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Any fractional reserve banking system depends on its ability to maintain confidence and convertibility. This basic principle is eroded if risks (in particularly systemic risk) are not properly mitigated (Levy and Post, 2005). Let's consider the cash ratio. It is clear that the smaller the cash ratio, the greater the size of the credit multiplier and the greater the volume of bank deposits created on a given cash base, and vice versa. In most countries, the commercial banks are required by law to maintain a minimum cash ratio, although no maximum is established.
For example, the minimum cash ratio in the US is fixed by the Federal Reserve and has legal force. In Britain there is no legally determined minimum, but by long convention the commercial banks work to a minimum cash ratio of eight per cent. Note that these differences did not stop runs on banks in both countries: Bear Stearns in the US and Northern Rock in Britain.
The manner in which both runs were handled was very different. In the US, the Federal Reserve – avoiding a disorderly closure of Stearns - simply facilitated the its purchase by JPMorgan Chase, while in Britain, the old problem of who should do what resurfaced and dragged on for a while and the Rock was eventually nationalised.
As a Northern Rock shareholder I am still waiting a letter from the government about my shareholding and I don't think it'll come through anytime soon. As a taxpayer, I have effectively been hit twice and I therefore agree with Persaud(2008) that the current model which celebrates ''...expropriation of gains by bankers and socialization of costs by taxpayers'' isn't working and is a dangerous one! The vexing thing about the Rock debacle is that its 'risky' business plan was known to the Bank of England and the FSA. Persaud(2008) seems to be advocating only a tweaking of the risk model.
I disagree here. The risk model also has many limitations. I note that Equitable Life, one of the world's oldsest assurance companies, became insolvent because of miscalculations regarding 'guaranteed' payouts on packaged products which triggered a legal battle after which investors starting withdrawing their money and ignoring steep penalty clauses. On the FSA's risk radar, Equitable Life was rated very low risk, if it appeared at all! My point is market participants should only be made aware of the risks they are running dealing with banks or other market participants, no bailouts whatsoever.
Northern Rock should have been allowed to hit the fan. Many businesses do, why not financial institutions? Even my beloved Birmingham City FC would not be playing top flight football next season. Am I bitter, yes of course but I won't support any endeavour which would allow club chairmen to take extravagant risks. I support only two government interventions: (i) the assurance that the rules of the game are being enforced and market participants are following the rules – nothing more; and (ii) a free programme to educate investors.