Learn about Banking 8: Reserve Ratios Video

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Learn about Banking 8: Reserve Ratios

In the last video I gave the example of this bank that I keep using and in this example as supposed to giving the goal out to make loans and be used for projects and that gold get redeposit and then relent out. What we did in this example is that the bank every time it made a loan, it just made a loan and that created an asset and then it had a corresponding liability where the liability was either of checking accounts that the entrepreneur could use or bank notes which are essentially cash and then the entrepreneur could use to pay their laborers or to buy their land whatever they needed to do. So an obvious question was how much could the bank do it? When does this stop, can a bank just keep increasing the left and right hand sides of the balance sheet? And to answer this question, we’ll introduce the idea of a reserve ratio. So just to I guess a minute of review and just to make sure were clearly reading this balance sheet and let me label things a little bit more because sometimes I assumed too much. Remember these are the assets; the assets are all of these. All of these as the assets of this bank including its building. Well these are the liabilities over here. And the equity, whoever owns the bank whether stock holders or maybe it's owned by an individual maybe it's owned by me is what's left over. This is the equity, so the question is how much can the bank continue to issue out more loans and increase its assets and its liabilities? Remember every time that it issue a loan like for here right here, it issued a 100 gold piece equivalent to d. And instead of giving d a 100 gold pieces from say right here, it just created a checking account for d which later d paid to a and that’s why it's labeled a right here. And let me relabeled another thing because gold is different color. Just so you see the gold, this is all the goose of the gold part of the assets. That’s all gold and there’s 500 gold pieces. So let's introduce the concept of a reserve ratio. Reserve ratio, now let's think a little bit about what even reserve is. A reserve is something that you keep aside because you might need it one day. And in this situation, all of this liabilities whether they are this bank note outstanding in this example, or whether they are this checking accounts, this demand accounts; these are all liabilities that someone can come back to the bank on any given day and say “Hey, I want my gold now” for whatever reason maybe I'm leaving town, maybe I don’t trust the bank anymore; for whatever reason they just want to build to make some jewelry. For whatever reason that person wants the gold back, these are demand accounts, these checking accounts are demand accounts. And these notes are things that can be exchanged for gold at any point in time. We talked a little bit about this earlier when we started the whole banking discussion. But you have to leave aside a little bit of gold just in case someone wants their gold back. So this amount of the gold that you have leave aside as a reserve, relative to the total amount of demands you have on that gold, that’s the reserve ratio. So the reserve ratio and this situation, this world that we've created the reserve, the reserve store value is gold. Later on were going to get ourselves off of this gold system and then that reserve store of values is actually going to turn it into cash but for right now and I think it's easier actually to conceptualized gold. Let's stick with gold. The reserve ratio is, for this bank is the amount of gold assets, you won't see this formal definition anywhere because no one and most people are off the gold standard right now. But it's the amount of gold assets divided by total, I don’t want to say total liabilities because the bank could take out loans that aren’t demand loans; everything on the liabilities right now are on demand loads which means whoever has that liability can come back and exchange it for gold in any moment in time. But the bank could have told, taken just a regular loan. And the regular loan might not be on demand. The regular loan might be a loan that the bank doesn’t have to pay back for 10 years and in which case there's no reason why the bank would have to set aside some gold to pay that back. So let's make our definition not total liabilities but total demand to liabilities. Total demand liabilities, so what we've told demand liabilities that would be total bank notes in this case. And bank notes are also something will you know, will later leave a world where every bank is issuing bank notes but I just wanted to give you that kind of historical context how bank notes even started up. Total bank notes and demand accounts, demand or checking accounts. So let's see what it is for this bank that we have here. So our total gold assets are 500 and what are our total demand accounts, it’s a 100 plus a 100 plus a 100 plus 100, let's see; one, two, three, 400, 600 and I think this was another hundred and you have 700. So it equals, see the total demand liabilities I just figured out was 700, and the gold assets in this bank are 500. So right now the reserve ratio of this bank is pretty high, 5/7 so I don’t know what 5/7 is; 5/7 is, I don’t know seven goes into five how many times? I'm doing my mental math right, it's about 62%, seven goes into 50, and no, no, seven goes into 57 times. Seven times and looks like 71%. Seven times seven is 49, it’s 71%, so that’s reserved ratio. And what keeps banks from just keep issuing more assets and debts to expand its balance sheet is a reserve ratio requirement. So right now, in the United States although we’re not on the gold standard but you could imagine in this world, our bank regulators, might say that you're reserve ratio on demand account. So the amount of gold you have to set aside for checking accounts. So reserve requirement, they might say the reserve requirement is equal to, let's say they want to be safe. Let's say they want to make it 20%. And the US right now, and it’s 10% although the reserve commodity isn’t gold anymore. But let's say your reserve requirement is 20%, that means as long as in at any given moment in time, more than 20% of this people don’t demand their money back the bank is going to have liquidity. The banks is going to be able to fulfill it's promise because all of this people think at any given moment they can go into the bank and get their gold. And in order for this system to work, there has to be confidence and in order for there to be confidence, the bank has to be good for it every time someone asks for their money. So the bank has to stay liquid. So essentially this reserve ratio is what the regulators think that a bank needs to maintain in order to be liquid. Our bank as it is right now; it has a reserve ratio of71%, so as long as no more than 71% of this people. Because some of these loans it might be out for year or two. So as long as in that year or two that these loans are out, as long as no more than 71% of this people don’t come asking for their gold, we should be okay. If all of a sudden for whatever weird reason, I don’t know 80% of this people who have demand deposits or bank notes come and want to switch their money for gold. This bank is going to run out of gold and that’s a bank run. And there are a couple of reasons why that’s really bad. One is all of the sudden this, this demand deposit accounts, all of a sudden don’t seemed to be that great because you're not really getting your gold on demand. Because more people are asking for gold than there is gold and then the other problem is all of the sudden everyone will loose confidence in the system and everyone is going to think “Boy, this banks that have this nice volt looking buildings maybe they're not as safe as I thought”. So everyone is going to start pulling their money out and that’s called the bank run. So in this example, if I assumed that this loan is really worth 300 gold pieces and it's really going to be paid back and this loan right here is really worth a 100 gold pieces and it really will be paid back. This bank is solvent; it has more assets than it does liabilities. So if it has enough time, it will be able to pay back all of its liabilities. But if all of this people, all of the sudden come in and want not just 500 gold pieces, if they want if they want 600 gold pieces. They’re owed actually 700, so if they want 600 gold pieces, all of a sudden everyone is going to loose confidence in the system. This people probably, if they're not able to get that they're probably going to want all their money back, so then all of this liabilities are going to come due. And then maybe the bank is going to have to try to sell these assets, these loans to someone else or maybe try to collect from someone. But as you can imagine it's a big mess in the whole system that which it depend on confidence will just start to crumble. But anyway, the initial question is what is the limit to how much you can expand the asset and the liabilities side of the balance sheet, just by creating these loans and these deposit accounts; and that limit is driven by the reserve ratio whatever the regulators set. Anyway, I’ll see you in the next video.

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In the last video I gave the example of this bank that I keep using and in this example as supposed to giving the goal out to make loans and be used for projects and that gold get redeposit and then relent out. What we did in this example is that the bank every time it made a loan, it just made a loan and that created an asset and then it had a corresponding liability where the liability was either of checking accounts that the entrepreneur could use or bank notes which are essentially cash and then the entrepreneur could use to pay their laborers or to buy their land whatever they needed to do.

So an obvious question was how much could the bank do it? When does this stop, can a bank just keep increasing the left and right hand sides of the balance sheet? And to answer this question, we’ll introduce the idea of a reserve ratio. So just to I guess a minute of review and just to make sure were clearly reading this balance sheet and let me label things a little bit more because sometimes I assumed too much. Remember these are the assets; the assets are all of these. All of these as the assets of this bank including its building. Well these are the liabilities over here. And the equity, whoever owns the bank whether stock holders or maybe it's owned by an individual maybe it's owned by me is what's left over.

This is the equity, so the question is how much can the bank continue to issue out more loans and increase its assets and its liabilities? Remember every time that it issue a loan like for here right here, it issued a 100 gold piece equivalent to d. And instead of giving d a 100 gold pieces from say right here, it just created a checking account for d which later d paid to a and that’s why it's labeled a right here. And let me relabeled another thing because gold is different color. Just so you see the gold, this is all the goose of the gold part of the assets. That’s all gold and there’s 500 gold pieces.

So let's introduce the concept of a reserve ratio. Reserve ratio, now let's think a little bit about what even reserve is. A reserve is something that you keep aside because you might need it one day. And in this situation, all of this liabilities whether they are this bank note outstanding in this example, or whether they are this checking accounts, this demand accounts; these are all liabilities that someone can come back to the bank on any given day and say “Hey, I want my gold now” for whatever reason maybe I'm leaving town, maybe I don’t trust the bank anymore; for whatever reason they just want to build to make some jewelry. For whatever reason that person wants the gold back, these are demand accounts, these checking accounts are demand accounts. And these notes are things that can be exchanged for gold at any point in time.

We talked a little bit about this earlier when we started the whole banking discussion. But you have to leave aside a little bit of gold just in case someone wants their gold back. So this amount of the gold that you have leave aside as a reserve, relative to the total amount of demands you have on that gold, that’s the reserve ratio. So the reserve ratio and this situation, this world that we've created the reserve, the reserve store value is gold. Later on were going to get ourselves off of this gold system and then that reserve store of values is actually going to turn it into cash but for right now and I think it's easier actually to conceptualized gold. Let's stick with gold. The reserve ratio is, for this bank is the amount of gold assets, you won't see this formal definition anywhere because no one and most people are off the gold standard right now.

But it's the amount of gold assets divided by total, I don’t want to say total liabilities because the bank could take out loans that aren’t demand loans; everything on the liabilities right now are on demand loads which means whoever has that liability can come back and exchange it for gold in any moment in time. But the bank could have told, taken just a regular loan. And the regular loan might not be on demand. The regular loan might be a loan that the bank doesn’t have to pay back for 10 years and in which case there's no reason why the bank would have to set aside some gold to pay that back. So let's make our definition not total liabilities but total demand to liabilities.

Total demand liabilities, so what we've told demand liabilities that would be total bank notes in this case. And bank notes are also something will you know, will later leave a world where every bank is issuing bank notes but I just wanted to give you that kind of historical context how bank notes even started up. Total bank notes and demand accounts, demand or checking accounts. So let's see what it is for this bank that we have here. So our total gold assets are 500 and what are our total demand accounts, it’s a 100 plus a 100 plus a 100 plus 100, let's see; one, two, three, 400, 600 and I think this was another hundred and you have 700.

So it equals, see the total demand liabilities I just figured out was 700, and the gold assets in this bank are 500. So right now the reserve ratio of this bank is pretty high, 5/7 so I don’t know what 5/7 is; 5/7 is, I don’t know seven goes into five how many times? I'm doing my mental math right, it's about 62%, seven goes into 50, and no, no, seven goes into 57 times. Seven times and looks like 71%. Seven times seven is 49, it’s 71%, so that’s reserved ratio.

And what keeps banks from just keep issuing more assets and debts to expand its balance sheet is a reserve ratio requirement. So right now, in the United States although we’re not on the gold standard but you could imagine in this world, our bank regulators, might say that you're reserve ratio on demand account. So the amount of gold you have to set aside for checking accounts. So reserve requirement, they might say the reserve requirement is equal to, let's say they want to be safe. Let's say they want to make it 20%. And the US right now, and it’s 10% although the reserve commodity isn’t gold anymore.

But let's say your reserve requirement is 20%, that means as long as in at any given moment in time, more than 20% of this people don’t demand their money back the bank is going to have liquidity. The banks is going to be able to fulfill it's promise because all of this people think at any given moment they can go into the bank and get their gold. And in order for this system to work, there has to be confidence and in order for there to be confidence, the bank has to be good for it every time someone asks for their money. So the bank has to stay liquid. So essentially this reserve ratio is what the regulators think that a bank needs to maintain in order to be liquid.

Our bank as it is right now; it has a reserve ratio of71%, so as long as no more than 71% of this people. Because some of these loans it might be out for year or two. So as long as in that year or two that these loans are out, as long as no more than 71% of this people don’t come asking for their gold, we should be okay. If all of a sudden for whatever weird reason, I don’t know 80% of this people who have demand deposits or bank notes come and want to switch their money for gold. This bank is going to run out of gold and that’s a bank run. And there are a couple of reasons why that’s really bad. One is all of the sudden this, this demand deposit accounts, all of a sudden don’t seemed to be that great because you're not really getting your gold on demand. Because more people are asking for gold than there is gold and then the other problem is all of the sudden everyone will loose confidence in the system and everyone is going to think “Boy, this banks that have this nice volt looking buildings maybe they're not as safe as I thought”. So everyone is going to start pulling their money out and that’s called the bank run.

So in this example, if I assumed that this loan is really worth 300 gold pieces and it's really going to be paid back and this loan right here is really worth a 100 gold pieces and it really will be paid back. This bank is solvent; it has more assets than it does liabilities. So if it has enough time, it will be able to pay back all of its liabilities. But if all of this people, all of the sudden come in and want not just 500 gold pieces, if they want if they want 600 gold pieces. They’re owed actually 700, so if they want 600 gold pieces, all of a sudden everyone is going to loose confidence in the system. This people probably, if they're not able to get that they're probably going to want all their money back, so then all of this liabilities are going to come due.

And then maybe the bank is going to have to try to sell these assets, these loans to someone else or maybe try to collect from someone. But as you can imagine it's a big mess in the whole system that which it depend on confidence will just start to crumble. But anyway, the initial question is what is the limit to how much you can expand the asset and the liabilities side of the balance sheet, just by creating these loans and these deposit accounts; and that limit is driven by the reserve ratio whatever the regulators set. Anyway, I’ll see you in the next video.

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