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
And then I have checking accounts for these people who
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.
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
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.