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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.

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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.

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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.

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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    833.32. Kazkommerts  766.73. Glitnir Bank  757.54. IKB   612.45. Landsbanki  604.66. Banca Italease  397.07. VTB Bank  332.58. Anglo Irish Bank 322.79. HBOS   236.710. Sberbank  221.311. West LB  212.512. UBS   209.013. Natixis   205.014. Bank of Ireland 202.515. Allied Irish Banks 195.816. Dexia   195.017. RBS   191.7

Source: Bloomberg (17/03/08)

Update 20/10/08

Worst credit default swap ratings

BTA Bank 3083.3Glitnir 2425.0Kaupthing 2100.0FCE Bank plc 1900.8Landsbanki Islands 1700.0Halyk Savings Bank 1572.5NIBC 1100.0IKB 779.2Banca Italease 721.6SNS Bank NV 337.5Natixis 263.0Raiffeisen 176.1BAWAG 175.9Erste Bank 158.1UBS 122.5NG 121.7Danske Bank 120.2Standard Life Bank 120.0Credit Suisse 118.3HBOS 115.4Bank of Ireland 111.3Banco Populare 111.3Unicredito 106.8Mediobanca 105.0

Selected other banks

RBS 102.5Barclays 100.0Allied Irish Banks 84.8Lloyds 80.8Standard Chartered 80.0Fortis 79.8Santander 79.7HSBC 65.0

Source: Bloomberg

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