In the previous episode we've shown that the bank introduced a red triangle, a very special financial instrument that induces the depositors, instead of going directly to the borrowers, to go through a bank. Now, that is all great but, now we have to show that the bank, after having the declared that it has this instrument, can actually offer it. By that will mean that the bank now not only can make sure that all the depositors' obligations are actually dealt with and properly delivered on, but at the same time, the bank does not lose money. Moreover, we will show that not only does the bank not lose money, but it also makes some money. In order to proceed, we go back to our model. Our three period model, well, it's the model of diamond but we'll use it here. So this is 0, 1, 2. And we assume that at point 1 only 20 depositors come, and the remaining 80 come at point 2. Now our instrument for analysis will be growth simplified bank balance sheet. We completely ignore bank capital and say that here on the here on the asset side the bank has some assets that hopefully will produce some cash for it at certain points in time. And on the liability side it will have these notorious red triangles. Now this is a three period stroboscopic world, so we will start with a certain prologue. Then we'll do something, then we'll see at first then act 1, then act 2, and then finally, the epilogue. Now, first of all we are here at point 0, there is light, and now the bank, this is the bank balance sheet, the bank sells 100, Red triangles. That means that 100 people come, they buy these triangles and they give to the bank $1 in cash. So as a result of this operation, the bank holds $100 in cash. What are the banks investment options? Well, the bank can invest in, let's say investment, Options. Here we say for a bank. Well the bank can obviously buy, Blue circles, but we know that they give the bank only $1 here and they are and clearly overall the bank can get at most $100 in cash, which is not enough to deliver on the obligations with respect to his depositors. Because remember, here they require 1.25 and here they require 1.85. So this is not an option. Well, it is an option, but it's not doable. Now, the bank can also just keep these, or by the same triangles. But in this case, let's say here we put 100 triangles. So the bank sold these 100 triangles, and it bought it from somewhere else. We suppose that it is doable. In this case, the bank can indeed deliver on its promises, but it's positive not to make any money. So this is maybe a doable option, but a poor option. Now there's a third option, to buy black boxes. And we will analyze this and I will show that this is the option that allows the bank to deliver on its obligations and to make money. So the bank takes $100 in cash and buys 100 boxes. Now, curtain, there's no light, there's darkness, and in darkness we live up to the point 1. At point 1, so this is the first act or drama, what we see? 20 people come to the bank and say well, dear bank, you promised to pay us 1.25 here, please give us our money. Well, let's go back to the bank balance sheet. The bank has no cash whatsoever, so the bank must liquidate some of its assets. How much money does the bank has to raise? Well, 20 times 1.25 each, so the bank needs, $25. Again, the bank has no cash, so the only way to raise this money is to sell black boxes. Well at point 1, unfortunately, a black box produces only $1, so the bank sells 25 boxes, too bad. Now, the bank sells 25 boxes, gets $25 in cash and gives it to its money depositors. What is the bank balance sheet at point 1 after having made all this? So we have 80 triangles remaining, Because 20 depositors have been already paid. And on this side, unfortunately, we have only 75 boxes remaining. So this is a bank balance sheet at 0.1. Now, curtain, and darkness again. So, so far we have shown just that the band delivered on its obligation to these 20 people who came at point 1. Let's see what happens at point 2. At point 2, well again I will reproduce this really quickly, so 0, 1 and 2. At point 2 we have 80 people who are willing to get as much as, here I will show, 1.85 each. Well, so the bank balance sheet again, at this time, looks like this, I will recall you. So we have 80 triangles and we have 75 boxes. Now the point 2 comes, what happens is these 80 people come and say to your bank you owe us 1.85 each, please give us back this money. Well, this amount is 80 times 1.85, which is $148. Well, the bank has no cash again, but the bank has 75 magic black boxes. So see what happens at point 2, the bank sells these 75 black boxes and each of them gives $2, so now how much does the bank have? It has 75 times 2 each, which is $150. See what happened? Now the bank takes this money, pays out 148. So the bank, bank's profit, is $2. See what happened? The bank not only promised to deliver on these red triangles, but actually delivered and made a positive amount of money. So this process is called creation of liquidity. So the bank ensures that the people who said fine, we buy these red triangle, these people got happy, and also the bank got these two box. Which is great so we can see that finally the bank introduce something to sort of force depositors to go through it by buying red triangles. Well great, there's one thing that basically is a pillar of the ability of the bank to do all this, this is these numbers, 20, I will again put it here, like this because it was on the previous side of the flip chart, 20 and 80. Let's think for a moment what happens if more than 20 people arrive here? Well, in the next episode we analyze the situation, but for now it's clear that if the number of people showing up at point 1 is different, then maybe the situation is not so great. In reality what we know is that this number, not only is not known with certainty, but is also changing all the time. And in the real world we do not deal with a three point in the economy, something happens here and we based on something that we thought about it and decided 0.0, 0.0 and 0.1 that what might happen. So our statement for now goes that we have shown the mechanics of liquidity creation. But unfortunately, what we'll see in what follows that this process, although it's extremely important for the economy, but there are certain important and damaging risks associated with that as well. And we will see how these risks influence this situation, and how they can be coped with. This will follow.
