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Sunday, August 15, 2010

More Detail on the Proposed BOE Act - Part Five

Note: This is the fifth part of a series filling in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. Bill Totten

Two Types of Customer Account

The first step of the reform is arguably one of the simplest. We simply require that banks keep safe the money which customers wish to keep safe, and invest only the money that customers wish to invest.

Customers who put money into the bank will be given two choices:

"Keep it safe for me" (Transaction Accounts)

Keep the money in the bank, at zero risk, and have instant access to the money at all times. Customers who wish to do this will put their money into a 'Transaction Account'.

- OR -

"Invest it for me" (Investment Accounts)

Hand it to the bank so that they can lend or invest it for a return (interest). For the period of the investment, the customer loses access to the money. Customers wishing to do this will put the money into an 'Investment Account'.

Transaction Accounts

'Transaction Accounts' Replace Current Accounts

Present-day 'current' accounts, are generally used for payment services (cheques, debit cards, cash machines, electronic fund transfers), and receiving money (such as a monthly salary). These current accounts will be replaced by 'Transaction Accounts'.

To the customer, a transaction account will appear to be almost exactly the same as a present-day current account, and members of the public will probably continue to call them 'current' accounts. However, to differentiate between the pre- and post-reform situations, we'll be using the technical term Transaction Accounts.

What Is Still The Same:

1. Transaction Accounts will still provide cheques, debit cards, cash machines, electronic fund transfers et cetera.

2. Salaries will still be paid into Transaction Accounts.

3. Payments between individuals and businesses will still be made from one Transaction Account to another.

4. Customers will still have instant access to money in the Transaction Accounts.

5. These accounts may still offer overdrafts. (The provision of overdrafts is a key, but complex part of the reform, which will be dealt with separately.)

What Is Different:

1. A bank will no longer be able to use the money in Transaction Accounts for making loans or funding its own investments.

2. These accounts will all be held 'off the balance sheet', and not be considered part of the liabilities of the bank.

3. The money paid into Transaction Accounts will be held in full within an account at the Bank of England. In other words, the money is 'in the bank' at all times, and could be repaid in full (to all customers) at any time, without having any impact on the bank's overall financial health. It is technically impossible for the money to be lost, and a bankrupt bank would still be able to repay all its Transaction Account holders.

4. Because the banks are unable to use the funds placed in these accounts to invest or lend, they will be unable to earn a return on these funds. As they will still incur the costs of providing payment services (cheque books, ATM cards, cash handling et cetera), they will almost certainly need to implement account charges to cover these costs.

Benefits of the Changes

1. The government and taxpayer would have absolutely no exposure to problems with individual banks.

2. It would now be impossible to suffer a 'run on the bank'. Even if all customers of one bank were to withdraw their money on a single day, the bank would be able to pay with no impact on its financial health and no need for emergency assistance from the Bank of England or government. We would never see another 'Northern Rock' (or Washington Mutual in the USA).

3. Money placed into a Transaction Account would be 100% safe.

4. Because of the way the clearing system under this reform would work (see 'The Payments System'), the time for payments to show up in the recipient's account could be as little as thirty seconds (as compared to two hours to four days as at the moment). This would provide a better service to both individuals and companies and would make the economy more efficient.

Costs of the Changes - Account Fees

As mentioned above, because the banks can not use these funds any more to make loans, they will want to recoup the costs of providing payment services through charging account fees. In addition they will no longer wish to pay interest on balances in these accounts.

While no-one likes to start paying for something that was previously free (although it should be noted that many banks are already introducing fees on current accounts), the fee that banks charge (say, GBP 10 per month) would be more than outweighed by the savings of between GBP 700 and GBP 6,750 that the average working adult could expect to make as a result of the reform (these savings are discussed later).

It is also worth remembering that the interest 'paid' on current accounts is often as low as 0.01% - in other words, nothing. Someone who had an account balance of GBP 1000 for a whole year would only earn GBP 1 in interest at the end of the year. The loss of this interest is therefore insignificant.

In addition, the post-reform payments system may be significantly cheaper to run than the present-day clearing system, as there would be no need for a complex 'clearing' system (transactions would be instant and final). This means that the only significant costs would be creating the physical ATM cards and cheque books, offering customer service, and maintaining the bank's main computer systems. The actual cost to a bank of collecting and distributing GBP 1,500 of salary and payments through an individual's bank account in a month is likely to be minimal, and therefore the charges passed on to customers should be quite low.

In practice, there will be significant market pressure to keep account fees as low as possible.

As the next chapter shows, to be able to make loans, post-reform banks will need to attract customers who wish to make investments with them. One way to attract customers and gain market share is to run a 'loss-leader' campaign with their Transaction Accounts. They would do this for the same reason that they currently offer free overdrafts to students - someone who banks with you for normal payment services is far more likely than the average consumer to save with you and come to you first for overdrafts, credit cards and mortgages.

As a result, competition between banks for market share means that the costs of payment services may be 'absorbed' by the banks as a cost of acquiring market share, and recouped from their investment earnings. In short, the cost passed on to customers is likely to be minimal.

Investment Accounts

'Investment Accounts' Replace Savings Accounts

The second type of account is the equivalent of what is currently known as 'Savings' accounts. We call them Investment Accounts, for the sake of clarity and because it more accurately describes the purpose of these accounts.

After the reform, the bank would need to attract the funds that it wants to use for any investment purpose (whether it is for loans, credit cards, mortgages, long term investing in stocks or short-term proprietary trading). These funds would be provided by customers, via their Investment Accounts.

What is Still the Same:

1. Savings accounts will still be used by customers who wish to 'put money aside' or earn interest on their spare money ('savings').

2. These accounts would still pay varying rates of interest.

3. They would still be provided by normal 'high-street' banks.

What is Different:

1. At the point of investment, customers lose access to their money for a pre-agreed period of time. There would no longer be any form of 'Instant Access Savings Accounts'. This would be a legal requirement (although see later features that provide flexibility for customers).

2. Customers would agree to either a 'maturity date' or a 'notice period' that would apply to the account. The maturity date is a specific date on which the customer wishes to be repaid the full amount of the investment, plus any interest/bonuses. The notice period refers to an agreed number of days or weeks notice that the customer will give to the bank before demanding repayment.

3. The Investment Account will never actually hold any money. Any money 'placed in' an Investment Account by a customer will actually be immediately transferred to a central 'Investment Pool' held by the bank, and then be used for making various investments.

4. At the point of opening an account, the bank will be required to inform the customer of the intended uses for the money that will be invested, along with the expected risk level. The broad categories of investment, and a consumer-friendly rating system for the risk of those investments, will be set by the authorities. See the 'Conscious Investment Clause' below.

5. The risk of the investment now stays with the bank and the investor, rather than falling on a third party (that is, the taxpayer). In some accounts, the risk will fall entirely upon the bank, while on others a large proportion of the risk will fall on the investor. Any investor opening an Investment Account will be fully aware of the risks at the time of the investment, and those who do not wish to take any risk will be able to opt for a no-risk (and consequently low-return) account. See the later section on Investment Account guarantees for further details.

Key Advantages of the Changes:

1. Banks will be better able to manage their 'cash flow'. Since all the investment funds that will be used by the bank come from Investment Accounts, and every Investment Account has a defined repayment date (or a maturity date), the amounts that the bank will need to repay on any one day will be statistically far more predictable than under the current system.

For Investment Accounts with Maturity Dates, they will know the exact amount that must be repaid on any particular date - they will also know, from experience, what percentage of customers with maturing accounts will ask for the investment to be rolled over for another period (in other words, what percentage of accounts will not need to be repaid on the maturity date).

With regards to minimum notice periods, they will know the statistical likelihood of an account being redeemed within the next 'x' days, and so be able to plan the payments that will come due on any particular day for up to six months into the future. In addition, because they have, on their loans-made side, a collection of contracts with specified monthly repayment dates and amount, they know almost exactly how much money they will receive on any particular date up to 24 months in the future (allowing for a small degree of variance due to defaults and late payments). Consequently the banks' computer systems will easily be able to forecast cash flow (money coming in and out) over the next six months or so, with a much greater degree of certainty than under the present-day banking system, and identify any future shortfalls that need to be prepared for (for example, by scaling back loan making activity and building up a buffer). At the same time, it will be able to identify periods when the money coming in will be greater than the repayments due to customers, and therefore increase loan making activity to soak up the surplus.

2. The government and taxpayers will be neither implicitly nor explicitly responsible for losses of banks. Because the customer making an investment has explicitly agreed to accept the risks of the investment, there is no need (nor a justifiable case) for the government to guarantee any investments. If a bank makes bad decisions and loses money, the customers who provided the money for those investments will lose money. See further discussion of this under 'Risks to Consumers' below.

3. By retaining the strong similarities with present-day 'savings accounts', we minimise confusion for the public. There are already many savings accounts with minimum notice periods or fixed term savings accounts of up to five years, so it is not a big leap to apply this to every type of savings account. We consider this to be easier for members of the public to understand than asking them to invest in mutual funds, or asking them to buy some form of investment certificate or investment bond from the bank.

Ensuring Flexibility for Customers - Early Redemption Options

Although the conditions of an Investment Account would mean that the customer loses access to his or her money during the Investment period, we can give Investment Account holders some flexibility in an emergency by allowing them to withdraw a certain percentage of their investment 'on demand'. With the right rules, this can be done without re-introducing 'fractional reserve banking', without allowing the banks to create money, and without introducing instability to the reformed system.

The provision of these 'Early Redemption Options' is a little complex, so it is discussed in detail in the appendix 'Early Redemption Options' at

For now it is enough to know that customers who wish to save/invest, but may need to call upon the money in the future, can opt to take an 'Early Redemption Option' which would allow them to withdraw some of their money before the Maturity Date or Minimum Notice Period. The bank would impose a forfeit for any customer 'exercising' this option (that is, actually taking the money out before the agreed date), by either reducing or cancelling any interest on the account, or imposing a fixed charge for withdrawing the money before the maturity date.

Bill Totten


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