Local councils could lose millions if our banks fail again

Every week a respected financial journalist or academic issues a warning on the next big financial bubble threatening the global economy.

Cambridge economist Ha Joon Chang recently sounded the alarm regarding stock market bubbles of historic proportions, despite GDP output in developed economies still well below 2007 highs. Frances Coppola has pointed to the “subprime student loan crisis,” including a stunning business insider graph showing declining US graduate wages decoupling from rising tuition fees post-2000. And UK MPs warned during climate week of a ‘carbon bubble’ with UK pension funds over-exposed to fossil fuels, following reports from ShareAction, Greenpeace and Carbon Tracker.

Amidst the growing mass of bubbles, we’d still be no wiser about where or when the next financial crisis will strike. But strike, it will. At LSE’s recent panel debate ‘Are we headed towards a new financial crisis?’ Professors Jon Danielsson, Charles Goodhart and Lars Jonung were in broad agreement that the present financial reform window had been “wasted” and future crises were “inevitable.”

With this in mind, rather than contemplating where or when the next crisis will come, it’s vital to consider the mechanisms by which the next financial shock will be transmitted through the UK financial system. In particular, what will the probable outcomes will be for the UK’s already ailing public sector – a sector completely outside the scope of UK financial regulators’ attention?

Post-2008, the public sector faces permanent austerity with stubbornly high unemployment and underemployment (particularly in the youth bracket). This stores up future problems for a welfare state facing the impact of decades of financialisation and under-investment. In addition, continuing unchecked tax evasion by multinational corporations undermines the ability of the state to fund public service delivery.

Last time the UK was in financial crisis, bailing out the banks with public money proved so politically unpopular that politicians have pledged not to repeat the process. Bank of International Settlements and the Treasury policy has recently shifted towards a ‘bail-in’ policy – demonstrated by the resolution of the Cyprus Laiki bank crisis, when bondholders were made to forfeit part of their investment before taxpayers were called upon to cover losses.

Ostensibly, a system that avoids the use of taxpayers’ money to bail out insolvent banks appears preferable. However, there are hidden dangers. The UK’s risk averse public sector has swallowed the ‘too big to fail’ lie hook line and sinker, over-consolidating treasury and pension fund investments within the five biggest banks.

This was done on the basis that banks like RBS enjoy ‘full government backing’ and would be bailed out in the event of failure, avoiding direct losses. But now the rules have changed.

While implicit government financial support for banks like RBS no longer exists, council investment behaviour is yet to adapt to the new bail-in regulatory environment, diversifying investment risk away from the big five banks.

Council deposits in banks have increased from £13.8bn in 2008/09 to £16.6bn in 2012/13, whilst deposits with building societies declined from £10.4bn in 2008 to just £1.8bn in 2012. Total council treasury funds in banks, building societies and money market funds stand at £35bn, compared with a combined annual UK council budget of £117bn.

North of the border, council investments in Scotland are even more consolidated. Figures collected by the Scottish Treasury Management forum reveal of £1.32bn deposited by Scottish councils with banks in December 2013, £681 million, or 51 per cent, is placed with Royal Bank of Scotland and Bank of Scotland.

Were RBS to collapse today, rather than a taxpayer rescue, our new bail-in policy sees depositor funds (including council deposits) bailed-in and converted into equities (shares) in a worthless bank, in order to shore up the banks deficient balance sheet. In other words, your council will be forced to bail out the bank!

Even worse, under ‘Dodd-Frank’ regulations – derivatives, the speculative instruments favoured by the financial sector, have ‘super priority status’ – meaning legally, derivatives holders get their money back before councils, in the event of bank collapse.

With these bail-in rules, what will likely follow the next financial crises at municipal level is the privatisation of council services to resolve losses. After all, that’s exactly what occurred at the Conservative-run London Borough of Barnet after the council lost £27.4 million in Iceland in 2008 on the advice of Sector (a subsidiary of Capita). Disturbingly, this resulted in the outsourcing of council services to – you guessed it – Capita.

So, what can be done to guard against bail-in losses at your local council?

City treasurers can guard against bail-in losses by diversifying investments amongst banks, building societies and money market funds, with no more than 10 per cent of total funds in any one institution.

Council should also seriously consider setting up publicly owned banks (like in Salford) to safeguard public funds from the next crash. There will be more on this idea in my article next week. Welcome to the brave new world of bail-in.