Consumer confidence and compensation arrangements :: BSA

Policy

Consumer confidence and compensation arrangements

26. Chapter 5 focuses on the compensation arrangements under the FSCS and deals with –

compensation limit (in principle only; the CP makes no definite proposals)
faster compensation payments (with a one week target)
risk-based FSCS levies
consumer awareness and additional consumer protections.

The following paragraphs provide our comments on these topics.

Compensation limit

27. We are open-minded on the question of an increased limit in relation to deposit-takers. The key point, in our view, is that very careful consideration be given before making a decision on this matter and we set out below a number of factors that need to be fully taken into account. However, we strongly oppose pre-funding, which would be counter-productive for the reasons given below (see paragraph 38).

28. Recent changes: it should be remembered that significant changes to the funding of the FSCS came into effect on 1 April 2008; the financial capacity of the entire scheme having been raised to a maximum of £4.03 billion per year. Therefore, taking this change together with the introduction of the retail cross-subsidy arrangements and the, slightly earlier, increase in the limit regarding deposit-takers (see below), substantial changes have already been made. The Authorities should be mindful, in assessing the validity of further changes to depositor protection arrangements, that the efficacy of these most recent improvements has not been tested and there should not be an automatic assumption that further changes are needed.

29. The BSA believes that the recent increase to 100% of the first £35,000 held with a deposit-taking institution was both proportionate in terms of the amount of increase, and simpler – because of the removal of the co-insurance element - and, therefore, more transparent for consumers than the previous arrangement.

30. Consumer confidence: there might be an increase in consumer confidence if compensation levels were higher, but the consumer research in the CP suggests that this would not be the case – only 1% of those responding correctly identifying the current level of £35,000 despite all the media attention to Northern Rock 5. Public confidence might increase in the light of a higher limit if the reasons for the provisions were clearly explained to consumers.

31. If consumer confidence is the fundamental objective, then it would be boosted by guarantees as to the strength of the depositor protection scheme. The Federal Deposit Insurance Scheme in the USA is backed by the United States Government. The UK Government may, for understandable reasons, be reluctant to take on a similar commitment in respect of UK depositors, and the BSA is not advocating such a change, but the power of government guarantees should not be underestimated - indeed, they have been used extensively in the Northern Rock situation.

32. Consumer benefit: the Association has researched the distribution of deposits (ie both 'share' and 'deposit' accounts) within the building society sector. The figures currently available show that approximately 95% of individuals saving with a building society have balances of £35,000 or less – very similar, indeed, to the figures for the banking sector. These balances account for approximately 69% of the total balances outstanding. We understand that the position of depositors with the banks is almost identical. An increase in the limit would raise the value of FSCS cover, but would have little effect on the number of depositors benefiting from the protection.

33. Market consequences: increased publicity surrounding the compensation limit would be needed in order to engender greater awareness. However, such awareness-raising carries other risks. It seems possible, for example, that it could stimulate the growth of intermediation in the deposit market, which may do nothing to enhance financial stability. Greater awareness of the compensation limit will likely mean that people with balances in excess of the compensation limit will want to spread their exposure by distributing their money between several institutions. Deposit broking services are likely to appeal to such depositors. Money is likely to be moved quickly between institutions as brokers chase the best deals for their clients. Advertising offering these services has already appeared in the financial press.

34. Although the number of depositors who have balances in excess of the current compensation limit is relatively small (ie about 5%), the balances they hold are significant: a similar phenomenon in the United States in the early 1980s contributed to instability in the US system at that time.

35. There is a risk of market distortion if the compensation levels for customers of one class are disproportionately high, although in the BSA's view £35,000 or even £50,000 would not be disproportionately high. However, if the deposit limit were to be further increased, say, to £50,000, then this would put the UK at the upper end of depositor compensation along with, broadly speaking, the United States and Italy.

36. Moral hazard: it is the case, as was illustrated by savings and loans organisations in the US during the 1980s, that an excessively high compensation limit can cause moral hazard for firms and customers. Callum McCarthy, the FSA's Chairman, made the point very effectively in a speech in February 2006 –

"Were the FSA to aim to relieve consumers of all adverse consequences, an environment would be created in which they no longer needed to weigh up the reasonableness of their financial decisions. No market can work effectively without involved customers. To relieve consumers of retail financial services of the consequences of their actions would destroy this as an effective market. Consumer responsibility is therefore vital to the effectiveness of financial markets."

Therefore, changes to the deposit protection scheme should be carefully designed to minimise the dysfunctional effects on incentives, weighed against the benefit of greater confidence such insurance provides. There might possibly be adverse incentives for the management of some institutions if it was clear that, whatever the risks they took with depositors’ funds, those funds would be protected.

37. Turning to the issue of pre-funding, in the BSA's view, it is preferable to introduce measures to speed up payments to depositors, under the current FSCS arrangements, than to introduce pre-funding; and we do not see the two as necessarily going hand-in-hand.

38. The BSA opposes pre-funding because –

it would deprive firms of, possibly significant, funds (this would be particularly unwelcome at a time of likely downturn in the economy)
estimating an appropriate level of pre-funding would be impossible; until losses had crystallised, the likelihood would be that far too much or far too little would have been pre-paid – this could amount to a very costly, but wasted, exercise.
any fund would be insufficient to cover deposits in the largest institutions. The high level of concentration in the UK market means that the majority of deposits would not be adequately covered by a fund.

There are other arguments against pre-funding, such as the extra costs for the FSCS in managing the funds, but we recognise that these are marginal when compared to the substantive objections noted above.

39. During the FSCS funding review, many financial services sectors, and the Financial Services Practitioner Panel, warned the FSA of the dangers in disregarding lack of capital among certain firms (especially among mortgage intermediaries) and, instead, regarding the proposed cross-sector general retail pool as a 'catch-all'. As the BSA has pointed out before, the FSCS is not a substitute for the regulator taking reasonable steps to seek to ensure that firms have the crucial building blocks of prudential regulation in place, such as prudent levels of liquidity and capital. This would be more sensible than pursuing pre-funding – and Northern Rock strongly evidences this point.

Faster compensation payments

40. We have had the benefit of seeing the BBA's response to the CP and agree with the BBA's analysis (in response to CP question 5.7) that there are numerous barriers to providing a one-week (5 working days) payout including scale, money laundering requirements, credit assessment etc. However, we fully support all proportionate endeavours to reduce the current period for payments from the FSCS in the consumer interest and are very keen to participate in ongoing discussions.

41. The obvious way of facilitating fast payments is for the FSCS, backed by the Government, to provide the initial funding. This could, if necessary, be up to the overall FSCS limit, which would be significantly less than the funding provided by the taxpayer in relation to Northern Rock. In principle, this would fit well with a 'gross payments' approach (see below).

42. We note that FSA will be consulting on gross payments and we look forward to contributing to that exercise. Our initial views are that, from a customer perspective, gross payment of depositor compensation has several merits and these include –

simplicity - it is easier for customers to understand
speed of payment - customers do not have to wait as long for their money
fairness - it gives customers a better deal: depositors who also have long-term mortgage loans do not have to suffer a loss of liquidity.

The BSA raised this point in 2004 in response to FSA DP24, as follows –

"The £35,000 maximum protected deposit under the Financial Services Compensation Scheme applies to each individual, not to each account held with the same firm. Accordingly, in the not uncommon event that an individual has one or more sole accounts with a firm, and/or one or more joint accounts (potentially with one or more different joint investors) with the same firm, it would be extremely difficult for most firms to track the amount actually covered by the FSCS in relation to individuals on a day-to-basis, or at all".

Nevertheless, it would be necessary to consider carefully any unintended consequences of a move towards gross payments and the FSCS consultation will provide an opportunity for more detailed scrutiny.

Risk-based FSCS levies

43. Risk-based charging has its potential merits, although the risk ratings would need to be kept secret because, if they became public, that could itself be a source of financial instability. For that reason, we doubt that risk-based charging is desirable. Moreover, it would only be relevant in a pre-funded Scheme, which (as noted above) we believe would be counter-productive and we oppose.

Consumer awareness and additional consumer protections

44. The foregoing paragraphs on the compensation limit contain a number of comments about consumer awareness.

45. In the light of recent developments, it would make sense to revisit the requirements in relation to the information firms must provide to customers about the FSCS. Currently, Regulation 46 of the - otherwise largely repealed - Credit Institutions (Protection of Depositors) Regulations 1995 (SI 1995 No 1442) requires the provision, on request, of a summary of the provisions of the relevant Scheme, including –

details of the level of protection
details of the scope of protection
a summary of any conditions that must be fulfilled, and
a summary of any procedural steps that must be taken.

46. Given recent events, there probably now needs to be greater specificity and uniformity as to the precise information that needs to be covered. Paragraph 5.69 of the CP notes that customers should be made aware that balances held under different brand names, owned by the same banking group, may be aggregated before the FSCS limit is applied. Full consideration should be given as to other information that might be considered for mandatory provision. Whatever the outcome, any new notification requirements should be consistent for all firms; moreover, as noted earlier, full consideration should also be given to the likely market impact of changes in this area.

Back to contents