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 therein the world. You have all of the shard working people– whatever they do– doctors, lawyers, engineers, construction workers– what ever 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 intheir 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 themsomething, 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’sa useful thing that I have. Let me just put itinto my mattress.
There’s this pool of savings and let’s say there’s this other pool of entrepreneursand they have a bunch of really good ideasfor projects. They’re like, you know what? If I could just to get– let meput this here: projects or investments. Let’s say that there’s someother entrepreneur and he says, boy, you know what? I have no claims on anygoods and resources, but I have an idea. I have an idea that if I couldget a bunch of people to dig canals to the crops, that we’llbe able to grow more crops throughout the year andwe’ll all be richer because we’ll all have more food andthat’s a true good and service in its best sense.
But how am I going to get thesepeople to build this ditch for me? I mean, I could maybe promisethem in the future that once all of this is done, I can dosomething, give them more food, but that’s notthe way it works.
No one’s willing to work for meunless they can feel very secure that they’re going toget something in return. So we have an interestingproblem here. You have a bunch of people whohave already provided goods and services to the world andthe world has given them trinkets– whether it’s goldcoins or paper money. Let’s just say it’sgold, right? And I want to make this pointbecause everyone always talks about gold as if it’s somethingspecial, as if it really represents wealth, whilepaper money really does not represent wealth.
And that’s just not true. There’s nothing about gold. Gold is not useful other thanthe fact that it is pretty. That’s the only thing thatmakes gold useful. Actually, it’s pretty and it’shard to counterfeit. Paper money– not so pretty, butit has other advantages. It’s lighter, and at least thepaper money we use now, is not so easy to counterfeit. I always want to make that–people always somehow feel that gold is somehow betterthan paper money.
And we’ll talk in the futureabout inflation and deflation and the fact that there is aconstraint on how much gold can be produced, but youcan print money. But we’ll talk about thatin a little bit. So in our modern world thatsavings are these green pieces of paper, but let’s say we’retalking about some primitive culture and they’reusing gold. So a bunch of people perform abunch of goods and services and they get theselittle coins. And these coins are essentiallythis society’s way of agreeing– if you have one ofthese coins in the future, if you give this coin to someoneelse, they’ll do something for you.
And how much of that coinyou have to give for them to do it? It’s based on supply and demandand price, whatever. These projects– I say, wellif I only had some way of convincing someone to dig acanal, it would be hugely beneficial and it willcreate wealth– or dig irrigation ditches. But how do I do that? Well, if I had gold or if Ihad these little coins, I could give these coins to thesepeople, they would dig the irrigation ditch and thenI could charge people the service of using my– or maybeI’ll charge people access to water and then I couldessentially generate a return.
But how do I do that? Well, what if I could borrowsome of these people, right? These people have these unitsof goods and services called a gold coin. If I could borrow some of theirmoney and use it to pay people that will essentially dothe goods and service or do the new project, then I’llgenerate wealth. And then I could share it withthese people, maybe in the form of some type of interest. Well, it’s very hard in a vacuumfor these people to evaluate these projects.
And maybe these projects, theydon’t require just part of the savings of one person, theyrequire the savings of 1,000 people because it’sa large project. It’s also hard for these peopleto evaluate who has a good project. It’s hard for these people toevaluate who has savings.
In fact, if I have savings, ifI’ve buried a bunch of stuff in my backyard or in mymattress, I don’t want to advertise it. That’s just going to makepeople come and rob me. So I’m a third entrepreneur and I see an opportunity for business and I call thatbusiness a bank. And so what is a bankgoing to do? What is my bank going to do? Let’s just talk about itfrom the bare bones. How am I going to startmy business? I’m actually one of theseentrepreneurs.
Let’s say I have some savings,just to make it simple so I don’t have to gointo this pool. So let’s say I have a milliongold 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 balancesheet is– I put in a million dollars of my gold coins. I’ll say a million dollarsjust because we’re used to that.
You could say a gold coin isworth a dollar, so it’s a million gold coins. We know that that’snot true anymore. And I use that essentially tobuild this big structure of solid stone that looks reallysafe and really secure. So I use it essentially just tobuild a big vault, right? So this is my equity, right,and I use it to build a vault– a big, nice, fancylooking building. So I’ll actually drawthe building. It has pillars in the front.
It looks like an old Greekor Roman temple. I think that’s not an accidentalappearance. So I build this nice lookingbuilding that people would feel comfortable keeping theirmoney in– and that could actually be safe forsafekeeping. And I tell everyone, look, Ihave this nice big building. Instead of having your moneyinsecure in your backyard or your bed, why don’t you put yoursavings in this building and if you ever need it, youcan come and get it? And on top of that,
I’m goingto pay you to keep your money with me. So everyone says, that’sa good deal and Sal’s trustworthy and, more than Sal,that building looks even more trustworthy because itlooks like a Greek temple. So everyone puts theirsavings with me. And let’s say that thatis $10 million of savings in my village. I have a fairly wealthyvillage. So that’s $10 millionof deposits. This is a liabilityfor me, right? Why is it a liability? Because I owe thatto other people.
They’re giving it tome for safekeeping. So this is my liabilities. This is my equity. If it wasn’t just me, if therewas 10 shareholders, each of us would have 1/10 of this. But this is a soleproprietorship so this is my equity. This is my building. I’m running a businesshere, right? I’m not doing thisas some type of nonprofit or charity work. So what am I going to do withthis $10 million of deposits? Well, I told people thatthey can take the money out any time.
I’m taking their moneyas safekeeping. If they put it in and then oneday they can’t get their money back, they’re going to bevery suspicious of me. So I have to keep some ofthe money set aside. This could be amongst 3,000or 4,000 people. So at any given day, noteveryone– hopefully not everyone’s– going to pulltheir money out or put their money in. But I need to keep some cashreserves 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 keep10% of it in cash. So I’m going to keep $1 millionin cash and then I have $9 million left thatI can hopefully put to productive use. And what I’d do with that $9million is I loan it out to people who have really goodprojects or investments. So $9 million in loans. That’s an asset, right? I give that moneyto someone else. They owe me $9 million.
I’m essentially borrowing $10million, keeping $1 million aside, and paying out$9 million in loans. There could be a bunch ofdifferent projects. There could be 100. I’m not just giving $9 millionto one person. I’m diversifying a bunchacross a bunch of different projects. So the natural question is,how am I making money? Well, these loans– I’mhopefully putting them to build irrigation ditches orbuild factories or do whatever, something thatactually is an investment, that creates more value thanit needed to start up. So I can actually chargeinterest and that interest should be a cut of that valuethat’s being created.
So let’s say that I charge10% 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 allof the best investments. So I’m getting 10%. And for their money, thesepeople, not only do they get to keep their money in this nice, safe deposit, but I’m also paying them 5%. So how much money doI make in a year? Well, I’m making 10%on this $9 million. So what is that? That’s $900,000 a yearI’m bringing in.
And how much am I payingout 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 andall of that. So essentially, I’mnetting $300,000. So I’m netting $300,000.
I’ll do it in a little moredetail in the next video. But if you look at it bigpicture, I put a million dollars in and every year, I’m making $300,000 by providing this service– by matchingup the savings with good investments. And everyone benefits. The pie’s getting biggerbecause these are real investments that are goingto benefit my village. And of course, these peoplebenefit because they get safekeeping for theiraccounts and their money is actually growing. They’re actually participating in this capital investment.