Why banks matter

If economists can be blamed for not anticipating the financial crash, then bankers (rightly) stand accused of causing it. A healthily functioning banking system performs a number of key economic functions, and four, arguably, are of particular importance. First, banks operate the payments system without which most financial transactions could not occur. Second, they take in customers’ deposits, thereby encouraging saving. Third, they channel funds from individual savers to small and medium-sized enterprises, and in so doing finance business investment. And fourth, they make mortgage and other personal loans, enabling families to purchase homes and consumer goods, activities which in turn support economic growth. Sometimes banks fail to perform these functions satisfactorily and go bust. This is normally because banks don’t just create debt in the form of mortgages and loans, but take on debt themselves to make investments and acquire additional assets, and in doing so become over-leveraged (‘leverage’ refers to the practice of using borrowed money to purchase an asset). This, essentially, is how the US housing bubble that preceded the 2008 crash was created.

Let’s briefly consider the ‘charge sheet’ against the banks before looking more closely at how the banking and financial system actually works. Four inter-linked charges can be brought against the banking system as it was operating at the beginning of the 21st century. The first is that some banks had become too big, both in absolute terms and relative to the size of national economies. The 2008 crash demonstrated that the very biggest banks could not be allowed to fail because if they did, many other businesses (including other banks), as well as households and employees, would go under too. National governments were effectively held hostage, having to step in and rescue ‘their’ banks at great cost to those countries’ public finances.

The second charge is that the ‘too big to fail’ banks had (and continue to have) too strong an incentive to take on excessive risk, since governments will bail them out in an emergency.