Bank balance sheets and fractional reserve banking | APⓇ Macroeconomics | Khan Academy

In this video, we're going to talk about balance sheets, and in particular, balance sheets for banks and a fractional reserve lending system. Now, it's not just banks that have balance sheets; all corporations have a balance sheet. You can even have your own individual balance sheet that is a snapshot of what you have of value and what you owe to other people.

Now, the things that you have of value, if we're talking about a bank, the things that the bank has of value, those are called assets, and that could be cash that the bank has in its vaults. It might be property that the bank owns, and the things that the bank owes to other people are liabilities. Why? This might be money that the bank owes to someone else, or some future obligation. Now, there's this other notion of equity, and when we're talking about a corporation like a bank, equity is what's left over if you take your assets and you subtract your liabilities. Equity is, you could view it as the net worth, how much net value is owned by the shareholders.

To make this tangible, you can look at an analogy to your everyday life. If you're thinking about your own personal balance sheet, let's say the only asset you owned was a car that was worth ten thousand dollars. A ten thousand dollar car, so that is your asset. And let's say that you only have one liability: you had to borrow eight thousand dollars in order to buy that ten thousand dollar car. So this is something that you owe to other folks, so that is your liability.

What would be your equity here? What would be your net worth? Well, if you own something worth ten thousand dollars, if all of your assets are ten thousand but you owe eight thousand, what you have left over, that's going to be two thousand dollars. This would be your equity. In everyday language, it is often times the net worth. So, assets minus liabilities is equal to equity. Or, if you add liabilities to both sides of that, you could say that assets are equal to liabilities plus equity.

When you see many balance sheets, it's typical to see it in two columns. On the left-hand side, you have assets, and on the right-hand side, you have liabilities plus equity. These two things should add up to the same amount. Whatever assets are, liabilities plus equity should add up to that same amount.

So now let's use this framework to start ourselves a bank. Let's say we immediately go and buy a building and some equipment worth a million dollars, just to even have a place to run the bank. So we immediately have assets of building plus equipment, totaling one million dollars. Now, I just said that whatever our total assets are, that would be our liabilities plus our equity.

So in this situation, what are our liabilities so far? Remember, the balance sheet gives us a snapshot at any moment in time. Well, so far, I don't owe anything to anyone; I'll just assume that I had that million dollars. I didn't have to borrow from anyone to get that million, so I have zero dollars in liabilities. What would the equity be? Pause the video and think about that.

Well, liabilities plus equity needs to be one million dollars. If liabilities is zero, then our equity is one million dollars. So if I'm the owner of the bank, this tells me that the value of what I own is one million dollars. But as we know, banks don't exist just to be a building; they take deposits from people and then make loans to people.

Let's say someone's walking down the street, and they see our bank and say, “Hey, that looks like a good place to deposit their money. It looks like a safe place; maybe they'll get some interest on it.” So they come and they give a million-dollar cash deposit. They have a suitcase with a million dollars of cash in it. So how would that be reflected on this balance sheet?

Well, it would actually get categorized as reserves. Reserves, you can view as the federal reserve notes, the cash that it has on hand. It could be money that's in its vaults; it could be an account that it has with the central bank, although that gets a little bit more sophisticated. But you should just visualize it as its cash. One way to simplify it is to note that, in this situation, your reserves are now going to be one million dollars. Where did that come from? It came from that suitcase of cash that that person gave.

Now, what happens on the right-hand side of this balance sheet? They didn't just give us the money; at some future point in time, they might withdraw some or all of that money. Our liabilities now, so we now have a demand deposit. Let me write it this way: demand deposit for one million dollars.

This is a good time to pause this video and really understand this because this is essential for understanding banks: yes, we got that cash, but it's offset by a liability because at some point in the future, we have to give that million dollars back to that person who made that deposit, and they can come on demand.

Now, you might be saying, “All right, this is all nice, but how am I as a bank going to make money?” The main way that banks make money is by making loans. But how do they loan out the money if all of this is on demand deposit? Well, in a fractional reserve system, you don't have to keep all of your demand deposits on hand as reserves.

You can actually lend out a good chunk of it, and it's dictated by what the required reserve ratios are. So let's say in the country we're in, or the jurisdiction we're in, the required reserve ratio is 10% of demand deposits. This means that we can look at whatever our demand deposits are; we have to keep ten percent of that in reserves, and then the excess reserves we can loan out.

So I can now group my reserves, and instead of saying a million dollars of just total reserves, I could sub categorize it as required reserves and excess reserves. Now, what do you think are going to be the required and excess reserves in this scenario? Pause this video and figure it out.

Well, required and excess are going to add up to my total million dollars of reserves. The required reserves are 10% of my demand deposits, so I have to keep 10% of this million dollars, which is one hundred thousand dollars, and then the rest is excess reserves of nine hundred thousand dollars.

So this model is based on the idea that statistically, especially if these demand deposits are coming from many different people, it's unlikely that more than 10% will be withdrawn at any moment in time. We can talk about runs on banks where this tends to break down, and so banks will then lend out this other 90% of the demand deposits or up to 90% of the demand deposits. They lend them out to people they think are likely to pay back the money with interest, and that interest is how banks make money.

So this bank could say, “Hey, I have nine hundred thousand dollars of excess reserves, which I can use to make loans to other people.” Let's say a bunch of people come by, and they have some good ideas, and we think that they're going to pay us back. So what we do is we can take those excess reserves—up to nine hundred thousand dollars of them—and instead of having it as excess reserves, we can put them out as loans.

So we can make loans of nine hundred thousand dollars. Now, one thing that might be counterintuitive to some of you is to say, “Wait, I'm used to a loan being something like a liability.” Here, we just said we owed people money, and so that was an obligation to other people. Why is it an asset here? Well, it depends: if you are the lender or the person borrowing the money. Here, as the bank, we are the lender. The loan is an asset because someone is going to pay us money back in the future. This has value.

If we owed money to someone else, well then that would be a liability. So now, notice here, the whole time that we were doing this, the assets were equal to the liabilities plus equity. Assets right now are two million dollars: one million plus one hundred thousand plus nine hundred thousand. And our liabilities plus equity are two million dollars: one million in liabilities, one million in equity.