I was interviewed, recently, for a school project on financial services. One of the questions concerned the reasons why, sometimes, a bank is described as ‘too big to fail’. Here is my take. Anything to add to help this Y12 student?
Financial services organisations do not create anything tangible; their value comes from bringing together lenders and borrowers. That means that the whole industry works on the basis of trust. Individual and institutional lenders hand their savings to the bank because they trust it to invest the money wisely on their behalf and generate some return for the lender.
Lenders also trust that the bank will still exist and will return their money if and when they decide to withdraw their savings. This trust results from the expectation that banks work in good faith (e.g., are not careless with the lenders’ money) and have the expertise to screen good from bad investments.
If I think that the bank might fail – because it was reckless or incompetent – I will run to the bank to get my money back. That’s what happened with Northern Rock in 2007 (see here). If we all do this, there is no money for the bank to invest and the whole system collapses.
Governments are really keen to ensure that the system does not collapse as it is at the core of our modern way of life.