Banking started as an external service for asset holders in need of safekeeping of their valuables. This was followed by deposit taking and capital provision to the general public. It matured into a financial ecosystem that provides society with a wide range of facilities in support of personal and corporate needs. The current financial system has a fiduciary character. It is based on confidence. Therefore, financial stability is crucial to maintain mutual trust and avoid bank panic.
The distinct scope and nature of individual spending behavior enable a position for financial institutions to match debit positions with credit facilities. This was first provided to bank customers with the overdraft facility. To ensure that assets were protected, gold was used as collateral and valuation. This gold standard was replaced by an advanced system of fractional reserve banking where financial reserves of the bank correspond only with a fraction of the deposit liabilities.
Risk in banking contains financial and non-financial elements. Conduct and the ownership of risk taking remains a true vulnerability. The global financial crisis put a pause on excessive growth and revealed several shortcomings in the financial system. However, when financial institutions were closed, nationalized, or bailed out with taxpayer money, things are now back to where they were before. The Bank of International Settlements instructed the participating central banks via its Basel accords to impose minimal capital requirements to commercial banks. Fluctuations in the banks profitability and losses are further protected by an improved and mandatory capital cushion but will be counterproductive in case of non-financial imperfections such as fraud.
The choice for the right banking partner contains several probes. Systemic banks are of crucial importance for the economy and central banks will do everything they can to avoid closure. Yet, as we saw during the European debt crisis, a bank in Cyprus was bailed out and creditors lost the excess deposit not covered by deposit insurance. From this perspective, a well-capitalized financial institution provides enhanced protection and is less vulnerable for heavy losses. Still, conduct risk in relation to fraud or anti-money laundering and counter terrorism financing relation is not covered by capitalization. As such, a holistic review of different risk factors is needed to decide on the appropriate banking partner.