Is the British banking crisis really over?

For centuries the banks have had a reputation of stability. In spite of the odd gripe about charges and interest rates, we trusted them with our savings and turned to them whenever we needed to borrow money to realise our dreams. But after the past two years that reputation has been blackened, possibly forever.
"The UK banking system has changed fundamentally," says Joshua Raymond, market strategist at City Index. "It's as if a nuclear bomb has gone off in the market, and we're still feeling the aftershock."
The catalyst for the change was the credit crunch in the US. After several years of sometimes reckless lending and rising mortgage defaults, appetite disappeared for the higher-risk loans and, as interest rates rose, it became harder for lenders to borrow money to support their lending strategies. Liquidity in the market simply dried up.

The first UK bank to feel the effects was Northern Rock. Finding it difficult to borrow money to support its lending strategy, it was forced to turn to the government in early September 2007 for emergency financial support.

This unusual step led to a run on the bank, with customers queuing for hours to withdraw their money, taking out £1 billion on the first day alone. Then, as the bank continued to struggle and no suitable takeover bids came forward, the government nationalised it in February 2008.
Almost a year on from Northern Rock's slide, Lehman Brothers in the US sent further shockwaves through the market when it collapsed on 15 September. "This created a huge amount of market uncertainty," says Raymond. "Lehmans caused something of a domino effect as it then became impossible to work out which bank had what toxic debts."
Against this backdrop, some unprecedented events occurred. First, several British banks had to turn to the government for financial support. Although they waited a little longer than Northern Rock for a bailout, in October 2008, Royal Bank of Scotland received £20 billion and Lloyds Banking Group, which had acquired HBOS, received £17 billion from the government.

Defaulting banks

On top of this, five banks went into default. These were Bradford & Bingley at the end of September last year, followed by Heritable Bank, Kaupthing Edge and Icesave in October, and London Scottish Bank in November. Then, in March this year, the Dunfermline Building Society also failed.
The failure of these banks resulted in compensation payouts totalling £20.9 billion to some 3.5 million account holders, with some, including the Dunfermline customers, transferred to other banks and building societies.

Although the spate of bank failures appears to be behind us, the extent of the shake-up in the banking sector can be seen in the latest round of results.

"When the banks announced their half-yearly figures at the beginning of August, there was a real polarisation between the haves and the have-nots," says Richard Hunter, head of UK equities at Hargreaves Lansdown.

"On one side you have the likes of Lloyds and RBS, both of which performed badly, while on the other side you get Barclays and HSBC, which are well-regarded."

For example, while Barclays and HSBC both announced profits of £2.98 billion for the first six months of the year, Lloyds announced losses of £4 billion and RBS a meagre profit of £15 million.

"As well as the government loans, Lloyds and RBS are very UK-focused, so they're at the mercy of our economy. On the other hand, HSBC has good global diversification, which has helped it," adds Hunter.

The future

The question now is: what do these results mean for you? While the banks seem to have come through the worst and further defaults seem unlikely, it's worth remembering that you do have rights if your bank does go bust.

"You would receive 100% of the first £50,000 you have with the bank if it defaults," says Sarah McShane, a spokesperson for the Financial Services Compensation Scheme (FSCS). "This amount is per person, so joint account holders would be covered for up to £100,000."
What's important to note, though, is that it only applies once per Financial Services Authority (FSA) authorisation, so you may need to spread your money around. For example, the Asda, Bradford & Bingley and Cahoot brands all sit within the same authorisation as Abbey, so if you held £80,000 across the four banks, you would only be entitled to a maximum of £50,000 in compensation.

The compensation rules have been amended slightly since they were first introduced, and savers' money will now no longer be used to offset any debt held with the same institution should the banking crisis lead to the collapse of more firms.

Previously, if you had any outstanding debt with the firm in question – such as an overdraft, a loan or mortgage – this would have been subtracted from the money you could expect to receive. For example, someone with £20,000 of savings and £15,000 of debt with a bank would only receive compensation of £5,000 from the FSCS.

However, new rules just announced will see savings ring-fenced from any debt with the same firm. This means the customer's savings will be protected to the limit of £50,000 and not used to offset loans.

The rules have also been amended so that customers of building societies are now given more protection. Following a spate of mergers across the mutual market in 2008, the FSA introduced new rules in December allowing building societies to merge but still retain their separate compensation limits.

This additional protection for building society savers was only intended to remain in place until September this year, but the FSA has now proposed an extension of 15 months to December 2010, and is also widening the rules to include building societies that merge with another mutual organisation. This would cover the merger between Britannia Building Society and the Co-operative.

If you do find yourself in the unfortunate position of having money with a failed bank, you'll need to make a claim to get it back. Sarah McShane explains: "As soon as we get details of the customers affected we'd contact them and ask them to complete an application form. In total, we'd aim to process claims within a six-month period."

The experience of the customers with the banks that defaulted in 2008 illustrates what can happen. While Bradford & Bingley customers were transferred to Abbey, and the majority of the accounts with Kaupthing Edge and Heritable to ING Direct, customers with Icesave and London Scottish Bank had to submit claims for compensation.

"London Scottish customers used paper applications, but due to the numbers involved we had to set up an online claims process for Icesave customers. They were able to complete an application in a couple of minutes," adds McShane.
Whether or not you were affected by a bank going into default, it's been a tough ride for most banking customers. And for investors, it's been close to catastrophic. "Share prices for the banks fell sharply after Lehmans collapsed, wiping as much as 96% off their value by the following January," says Joshua Raymond.

As an example, between 19 September 2008 and 19 January this year Barclays fell 90% to its low on 25 January 2009; Lloyds fell 96% by 21 January; and RBS fell 96% to a low of 10p. Even the more diversified banks – HSBC and Standard Chartered – saw around 60% wiped off their share price over this period.

Although they didn't take quite the same hit, borrowers have also found it hard over the past year or so. "Because the banks have had to take a more careful look at their risk profile, they're being ultra-cautious with their lending criteria. New customers have to have a clean credit record," says Andrew Hagger, spokesperson for price comparison website

As well as only entertaining the lower-risk borrower, banks require a much larger deposit from today's mortgage customers. "It's beginning to relax, but at the beginning of the year, the best deals were for loans to value of 60% or less.

You'll still need a deposit of at least 25% to get a decent deal. Compare this with the 125% mortgage that Northern Rock used to offer," adds Hagger. 

Credit-card holders are also victims of the banks' greater caution. With credit limits included on a bank's balance sheet, whether or not you use the card, some cardholders have seen their limits slashed to improve the figures. 

Savers feel the pain

Savers have also fared badly, although much of their pain has been due to the sharp cut in the Bank of England base rate.

"Earlier in 2009 the majority of instant access accounts were paying less than 0.5%, with many paying 0.1%," says Hagger. "There are signs of improvement, though, with fixed-rates starting to pick up.

However, anyone using their savings to generate an income - for example, pensioners - will have seen their income drop significantly. A year ago they could have fixed at rates of more than 7% a year; now they'd get just shy of 4% on a one-year bond."

Although there are signs of improvement with interest rates rising and more flexibility coming back into the mortgage market, the situation is unlikely to change dramatically in the short term.

Speaking at the release of the Bank of England's inflation report in August, governor Mervyn King said that it would take several years before the banks would be able to repay the loans they received from the government.
But paying them off as quickly as possible should be the banks' priority. Raymond explains: "Because of the government support, these banks need to maintain a solid cash strategy; they can't take some of the risks that could make them larger profits. They need to return to stability as soon as possible to loosen the government's grip on their business models."

However, stability may still be some time off. "The banks that have investment banking arms will recover quickly, and we've already seen better results coming through from the likes of Barclays, Credit Suisse and Goldman Sachs," says Colin McLean, managing director of SVM Asset Management. "But for the retail banks, it's likely to take three to four years to unravel the mess they got into, and I expect we'll see more losses emerge in the next few years."

And, despite the carnage of the last couple of years, there are rumours that new players could be considering an entry into the market. Among the names bandied around for potential new banking ventures are Tesco and Virgin; the latter has already indicated its interest by putting an offer in for Northern Rock.

"The economy will pick up in a couple of years and a new bank, without the legacy issues of its peers, would be in a strong position," says McLean. 

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