Select Committee on Treasury Fifth Report

6  Depositor protection

Introduction

217. Since 2001, the Financial Services Compensation Scheme has offered protection to depositors (and some other customers) of UK financial firms. The events surrounding Northern Rock in 2007 have raised questions about the adequacy of current deposit protection arrangements. The existence of a deposit protection scheme did not prevent the formation of long queues of depositors outside Northern Rock branches, a sure sign that that bank's customers lacked confidence that their deposits would be protected. The formation of the queues outside Northern Rock branches was, in part, an indictment of the UK's deposit insurance arrangements, arrangements which Professor Buiter decried as "a shambles".[448]

218. Depositor protection arrangements vary widely across countries. Members of this Committee travelled to the United States and Sweden during the course of our inquiry, to learn, amongst other topics, about the schemes in those countries. In considering reform to the UK deposit protection arrangements, the Government can mine a rich seam of experience from around the world. The FSA has already admitted that a US-style system of depositor protection, for example, "would have undoubtedly been of real help in preventing the retail run" on Northern Rock.[449] The Governor of the Bank of England highlighted some of the attractive elements of deposit protection schemes in other countries:

A model for deposit insurance that draws on international experience would have permanent 100% coverage up to a limit with transparent and widely understood prompt payout commitments.[450]

Box 2: The Financial Services Compensation Scheme

The Financial Services Compensation Scheme (FSCS) is the UK's statutory fund of last resort for customers of FSA-authorised financial services firms. It can pay compensation if a firm is unable, or likely to be unable, to pay claims against it. This will generally be because it has stopped trading and has insufficient assets to meet claims, or is in insolvency. This is described as being "in default".

The FSCS is an independent body and was created under the Financial Services and Markets Act 2000 (FSMA), replacing eight previous compensation arrangements (including the Building Societies Investor Protection Scheme, the Deposit Protection Board, the Friendly Societies Protection Scheme, the Investor Compensation Scheme, the Personal Investment Authority Indemnity Scheme, the Policyholders Protection Scheme, the Section 43 Scheme (which covered business with money-market institutions), and the arrangements between the Association of British Insurers and the Investor Compensation Scheme for paying compensation in relation to Pensions Review cases).[451] The FSCS became operational on 1 December 2001 when FSMA came into force. The FSA is responsible for setting the rules within which the FSCS operates, including on eligibility of claims and compensation limits. The FSCS, as the management company that operates the Scheme, is required by FSMA to be operationally independent. It is not part of the FSA, but accountable to it (and, ultimately, to the Treasury).

The FSCS is free to consumers. It protects deposits, insurance policies, insurance broking, investment business, and mortgage advice and arranging. Since 2001 it has paid out £1.004 billion in compensation to consumers and declared 1800 firms in default, of which 29 were credit union failures. The total number of claims completed for investment and deposit-taking business is 87,000.[452]

Rationale for deposit protection

219. The FSA told us that the main function of the FSCS was consumer protection, by providing consumers with a measure of compensation in the event of failure of an institution in the financial sector. The FSA also noted that the existence of a compensation scheme helped to reduce the systemic risk that a single failure of a financial firm might trigger a wider loss of confidence. The FSA cautioned that, "while it contributes to encouraging consumer confidence in the markets, the FSCS was not designed, on its own, to be able to deal with all potential failures of financial firms, nor to be a crisis management tool in the event of a large-scale failure".[453]

220. Professor Wood considered deposit insurance to be a social provision, to protect what used to be called in the banking industry "widows and orphans".[454] Professor Buiter agreed with this view, but added that the "widows and orphans" rationale should extend only to natural persons, and not wholesale or business deposits.[455] Professor Buiter disagreed with the FSA's rationale for a depositor protection scheme, claiming such a scheme was purely "social policy" and had no purpose as a financial stability tool.[456] Sir Callum McCarthy, however, argued that a well-designed scheme, where depositors had confidence that they were covered 100% up to a certain amount, and that they would get a very rapid repayment, would make it "much less likely" that there would be a retail bank run, and that had implications again for financial stability.[457]

Co-insurance

221. Co-insurance is an attempt to share, in the context of deposit protection, the risk of bank failure between the deposit protection scheme and the depositor. Under a co-insurance scheme, depositors receive less than 100% of their guaranteed deposits if their bank fails. In the UK prior to 1 October 2007, for example, the FSCS would cover 100% of the first £2,000 of deposits but only 90% of the next £33,000. Theoretically, introducing co-insurance should reduce moral hazard on the part of depositors, by encouraging depositors to take a keener interest in choosing a financially-sound bank. In 1992, following the collapse of the Bank of Credit and Commerce International (BCCI), the then Government set out the rationale for co-insurance, under a deposit protection scheme which at the time guaranteed only 75% of qualifying deposits up to a value of £20,000:

If depositors expected full compensation for losses, then they too would no longer need to consider the risk associated with the particular banks in which they placed their money. This, in turn, would have serious and potentially damaging consequences for the whole banking system as it would favour institutions which, for example, offered unrealistically high rates of interest, at the expense of more prudent ones. And it would encourage managers who wanted to attract deposits to adopt riskier strategies. The recent experience of US savings and loans institutions shows all too clearly that this is a real—and not simply a theoretical danger.[458]

222. More recently, in a speech made in February 2006, Sir Callum McCarthy warned that

were the FSA to aim to relieve consumers of all adverse consequences, an environment would be created in which they no longer needed to weigh up the reasonableness of their financial decisions. No market can work effectively without involved customers. To relieve consumers of retail financial services of the consequences of their actions would destroy this as an effective market. Consumer responsibility is therefore vital to the effectiveness of financial markets.[459]

Sir Callum noted that, in the US during the savings and loan problems, "it was quite clear that 100% coverage resulted in some distortion of behaviour and some serious moral hazard."[460] The London Investment Banking Association also mentioned the US savings and loan problem, arguing that it would be:

important to avoid arrangements that could lead to the kind of costs borne by taxpayers following the losses of US Savings and Loans depositors in 1986-95. In order to address moral hazard issues, in reviewing the UK scheme it will be necessary to consider arrangements that address the risk of depositors simply opting for accounts paying the highest rate of interest.[461]

223. Although using co-insurance to encourage consumers to invest their savings in healthy institutions was attractive in theory, several witnesses argued that it did not work in practice. Professor Wood said that, if the purpose of depositor protection were protecting "widows and orphans", coverage had to be 100%, because it was unreasonable to expect such people to have the time or the knowledge to police their banks.[462] Professor Buiter argued that if coverage was anything less than 100%, it was still an invitation to have a bank run:

Unfortunately while co-insurance is a good idea for most insurance—you cannot have a run on your life insurance company but you can have a run on the bank—I really would not recommend anything less than 100%.[463]

224. The Governor of the Bank of England also rejected the concept of co-insurance in depositor protection:

if you have deposit insurance, there is no point having 90%, because that will not stop the bank run, as we saw, it has to be 100% but only up to some limit. In order to prevent banks taking excessive risks on the back of that deposit insurance—the moral hazard risk—it is much more important to have in place the special resolution regime whereby the authorities can get control of a bank that has been taking too many risks, particularly on the liquidity front. That is why … the FDIC mechanism does naturally go hand in hand with the deposit insurance for banks, but only for banks.[464]

225. Sir Callum McCarthy acknowledged that, at the time of the run on Northern Rock, the fact that the FSCS only guaranteed 100% up to the first £2,000, and 90% of the next £33,000 was a problem.[465] The FSA said that in making the decision to remove the coinsurance element of £35,000, it was "reflecting a belief that it is probably unrealistic to expect the consumer to have the necessary information and ability to judge funding risk … our current thinking … is that it is a little too ambitious to expect the consumers to have detailed understanding of funding risk".[466]

226. Not only did witnesses consider the expectation that consumers be in a position to judge the health of banks, they also commented on how the complexity of co-insurance made it hard to explain to customers. Northern Rock explained to us that the scheme's co-insurance element between £2,000 and £35,000, "does not lend to sound bites when you are trying to deal with customers either on the telephone or queuing outside your branch.[467] Adrian Coles, of the BSA, also cited the complexity of coinsurance as causing difficulty,[468] as did Gerald Corrigan from Goldman Sachs:

The other point I make for your consideration is that the payout provisions should be very simple and straightforward; in other words, in the United States the payout provision is $100,000—full stop. As I understand it, the current system here in the UK is a bit more complex than that and it has different layers and percentages. I am a little concerned that that may be a bit of a structured product in its own right.[469]

227. The presence of an element of co-insurance in a deposit protection scheme adds considerable complexity for customers to understand: Northern Rock pointed to the difficulty of explaining the scheme's intricacies to their customers when the bank run occurred. Not only does co-insurance add complexity, it also does not work. Co-insurance implies that a potential depositor would have the means, time and ability to assess the financial strength of an institution through the examination of publicly-available information about that company. We do not believe this to be a realistic proposition. The main way the ordinary depositor can gauge the financial health of a bank is by considering the strength of the brand and whether the bank has a reputation for financial strength. Tellingly, Northern Rock did well on both of these counts. Rather than contributing to financial stability, co-insurance directly undermines it, by offering an incentive to join a bank run. We consider the co-insurance model to be discredited with regard to depositor protection. The moral hazard argument, that banks would offer excessively high rates to customers, on the back of the full deposit insurance for customers, would be mitigated by our proposals for a system of prompt corrective action and a special resolution regime, together with a modest compensation limit, to discussion of which we now turn.

Compensation limit

228. A key consideration for future deposit protection arrangements relates to the limit up to which deposits are guaranteed. The FSA emphasised the importance of striking the right balance between protection for individuals on the one hand, and not encouraging irresponsible behaviour by institutions on the other.[470] Professor Wood argued that, if the compensation limit were set at a low level, large depositors and other banks might pay closer attention to those to whom they lent. Also, if it were set at a low level it could continue to be financed by a mutual scheme and thus the taxpayer would have less interest in propping up banks.[471] On the setting of the compensation limit, he added that "basically it is a political decision", rather than an economic one.[472]

229. The BBA believed that the existing coverage limit of £35,000 combined with the removal of co-insurance fulfilled the objective of protecting the vast majority of retail depositors. Data collected from BBA members suggested that 96% of consumer savings accounts were covered by a £35,000 limit, "which compares favourably with coverage in other countries". They argued that any further increase in coverage would undermine longer-term financial stability through increasing scheme costs and by placing emphasis on deposit insurance rather than prudential regulation as the primary mechanism for depositor protection.[473] The BBA said that a further increase in the limit to, say, £100,000 would significantly increase costs to industry for a relatively small impact in terms of increasing consumer confidence. Such a move, they added, would primarily benefit business customers—currently the FSCS offers protection for small businesses as well as individuals—and wealthy individuals, whilst providing marginal additional benefit to those consumers most in need of deposit protection, and would leave the UK scheme "significantly out of step with its international competitors and also increase moral hazard".[474]

230. The Association of British Insurers (ABI) noted that the FSA had to ensure that compensation limits were sufficiently generous to protect ordinary investors, but did not give rise to issues of moral hazard, or distort competition between different products. There had to be a limit to the protection offered, because otherwise financial institutions and consumers would become reckless, thereby, paradoxically, increasing the likelihood of a serious failure.[475] Research carried out on behalf of the ABI in 2006 suggested that a limit of £35,000 provided full coverage for 98% of cash-only savers, a proportion very similar to the BBA's estimates noted above. The ABI stated that such an amount would cover the total non-pension savings, across all types of instruments, of over 80% of the population.[476] A higher level of guarantee, the ABI warned, risked distorting the market by rendering bank deposits more attractive relative to other savings: "That is not necessarily good for the savings industry and the country's overall propensity to save".[477]

231. The BSA considered that an increase in the current compensation limit was not necessary.[478] The BSA's analysis of the distribution of savings within the building society sector showed that approximately 95% of individuals saving with a building society had balances of £35,000 or less.[479] The BSA also mentioned the risk of market distortion if the compensation levels for customers of one class of financial services provider were disproportionately high. The BSA argued that, as illustrated by savings and loans organisations in the US during the 1980s, an excessively high compensation limit could cause moral hazard for both firms and customers alike.[480] Professor Buiter believed that "certainly £100,000 would be way in excess of the widows and orphans criterion".[481]

232. The only evidence we received that argued for the limit to be raised above £35,000 was from the Financial Services Consumer Panel (FSCP). They argued that inflation had significantly eroded the real value of compensation and that the deposit limit should be raised above £35,000. According to the FSCP, consumers who sold their homes, and waited before buying another, were likely to have large sums of money on deposit with banks and building societies.[482]

233. The setting of an appropriate compensation limit should balance the objective of enhancing consumer confidence through adequate coverage against the implications for moral hazard and the problems of increasing the cost of the scheme. The current limit of £35,000 is easy to remember and covers the vast majority of depositors. The case has not yet been made for any extension above the current limit of £35,000. We do, however, recommend that whatever limit is adopted, it should be indexed to a measure of inflation, but such that the guaranteed limit is always an easily memorable sum.

234. We do not believe that very large deposits held for short periods of time, perhaps in the course of residential property transactions, should be covered by the deposit protection scheme. However, we do think that the concerns raised by the Financial Services Consumer Panel are important, particularly where customers are placing deposits for purely transactional reasons, rather than seeking to earn interest. We recommend that the Government, in its response to this Report, set out what arrangements are available, or might become available, for depositors in such circumstances. One possible solution would be for depositors to invest in a risk-free National Savings & Investment product, and the Government should consider introducing a product targeted at those selling and then buying property, to raise awareness of this option.

Speedy release of funds

235. Under the UK's existing arrangements, depositors of a failed institution do not gain access to their deposits until the winding-up administration process has been concluded. This could be a matter of weeks in the case of a credit union, or many months, or even years, for a larger institution. The BBA believed that the expected speed of payout was an important factor in consumer confidence in the FSCS.[483]

236. The BSA stated that the potential speed of payout was related to the size of the institution. Payments made by the FSCS to the depositors of credit unions, according to the BSA, have typically taken seven to ten days, but for much larger institutions it was much more difficult.[484] The FSCS website states that:

After a declaration of default, FSCS aims to process all claims within six months. However, the time this takes depends very much on the type of claim. For example, most credit union claims can be completed within four weeks. For other types of claim it may take longer, depending on how complex it is and on some factors that may be outside of our control, such as waiting for information from third parties.[485]

237. Dr Hamalainen argued that depositors need "to be assured that within one day of bank failure they will have access to their insured deposits", because the time taken to repay could be thought of as a liquidity risk for depositors. He noted that the prospect of having their deposits inaccessible for up to six months was one of the two main factors "that drove insured Northern Rock depositors to withdraw their money" (along with the co-insurance element).[486]

238. The Governor of the Bank of England argued that "the system of administration for banks which means that retail depositors find their deposits frozen for months on end and they cannot access them is a system which is a direct inducement for retail depositors to take their money out at any sign of trouble".[487]

239. The BBA stated that it was not feasible to expect customer account data to be exported from one institution to another in the case of a failed bank, due to the diversity and complexity of the systems used by different banks. Speedy payout was best achieved, they argued, through existing bank channels (cheques, cash or electronic). Payments would need to be paid within a few days and facilitated by:

• Deposits being repaid on a gross basis without netting of customer liabilities;
• Arrangements which make it possible for the staff of Bank A (or a special administrator) to take over and operate distressed Bank B's payment systems. [488]

240. The current arrangements, under which the Financial Services Compensation Scheme could take months, maybe years, to reimburse the depositors of a large failed institution, are completely inadequate. The speed of release of funds is of critical importance. However generous a compensation scheme may be, and however much confidence consumers may have in eventually getting back their deposits, it would still be rational for a depositor to withdraw their funds from a failing bank if there were a prospect of them losing access for more than a few days. There should be a requirement in law that all insured deposits should have to be paid within a few days of a bank failing and calling on the deposit protection scheme. The relevant authority must ensure that banks' information systems and procedures are capable of such a speedy release of funds.

Communication

241. The BBA identified three points that were "essential for consumers to understand" about a deposit protection scheme. The first was clarity regarding their personal situation, including limit levels, any co-insurance arrangements and any offsetting of loans against deposits; the banks, account types and customers covered; and the speed and method of payout. Secondly, there was a requirement for consumer confidence in the banking system's ability to handle failures, which would require the communication of a clear intervention plan. Thirdly, customers ought never to believe a bank is "closed for business", so website and branch shutdowns had to be avoided.[489] The BBA said that its members were prepared to support the Tripartite authorities in developing appropriate forms of communication to raise awareness of the FSCS. They believed that this task would be made significantly easier by adhering to an approach geared towards simplicity.[490] Angela Knight admitted that communications of the FSCS currently lacked "the sort of pulsating clarity which maybe we should be looking at now".[491] The BSA suggested that the FSCS should prepare standard wording for all firms covered by the Scheme, to use to help inform customers and to help ensure consistency in the provision of information.[492] Professor Buiter suggested that every branch in the country should have large signs explaining the extent to which customers' deposits were protected.[493]

242. Ms Minghella, the Chief Executive of the FSCS, told us that the Scheme was aware of the importance of consumers understanding the protection that was available to them in the event of a failure, and said that, when a business did fail, the FSCS took steps to inform every consumer who was affected of their right to claim on the scheme. She also highlighted the Scheme's work with a number of stakeholders, Consumer Advice Centres, Money Advice Bureaux, journalists, and MPs, to try and bring the scheme to general attention in advance of failures.[494] She agreed that a firm should have an obligation to communicate with its customers about the scheme. She argued that firms currently did have that obligation at the point of giving explanatory information about a product, but she felt that this could be further enforced.[495]

243. Depositors' understanding of the intricacies of the Financial Services Compensation Scheme, prior to the post-Northern Rock changes, was inadequate. We favour as simple and as transparent a scheme as possible. Alongside the removal of co-insurance and the adoption of a simple compensation limit, depositors need to understand that they can maximise their protection by dividing their savings between different institutions. In addition, there needs to be am emphasis on the fact that the compensation limit is per customer, rather than per account. For the scheme to have the maximum impact in protecting financial stability, the details of the scheme must be well-advertised, both in national and regional media, and through the display of posters in individual bank branches.

Identifying insured depositors

The need for identification

244. In the event of a bank or building society failure, the administrator of that institution (or the deposit insurance scheme, bridge bank, or other resolution agent) would have the complex task of identifying those account holders who were eligible for reimbursement of their deposits.

Multiple institutions with one FSA registration

245. As a result of takeovers and mergers, many financial services groups now contain several deposit-taking institutions. In some cases, these individual institutions have maintained a separate authorisation with the Financial Services Authority (FSA). In other cases, the parent group has a single FSA authorisation, covering all their subsidiary firms and brands. The coverage provided under the FSCS differs accordingly:

For people who hold multiple accounts in banks that are part of a larger group such as Halifax Bank of Scotland, if each of the banks is separately authorised by the Financial Services Authority, the FSCS would pay compensation up to the limit of £35,000 per person, per authorised institution.

If each of the banks is not separately authorised but is covered by the parent company's authorisation, the FSCS would pay compensation up to the limit of £35,000 once, irrespective of how many different institutions a person held accounts with.[496]

246. The FSCS website advises its users to telephone the FSA's Consumer Contact Centre if they have a question about how a bank or building society is authorised. Despite the availability of this facility, the BSA commented that "there appears to be public confusion about whether the limit is per account or per deposit-taker, and over the protection where a customer has separate deposits within a financial institutional group".[497]

Joint accounts

247. An additional complexity for depositors to consider surrounds joint accounts. The FSCS website states that:

The compensation limit of £35,000 applies to each depositor for the total of their deposits with an organisation, regardless of how many accounts they hold or whether they are a single or joint account holder. In the case of a joint account, FSCS will assume that the money in that account is split equally between account holders, unless evidence shows otherwise.[498]

Conclusions

248. It is important for the relevant authority operating a deposit protection scheme to understand the size and profile of the depositors it is insuring, not least so that that authority can calculate an appropriate funding requirement. Furthermore, an essential prerequisite of the speedy reimbursement of funds to the depositors of a failed institution is that insured depositors can be quickly identified. At present, we doubt that all financial institutions would be able to produce such data at short notice. We recommend that each financial institution (or, each FSA-registered group, where several institutions share one FSA registration) maintain a register of each depositor's insured deposits under the scheme. The existence of a register would greatly simplify the task faced by the relevant authority if a failed bank's depositors were to be ring-fenced or placed under the control of a Bridge Bank. This register must take into consideration individual shares of joint accounts in calculating the extent of coverage. The relevant authority should confirm that every bank and building society is able to produce such a register at a day's notice, so that the authority can be assured that, in the event of a bank failing, the speedy release of funds would not be jeopardised by an inability to identify insured depositors.

249. Not only is it important for firms and the deposit insurance scheme to know which depositors are insured, but the depositors themselves must be aware of the extent to which their deposits are insured. We recommend that depositors should be alerted, via a letter from the financial institution, if a portion of their deposits is, or becomes, uninsured. Again, this notification should take into consideration whether the depositor has savings at other organisations within the FSA-registered group which is writing to the depositor, and where a depositor has invested in a joint account.

Off-setting of loans and mortgages against deposits

250. If a financial institution were to fail, the question arises as to whether any debts owed by a depositor to the institution could be offset against that depositor's savings. The Frequently asked questions section of the FSCS website is unambiguous in stating that they could:

Amounts owed to the failed firm (for example, loans, mortgage or credit card debts) are taken into account before any compensation is paid. We may also take steps to recover any amounts owed by depositors.[499]

251. The implication of the statement on the Financial Services Compensation Scheme website is startling: a customer of a bank or building society who had savings, but also a larger mortgage, with the same institution, might receive no compensation through the deposit insurance scheme, but would instead have a smaller balance on their mortgage. We consider that such off-setting of a highly liquid asset (deposits) against a more illiquid liability (mortgage) to be in conflict with the entire purpose of a deposit protection scheme. A deposit scheme's two purposes—to protect depositor's liquid assets, and reduce the incentive for joining bank runs—are both fundamentally weakened by off-setting. It could be argued that off-setting an overdraft might be legitimate, but as a general rule, the widespread off-setting of savings and loans should not be permitted. We expect the Government to re-design the deposit protection scheme so that off-setting of deposits against illiquid liabilities is not permitted.

Funding

Background

252. The Financial Services Compensation Scheme, is currently funded through annual levies on regulated firms, across five sub-schemes. Alongside deposit protection, the sub-schemes are insurance business, insurance mediation, designated investments and mortgage advice and arrangement. As Table 2 shows, the compensation paid by the FSCS to depositors amounts to a miniscule proportion (0.21%) of total compensation.

Table 2: FSCS compensation paid to depositors since 2001

Year	FSCS compensation paid to depositors (£m)	FSCS total compensation (£m)	FSCS deposit compensation as a percentage of total (%)
01-02	0.02	40.9	0.05
02-03	0.06	194.4	0.03
03-04	0.4	197.6	0.2
04-05	0.23	174.71	0.13
05-06	0.09	201.22	0.04
06-07	1.21	149.47	0.81
Total	2.01	958.3	0.21

Sources: Financial Services Compensation Scheme Annual Report 2001-02, p 8; FSCS Annual Report 2002-03, p 10; FSCS Annual Report 2003-04, p 12; FSCS Annual Report 2004-05, p 10; FSCS Annual Report 2005-06, p 16; FSCS Annual Report 2006-07, p 21.

The maximum levy that the deposit sub-scheme's participant firms can be charged in each year is equal to 0.3% of their deposit base. The Director-General of the BSA, Adrian Coles, told us that this meant that the current extent of support would be about £2.5 billion.[500] The FSCS explained that each year they prepared a forecast of expected failures, based on past experience and other information available at the time. If a failure were to occur that had not been forecast, the FSCS would charge an additional levy for it at the time, and the industry would be obliged to pay that levy within 30 days.[501]

RECENT CHANGES

253. In 2005, the FSA commenced a review of the funding model for the FSCS, and on 14 November 2007 announced the changes that it had decided to make.[502] The revised model, which will come into effect in April 2008, will increase the financial capacity of the scheme for compensation arising from deposit-takers from £2.7 billion to £4.03 billion. The FSA argued that the new model would mean a more "robust, resilient, efficient and cost-effective" scheme.[503] The new funding model will include five broad classes: life and pensions; deposits; investment; general insurance and home finance. For the first time, the FSCS will feature explicit cross-subsidy arrangements, so that sub-classes can pick up liabilities from other sectors if that is required.[504]

254. The FSA noted that nearly all in the financial services industry "strongly opposed" its proposals for change, arguing that the current arrangements were fit for purpose, and that introducing greater cross-subsidy between different classes of firms was inappropriate.[505] The ABI was opposed to the new funding system, believing that cross-subsidy between deposit protection and other parts of the financial sector would increase the risk that difficulties in one sector could be passed onto others, leading to a loss of confidence in financial services as a whole.[506]

255. On 11 October 2007, the Tripartite authorities jointly published a discussion paper on reform of depositor protection, the first stage of a wider process of stakeholder consultation to continue into 2008.[507] The results of this consultation process may lead to significant changes to deposit protection arrangements, in light of the events surrounding Northern Rock. When asked why the FSA was pushing ahead with funding reform to the FSCS, regardless of the likelihood that changes to the FSCS would be announced in 2008, Sir Callum McCarthy argued that "whatever changes come about from the legislation the Government plans to introduce next year, it would be sensible to make [the funding] changes in the meantime because we did not think there would be any conflict between improvements we are planning to make and had planned for some time and whatever comes out of that legislation".[508]

256. We regret the FSA's decision to press ahead in November 2007 with changes to the funding of the Financial Services Compensation Scheme, in view of the FSA's knowledge that substantial changes to the Scheme were highly likely in 2008. The FSA's decision to do so pre-empts the Tripartite review of funding issues in relation to deposit protection in which the FSA itself is involved.

PAY AS YOU GO?

257. The amount levied for compensation payments by the FSCS is an estimate of the compensation that the FSCS expects to pay based on estimated claims for the 12 months following the levy date, after allowing for fund balances. Levies are normally made once every financial year, although further levies can be made if costs exceed those anticipated.[509] This system contrasts with the funding regime employed in the US by the Federal Deposit Insurance Corporation (FDIC- see Box 3), which has built up a fund of almost $50 billion and stands ready to reimburse depositors almost immediately if a bank were to fail. The FSCS system has been referred to as 'ex-post' or 'pay-as-you-go', whilst that of the FDIC is known as 'ex-ante' or 'pre-funded'.

258. Dr Hamalainen pointed to two problems with the 'pay as you go' approach. First, because a 'pay as you go' scheme does not hold sufficient funds to cope with a large bank failure, such a scheme would be unlikely to deliver funds to depositors quickly enough to avoid disruptions to customer service. In consequence, the Government would have to step in to cover the deposit insurance fund's shortfall whilst the levies were being collected from other deposit-taking institutions. Secondly, a 'pay as you go' scheme would be very likely to lead to pro-cyclical problems, where demands for levy contributions were made at exactly the time when deposit-taking institutions were experiencing a period of distress. This, Dr Hamalainen argued, could cause an exacerbated slow down in banking activity during business cycle downturns. In contrast, a 'pre-funded' model could be constructed to allow depositor protection funds to rise during more favourable economic conditions and decrease during less favourable ones.[510]

259. Instituting a pre-funded scheme could resolve the problems raised by Dr Hamalainen. When we visited the US and met officials from the FDIC, we were told how the existence of a large, dedicated fund for deposit protection bolstered the confidence of depositors and acted as a brake on depositors rushing to withdraw their money from a bank at the first sign of trouble. Conversely, if a UK bank were to become distressed under the current system, depositors would soon discover that the FSCS lacked sufficient funds for reimbursement, and could not be certain whether the bank would receive any assistance from the State.

260. US stakeholders, including the American Bankers Association, also favoured a system whereby contributions to the fund were adjusted such that banks' paid more in the more profitable years, and less when they had tighter capital constraints. Introducing such cyclicality to the UK deposit protection scheme would remove the paradox whereby, when the FSCS reimburses the depositors of a failed institution, other financial firms, who are also likely to be relatively capital-constrained, are required to pay an additional levy.

Box 3: Funding of the US FDIC

The Federal Deposit Insurance Corporation is an insurance-based system covering deposits up to $100,000. It currently has a fund of $49 billion covering US deposits of $3 trillion. In the case of a failing bank, the FDIC can take control, selling the deposits to a third-party bank (a Bridge Bank), which would take on the customers automatically and enable them to reclaim their money quickly. In the US (in contrast to the UK), depositors are a favoured creditor in the event of a bank failing.

261. Some witnesses argued that, although a pre-funded scheme might suit the US, the UK banking market required a different deposit protection system. The BBA believed that an ex-post funding system was appropriate in the UK due to the concentrated nature of its banking sector, unlike the US which had many smaller institutions and an ex-ante scheme. Witnesses made three primary arguments in favour of ex-post systems in concentrated markets. First, consumer confidence in the viability of an ex-ante fund might be low due to the small size of the fund relative to some single, large member institutions.[511] The second reason was that a readily available liquidity pool would not be required because "big bank" failure was much less likely due to risk diversification.[512] The Chancellor of the Exchequer admitted that "I have my doubts as to whether or not we would want to maintain here a standing body that might never be used.[513]

262. The third argument was that an ex-ante scheme would tie up capital that could otherwise be effectively utilised and would cause an unnecessary drain on the liquidity position of banks.[514] Indeed, it would seem that the main disadvantage of a pre-funded system would be the cost to the industry—costs which would eventually be passed on to banks' customers. The Chancellor said that:

Of course [a pre-funded scheme] would mean that you would be taking money out of the system at the moment, it would not be free to be lent, and therefore there would be a cost to both savers and borrowers because the banks would have less money available and they would charge more to lend it; so I think there is a trade off. You either take the money out, if you like, up front and, therefore, savers pay by getting less interest rates or those who borrow pay more, or you operate the present system, but that is something which will be part of this consultation that we will look at.[515]

263. We believe that the 'pay as you go' approach to funding depositor protection, as currently used by the Financial Services Compensation Scheme, has two fundamental disadvantages. First, it does not create the requisite depositor confidence in the availability of a source of prompt funding, so fails to contribute towards financial stability. Second, a 'pay as you go' approach could cause significant pro-cyclicality problems. Such an approach could mean obtaining funding from banks at the worst possible time, whereas a pre-funded model could obtain most of its funding at times of plenty. We have noted the arguments of the British Bankers' Association that ex-ante funding is not appropriate in the United Kingdom due to the concentrated nature of the United Kingdom's banking sector. We do not believe that the nature of the banking sector is itself a barrier to the adoption of such a funding arrangement. Objections to an ex-ante scheme appear to be based on the notion that certain United Kingdom banks are 'too big to fail'. We reject this notion. The principle that must underpin a future scheme is that it should be capable of coping with any foreseeable bank failure. We recommend accordingly the establishment of a Deposit Protection Fund, with ex-ante funding. The Fund would receive contributions from banks and building societies on a regular basis, and be of sufficient size to obviate the need for the Government to step in to rescue a major bank. The establishment of a pre-funded scheme would be a significant cost to the institutions involved, but it seems only right to us that the costs of bank failure should be borne by the industry rather than the taxpayer, as would currently be the case. To ensure that the Fund is adequately resourced from the outset, we recommend that it be financed initially by a Government loan, which would then be repaid over time as banks' contributions accumulated.

RISK-BASED CONTRIBUTIONS

264. Mr Corrigan noted that the FDIC in the US had a risk-based fee system applied to deposit-taking institutions, which, in his view, was "a pretty good idea".[516] Dr Hamalainen argued that, regardless of the funding model chosen, there should be some consideration of risk-based contributions. He suggested that this could be based on a deposit-taking institution's probability, and potential impact, of causing a loss to the deposit insurance fund.[517] The BBA argued that the current uniform pricing structure did nothing to force riskier institutions to pay more to the fund to reflect their higher probability of default. The BBA favoured the introduction of a risk-based approach, providing incentives to encourage prudential risk management, so long as this did not distort competition.[518] Experience from other countries suggests that the introduction of such an approach should be feasible. The Canadian Deposit Insurance Corporation, for example, levies contributions from members using risk-based premia. Each year, every member institution is classified into one of four premium categories, based on a system that scores each institution according to a number of factors including capital adequacy, profitability, asset quality and concentration.

265. However, great care would have to be taken in the design of a risk-based system. Banks could be classified as risky for two reasons; these might require a different treatment under the scheme. A bank could be "risky" if it deliberately followed a risky business model, in which case it might be argued that it ought to contribute more to a deposit protection scheme. On the other hand, a bank could be "risky" as a result of it being under-capitalised, and forcing it to contribute more than its fair share could drive that bank into deeper trouble. In other words, risk-sharing could push some banks towards prudence, and others towards bankruptcy.

266. In the previous section we recommended the establishment of a Deposit Protection Fund, and suggested how the cost of building up this Fund should be spread over several years. During this initial phase, we recommend that banks' contributions be based solely on the size of their insured deposit base, in order to minimise complexity. Once the Fund is established, however, there may be a case for the introduction of a system of risk-based premia, whereby each bank contributes according to the Fund's assessment of the likelihood of needing to compensate depositors. We recommend that the Government, in bringing forward legislation on the establishment of a Deposit Protection Fund, grant powers to that Fund to consult on and introduce risk-based premia once the Fund has been established.

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448   Q 891 Back

449   Q1452 Back

450   Q1608 Back

451   Funding of the Financial Services Compensation Scheme, A Report by Oxera for the FSA, March 2006 Back

452   Ev 230 Back

453   Ev 222 Back

454   Q 905 Back

455   Q 906; The current scheme covers deposits by businesses with a turnover of less than £5.6 million Back

456   Qq 907-8 Back

457   Q1431 Back

458   Treasury and Civil Service Committee, Second Report of Session 1992-3, Banking supervision and BCCI: The implications of the Bingham Report, HC 250, p 27 Back

459   Speech by Sir Callum McCarthy to the Financial Services Forum, 9 February 2006 Back

460   Q1425  Back

461   Ev 248 Back

462   Q 913 Back

463   Q 913 (will become Ibid. once previous amendment is made) Back

464   Q 1743 Back

465   Q 345 Back

466   Q1429 Back

467   Q 677 Back

468   Q1558 Back

469   Q1254 Back

470   Q 1426 Back

471   Q 905 Back

472   Q 909 Back

473   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,

page 3 Back

474   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 4 Back

475   Ev 267 Back

476   Ibid. Back

477   Q 1418 Back

478   Building Societies Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors, para 10 Back

479   Ev 306 Back

480   Ev 307 Back

481   Q 913 Back

482   Ev 219 Back

483   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 5 Back

484   Q 1556 Back

485   www.fscs.org.uk/consumer/FAQs/Deposit_claims_FAQs/  Back

486   Ev 255 Back

487   Q 30 Back

488   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 5 Back

489   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 12 Back

490   Ibid., page 5 Back

491   Q 1554 Back

492   Building Societies Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors, page 8 Back

493   Q 910 Back

494   Q 1427 Back

495   Q 1428 Back

496   www.fscs.org.uk/consumer/FAQs/Deposit_claims_FAQs/  Back

497   Building Societies Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors, page 8 Back

498   Error! Bookmark not defined._claims_FAQs/ Back

499   Ibid Back

500   Q 1552 Back

501   Q 1442 Back

502   FSCS Funding Review, Financial Services Authority, 14 November 2007 Back

503   Ev 228 Back

504   Ev 227 Back

505   Ev 223 Back

506   Ev 268 Back

507   Tripartite Discussion Paper: Banking Reform-Protecting Depositors Back

508   Q 1424 Back

509   www.fscs.org.uk/industry/funding/levy_information/  Back

510   Ev 256 Back

511   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 4 Back

512   Ibid., page 4. Also see Ev 267 Back

513   Q 1755 Back

514   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 4 Back

515   Q 1836 Back

516   Q 1253 Back

517   Ev 256 Back

518   British Bankers' Association Response to the Tripartite Discussion Paper: Banking Reform-Protecting Depositors,
page 11 Back

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Prepared 26 January 2008