Banking StandardsWritten evidence from the Charity Finance Group, the Charities Aid Foundation, the Association of Chief Executives of Voluntary Organisations and the National Council for Voluntary Organisations

Executive summary

As organisations which represent the interests of the charity and voluntary sector, we welcome efforts to reform the UK banking system to enhance stability and integrity and encourage competition. The charity sector holds around £18 billion in cash deposits; protecting this money is of the utmost importance.

The purpose of this submission is to reiterate our concerns, the unique features of charity banking and the lessons learned from the collapse of the Icelandic banks, and ask that the Commission take these into consideration in their scrutiny of the reforms.

We recognise that the impact of the banking reforms on the charity sector is just one element of what is a vastly extensive undertaking. However, in scrutinising the impact and effectiveness of the reforms it is important that charities are recognised as a distinct category of customer with unique needs. We are concerned that failing to do so could result in unintended negative impacts on the charitable sector further down the line.

Many charities held money in the Icelandic banks and were affected by their collapse in 2008. In the aftermath of the Icelandic banking crisis, we have had a number of concerns with the banking system and protections in place for charities:

Charities have a unique set of requirements when it comes to banking. Their funding structure, public benefit function and activities all mean that they bank differently from other classes of customer (for example, individuals and businesses), however the protections in place for charities (i.e. FSCS coverage) does not recognise the distinctive nature of charity banking.

In the period following the crisis it became apparent that there was a clear gulf between charities’ exposure to risk and capacity to manage it, and their level of protection. This was also acknowledged by the Treasury Select Committee during their inquiry into the banking crisis.

The depositor preference principle laid out in the draft Bill fails to recognise the unique position of charities and in fact increases risk by pushing them further down the creditor hierarchy. Our proposed solution was to grant charities preferred creditor status, so that charity deposits ranked alongside those of the FSCS in the event of bank failure.

These concerns were outlined in our response to the Banking Reform white paper, however HM Treasury did not adopt our recommended solution as it was felt extending depositor preference would dilute key aims of the policy and reduce the alignment between risk and reward in investment decisions. The need for fairer protection for charities therefore remains and we believe that it is essential that these concerns are considered during the process of pre-legislative scrutiny and the current focus on banking reform.

1. Why we are submitting evidence

1.1. This is a joint submission on behalf of Charity Finance Group (CFG), the Association of Chief Executives of Voluntary Organisations (ACEVO), Charities Aid Foundation (CAF) and the National Council for Voluntary Organisations (NCVO). Our organisations represent charity finance professionals, donors, and the wider voluntary sector.

1.2. We welcome efforts to reform the UK banking system to enhance stability and integrity and encourage competition. However, we have raised a number of concerns with the reforms, principally the impact of depositor preference on charities. Section 4 of this submission outlines our activity in this area.

1.3. We recognise that the impact of the banking reforms on the charity sector is just one element of what is an extensive undertaking. However, the charity sector is a major contributor to the UK economy and supports millions of beneficiaries across many areas of society. This submission sets out some of the features of charity banking, and asks that the Commission consider these in their scrutiny of the reforms. These unique features are the reason why charities were particularly affected by the collapse of the Icelandic banks (as detailed in section 3) and why depositor preference could prove particularly detrimental.

2. The unique position of charities

Charity funding and the impact of bank failure

2.1. The unique way charities hold and manage funds mean that the impact of losses—for example as a result of bank failure—can be particularly severe.

2.2. Charities typically hold large amounts on deposit (approximately £18 billion across the sector) as they require quick and easy access to cash to ensure service delivery commitments are met or to fund specific long-term projects. Charities therefore stand to lose a lot more, relative to their size, than other creditors who generally have a smaller proportion of their income in the bank, and a much more fluid cash flow.

2.3. To give an example, one large London-based charity holds around £50–60 million on deposit, which is around 100% of turnover. Another holds £25 million on deposit, approximately 40% of turnover. Most charities (particularly the large ones like these) split deposits between carefully-selected banks to manage the risk; however this can still mean millions in one bank in some cases.

2.4. Charities’ funding arrangements are also unique in that they hold a mix of unrestricted funds, which a charity can choose to spend as they wish, and restricted funds, which are given and can be used only for a specific purpose, e.g. DfID funding for a project in Malawi. This separation means the impact of any losses is often amplified. For example, loss of restricted funds means the shortfall has to be sourced from somewhere else (and if the project is not delivered the funds often have to be paid back) and loss of unrestricted funds will impact on a charity’s ability to cover general overhead costs and therefore operate. This strict division of funds therefore means an organisation may be cash rich, yet disruption to just one pot of funding can have serious consequences.

Public benefit function and accountability to the public

2.5. The nature of charitable activities means in many cases the effects of losses are wide-reaching and long-term. Charities must demonstrate that their activities are for the public benefit and ultimately beneficiaries—often the most vulnerable in society—are the ones who lose out. In contrast to the commercial sector, it is extremely difficult for other charities to step in to take on and deliver the services of another if it has closed.

2.6. Unlike businesses or individuals’ funds, charity funds are for public, not private, benefit. Charity deposits do not “belong” to the charity—instead the charity is simply the vehicle channelling money from the donor/funder to the beneficiary, and so any losses will impact on both these groups.

2.7. Charities rely on the trust and confidence of the giving public to support them—financially and otherwise. Charities therefore must carefully consider the reputational implications when managing their money and banking arrangements. There are a number of elements to this, including:

Individuals choose to give to charity on the grounds that the money will be spent as intended. Losing money as a result of bank failure, or a perceived increase in the likelihood of this happening, could impact on an individual’s inclination to donate.

While charities have to spend a proportion on overheads to ensure the efficient running of the charity—and should not shy away from making the public aware of this—charities still have a duty to be extremely careful when it comes to these types of costs (see paragraph 2.9).

Capacity to manage risk

2.8. We would be extremely concerned with any measure that increases banking risks for charity (hence our concerns with depositor preference). In the notes accompanying the draft Bill, HM Treasury reject the extension of depositor preference on the grounds that “[charities and other creditors] are likely to be at least as well positioned to monitor and manage risk as many other groups of senior unsecured creditors”. However, the reality is many charities are not as well positioned as commercial organisations to do so.

2.9. The vast majority of charities manage their finances and risk extremely well, yet most simply do not have the same level of technical banking knowledge and expertise as other creditors of comparable size. Managing increased banking risk is extremely resource-heavy and investing in up-to-the-minute treasury management diverts funds away from frontline services. It is therefore difficult to justify using substantial charitable funds for this purpose, particularly given the challenging funding environment.

2.10. Another aspect of managing risk for charities is the trade-off between risk and return. While this is the key consideration when making all types of investment, for charities the tension between these is particularly pronounced. This is because charity trustees are required to protect charity funds and ensure they are used as intended (making them risk averse) but also have a legal duty of care to achieve the best risk adjusted returns on charitable deposits under the Trustees Act 2000 (which sets out a Trustee’s duty of care and investment powers).

2.11. We would ask that Government keeps this tension in mind when shaping the rules around ring-fencing and the retail-wholesale split. Creating a clear division and choice between greater security (depositing in the ring-fenced area) and higher returns (depositing in the non-ringfenced area) could exacerbate this tension.

3. Impact of the collapse of the Icelandic banks

3.1. For many charities, the banking reforms will be considered in the context of how successfully they address the failures in the system that became apparent following the collapse of the Icelandic banks and financial crisis. In the Treasury Select Committee’s inquiry report the unique position of charities and consequences of this were acknowledged, and it is important that the lessons learned are taken into consideration when shaping the reforms.

3.2. Following a request from CAF and CFG, 48 charities indicated that they had held funds in Icelandic banks that they had not immediately been able to recover. The combined total amount was £86.6 million.

3.3. This data was a conservative indication of the level of impact on the charity sector. Many charities did not want to be named or were reluctant to speak up as they feared it would negatively impact their reputation. Many charities held deposits with Kaupthing, Singer & Friedlander in particular—it was a respected City firm that had long provided bespoke charity banking services.

3.4. In the aftermath of the collapse, there was confusion and frustration around FSCS coverage. Many charities were unaware of whether they were entitled to protection or not, or had assumed they were but were found to be ineligible by virtue of their constitutional/corporate structure. It was extremely difficult to obtain clear advice from the FSCS and the need for greater clarity remains.

3.5. The retail-wholesale split which dictated FSCS eligibility was considered wholly inappropriate and unfair in the charity context. Many charities were deemed “sophisticated” wholesale investors by virtue of their size, and therefore were left without any financial support when others were fully compensated.

3.6. It was widely accepted that charities and others could not have been expected to foresee the crisis, particularly given the Bank of England’s failure to do so and the fact that the credit ratings were only downgraded days before institutions went into administration. For many charities this rendered the fact that they were deemed wholesale depositors and therefore better placed to foresee the crisis even more unjust.

3.7. In the Treasury Select Committee’s inquiry into the impact of the failure of the Icelandic banks, a number of points were raised with regard to the charity situation. We believe that these should be noted when considering the new reforms.

We recommend that the Government consider the case for providing charities with further statutory guidance relating to the management of a charity’s finances and investments. We further recommend that the Government take steps to clarify what protection is available to charities under the Financial Services Compensation Scheme.

We are concerned that one of the tests a charity must pass to be protected under the FSCS definition of a retail depositor is inappropriate for those charities using fixed assets in the course of their work... we recommend that the FSCS re-examine the criteria for the classification of charities as retail or wholesale depositors…1.

4. Our position and activity

4.1. Our work on the banking reforms has so far focused on our concerns around the impact of depositor preference on charities, and the effects pushing charities further down the creditor hierarchy in the event of bank failure will have.

4.2. We anticipate that there will be two main impacts as a result of depositor preference: Firstly, charities will stand to recover a smaller percentage of their deposits should a bank fail. The other, more immediate impact and area of concern was that charities would then need to invest substantial resources into mitigating this additional risk.

4.3. More broadly, we were concerned that the proposals failed to recognise the unique nature of charity funding and banking, and undermined one of the reforms’ underlying aims that the cost of bank failure should be borne by those best able to understand the risks and who can absorb loss best. Charities are not as well placed as other creditors of a similar size to manage the risks and absorb losses, and many of the perceived benefits of depositor preference (e.g. that it incentivises other creditors to exert discipline on banks’ behaviour) would not apply to charities.

4.4. Our proposed solution was to grant charities preferred creditor status, so that charity deposits ranked alongside those of the FSCS in the event of bank failure. We raised this, along with our concerns, in a letter to the minister and in our response to the Banking Reform white paper.

4.5. In the notes accompanying the draft Bill, HM Treasury said that it did not feel there was a compelling enough case for extending depositor preference to charities and that therefore only FSCS -protected deposits would be preferred. While we appreciate the reasons for doing so, and understand that an improved banking system will inherently mean greater protection and fewer risks for all bank users, anything that puts charities in a materially worse situation is extremely concerning. It is important that fairer protections for charities are put in place (see below) and we believe failing to do so would be a missed opportunity.

5. Making the reforms work for charities

5.1. In addition to granting charities preferred creditor status, we have also made a number of recommendations for making the reforms work better for charities to HM Treasury. In light of their decision not to extend depositor preference it is particularly important that these measures, outlined below, are included.

Government support for the development of additional training or guidance for the sector on managing banking risk. The standards of financial management in charities are generally high, however managing this type of risk is a niche skill and charities could benefit from clear information and support on how to manage exposure and make the most of the current protections in place.

Ensuring the FSCS provide greater clarity on which charities are protected and to what extent. While the quality of the information provided has improved since the collapse of the Icelandic banks, progress is still needed in this area.

There needs to be greater transparency around the ownership of banks and how this impacts on levels of FSCS protection. Depositors may think that they are splitting their deposits to effectively manage risk and ensure full FSCS protection, however if the financial institutions fall under the same savings compensation licence the depositor will only be eligible for £85,000 across both. Financial institutions must be forced to be much more explicit about whether their protections fall within the same compensation licence as another “parent” bank.

The banking reforms will result in significant changes to the way banks are run and what will happen in the event of bank failure. Government must clearly communicate what these changes are and exactly what they will mean in practical terms. The impact of depositor preference and ring-fencing, for example, will change levels of risk for charities; however few are aware of what effects the changes may have on their organisations. The information needs to be clearly communicated, and must come directly from Government.

31 October 2012

1 This point will be addressed if FSCS protection is extended to all non-financial customers, as it expected when the relevant Directive is enacted. However, we believe the important point to note is that the unique position of charities was acknowledged during the inquiry.

Prepared 2nd January 2013