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Understanding the basics of banking

What happens to your money after you put it in the bank? Join Sal Khan inside a bank's balance sheet to see how your savings goes to work and how you may benefit.

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Let's learn a little bit about just how a plain vanilla bank works.

So let's say that I'm an entrepreneur and I see a problem out there in the world.  You have all of these hardworking 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, right? 

So right now, they're just-- whatever.  They're burying it in their backyards.  And they're just collecting there, right?  That "money" is doing nothing.  They've provided some goods and services 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 these people said, that's a useful thing that I have.  Let me just put it into my mattress.

There's this pool of savings and let's say there's this other pool of entrepreneurs and they have a bunch of really good ideas for projects.  They're like, you know what? If I could just to get--let me put this here: projects or investments. 

Let's say that there's 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 get a bunch of people to dig canals to the crops, that we'll be able to grow more crops throughout the year and we'll all be richer because we'll all have more food and that's a true good 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, give them 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 have 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, right?  And I want to make this point because everyone always talks about gold as if it's something special, as if it really represents wealth, while paper money really does not represent wealth.  And that's just not true.
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 useful.  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. 

I always want to make that--people always somehow feel that gold is somehow better than paper money.  And we'll talk in the future about inflation and deflation and the fact that there is a constraint on how much gold can be produced, 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 a bunch of people perform a bunch of goods and services and they get these little coins.  And these coins are essentially this society's 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?  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 would be hugely beneficial and it will create wealth--or dig irrigation ditches.  But how do I do that?  Well, if 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 service of using my--or maybe I'll charge people access to water and then I could essentially generate a return. 

But how do I do that? Well, 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 goods and service or do the new project, then I'll 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 1,000 people because it's a large project.  It's also hard for these people to evaluate who has a good project.  It's hard for these people to evaluate who has savings.  In fact, if I have savings, if I've 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 a bank going to do?  What is my bank going to do?  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 pool. 

So let's say I have a million gold coins of savings--let's say it's a million dollars.  Let me draw my balance sheet.  And balance sheets, as you see, they were useful even in primitive cultures.  So that's my balance sheet.

Let's say my initial balance sheet is--I put in a million dollars of my gold coins.  I'll say a million dollars just because we're used to 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 use that essentially to build this big structure of solid stone that looks really safe and really secure.

So I use it essentially just to build a big vault, right? So this is my equity, right, and I use it to build a vault--a big, nice, fancy looking building.  So I'll actually draw the building.  It has pillars in the front.  It looks like an old Greek or Roman temple.  I think that's not an accidental appearance.  So I build this nice looking building that people would feel comfortable keeping their money in--and that could actually be safe for safekeeping.

And I tell everyone, look, I have this nice big building.  Instead of having your money insecure in your backyard or your 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 Sal's trustworthy and, 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 fairly 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.  They're giving it to me for safekeeping.  So this is my liabilities.  This is my equity.  If it wasn't just me, if there was 10 shareholders, each of us would have 1/10 of this.  But this is a sole proprietorship so this is my equity.  This is my building. 

I'm running a business here, right?  I'm not doing this as some type of nonprofit 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.  I'm taking their money as safekeeping. If they put it in and then one day they can't get their money back, they're going to be very suspicious of me.

So I have to keep some of the money set aside.  This could be amongst 3,000 or 4,000 people.  So at any given day, not everyone--hopefully not everyone's going to pull their money out or put their money in.  But I need to keep some cash reserves in case people want their money back.  So I need to keep some of that $10 million in cash.

So let me do that in magenta.  Let me say I want to keep 10% of it in cash.  So I'm going to keep $1 million in cash and then I have $9 million left that I can hopefully put to productive use.  And what I'd 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, right?  I give that money to someone else.  They owe me $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.  There could be 100.  I'm not just giving $9 million to one person.  I'm diversifying a bunch across a 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 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 charge 10% on this money.  And just for the sake of it, 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, not only do they get to keep their money in this nice, safe deposit, I'm also paying them 5%.

So how much money do I make in a year?  Well, I'm making 10% on this $9 million.  So what is that?  That's $900,000 a year $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 nets me $400,000.  And let's say I pay another $100,000 for salaries and for security guards and all of that.  So essentially, I'm netting $300,000.  So I'm netting $300,000.

I'll do it in a little more detail in the next video.  But if you look at it big picture, I put a million dollars in and every year, I'm making $300,000 by providing this service--by matching up the savings with good investments.  And everyone benefits.  The pie's getting bigger because these are real investments that are going to benefit my village.  And of course, these people benefit because they get safekeeping for their accounts and their money is actually growing.  They're actually participating in this capital investment.

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