Monday, September 6, 2010

Mandated - Too important to fail

Recently, I visited Scotland and the first thing that I noticed (apart from the breathtaking view, that is) was the fact that currency notes were guaranteed by the Royal Bank of Scotland. It was extremely surprising given the fact that most banks that guarantee the payments of the amounts denominated are central banks. And central banks do not operate as commercial or investment banks (which RBS does).

And the fact that RBS was indeed rescued by the British taxpayer during the last crisis, gives more weight to my suspicion that it is mandated by the government to be too important to fail. A vast majority of the notes in circulation in Scotland are RBS guaranteed and hence the government can just not afford it collapsing.

Some thing even more surprising was the fact that England was one of the first countries to have a central bank and almost all of world's central banks are based on its model. Central banks operate in accordance to the government's fiscal policy and since they do not have any financial arms, they are immune to shocks from market crashes. This typically gives more credibility to a country's economic system. So if tomorrow the markets crash down, and RBS looses so much money that people lose trust in RBS's promise to pay the bearer an amount equal to the denominated pound value, a run on the bank occurs and all of the country's financial system stops working. To me that is a very scary thought. The only was the government can stop a run on the bank is such a case, is by mandating that RBS is too big and important to fail. So whatever happens, government will have to provide assets to back up all the banks that issue notes on its behalf.

As I later realised, "Clydesdale Bank" also issues currency notes. Now what is not clear to me is if all banks in Scotland are mandated to issue notes on their own or not. Though entirely possible,  this does not strike me as particularly prudent. Essentially the government then risks having the credit rating of the worst credit rating of the bank issuing notes.

It is possible that the government has only allowed banks to issue notes in return of some highly under valued collateral so that it can withstand the shocks, but I am not sure about it. Anyone who can enlighten me on that? Also I would really like to know how such a sytem evolved in Scotland when England had a central bank system. Any guesses?

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Tanwi Kiran said...

nice analysis ....informative piece.... but cud not answer ur questions .....

Tanwi Kiran said...

gud one .....informative too....but cu not answer your questions

deathmetal124 said...

Lots of guys here in India tried that too man (printing their own currency notes). But they all got locked up. No value for innovation, I tell you.

Ankit Ashok said...

:) True that, man!