Fall-Out From Lehman Brothers Explained

TEP - 8 October 2008

Q: I have noticed that shares in banks have fallen steeply since the news that Lehman Brothers had filed for bankruptcy protection. Is there a danger that a UK bank could collapse?

A: Shares in banks have been hit by concerns that they could have exposure to Lehman Brothers through credit derivative contracts. These are complex and it could be months before the full extent of their liabilities is known. A “fire sale” of Lehman’s risky assets could also lead to lower prices and therefore more write-downs for UK banks.

There are also fears that events at the US investment bank will lead to a renewed tightening in wholesale money markets, where banks raise their funds, and an increase in Libor rates, making borrowing more expensive. All of these factors have hit banks’ share prices.

But the City watchdog Financial Services Authority is in close contact with the banks over their funding positions and it is unlikely the Government would allow a major financial institution to go under.

Q: I’m worried about how safe my savings are. What would happen if a UK bank went bankrupt?

A: If a UK bank collapsed and savers lost money as a result the Financial Services Compensation Scheme (FSCS) would step in to compensate consumers and small businesses.

The scheme can pay compensation for financial loss of up to £50,000 that people have lost in savings, although a consultation is under way on whether to increase this limit.

It can currently take several weeks, or even months, for money to be returned to savers, but the Government is expected to introduce legislation requiring people to receive the bulk of their money within seven days.

Q: I also have money invested in shares. How safe is this?

A: Investing in shares is never as safe as holding money in cash and there is always a risk that the value of your investment will fall. However, people putting money into the stock market are usually investing for the long-term and should have an investment horizon of at least five years, to give the markets time to bounce back before people need to get their money out.

If you lose money because the firm you have invested through, such as a unit trust or ISA provider, goes bust, the FSCS will step in and pay compensation as long as it was regulated by the Financial Services Authority.

The scheme currently pays out the first £30,000 that is lost through an investment in full, followed by 90% of the next £20,000, with compensation capped at £48,000. These payouts apply to all types of investment and not just equity-based ones.

Different rules apply to life assurance, such as with-profits funds, where the first £2,000 lost is paid out in full, followed by 90% of the rest of the money, with no limit placed on compensation.

If you have invested directly in a company’s shares yourself and that company goes under you are not covered by the FSCS.

Q: I have read that pension funds will be hit by the collapse of Lehman Brothers, does that mean my pension is in danger?

A: Nearly all pension funds invest in shares and so the value of their assets will have been hit by the slide in world stock markets. Around £9 billion was wiped off the value of the UK’s 200 biggest defined contribution schemes yesterday.

The fall in asset values is bad news for people with defined benefit pensions as it increases the likelihood that the scheme will become too expensive for employers to fund, leading to it being closed to future accruals.

Stock market slides are also bad news for people with defined contribution pensions, as with these schemes individuals, and not their company, shoulder the investment risk, meaning the falls will directly impact the value of their pension. But pensions should be seen as long-term investments and the market should recover in the years ahead.

Q: What would happen if the company that I invest my pension with went bankrupt?

A: As with other financial services companies, as long as it was regulated by the FSA you would be covered by the FSCS. The schemes will pay compensation of 100% of the first £2,000 you lose, followed by 90% of the rest, with no limit placed on payouts.

Q: I have a home insurance policy with American International Group (AIG) and have read about the problems at the group. What should I do?A:

Nothing. AIG has been allowed to borrow 20 billion US dollar (£11.2bn) from its subsidiaries and its insurance policies remain in force.If an insurance company did go under you would need to arrange new cover and in some cases the FSCS would compensate you for the premiums you had previously paid out. If you had a claim outstanding the FSCS would step in and pay 100% of the claim for compulsory insurance, such as third party, fire and theft motor cover, and 100% of the first £2,000 plus 90% of the remainder of the claim for non-compulsory insurance.

Q: The FSCS covers a lot of things. Would it be able to cope if a major institution went under?

A: The FSCS is funded through an annual levy on the industry based on predictions of the size of claims that would be made in that year. However, if claims exceed this amount the FSCS can go back to companies and demand more money up to £4.03 billion a year. It also has a central pool of funding it can draw on, as well as access to commercial borrowing, and a consultation is currently under way over enabling it to borrow from the Government.