Wednesday, 21 August 2013

Lender, beware

"It is time that people took responsibility for managing their own money, and stopped expecting banks to do it for them."

My new post at Pieria talks about the nature of the relationship between banks and depositors:
"I recently wrote a post with Euronomist in which we suggested that depositors should be explicitly charged for deposit insurance, rather than insurance being implictly provided by the state or covered by a levy on financial institutions.
"This did not go down too well in some quarters. There were a number of comments along the lines of "why should I pay for the risks that banks take?" and "banks should look after their customers' money". Underlying these remarks was a fundamentally wrong understanding of the nature of the relationship between modern banks and their depositors. And this wrong understanding is the main source of anger towards banks for putting depositors' money at risk, and anger towards banks for giving rubbish returns to savers. Most depositors believe that the job of banks is to keep their money safe. Many depositors also believe that they are entitled to a share in the returns that banks make from "lending their money out".  In short, depositors expect banks to invest their money responsibly to generate good returns, and absorb the risk of those investments so that depositors do not suffer losses. But that is not how banks see it. And the law is on the side of banks.......

Read more here.


  1. There is a rumour that EU authorities are thinking of abandoning taxpayer funded deposit insurance. The source of this information does not look reliable. But for anyone interested, see:

    On a separate point, Frances suggests that it is not reasonable for depositors to expect much protection because “that is not how banks see it. And the law is on the side of banks....”. I suggest there is a better argument than the latter two, and as follows.

    If a depositor plonks money in a bank which is riskier than something ultra-safe, like National Savings and Investments, the extra interest the depositor will demand and expect will simply reflect the extra risk: no more and no less. But if government insures that deposit, the premium will simply reflect the risk: no more and no less.

    Ergo the premium wipes out the extra interest (assuming everyone gauges risks correctly). Plus if depositors bear the cost of the premium (which they should) then putting your money in anything more risky than NS&I makes no sense. Alternatively, if the taxpayer pays the premium, then that’s a subsidy of banking, and subsidies are a misallocation of resources.

    Ergo, if Joe Bloggs wants to undertake risk, then bully for him, but it’s Bloggs and Bloggs alone that should carry the risk: deposit insurance makes no sense.

    1. Ralph,

      This isn't right. But the reasons why it isn't right are complex, since they are not to do with the bank's risk (which is the same for everyone) but the effect of that risk on the depositor and the insurer. The impact of default on the insurer is (or should be) much less than it is on the depositors, so premiums can be less than the returns on the assets protected. It is the whole basis of insurance for financial assets, actually: CDS premiums do not wipe out the returns on underlying assets, otherwise no-one would buy them as hedges (which they do). Deposit insurance is really only CDS on retail deposits.

    2. Frances,

      “The impact of default on the insurer is (or should be) much less than it is on the depositors..”. True, but I don’t think that invalidates my argument. Take car insurance….

      Me writing off my £10,000 car in an accident would a big problem for me if it wasn’t insured, but £10,000 is nothing for my insurance company. However that doesn’t alter the fact that the insurance company has to charge a premium for EVERY car owner that reflects the risk of a write off. E.g. if the chance of a write off in any year is 1%, then the premium would need to be 1% of the value of all cars insured (ignoring third party and other risks).

      Same goes for deposit insurance. E.g. and taking a simple example, if the chance of each depositor losing everything is 1%, then the premium needs to be 1% of total deposits.

      Plus the return that depositor gets from depositing at a commercial bank rather than NS&I, ought to simply reflect or be equal to the additional risk undertaken. If the return were much more than the risk, then people would just deposit more money in commercial banks till the return and risk were equalised.

      That all assumes that depositors are well informed about risks and that the market works perfectly, which of course is an over-simple assumption. But absent better information, it’s the best assumption one can make.

    3. Ralph,

      I'm afraid it does invalidate your argument, actually. The fact that the risk for the insurer is less means that the premium is also less than the return to the depositor. This is how reinsurance works: insurers lay off risks to reinsurers for a premium that is lower than the premium they charge you to insure your car. The reinsurer charges a lower premium because he is pooling risks, so in aggregate is taking less risk than the individual insurer.

    4. Frances,

      My answer below will be too complicated for 99% of readers of this blog (or any other blog). But here goes.

      Your comparison with reinsurance does not hold. Reinsurance involves risk pooling because the original insurer keeps part of the risk: i.e. passes on just SOME OF the risk to the reinsurer. In contrast, under deposit insurance, the risk is transferred lock stock and barrel from depositors to government. And even if risk pooling were involved, the point is still not relevant for the following reasons.

      The risks run by an asset owner and their insurer come in two types (although there is no 100% sharp dividing line between the two). First there is the risk of a ruinous loss. And second, there are smaller losses which asset owners could absorb themselves without going bust.

      Next, anyone doing anything that involves the possibility of ruinous loss will want a significantly bigger reward than doing something that involves a smaller risk. Thus if spreading a risk disposes of the possibly of anyone being totally ruined, than the total costs of insuring the risk will decline. However, the “total ruin” risk is already catered for by the risk pooling characteristics of banks. To illustrate, the typical UK high street bank has several million depositors and borrowers. That’s risk pooling on a big scale. I.e., I’d guess the chances of depositors (absent deposit insurance) losing more than 20p in the £ in the case of UK high street bank going insolvent would be vanishingly small.

      So all deposit insurance does is to deal with the remaining risk: the risk of losing that 20p in the £. And losing 20p in the £ will ruin very few people. So the total cost of insurance won’t come down to any significant extent. I.e. all that happens is that risk is transferred from depositors to government.

      So, getting back to my original argument, the amount charged by those two groups (depositors and government), assuming they gauge the risk correctly, will be the same. Plus when depositors put money in a commercial bank rather than something near 100% safe, they’ve no reason to demand any more interest than is needed to cover the “20p” risk. Ergo, the insurance premium wipes out the interest.

    5. Er no. The risk reduces because of the size of the pool and the manner in which the risk is distributed. Same with derivatives as hedges - they take the entire risk but not the entire return.

    6. Also, can I suggest you refrain from patronising people? This blog is read by professionals from the financial industry. I don't think they would appreciate your suggestion that what you say is too complicated for them to understand.

    7. This comment has been removed by the author.

  2. I wholeheartedly agree. For one thing, I think it would do most people the world of good to be charged for what is, essentially, a service. It would focus their minds on what service they're getting and what risks are involved. I think it would force people to take their own financial planning and financial affairs more seriously. I

    It would also be fairer on poorer account holders who, let's be honest, are subsidising wealthier account holders at the moment through extortionate overdraft fees/unpaid DD fees etc.

    What would your thought be Frances on the option of a public bank - ie one where you can keep your money (for a fee) knowing it's absolutely guaranteed, but with no interest. Just a place to keep money safe and from which to pay bills for those who don't want or who cannot afford risk. If you want growth/interest/return (call it what you will) on your money you have to go to the market and take the associated risk.

    1. I wholeheartedly agree with the idea of a public bank for those who can't or don't want to take risk.

  3. I found this a fascinating column because it is a special case of a wider phenomenon in our society, which is the cognitive dissonance that permeates a lot of public debate.

    People want their soccer to be highly competitive, but they want their schools to reward all equally. They want to be able to buy a better car than their neighbour, but they don't want one parent to be able to buy a better education for their child than another parent. They want to be able to spend their own money on better clothes, but they don't want you to be able to spend your money on private health care. And of course they want credit to be freely available, but if they default on their mortgage, they want that to be the fault of the Bank that "mis-sold" the mortgage to them, and as you point out, they expect real returns with zero risk.

    Two things need to happen to help to fix this, but I am not optimistic that either of them will. First, children need to be educated that they must assemble the skills to make good life decisions, and to avoid making decisions they are not yet qualified to make, but I don't think that will happen as long as education is busy pushing the idea of "fairness" as an intrinsic element of life. An education system that is committed to the idea that everyone is equal isn't going to let children in on the dirty secret that your success in life is due to the skills you assemble, rather than to society's benevolence and care.

    The second thing I would like to see, but don't think I ever will, is for ordinary citizens to find it as normal to discuss personal finance as they find it to discuss Saturday's soccer game.

    As long as we treat "profit" as a dirty word, "risk" as a scare-word, and "reward" as something only the rich receive, ordinary people will continue to get out of their financial depth, will continue to get financial advice from "experts" who have conflicts of interest, will continue to chase bubbles, and will continue to make the mistake of confusing Banks with benevolent societies.

  4. "It is time that people took responsibility for managing their own money, and stopped expecting banks to do it for them."

    A fine aspiration. But given the level of maths, let alone finance education, the perverse incentives of the fund management industry, and the high costs of receiving proper advice, how successful do you think the outcome will be?

  5. The reason for deposit insurance is to prevent runs on banks. Once we say "It is time that people took responsibility for managing their own money, and stopped expecting banks to do it for them" the the logical and proper response of the general public is to start stuffing the mattress.

    1. Logical? Hardly. Paper money in mattresses is at risk from fire, flood, vermin and thieves. People can of course insure themselves against these losses by paying money to an insurance company. How does that differ from paying money to insure money in the bank against losses?

    2. Frances, you took me too literally.^^ All I meant is that they will take their money out of the bank. Maybe they will keep cash in a safe deposit box. My main point is that there is no reason to deposit money with a bank if you aren't going to earn any interest and your deposit is not protected.

    3. Then if banks want deposits they will have to offer better interest rates, won't they!

    4. "Then if banks want deposits they will have to offer better interest rates, won't they! "

      And that is why the "Public Bank" option mentioned above will be resisted at all costs. The electronic payments system effectively gives the retail banks a monopoly position over the public's savings / deposits from which the banks are able to extract economic rent through not having to pay a fair return to savers.

      A Public Bank that offered electronic transfers would pose real competition for the commercial banks and should a Public Bank be able to make loans, then that would be a double whammy. Our government shows every intention of preventing that challenge to the rebuilding of commercial banks' sound economic status. After all, how difficult would it be to turn Lloyds (or part of it) into a full Public Bank?

      The Wall Street banks are, it appears, presently trying to erase the competition from credit unions that threaten their monopoly.

  6. If every saver withdrew all their money on one particular day you can be very sure interest rates would rapidly go up

    As for suggestions that we should pay banks to keep our money safe there would be no point in bothering to save at all

    Theres far too many people who think Investment is a better idea but it simply is not a good idea for millions of people and the worry and need to constantly check on things would be too much for many especially as they get older

    The plain fact is that a year ago before FLS was foisted on the scene savers were getting a lower but at least maneable return

    Its that savings rates have been decimated by FLS that has hurt so many people so badly and extremely unfairly

    While all those who caused the crisis get off scot free

    1. Deborah,

      You already pay to keep your money safe. You just don't know you do. I'm trying to explain what your relationship with banks REALLY is.

      You haven't read this post properly. Please follow the link to the rest of the post on Pieria, where you will see that I suggest Government safe saving schemes for those who can't or don't want to take risk with short-term or rainy day savings.

      Your notion that investments are a bad idea because you have to "check up on things all the time" is simply wrong. Long-term investments in professionally managed funds are much safer and give better returns than large bank deposits. I'm sorry, but they are.

    2. "Long term investments in professionally managed funds are much safer and give better results "

      SADLY NOT IN MY EXPERIENCE and unlike all the PPI claims etc Neither I or others can claim compensation

  7. I am struck by the comments that long-term investment is "not a good idea" or too complicated for ordinary people.

    To me, that is a pretty good example of the bad ideas that schools propagate about personal finance. If you read the readers' comments on finance stories in, say the Guardian - I don't seriously suggest you waste your time doing so - one of the themes that come across very strongly is how many people have come to believe that Banks are criminal enterprises, exchanges are rigged, and only the rich can make money investing.

    And then the same people turn around and insist that they are entitled to a real return and zero risk on money they deposit in a Bank.

    They simply refuse to recognize that risk and yield are correlated, and if you want zero risk you will get close to zero reward.

    Investment isn't magic. It is hard work and most people won't do the work it takes to be as familiar with your investments as you are with your local football team, national politics, or daytime TV.

  8. Great post overall, and I hope it helps people understand better what banks are.

    One of your suggestion though will help confuse people: your government guaranteed infrastructure investment vehicles are really just gilts. It is confusing to pretend otherwise, plus whatever cost a dedicated vehicle has is 100% wasted. So if it's good for government to fund infrastructure (I will usually agree), let's just issue more gilts. Dedicated vehicles would only make sense with risk sharing: no or partial repayment if the underlying projects fails.

    I'm also sceptical about your clumsy idea of insuring savings accounts. It would be simpler, cheaper and less confusing to ban outright interest on savings and move to a brokerage model: transaction cash accounts, central bank insured, with a ban on interest, and a facility to buy gilts and corporate bonds regulated like existing brokerages. Then the choice is clearer: buy gilts if you want safety, corporate bonds if you want yield.

    (And btw in the UK, it's already not that hard for retail to buy gilts, the tricky rules are only on new issues tenders, plus the regrettable 5 year duration minimum on ISAs that would be trivial to abolish.)

  9. Frances

    I agree with you that people harbour incoherent views on retail banks. Of course banks are not managing their money for them. But what is wrong with a model where banks need to pay an insurance premium to the govt on all their retail deposits (whether these premiums are passed on to depositors or not), and depositors themselves are given the choice whether to hold their funds as bank deposits, NS&I or securities?

    If you are ultimately saying that everyday people should be forced to become investors, this seems both unrealistic and unreasonable.

    Most people barely understand any mathematical / financial concepts beyond (or including!) compound interest. Your policy recommendations would need (not just most but) all of the public to grasp relative value, risk-reward etc. I can't see this happening in my lifetime. And frankly, people have an increasingly tenuous grip of their own lifetime investment horizon: how many people can say with any confidence when they will retire and what income they will need? And I'm shocked at your relaxed attitude to professionally-managed funds, when the majority of active funds lag their index after mgt fees.

    But fundamentally, how fair is it to force the public at large to have their entire lifetime savings exposed to the vicissitudes of asset price cycles (as opposed to that portion which they want to venture)? Do you think the authorities should merely shrug at the possibility - in a world where all long-term wealth is managed professionally - that two people with equal starting endowments, real wage income and lifestyles, will face radically different pension endowments depending on when they were born?

    1. I did say that I thought Government should provide safe savings schemes for people who can't or don't want to take risk. You must have missed that bit.

      But yes, I do think people should pay to protect savings in commercial banks. Banks are not safe deposits, they are lenders. If you put your money in banks it is at risk unless you do something to protect it. It is essential that people understand that.