Banking on debt problems: what if my bank goes bust?

22 April 2008

The expression ‘money in the bank’ has always referred to cash that’s 100% secure. But it seems banks might not be quite as safe as we thought – like individuals, they can have their own problems with debt. Although the government stepped in to save Northern Rock, the nation was still shocked by the reminder that it is possible for banks to collapse.

So what happens to investors’ savings if a bank does go bust? Thanks to the Financial Services Compensation Scheme (FSCS), they WON’T lose all their money, no matter what debt problems the bank is facing.

The Financial Services Compensation Scheme
The FSCS protects customers of companies regulated by the Financial Services Authority (FSA). As the ‘fund of last resort’, it will compensate these people if the company cannot pay what it owes them (normally because it is ‘in default’ – i.e. it has stopped trading and its debts outweigh its assets, or it has been declared insolvent).

The compensation rules changed on 1 October 2007.

• Before that date, if a company was declared in default, the FSCS would compensate 100% of someone’s deposit up to £2,000, then 90% of the next £33,000.
• But now, if a company is declared in default, the FSCS will refund every penny of someone’s deposit all the way up to £35,000.

So if you have more than £35,000 in savings, it makes sense to keep it in two or more separate banks. If you split £70,000 between two banks, just make sure they don’t belong to the same ‘parent’ organisation – if they share the same FSA registration, they’ll only count as one institution, so you’ll only be compensated for £35,000 (not £70,000) if they collapse.

How can a bank collapse?
In today’s financial climate, consumers aren’t the only ones facing debt problems. Banks and building societies can have their own problems with debt. A common, regular feature of the banking world, borrowing in itself is nothing to worry about, but the funds available to banks are becoming more limited right now: borrowing too much can be dangerous for a bank, and so can lending too much.

Take mortgages for example. Any company offering mortgages is aware that its customers might default on their payments or even have their homes repossessed. Some of them have granted mortgages worth billions of pounds, but today – with so many people struggling against serious debt problems – they’re not sure how much they’re going to get back.

So if enough people have enough problems with debt, this could spell serious trouble for a bank. Today, the LIBOR rate (London InterBank Offer Rate – the rate at which banks borrow from each other) is almost 1% higher than the base rate, which the Bank of England has just reduced to 5%.

Now that the nation as a whole is facing problems with debt, banks are very careful about lending money to each other, as they’re not sure if they would be able to borrow more money!

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Gregory Pennington are founder members of DEMSA (Debt Managers Standards Association).

DEMSA are the first trade body within the finance industry to successfully secure approval for its code of practice under the OFT Consumer Codes Approval Scheme (CCAS).