Back in 2008, I was sat in an office in Canary Wharf sipping a coffee and gazing out over the South Quay, when I noticed a frenzy of activity occurring over the other side of the water.
My view was dominated by the Lehman Brothers building – a huge skyscraper – and another building used by the organisation that we all stared at jealously because it had a rooftop swimming pool. No one was swimming that morning. As my colleagues and I watched, every floor of the second building filled up with Lehman Brothers staff. They were getting their marching orders as the ‘unbreakable’ global financial behemoth collapsed. A journalist called me to ask if I had heard what was going on. I told her I was watching it happen.
Lots of financial commentators claim to be wise after the fact, but back in 2008, the idea that a large financial institution could fall apart so spectacularly was almost unheard of. In fact, within the thousands of pages I studied for my rather tedious financial exams, there was just one reference to financial collapses – and that was caveated by saying that such an eventuality was incredibly unlikely.
Flash forward to 2023 and two American banks have collapsed and one of the ‘Big 30’ – Credit Suisse – is to be taken over by UBS. Should we be worried?
The good news is this is highly unlikely in the UK. But it pays to know how things work and your rights when things go wrong.
What happens when a bank collapses?
Talking about bank collapses is a delicate art. After all, you don’t want to create a panic and find yourself a hostage to fortune. The phrase ‘run on a bank’ literally describes the act of panicking depositors running to the bank to try and get their hands on their cash when word gets round that there’s a problem.
Bank collapses can occur quickly, as happened with Silicon Valley Bank (SVB) and Signature Bank in America, or they can happen over a period of time, as we’ve seen with Credit Suisse, which stumbled from scandal to scandal but managed to stay afloat for years.
When a business goes bust, the rules and regulations in that particular country kick in. If you’ve managed to get your cash out in time, then great. But if not, what happens next depends on the decisions of regulators, liquidators, central banks and compensation schemes – not to mention decisions made by the Government.
In theory, when a business goes bust owing you money, you join a long list of creditors. However, in the UK we have the Financial Services Compensation Scheme (FSCS) which offers savers and investors some degree of protection (more on this later).
What are the chances of your bank collapsing?
There are lots of scenarios that can lead to a bank or financial institution collapsing. The main factor though is when the people investing in the bank and those who have money held within it start to worry that the bank’s capacity to stay afloat is in doubt. This leads to a knock-on effect of plunging shares followed by a rush to transfer cash out of the bank.
Runs on banks can be caused by things like ‘credit risk’ where the credit (loans, mortgages, business lending) the bank has given looks unlikely to be paid back.
This is linked to ‘liquidity risk’ where there is an imbalance between the money that has been leant out versus what is coming in. Liquidity is a complex beast, but in short, financial regulations around the world usually require banks to have enough funds to meet demands from both people putting cash in (depositors and investors) and those who have borrowed it.
In addition, there is also ‘interest rate risk’ – where interest rate rises mean the bank is paying out more on their obligations, like bonds. As we are all aware, interest rates are rising at the moment.
Finally, there is the risk of borrower default. So if a big chunk of mortgage borrowers can’t afford their bills, these ‘bad loans’ can have an impact on lender. This is the origin of the ‘sub-prime lending scandal’ that was responsible in a large part for the last financial services collapse in the USA and subsequent worldwide recession.
Put like that, it could be easy to conclude that we are all doomed. But in the UK, the regulator, the Financial Conduct Authority (FCA) has a ton of rules around liquidity, protecting deposits and irresponsible lending. This is not a perfect system as previous failures have shown, but we do have very strong protections in place to calm jittery markets when things look bleak.
What happens to your money?
Back in 2001, the Financial Services Compensation Scheme (FSCS) was set up under the introduction of the Financial Services and Markets Act (2000) where most of our current financial regulations come from.
And thank God for the FSCS, because it provides an essential safety net if financial firms regulated in the UK collapse. Funded by a levy that regulated businesses are obliged to pay, the FSCS can compensate people if a financial institution collapses. They can also consider some complaints about businesses that have gone bust. During the mortgage endowment mis-selling scandal (there are a lot of scandals in this week’s column), the FSCS helped lots of people get compensation when their brokers or lenders had collapsed – though only if their mis-selling complaints were upheld.
There are limits though. Sorry to state the obvious, but these are the maximum sums you get back based on what you’ve paid in. So if you have £100,000 saved with one bank that collapses, the most you can get back is £85,000. These limits are:
- Banks, building societies and credit unions. Compensation limits are £85,000 per person, per bank/building society or credit union. This rises to £170,000 for joint accounts.
- Debt management firms. You may be compensated for up to £85,000 per debt management firm.
- Funeral plans. These have only just become formally regulated. So you could be covered for up to £85,000 – but only for plans bought on or after 29 July 2022.
- This is where things get complicated. Basically, the FSCS covers what you’ve paid in to certain types of insurance – but not always 100%. This also includes some claims sums. Check out their summary here
- Compensation for bad mortgage advice (like the endowment mortgages I mentioned earlier) is capped at £85,000 per firm.
- The £85,000 limit applies per firm here too, though be aware that it is only the investment firm or brokerage that the FSCS covers.
- This is the biggie, though it depends on what pension you have. If your provider collapses, then you are potentially covered for up to 100% of your claim. With a SIPP it’s up to £85,000 per person, per firm and the same for bad pension advice. It’s dead complicated though, so read the full guidance here.
As is always the case in all things financial, there are caveats. The rules and limits have changed quite a bit over the years, so when the incident happened is a major factor if you are seeking compensation, for example.
How safe are your savings?
As a general rule, your savings are pretty safe in the UK. This is due to the extensive financial regulations in place to ensure banks and financial institutions can withstand situations like those in the news right now. In addition, we have the additional protection of the FSCS (up to the limits I just mentioned).
However, these rules apply only to firms regulated in the UK. If you’ve put your cash in a foreign bank, then the rules in that country apply. Back in the last financial crisis, it became apparent that many individuals and business, including charities and local councils, had popped their savings in Icelandic banks. Gordon Brown sabre rattled and rather controversially tried to hold Iceland responsible for UK deposits. This went down so badly in Reykjavik that I was forced to put on a comedy French accent when I visited the country a few months later for the duration of my stay.
The moral – if there is one – to this story, is don’t bank on your non-UK regulated savings and investments being covered if a foreign financial institution goes under.
What happens if you have a mortgage with that lender?
I’d love to tell you that you get the mortgage written off, but predictably, you’ll need to keep on paying as normal.
After a bit of negotiation, then mortgage ‘book’ is usually packaged up and sold on to another investor. This tends to happen in a relatively straightforward manner in most cases as these debts are seen as assets because a purchaser on the ‘secondary market’ (where these loans are sold) will receive the interest from the loans. Your rights to complain should remain in place with UK regulated businesses.
Things do sometimes go wrong though. It’s recently been announced that Northern Rock mortgage holders are collectively suing for £150 million. The business that bought their mortgages when Northern Rock went under is accused of keeping the standard variable rates these customers were on at high rates of 5% or more, despite drops in the underlying interest rate.
Things you can do to protect yourself
Diversification is the key to protecting your savings. There are lots of great savings rates available through new financial institutions online at the moment. If you’re not familiar with the brand, do a bit of research first before signing up. Make sure you keep your investments to under £85,000 per bank, building society or credit union.
I’d also strongly recommend that you check the small print when you hand over your cash. A business may have a UK office or postal address. But don’t assume that it’s covered. Check your documents which will state (usually in the small print at the bottom of documents or on websites) that the firm is regulated by the FSC and falls within the remit of the Financial Ombudsman Service and FSCS.
Featured in Times Money Mentor – Martyn James