Banking 9: More on reserve ratios (bad sound)

Let's talk a little bit more about reserve ratio requirements and then if I have time, I want to introduce another, almost related and often confused, topic, and that is leverage. So let's do reserve ratio requirement and let's say in whatever jurisdiction or world that I live in, that requirement is 10%. So that means that for every dollar of checking account liabilities or notes libraries that I have outstanding, that I have to keep at least 10% of that in actual whatever the reserve currency is. In our world we've been dealing so far it's been gold. In the current world, it's not gold. It's actually dollar bills. But anyway, we'll stay in the gold world and later on we'll get ourselves off the gold standard and see how that works. But let's just do the example from scratch again and just see how big I can get my balance sheet and see exactly how this stops me from getting too big. So I have my bank like I always did. Let's say my building is worth 100 gold pieces and then I capitalize it with another 200 gold pieces. This is the building. And this is my equity that I start off with. So I start off with 300 equity. I should always do the equity in a different color because sometimes it gets confused with the liabilities because they're both on the right-hand side. So this is my equity. And then I might take some deposits. Let's just-- I don't want to make this too large of a diagram, so let's just say I take another 100 gold pieces in deposits. And then I have checking accounts for these people who deposited them. I'll do that in purple. These are checking accounts or notes deposit accounts for people. These are my liabilities. So my question is, if these are all the deposits I have, or this is all of the reserves I have, how much can I lend out. Or, how much can I expand my balance sheet? Well, the reserve ratio requirement says that my reserves over my total checking accounts that I have on my liabilities and the notes that I issue, that my reserves can be no more-- or have to be at least 10% of that. So right now I only have 100-- whoops. I pressed the wrong button. Right now I only have 100 gold pieces of on demand checking accounts. And I'm not going to worry too much about the notes outstanding right now. They're really the same thing, at least from a balance sheet point of view. And I have 300 gold pieces. So I actually have more reserves than I have on demand accounts because I've actually pre-capitalized it with some of my initial equity. So how much lending can I do? Well, this requirement says that I can only expand these on demand accounts so that this is at least 10% of it, this 300 gold pieces is at least 10% of it, right? These are my actual reserves. So let's think of it this way. 10% has to equal my reserves. I have 300 gold pieces of reserves. 100 from actual deposits, 200 that I actually put in ahead of time to start up my bank. That was my own gold-- over the total amount of-- I'll just say demand deposits. I won't worry-- it's demand deposits plus bank notes, but we'll keep it simple right now. I think you get the idea. So we can do a little bit of math. Let's see. Multiply so we get 10% of the demand deposits have to equal 300-- or divide both sides by 0.1 and then you say, well, I could have up to 3,000 gold pieces of demand deposits. So how much could I expand my balance sheet? Well, I could keep making loans until I have 3,000 gold pieces of demand deposits. Let me start making loans out. So someone has a project where, say, 900 gold pieces. They need to build a factory of some kind. I say, sure, here you go. 900 gold pieces-- I'll draw it a little bit less high than it should be if it would be proportional to that. So 900 loan. And I don't hand that person gold. I just give them a checking account. So it's a 900 checking account. Of course they're going to use this maybe to write checks to their laborers or their contractors, whoever needs to build a factory. And so let's see. How much do I have outstanding right now in terms of demand deposits? I have 900 plus 100. I have 1,000. So I have 2,000 left. So let's say someone has a really big project. They want to build a bridge over the local river or whatever and they'll charge a toll and I think that's a pretty good idea because people are very likely to use that bridge. So I'll give out a loan to that person. So I'll give out a 2,000 gold piece loan to that person. And then instead of giving them actual gold, I'll just create a checking account for them. I could've actually issued bank notes, same idea. So 2,000 checking account. And then I'm done, right? Because are my total demand deposits? 2,000 plus 900 plus 100. I have 300 in total demand deposits-- and actually all of my liabilities at this point are demand deposits. I could have borrowed money in some other way, but I won't worry about right now. So the ratio of my reserves-- 300 to my demand deposits, which is this part right here, which is essentially all of my liabilities right now-- is 10%. And what this allows-- because of this requirement, one, it kept me from keep making loans out. I've essentially maxed out what I can do under this type of reserve ratio requirement. And what it says is, it allows 10%-- essentially it makes sure that I'm liquid enough. It makes sure that when these people, who I've said, at any point in time, you can come and ask for your money, that if people actually do want their money in terms of gold-- remember, they can transact with this money. They can write checks or if these were bank notes, they could exchange those bank notes. But if whoever has access to this checking account at some point in time actually wants their gold, I need to keep at least 10% aside, assuming that no more than 10% need it at one time. So that's what these reserve requirements are. It keeps me liquid. Liquid means when someone actually asks for their gold, I have the gold to give it to them. Now a separate question is, am I solvent? Solvent means, am I good for the money? And solvent is just an issue of, are your assets larger than your liabilities? So right now in this world, my assets are what? I have 3,000 plus my initial equity. This was 100 down here. So my assets are 3,300. So I'm also solvent. As long as my assets-- which are this entire left-hand side of the balance sheet-- as long as my assets are bigger than my liabilities, I'm solvent. Which means that even if in a world-- let's say in a world where for whatever reason, people wanted gold again, they'd come to me and let's say they wanted 400 gold pieces. I would not be liquid in that situation because I do not have 400 gold pieces to immediately give them. So I would have a liquidity problem. Maybe I would have to borrow gold from someone else, but I would be solvent assuming that these two loans are still good. And if someone gave me enough time, either these loans would be paid back or maybe I could sell these assets, which these loans are, to somebody else and get 900 gold pieces for them, in which case I could pay these people with the gold that they need. So anyway, I just wanted to show you that difference between liquidity and solvency. And actually, I realize that I almost used up all my time. So in the next video, I'm going to show you about leverage. And leverage and leverage requirements have a lot more to do with solvency than liquidity. And just to give you a little bit of a preview, it essentially says, how much of a cushion do you need to have before you're insolvent-- before your liabilities are greater than your assets? So how much loss can you take here before you're out of business? Anyway, I'll see you in the next video. It ended up being just on reserve ratios, this one. The next one, I'll do leverage.