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In the wake of recent bank failures, questions are being raised over the UK’s compensation scheme – is there more that can be done? By Tom Aries.
There have been several US bank failures this year: Silicon Valley Bank (SVB), Signature Bank and most recently First Republic Bank. The SVB saga in particular has identified interesting differences in the way the UK and US address deposit insurance.
The reported $42bn bank run on SVB shines a light on the current compensation limits and speed in which it is paid out in the UK in comparison to the US.
Transatlantic divide
The UK’s Financial Service Compensation Scheme (FSCS) largely implements the EU’s Deposit Guarantee Schemes Directive.
Currently, eligible deposits in the UK are protected by the FSCS up to the maximum compensation limit of £85,000 per aggregate deposit per bank (and up to £170,000 for joint accounts of individuals). There are additional protections of up to £1m for ‘temporary high balances’, such as a holding payment for a property purchase.
As well as deposits held by individuals, most businesses like limited companies and LLPs are also protected by the scheme provided they meet relevant eligibility criteria, which broadly means as long as the business is not an authorised financial services firm.
Where the FSCS considers a firm whose deposits are covered by the scheme to be in default, it will pay out to eligible claimants up to the limits of compensation.
Read more about deposit guarantees
However, it is important to remember it is a scheme of last resort, and in theory at least, prudential requirements imposed on banks should reduce the likelihood of failure and thus an FSCS payout.
The US equivalent of the FSCS is the Federal Deposit Insurance Corporation (FDIC).
As opposed to the FSCS’s more limited £85,000 deposit guarantee, the FDIC guarantees up to $250,000. There is a further surprising difference though – the speed in which the FDIC can pay out compensation.
The UK’s FSCS promises to pay out compensation within seven days of a bank failing, which is what was communicated to depositors of SVB’s UK subsidiary when it looked like the FSCS may have to step in. The FDIC by comparison promised to pay out to SVB’s US depositors the next working day.
The FSCS’s slower reaction appears to be in part due to its lower levels of advance funding – it first relies on the Treasury to provide the funds for compensation, then seeks to claim back the funds through levies on firms.
The FDIC by comparison has higher levels of pre-funding, meaning it is more likely to already have access to the cash needed to compensate depositors.
Is this a problem?
The amount of compensation and speed in which the FDIC can pay out has raised the question of whether the UK’s scheme needs to do more on both those counts.
The issue is most pressing for small businesses. It is certainly questionable whether the £85,000 limit is appropriate for them, given they likely hold higher deposits. For individuals, it is probably arguable, although perhaps more marginal, whether that limit is appropriate too.
The current speed in which compensation is paid by the FSCS must certainly raise issues for businesses who hold deposits with a bank in default too. Many small businesses would likely find the seven-day wait to access their cash again problematic. Individuals may also find this delay in payment difficult to manage when payments are due.
What could reform to the scheme look like?
Reform could come in the form of changing the way the FSCS is funded. Moving to a higher level of pre-funding like that of the US’s FDIC could offer greater consumer protection through quicker payouts. However, this would likely require complex, sweeping reform, requiring one or more industry consultations, PRA Rulebook changes, and/or Treasury orders.
While moving to higher levels of pre-funding may provide the resources needed to allow for swifter payments on a bank’s failure, this would not necessarily mean an increase to the limit would follow. Separate consideration would need to be given on this point, which raises a further question: should there be more regular reviews of compensation limits?
Recent bank failures suggest [compensation limit reviews] should be more regular
Currently, the compensation limit is reviewed by the PRA, and any recommended changes approved by the Treasury, every five years. The next review is due by the end of 2025. Recent bank failures suggest that these should be more regular.
More regular reviews may in themselves provide a greater degree of protection (or at least enough to provide comfort), and in comparison to funding reforms, should be relatively easy to introduce.
To increase the compensation limit and/or reform the FSCS’s funding, however, would require an increase in the levy. Some may argue that this is disproportionate against the backdrop of the prudential regulation currently in place which is designed to try and stop any bank failure in the first place.
That said, it may be that the Bank of England looks to focus on why recent failures have occurred – which largely appears to be due to poor interest rate risk management – and seek to shore up any weaknesses in current prudential regulations.
Whatever the answer is, it is clearly a balancing act. One thing seems likely: if reform is introduced, there will be a cost attached.
Tom Aries is an associate at law firm Pinsent Masons.
