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Banking 10: Introduction to leverage (bad sound) - YouTube
Channel: Khan Academy
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I now want to introduce you to
the concept of leverage.
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And then in future videos, we'll
talk about this more in
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terms of what leverage does
and when it's good
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and when it's bad.
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We'll talk about it in a lot
of different contexts.
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Right now, I'll talk about
a little bit more in the
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context of a bank.
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So let's say I start off my bank
again and I have 300 gold
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pieces of equity and let's say
I use that for my building.
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That was 100 gold pieces.
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And then I have 200 gold pieces
that I just put into my
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building just to start it off.
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Let's say I take a 100 gold
piece deposit, and of course I
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have an offsetting checking
account that those people can
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at any point use-- either to
write checks or at some point
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they can come back and demand
their money back.
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Let's say I make out some loans
for different projects.
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Let's say 300 gold pieces loan
A-- and I do that just by
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giving Person A or Entrepreneur
A or whoever took
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this loan out a 300 gold
piece checking account.
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Let me just do one more loan.
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Let's say I make another
loan for 300.
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Loan B-- and I can give that.
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I could have also issued notes
and all of that, but let's say
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I just give them a
checking account.
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And we have explored reserve
requirements and all that.
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Let's think a little
bit about leverage.
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And leverage is essentially, how
much assets do you control
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with a certain amount
of equity?
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So in our example right now,
what is our equity?
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Our equity is equal to
300 gold pieces.
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Let me do it in a different
color just so the equity
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stands out from the
liabilities.
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And how many assets are we
controlling with that 300 gold
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pieces of equity?
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So I have 300, 400,
700, 1,000.
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So, assets are equal to
1,000 gold pieces.
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So a lot of times people-- when
they talk about leverage,
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you might hear someone
say, 2:1 leverage.
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Well, that means the ratio
of the assets to
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the equity is 2:1.
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In this case, the ratio of our
assets to equity-- so we have
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assets to equity leverage, is
what people say-- in this
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case, it's 1,000 to 300--
or what is it?
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10:3.
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You seldom hear 10:3 leverage.
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You'll hear people talking in
terms of 10:1 or 2:1, or
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something to one, but 10:3
is a fair leverage ratio.
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It tells you just how many
assets we're controlling with
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a certain amount of equity.
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I guess a very good reason why
a bank wants to do this,
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because if it's making more
money on its assets than it's
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paying on its liabilities, in
theory, a bank will want to
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take on as much leverage
as possible, right?
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Because with this original 300
investment, every time it adds
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some assets and some
liabilities, it's going to
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make a difference.
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It's going to make the spread on
that money and so it wants
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to keep doing that.
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But there's a downside to
leverage because what if the
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bank-- what if some of these
loans aren't so good?
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your What if some of these loans
just don't turn out to
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be so good?
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So leverage, when things are
good, when they go on the
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upside, it kind of multiplies
how much money
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you're going to make.
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But as you're going to see in
about a second, on the down
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side, leverage also multiplies
the loss you would take.
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So in this situation, what
happens if I had a 30% loss--
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let's say I have a 50% loss on
these loans that I made.
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In a world without leverage--
so if I didn't have all this
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leverage, if I just had the
same amount of assets and
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equity-- so in an example like
this where my assets are equal
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to my equity-- if my assets go
down by 50%-- notice here I
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have no liability.
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So this is all equity and
this is all assets.
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In this example, if my assets--
for whatever reason,
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I take a loss.
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If they go down by 50%, my new
balance sheet looks like this.
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Let me scroll down
a little bit.
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My new balance you will look
like this-- 150 and 150.
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So my equity also went
down by 50%.
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I took a 50% loss because
maybe I made some bad
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investments.
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But now that I have leverage,
what happens if the value of
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my assets get written down
by-- at some point, I
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determine that Loan B-- they're
probably not going to
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pay up and Loan A maybe
won't pay up.
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So the value of my assets
go down by 50%.
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So I have 1,000 of assets-- so
essentially I'm writing down
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my assets by 500.
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So let's say that I think Loan B
is only worth 50 and I think
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that this is only worth 50--
because for whatever reason,
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maybe I give these loans out to
build real estate or these
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were loans to sub-prime
individuals.
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Who knows?
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Whatever loans these were, they
just weren't good loans
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and I realize I'm not going to
get 300 gold pieces back.
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I'm only going to get
50 gold pieces back.
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But in this situation,
what does my balance
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sheet now look like?
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Now that I had leverage, my
balance sheet looks like this.
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I have 100 in terms of
the building itself.
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Then I have 300 of
gold deposits.
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And then that first loan shrinks
to 50 only and then
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that second loan
shrinks to 50.
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So now, what are my
total assets?
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This is 50 and this is 50.
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So I have 100 plus 300 plus
250-- so it's 100.
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So I have 500 of assets,
which is
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consistent with what I said.
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Our assets go down by
50% because I had
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1,000 of assets before.
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And then what are
my liabilities?
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Well, I owe this 300 checking
account, this 300 checking
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account-- because he might have
written checks to other
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people so it's not necessarily
the same person that I lent it
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to initially.
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But I have-- let's see--
700 of liabilities.
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So notice, I now have negative
equity, right?
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Because assets are equal to
liabilities plus equity.
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Well, if my assets are 500 and
my liabilities are 700, then
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what is my equity?
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Well, my equity's going
to be minus 200.
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So essentially I'm broke.
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This bank is out of business.
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And in this situation, there's
a very good reason for people
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to want to get their
money back.
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There's a very good reason to
have a run on this bank
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because frankly, even if you
gave this bank all the time in
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the world, this bank is not
going to be able to
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pay back its money.
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Even if it were able to offload
these loans, it still
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does not have enough money to
satisfy all of the demand
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deposits or all of
the liabilities.
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And this situation is
called insolvency.
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Let me do that in
another color.
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And that just means you
don't have the money.
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You're not good for it.
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Remember, when we talked about
the reserve ratio, that dealt
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with illiquidity.
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You wanted to make sure you
had enough gold left aside
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that when people came and said,
I want my gold back,
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that you had gold to
give it to them.
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But if by chance, people ask for
more gold than you had, it
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doesn't mean you're
out of business.
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You just essentially have to
tell them, oh well, can you
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wait a little while while I deal
with my assets and wait
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for those loans to
get paid back?
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You're still solvent.
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Insolvency is when you actually,
because of bad
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investments, you actually end
up with less assets then do
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have liabilities and then
there's nothing left over in
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the equity column.
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And that's what leverage is a
measure of, because if you
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have really high leverage, then
you-- notice, when we had
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no leverage, you could take a
50% loss really easy, but now
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that we had even 10:3 leverage,
even a 50% loss
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wiped us out.
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And if you had 10:1 leverage,
then even a 10% loss would
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wipe you out.
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So leverage really is a measure
of how much cushion do
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you have to take losses
in the future.
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Anyway, before I run out of
time-- and in the next video,
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I'll actually talk about how
leverage is regulated within
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banks, but just to give you
another measure of leverage--
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because this measure I gave
you-- if someone says 10:3
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leverage, it's assets to
equity-- another one that
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people often use, often
in the investing
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world, is debt to equity.
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But it's really a measure
of the same thing.
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Because if someone tells you
debt to equity, you can figure
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out the assets to equity, but
in this case, the debt to
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equity ratio before I took
any losses-- it was what?
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My liabilities are-- this, you
can view that as debt because
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I owe these people that
money-- is 700 and
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my equity is 300.
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So it's 7:3 is my debt
to equity ratio.
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Anyway, see you in
the next video.
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