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Studying for a test? Prepare with these 5 lessons on The monetary system.
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Voiceover: In the last video, we saw how a bank would account for fractional reserve lending on its balance sheet, and we did it with kind of the conceptual understanding that we've been talking about fractional reserve lending the entire time. Someone deposits 100 million in reserves, and 90 million of it gets lent out. Of course, the offsetting liability is that person could come at any time and demand their money back. When that 90 million of currency is lent out, the asset that it's gotten in exchange for it is 90 million worth of IOUs. Now what I want to do in this video is to clarify that this is conceptually a good way of thinking about fractional reserve lending, but what the bank can actually do is slightly different than this. They can actually create, they can actually create the they can expand both the asset and the liability side of their account with just 10 million of reserves to make this exact same thing happen. One thing I do want to clarify. These videos, they are not an attempt to either justify fractional reserve lending or in some way indict fractional reserve lending. It's really just to show how it is accounted for. You can take that debate on your own side, whether you think it's worth doing or not, fractional reserve lending. Let's take the same example, but now let's take an example where so we're going to start the same way that we started in the previous video, where I go buy, I go buy $10 million worth of assets, which are essentially the building and things for my bank: The buildings, the ATM, the computer systems, all of that. I didn't take a loan to do it. Let's just say I had that money, so once again, I am the owner of this bank, and so I get 10 ... I have all of the assets are owned by me, so my owner's equity is $10 million, is $10 million. Now, in this example, instead of getting $100 million of deposits like we saw in the last one, let's say that person A shows up and gives us $10 million of deposits. So they come, and they deposit $10 million of currency, so $10 million of federal reserve notes. So write over there, $10 million, and they can demand, person A has a right to demand their $10 million. So this person, let's call them person B, person B is one-tenth as wealthy as person A, so this is person B. I'll just call it B's checking, B's checking account. Now, this is going to seem very unintuitive, what I'm about to do. Because a bank only has to keep of the amount of checkable deposits they have, only 10% of that has to be in reserves, and we saw that over here, instead of just only being able to lend this money over here, the bank could keep these reserves, but then automatically expand their checking, their checkable deposits. Let's say I go to this bank right over here, and I want a $50 million loan. They're going to say, "Okay, is he good for the $50 million loan? "Is he going to put it to good use? "Is he likely to pay?" Let's say they do decide that Sal is good for the money. what they can do, what they can do, they're going to lend me the money, but they don't even have $50 of currency to lend the money with. What they will do is that they will create a $50 million checking account for me. So they will create a $50 million checking account, so Sal's checking, Sal's checking account, and obviously, the bank isn't in the business of just giving away money. What they will do is they'll have an offsetting asset that they will get from Sal, which is an IOU from Sal. So let me write it this way. Loan to Sal would be an asset, because in the future, Sal's going to pay the bank. We could call this "Loan to Sal" or we could call this "IOU from Sal". Let's say that Bill comes along, I'm just making up names, let's say Bill comes along, and he wants to borrow another, let's say, $40 million, and the bank determines that it's a good investment, and so let me actually, this is a, just to make clear, this was a $50 million, this was a $50 million IOU from Sal, and this is, I have 50 million worth of, I guess I can write checks up to $50 million to go buy, this was a $50 million loan, so I can write checks against this now to go and build my business or whatever, or I could even take those checks, and I could cash them out, and of course the bank has to make sure it has enough reserves. It wouldn't want me to show up and try to cash out more than $10 million. If that started to happen, they would have to go and borrow reserves from either another bank or, as a last resort, from a central bank. But let's just continue this just to show that we can actually end up having identical balance sheets. Let's say another businessman, let's call him Bill, comes along, and let's say that he wants to borrow $40 million. So the exact same thing, the bank decides to do it, so what they will do is they will lend Bill $40 million, but once again, they don't have that much in reserves. They will essentially create a checking account for Bill. So, Bill's $40-million checking account, and of course they don't want to just hand him the money, there's going to be an offsetting asset they get from Bill, which is essentially a 40-million IOU, IOU from Bill. Now you might say, well, can't the bank just keep doing this? Just creating, keep getting more and more IOUs, keep, kind of, creating money because these checking accounts really are money. You're money-creating. These people can now write checks against the bank's ability to cash those checks, and the answer is what's limiting this bank right over here is the reserve requirements. The bank can only, the ratio of checkable deposits to reserves can only be 10 to 1, or reserves have to be at least, and this varies from country to country, and this can change, depending on the policies of the federal reserve, and that's one way they have of controlling money, although that's not the most typical way. They have a reserve requirement here. You have a 10%. So, 10% of checkable deposits, and this is true for large banks in the US, have to be held as reserves. There has to be reserves for, reserves for, 10% of checkable deposits. That's what essentially keeps these banks from doing this forever. Now, this bank is all tapped out. It's limited by the amount of loans it has by its reserves. I know it looks a little bit, it looks a little bit suspect, that they were able to essentially create these checking accounts out of scratch, and only have, they're essentially telling people, "Look, there's 100 million that you can have "on demand now to do whatever you need," when they only have 10 million in reserves to back that up. The rest of their assets are IOUs from people, but this is exactly what's happening with the other conceptual version. I guess the more traditional conceptual reserve, the more traditional conceptual understanding of fractional reserve lending. You're telling someone that they have 100 million on demand, but you're loaning 90 million of it out. What they really have, truly in the vault, is $10 million. So these two things, these two things, are actually functionally, these two things are completely equivalent, and if you have a problem with one of these, if you feel like just money is being created by the bank, it's actually happening in both cases. In that case, you would be having trouble with fractional reserve lending, not just this idea right over here.