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Banking 7: Giving out loans without giving out gold

How banks can give out loans without ever giving out gold. Created by Sal Khan.

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  • male robot johnny style avatar for user Paras Doshi
    Can i go into any bank and ask for GOLD in place of dollars bill i have?
    Can i just go to "Bank of America" branch and ask them for Gold in return to dollar bills i have - Can they?
    If not, why?
    (8 votes)
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    • leaf green style avatar for user uh
      Gold is no longer a currency, unless you would consider anything with monetary value a "currency". You could get gold from a very (repeated about 1,000,000 times) old bank that has not adapted to modern currencies, a jewelry store, or a gold mine. The Bank Of America has certainly adapted to modern currency, because it is not a completely independent bank. It issues bank notes of the Federal Reserve Bank, which is somewhat similar to this "Bank Of Sal", for it does reserve gold, a universal currency. So you could get gold from the Federal Reserve Bank. Anyway, the Bank Of America is probably structured in a way similar to how the "Bank Of Sal" is structured: it uses a portion of your money for loans, profits off of it; and it leaves the rest for you to access anytime. It would take an ahead-of-time request to remove your entire account's containings, and it would also be wise to delete the account itself, because of the under-minimum fee (another way that the bank makes money). (It would be quite a heaping load of bills, anyway.)
      (11 votes)
  • leaf green style avatar for user Acunhasilva14
    I don't get it. If the bank "creates" money out of thin air, then if the loan doesn't go right he does not loose real money, am I right? There's no risk for the bank...
    And if the loan goes well and the client pays all then the bank gains the equivalent of the loan it self plus the interest rates, or is it not like this?
    If so the more the bank lends the best as it will always going to win in the end?
    Something is not right in my assumptions but I really don't quite figure it out yet...
    (7 votes)
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    • piceratops tree style avatar for user Tim Benton
      There is a risk for the bank. By giving you a loan of, say, 100 "Gold Pieces" the bank is creating 100 GP worth of liabilities for itself, although it only needs a fraction of that loan in actual reserves. If you write a check, or give 100GP in notes to another party, that party can come back to the bank and demand 100 gold pieces. If you do not repay the loan, the bank still has to pay out 100 GP to the third party but will not receive anything in return from you, and therefore loses the full amount of the loan.
      (10 votes)
  • blobby green style avatar for user dhroovgajjar
    What would happen if you gave a check to someone that was a lot of money. And you wouldn't be able to pay for it. Would the transfer of the money pass through or would it create a conflict?
    (6 votes)
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  • blobby green style avatar for user Michael Stollenwerk
    If the Bank of Sal can create demand deposits, then what stoppes Sal from creating a demand deposit for himself, up to not violating the reserve ratio, and simply consuming his demand deposit? i.e getting insanely rich compared to the other agents in the economy by just printing money for himself?
    (2 votes)
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  • aqualine ultimate style avatar for user Essam Shayboub
    What if the bank lend my deposits and I asked for all of it in one time?
    (1 vote)
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  • hopper jumping style avatar for user Smart-guy
    So the bank can always give out a bank note without they have gold in the bank?
    And how can this leads to making of more money?
    (2 votes)
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  • blobby green style avatar for user tianlong.wang.13
    What happens if bank can sell all loans to investors and in turn convert loans into government issued currency, thus bank can increase this loaning process infinitely?
    (1 vote)
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  • aqualine ultimate style avatar for user patel.dev.m
    If you arent involved with the bank and happened to stumble upon a sal's bank bank note and you redeemed the gold from the bank from whos gold would they give the man gold
    (1 vote)
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  • leaf orange style avatar for user Harshit Kacholiya
    Hi Sal
    What about if a person A gives bank notes to a person B and the person B does not have an account in the bank?
    (1 vote)
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  • blobby green style avatar for user Kelvin Low
    If we scale all of this up to the size of a country, let's say someone dug up some gold and sells it to the local bank for some bank notes. Will this make a bank's gold reserve bigger? Also, if country A is geographically rich in gold resources but poor at managing its trades and businesses, could Country A sustain itself by digging up gold and issuing bank notes? (I guess the answer is no, but I don't understand why) Is there a limit or a peg to how much physical gold a bank can have for the gold to actually have value and the bank printing bank notes on basis of that gold itself?
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      If someone sells gold to a bank, then that would indeed increase the bank's gold reserves. They have more gold than when they started, so yes.

      If a country is rich in gold resources, that would help for a time, but not forever. Eventually, inflation would take over, and the gold would become worth less. This actual situation happened once. When the Spanish empire conquered much of the Americas, it immediately went to work digging up gold and silver from the newly conquered territories. Both devalued extremely quickly, and the Spanish economy collapsed soon afterward.
      (1 vote)

Video transcript

Welcome back. And I just want to apologize ahead of time because I'm actually in a hotel right now because my wife is at a medical conference and I'm using my laptop, with a kind of ad hoc configuration. So it might not sound as good as it normally does, but let's just try to keep learning. So let's start off the way I start off every video, but maybe I'll do it a little different this time. So I want to start a bank. So I use 300 gold pieces, 100 to actually build a bank. So this is my vault. The actual physical structure-- that took 100 gold pieces and I'm actually going to initially capitalize this bank with 200 gold pieces. You want to show people what it looks like for gold to be sitting in the vault to get the idea. So my initial equity is 300 gold pieces. Like all of the other examples, I start off by taking deposits. The villagers trust me. So Villager A comes and gives me-- let me just do Villager A in green. He comes and gives me his 100 gold pieces. This is just all gold. And then that's an asset sitting in my vault and then the offsetting liability for me, although this would be an asset for him, is a checking account. So account for Person A and he can write checks against that and we know how that can be used as actual currency or actually be used to make payments. And then Person B comes. He's a little bit richer, gives 200 gold pieces. And he wants half of that in his checking account and he wants the other half essentially in cash. Or in bank notes, as we've learned. And then half of it, he wants in terms of bank notes. So this liability would be bank notes outstanding, 400 gold pieces. This is 100 right here. And I'll print up some bank notes. Maybe he wants five 20s. So I'll give him five times-- each of the bank notes might look something like this-- 20 gold piece denomination, have a picture of a handsome bank founder. It'll say Bank of Sal at the bottom. I'll give it to him and then he could use that for transactions with people who maybe don't like to leave a paper trail. But anyway-- or whatever, buying a newspaper, whatever he needs to do. But he can use these and then whoever he hands these to, if they have one of these 20 gold piece bills, they can come back to the Bank of Sal and actually redeem 20 gold pieces. So it's kind of like a checking account, but you don't know who actually has rights to it at any given moment in time. But anyway, we've done that in the last couple of videos and we've shown how you can change hands and how when someone writes a check, say, between A and B, you're just kind of-- you're just changing what happens in the books and the gold never has to leave. But let's think about what happens now when we actually start to lend some money. So the old example-- if someone had a project that required, let's say, 300 gold pieces, we would actually give them the 300 gold pieces. We would actually take it out of our vaults. They would use that 300 gold pieces to hire the people or buy whatever supplies they needed to actually do their project and then those people maybe would redeposit it back in the bank and that process would continue. What we're going to do now is try to think about, how could we do this without the bank ever having to give the gold out? One, it's just a safety concern and then the gold is just not an easy thing to transact with. If someone wants to sell something worth half a gold piece, do they cut it? If someone wants to sell something worth 1,000 gold pieces, it's a security risk and it weighs a lot. So what can we do? So let's say entrepreneur-- let's see. We did A, B-- so let's do Entrepreneur C. He has an idea. Let's say it's the irrigation ditch again. And he needs 300 gold pieces. So what we do is, we lend him 300 gold pieces. So I have an asset-- 300 gold piece loan to Entrepreneur C. And instead of actually taking it out of my assets here and then waiting maybe for his laborers to redeposit it, I can just create a checking account for Entrepreneur C. In fact, it can be maybe part checking, maybe part cash. What I could do is maybe 100 of it, I can make a checking account and then the other 200, I could put some more bank notes outstanding. So maybe I do 20, maybe he wants it in 10s. And I give him a bunch of these things that I've printed out from the Bank of Sal. And maybe he could use this to pay his laborers. And if the laborers later on, they don't want to just hold these pieces of paper, they can come back to the Bank of Sal and get gold in exchange for it. And then let's say another entrepreneur comes and he wants to build a factory. He needs 100 gold pieces. So I have a loan-- 100 loan. That's my asset. And then I can create a checking account for him. So this is account for D. And I know what you're thinking. It looks like I'm making money out of nowhere. I'm just increasing both the left and the right-hand side of the balance sheet for every new loan I make. And if you think about, this was actually not that different when we issued the gold. It's just that we had to wait for the gold to come back to the bank. This is essentially a way of keeping the gold here and we just use these checking accounts and these bank notes as a way of transacting instead of the gold itself. So for example, let's say this Entrepreneur D, he wants to build a factory. Let's say that person A is the person who actually builds the factory. Person D can write Person A a check. He could write 100-- You know what a check looks like. He'll sign it. Person D-- He'll say it's for a factory. He'll write out 100 here and he'll write it out in words. However a check is, just something that shows-- it has to be authenticated so that when A takes it back to the bank, the bank believes that D actually wrote it in his checkbook as opposed to somehow A forging it. And in return, A is going to build D a factory. And then when A takes this check that he got from D, brings it back to the bank, then the bank says, OK, well, D is going to take all this money out of his account and we have to transfer it to A. So I could move that down or I could just change it to A's color. And I think you get the point. All this 100 gold pieces is now A's. And once again, we did not have to change anything. We didn't have to deal with any gold. Now the natural question is, how far can this process continue? Can a bank just continue issuing loans and checking accounts indefinitely and essentially collecting the difference in the interest between the interest it gets on the loan and the interest it gives on the checking account? Well, no. Because then a bank take on arbitrary amounts of risk-- and there are regulations, although I think a bank would do it on their own to some degree, but there are regulations called reserve requirements that tell us how much lending can a bank do relative to its actual reserves. In this case, it's reserves of gold. Actually, even a better definition-- How much checking accounts and bank notes it can issue relative to its reserves. And in the next video-- The point of this video was showing you how this loan process can occur with the gold never leaving. In the next video, we'll actually talk about reserve requirements and think about why reserve requirements are what they are and what happens in extreme circumstances. See you in the next video.