybe I'll get 5% for that. And now me, the commercial bank that's not participating in fractional reserve banking, can say, look, this guy has this $10 that he wants access to whenever and I'm not paying any interest on that. I'm just allowing him to use my financial infrastructure so I'm just going to put that aside. I'm just going to put it in my vaults and he can access that from his ATM or wherever, but this money out here, I can then lend this out. So if someone comes to me and say, hey Sal-- or Sal Bank-- I have this project and I want to be able to borrow-- let's say that this right here is $45. I need to borrow $45 for eight years. You say, sure. I don't have to give this guy his money back until 10 years from now. So what you do is you take that $45 and you loan it out-- which is fine because you know it's going to be back. As long as you're loaning it out properly, it should be back in time to pay this guy. And this guy knows that you're loaning out this money so he knows that there's some risk inherentness and he should do his homework before he buys this 10 year CD from you. He should see where you're loaning your money and how risky it is and if it's really risky, he should want more than 5%-- he should focus on the interest rate or he should just not give you his money. So the natural supply and demand and the natural feedback forces of capitalism would come into play. So you could completely run a financial system with banks and all sorts of financial intermediaries without fractional reserve banking. So now the next question is, OK. You can do without factional reserve banking, but what's really wrong about what fractional reserve banking is enabling? And for that I'll have to review the yield curve for you. So the yield curve-- it's nothing fancy. It's really just a graph showing how much interest you pay for different durations or how much interest you get. So let's say this is the yield curve. Let's say right here I have overnight money. So let's say this is if you give a loan for one day. This is if you give a loan for one year. And this is-- let's say you gave a loan for 10 years. And there could be all sorts of-- a duration is just how long you're giving the loan out for. Now, if you're lending money to the government, which you view as safe-- maybe the safest person to lend money to, then you can say, look, the government for one day-- I'm willing to lend money to them for 1%. For one year-- I'm locking it up-- maybe 2% and then for 10 years, I'm willing to lend it to them for 5%. The yield curve will look something like this. Doesn't always go upward sloping like that, but it tends to go upwards sloping like that. So that's the yield curve and this might be for treasuries. So one day, 1%, one year, maybe-- the way I drew it-- maybe this is 3%, maybe for 10 years, this would be 5%. This isn't the current yield curve, but you you get the idea. This would just be for treasuries, the safest borrower. Now for investment grade companies-- if I'm trying to lend money to them, maybe to a GE or someone like that-- or a Berkshire Hathaway, I'd want some premium over the treasuries because they're not as safe as the U.S. government, but it's going to have a curve similar to that. Maybe it looks like that, right? And this premium right here is essentially the amount of more interest you'd want from these still relatively safe companies. relative to treasuries, but you still have this upward sloping as you go up. And then, finally, you might have your really risky guys-- and every company will have its own yield curve based on its borrowing costs, but you might group a bunch of risky guys together and say, look, the risky guys-- the yield curve looks like that. If there's some guy who's looking to start some biotech firm and he wants to borrow money from them, I'm going to charge a much higher premium over treasuries because I don't even know if he's going to be around in five years. So this is just the yield curve and the whole reason why I drew this is to show how fractional reserve banking allows banks to essentially take advantage of the yield curve without really adding any true value to society. This notion of a financial intermediary does add value to society. When you have fractional reserve banking, what you're allowing banks to do is to take deposits and this-- fractional reserve banking isn't the only place where this happens. This happens a lot of places, but they take deposits-- and they're demand deposits, right? These are checking deposits, which are essentially loans from their depositors and they are essentially overnight loans, right? These are on demand loans. They're essentially-- when you give your money to a bank in a checking deposit, that's essentially every hour that you don't go and take your money back, they're essentially just renewing that loan. It's kind of the shortest possible duration loan. And every day you don't do it, it's just kind of a renewal of that loan, right? You could imagine a world where every year you renew a loan. Every year that you don't withdraw it, you just keep rolling it over. When you do on demand, it's every second that you don't withdraw it, you're renewing it. So they're able to borrow money at this part of the yield curve and they can do it very safely, pay very little interest, because people-- even though they might be doing risky activities. Maybe they're lending to people like this guy. Because of the FDIC insurance, people are lending to them like they're the government because they're going to get paid back if the government can pay them back. So it really lowers their borrowing costs, so they borrow down here and what it does is, it allows them to lend money over longer durations. So this could be a 10 year loan. So the money doesn't get paid back, only interest does in the interirm, but the money doesn't get paid back for 10 years. Maybe this right here is a five year loan. And they can do it to riskier investments. I mean, one, they could just borrow money here, which is what they're paying the depositors-- like 1%-- and then they could just invest it if they wanted to and if the yield curve looked like this, they could invest it in treasuries or maybe investment grade bonds, essentially lending to the Berkshire Hathaways of the world-- and getting a lot more interest. And what they did here-- it doesn't take any special genius to do this. Everyone knows that you'll get higher interest here than over here, but the only reason why they can do it this way is because they have this implicit guarantee-- actually it's an explicit guarantee-- from the FDIC. So this FDIC insurance is what allows people to lend them money. People are only willing to part with their money at this point of the yield curve because of the FDIC insurance. And then the bank can then go and invest at this point of the yield curve and then make the difference on the spread. They'll get 5% on the money and then only pay 1%. And where's the value here? Because I could do this, but I'm not an FDIC insured entity. Clearly these people would love to get 5% on their money, get that money that the bank's getting, but they don't get that insurance from the FDIC so it doesn't allow them to. So essentially what fractional reserve banking and the insurance that's come about to make fractional reserve lending viable-- all it does is it allows banks to arbitrage the yield curve-- to borrow money at the short end and lend it out in the long end, and make up the spread. And this is kind of a, one, that doesn't add any value. Anyone can do this. You don't need a a fancy MBA to figure this out. This doesn't add any true value to society. It actually just flattens out the yield curve a little bit, but we can debate about the value of that. But I want to kind of make a bigger point here-- is that obviously a lot of people in the banking system are kind of the champions of capitalism and unless they're being bailed out, they're the first ones to be against any form of government intervention or government safety net. But their whole industry is predicated on a government safety net. This notion of a financial intermediary that I outlined here and venture capitalists and private equity-- they still operate on this model right here. They are in no way dependent on the Federal government. I mean, some of them might end up being indirectly, but they don't need a whole elaborate system of FDIC insurance and the Federal and the discount window and all of these interventions that the Federal government does. They don't need that to operate efficiently-- or to operate in general. And even this banking system here, where you just had people get CDs instead of having this kind of halfway truth of fractional reserve lending-- this could completely operate without any government intervention. This system, on the other hand, fractional reserve lending-- it could not exist without government intervention. And so you have to you have to debate-- or I guess think in your mind-- some system like fractional reserve banking that is dependent on the government-- is this even capitalism? I mean, where is the competition here? Where is the innovation here? If you're big enough, you get your FDIC insurance and you just keep arbitraging the yield curve and you make money to buy your Rolex and your fancy trips in your private jets, but there's no innovation here. You're just big and you were one of the lucky ones to get a bank charter with the FDIC and be insured by them-- there's no innovation here. Where's the competition? If anything, the person who takes the most risk and who does the most silly things is going to be able to generate the highest yield and they have the subsidized insurance from the Federal government and so they're going to be the most successful. It's all dependent on government. It's all dependent on a subsidy. And in the end, this money that these people are making by arbitraging this, this is coming from a subsidy from the Federal government and it's coming from the taxpayer. So you essentially have the taxpayers subsidizing this world where people can just arbitrage this yield curve-- not take on real risk and make real investments and efficiently allocate capital, just arbitraging the yield curve with cheap insurance-- and you're essentially making a small percentage of the population-- being able to extract, essentially, rents or or some type of subsidy from the rest of the population. And obviously this isn't the part of our economic system that is the most in need. So I'm not saying this to kind of impugn the financial system. I think for the most part, people here, they're taking on risk and they're getting return and the savers here know what they're getting into, but there's no government intervention here. There's no implicit government subsidy. This whole thing is based on a government subsidy. Fractional reserve banking could not exist without the FDIC and the FDIC could not exist without the implicit backing that the Congress would make them solvent if they ever ran out of money, like is the case right now. Anyway, hopefully this informs your view a little bit more. I don't want to be some kind of crazy reactionary. I'm resigned to the fact that fractional reserve banking isn't going to go away, but it does bother me a little bit because it is completely dependent on government intervention. As you see right now over the past year, you have this whole financial system where we're piling more and more money into the very same entities that took on the most risk-- and essentially they have us at gunpoint. They're like, you better pour more money into us or else we're going to blow up because of the risk I took, but I'm going to take you down with me.