Every time we use money, we interact with
the financial system in some way. It’s central to our daily lives. So its reliability and
stability is as important as maintaining the value of money.
Financial institutions such as banks allow us to exchange money with others – making
millions of regular payments and transactions, buying in the shops and online, paying bills,
getting paid and so on. But they also perform two other vital tasks.
They connect those who have money to save and invest and those who need money to borrow
– be it for a mortgage or business growth. And they also allow people to insure against
the risks they face in their businesses or daily lives.
And risk is an integral part of the financial system. When a bank takes our savings and
lends them, it converts money that is available for instant withdrawal, into lending that
can be tied up for years. Not only is it now less accessible but if things go wrong it
may not come back at all. Banks need to manage these risks and they
monitor their lending carefully, spreading the risks across many loans to differing sectors.
They also have to be able to withstand loans going bad. Shareholders’ capital – the value
of their stake in the bank – does that job. Banks need enough capital to provide a strong
basis for their lending in case things go wrong.
And to manage all the potential flows of money in and out of banks, they have to have a stock
of cash and other liquid assets to make payments. Maintaining the right ratio between liquid
assets – cash, or assets that can be turned into cash easily – and loans and other investments
is crucial if banks and other financial institutions are to be secure.
What keeps the whole thing afloat is our confidence that if we put our money in, we’ll be able
to get it out again. Banks and other financial institutions need to be in good shape so they
can keep providing vital services to the rest of us, even in difficult times.