Banks may have to set up compensation scheme for savers

The run on Northern Rock

Banks may be required to pay into a fund to refund savers if a bank fails in the same way that Northern Rock did last September.

The government has presented a proposal to Parliament for consultation outlining the ways customers can be protected from failing banks and building societies. The report also proposes that banks should be able to receive help from the Bank of England in secret.

Currently, the government has a guarantee protecting the first £35,000 of savers' deposits. The Conservative party wants to see this limit increased to £50,000.

In his presentation to Parliament, chancellor Alistair Darling proposes keeping this protection guarantee at its current level and instead creating a new law which would see banks and building societies make pre-payments into a compensation fund.

If the proposals get the green light, then banks would have to make pre-payments into the fund in anticipation on another institution getting into difficulty. This would mean the Financial Services Compensation Scheme would have a reserve fund from which to refund customers whose deposits are above the £35,000 limit.

However, it is feared that establishing such a fund might damage consumer confidence in the stability of banks. It would also put additional financial pressure on banks, as those suffering in the current climate might struggle to make pre-payments.

The other key proposal in the presentation is that banks are able to receive loans from the Bank of England in secret.

Currently the central bank publishes weekly accounts which show exactly how much money it has lent to financial institions. In the case of Northern Rock, the disclosure of the Bank of England’s financial aim caused panic among customers leading to the run on the bank.

The proposal will also protect the Bank of England from any prosecution attempts by shareholders who are unhappy with the way it has treated a particular bank.

Richard Lambert, director-general of the Confederation of British Industry, says: "Financial stability and the protection of depositors are essential components of a healthy economy.

"Northern Rock exposed serious weaknesses in our current approach, and it is vital that we draw the right lessons from what happened.

"It will also be very important to avoid any knee jerk responses, or the kind of heavy handed regulation that would kill competition and innovation in the financial services sector."