3.2.7 The Financial System
Money is the medium of exchange between the elements of the economy. The money within the financial system is a necessary resource for all forms of wealth creation.
The financial system, for the purpose of this analysis, includes banking, government finance, insurance and other financial services. It processes the payment transactions between individuals and organisations, receives money from savers and investors, and lends it to borrowers – who may be individuals, companies or governments.
Banks use money that belongs to savers and investors, in order to lend it to other people. They assume that not everybody will want to withdraw their savings simultaneously (though this sometimes happens if there is a loss of confidence, as happened in 2007 – described in a BBC article: The collapse of Northern Rock: Ten years on). A bank has to hold some funds in reserve but almost all modern banks hold reserves which are only a fraction of their total liabilities; Murray Rothbard criticised this practice in an article: Fractional-reserve banking.
The money managed in the financial system can be used in various ways:
- Savers perceive the financial system as holding their money until they need it. They are delaying the moment of their own consumer spend, but by doing so they enable the financial system to make the funds available for other purposes.
- Consumers and governments borrow so that they can make purchases sooner – or just so that they can keep going during a difficult period.
- Businesses need finance to start up, to grow, and to compensate for the time delay between costs incurred and income received.
- People and businesses pay to insure themselves against risk, so a corresponding pool of finance must be available to meet claims.
- The financial system holds a contingency against the risk of borrowers who default.
- It needs reserves to even out the time delays between its receipts and its payments.
- As described later (3.3.4), some financial organisations speculate with the money they manage to make additional profits on the financial markets.
The first six aspects of the financial system could be described as constituting its baseline role: to provide liquidity, which benefits society by supporting the creation of wealth and maintaining stability. The financial organisations create wealth for themselves in these roles by charging for the services that they provide.
The speculative aspect is more contentious. It is a form of wealth creation for the employees and shareholders in the financial sector, with other people’s wealth as an input. The employees used their financial knowledge to speculate, and those involved made a lot of money but, as was vividly illustrated in the financial crisis of 2007-8, speculation can also destroy value and cause those financial institutions to fail. In an article in Prospect Magazine, Making banks boring again, John Kay observed that: “The modern financial services industry is a casino attached to a utility”.