Are banks ripping us off with such low interest rates on savings?

25 October 2019

You want to do the right thing financially, so you are thrifty and save your money in the bank. Then come the end of the month you receive a pittance on your cash

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For those of us who can remember the last time we crashed out of something European (the ERM), rates of interest measured in tenths rather than tens of percent seem almost insulting.

Many of us ask - how can banks lend at rates which seem eye-wateringly high, yet reward savers with almost nothing? Surely the competition authorities should deal with this high street “rip off”?

The problem is this is an oversimplification of how interest on savings works. There is in fact no direct relationship between the amount banks charge for loans and the amount they pay savers in interest.

This is counter-intuitive and doesn’t make sense to most of us because we don’t understand how banks, or money for that matter, actually work. Most people think banks take in cash as savings to lend out as loans.

Peer-to-peer lenders do this (the reason they are regulated differently from banks) and, to a lesser extent, building societies lend cash deposits to borrowers directly. But banks do not.

Banks are much more complex in the way they lend money and the way they are regulated to do it. They are not simply ‘safes’ for keeping your hard-earned cash.

There are different theories about how this works in practice, but it is now accepted by most Central Banks that it is better to think of banks as creating deposits when they lend money rather than as simple ‘financial intermediaries’.

Thus, there is only an indirect connection between banks’ saving and lending rates.

The Bank of England – the UK’s Central Bank - sets the ‘Base Rate’ which is the benchmark against which both savings and lending are priced. The Bank of England has a responsibility to set a rate it believes will keep inflation on or around 2%.

If it increases the rate, the ‘cost of money’ (what the bank pays commercial banks for holding cash reserves in its accounts, and the rate at which banks will lend to each other) goes up.

The result is people tend to borrow less and save more, cooling demand in the economy which in turn cools the rate of price rises of the things we buy. 

Decreasing the rates, as the Bank did during the financial crisis, makes it less attractive to save, easier to borrow, and consumers are more likely to spend and keep the economy moving.

So the problem is not that banks aren’t paying enough on savings - they are simply reflecting the ‘cost’ of money.  It is that there aren’t enough options for people who want to preserve the value of their savings against inflation.

To do that you need to invest, which means taking some risk with your money because sadly, you don't get something for nothing. To get a return on your money greater than inflation, you have to take some risk.

Pension funds invest your money – exposing it to risk to seek a return bigger than inflation - because they want to make sure your pension pot will be worth something meaningful when you retire.

A capitalist system depends on prices rising - if there is no inflation, there is no investment and without investment, there is no capitalism.

So in effect what campaigners for ‘a fair deal for savers’ are asking for is essentially a universal income for savers – a.k.a. a very peculiar form of socialism.

But while capitalism rules, campaigning for people to get a better understanding of these realities and how to take sensible first steps into investing would be much more helpful.  

Bruce Davis is joint managing director of Abundance Investment