Are financial crises like fires?

Fires and financial crisis seems pretty unrelated. Take the Great Fire of London in 1666, the damage was immense. 13,000 homes burning down. If you fast forward to the 2007 global financial crisis, the damage here was of a different nature. Economic growth was its weakest for sixty years in the UK and many people lost their jobs. But while very different things, the causes of fires, and the best way to handle them can help us understand financial crises. So what were the causes?  The first is shaky foundations. At the time of the Great Fire many houses were built of wood, it was easy for them to catch fire. Likewise in the run up to the recent crisis, banks’ activities were built on shaky foundations. For one thing, banks had taken on too much debt. 

Then there’s connectedness. In 17th century London, houses were built extremely close together, making it easy for a fire to spread. Similarly, in the run up to the financial crisis more and more transactions were made between banks, making them very interconnected. So that’s the causes, what about the solutions?

First of all, after the Great Fire, individual houses had to be built from bricks and stone which are more fire resistant than wood. Today, fire inspectors can check smoke alarms and evacuation routes.  Likewise individual banks, now need to build up financial resources in good times, to fall back on in bad times. Banking supervisors, the equivalent of fire inspectors, carry out safety inspections to ensure that banks operate in a safe and sound way. 

The second solution when rebuilding London was to make the roads wider so that fires couldn’t spread so easily. They fixed the design of the City as whole. 

Likewise for fixing the financial system, as well as supervising individual institutions, the crisis showed the need to monitor the system as a whole.  

It’s the Bank of England’s job to look out for risks such as a wide spread build-up of debt that could destabilise the financial system. 

Today if a building caught fire, you would call the fire brigade who would try to put it out. In a financial crisis, the Bank of England could step in, for instance by offering emergency loans to banks in extreme financial distress. 

And even if a bank does collapse, the Bank of England now has the tools to make sure it does so in a safe and orderly way. You wouldn’t need to worry about losing any money up to £75,000 or your ability to make payments. In summary, the financial system is safer than before. 

The Bank of England inspects individual banks, monitors risks to the system as a whole and has the tools it needs to step in where needed.