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.
In days of old, when bank managers were real men and cash points weren't invented, the UK had things called "savings banks", which were intended to encourage ordinary people to save. The best-known of them was Post Office Savings, where people saved both for themselves and for their children: I had a Post Office savings account when I was a child. This was a Government savings bank, the forerunner of the modern NS&I. But there were also numerous "Trustee Savings Banks", so called because, rather than having shareholders or being owned by their customers (the mutual ownership model), they were non-profit making organisations owned and managed by trustees on a strictly voluntary basis - no personal benefit was permitted. I read an article in the Daily Telegraph recently which claimed that the UK's savings banks were the equivalent of the German Sparkassen, which are savings banks that lend to small businesses. No they weren't. They lent to nobody. The Savings Bank (England) Act of 1817 forced them to invest the saved money in government debt or place it with the Bank of England, and this requirement was extended to Scottish savings banks in 1835. The Trustee Savings Banks guaranteed 100% return of nominal funds to their depositors, rather as money market funds in the US did until 2008, and their safe asset investments enabled them to offer low stable returns on savings.
In this article in the Daily Telegraph, Andrew Lilico explains how the Trustee Savings Banks fell victim to the high inflation of the 1970s and the introduction of deposit insurance in fractional reserve banks as a result of the Secondary Banking Crisis of 1973. Trustee Savings Banks guaranteed return of nominal funds, but not real returns. Because they were restricted to safe assets, they were unable to generate the returns needed to protect depositors from inflation, so when inflation was high, depositors' principal was eroded. In response, depositors moved their funds to fractional reserve banks which could offer higher returns by taking risks with the funds. The 1976 Trustee Savings Bank Act removed the restrictions on Trustee Savings Banks, enabling them to compete with fractional reserve banks - but it killed the savings bank model. By 1979 the Trustee Savings Banks had been merged into a single organisation, the TSB, which was to all intents and purposes a fractional reserve lending bank rather than a savings bank. And in 1995, nine years after the TSB was floated on the stock market, it was taken over by Lloyds.
But the beliefs that the Trustee Savings Banks engendered about the responsibility of banks towards their depositors live on to this day. And this explains much of the fear and anger that depositors feel when it is brought home to them that their money is not safe in banks. It explains savers' demands for the nominal value of deposits to be regarded as sacrosanct - hence the dusty reception to our suggestion that depositors might be charged for deposit insurance. And it explains the popular belief that the job of banks is to "keep our money safe". But it doesn't explain some depositors' belief that the real returns on their deposits should be protected from inflation. That appears to arise from the fact that until the 2008 financial crisis, fractional reserve banks gave returns above inflation on most deposit accounts. But this was always an illusion. No private sector institution has ever guaranteed returns above inflation on low-risk savings. High returns mean high risk. And now depositors don't want banks taking the sort of risks that would be needed to ensure returns above inflation, fractional reserve banks are in a similar position to the Trustee Savings Banks in the 1970s. The difference is that depositors have nowhere else to go. The days of above-inflation returns on bank savings are over.
But the sad fact is that we no longer have savings banks. Modern banks (and building societies, which are really specialist lending banks serving the housing market) are fractional reserve lending banks - and their responsibilities are entirely different. Their job is to provide finance to households and businesses, not to manage depositors' money.
A deposit in a lending bank is simply an unsecured loan to that bank. The bank can do whatever it likes with the money, and there is no legally-enforceable guarantee that it will even return the money, let alone invest it responsibly for decent returns. In the event of bank failure, depositors are only entitled to a share of the failed bank's assets in accordance with seniority rules - and that means, at present, that they rank behind secured creditors such as covered bond holders and equally ("pari passu") with other unsecured creditors such as senior bond holders. To be sure, there is some protection for depositors, through the deposit insurance scheme mandated by government and supposedly paid for by the banks through a levy on deposits. But anyone who thinks this levy is actually paid by banks from their profits is dreaming. It is a tax, and as with all corporation taxes the incidence actually falls on people. When you tax a corporation, it is their customers, employees and shareholders who pay that tax. When you impose a levy on banks, it is their customers, employees and shareholders who pay that levy - principally their customers, since the UK's banking market is so concentrated that there is too little competition to drive up returns on deposits and force bank employees and shareholders to take the hit.
To modern lending banks, retail deposits are merely a source of funds. Lending banks like retail deposits because they are less likely to run than other forms of short-term funding. And they like retail depositors because they can sell them loans. But contrary to popular belief, banks don't "need" retail deposits in order to lend. Banks can, and do, find other sources of funds, such as issuing bonds (perhaps through securitising loans, as Northern Rock did) and borrowing from other financial institutions. They have little reason to treat retail depositors more favourably than other suppliers of funds, and certainly no reason to pay them much more than the rates they would pay other suppliers. So when LIBOR - the benchmark rate for interbank lending - is low, rates to retail depositors are also low. Banks will not offer higher rates to retail depositors simply because retail depositors want them to. After all, they can always get funding elsewhere.
Nor do depositors have any right to a share in the returns that banks make on lending, as some have suggested. That is the right of shareholders, not creditors. All that depositors are entitled to is the interest that the bank has agreed to pay. If the terms of the account are such that the bank can raise or lower interest rates at will, then the bank can cut interest rates on deposits to near-zero while still making 20% or more on some forms of lending. Depositors have no right to higher rates simply because the bank is making more profits. Their only right is to withdraw their funds in accordance with the terms and conditions on the account (including giving notice where that is required).
So depositors' expectations of banks are utterly wrong. In fact depositors' description of themselves as "customers" of banks is wrong. As far as banks are concerned, their customers are the people and businesses from whom they make money - their borrowers. The only depositors who are customers of banks are those who use banks' payment services (for which they are currently not charged, but that is inevitably going to change) and those who also borrow. All other depositors are suppliers, not customers.
I have some sympathy for Andrew Lilico's argument that savings banks should return. But we have moved on from the days of the Trustee Savings Banks, and people now have a range of alternatives for long-term savings, although for short-term and rainy day funds there are still few alternatives to bank accounts. In Western economies, it is transaction accounts that most need to be kept safe from erosion or loss, since they contain the essential money that people and businesses need for day-to-day expenses. So there could be a case for full reserve ("narrow") banking for transaction accounts, although I would prefer deposit insurance backed by the central bank (so it can never be insufficient) and emergency lines of credit provided by the central bank, as I have discussed in previous posts . There might also be a case for deposit insurance or narrow banking for instant access deposit accounts, so that people's rainy day funds are covered. Alternatively, NS&I could be expanded to provide a safe "instant access" savings vehicle for rainy day funds. However, I don't believe that transaction accounts and insured deposit accounts should give much in the way of a return. Safety comes at a price.
I do not think that banks - whether lending banks or savings banks - are the right place for long-term savings such as pensions. Money is not a safe store of value over the longer-term, since it is eroded by inflation. And long-term savings need to give higher returns than short-term and rainy day funds, since the returns will eventually form part of income. Higher returns come from taking risk - or, putting it more positively, from investing productively in businesses to generate profits. But risk requires management. Indeed the safest form of investment is a well-managed portfolio of risky assets, since supposedly safe assets have a distressing habit of becoming unsafe just when everyone is piling into them in the belief that they can never fail. The underlying problem in both the financial crisis of 2007/8 and the Eurozone crisis of 2010/11 was failure of assets that were believed to be "safe". Risk, properly managed, is safety: safety, left to its own devices, is the worst form of risk.
In my view, most people's long-term savings should be invested in portfolios of financial and hard assets, professionally managed by people who know what they are doing. I am amazed that some people apparently believe bank deposit accounts are safer than professionally managed funds. Banks DO NOT manage money responsibly on behalf of depositors: indeed retail bankers lack the skills to do so. But fund managers do. Their jobs depend on it.
There is in my view room for Government to provide an expanded range of safe savings vehicles giving low stable returns. I've already mentioned NS&I, which I think could be significantly extended to give people a realistic alternative to banks for short-term and "rainy day" saving: at the moment the investment limits are too low and the access conditions too restrictive, which is probably why it is not used as much as it could be. It would also be helpful to make it easier for ordinary people to invest directly in gilts. But I would also like Government to move faster on creating an investment fund selling long-term bonds to institutional investors, and perhaps households, to finance infrastructure, energy and R&D projects. These could be either public sector projects (including local authority projects) or private sector projects funded by the public sector. The intrinsic risk of the projects would not matter to investors, since the Government would be standing as guarantor of the funds. This would enable people's savings to be productively recycled into the economy without people having to take risks that to them appear unacceptable, and because the potential returns of the projects would be higher, people could receive higher returns on these bonds than on standard gilts.
But the real theme of this post is personal responsiblity. I really think the "people can't be expected to understand" argument has had its day. People can, and should, decide for themselves how best to manage their money, getting appropriate advice when they need it. They should think about the purpose for which they are saving money, and invest it appropriately. Bank savings accounts are good places for short-term funds (e.g. saving up for a holiday) and "rainy day" funds (to cover emergencies such as car repairs) - but people should be aware of deposit insurance limits: larger amounts of money that really can't be put at risk should be invested directly in safe assets or Government savings schemes. Managed funds are the right places for long-term savings such as pensions. And people need to think about their attitude to risk. Risk-happy people may need to temper their love of gambling with a responsible attitude to portfolio management. Risk-averse people need to accept that returns are likely to be low on their savings, and plan their saving and expenditure accordingly. It is time that people took responsibility for managing their own money, and stopped expecting banks to do it for them.
Cleaning up the mess - Coppola Comment
A new approach to deposit insurance - Euronomist with Frances Coppola (Pieria)
(also at PragCap and Coppola Comment)
Hull Savings Bank - Ann Godden (Hullwebs) (pdf)
Local banks for local people - Daily Telegraph
Resurrecting the TSB would be fine if it were to be truly a savings bank - Andrew Lilico (Daily Telegraph)
Is the window for infrastructure investment closing? - Tomas Hirst and Keith Wade (Pieria)