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Current time:0:00Total duration:7:05

Video transcript

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 one hundred million in reserves and ninety million of it gets lent out and of course the offsetting liability is that that person could come at any time and demand their money back and when that 90 million of currency is lent out the asset that's got 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 of the asset and the liability side of their account with just ten million of reserves to make this exact same thing happen and one thing I do want to clarify these videos they are not 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 so 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 start in the previous video where I go by I go by 10 million dollars worth of assets which are essentially the building and things for my bank the building is the ATM is the computer systems all of that and 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 ten so I have all of the assets are owned by me so my owner's equity is ten million dollars is ten million dollars and now in this example instead of getting a hundred million dollars of deposits like we saw in the last one let's say that person a shows up and gives us ten million dollars of deposits so they come and they deposit ten million dollars of currency so ten million dollars of Federal Reserve notes so right over there ten million and then they they can demand person a has a right to demand their ten million dollars so this person let's call them person B person B is one-tenth as wealthiest person a so this is person B I'll just call it B's B's checking B's checking account now this is going to seem very unintuitive what I'm about to do so because a bank only has to keep of the amount of checkable deposits they have only ten percent of that has to be in reserves and we saw that over here instead of just be only being able to lend this money over here the bank could keep these reserves but then automatically expand their checking there checkable deposits so let's say I go to this bank right over here and I want a fifty million dollar loan so they're going to say okay is he good for the fifty million dollar loan is 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 so what they can do what they can do they're going to lend me the money but they're not they don't 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 dollar checking account for me so they will create a 50 million dollar checking account so Sal's Sal's 50 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 so loan to Sal would be an asset because in the future Sal's going to pay the bank so we could call this loan to Sal or we could call this IOU IOU from Sal and 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 dollars and the bank determines that it's a good it's a good investment and so let me actually this is a this just to make clear this was a 50 million this is 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 by you know this was a 50 million dollar 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 ten million dollars if I 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 identical balance sheets so let's say another another businessman let's call him bill comes along and let's say that he wants to borrow 40 million dollars so the exact same thing in the bank decides to do it so what they will do is they will lend bill 40 million dollars but once again they don't have that mention reserves they will essentially create a checking account for Bill so bills bills 40 million 40 million dollar checking account and of course they don't want to just hand them the money there's going to be an offsetting asset they get from Bill which is essentially a 40 million 40 million IOU IOU from from bill and now you might say well can't the bank just keep doing this just creating keep getting more and more I use keep kind of creating money because these checking accounts really are money your 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 ten to one or reserves have to be at least and this is varies from country to country and this can change depending on the policies of the Federal Reserve and that's one way that they have of controlling money although that's not the most typical way they have a reserve requirement here you have a ten percent so ten percent ten percent 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 ten percent of ten percent of checkable deposits and that's what essentially keeps these banks from doing this forever so now this bank is all tapped out it's limited by the amount of loans it has by its reserves and I know it looks a little bit it looks a little bit suspect that they were able to essentially create these checking accounts out out of scratch and and only have they're essentially there's telling people look there's a hundred million that you can have on demand now to do whatever you need when they only have ten 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 that gets the more traditional conceptual reserve the more traditional conceptual understanding of fractional reserve lending you're telling someone that they have a hundred million on demand you're loaning 90 million of it out what they really have truly in the vault is ten million dollars 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 that's actually happening in both cases and in that case you would actually have be having a trouble with with a fractional reserve lending not not just this idea right over here