George Kerevan: How we could have kept runaway horse in its stable

Published on Wednesday 1 October 2008 22:45

IT WILL be all right on the night. That is Gordon Brown's position as far as guaranteeing savers' deposits if a UK bank collapses.

The PM is refusing to follow the Irish government, which has issued a blanket guarantee covering 100 per cent of all deposits in six main Irish banks (including our own UK Post Office Savings, which is part-owned by Bank of Ireland). Instead, Mr Brown has limited himself to saying he will do "whatever it takes" to protect savings in the event of yet another bank failure.

To be fair: no depositor lost money in the collapse of Northern Rock or Bradford & Bingley, because the state nationalised them. Mr Brown could do no less, because otherwise there would have been a run on every bank.

However, we have moved on from Northern Rock and B&B. Guaranteeing the safety of savings on a case-by-case basis may no longer be enough, because depositors have become jittery about holding cash. Depositors treat the daily gyrations in bank share prices as proxies for the health of those banks. It does not matter that Bank X meets the regulator's capital reserve requirements. When depositors see shares tanking, they figure that the market knows something they don't and begin moving their money elsewhere.

Example: in the wake of the announcement of the Irish blanket deposit guarantee, UK savers started shifting cash into Irish banks. Bank of Ireland and Allied Irish Banks said they were inundated by calls from British customers wanting to open an account.

Gordon Brown does not seem to have grasped that crisis of confidence in the financial sector has moved on from investors to savers. As a result, improving deposit guarantees is now as necessary as strengthening capital reserves or stripping out toxic loans.

This week, all round the world, the need to provide clear, legal guarantees to depositors that their money is safe has become a key issue. The Irish guarantees were made because big depositors had started to withdraw cash and the Irish government thought it more prudent to stabilise the situation than wait for a bank to fail (the British way).

In America, in the wake of Congress voting down the Paulson bail-out plan, both Barack Obama and John McCain demanded that the limits on deposit guarantees should be increased, from 56,000 to 140,000. They argue this is a quid pro quo to win over public support for the bail-out legislation.

Why is the UK government against guaranteeing all deposits? Instead, we have something called the Financial Services Compensation Scheme (FSCS). In theory, this guarantees any saver's deposit up to 35,000. The government wants to increase the limit to 50,000. The weakness in the FSCS is that it only pays out net of what you owe the bank, say, on your outstanding mortgage. So if you have 1,000 on deposit, but owe 150,000 on your mortgage, you won't see anything back if the bank fails. That is countered by having a nest-egg in another institution (the Post Office?), but it could catch a lot of folk out.

In theory, the FSCS is paid for by the banks themselves – which explains why they are unhappy about raising the limit on guarantees. Here we get to the root of why the current FSCS scheme is in need of repair. It was designed to cope with the failure of small building societies, not the whole British banking system.

So when Bradford & Bingley went belly-up, there was no way the other banks could actually meet the guarantee to give B&B depositors their cash. Instead, on Monday, the Treasury had to pump 14 billion into the FSCS scheme. The FSCS then gave this 14 billion to Abbey, which had "bought" these B&B deposits for a mere 612 million.

If that sounds slightly bonkers, consider this. Technically, the 14 billion that the Treasury gave to the FSCS (which it handed over to Abbey) is a loan on which the rest of the UK banks and building societies will have to pay the 900-million-a-year interest. For instance, that works out at roughly 100 million a year for RBS to pay, which I and other RBS customers will soon find slapped on to our bank charges and mortgage payments. In theory, the FSCS will be able to sell off the B&B loan book and recoup some of the 14 billion, but in the meantime we are all forking out.

One alternative is to fully fund any deposit insurance scheme, by charging a levy on the banks in good times. This is how the US system works. But in cheapskate Britain, with its "light" regulatory touch, the banks fund the FSCS only when something goes wrong. Of course, at that point – with the financial system in meltdown – they have run out of the wherewithal to pay, which means the taxpayer has to step in. We need a better way.

Which brings us back to the Irish solution. The Irish blanket guarantee covers not only depositors' money, but also bank liabilities. Together, these amount to roughly twice Ireland's GDP – so how can the Irish government afford it? In fact, the Irish scheme is quite clever. Essentially, the Irish government has offered to insure all bank debts and liabilities for two years. For this, it will charge the banks a fee. The fee will be higher for banks which have engaged in risky lending, which helps to take care of the moral hazard problem.

To fund the deposit guarantee, the Irish government will not borrow, but instead take out its own insurance policy (called a credit default swap) at a rate far less than individual commercial banks would have to pay. In the event of the guarantee being triggered, the Irish state will take over bank assets as collateral.

The aim here is to keep the financial horse in the stable, not bolt the door after it has gone, as we do in the UK.

The Treasury maintains that the scale of UK bank liabilities is too great to offer a blanket state guarantee – at least without destroying the government's fragile credit rating. If so, we are paying yet another penalty for hitching the economy's fortunes to the City of London. Hoping things will be "all right on the night" is no way to run a country.