Finance and capital markets
- Banking 1
- Banking 2: A bank's income statement
- Banking 3: Fractional reserve banking
- Banking 4: Multiplier effect and the money supply
- Banking 5: Introduction to bank notes
- Banking 6: Bank notes and checks
- Banking 7: Giving out loans without giving out gold
- Banking 8: Reserve ratios
- Banking 9: More on reserve ratios (bad sound)
- Banking 10: Introduction to leverage (bad sound)
- Banking 11: A reserve bank
- Banking 12: Treasuries (government debt)
- Banking 13: Open market operations
- Banking 14: Fed funds rate
- Banking 15: More on the Fed funds rate
- Banking 16: Why target rates vs. money supply
- Banking 17: What happened to the gold?
- Banking 18: Big picture discussion
- The discount rate
- Repurchase agreements (repo transactions)
- Federal Reserve balance sheet
- Fractional Reserve banking commentary 1
- FRB commentary 2: Deposit insurance
- FRB commentary 3: Big picture
Seeing how reserve ratios limit how much lending I can do. Created by Sal Khan.
Want to join the conversation?
- Hi everyone, I do not really get how Reserve requirements work. It is 10 per cent is it meant that I need to keep 10 percent of the total liabilities which is 300GP? but, this would only work in the case where we are sure that the person would not withdrawn all money right away, am I right?
Because if loan borrowed are to be withdrawn right away, which is gold in this case. The bank would not have enough gold to pay the person. even if it kept the within the 10per cent.
- A bank will normally have many many depositors and it is very unlikely any depositor alone, or even several together, will have even as much as 5% of the total deposits that the bank took in.
So if a bank holds on to 10% of the total deposited by everyone, even if quite a few depositors show up and say "we want all our money now!" it will not require paying out anywhere near the 10% of all deposits that the bank has on hand as a reserve.(5 votes)
- How did you have 300 gold coins, then suddenly have 2900 gold coins in loans when that money doesn't even exist? That's causing inflation.
And the reserve ratio is only 10% in the U.S? If there was a run on the bank in America, the banks would be screwed.(3 votes)
- Perhaps. Sal goes into it in the banking videos preceding this (worth watching if you haven't) but yes, if everybody went and pulled their cash out there would be a huge problem But that isn't all that likely. How many people pull out their entire life savings, every penny, in a day? Certainly not nearly 10%, and 20% of people aren't liable to take out 50% of their savings. It can be dangerous for some banks, especially small local ones that behave poorly, but if keeping your cash in your mattress becomes the safer option then we have bigger issues than "some banks will go out of business."(3 votes)
- I hope I'm getting the concept right. So does this mean that with higher reserve ratio (let's say 71% instead of the 10% in the video), the bank is more liquid (i.e. is able to meet even higher demands for gold from its customers more readily/quickly)?
Also, it's possible for a bank to be solvent and not be liquid, but it isn't possible vice-versa right (i.e. bank is liquid but not solvent)?(1 vote)
- Liquidity is the ability to meet short term expenses and means you have a lot of assets that can easily be turned into cash. Solvency is the ability to meet long term expenses. This video explains it well: https://www.khanacademy.org/science/core-finance/housing/paulson-bailout/v/bailout-1--liquidity-vs--solvency
If a bank has a higher level of reserves, it is able to more easily meet it's short term liabilities. Therefor it is more liquid.(5 votes)
- Then what will the bank do, if there are excessive people wanting to borrowing money?(1 vote)
- They can raise the rates they pay on deposits, to draw more deposits, or they can raise the rates offered on their loans to lower the number of borrowers.(2 votes)
- What is the basis for banks placing loans in the asset column of the balance sheet? I'm not an economist or accountant, but that seems fundamentally counter-intuitive because the money/gold simply is not there. The "asset," as such, is just a hope and fingers-crossed assumption that the debtor will repay. I suppose that guesswork is based on the "creditworthiness" of the debtor who is supposed to, at loan maturity, actually fund the asset. What am I missing?(0 votes)
- Let's say you buy a machine to make stuff that you are going to sell. Is that an asset? It's just a hope that people will buy the stuff you make, right? But it is definitely an asset.
A loan is not just fingers-crossed hope. The loan is secured by property that is supposed to be worth more than the amount of the loan. If the debtor doesn't pay, the bank takes the property.(4 votes)
- At4:14Sal says, "I could keep making loans until I have 3000 gold pieces of demand deposits." This is because he has 300 GP of assets and the reserve ratio requirement is 10%. That makes sense, numerically. Then he gives out a 900 GP loan and a 2000 GP loan (in the form of checking accounts).
How does he make the loans without any deposits to back them up?
In past videos, his bank always first accepted a deposit (either as gold, bank notes, or checking account) and then gave out a loan (on the asset side). Essentially, loans are made from deposits to expand the money supply. But, in this video, the loan is made first and then the deposit is created--i.e., deposits are made from loans. I understand how banks can increase the money supply via credit--that's been discussed in earlier videos--but this video shows the bank creating checking accounts out of thin air. According to past videos, if I start a new bank with $10 of reserves (initial deposits and paid-in capital), I can give you a $9 loan--the first step in the multiplier effect. According to this video, if I start a new bank with $10 of reserves, I can immediately give you a $90 loan. What gives?
People have asked this same question in the discussion area, but it seems that we still don't have an answer.(1 vote)
- Essentially you are correct in your analysis. With a given reserve requirement you can only issue a loan up to the value of total assets minus the reserve required. Any valuation beyond that is forward looking and not realized until the process plays out. It should be noted however, that this has not always been the case in the real world. One needs not look very hard for example after example of banks making loans based on faulty (fraudulent) accounting rules that result in higher profits in the good times and failures and calamity when the market "corrects."(1 vote)
- The gold that Sal's customers deposited didn't count towards his reserve ratios because it could be withdrawn at anytime. In that case, only Sal's equity was able to be used as reserves. In the case of big banks, who have billions of dollars worth of loans, do they have enough equity to cover this requirement, or do they meet it some other way?(1 vote)
- What is the difference between equity and liabilities?(1 vote)
- what is checking account(1 vote)
- checking account is the account at the bank where you keep your money and can withdraw it whenever you want(1 vote)
- What effect does it has on money supply if a bank reserve amount raised from 10% to a large number say, 71%? was the reserve ratio fixed to a minimum amount(10%) or shall a banks can increase to the best of their interest?(1 vote)
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.