Why Do We Need Banks?

boeWhat is a bank? It’s an essential institution that provides people with a source of credit as well as providing a return on a person’s savings. Banks have always existed in some form which proves how vital they are in society as they naturally evolved with humanity. The Ancient Egyptians had such methods, as did the Romans, Medieval Europe, and they will always exist. But why are they so vital?

Firstly, they provide a safe place where people can store their money and their income, a much more reliable place than shoved in a cardboard box under their bed. What’s more, banks encourage people to give them their money i.e. investment, by offering a certain rate of interest on the savings so that in the long-term, the person can increase their wealth. And what do banks use all these savings for? They lend them back out to the people who need them most. Of course, to make it attractive to function, they must make a profit, and so they charge the borrowers interest rates.

They provide an absolutely vital service to the people. And by judging a person on their level of risk, their reliability to pay back what they borrow, they protect themselves. They also encourage social mobility in society because people can build up their wealth over generations. This promotes the values at the core of a free, democratic society. Without the ability to borrow a loan from a bank, people would be vastly limited in all areas of their lives. Especially with respect to buying a house, a car, without the service a bank offers of borrowing a certain amount of money, they would not be able to make this purchase. It’s simple. If banks did not exist, there would be far higher levels of poverty. Obviously the bank is entering into an agreement with the person, and entrusting them to pay back the money at the agreed time, and if they fail to do this, the bank has the right to repossess their homes, for example. This is the nature of the system.

However, the extreme risk that the banking system itself can pose to society must also be taken into account. As can be seen in the global crises of 1929, and 2008, banks can potentially lead to utter economic collapse in a country. If we look at the example of the 2008 world financial crisis.

financial-crisisBasically, banks became bigger and bigger, taking greater and greater risks as they greatly decreased their loan to asset ratio and started giving out sub-prime loans. The amount of assets a bank holds, its liquidity, is essentially its buffer zone, the free cash it has access to if there is a sudden run on the banks. Whether this be cash itself, or easily sellable things like bonds, liquidity is essential to avert disaster.

However, they began to give out more and more loans until their assets fell from a relatively safe value of 20% to figures as low as 5% or less. Why did they do this? Their ‘Value at Risk’ risk assessment models told them that it was becoming safer and safer to lend out loans and that bankers were getting better and better at their jobs, essentially. But there was a fatal flaw. They failed to take into account that there was a major financial crisis every fifty years or so. Furthermore, in 2008, the majority of the business done by investment banks such as Morgan Stanley, billions of dollars of their revenue, were not made in bonds, but in collateralised debt obligations. They were literally dealing debt. CDOs are hashed together bits and pieces of bonds and so a fragile structure arose of debt, an inverted house of cards, with those at the top being worth even less than that which they had been derived from. So when investors lost confidence in the market and people rushed to get their money back, the banks simply imploded as they did not have enough liquid assets. This is the danger of banks. However, the country recovered each time. And these crises can be averted with the proper foresight.

The real issues would occur if there weren’t banks in the first place. People would have no means to safely store their income and this would likely lead to increased crime in society. But more importantly, there would be much higher levels of poverty because they would be unable to take out loans when they needed it most. Banks are a key aspect of a well-functioning civilisation that arise because of necessity. The consequences if they didn’t exist would be dire. They provide an invaluable service that supports all other areas of society.

Furthermore, they are a means for the government to influence demand, and therefore economic growth, and the wealth and happiness of their nation. Through monetary policy, the use of interest rates to encourage or discourage spending and saving, the MPC and the Bank of England influence all the other banks and are a vital means for the Chancellor of the Exchequer to control the economy, the other method being fiscal policy. This system of influencing borrowing in the economy is essential to, in turn, influence economic growth.

In conclusion, why do we need banks? Because they are essential.

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