What should Northern Rock savers do?

The Northern Rock crisis has dominated the papers for the last two weeks. Savers have been queuing round the block to withdraw their money, despite repeated assurances from the government. Meanwhile Northern Rock shares have plunged from over £12.50 earlier in the year to below £2.

The cause of the crisis

Northern Rock’s origins date back to 1850. It wasn’t known as Northern Rock until the merger of Northern Counties Permanent Building Society and Rock Building Society in 1965. Further mergers with numerous smaller building societies continued until the company floated on the stock market in 1997 and turned into a bank.

Since then it has aggressively expanded its lending activities while slimming down its branch network in the North East. As at 30 June it had loans outstanding of £97 billion, making it the country’s fifth biggest mortgage lender ahead of better known banks such as Royal Bank of Scotland, Barclays and HSBC.

But this August things began to go horribly wrong. More than any other bank, Northern Rock used the money markets to fund its lending activities, rather than the more usual practice of using money deposited by savers. These money markets seized up following the well documented problems in the US mortgage market earlier this summer. This meant Northern Rock was in danger of not being able to access the funds it needed to keep its day to day operations running.

After it became clear that the problem would not solve itself in the short term, Northern Rock approached the Bank of England to arrange an emergency funding facility.

The government guarantee

Northern Rock’s savers, who had around £30b saved with the bank, were not surprisingly spooked. Many of them have withdrawn their funds, taking out around £3b in total. This resulted in the government making the unprecedented move to guarantee the money held by Northern Rock’s savers, over and above the normal compensation limits that currently exist.

The government’s guarantee covers future interest payments, movements of funds between existing accounts, and new deposits into existing accounts. The guarantee also covers accounts re-opened in the future by those who closed them between Thursday 13 September and Wednesday 19 September. The government said the guarantee will remain in place during the current instability in the financial markets, so it is only intended to be a temporary measure.

The crisis at Northern Rock has highlighted the deficiencies in the normal compensation system that exists to protect savers here in the UK. In the event a bank is unable to meet its obligations, the Financial Services Compensation Scheme pays out all of the first £2,000 deposited and 90% of any amounts between £2,000 and £35,000. So the maximum compensation you can get £31,700.

These limits apply per account holder so joint account holders could get compensation of up to £63,400. However, the compensation is also limited to one banking licence, meaning that if you hold two accounts with the same group (Royal Bank of Scotland and NatWest for example) you do not get separate compensation limits for each account.

It seems very likely that these limits will be reviewed following events at Northern Rock. The government indicated over the weekend that it was considering increasing the compensation limits to as much as £100,000. These limits haven’t increased since the scheme was set up in 2001 and, rather perversely, savers currently get less protection than investors who are covered for 100% of their first £30,000 invested and 90% of amounts between £30,000 and £48,000.

Northern Rock’s savings accounts

While some people have accused those withdrawing their money of overreacting, they are in fact acting perfectly rationally, especially in the case of those with large funds deposited. We put our money in savings accounts because we don’t want to risk losing a penny. So when there is a chance of losing it all, even if it is a miniscule risk, many people will move their money elsewhere.

In any event, the accounts offered by Northern Rock are a decidedly mixed affair and most people would be better moving their money elsewhere anyway.

The pick of Northern Rock’s savings accounts is Silver Savings Online which pays 6.3% AER to those aged 50 and over. The branch based version is less attractive offering 5.75% AER. Both accounts are guaranteed to pay at least the base rate until January 2010 but the branch based account has a minimum balance of £5,000 (only 0.1% is paid below this level).

For younger savers, Northern Rock’s Tracker Online offers a headline rate of 6.31% AER. However, this includes a large bonus of 1.06% for the first twelve months. After this time the rate falls to a far less attractive 5.25%, which a full percentage point lower than the most competitive accounts offered by the likes of ICICI at 6.3% AER.

For cash ISAs, Northern Rock is also uncompetitive, offering just 4.79% for its instant access version and up to 5.15% for 30 days’ notice. If you’re looking for a new cash ISA, always transfer your money to the new account. Don’t simply close your old cash ISA as you will lose its tax perks.

Normal branch-based savers with Northern Rock get the worst deals at the moment. Save Direct pays just 4.05% AER while Select 120 pays 4.76% AER. It’s a fair bet that not many savers will want to keep their money in an account with Northern Rock that requires four months’ notice following recent events!

Lessons to be learnt

Northern Rock is a good example of why you should expected the unexpected. The speed and scale of the crisis caught everyone by surprise and is an illustration of why instant access accounts are usually superior to notice accounts, especially as they often pay out more in the way of interest.

Savers lucky enough to have more than £35,000 to put aside can get more protection by splitting up their funds between different banks, at least until the compensation limits are reviewed. Those who have mortgages with Northern Rock should also keep a close eye on the rate they are being charged as it seems likely that it may become more uncompetitive now that it is no longer looking to attract such large amounts of new business.