This article is taken from Merryn Somerset Webb's free weekly personal finance email, Money Sense.
After the Northern Rock crisis, I've had many readers write in to ask about which banks are actually safe to put your money into.
Now we all know that banks lend more money than they keep in their vaults. We all know that if everyone decided to empty their bank accounts at once, then there would be trouble. But some banks would be in trouble more quickly than others.
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Broadly speaking, most banks get money to lend out by attracting savings. Effectively, you give money to the bank to look after, and it then lends that money to someone to buy a house. It gets more back in interest from the payments on the loans than it has to pay you in interest to attract your savings that's one of the ways that banks make their money.
Northern Rock's problem was that, rather than relying on deposits, it relied very heavily on the money markets to fund it. In other words, most of the money it had loaned out in mortgages (long-term loans) was actually borrowed from other banks (short-term loans, usually lasting for three months or so), rather than already in its reserves in the form of other people's savings.
When the US subprime crisis started to spread through the markets, banks suddenly got very scared of lending to one another. They didn't know who had exposure to sub-prime, and more importantly, they were worried that they themselves might need the money to back up private equity deals that were falling through, or to protect against their own exposure to sub-prime.
Now, when Northern Rock was borrowing money in the short-term, it was used to being able to roll over the loans so when one three-month term ended, another would begin. But as banks stopped being willing to lend, the three-month lending rates shot up, and suddenly it became near-impossible, or at least very expensive, to roll over those loans.
So that's how Northern Rock ended up having to go to the Bank of England for a loan. Although its own mortgage book turned out to be high quality the bank didn't have much exposure to subprime itself its strategy of borrowing short and lending long stopped working when the money markets dried up.
So what of other banks? Well, the good news is that Northern Rock had been relying on external funding far more than its peers. Figures from The Daily Telegraph, compiled at the end of September as the queues from Northern Rock were streaming down the high street, show that it was by far the most exposed to the chaos in the money markets for every £1 it had on deposit, it had loaned out £3.21.
The next most-exposed bank on the list was Standard Life Bank, which has £2.40 on loan for every £1 in deposits it has. Of the better-known banks, HBOS has £1.74 on loan for every £1 in deposits, while Alliance & Leicester (which saw its shares take a hammering in the wake of the Northern Rock crisis) lends out £1.57 for every £1 in savings less than its rival mortgage lender, Bradford & Bingley, which is on £1.63 for every £1. You can view the whole list here: Banks exposed to dangers of money markets.
The good news for any savers in the North who want to stay loyal to their region is that Yorkshire Building Society looks to be one of the more conservative financial institutions, with just £1.06 on loan for every £1 on deposit. But the safest of all should be HSBC, which actually has enough deposits to cover all its lending it only lends out 97p for every £1 in savings it has.
Of course, there are other things to worry about, such as how exposed a bank is to subprime in the US. Just last week, US internet bank Netbank went to the wall, and was bought over by Dutch rival ING, effectively because it had made too many bad loans. The trouble is that there aren't really any comparable figures for this.
However, in that light, when choosing a bank, it might be a good idea to consider how much of its business comes from mortgage lending, particularly at a time when the UK housing market is looking so wobbly which again makes the likes of Alliance & Leicester and Bradford & Bingley look less attractive.
One possible guide to the safest bank - given that Northern Rock's shareholders have been hurt far more than the bank's customers - might be to look at the banks that share tipsters still feel comfortable with. Tim Price, a regular columnist for MoneyWeek, is no fan of banks in the current economic climate but if pushed, he reckons he would pick HSBC as the best of a bad bunch.
Let's make something plain here. It looks very unlikely that another bank would go the way of Northern Rock, which was clearly far more over-extended than any of its peers. And the government's reaction suggests that if another bank did go to the wall, it would more than likely get the same bail-out as Northern Rock did. Meanwhile, the government is frantically trying to make the Financial Services Compensation Scheme more water-tight, though it remains to be seen how much difference that will actually make.
But the Northern Rock debacle is a good reminder that it's certainly worth making sure that you don't keep all your money with one bank. If nothing else, it's good sense to have an emergency bank account after all, you never know when your plastic cards might get lost or stolen.
For more tips and advice, visit our Personal Finance section or see our comparison table to compare savings accounts
Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).
After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times
Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.
Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.
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