IF you leave your suit at a dry-cleaner, you retain ownership of the garment, even though possession has passed (temporarily) to the shop. But if you deposit £1,000 in a bank account, who owns the money? It’s still yours, held in trust by the bank, just as with the dry cleaner, right? Wrong. Ever since 1811, it has been established that money deposited in this way is no longer owned by the “customer” – he or she is deemed to have lent the money to the bank, which can do whatever it wants with it. As part of the implicit contract, the depositor is in fact a creditor to the tune of £1,000, and the bank promises to repay the money whenever asked to do so. If the bank is liquidated, depositors must take their place in the queue of claimants on the bank’s assets. They rank equal with bondholders and below preferred creditors such as staff and the taxman. A mainstream bank account is not like putting jewelery into a special vault for safe keeping: it is an investment which carries a risk, which is why interest can be paid.
Don’t worry if you didn’t know this. Virtually nobody does. Yet this crucial misconception that bank accounts are like vaults means nobody undertakes checks on the prudence of the banks in which they place their cash. Thousands trusted Icelandic banks without thinking that great interest rates imply high risk. This risk-taking by the general public is reinforced by absurdly generous government-provided deposit insurance (imposed on the UK by a EU directive in 1979).
Clearly, the current system is broken: the public doesn’t understand the financial system and wants to have the benefit of interest-bearing bank accounts while not shouldering any losses, ever. So what should be done? Andrew Lilico, chief economist at Policy Exchange, has come up with an intriguing proposal to reduce moral hazard, retain some consumer protection while preserving the benefits of fractional reserve, competitive and universal banking. Every bank that accepts retail deposits would be required to offer ultra low-risk “storage deposit” accounts in addition to regular risky “investment deposits.”
Storage deposits would be 100 per cent backed by gilts (or equivalent low-risk, high-liquidity securities) and exist in a legally-nested structure (they would not be exposed to the bank’s wider activities). They would be similar to the accounts available in the old savings banks (the trustee savings banks (TSB) and the post office savings bank (now NS&I)) and be as safe, boring and low-return as can be. Storage deposits could not be used for fractional reserve banking (in which only a small proportion of deposits are backed by liquid assets).
Investment deposits would be regular, deregulated accounts; funds could be used freely by the banks – and deposit insurance would be abolished so only those willing to risk a loss in return for a decent interest rate would choose them. Customers would be preferred creditors, as is the case in Switzerland: they would be first in line to get money back if a bank is liquidated. In the event of administration, depositors would be able to withdraw money as normal but this would be a form of borrowing from the state; losses could be incurred. Money could be shifted at will from one kind of account to the other.
All of which makes a nice change from the usual nonsense promoting Glass-Steagall or endless new taxes on the City. Lilico’s plan should be considered carefully by the new government.