In light of the recent financial crisis, Neil Cullum discusses risk and return in relation to cash deposits.

Generally, people are able to accept that their investments in stocks and shares might go down in value. They are even able to come to terms with the fact that their house might be worth less now than it was a year ago. However, they find it hard to believe that their cash might not be safe in the bank.

Since the rescue of Northern Rock, we have seen the near collapse of the international financial system. Governments have stepped in with everincreasing injections of liquidity, which has culminated in a co-ordinated approach to recapitalising the system. At last, the strategy appears to be working and interbank lending rates are starting to return to more 'normal' levels. However, we are unlikely to see inter-bank rates restored to the previous structure where, in effect, they contained no risk premium.

Playing it safe

As memories fade and official base rates come down, yield will resume its importance. But in the meantime, individuals are likely to favour a low risk position and to accept a lower rate of interest from institutions they regard as 'safe'.

Deposits in UK banks, with a limit of £50,000 for each individual in each bank, are protected by the Financial Services Compensation Scheme (FSCS). Alongside this statutory protection lies the Government's commitment to "do whatever it takes to stabilise the banking system; protect savers and the taxpayers; and support the wider economy".1 To a certain extent, therefore, savers ought to be reassured about a deposit with any major UK bank or building society. However, many will still wish either to diversify their risk widely or concentrate it in only the largest, most recognisable names.

Professional firms' client accounts with UK banks offer FSCS protection up to the statutory limits and remain suitable for transient, transactional funds. However, there is normally a requirement that these sums are held at a bank. For firm's money that is likely to be held in cash in the longer term but where access might be required at short notice, a money market fund could be an attractive option. Such funds diversify risk, by being invested with a wide range of banks. They offer easy access, transparent pricing, enhanced yields and, in some cases, an attractive tax treatment.

Footnote

1 Chancellor of the Exchequer's statement to the House of Commons, 13 October 2008. http://www.hm-treasury.gov. uk/statement_chx_131008.htm