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Finance and capital markets
Course: Finance and capital markets > Unit 8
Lesson 1: Banking and money- 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
- LIBOR
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Fractional Reserve banking commentary 1
Understanding the weak points of Fractional Reserve Banking. Created by Sal Khan.
Want to join the conversation?
Is an answer to the fractional reserve problems to move to a full reserve system? What would be the disadvantages of this?(5 votes)
A full reserve system would not allow the money supply to be expansionary/contractionary. If there is a fixed money supply, in periods of growth there will be a lack of money for transaction purposes, and vice versa for periods of recessions (there would be lot of money around causing inflation). An alternative to this is to allow the money supply to grow according to some indicator. The fractional reserve system answers this question by allowing the money supply to expand/contract in respect to the amount of loans being taken out/paid. Is this a reliable indicator of economic expansion? It has some merit.
Also, money put in banks would sit there and be inactive, as opposed to fractional reserve systems which put excess reserves into productive use by making loans to (ideally, the best long run, solid) investments. After all, well made loans are the engine of economic growth.(6 votes)
Is the 'run on the bank' a common scenario these days?(1 vote)- In failing financial markets, like cyprus, they tried to prevent a bank run by closing the banks, freezing accounts and lower the daily withdrawal limit at ATM's. The incentive is there, but also there are political/juristical means to slow it down.(5 votes)
So CAN the federal reserve determine if a bank is making really bad loans or not? or they just don't care?(1 vote)- The new Basel III accords that are coming into effect will do a lot to prevent banks from making bad loans. The banks will be required to holed a certain amount of financial capital on hand based on the risk-weighted value of their loans. The higher the risk, the more capital they will have to hold onto. And if they are holding onto that capital and not loaning it the money is effectively dead, lowering the firms ROE to its share holders.(4 votes)
13:50When a bank becomes insolvent & file for bankruptcy, do some on-demand account holders lose money? If a individual default on his loan from bank, what punishment he receives? Is there any prison term as punishment.(1 vote)
In the US all deposits are federally insured up to $250k per account.
In the US we do not send people to prison for failing to repay loans.(3 votes)
- if a person puts money i a bank as savings, how come the banks are allowed to invest this money? Surely, if the person wanted to invest the money he would have used a stock broker not a bank.(0 votes)
- Banks are centers of information. The average individual does not collect the amount and type of information that the bank does. Therefore the bank works as a financial intermediary, reducing the cost of gathering information and investing, which could be huge if a private individual were to gather it him/herself. If banks are allowed to do this, money in the economy is channeled towards what are considered the best opportunities for investment. Financial intermediaries are actually helpful to the economy if they do their job right.(2 votes)
18:15--- The collapse of Lehman is known to "trigger" the Great Recession. Is it fair to make that assumption?(1 vote)
Yes, Lehman Brothers, before its bankruptcy, was considered very high credit and so low risk. Many banks would accept bonds from Lehman Brothers as collateral, and many corporations had given Lehman Brothers loans which they would now have to write off. Additionally, the government refused to save Lehman like it had done with previous banks, which told banks that they should not take as much risk as they had been doing previously, so they stopped making risky loans like buying on margin. This caused a collapse of the stock market across the economy.(2 votes)
Could a government (in general, not specifically USA) prevent a bank run by passing some (temporary) law that limits how much money people are permitted to withdraw in say a day or week, across all banks, until liquidity and confidence are restored? Assuming there is no mass insolvency.
If not, is it simply a question of the legal gears not being able to react fast enough or is there some underlying economic reason why it would be a bad idea?(1 vote)
A large portion of the population will not be directly affected by a banking crisis. If you can keep your job, all that matters is that you can withdraw your paycheck and buy stuff to keep yourself alive.
If the government limited your ability to withdraw it would be admitting to everyone (including those that aren't really affected) that their money is not safe in the banking system. If this happened everyone would want to withdraw the max amount every day. In times of crisis often what is said is just as important as what happens. Limiting withdraws pretty much guarantees that there would be added pressure on the banking system.(1 vote)
- Is it true then that banks no longer have incentive to lend to business projects for there is much greater rewards to be gained by banks gambling on the stock market direct?(1 vote)
- In finance opportunities need to be analyzed under a risk/reward framework. Gambling and the stock market represent high yield opportunities, but they are very risky. The maximization of wealth would ideally go for the maximum reward for a tolerable amount of risk. Gambling would be too much risk in my opinion, and would be a poor long run strategy for banks.(1 vote)
- How did the modern bank, which only has 10G, magically make 90G loans to A and B?(1 vote)
- Banks make money (by investing it) during the "float" between the time you write the check or use the credit card and the receiver or merchant cashes the check or credit card.(1 vote)
How about all banks depositing their reserves into a unique Reserve Bank, which is responsible for dealing with Bank Runs ? This Reserve Bank wouldn't save the Riskier Bank, only the other two good banks - good investors - that certainly require less money from the "safe". The amount supposedly used to save the Riskier Bank may be rationed to the people who want their money, not the bank.(1 vote)- First, the Reserve Bank would find it difficult to determine which bank is risky and which banks are good banks. Sal kept on reiterating this. Just because one bank needs more money right now does not mean that that bank is the insolvent one. The bank that needs the most money is probably the one that has given out the most in loans, but those loans may be the best loans.
Second, why should the Reserve Bank give the depositors their money? It's not the Reserve Bank that owes these depositors; it's the risky bank in which the depositors put their money. Why should the Reserve Bank take on the risky bank's debt by paying the depositors?(1 vote)
13:50Video transcript
I've talked a lot about what
fractional reserve banking is, but I have kind of reserved
making any commentary on it, and that's what I'm actually
going to do in this video. So just as a bit of a review on
the whole banking playlist, I started off with a
very simple example of we're on an island. Let's say you had all of the
gold on an island and you give it to me for safekeeping. So now, I have this asset called
gold, and let's say it's 100 gold pieces
that you gave me. And I also have a liability. This is my primitive island
bank, and my liability is that you could demand this gold from
me whenever you want, so this is my liability. If I were to draw your
balance sheet, this would be your asset. So this would be an
IOU to depositor. So at any point in time, I've
told you, look, I have this nice safe, this vault there,
but you can come to me any time and take as much of
your gold as you want. And we, of course, know from the
fractional reserve banking playlist that there's a slight
discrepancy between what I told you, the depositor, and the
reality of the situation, because the first thing that I'm
going to do when you take this is, you know, I've taken
your deposits and I could charge you for keeping your
money with me, but I've come up with a slightly sneakier
scheme, where I say, hey, I've seen your behavior. You never withdraw more than 10
gold pieces out at a time. So what I do is I lend out all
but 10 of your gold pieces. So we end up with
the situation. I have an IOU to you of 100 gold
pieces like that, and I take the other 90 gold pieces
and I lend it out to random entrepreneurs on our island. So loan to A and that
is loan to B. And I think this is great,
because I obviously collect interest from these guys, and
assuming that these guys don't blow the money, I'll get all the
money back, so you'll get all your money back and I'll get
some interest, and I can say, hey, I'm keeping
your money for free. You get safekeeping, and I
collect the interest on it, and maybe that helps to fund
making the vault nice, and everyone's happy. But clearly here, there
is a discrepancy. What did I tell you? What did I tell you,
the depositor? I told you that you can
withdraw 100 gold pieces at any time. Now, what is the reality? The reality is you can withdraw
10 gold pieces at any time, and clearly, this is-- I
don't know if you want to call this a lie or not,
but this isn't completely true right here. And I know some of you might be
saying, hey, Sal, this is kind of a very primitive example
of gold pieces, but our current banking system
doesn't work quite like this. And just to make sure that you
understand that the analogy isn't completely off from our
current baking system, our current banking system is more
like this: You have 10 gold pieces that you give me. I'll draw it here. This is the modern
banking system. What you do is you give me a
deposit of 10 gold pieces like that, and so I say that,
yeah, sure, I owe you 10 gold pieces. So this is my IOU to you. Everything looks nice and clean
right now, but what I then do is then I issue checking
deposits to other people, and my limit on how many
checking deposits I can issue is based on the reserve
requirements and all of that. But let's say I have to keep
at least 10% reserves, just keep the math simple. So what I do in our modern
system is I make a loan to B like that and I gave B a
checking account that is equivalent to your
checking account. So this is an IOU to B. So this is essentially a promise
to B that, look, this is a checking account, and
any time you can come and get this much. Maybe this was 40, maybe
this is 50 gold pieces. This means that you can come
at any time and get 40 gold pieces from me. But we know the reality that
people actually don't actually get the gold pieces. In our modern system, we're not
even dealing with gold. This will be reserve currency,
but it's the same idea that people are getting money that
really isn't necessarily in the reserves. And, of course, I'm going to
make another loan to person A, and I'm just going to
create a checking account deposit for them. I'm just going to create an IOU
to A for 50, and the whole reason why this works is because
people use these checking account deposits
as a form of money. When I write you a check,
notice what's happening. I'm just transferring one of
these checking account deposits from me to you without
any gold or without any reserve currency actually
changing hands. So that's how it works. But if you look at these two
balance sheets, one is kind of the primitive example. On my island where I had 100
gold pieces and I lent out 90, I owe 100. I've told people, maybe it's
just one person, that hey, you can come to me at any time and
get your 100 gold pieces, but the reality is I've lent
all but 10 of it out to other people. Now what's the situation
in the modern? Well, I've told people that
there's 100 gold pieces that can come from me, right? 10 to the original depositor,
40 to this guy that I gave a loan to, and another 50 to that
guy, but the reality is that I only have 10 gold pieces
in my vault and my other assets are just
loans to people. So if you look at these two
balance sheets, you see that they are equivalent. I always like to start with this
one because this one at least makes more sense. If you were to just walk up to a
five-year-old and say, look, this is what fractional reserve
banking is, this one starts to seem even a little
bit even shadier, because you're creating these loans and
you're creating these IOUs out of thin air, but your end
result is that they're equally shady because they both
have the same resulting balance sheet. So your next question is, hey
Sal, what's wrong with this? And I could ask my son, once
he learns to talk, what's wrong with this is that there's
a discrepancy between what I told the depositor-- so
in this case, I told the depositor you can withdraw 100
gold pieces at any time, when the reality is they
can withdraw 10. Here, I'm telling the depositor,
you can take your money whenever, where the
reality in this modern system is that you can demand
whenever-- and I would throw an asterisk there-- as long as
no more than 10% ask for the money at the same time. Now, obviously, I think this
is-- everyone already becomes a little uncomfortable when
you say this, but you say, look, this is what our modern
financial system is based on and what this allows is this
guy, this bank, however you want to view it, is allowed to
be an intermediary between the savers, the people who are
giving their deposits, and the people who need to invest the
capital in building new projects and whatever else. And the counterargument to that
for someone who's against fractional banking is there's
nothing to stop you from doing this. All you have to do is tell
this guy the truth. What you do is, you do this
exact same scenario. You don't tell him you
can withdraw 100 gold pieces at any time. You tell him you can withdraw 10
gold pieces at any time and that maybe another 40 gold
pieces will be available whenever this guy is supposed to
pay back his loan, maybe in a year, and that the other 50
gold pieces would be available whenever this guy pays
his loan back. Maybe it's in two years. So the question is why
doesn't this happen? Well, the reality is because if
you told the depositor that they can't have all of their
money on demand, he'd say, OK, fine. One, assuming that you're giving
these guys-- these are legitimate people to give your
money to-- I want some of the interest that you're taking
because you're just lending out my money. If you were to lock up your
money for longer, people would want interest for this. But when the bank is allowed
to kind of tell this half-truth, they don't have to
give as much interest on it, because when people say, oh, I
can get my money whenever I want, they say, well, then I
don't need that much interest on it, because it's on demand. But the reality is they
can't get all of their money at any time. They can only get some
fraction of their money at any time. So the next thought might be,
OK, you're being a little bit disingenuous when you tell the
depositor that it's on demand and because you're being
disingenuous, you're allowed to kind of not give them as
much interest as you would have to give them if you told
them that their money is locked up, but what's wrong
as long as you are a good investor and that you put
this money to good use? Doesn't the whole
world benefit? And that might be true most of
the time, assuming everything I just told you, but imagine
a situation where we have multiple banks in
our universe. Let me draw my multiple banks. So this is bank one, I have bank
two, and then bank three. And bank one and bank
two are very honest and good investors. And we all know it's very hard
to know who's a good or a bad investor, especially when times
are good, because then most loans tend to
come out good. So they're good investors. But bank three takes
on extra risk. Let me write it down. And what's their incentive
for taking extra risk? Let's say that bank three is
willing to lend to people that banks one and two weren't
willing to lend to. So bank three's balance sheet
here, these loans, are going to be riskier loans. Now why would they do that? Because when you give it to
riskier people, you're able to take more interest from them. So they take extra risk, which
leads to extra interest. And actually, if you were to look at
these banks, you would say that this guy's the most
profitable bank. Even worse, because he's getting
extra interest, he can actually share more of that
extra interest with their depositors. So you can give higher yielding
checking accounts, I guess I could call it. Higher interest on deposits. So in this situation, the person
who's taking the most risk is going to be the most
profitable and they're going to give the higher interest
and that might actually attract the most deposits,
right? If all these guys look the same
to me, and we all know it's very hard to know what
banks are actually doing with their money, then I'll say,
hey, I'm going to give my money to this guy right
over there. But then what happens as
soon as things go bad? As soon as the world gets a
little bit of difficult, this extra risk actually starts
rearing its ugly head and then this guy becomes insolvent. So this guy's-- let me see if I
can draw his balance sheet. His balance sheet will look
something like that. He has a bunch of loans out. He's got some reserves right
there and then he's got a bunch of deposits that you or
I might have given him. These are our IOUs to us. These are his loans out. As soon as things start going
bad, some of these loans are going to go bad. As soon as one of those loans
go bad, I'm going to hear about it on the news, and I'm
going to run over to the bank, and I'm going to say, let me get
my money back as quickly as possible. And let's say I'm the first
one there and I get my money back. They promised it to me. So I withdraw my account right
there, and I get all my money back, and I essentially
deplete the reserves. Now the next guy's going
to come along. This guy was a little bit of
a slower runner than me. He comes to the bank, and he
says give me back my reserves. And the bank says there
are no reserves. And then this guy is mad. He has no reserves. And, of course, the whole time
this guy's assets are just becoming worthless because he's
loaned it to people who invested it badly. And so you have all of these
people-- when he finds out that this guy didn't get his
money, all of these people are going to go there and demand
their money and the bank is going to be insolvent. It's going to be two things. It's going to be illiquid
and insolvent. And I've explained the
difference, but illiquid might mean the loans might be good--
and actually I'll reiterate it in this video-- but the loans
might be good, it just doesn't have the cash. Insolvent means that these loans
aren't good, that the value of these loans aren't
equal to these deposits. So I'll say that this risky
bank is insolvent. Now, you might say these guys
right here deserve it. They guys deserve what they got
because they were greedy. They invested in this risky
bank that was doing shady things just to get a
little bit higher interest on their deposits. But what happens when
this happens? Well, you have these good banks
over here that maybe did really conservative lending. So this is what their balance
sheets-- maybe both of their balance sheets look like this. They have some reserves
right there. They've made out some good loans
to good entrepreneurs and then you have their
depositors. But as soon as this guy finds
out about what happened at that bank, he's like, things
are really bad. Let me just be careful and go
to my bank-- let's say it's this depositor right here-- and
take my money out and put it into my mattress. So he goes to the bank and
he's the first one there. He's the fastest runner of
all of the depositors. So he claims his deposit. So his deposit, he
withdraws, and he depletes all of the reserves. Now, he wasn't the only
guy who was afraid. This guy was afraid as well. So he comes running to the bank,
and the bank now says, gee, I know I made this promise
to you that you have an on-demand account, but that
guy you saw leaving the bank with the running shoes on, he
actually just took all of the reserves, and I guess I have
to admit now that I lied to you, that it isn't completely
on demand. I actually loaned out the
rest of your money. But I was a good banker. These are actually good loans. These loans are still worth
what they want. If you just wait long enough,
you'll get your money back. And, of course, this guy's
going to be not so happy because he was lied to. And that's not going
to be the only guy. Slightly slower runners are
going to come there and also demand their money. And this is known
as a bank run. Where because one maybe bad
apple in the system actually is insolvent, everyone becomes
afraid and comes and says, give me my money, and because
we have this fractional reserve system, the
money isn't there. It just will not be there
because 90% of it is lent out. And so once this happens there,
then you're going to have a run on bank two, and then
everyone is going to take their money out of the
banking system. So the whole banking system,
this situation right here where the assets maybe still
are worth the same or more than the liabilities, this guy's
still solvent, but he doesn't have any money to pay
these on-demand accounts, so this guy is running into
a liquidity problem. He doesn't have the reserves,
and that's why we have the whole Federal Reserve that's
a lender of last resort. This guy can walk to the Federal
Reserve and say, hey, I have some people knocking
on my door. Give me some loans. The Federal Reserve will lend
this guy some money, and, of course, then this guy's going
to have another lender to it called the Federal Reserve and
he can use this to pay off these guys. But that leaves another
question: How does the Federal Reserve really know the
difference between this guy-- he might say, OK,
this guy's good. Let me just lend to him to make
sure that he doesn't have a liquidity problem. How does the Federal Reserve
really know the difference between this guy and this
guy right here? This guy's going to also run
to the Federal Reserve. Hey, Federal Reserve, these
loans are still good. Just give me a loan so I can pay
these people right there. So the Federal Reserve says,
hey, you look good. You're a nice clean banker in a
nice, fancy building wearing a Rolex on your arm. You must be good for it. So the Federal Reserve will also
lend this guy, and now this guy also owes the Federal
Reserve some money. We can already see that in
this fractional reserve banking system, you have two
problems. You have an unstable equilibrium, where one bad apple
can lead to a run on the entire system. And I'll talk about what's been
engineered to fix this problem: essentially
banking insurance. I'll probably wait for that
to the next video. So this is the first
problem right here. And then the second problem is
that it really becomes hard to differentiate between the
good and bad banks. I mean, it's not so hard to
differentiate at face-- well, it is hard to differentiate at
first and becomes even harder to differentiate when you
always have the Federal Reserve willing to be a
lender of last resort. And when I talk about the
Federal Reserve insurance, that makes it even harder to
differentiate, and because it's harder to differentiate,
there's a huge incentive for banks to take on risk. Because when times are good,
they'll make more money than everyone else, and then when
times are bad, it's really hard, that they'll all
suffer equally. So in the video, I'll talk about
some of what has been engineered to fix these problems
and see if they actually make sense.