Helping savers and attending to credit risk

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The public interest does not require taxpayer support of financial institutions: indeed it requires that some of them make substantial losses in this crisis. Only then will credit risk begin to be priced appropriately and lenders do their diligence.

If Alistair Darling, UK chancellor of the exchequer, had any doubts about the wisdom of bailing out the mortgage bank Northern Rock, such doubts would have been quickly dispelled by the picture of long queues of voters standing outside its branches to get their money back.

The political imperative is that savers who put their cash on deposit with a respected institution cannot be allowed to lose money, or even to seem to be at significant risk of losing money. I do not think it is reasonable to ask the person in the street to do more due diligence than is implied in the selection of a long-established bank with an extensive branch network. You may think otherwise but you would be ill-advised to defend your view at a public meeting – and that is what politicians must do. There is little more to be said.

The Financial Services Compensation Scheme protects politicians by protecting depositors. The scheme repays the first £2,000 of any deposit and 90 per cent of the balance up to £35,000, financed through a levy on other banks. The scheme is a compromise – generous enough to be resented by the industry, but too stingy to meet the requirements of practical politics.

Because of this inadequacy, the government feels obliged to intervene to ensure that no financial institution that deals extensively with the public can fail. But such a policy underwrites not just the retail deposits but the whole funding of the institution. Securitisation has pushed small savers to the back of the queue: while those Northern Rock customers were standing in the street outside, many of the bank’s mortgage loans were already pledged to wholesale lenders. And banking supervision is directed at the solvency of the institution and only incidentally at the protection of small savers.

But the public interest does not require taxpayer support of financial institutions: indeed it requires that some of them make substantial losses in this crisis. Only then will credit risk begin to be priced appropriately and lenders do the diligence they have recently failed to perform.

So the limits on deposit protection should be raised substantially – to cover at least the whole of the first £250,000. This may be expensive. In the US the savings and loans debacle of the 1980s cost the taxpayer tens of billions of dollars. Banking failures are rare, but when they happen they may be on a large scale. A serious collapse would push the Financial Services Compensation Scheme to, and probably beyond, its limits.

Yet well-run banks have a legitimate objection to writing unlimited cheques for the losses of their less competent rivals. Their lobbying explains why the current limits of compensation are so meagre. So government must accept that it will contribute to deposit protection in the event of catastrophic loss. That acknowledgment simply recognises reality. Treasury support will be needed in any big crisis, as it has been in this one.

Then, government should jump the queue of creditors on behalf of small savers. Legislation might enable the Financial Services Compensation Scheme to recover its payments to depositors as a priority creditor in any liquidation. More radically, supervision might insist that retail deposits are substantially or wholly covered by an earmarked pool of high quality assets. The costs of a collapse would then still fall on the banking sector, but on those who had done business with the failed bank rather than on the industry as a whole.

The main objection to this proposal is that it would restrict the ability of banks to use their retail deposit base as collateral for their broader activities. That is precisely the intention. The belief that governments will intervene to protect their voters from the consequences of any banking failure has enabled banks to engage in complex debt transactions and to cut margins on riskier lending. The market believes that central banks will ride to the rescue and so far they have mostly been proved right.

It would create a competitive disadvantage for British banks if the British government were the first to make clear that this implicit subsidy is no longer available. But perhaps other governments would see the merits of following suit.

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