Khan Academy Presents: Introduction to how banks make money and the value they (potentially) add to society.
Learn about Banking 1 Let’s learn a little bit about just how a plain vanilla bank works. So let’s say that an entrepreneur and I see a problem out there in the world. You have all these hard working people, whatever they do, doctors, lawyers, engineers, construction workers whatever they might do, they work, they provide services to each other and they have savings. So they’re--right now they’re just--whatever they’re putting on—they burying there in their backyards, so savings. And there’s collecting there that quote and quote, “money is doing nothing.” They’ve provided some goods and vices to someone else, those people gave them something whether it’s gold or a green piece of paper that essentially says this gold or this green piece of paper entitles you to some future goods and services. And those people said, that’s a useful thing that I have, let me just put it into my mattress, so whatever. The world, there’s this pull of savings and let’s say there’s this other pull of entrepreneurs and they have a bunch of really good ideas for projects. They’re like, you know what? If I could just get—let me put this here, projects or investments. So let’s say that there are some other entrepreneur and he says, boy, you know what? I have no claims on any goods and resources but I have an idea. I have an idea that if I could I get a bunch of people to dig canals to the crops that will be able to grow more crops and grow out through out the year and we’ll all be richer because we’ll all have more food and that’s a true goods and service in its best sense. But how am I going to get these people to build this ditch for me I mean I could maybe promise them in the future that once all of this is done I can do something even more food but that’s not the way it works, no one’s willing to work for me unless they can feel very secure that they’re going to get something in return. So we have an interesting problem here. You have a bunch of people who’ve already provided goods and services to the world and the world has given them trinkets whether it’s gold, coins or paper money, let’s just say it’s gold. And I want to make this point because everyone always talks about gold if it’s something special as if it really represents wealth, well, paper money really doesn’t represent wealth. And there’s nothing about gold. Gold is not useful other than the fact that it is pretty. That’s the only thing that makes gold—actually it’s pretty and it’s hard to counterfeit. Paper money, not so pretty but it has other advantages. It’s lighter and at least the paper money we use now is not so easy to counterfeit. So I always want to make that people always somehow feel that gold is somehow better than paper money. And then we’ll talk about in the future about inflation and deflation and the fact that there’s a constrained on how much gold can be produce but you can print money but we’ll talk about that in a little bit. So in our modern world that savings are these green pieces of paper but let’s say we’re talking about some primitive culture and they’re using gold. So we perform—a bunch of people perform a bunch of goods and services and they get this little coins and these coins are essentially—this society is way of agreeing. If you have one of these coins, in the future if you give this coin to someone else they’ll do something for you and how much of that coin you have to give for them to do it? Well, it’s based on supply and demand and price whatever. These projects, I say, well, if I only had some way of convincing someone to dig a canal it will be hugely beneficial and they will create welter dig irrigation ditch but how do I do that? Well, I had gold or if I had these little coins, I could give these coins to these people they would dig the irrigation ditch and then I could charge people the services of using my—I’ll charge people access to water and then I could essentially generate a turn. But how do I do that? What if I could borrow some of these people right these people have these units of goods and services called a gold coin. If I could borrow some of their money and use it to pay people that will essentially do the good and service or do the new project then I will generate wealth and then I could share it with these people maybe in the form of some type of interest. Well, it’s very hard in a vacuum for these people to evaluate these projects and maybe these projects, they don’t require just part of the savings of one person, they require the savings of a thousand people because it’s a large project. It’s also hard for these people to evaluate who has a good project and it’s hard for these people to evaluate who has savings. In fact if I have savings, if I buried a bunch of stuff in my backyard or in my mattress, I don’t want to advertise it that’s just going to make people come and rob me. So I’m a third entrepreneur and I see an opportunity for business and I call that business a bank. And so what is the bank going to do? What is my bank going to do? Well, let’s just talk about it from the bare bones, how am I going to start my business? I’m actually one of these entrepreneurs. Let’s say I have some savings just to make it simple so I don’t have to go into this bull. So let’s say I have a million gold coins of savings, let’s say some million dollars, let me draw my balance sheet. So let’s say I have—this is my balance sheet and the balance sheet as you see they were useful that even in primitive cultures. So that’s my balance sheet. And let’s say initially my balance sheet, I drew—let me draw my initial balance sheet. Let’s say my initial balance sheet is I put in a million dollars of my gold coins so let’s just say it’s a million gold—oh I said a million dollars because we’re used to that—a million dollars and that you could say a gold coin is worth a dollar, so it’s a million gold coins we know that that’s not true anymore. And I used that initially to build this big structure of solid stone that looks really safe and really secure so I used it essentially just to build a big vault. So this is my equity, and I used it to build a vault, a big nice, fancy looking building. So I actually draw the building, it has pillars in the front, it really looks like something—it looks like an old Greek or Roman temple and I think that’s not an accidental appearance. So I build this nice looking building that people would feel comfortable keeping their money and they could actually be safe for safe keeping. And I tell everyone, look, I have this nice big building instead of having your money in secure in your backyard or you bed why don’t you put your savings in this building and if you ever need it you can come and get it. And on top of that, I’m going to pay you to keep your money with me. So everyone says, that’s a good deal and sounds trustworthy and that more than Sal, that building looks even more trustworthy because it looks like a Greek temple. So everyone puts their savings with me. And let’s say that is $10 million of savings in my village. I have a very wealthy village. So that’s $10 million of deposits. This is a liability for me, right? Why is it a liability because I owe that to other people that they’re giving it to me for safe keeping so this is my liabilities. This is my equity, I had multiple—if it wasn’t just me if there were 10 shareholders each of us would have 1/10 of this. But this is sold proprietorship, so this is my equity, this is my building. So I’m running a business here, I’m not doing this as some type of none profit or charity work. So what am I going to do with this $10 million of deposits? Well, I told people that they can take the money out any time if—I’m taking their money to safe keeping if they put it in and then one day they can’t get their money back they’re going to be very suspicious at me so I have to keep some of the money set aside. There’s a lot of—this could be amongst 3,000 or 4,000 people. So at any given day not everyone’s—or hopefully not everyone’s going to pull their money put or put their money in. But I need to keep some cash reserves incase people want their money back. So I need to keep some of that $10 million in cash. So let me do that in magenta. So let me see I want to keep 10% of it in cash. So I’m going to keep $1 million at cash and then I have $9 million left that I can hopefully put to productive use. And what I do with that $9 million is I loan it out to people who have really good projects or investments, so $9 million in loans that’s an asset. I gave that money to someone else they owe $9 million. I’m essentially borrowing $10 million keeping $1 million aside and paying out $9 million in loans. There could be a bunch of different projects. So it’s not—there could be $100—I’m not just giving $9 million to one person, I’m diversifying a bunch across of bunch of different projects. So the natural question is, how am I making money? Well, these loans, I’m hopefully putting them to build irrigation ditches or build factories or do whatever something that actually is an investment that creates more value than it needed to start it up. So I can actually charge interest and that interest should be a cut of that value that’s being created. So let’s say that I’ve charged 10% on this money, so I’m charging 10% and just for the sake, let’s say I invest really well and no one defaults—I’m the first bank so I get all of the best investments so I’m getting 10%. And for their money, these people now 1025 to keep their money in this nice safe deposit but I’m also paying them 5%. So how much money do I make in a year? Well, I’m making 10% on his $9 million so what is that? That’s $900,000 a year I’m bringing in and how much am I paying out every year? Well, 5% of $10 million I’m paying out $500,000. So interest income $900,000, interest expense $500,000 that less me $400,000. And let’s say I pay another $100,000 for salaries and for security guard and all of that. So essentially I’m making $300,000 I’ll do it a little more detailed in the next video. But if you look at big picture I put a million dollars in, in every year I’m making $300,000 by providing the service, by matching up the savings with good investments and everyone benefits. The pie is getting bigger because these are real investments that are going to benefit my village and of course these people benefit because they get safe keeping for their accounts and their money is actually growing, they’re actually participating in this capital investment. Anyway, see you in the next video.