Learn about Banking 11: A reserve bank Video

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Learn about Banking 11: A reserve bank

Learn about Banking 11: A Reserve Bank Everything we’ve covered so far dealt in a world of only one bank and we all know that there are more than one banks in this world. So let’s see what happens in that example. So I’ve drawn the balance sheets for three hypothetical banks in the world where gold is the reserve currency and let’s see what happens in that world. So let me just show you all of that—so that’s the first one and that’s the last one—they didn’t all fit on the screen. But just so you understand in a better review what we’ve covered in the last several videos. In these balance sheets of course the left side are the assets, the right hand side up until here is the liability so from here to here, that’s liabilities and what’s left over is the equity. So in every balance sheet, just to be consistent I made this blue color is equal to the equity. Let me write that down. The blue color is the equity in every one of these banks and just to be consistent I made this little orange color the building, brown for building and this yellow or this gold color that’s actually the gold reserves of that bank. And each of these lines, these divide the various other assets of the bank, in this case they’re just loans maybe to different entrepreneurs and then this green line separates the different demand deposits or checking accounts that are with that bank and then the green, this filled in green for example in this middle bank that shows its note outstanding. Remember there are two ways that you can essentially give someone kind of an IOU from this bank. One is to say “Oh, you have a checking account and you can write checks accounts so the other way is to issue this bank note and someone can come back later with this bank note and you should have to give them an equivalent amount of gold. So in this middle bank, this green area that shows its bank note outstanding, this purple area in this bank that’s its bank note outstanding and then down here, this off white color is its bank note outstanding, fair enough. We’ve created a world with three banks. Now, what is the problem here or are there any problems? So there are couples that I see immediately. The first is all of them might have different reserve ratios. In the last video I kind of talk about the world with regulation but let’s say in this world since every bank is kind of its separate entrepreneur and maybe was originally the goldsmiths they all just made their own rule of thumb that if I have this amount of demand deposits based on how my customers act or whatever or based on my liabilities or however it works. I’m going to keep this amount of gold. So maybe these guys reserve ratio, I don’t know what the ratio this is but maybe his reserve ratio is 8% so for every 100 gold pieces of demand deposits and bank notes he keeps 8 gold pieces on reserve. Maybe this guy is 10%, it looks a little better. Maybe this guy up here is keeping a 12% reserve ratio. So there’s no consistent reserve ratio, let me write that down reserve ratio is inconsistent, ratio is not equal. There’s a couple of things that that might lead to. Maybe this guy right here as he was the first bank to start or maybe this guy has 12% reserve ratio and people really trusted it for a long time every time they deposited money and then they come back later. They were able to find it. He really lent money really well so that there was never any scare on this bank. No one ever felt afraid to keep their deposit there. But as the banking business got more and more profitable, more and more risky people showed up and this guy only has an 8% reserve ratio. And maybe, one day 9% of their checking accounts want their money back and this guy is not good for it. This guy up here, the 12% guy, he knew that 9% could happen that on any given day 9% of your demand deposits might want the gold back so that’s why he kept to 12%. But this guy kept an 8% so he could get an extra interest on more loans. So one day, he can’t give his gold back and that scares everyone. So everyone comes and he never run on this bank but it’s not the only bank, everyone starts having less trust in the banking systems as a whole and so there are runs on all of these banks and that’s unfortunate for two reasons. One, these guys were safe to begin with. They kept enough reserve ratios so that people could get their gold and then the other sad thing about it is if this guy just needed another 1% of gold he could have borrowed it from the top guy and then you have prevented this whole banking crisis. You could have borrowed it from either this guy or that guy. If this guy has gold just to plead and more people still want money, this guy would clearly rather borrow it to lend the money to this guy as long as he’s still solvent than have a systemic run on all banks. Bank runs affect everyone. So on this world that we’re dealing with right now just one weak link in the chain can break the whole chain. If you just have one irresponsible bank it will create a bank run on all of them even though some of the more capital rich banks could have led to the other ones. And then finally I did this here and this is a situation that we’re not familiar with today but it’s a situation that happened many times in history. It happened in the colonies before we had our independence and if you had a bunch of different banks each issuing their own bank note as a form of currency. So this one up here issues the purple bill, this bank here issues a green bill and this bank here issues us off-white bill. Besides the confusion you’re always going to have all of these exchange rates difference and say, “Sir, you don’t know ahead of time this guy is the riskiest bank so maybe his bills should be worth a little bit less than this guy up here.” It really just becomes a big mess to the economy for someone in a cash register to keep track off. In this case, I only have three banks. Well, imagine if all 13 colonies each had their own banks. They were each issuing their bank note and you always have to translate between them and then one bank default and their bank notes are worth nothing and you have to worry about that so you have another problem, inconsistent paper currency and I think you know where I’m going with this. So what’s the solution to all of this? Or what if there are ways. One and I guess you could do this without any extra institutions, you could just regulate reserve ratio. So that’s easy to do. That’s just government intervention. Just say, if you want to be a bank in our world you have to keep at least 10% reserve ratios. But we have to think about who regulates that and who sets that reserve ratio but it’s fair enough that we need someone to regulate it, we don’t need to separate institution. But how could we do this mechanism where we can prevent bank runs especially when there’s money to lend from one bank to the other. And if we could use a mechanism that prevents this and provides the consistent currency then we’re all set. Well, the only you could provide a consistent currency is if you only had one bank issuing currency. So let’s call that bank a reserve bank. Let me draw balance sheet, maybe I should just copy and paste one of this, this is what happens. So let’s say these three banks get together, all the banks in this world get together so let’s start a new institution where we all keep our gold reserves there. So what happens is this guy, this guy and this guy they all keep their gold reserves at this Central Bank. Let me ask to put more gold reserves in this Central Bank so let me draw it out. So this guy’s gold reserves then this middle guy’s gold reserves and this third guy’s gold reserves, I’ll go there. And now, with these guys instead of having gold reserves here, what do they have? They have checking accounts. They have checking accounts with the reserve bank. So now these all become checking accounts with the reserve bank. So that’s a checking account with the reserve bank. So that’s the balance sheet that are reserve bank now has. Now, what does this do? Well, it definitely solves that bank run problem because now in this world and of course we’re regulating it now and I kind of threw it out there because this guy will be the regulator, the Central Bank will be the regulator. But what you could say now is for some reason let’s say 11% of this demand deposits come to 11% of these people want their money all of a sudden. This guy just asked to go to his reserve bank account and he can borrow from one of the other player. The gold is centrally in one place. Now, the notes issue. How do we solve that? Well, what if by government law, from now on only one bank can issue bank notes and that’s the Central Bank. So maybe this, let’s say this middle guy instead of having just a checking account maybe he took half of it as a checking account and half of his gold deposits he gets in this bank notes of this reserve bank. So now, this turn to bank notes of the reserve bank and these bank notes of the reserve bank are the only currency that is allowable. So we’ve already solved two problems. We’ve solved that inconsistent currency and now think about what starts to happen. The reserves that these banks no longer become gold. The reserves that the banks that people actually interact with now become these bank notes. The bank notes of this central reserve bank and this gold is just sitting in some big vault some place in this world right now. I know it’s a little bit disjointed so reserve ratios. Now you have a Central banking authority where they all chipped in a little bit of money created this big vault and this Central Bank dictates reserve ratios. It prevents bank runs because if for whatever reason let’s say someday all of these banks customers get scared and want their gold bank, this bank can just go to its checking account and borrow gold from the other banks and it will get transferred to it. But if you think about it in a world where people get used to enough of this one Central Bank note then people probably won’t even want that gold back. They’ll probably start viewing this one currency as the equivalent of gold. So when people actually want their money back, they don’t even have to give gold but they can just give bank notes. But there’s this one consistent bank note now from this Central Reserve Bank. Anyway, I think I said the word central and reserve too much. But I will see you in the next video. Hopefully it wasn’t too complicated and I think you see where this is going. We’ll slowly extend this to getting off the gold standard and how this relates to the Federal Reserve or Central Bank as we know them today. See you soon.

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Learn about Banking 11: A Reserve Bank

Everything we’ve covered so far dealt in a world of only one bank and we all know that there are more than one banks in this world. So let’s see what happens in that example. So I’ve drawn the balance sheets for three hypothetical banks in the world where gold is the reserve currency and let’s see what happens in that world. So let me just show you all of that—so that’s the first one and that’s the last one—they didn’t all fit on the screen. But just so you understand in a better review what we’ve covered in the last several videos. In these balance sheets of course the left side are the assets, the right hand side up until here is the liability so from here to here, that’s liabilities and what’s left over is the equity. So in every balance sheet, just to be consistent I made this blue color is equal to the equity. Let me write that down. The blue color is the equity in every one of these banks and just to be consistent I made this little orange color the building, brown for building and this yellow or this gold color that’s actually the gold reserves of that bank.

And each of these lines, these divide the various other assets of the bank, in this case they’re just loans maybe to different entrepreneurs and then this green line separates the different demand deposits or checking accounts that are with that bank and then the green, this filled in green for example in this middle bank that shows its note outstanding. Remember there are two ways that you can essentially give someone kind of an IOU from this bank. One is to say “Oh, you have a checking account and you can write checks accounts so the other way is to issue this bank note and someone can come back later with this bank note and you should have to give them an equivalent amount of gold. So in this middle bank, this green area that shows its bank note outstanding, this purple area in this bank that’s its bank note outstanding and then down here, this off white color is its bank note outstanding, fair enough. We’ve created a world with three banks.

Now, what is the problem here or are there any problems? So there are couples that I see immediately. The first is all of them might have different reserve ratios. In the last video I kind of talk about the world with regulation but let’s say in this world since every bank is kind of its separate entrepreneur and maybe was originally the goldsmiths they all just made their own rule of thumb that if I have this amount of demand deposits based on how my customers act or whatever or based on my liabilities or however it works. I’m going to keep this amount of gold. So maybe these guys reserve ratio, I don’t know what the ratio this is but maybe his reserve ratio is 8% so for every 100 gold pieces of demand deposits and bank notes he keeps 8 gold pieces on reserve. Maybe this guy is 10%, it looks a little better. Maybe this guy up here is keeping a 12% reserve ratio. So there’s no consistent reserve ratio, let me write that down reserve ratio is inconsistent, ratio is not equal.

There’s a couple of things that that might lead to. Maybe this guy right here as he was the first bank to start or maybe this guy has 12% reserve ratio and people really trusted it for a long time every time they deposited money and then they come back later. They were able to find it. He really lent money really well so that there was never any scare on this bank. No one ever felt afraid to keep their deposit there. But as the banking business got more and more profitable, more and more risky people showed up and this guy only has an 8% reserve ratio. And maybe, one day 9% of their checking accounts want their money back and this guy is not good for it. This guy up here, the 12% guy, he knew that 9% could happen that on any given day 9% of your demand deposits might want the gold back so that’s why he kept to 12%. But this guy kept an 8% so he could get an extra interest on more loans. So one day, he can’t give his gold back and that scares everyone. So everyone comes and he never run on this bank but it’s not the only bank, everyone starts having less trust in the banking systems as a whole and so there are runs on all of these banks and that’s unfortunate for two reasons.

One, these guys were safe to begin with. They kept enough reserve ratios so that people could get their gold and then the other sad thing about it is if this guy just needed another 1% of gold he could have borrowed it from the top guy and then you have prevented this whole banking crisis. You could have borrowed it from either this guy or that guy. If this guy has gold just to plead and more people still want money, this guy would clearly rather borrow it to lend the money to this guy as long as he’s still solvent than have a systemic run on all banks. Bank runs affect everyone.

So on this world that we’re dealing with right now just one weak link in the chain can break the whole chain. If you just have one irresponsible bank it will create a bank run on all of them even though some of the more capital rich banks could have led to the other ones. And then finally I did this here and this is a situation that we’re not familiar with today but it’s a situation that happened many times in history. It happened in the colonies before we had our independence and if you had a bunch of different banks each issuing their own bank note as a form of currency. So this one up here issues the purple bill, this bank here issues a green bill and this bank here issues us off-white bill.

Besides the confusion you’re always going to have all of these exchange rates difference and say, “Sir, you don’t know ahead of time this guy is the riskiest bank so maybe his bills should be worth a little bit less than this guy up here.” It really just becomes a big mess to the economy for someone in a cash register to keep track off. In this case, I only have three banks. Well, imagine if all 13 colonies each had their own banks. They were each issuing their bank note and you always have to translate between them and then one bank default and their bank notes are worth nothing and you have to worry about that so you have another problem, inconsistent paper currency and I think you know where I’m going with this.

So what’s the solution to all of this? Or what if there are ways. One and I guess you could do this without any extra institutions, you could just regulate reserve ratio. So that’s easy to do. That’s just government intervention. Just say, if you want to be a bank in our world you have to keep at least 10% reserve ratios. But we have to think about who regulates that and who sets that reserve ratio but it’s fair enough that we need someone to regulate it, we don’t need to separate institution. But how could we do this mechanism where we can prevent bank runs especially when there’s money to lend from one bank to the other. And if we could use a mechanism that prevents this and provides the consistent currency then we’re all set.

Well, the only you could provide a consistent currency is if you only had one bank issuing currency. So let’s call that bank a reserve bank. Let me draw balance sheet, maybe I should just copy and paste one of this, this is what happens. So let’s say these three banks get together, all the banks in this world get together so let’s start a new institution where we all keep our gold reserves there. So what happens is this guy, this guy and this guy they all keep their gold reserves at this Central Bank. Let me ask to put more gold reserves in this Central Bank so let me draw it out. So this guy’s gold reserves then this middle guy’s gold reserves and this third guy’s gold reserves, I’ll go there.

And now, with these guys instead of having gold reserves here, what do they have? They have checking accounts. They have checking accounts with the reserve bank. So now these all become checking accounts with the reserve bank. So that’s a checking account with the reserve bank. So that’s the balance sheet that are reserve bank now has. Now, what does this do? Well, it definitely solves that bank run problem because now in this world and of course we’re regulating it now and I kind of threw it out there because this guy will be the regulator, the Central Bank will be the regulator. But what you could say now is for some reason let’s say 11% of this demand deposits come to 11% of these people want their money all of a sudden. This guy just asked to go to his reserve bank account and he can borrow from one of the other player. The gold is centrally in one place.

Now, the notes issue. How do we solve that? Well, what if by government law, from now on only one bank can issue bank notes and that’s the Central Bank. So maybe this, let’s say this middle guy instead of having just a checking account maybe he took half of it as a checking account and half of his gold deposits he gets in this bank notes of this reserve bank. So now, this turn to bank notes of the reserve bank and these bank notes of the reserve bank are the only currency that is allowable. So we’ve already solved two problems. We’ve solved that inconsistent currency and now think about what starts to happen. The reserves that these banks no longer become gold. The reserves that the banks that people actually interact with now become these bank notes. The bank notes of this central reserve bank and this gold is just sitting in some big vault some place in this world right now.

I know it’s a little bit disjointed so reserve ratios. Now you have a Central banking authority where they all chipped in a little bit of money created this big vault and this Central Bank dictates reserve ratios. It prevents bank runs because if for whatever reason let’s say someday all of these banks customers get scared and want their gold bank, this bank can just go to its checking account and borrow gold from the other banks and it will get transferred to it.

But if you think about it in a world where people get used to enough of this one Central Bank note then people probably won’t even want that gold back. They’ll probably start viewing this one currency as the equivalent of gold. So when people actually want their money back, they don’t even have to give gold but they can just give bank notes. But there’s this one consistent bank note now from this Central Reserve Bank. Anyway, I think I said the word central and reserve too much. But I will see you in the next video. Hopefully it wasn’t too complicated and I think you see where this is going. We’ll slowly extend this to getting off the gold standard and how this relates to the Federal Reserve or Central Bank as we know them today. See you soon.

Transcription by: Scribe4you Transcription Services