What is the probability of a banking disaster and what to do in this case?

Back in 2008, I was sitting in an office in Canary Wharf sipping a coffee and gazing out over the river, when I noticed a frenzy of activity in the building opposite me.

It was the Lehman Brothers office – well, two of its offices to be precise, one situated just next door to the other with a huge rooftop swimming pool. No one was swimming that morning. It was the start of the financial crisis.

As my colleagues and I watched, every floor of the second building filled up with Lehman Brothers staff. They were getting their marching orders as the “unbreakable” global financial behemoth collapsed. A journalist called me to ask if I had heard what was going on. I told her I was watching it happen.

Lots of financial commentators claim to be wise after the fact, but back in 2008, the idea that a large financial institution could fall apart so spectacularly was almost unheard of. In fact, the thousands of pages I studied for my financial exams contained just one reference to this topic. Even then, it carried the caveat that such an eventuality was incredibly unlikely.

Flash forward to 2023 and two American banks have collapsed and one of the “big 30” globally – Credit Suisse – is to be taken over by its compatriot UBS. Should we be worried?

The good news is that this is highly unlikely in the UK. But it pays to know how things work and your rights when things go wrong.

What happens when a bank collapses?

Talking about bank collapses is a delicate art. After all, you don’t want to create a panic and find yourself a hostage to fortune. The phrase “run on a bank” literally describes panicking depositors running to the bank to try and get their hands on their cash when word gets round that there’s a problem.

Bank collapses can occur quickly, as happened with Silicon Valley Bank (SVB) and Signature Bank in America. But they can happen over a longer period of time, too – as we’ve seen with Credit Suisse, which stumbled from scandal to scandal but managed to stay afloat for years.

When a business goes bust, the rules and regulations in that particular country kick in. If you’ve managed to get your cash out in time, then great. But if not, what happens next depends on the decisions of regulators, liquidators, central banks, compensation schemes and the government.

In theory, when a business goes bust owing you money, you join a long list of creditors. However, in the UK we have the Financial Services Compensation Scheme (FSCS), which offers savers and investors some degree of protection (more on this later).

What are the chances of your bank collapsing?

There are lots of scenarios that can lead to a bank or other financial institution collapsing. The main factor, though, is when its investors and customers start to worry that the bank’s capacity to stay afloat is in doubt. This leads to a knock-on effect of plunging shares followed customers rushing to transfer cash out of the bank.

Runs on a bank can be caused by factors such as “credit risk”, where the mortgages and personal and business loans that it has advanced look unlikely to be paid back.

This is linked to “liquidity risk” – the imbalance between the money that has been loaned out versus what’s coming in. Liquidity is a complex beast, but in short, regulations around the world require banks to have enough funds to meet demands from both people putting cash in (depositors/investors) and borrowers.

In addition, there is “interest rate risk”. While banks tend to benefit from higher interest rates, it can also mean paying out more on obligations, such as bonds. As we are all aware, interest rates are rising at the moment.

Finally, there is the risk of borrower default. If a big chunk of mortgage borrowers can’t afford to make their their repayments, the lender becomes vulnerable. This is the origin of the “sub-prime lending scandal” that was responsible in large part for the last financial crisis and recession.

Put like that, it could be easy to conclude that we are all doomed. But in the UK, the regulator, the Financial Conduct Authority (FCA), has a ton of rules around irresponsible lending, liquidity, and protecting deposits. This is not perfect, but we do have strong protections in place to calm jittery markets when things look bleak.

What happens to your money if a bank goes bust?

In 2001, the Financial Services Compensation Scheme (FSCS) was set up. This is where most of our current financial regulations come from.

The FSCS essentially provides an essential safety net for our money if financial firms regulated in the UK collapse.

Funded by a levy that regulated businesses must pay, the FSCS can compensate people if a financial institution fails. It can also consider some complaints about businesses that have gone bust. During the mortgage endowment mis-selling scandal, the FSCS helped many people get compensation when their brokers or lenders had collapsed – though only if their mis-selling complaints were upheld.

There are limits, though. Say you have £100,000 saved with a bank that collapses – you won’t get all of it back through the FSCS. These limits are:

  • Banks, building societies and credit unions: the compensation limit is £85,000 per person, per bank/building society licence or credit union. This rises to £170,000 for joint accounts. Note that this £85,000 limit applies “per licence”, so if you have accounts with two banks that are part of the same group, such as HSBC and First Direct, you may only be covered up to £85,000 between them.
  • Debt-management firms: you may be compensated for up to £85,000 per debt-management firm.
  • Funeral plans: these have only recently become formally regulated. So you could be covered for up to £85,000 – but only for plans bought on or after July 29, 2022.
  • Insurance: this is where things get complicated. Basically, the FSCS covers what you have paid into certain types of insurance – but not always 100%. This also includes some claims.
  • Mortgages: compensation for bad mortgage advice is capped at £85,000 per firm.
  • Investments: the £85,000 limit applies per firm here too. However, be aware that it is only the investment firm or brokerage that the FSCS covers.
  • Pensions: this is the biggie, though it depends on what pension you have. If your provider collapses, then you are potentially covered for up to 100% of your claim. With a self-invested personal pension (Sipp), it’s up to £85,000 per person, per firm, and it’s the same for bad pension advice.

As is always the case with all things financial, there are caveats. The rules and limits have changed quite a bit over the years, so, for example, when the incident happened is a major factor if you are seeking compensation.

How safe are your savings?

As a general rule, your savings are pretty safe in the UK. This is due to the extensive financial regulations in place to ensure banks and financial institutions can withstand situations such as those in the news right now. In addition, we have the additional protection of the FSCS (up to the limits I just mentioned).

However, these rules apply only to firms regulated in the UK. If you have put your cash in a foreign bank, then the rules in that country apply. Back in the last financial crisis, it became apparent that many individuals and businesses, including charities and local councils, had popped their savings in Icelandic banks. Gordon Brown, the prime minister at the time, sabre-rattled and rather controversially tried to hold Iceland responsible for UK deposits. This went down so badly in Reykjavik that I was forced to put on a comedy French accent when I visited the country a few months later.

The moral to this story is don’t bank on your non-UK-regulated savings and investments being covered if a foreign financial institution goes under.

What happens if you have a mortgage with a bank that collapses?

I’d love to tell you that the mortgage would get written off, but you will need to keep paying as normal.

After a bit of negotiation, the mortgage “book” will be packaged up and sold on to another investor. This tends to be relatively straightforward because these debts are seen as assets which the buyer will receive interest on. Your rights to complain should remain in place with UK-regulated businesses.

Things do sometimes go wrong, though. It was announced earlier this year that Northern Rock mortgage holders are collectively suing for £150 million. The business that bought their mortgages when Northern Rock went under is accused of keeping the standard variable rates these customers were on at high levels of 5% or more, despite drops in the underlying interest rate.

Things you can do to protect yourself

Diversification is the key to protecting the money you hold on deposit at a bank. There are lots of great savings rates available through new financial firms online at the moment. If you are not familiar with the brand, do a bit of research first before signing up. Make sure you keep your investments to under £85,000 per bank, building society or credit union.

I’d also strongly recommend that you check the small print when you hand over your cash. A business may have a UK office or postal address, but don’t assume that it’s covered by UK regulations. Check your documents, which will state (usually in the terms at the bottom of documents or website pages) that the firm is regulated by the FCA and falls within the remit of the Financial Ombudsman Service and the FSCS. If in doubt, go on the FSCS website and look it up yourself.