Confiscated savings and bank runs

One year ago, you invested £100,000 in a money market investment account.

Unfortunately, you chose to keep it with a small UK bank which has lent too much money to subprime borrowers. You signed up for a fixed-term deal where you receive 6% interest for four years in return for keeping your money in there.

Reading Robert Peston's blog one day, you find out that the bank is about to get into trouble. It has had to write off 15% of its asset base. Your deposit is not covered by government insurance and the bank is going to be partially liquidated; you are going to lose 11% of your money! Overnight your balance will drop to 89% of its previous value. The bank is still going to keep trading so you won't get your money back - the term deposit will remain in place, but at least they will keep paying interest on the reduced balance. What remains of the bank will be taken over by the government so there seems to be no risk of a further writedown.

You figure there is about 30 seconds to act before the news spreads and the bank bolts the stable door. You can get onto their website, pull your money out and transfer it to your current account. Because you are on a four-year fixed deposit, you would only get your original deposit back and not the interest paid so far. You might be helping to cause a run on the bank - irresponsible perhaps - but at least you'll have your cash. Decide now! Do you do it?

If you said yes, your motives are part of the reason for the financial crisis. But not because you caused a bank run.

Loss aversion - which means that we think a loss of existing resources is bigger than an equivalent gain in resources we don't have yet - is the only reason to answer yes to this question. If you take the money out, you probably won't earn more than 1-2% interest on it for the next three years. Your £100,000 may become £105,000 if you're lucky. But if you keep it in, even with the 11% haircut, you'll end up with £112,000.

High interest rates are linked with higher risk, but even when the risk goes bad, they may still be a worthwhile investment. Don't worry so much about capital loss if you are getting high interest in return. Capital defaults are rarely all-or-nothing - you'll get to keep something, and even in default you may well end up with more than if you invested in low-risk, low-return government bonds.


Justeconomics said…
The problem is much deeper than that. The loss averse individual you describe makes two mistakes not one. The second, as you describe might be to withdraw his or her money, but the first was to invest the money in the first place.

Most people do not have the market knowledge to invest their money properly. If this individual was looking for principal protection, then he or she should not have invested the money in an account where it could be lost.

In the United States, many retirees or other investors with no risk appetite invested their money in bonds of Enron or other highly rated companies without understanding that highly rated does not mean risk-free, and that the rating agencies are not actually good at their jobs. Then these same investors were upset that they lost money that they thought was risk free.

As recently as 2004, President Bush advocating the conversion of Social Security into personal accounts where workers could invest in "a conservative mix of stocks and bonds". All of these people would be in a great deal of trouble today if this change had taken place.

Lastly, the individual you describe could have been cheated. Perhaps he was told that this was a deposit in a bank. The word "bank" for common people means "safe". In truth, the practice of fractional reserve banking means that the bank is not safe and depends on a Ponzi scheme for its liquidity. Fractional reserve banking is what makes a bank vulnerable to bank runs. Fractional reserve banking is what causes dramatic swings in liquidity during recession (and not individuals collectively saving).
Leigh Caldwell said…
Good points - most people indeed don't understand the nature of money and the kind of investments that they're making.

I don't share the same degree of concern about fractional reserve banking - yes, it can lead to bank runs, but it also enables a very much more efficient allocation of capital than would otherwise be possible.

In discussing fractional reserves, it's important to distinguish between two different phenomena. [the following note is for the general reader, as I don't mean to imply that you personally are unaware of the distinction].

The first is that banks only keep a part of their deposits available for withdrawal. This is fairly obvious, because of course they could not otherwise pay any interest. They need to lend out most of their deposits, and hope that savers won't want all their money at once. This type of fractional reserve does not result in money creation - the bank is only using money issued by the government.

It would be possible to run a bank without doing this, by offering savers long-term deposit accounts and only lending from these, keeping the money in short-term current accounts fully in reserve. However, while this would prevent bank runs, it would also have a huge impact on the availability of capital.

The other, and more controversial, form of fractional reserve banking is where banks essentially create money which does not exist beforehand. They do this when they lend money, by creating a credit for that borrower in their current account and a corresponding debit in the form of a long-term loan agreement.

The credit in the borrower's current account has value because other banks will accept this bank's promises, on the basis that the bank has the long-term ability to fulfil them (and that most promises by banks to each other will cancel out through the clearing system).

So if the borrower transfers the money from bank A to bank B (for instance when they buy a house) bank B is willing to honour the promise by paying its depositor (the house seller) on behalf of bank A and the buyer. In return, bank B has a claim on bank A for which they can, at some point in the future, demand cash.

In reality, bank B's depositor probably won't take much money out in the short term; and bank B probably won't demand actual cash from bank A. Most interbank claims net out against each other and only a small transfer needs to take place through clearing in a given period.

This is definitely money creation - but that's okay, because money is only a promise by one party to pay another; in normal times, a promise from a bank or another creditworthy party is nearly as good as a promise from the government. Money creation is just people making more promises to each other.

Yes, this process can lead to instability, but that cost must be compared with the clear benefits of a more liquid system with more capital available. My opinion: it's clear that the benefits outweigh the costs.

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