Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Understanding Weaknesses in the Financial System

No structure, method, organisation or indeed person is perfect, and the financial system is no exception. If anything positive is to be gained from the

terrible events of 2008, economists need to analyse what happened and ensure – as much as possible – that history does not repeat itself. Identifying specific weaknesses is the start so systemic vulnerabilities can be addressed.

The financial system is an extremely large and complex system with many actors all interacting with one another: banks, insurance companies, households, regulators, traders and more. Unsurprisingly the system has weaknesses, including: the propensity for problems to spread quickly from one part of the system to another; the fact that a loss of confidence in a bank can cause it to fail; the incentives individuals and organisations sometimes face to behave badly; and constant innovation that makes it tough for regulators to monitor financial institutions.

We choose to focus in this chapter on two main weaknesses, as follows:

Fractional reserve banking: Where banks keep only a small fraction of the money deposited with them in reserve.


Systemic risk: The risk that – due to the interconnectedness of financial institutions – problems in one bank can quickly spread to others.

These two weaknesses make clear two of the scariest lessons about our financial system as it currently stands:

Any bank, no matter how well run, can fail if it suffers a loss of confidence.


The failure of one financial institution can lead to the failure of many more financial institutions.


Finding Out about Fractional Reserve Banking

Fractional reserve banking is the method of banking practised throughout the world. As the name suggests, it involves banks keeping a fraction of deposits in reserve. Here we discuss what fractional reserve banking means in practice, including how it works and potential problems. You discover what happens to your money when you put it in the bank, how banks can quite

literally create money out of thin air and how an otherwise healthy bank can fail.