Credit default swaps: how to spot the riskiest banks

When banks give you a higher savings rate, it’s not because they’re being generous, it’s because they have to compete for funds with more secure institutions.

This article was first published in March 2008. We have since updated the credit default swap ratings so they reflect the current positions.

The whole point about the 'credit crunch' - is that it means banks won't or can't lend as easily or as cheaply as they once did.

The reason for this is that they are under-capitalised, either because losses have eroded their capital base or because they have had to take off-balance sheet loans back onto their books (in reality, much the same thing) This is a glorified way of saying that some banks are (at least technically) bankrupt.

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Now, the system doesn't like to admit such things - for obvious reasons - so we can expect the banks along with the central banks, such as the Bank of England and the regulators such as the FSA to try to keep it under wraps.

As such, it is highly unlikely that any bank will be allowed to fail (witness Northern Rock, which isn't even a real bank) but that doesn't stop the markets having a view as to who they are least comfortable lending to and which banks therefore need to pay more to get their hands on the cash they need to keep operating. We can get a view on this by looking at the interest rates the banks offer to us on their savings accounts - the higher the rate clearly the more desperate they are for cash.

However another way to gauge the risk of your bank account it is to look at the credit default swap market. Credit default swap (CDS) spreads measure the premium to the risk-free interest rate that a bank can expect to pay in the market for 5-year loans. The higher the CDS for any given bank, the riskier the market thinks that particular bank's debt is.

So what is the market telling us now? Riskiest of all the major banks is HBOS, with a senior 5-year debt premium of 236 basis points (2.36% above the 5-year gilt yield of 3.8%, i.e. 6.2%). 6.2% is therefore what they have to pay the market for funds. (If they're paying you much less that's not a good risk/reward). RBS, Santander (Abbey National) and Barclays aren't much better but HSBC and Lloyds are considered by the market to be the safest. If you can get a good rate from either of these banks, then given the risks the market thinks you're taking, that's a good deal and you should be able to sleep well at night.

Then, there are the foreign banks who are offering us internet savings accounts. The basic rule of thumb here is: if they're ING, they're no worse a risk than a UK high Street bank. If they're Irish, they're likely to be over leveraged and a bit more of a worry (especially Anglo Irish Bank). But if they're Icelandic, then be afraid; these banks are starting to be priced for bankruptcy risk.

Kaupthing is now having to pay almost 8.5% more than 5-year government bond yields (i.e. 12.3%) to raise funds. Kaupthing's savings account pays just 6.5% AER, which doesn't even come close to compensating us for the risk I'd say. The markets seem to be telling us that there is a very real default risk here. Glitnir Bank is not much better and even Landsbanki (owner of the popular Icesave internet banking business) has to pay the credit markets 6.0% more than risk-free rates and 4.2% more than ING does, for funds.

Given that Icesave pays 6.05% on their easy access internet savings account and ING pays 6.0%, perhaps shopping around for the highest savings rate right now is not actually the best thing to do. Perhaps, just perhaps, we should pay more attention to the risk side of the equation too.

So who's best on the risk/reward basis? Lloyds TSB has the lowest current CDS spread (1.3%) of any UK bank. For one year, Lloyds' internet account is paying 5.5% (dropping to 4.5% after one year is up) as long as you have £100,000 to save. This looks like the safest place to park your savings for the time being if the credit markets are anything to go by.

Update, October 2008: for more on credit default swaps, see: All you need to know about credit default swaps

Worst credit default swap ratings:

1. Kaupthing 833.3

2. Kazkommerts 766.7

3. Glitnir Bank 757.5

4. IKB 612.4

5. Landsbanki 604.6

6. Banca Italease 397.0

7. VTB Bank 332.5

8. Anglo Irish Bank 322.7

9. HBOS 236.7

10. Sberbank 221.3

11. West LB 212.5

12. UBS 209.0

13. Natixis 205.0

14. Bank of Ireland 202.5

15. Allied Irish Banks 195.8

16. Dexia 195.0

17. RBS 191.7

Source: Bloomberg (17/03/08)

Update 20/10/08

Worst credit default swap ratings

BTA Bank 3083.3

Glitnir 2425.0

Kaupthing 2100.0

FCE Bank plc 1900.8

Landsbanki Islands 1700.0

Halyk Savings Bank 1572.5

NIBC 1100.0

IKB 779.2

Banca Italease 721.6

SNS Bank NV 337.5

Natixis 263.0

Raiffeisen 176.1

BAWAG 175.9

Erste Bank 158.1

UBS 122.5

NG 121.7

Danske Bank 120.2

Standard Life Bank 120.0

Credit Suisse 118.3

HBOS 115.4

Bank of Ireland 111.3

Banco Populare 111.3

Unicredito 106.8

Mediobanca 105.0

Selected other banks

RBS 102.5

Barclays 100.0

Allied Irish Banks 84.8

Lloyds 80.8

Standard Chartered 80.0

Fortis 79.8

Santander 79.7

HSBC 65.0

Source: Bloomberg

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.