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Monday, August 16, 2010

More Detail on the Proposed BOE Act - Part Six

Note: This is the sixth 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

Investment Account Guarantees

Under the existing system, if a bank fails due to bad investments, a third party (the taxpayer) will reimburse the savers who have money invested with that bank.

This creates a few serious flaws or 'distortions' in the economic system:

1. It means that the banks can gamble with their customers' money in the knowledge that the government will step in to cover any serious losses. This creates 'moral hazard' and encourages the banks to take greater risks in their investments.

2. It means that one group stands to benefit if the bank is successful in its investments, while another group (taxpayers) stands to lose if the bank is unsuccessful. The government-backed guarantee on funds in any UK bank accounts means that bank account customers do not need to pay any attention to the activities of the bank that they choose to invest with. If customers bear at least some of the risk of the investment, it should encourage them to be more vocal in how the banks invests their customers' money - maybe expressing concern that large sums of money go in to risky proprietary trading, or requesting accounts where the money is ring-fenced for certain types of investment.

Our proposal contains a few simple rules that collectively 'fix' these fundamental problems in the current design of the banking system. Practically, it works as follows:

1. An institution has the option of offering Investment Account holders a guarantee that they will be repaid a minimum percentage of their original investment. For example, the bank may say that a particular Investment Account product guarantees to repay the investor at least 100%, or eighty per cent, or sixty per cent, of the amount originally invested.

2. The institution may also offer a guarantee on the rate of interest that will be paid on the Investment Account product, for example, guaranteeing to pay two per cent, four per cent, or five per cent interest.

A Worked Example:

Let's look at a worked example. Imagine that a bank wants to attract funds to fund conservative housing market loans to middle-income families. It charges an interest rate of eight per cent on the mortgages, and it knows that only a tiny percentage of the loans that it makes to these middle-income families will actually default. Consequently, allowing for defaults, the normal case rate-of-return will probably be around 7.8% overall (over all the funds invested in this type of mortgage), and in the very worst case scenario, with a high rate of defaults, the rate of return might drop to two per cent (with the losses of the defaults being cancelled out by the interest paid by those who don't default).

Because the bank knows that, in the very worst case scenario it is still likely to make a return of two per cent, then it knows that investing in this market is effectively 'risk free', in that it is highly unlikely to lose more than the bank originally invests.

Consequently, in order to attract more funds into its Investment Accounts in order to fund more lending in this particular market (that is, Mortgages for middle-income families), it may offer to guarantee the original sum invested, and guarantee a rate of return of two per cent. This makes this a 'risk-free' investment for the Investment Account holders, and provides a good investment vehicle for savers/investors who don't want to take much risk and don't need a very high return.

In this situation, the bank holds all the risk of the investment. If the investments were made badly and the bank actually lost twenty per cent of everything it invested, it would still need to repay the entire original sum to each Investment Account holders, plus two per cent interest. It would then need to cover its losses with its own profits - in other words, bad investments by the banks would wipe out their profits for the year (or the next few years, if they really miscalculated their investments).

Let's look at another scenario. Imagine that the bank wants to raise funds for investing in a risky, emerging market. The possible return here is much higher, but the risk of loss is much greater too. The bank wants to limit its own risk by sharing some of the risk with customers. The potential interest rate that it will offer if its investments are successful is eight per cent. However, if it is unsuccessful, and the market turns out to be a bubble about to burst, it could end up losing up to fifty per cent of the funds invested.

In this case, the bank may opt to offer no guarantee on the rate of return, and to offer a guarantee of sixty per cent of the principal invested. This would attract funds but would force the investors to share the risk with the bank. If the investments failed badly, the investors would lose forty per cent of the principal, and the bank would need to make up the other ten per cent of the losses from its own profits.

Some of us may read the figures above and say that it is not 'fair' that the bank only risks ten per cent while the investors risk forty per cent of their investment. However, in every case, each investor would have been made aware of the guarantees, and therefore made their own decision to invest in a particular Investment Account, knowing the risk to them and the potential upside.

These two 'guarantees' set up the conditions in which competition between the banks will lead them to offer a full range of products for every type of investor. Investors who want a high rate of return will need to take on some of the risk themselves, and investors who are happy with a low rate of return will be able to invest effectively risk-free.

No Government Guarantee on Investment Accounts

The Treasury and government do not back the guarantees made by the banks. If a bank went bankrupt, Investment Account holders would become creditors of the bank and would have to wait for normal liquidation procedures to take place to see if they will get back part of their investment. While this is likely to be unpopular with savers who have, to date, been able to save without taking any risk at all (thanks to the taxpayer-funded guarantee) there is no morally or economically justifiable reason why savers/investors should have their investments effectively insured by UK taxpayers.

The Financial Services Authority or Bank of England May Forbid Specific Guarantees

We have allowed whichever institution that is charged with supervising the UK banking system to forbid an institution from offering a particular rate of return on a particular Investment Account product. This provision is necessary to prevent banks from offering unrealistic guarantees.

We know from history that professionals in the financial sector are not very good at identifying bubbles while they are in one. When a bubble takes off in say, hotel construction, a bank has an incentive to offer a better guarantee than all its competitors in a particular Investment Account product in order to attract the maximum amount of funds for investment in the bubble. The guarantee they offer may be one that is based on the 'best case scenario'.

If the bank tries to offer an Investment Account product with a guaranteed rate of return of eight per cent, the FSA may judge that it is highly likely that the investments themselves will not generate a return of eight per cent, and therefore the bank will end up with a shortfall, which will increase the likelihood of the bank going bankrupt or appealing to the Bank of England for emergency funding. In short, offering a guarantee (on either the rate of return or the principal) which bears no relation to the real risks of the investment makes it more likely that the bank will run into financial difficulties, and therefore the FSA or Bank of England should be allowed to disallow any guarantee in order to maintain the stability of the banking system.

Bill Totten


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