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Is your money safer under the mattress?

11 March 2013

There has been remarkably little press coverage of the threats posed to bank depositors by recent measures, notably in statements by the Government and in draft primary and secondary legislation now before Parliament. And while the  Banking Standards Commission’s second paper (published today, 11 March) contains much laudable criticism of other aspects of the Government’s banking reforms (notably on the inadequacy of a 33 times leverage restriction), it is strangely silent when it comes to the question of “depositor preference”. In their first report, issued in December, the Commission recommended that a joint group should look into the matter, but they were fobbed off with a Government response referring to European harmonisation initiatives on deposit guarantee protection, otherwise known as “the long grass”. Meanwhile the unchallenged measures set out in clause 9 of the Banking Reform bill ensure that we are sleepwalking towards a repeat of the Northern Rock panic. These proposals represent a fundamental threat to the safety of banking in the UK, and combine unfairness with a structural instability that makes it quite impossible to meet the proviso in the evidence given by Lord Turner to the  Banking Standards Commission (27 February) when he reported “a [new] philosophy that we are going to accept in future that the actual failure of a bank – provided that it happens in a smooth fashion…with rapid payout of insured deposits – is not a regulatory failure.”

Everyone now knows that bank bondholders are at risk. The question is what is to be the plight of uninsured depositors – ordinary people who happen to have more than £85,000 in the bank when it collapses? These may be short term transactional balances, or fixed term deposits placed recently before this change in philosophy in the legitimate expectation, following Northern Rock, that whatever the legal position, Realpolitik would require support for retail depositors. There is ample evidence that this belief was rational. For example, in 2010 a High Court judge (Henderson J in Alliance & Leicester) said “It will be recalled that, when Northern Rock was on the point of collapse in September 2007, the government stepped in to guarantee deposits of any size with that institution, and I find it difficult to envisage circumstances where similar steps would not be taken in the future.”

When the Chancellor gave evidence to the Banking Standards Commission in November 2012, he signalled the new philosophy, mentioning the “unremarked on” failure of Southsea Mortgage and Investment Company, where depositors lost their money above £85,000, adding “We have demonstrated, and we wanted to demonstrate, that we are in the business of protecting £85,000 of deposits, and not beyond that.” But Sir Mervyn King’s comments to the same committee indicated that he thought that the Southsea approach could not be repeated with a larger bank. And in Dr Mark Carney’s written evidence before the UK Treasury select committee hearing on 7 February, he stated that in future bank failures, resolution procedures should mean that losses are borne by “bondholders, shareholders and management – rather than taxpayers” (or, by implication, uninsured depositors), suggesting that he too would be uncomfortable with bailing-in retail depositors.

Last month I appeared in the High Court to oppose the banking business transfer from ING Direct to Barclays. I was unable to convince the judge that there was any significant issue in the compulsory novation of my uninsured ING deposits (which arguably enjoyed the implicit support of the AAA-rated Dutch government) to Barclays, to whom I am already overexposed. I suspect that this judge too believed that Barclays would simply not be allowed to go under.

In response to my complaint, Greg Clark, Financial Secretary to the Treasury, told me that “those who place deposits above [£85,000] must be responsible for monitoring and managing the risk associated with their investments.” That of course is precisely what we cannot do – even customers like me, a former banker, well versed in credit analysis – since Government policies have compounded the obscurity of bank financial information by continuing to allow banks to borrow from one another secured, while retail depositors cannot negotiate such protection.

The Chancellor’s determination is now reflected also in clause 9 of the draft Banking Reform bill currently before Parliament: not merely are uninsured depositors to be bailed in, but they are to be subordinated to the claims of the rest of the banking industry whose rights to recover their FSCS contributions are now to be given priority. The effect is that on liquidation, an uninsured depositor is likely to receive nothing, even where a bank’s asset quality might conceivably have been quite good and where the payout to senior creditors with pari passu treatment would have been high.1

It is worth noting that a generation ago, under the tradtional pari passu approach, banks did not give security over their assets (so that all creditors were entitled to an equal proportion of their claims). This tradition has been gradually eroded, as banks can no longer accept the unsecured credit risk of other banks (which they find as unfathomable as we do), so that almost all term interbank lending is now secured (that was why the LIBOR scandal was able to happen). And Governement policies, such as the ill-conceived Funding for Lending Scheme, compound the problem by also taking security over banks’ better assets: that the Bank of England should protect the public’s position by exacerbating the instability of banks’ balance sheets is a particular irony.2

The Government’s failure to accept the Commission’s recommendations on leverage will of course compound this by reducing the cushion of net worth, so that quite modest shrinkage in a major asset class will precipitate the run that tests these priority rules.

In a properly functional economy the answer might be offered by competition. But banks that maintain safe levels of leverage or operate negative pledges on granting security have all vanished. The Government however have dismissed (and omitted from the bill) the Vickers commission’s recommendations on the need for increased competition on the grounds that the necessary changes are already in hand – one of the four main bases for this contention being Project Verde, now known to be in difficulty. Despite this, the Barclays/ING Direct transaction was allowed to proceed before the emergence of serious challenger banks, and (as the Treasury’s own impact assessment, published with the bill, acknowledges), depositors may now have to accept lower rates of interest despite facing higher risks since they are forced to divide their deposits among less competitive providers. This indicates a complete breakdown of a free market.

The matter has now been compounded by the publication last Thursday of drafts of the secondary legislation to accompany the Banking Reform bill. They include provisions for large or non-core deposits, under which a “certified high net worth individual” is allowed to place deposits with non-ring-fenced banks and thereby no doubt enjoy a higher interest rate. The requirement is a rather modest level of £250,000 of “free and investible assets” (a level of capital from which the annual income at today’s rates, around £2500, hardly qualifies the possessor as rich: the Government had originally indicated £750,000), but the drafting around even this protection seems particularly poor. There is an attempt to stop you mortgaging your home to invest but nothing otherwise to stop you borrowing to take up the deals that investment banks will offer. There is a requirement for an accountant to countersign the form, but that should not be mistaken for an assessment of whether you can afford to lose the amount of the deposit. No doubt some banks will even offer to find an accountant for you.

The political question that must now be confronted is whether we wish to see retail depositors having to choose between utility level returns of say 1% in regulated building societies versus say 4% in investment banks. We would also in effect force poorer customers to pay 3% per annum for the FSCS guarantee, the cost of which was always supposed to be borne by the banks. This is a two-tier system in which the rich get richer and the poor pay for it. The Banking Standards Commission seem curiously relaxed about it. But they may not be when the investment banks start to exploit inflation-squeezed depositors’ hunger for return by feeding them mispriced junk: that may be the next PPI scandal, and it is state-sponsored.

These measures cannot be an acceptable way in which to fix our broken banking industry. In a modern economy such confusion about the safety of banks is unacceptable: it is no good if politicians take postures which senior bankers and judges don’t believe, and the public are left to guess. It is a recipe for panic – not a “smooth” failure. It is also unnecessary: moral hazard is adequately dealt with by bailing-in bondholders, shareholders and management, and a banking system in which six-figure sums are not safe is a far greater deterrent to inward investment than bogeys such as EU interference. The catastrophe of 2008 should be met by transparency and honesty, not with a political finesse which belongs at the gaming table.

Footnotes

1. Perhaps a simple example will help. Suppose a bank has £100 of assets (all unpledged for simplicity), funded by £3 of equity, £90 of insured deposits and £7 of uninsured deposits. Its assets then shrink by say 10% to £90, and it is wound up. Under current rules the uninsured depositors will get back (7/97)x90 or 93p in the £ (the same rate as the FSCS, who have had to pay out the smaller depositors in full), while under the new rules  the FSCS lays first claim on the £90 assets having paid out that amount to the smaller depositors, and nothing is left over for the uninsured depositors.
2. Secured creditors have access to assets ahead even of priority creditors. They are also likely to have control over the best quality, most saleable assets; what is left to the unsecured depositor is likely to bear most of the shrinkage.

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