The financial system

“Money is the oxygen on which the fire of global warming burns”

Bill McKibben

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(Consider reading The Economy before you read this post)

The financial system is a subset of the economy. Like the economic system, it too has elements, interconnections, and a function/purpose.

Here’s my miro drawing of the main elements and interconnections of the financial system:

Collectively, these elements and interconnections have a purpose. The financial system contributes to the economy and society by:

1. Making payments. The payments system is the means by which we receive wages and salaries
2. Allocating capital. The matching of borrowers and lenders, helping direct savings to their most effective uses
3. Managing personal finances. The management of our household finances across our lifetimes and between generations
4. Handling risk. The control of risk which is inevitably part of everyday life and therefore economic activity

By reconnecting financial practices to these core purposes, we can transform an extractive system into one that genuinely serves the wider real economy.

The structure of finance

The financial system operates through a complex network of institutions and markets. As illustrated in the map above, the system can be broadly divided into:

Sell-side and Buy-side

The sell-side consists of entities involved in creating, promoting, and selling financial instruments, while the buy-side comprises institutions managing investment decisions and asset allocation.

The same actors can show up on both the sell-side and buy-side in different guises. For example, as someone working for a company which might go public or sell debt to investors (sell-side) also has retirement savings in a pension fund and has paid taxes being invested in a sovereign wealth fund (buy-side).

Debt and equity

Within this ecosystem, two fundamental structures underpin all activity:

• Debt represents a contractual obligation where borrowers must repay principal plus interest regardless of their financial performance. (Debt markets: bonds)
• Equity, in contrast, represents ownership and a claim on future profits without guaranteed returns. (Equity markets: stocks, currencies, commodities, derivatives)

Debt and equity represent different claims on future value. This seemingly simple distinction has profound implications for how risk flows through the financial system. Debt creates fixed obligations that must be met, while equity absorbs outcome variability.

“Equity, debt and insurance are the basic financial contracts underpinning our economy”

Mervyn King, Governor of the Bank of England 2003-2013

The distortion of purpose

While the four functions that comprise the financial system’s purpose are essential for economic activity, it’s not obvious that they should be so disproportionately profitable.

We sometimes talk about “the real economy” to mean the non-financial economy. While often pejorative, it’s also insightful. There is something unreal about the detachment and dematerialisation of the financial system from ordinary business and everyday life, which comes about when the financial system is no longer focused on meeting the needs of the real economy.

Decades of financialisation – the growth of the financial sector in size, revenue and sophistication starting in the 1970s – separated the scale of bank balance sheets from the scale of the real household and business activities in the economy and led to the following shifts:

• From Service to Self-Interest: Finance has evolved from serving its essential functions to prioritising its own profitability.
  • (An aside to share with you a quote I enjoy: This is perhaps best illustrated by neglect of the payments system. Operating a payments system isn’t the cash cow of the modern bank. This means that some of the primary architecture of the financial system is also its most neglected. Martin Taylor, former chief exec of Barclays, described the state of banking payment systems in this way: “the systems architecture at the typical big bank, especially if it has grown through merger and acquisition, has departed from the Palladian villa envisaged by its original designers and morphed into a gothic house of horrors, full of turrets, broken glass and uneven paving”)
• From Loans to Trading: Banks have shifted focus from making loans with a careful local assessment of borrowers to trading securities with a centralized assessment and monitoring of transactions.
• From risk management to risk financialisation: Complex derivatives (financial instruments deriving value from underlying assets, e.g. options, futures, credit default swaps, collateralised debt obligations) that theoretically manage risk often amplify it through leverage, and blur the line between debt and equity.

These shifts mean that modern banks maintain massive balance sheets, with nearly equal assets and liabilities.

This apparent equilibrium masks fragility:

1. Banks operate on thin capital margins
2. Asset values depend on market confidence
3. Liabilities can become due instantly during crises

Markets believe themselves to be liquid, but this is an illusion. The underlying assets of a market are usually illiquid. Liquidity depends on a continuing stream of buyers and sellers on opposite sides of the market. This is what dissipates in a crisis.

The 2008 financial crisis revealed how quickly this apparent stability can unravel. When confidence evaporated, the gap between assets and liabilities became catastrophically apparent.

The market test which finance fails

The disconnect between finance’s stated purposes and its actual operations becomes even more striking when we apply the market’s own logic to the financial system itself.

The logic of market economics is brutally simple. If a business cannot raise sufficient equity to properly capitalise itself, or cannot generate satisfactory returns on that equity, the verdict is clear: this activity should not exist—at least not at its current scale.

Apply this standard to our banking system and the conclusion is inescapable.

Banks operate with minimal capital buffers and extreme leverage ratios that would be unthinkable in any other industry. They rely on implicit government guarantees rather than sound business models. When crises inevitably arrive, the taxpayer becomes the reluctant backstop.

This represents a fundamental distortion of capitalism’s principles. The banking system has effectively exempted itself from the market discipline that governs every small business, tech startup, and industrial enterprise in the economy.

If we truly respected market forces, we would recognise that many banking activities are economically unsustainable without artificial support. These activities would either transform radically or contract to a fraction of their current scale.

Returning to Purpose

If the financial system exists to serve the four functions outlined earlier (payments, capital allocation, personal financial management, and risk handling), we must question whether its current structure effectively fulfills these purposes.

The extraordinary profitability of finance suggests a distortion of purpose—a system that increasingly serves itself rather than the broader economy.

The continued existence of our banking system in its present form doesn’t validate its economic viability—it merely confirms its political untouchability.

By reconnecting finance to its core purposes, we can build a system that:

• Allocates capital to sustainable, productive uses;
• Manages risk rather than obscuring or amplifying it;
• Serves individuals and communities across generations;
• Supports rather than overshadows the real economy.

Finance must serve purpose, not profit alone.