While exchange rate changes have this potentially stabilizing effect, they can also be destabilizing. When exchange rates are allowed to fluctuate, they are set in currency markets according to the demands and supplies of forward-looking traders, and they can be very volatile, often overshooting long term values. This volatility can destabilize trade and impart significant uncertainty to international lending. Borrowers may borrow in international markets expecting to repay at one exchange rate, and when the bill comes due, the exchange rate may differ, by a lot. Lenders and borrowers can both hedge, but hedging is costly, and institutions providing this hedge can go broke.
Financial institutions engage in what is known as maturity transformation.
They take deposits from you and me, which deposits can be redeemed any time we take out our check book, and make long term loans to mortgage borrowers and businesses. There are fantastic efficiencies in this process - consumers can get higher returns on their saving, and business can borrow and invest in productive equipment. Indeed, banks and other financial institutions play the same role in allocating domestic saving to its best uses that the international capital market plays for international capital. But as with capital flows, there are risks. If the banks' loans go bad, the institution is in trouble and may not be able to redeem deposits.