ShmoopTube

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macro economics La shmoop banks or uh thank you very

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much Okay When a bank takes your money it reserves

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some and it uses the rest toe by financial assets

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Okay So what does all this mean while aren't reserves

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what you spread on toast No actually reserving assets means

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that the bank will take some percentage of the 10

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grand gift you just got from Grandmama and the bank

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will loan out the rest Essentially banks multiply their financial

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returns to shareholders who owned them They loan out their

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deposits think money for shareholders and it's likely you're one

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of them Will banks decide to carry highly varying levels

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of risk and they then get varying levels of return

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Conservative Bank of America might cap the maximum of which

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they loan it only three times their collateral So if

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they have $100,000,000 in equity or cash just sitting around

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in the bank vault that you know bank robbers used

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to rob that kind of fall then they might loan

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up to $300,000,000 Well if they make a 4% spread

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on that loan while then they can reliably expect to

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have $12,000,000 in pretty safe loan revenues Well if riverboat

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gambling Bank of the West lives at the opposite end

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of the risk spectrum it also has 100,000,000 inequity But

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it will loan upto 12 times that number in collateral

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So that bank may loan upto one point $2,000,000,000 at

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the same 4% spread meaning it cost them 2% to

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get 6% for people They loan it D'oh Well they'd

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expect $48,000,000 in revenues from their loans assuming nothing goes

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wrong You think about that A moment The same collateral

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base at the bank 100,000,000 for both B of A

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and for riverboat gambler And that $100,000,000 gets B of

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A on ly 12,000,000 in revenues while 48,000,000 goes to

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riverboat So yeah you could make a lot of money

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in the banking business if you're smarter and or lucky

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So all this sad note that if a relatively small

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handful of lone takers ah default Well then riverboat gambling

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bank is uh you know swimming with the fishes So

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how does this spread thing work Well like a bank

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might have Ah 10% reserve requirement So think about how

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that affects Grandmama's $10,000 deposit Well the bank keeps a

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grand of it in their vault or more likely in

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safe steady secure US government Very liquid paper you know

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like T bills stuff like that That's a grand out

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of Grandma's 10 grand And they find a home at

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much higher rent than the T bill collections from Uncle

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Sam for the remaining nine grand like let's say this

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guy Joe Bob Billy who never graduated high school really

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wants that 600 horsepower truck with thehe trailer hitch thing

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and will happily pay 12% interest on the loan while

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the bank then makes money in paying grandmama 1% on

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her savings account dough and loaning money to Joe Bob

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Billy A 12% note that the 11% spread on this

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highly risky alone while they're right there on the 10

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grand in the bank Well that's worth 1100 bucks a

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year in kind of easy money or at least revenues

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from the loan using Grandmama's money If the loan works

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and the guy keeps paying off his truck while the

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bank pockets all that money with not much more than

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an envelope a stamp and an accountant Just checking the

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numbers You might ask Why didn't Grandmama just directly loan

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her money to Joe Bob Billy Well she could have

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but Grandmama is not in the business of loaning money

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So Joe Bob Billy didn't know to contact her And

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in all reality Joe by Billy is way too high

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of a risk for credit for grandmama to risk him

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crashing into a tree and you know defaulting So that's

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the structure of a bank Loans the spread What about

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the logistics How does that bank keep track of all

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this money and moving around Well they have to match

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the money that comes in and the money that goes

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out since they should in theory be you know equal

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keeping track of this money is made easier with use

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of a T account It gets its name from this

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T shape the chart thinking that's what they look like

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where they're liabilities a k What comes in on one

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side of the tea than they have assets A k

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What goes out on the other side Right All right

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we're on the right side banks right down their liabilities

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which usually our demand deposits from bank goers like banks

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are responsible or liable for this money since customers deposited

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with the trust that they can get it returned back

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to them lickety split on the other side of the

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T account the bank writes their assets this Khun B

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required or excess reserves of cash stored in their vaults

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Or it could be financial assets like bonds from the

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U S Government or China or just some kind of

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lone Well the important thing to remember is that any

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changes toe one side of the team must match the

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other side Let's take a look at the bank up

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shmoop Well It has $10,000,000 in demand deposits which it

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records his liabilities and the required reserves is 10% Note

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that a demand deposit is dough that a customer can

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demand be paid back to them more less at any

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moment or within a few days Notice And it's why

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you get lower interest rate on like a checking account

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where you get your money immediately It's versus a savings

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account where you have to give like six months notice

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If you're going to take money out So one more

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time just for those in the cheap seats Let's walk

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through some math here Banker shmoop is required to have

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at least 10% that's demand deposit stored in cash in

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his vault Since it has $10,000,000 in demand deposit It

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stores at the very least 1,000,000 bucks in cash as

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reserve requirements But what does B O S do with

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remaining 9,000,000 well in might store some of it in

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its vault to be extra cautious as excess reserves like

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it could be Mork conservative than it legally has to

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be Or it could use that money to invest in

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some financial assets like Bill West could convert the $9,000,000

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into gold coins and swim in them like Scrooge McDuck

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We love doing that which might be fun but not

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the most financially savvy decision to make how Khun B

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O S used that money more intelligently to make more

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cash for its shareholders Well they could buy debt assets

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even risky ones that pay high interest and they could

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earn revenue on their money instead of letting it just

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sitting evolved doing a whole lot of nothing One option

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is to buy bonds from the U S Government Right

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Investors presume the USG is trustworthy at least in terms

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of paying back the money In fact the reliance on

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the U S Government financial promises arguably the best asset

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America has I even trust And it's based financially not

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on what the government owned today but rather on its

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ability to tax future revenues or assets of its citizens

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Since we're almost guaranteed to get our money back from

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a government bond was the U S Government one There

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is low risk and understandably low reward like the interest

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rates are low Okay well higher up the risk ladder

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Live consumer loans The credit of Jerry the gambling plumber

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is a lot riskier than the credit of Uncle Sam

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Of course banks check credit scores and review loan recipients

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to determine whether they're likely to pay back the money

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or not But you know failures happen all the time

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Note that with the extra risk banks charge higher interest

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rates for the money they're loaning to the General Jerry's

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of the world Instead of the 3% market rates on

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US government bonds well banks charge Geri more like 556

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and nine maybe 15% interest rates on loans to him

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depending on the investing climate and how well or poorly

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Jerry checks out on paper is a risk Okay so

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with our $9,000,000 in excess reserves at the bank shmoop

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let's say we've loan out 8,000,000 The excess reserves tab

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on Artie account turns into $1,000,000 we add a new

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loan section to our assets with 8,000,000 bucks right there

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Well as this money gets paid back with interest we

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get our money and then some So that's a look

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at just one banks operations and accounts that $8,000,000 doesn't

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flowed into the ether It gets invested in the capital

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and eventually makes its way back to the bank Might

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be a different bank or some of it could find

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its way back to our very own Bank of shmoop

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Banks sell loans to each other all the time Doesn't

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matter which bank it's in It just matters that the

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banks all over we'll see some of that 8,000,000 bucks

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store Some of it is required reserve and then alone

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the rest out again or at least a portion of

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the rest Well initially there was $10,000,000 in the economy

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The deposit tour always owned that $10,000,000 They just gave

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it to the bank shmoop to hold for a bit

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But when the boson loaned out that $8,000,000 Vivian's of

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the 8,000,000 bucks get that money to spend into the

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economy that means the total money supply just increased by

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8,000,000 bucks They were getting to the multiplier Well This

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system of saving a fraction of demand deposits as required

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reserves and then loaning the rest out is called fractional

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Reserve banking And it allows the money supply of the

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nation in the world to multiply with each deposit to

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a bank Well that $8,000,000 that got loaned out isn't

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stagnant Remember it gets re deposited and re loaned again

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and again and again If banks were alone out all

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of their excess reserves and all of the loan money

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got re deposited in Bank 12 the money supply would

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be multiplied by one over the reserve requirement right There's

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a minimum reserve banks have to keep Well you can

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get to that multiplier using some fancy calculus and infinite

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Siri's But the end result is that the greater portion

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of a deposit that a bank can loan out the

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bigger the multiplier in the bigger the change in the

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money supply So if the reserve requirements 10% while the

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money supply gets multiplied by a factor of 10 if

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the reserve requirements 5% than its 20 and if the

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reserve requirements 50% well then it's only multiplied by two

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Well since the Fed controls the reserve requirement they can

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control the scaling factor of banks in this country The

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Maur the Fed requires in reserves the less money or

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money supplied gets multiplied The more the Fed allows to

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be loaned out the Mohr money gets supplied to the

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world right We get mohr liquid the lower the reserve

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will harm it is But that scaling factor is on

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ly an upper bound Not all the money immediately makes

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it back into the bank The multiplication effect of fractional

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reserve banking depends on the idea that the money that

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gets loaned out gets re deposited and real owned in

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a cycle Theoretically all the money that goes out comes

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back in But we don't live in the perfect ideal

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theoretical land that many economists livin We live in the

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harsh world of reality where well some cash gets stuffed

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into couch is eaten by dogs or well it just

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takes its sweet time to get Rita positive Well these

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leaks in the cycle make the rial scaling factor last

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than this theoretical won over the reserve requirement Oh and

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by the way if you have a leak in this

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cycle well you might want to swing into a gas

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station for some inexpensively price toe hot air or you

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could just swing by DC and being out of Congress

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