Your Savings Account is Not as Safe as You Think (And What a Safe One Looks Like)

Keeping your money in a savings account can be riskier than you think.

For starters, a savings account is part of the core banking system and is therefore subject to the risks that the banks are exposed to. This puts your principal and possible returns at the risk of loss.

It’s important to dive deeper into the matter to understand the reasons why a savings account is not risk-proof.

Interest rate risk

Funds deposited into a savings account usually accrue (nowadays get charged) interest on a monthly basis. Whether this is a fixed or variable interest rate depends on the depositor’s preference. While fixed interest rates may sound like a better option, variable interest rates allow account holders to benefit in case interest rates rise, but they are subject to the inverse trend too.

The current market conditions and economic trends have to be considered when opting for one of the interest modalities. The ongoing Covid-19 pandemic and the global economic crisis that is developing into a recession have aggravated the downward trend in interest rates.

Countries are opting for a more expansionary monetary policy in order to prevent aggregate demand from shrinking and this means that, as long as the pandemic and the global economic crisis lasts, the interest rates will remain low.

The future of interest earnings on funds kept in savings accounts is not promising. Since commercial banks have to follow monetary policy rates, the possibility of an increase in interest rates is low.

In these conditions, placing funds in savings accounts is tantamount to keeping them idle, as in some instances the rate may be lower than the prevalent rate of inflation. Depositors may be able to get much better rates of return on other assets and investment options as compared to savings accounts.

Liquidity and Solvency Risk

Banks do not keep the entirety of the funds deposited in checking and savings accounts in reserve. If that were the case, they would have no way to generate interest. Banks therefore resort to investing and lending deposited funds to other parties or borrowers. As a consequence, at any given time, they keep only a minimum amount of deposited funds in reserve.

The fractional reserve system allows banks to thrive, creating money themselves. Usually the limit of reserves to be kept is determined by the Central banks. This limit is often kept at 10%, allowing banks to lend out the other 90%. Thus, if you deposit $10,000 into your account, the bank will lend $9000 of your money.

The sequence below explains the effect of placing these funds into a savings account.

As you can see, your $10,000 turned into $24,390 in the banks’ hands with just 3 iterations, while only $1,710 was kept in their vaults.

A question arises at this point. Why don’t banks run out of money then?

The first answer is that the sheer volume of transactions allows banks to keep lending (add more iterations to the sequence above, creating even more money).

Secondly, the whole banking system is based on trust. The trust expressed by account holders that the bank will pay their funds back is the beating heart keeping the system running.

As long as everything is working fine — transactions happening and depositors placing funds — there is no problem.

But in case of a financial or economic crisis like the one that is unfolding now, the fractional reserve banking is threatened by a credit crunch.

You can figure out what happens if, at the same time, too many account holders ask the bank for their funds and too many debtors default on payments: the bank will simply not have enough money to pay back everyone.

You’re remembering this from somewhere, aren’t you?

The 2008 financial crisis is a textbook example of the problems inherent to the fractional banking system.

One of the biggest banking failures in the history of the USA occurred when Washington Mutual defaulted on payments. It had assets worth over $300 billion but lost its liquidity and was rescued by JP Morgan. Lehman Brothers is another major banking name that fell in the 2008 financial crisis with assets worth over $600 billion. Similarly, the crisis damaged ABN Amro, Northern Rock, Goldman Sachs, Merrill Lynch, RBS, Bank of America, JP Morgan and just about any bank deemed too big to fail.

Due to these high-profile failings, public confidence in banks took a major hit. Around 2015 the “European Deposit Insurance Scheme (EDIS)” was set up and under this scheme funds up to €100,000 in Euro zone bank accounts were insured in case of bank defaults. The USA has a similar insurance scheme for bank accounts where banks under Federal Deposit Insurance Corporation have funds up to $250,000 insured.

What a lot of people don’t know is that the amount covered is per depositor, per insured bank. Every penny beyond this threshold kept in any other bank product may never return to you in case of a bank bankruptcy.

This is one of the biggest drawbacks of keeping funds in a savings account, especially at present when the regulatory authorities of Europe, Australia and New Zealand have advised their banks to either stop or reduce dividend payments this year in order to fortify their liquidity ahead of an impending recession.

Not every bank will brace for impact and when a bank sinks its clients’ funds will sink with it.

Lending risk

Another drawback of keeping funds in a savings account is that account holders never know who their money is being lent to.

Banks lend out most of the deposits, as we have discussed above. But who are these funds lent out to?

Banks have different sources they invest in; these sources include investment funds and the interbank market. The latter is where banks lend funds to each other on a short-term basis. The problem is that the interbank lending market is not the most reliable market in the world.

The 2008 financial crash happened because the interbank lending market and the subprime mortgages collapsed. Banks were not able to return the funds they had taken from each other and the funds that they had lent for mortgage. You see, banks are notoriously interconnected, especially through the interbank lending market: when one part of the chain collapsed, the whole chain collapsed like a domino.

Again, the banking system is established upon trust and this trust comes from credit ratings. When the liquidity begins to worsen, the credit ratings go down and a self-sustaining downward spiral of doom is created. Just like the one that ended up in the 2008 crash and that will probably repeat itself. ,

The takeaway is that you, as the savings account holder, can never know the reliability or the quality of the debtors your bank has got.

Lack of transparency

Banks are regulated by banking laws that sometimes prevent the public from having a detailed look at how they operate. Once again, the 2008 financial crisis serves as a fitting case study.

Banks took advantage of ambiguous transparency laws to indulge in deals that weren’t in the best interest of borrowers and shareholders.

A good example is the entire round of capital raisings that saved Barclays in 2008 — a £4.5 billion injection in June by existing shareholders, followed by the £7.3 billion injection in November by Qatari investors — that have been shrouded in rumor, mystery, intrigue and speculation. In 2017, Britain charged Barclays and four former top executives after a 5-year investigation. In February this year, three defendants were cleared of the accusations, but many of the details remain unknown.

Transparency in the financial and banking sector is a key concern for investors and authorities alike.

The lack of transparency allows banks to take more risks than their condition would deem appropriate and make unlawful deals that compromise their assets. One way or another, it is the depositor (and the taxpayer) who pays the bill.

What a really safe savings account looks like

The current economic environment is prolonging the War on Savers, further eroding the utility of traditional savings accounts as an investment vehicle. In the face of the above-mentioned reasons, investors urgently need safer and more profitable alternatives. To solve the problems of traditional savings accounts, they need a product that:

  • is independent from central banks’ interest rates: no matter the direction the markets are swinging towards, investors need a steady place to grow their money;
  • is bent on matched funding: no money creation. Every loan is backed by a deposit;
  • employs rigorous criteria to evaluate debtors: this lets investors know that their money is in the right hands, working for a good cause;
  • is fully insured: something can always go wrong, even with quality debtors. So, it’s best to ensure that principal and interest are safe no matter what; and
  • is transparent: it’s better to trust with wide open eyes. It’s your money after all.

And since we’re at it, why not add:

  • the use of blockchain technology, to prevent data leaking, misleading information or manipulation.
  • full ownership of funds, because what’s yours has to be in your name;
  • short term commitment, so you have total control over your money.

A savings account is arguably the most fundamental of personal financial tools. Isn’t it time someone treated it as such?

Slavian Oatu

Ardent believer that finance has to work for everyone. I want a better banking model, for a better world.