Thursday, 26 February 2009
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.