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Current time:0:00Total duration:9:01

Simple fractional reserve accounting (part 1)

Video transcript

what I want to do in this video is start to visualize the balance sheet for a simple bank and so we can start to understand the actual mechanics for how a bank accounts for its assets and liabilities in the context of a fractional reserve system so first let's just give a general idea of what a balance sheet is and I go into a lot more depth in other playlists but when we talk about a balance sheet we're really just talking about how many assets to something have and how many liabilities offset it and then how much is left over for the owners of the firm or whatever we're talking about so for example so for example if I have let's say just let's just say generalize it to any type of company let's say that they have so over here I'll draw their assets so their assets I'll do it in this green box the height of it is kind of the magnitude of their assets let's say that there's some company that has 100 million dollars in assets and assets you probably understand it's something that gives you some type of benefit the more formal definition is something that gives you some future value and it's generally considered to have some positive economic value so it could be cash because cash can be converted into other things you can go buy a cow and that cow can provide milk for you and give you future benefit a cow itself would be an asset a building would be an asset because it gives you the future value of giving you shelter so assets could be anything but here for the sake of this company we could even visualize it as cash if you like so it has a hundred million dollars of assets and let's say it has some liabilities so let's say this company right over here has sixty million in liabilities and I'm trying to do it roughly equal to the height it's not exact but let's say that they have 60 million in liabilities and liabilities are just obligations so it owes people sixty million dollars worth of stuff and so when you look at it this way this entity here which could be a company affirm it could even this you could even call this a person if this was a person they'd have a hundred million dollars of assets but they owe sixty million of that hundred or you could say they owe sixty and you could view it of that hundred million so they would have forty million left over for themselves if you were to say what is the value of this how much do the owners of this entity actually how much are they worth from this entity it would be the hundred minus the sixty they have a hundred they owe sixty so the owners right over here would be 40 million dollars so that's really kind of the value of what the owners have and it's called owners owner's equity so that's just a basic primary primer in assets and liabilities and now I want to use I want to build on that to think about what's actually happening in a fractional reserve system with the bank and what we're going to see is the way it's actually done mechanically in a modern fractional reserve system is slightly different than the way you would conceptualize it the way you actually I've been conceptualizing it for you guys because that's just an easier way to think about things so let's just say we're going to go start a bank so let's say I I want to start a bank and what I do is I go and I take I go by I don't know let's say I go by a 10 million dollar existing bank so here I have an asset which is my equipment and the building and all of the ID computers and all of the things all of the things that can essentially run a bank and that's worth that's worth ten million dollars and this is my owner's equity so I have 10 million dollars of owner's equity maybe do it in those same colors that I did so let me do this in that green color so this is an asset and I have no liabilities yet let's just say that I inherited that money or that was just money that I had saved up so I went I bought a 10 million dollar asset and so my equity since there's no offsetting liabilities is ten million dollars so this is my owner's equity right over here is 10 million dollars so I'll just call it equity now let's say that you know you you lot you're impressed with my building and my IT systems and the number of ATMs that I have around town so you decide that you want to deposit some money with me so let's say that you take your you take a wheelbarrow and in your wheelbarrow you come and you deposit let's say you deposit a hundred million dollars in my bank in cash so these are cash reserves these are Federal Reserve notes that you're depositing in my bank so I'll draw these as assets so this is so let me do a hundred million just should be about ten times as high as what I've already drawn so you're going to come here and you're going to deposit you are going to deposit a hundred million dollars so this is a hundred million dollars one hundred million of of I'll call it cache of cash will visualize it as physical cash and it goes into these vaults that I had purchased and so that's the asset that I got but obviously you're not just giving me this cash then I would be 100 million dollars richer you're keeping that your you want that on demand you want that in the checking account so that you can write checks against it and access it from your ATM and so I have an offsetting liability my my offsetting liability is that this is essentially a demand deposit for you so this is I guess the way we can view it is the way we can view it is we could write it as a checkable checkable checkable deposit and i'm viewing it from the bank's perspective and that's why it's a liability because someone can hand me a check and I would have to give them some money this is this is an obligation if someone writes a check against these deposits to someone else that's an obligation that I is the bank half the surface I could call this just checking accounts or checking accounts of person a maybe that makes it easier to ace checking account is a liability for me so let me call it if I haven't called them person a already I'm calling them now person a's checking account checking account and that's a liability because person a can come at any time and they can demand one hundred million dollars of cash now this right over here I haven't done anything fractional yet this is just as just regular so far this would be equivalent to full reserve banking I'm just keeping person a's money safe but we know in a fractional reserve system i can lend out a good bit of money and so that's essentially what i could then do if we're talking about fractional reserve i can lend out 90% of this money I could lend out 90% of this so let me take out 90% so let me clear this right over here so let me clear that and so let's say I took ninety percent of it lent it out and so we only have ten million of the original cash there as reserves and I call them reserves now but that's ten million of the original so I'm going to have ten million of reserves left and everything else I lent out so everything else I lent out so 1990 million I lent 90 million of lending so we can even visualize it as big stacks of cash that I hand it out to people and then you might say well okay I didn't just give that to those people in exchange for that they are saying I'm going to pay me back and so that's an asset if you borrow money from me it's an obligation for you it's a liability for you but it's an asset for me let me make this clear so if I'm a bank if I'm a bank and there's a borrower I there is a borrower there is a borrower and if I give the borrower if I give the borrower a dollar if I give them a dollar you could visualize it although it's not exactly how it works is that they give an IOU they give the bank an IOU I owe you one dollar at some future date now from the bank's point of view this IOU is an asset they're essentially exchanging assets the bank is giving it a dollar the borrower is giving an IOU from the borrower's point of view the dollar is an asset and this IOU is a liability but from the bank's point of view there's like oh I have this IOU maybe I could give this to someone else maybe I could sell this I'll you this I use going to give me future benefit because assuming this person is good for their money they're going to give that money back and that's the same reason why a check is a liability of the bank if you write a check to someone the bank has a responsibility to if someone were to give that check to the bank to give them cash so the similar way when the bank lends out all of this money they're going to get IOUs from all the people that they lent it to so they're going to have they're going to get 90 million of IOUs we could say 90 million worth of loans but you really could just view those as these are io u--'s to other people this is an asset because it's going to give some future benefit at some future time now I'm going to leave you there because what I did here this is conceptually identical to everything we've been talking about this is how frankly most people visualize fractional reserve lending you get you get a hundred million reserves you lend out ninety million of that reserves and to exchange that for an asset which is essentially an IOU but we'll see in the next videos this isn't exactly true what a bank can actually do is actually create it can actually take just the ten million of reserves and then it can create these assets which are functionally equivalent it looks a little bit shady the first time you think about it but they are actually functionally equivalent so it's not as shady as you might initially think it to be and we'll cover that in the next video