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Simple fractional reserve accounting (part 2)

How banks can actually create checking accounts under a fractional reserve system. Created by Sal Khan.

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  • blobby green style avatar for user jdister1
    Ok, so say I'm Bill and I got the 40 million dollar loan from the bank. Maybe, I wanted this money start a business. I need to buy something like a building. So I purchase raw materials, hire people to work on it, and buy the plot of land. When I do this, I have to pay for the materials, workers and the land. If the bank that I got the loan from does not 'technically' have this 40 million dollars, how do I pay these workers? How do I pay home depot for the raw materials? How do I pay for the land? I get conceptually what Sal is saying, I'm just confused how this works in practice.
    (13 votes)
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    • starky ultimate style avatar for user Geoff Ball
      That money is numbers on a ledger. It exists in a legal sense and an accounting sense, just not a physical sense.

      You go to work and expect a salary in return. You pay your rent or mortgage. You buy groceries and clothing, and maybe go out to the movies. You go on vacations. You buy a car, and gas, and more gas.

      With all that "money" changing hands, how much actually changed hands? My guess is, not much. You probably saw very little actual cash along the way. Your employer paid you directly into your bank account or by cheque. You bought groceries with a debit card. You went on vacation with a credit card. You bought your car with a loan from the bank. Your house was paid by some other bank, which you repay once or twice a month (but not with cash—they just pull the funds right out of your account).

      It can be hard to grasp, and it's easy to speculate that if enough people just "realize" it, the whole system could fall apart. Fight Club even touched on it; the whole point of Project Mayhem was to blow up all the credit records so everyone could start over. If there's ever a World War III, maybe we'll go back to hoarding goods and the system will crash. Even then—in the worst case scenario—it won't take long to realize the importance of a currency to allow for specialization and increase efficiency. And then people will realize the need to store their money. Soon, these "banks" will realize that no one is ever coming for all their money all at once, so they can start investing some of it to earn higher profits. And so it begins...
      (39 votes)
  • leafers ultimate style avatar for user matt miller
    Deposits = 100 million
    Loans = 90 million
    Loans/Deposits = 90%

    Deposits = 10 million
    Loans = 90 million
    Loans/Deposits = 900%

    Why did bank-1 stop at 90m in loans? Wouldn't they rather earn interest on 900 million?
    (14 votes)
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  • male robot hal style avatar for user Eric
    At Sal says both are exactly the same but why could't bank 1 use the 100M in checking deposits as reserve and lend out 9 fold this amount. This would lead to total assets of 1.000 M
    (8 votes)
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    • leaf green style avatar for user Vito Corleone
      You are right Bank 1 can grow to 1 bn. assets ,and he never says they can't, but Sal is right they are exactly the same in terms of the end result, once they have reached the point where neither can lend out more without new deposits.

      Both end up with liabilities of £100m in demand deposits whereas they have only £10m in cash to back it up, so both came to the same destination but took totally different paths. Bank 1 lent out the physical cash it had from its depositors to make loans, whereas Bank 2 used the cash from the depositors as a base to increase the money supply, leverageing its returns.
      (8 votes)
  • orange juice squid orange style avatar for user David Gretzschel
    So, let's say we have a new central bank lending 10 million of a currency to a normal bank. How can the normal bank pay the interest, if it holds all the currency available? Or how can 100 banks with each 10 million of currency lent by the central bank pay back the interest if there is no base money available?
    (4 votes)
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    • mr pants teal style avatar for user Wrath Of Academy
      Ok, I think I understand the question now. If the central bank starts off by creating money, and then charges interest on lending all of it, the issue is how to avoid the central bank just reacquiring all the country's money, leaving nothing for the member banks.

      The original money supply is M0, which can be imagined as the total amount of paper dollars printed. But the member banks are able to increase the money supply to M1, M2 etc. Their member deposits are backed by real assets, such as factories or houses, and those assets can increase in value as people add on to their houses or build more factories. As the money supply expands, it becomes easier to pay back the central bank.
      (4 votes)
  • leaf green style avatar for user gabriellageorgette
    I don't understand why fractional reserve lending does not create an infinite amount of money. Can anyone explain this to me?
    (3 votes)
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    • hopper happy style avatar for user Juan Martin
      Because there is a limit and this limit is usually set by the central bank of a specific country so that they do not lend out more than what they have.
      At , what is limiting the banks is the reserve requirements, the ratio of checkable deposits against reserves is 10% (in this case). Keep in mind this varies according to the country and it's central bank policy.
      (3 votes)
  • leafers tree style avatar for user Bory
    I understand the concept of reserves, but if you take your loan and instead of paying a house or anything else you go to another bank (in another country per example) with the money loaned. Can the other bank use this money as reserve even if this money as to be return to the first bank ? if yes, can the second bank creates a new loan with leverage as well ?

    So, starting from 10m deposite, the bank loan 90m. If the people who has this loan takes it as cash and goes to the second bank and use this money as fresh deposit. The second bank can do a loan of 810m right ?
    (5 votes)
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  • primosaur seedling style avatar for user Liam
    OK so for countries without reserve limits (UK, Canada, Sweden) Wikipedia tells me:
    "This does not mean that banks can - even in theory - create money without limit. On the contrary: banks are constrained by capital requirements, which are arguably more important than reserve requirements even in countries that have reserve requirements."

    Can someone tell me what these "capital requirements" are, and why they stop banks from creating unlimited amounts of money when the central bank issues no reserve requirements?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      A capital requirement is a legal requirement that a bank has to keep its loan balances within certain limits determined by the amount of capital the bank has. Capital, roughly speaking, is the money that the bank's owners have put in as an investment. If the bank loses money on its loans, the loss comes out of the capital. The capital is a cushion that protects the depositors from losing their money even if the bank makes a lot of bad loans.
      (3 votes)
  • leaf blue style avatar for user Pi is the best
    When a bank is calculating their reverse requirements, are these requirements based off total assets or total liquid assets? From the example Sal gave in the video it makes it sound like it is based on total assets. For example, a bank owns several buildings worth 50 million dollars, does this mean it can issue loans based on the value of these buildings? Or do the loans need to be based on assets that are liquid in nature so they can meet demand deposits? If the loans are based on total assets of a bank such as buildings and computers, I find this scenario kind of frightening.
    (2 votes)
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    • ohnoes default style avatar for user Tejas
      It is based on their total demand deposits. Banks must keep at least 10% of their demand deposits as reserves. The reserve requirement doesn't care how many assets the bank has at all. If a bank has other assets that were not received as demand deposits, then they can loan out all of them. As for buildings, it could try and lend them out, if it wanted to.
      (3 votes)
  • orange juice squid orange style avatar for user JX Ang
    Hi all, after watching the videos, is it true if I say that:
    The bank can only loan out their assets. Considering the same amount of 10% reserve requirement ratio as in the video, the bank can only loan 90% of their deposits and securities & keep the rest as their reserves?
    Please help if you do have an idea how this reserve requirement works. Cheers. :)
    (2 votes)
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  • female robot grace style avatar for user Angela.Galileo
    How does this work in Australia where there are no reserve requirements, but there are capital requirements? http://en.wikipedia.org/wiki/Reserve_requirement
    (2 votes)
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    • aqualine ultimate style avatar for user SirReal14
      Reserve requirements arn't "the only thing" stopping banks from lending out unlimited money, they also have to think about long term viability. Banks require some reserves for day-to-day operations so as to not become insolvent when you want to buy something with your debit card. So in countries without reserve requirements, banks still hold reserves. Even in the Untied States, most banks hold more than they are required to, so as to mitigate risks.
      (3 votes)

Video transcript

Voiceover: In the last video, we saw how a bank would account for fractional reserve lending on its balance sheet, and we did it with kind of the conceptual understanding that we've been talking about fractional reserve lending the entire time. Someone deposits 100 million in reserves, and 90 million of it gets lent out. Of course, the offsetting liability is that person could come at any time and demand their money back. When that 90 million of currency is lent out, the asset that it's gotten in exchange for it is 90 million worth of IOUs. Now what I want to do in this video is to clarify that this is conceptually a good way of thinking about fractional reserve lending, but what the bank can actually do is slightly different than this. They can actually create, they can actually create the they can expand both the asset and the liability side of their account with just 10 million of reserves to make this exact same thing happen. One thing I do want to clarify. These videos, they are not an attempt to either justify fractional reserve lending or in some way indict fractional reserve lending. It's really just to show how it is accounted for. You can take that debate on your own side, whether you think it's worth doing or not, fractional reserve lending. Let's take the same example, but now let's take an example where so we're going to start the same way that we started in the previous video, where I go buy, I go buy $10 million worth of assets, which are essentially the building and things for my bank: The buildings, the ATM, the computer systems, all of that. I didn't take a loan to do it. Let's just say I had that money, so once again, I am the owner of this bank, and so I get 10 ... I have all of the assets are owned by me, so my owner's equity is $10 million, is $10 million. Now, in this example, instead of getting $100 million of deposits like we saw in the last one, let's say that person A shows up and gives us $10 million of deposits. So they come, and they deposit $10 million of currency, so $10 million of federal reserve notes. So write over there, $10 million, and they can demand, person A has a right to demand their $10 million. So this person, let's call them person B, person B is one-tenth as wealthy as person A, so this is person B. I'll just call it B's checking, B's checking account. Now, this is going to seem very unintuitive, what I'm about to do. Because a bank only has to keep of the amount of checkable deposits they have, only 10% of that has to be in reserves, and we saw that over here, instead of just only being able to lend this money over here, the bank could keep these reserves, but then automatically expand their checking, their checkable deposits. Let's say I go to this bank right over here, and I want a $50 million loan. They're going to say, "Okay, is he good for the $50 million loan? "Is he going to put it to good use? "Is he likely to pay?" Let's say they do decide that Sal is good for the money. what they can do, what they can do, they're going to lend me the money, but they don't even have $50 of currency to lend the money with. What they will do is that they will create a $50 million checking account for me. So they will create a $50 million checking account, so Sal's checking, Sal's checking account, and obviously, the bank isn't in the business of just giving away money. What they will do is they'll have an offsetting asset that they will get from Sal, which is an IOU from Sal. So let me write it this way. Loan to Sal would be an asset, because in the future, Sal's going to pay the bank. We could call this "Loan to Sal" or we could call this "IOU from Sal". Let's say that Bill comes along, I'm just making up names, let's say Bill comes along, and he wants to borrow another, let's say, $40 million, and the bank determines that it's a good investment, and so let me actually, this is a, just to make clear, this was a $50 million, this was a $50 million IOU from Sal, and this is, I have 50 million worth of, I guess I can write checks up to $50 million to go buy, this was a $50 million loan, so I can write checks against this now to go and build my business or whatever, or I could even take those checks, and I could cash them out, and of course the bank has to make sure it has enough reserves. It wouldn't want me to show up and try to cash out more than $10 million. If that started to happen, they would have to go and borrow reserves from either another bank or, as a last resort, from a central bank. But let's just continue this just to show that we can actually end up having identical balance sheets. Let's say another businessman, let's call him Bill, comes along, and let's say that he wants to borrow $40 million. So the exact same thing, the bank decides to do it, so what they will do is they will lend Bill $40 million, but once again, they don't have that much in reserves. They will essentially create a checking account for Bill. So, Bill's $40-million checking account, and of course they don't want to just hand him the money, there's going to be an offsetting asset they get from Bill, which is essentially a 40-million IOU, IOU from Bill. Now you might say, well, can't the bank just keep doing this? Just creating, keep getting more and more IOUs, keep, kind of, creating money because these checking accounts really are money. You're money-creating. These people can now write checks against the bank's ability to cash those checks, and the answer is what's limiting this bank right over here is the reserve requirements. The bank can only, the ratio of checkable deposits to reserves can only be 10 to 1, or reserves have to be at least, and this varies from country to country, and this can change, depending on the policies of the federal reserve, and that's one way they have of controlling money, although that's not the most typical way. They have a reserve requirement here. You have a 10%. So, 10% of checkable deposits, and this is true for large banks in the US, have to be held as reserves. There has to be reserves for, reserves for, 10% of checkable deposits. That's what essentially keeps these banks from doing this forever. Now, this bank is all tapped out. It's limited by the amount of loans it has by its reserves. I know it looks a little bit, it looks a little bit suspect, that they were able to essentially create these checking accounts out of scratch, and only have, they're essentially telling people, "Look, there's 100 million that you can have "on demand now to do whatever you need," when they only have 10 million in reserves to back that up. The rest of their assets are IOUs from people, but this is exactly what's happening with the other conceptual version. I guess the more traditional conceptual reserve, the more traditional conceptual understanding of fractional reserve lending. You're telling someone that they have 100 million on demand, but you're loaning 90 million of it out. What they really have, truly in the vault, is $10 million. So these two things, these two things, are actually functionally, these two things are completely equivalent, and if you have a problem with one of these, if you feel like just money is being created by the bank, it's actually happening in both cases. In that case, you would be having trouble with fractional reserve lending, not just this idea right over here.