Savers are smiling as interest rates locally and around the world have increased sharply over recent months, resulting in the best returns on bank deposits that we have seen for many years. Cash is king again.
Bank deposits are a vital part of our lives and an indispensable component of any investor’s portfolio and most people think that money in the bank is risk-free. However, bank deposits like all other investments, carry real risks that you should be aware of.
Let’s have a look at these risks.
Bank Collapse
When you deposit cash with a bank what you are really doing is lending that bank your money. The bank pays you interest on your deposit and in turn uses your funds to provide loans, mortgages, and other services to its clients at higher rates, and the difference is the bank’s revenue.
Most banks fail not because they are technically insolvent, but because they experience a bank run. This is when a large number of customers become nervous, based on newspaper reports or rumours, and demand to withdraw their deposits. Since banks only have a fraction of deposits on hand at any time it is not possible to pay out all depositors immediately. As more people withdraw their funds, the probability of default increases, which, in turn, can cause more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals and customers lose their deposits.
In South Africa, we have a very well-run banking sector with world-class banks. Even so, we have seen several banking collapses including Saambou in 2002, African Bank in 2014, and VBS Bank in 2018.
In the 2008 Global Financial Crisis, the first major bank to fail was Lehman Brothers in the US. Governments around the world stepped in to save many large banks that were regarded as “too big to fail” including Bear Sterns and Washington Mutual in the US, and Bradford & Bingley, Bank of Scotland, and Halifax in the UK.
Earlier this year several banks experienced bank runs starting with Silicon Valley Bank in the US and spreading to Credit Suisse in Switzerland. There have been 565 bank failures in the US alone since 2000.
Deposit Guarantees
To safeguard depositors in the event of a bank failure the South African Reserve Bank has established the Corporation for Deposit Insurance which guarantees customer deposits up to a limit of R100,000. Larger bank accounts above this limit may be lost if the bank fails. In the US deposits are guaranteed up to a limit of $250,000 while in the UK the deposit guarantee is £85,000.
Many South Africans leave large deposits in overseas banks believing that these are extremely safe, however, the recent demise of the giant Credit Suisse, which was established in Switzerland in 1856 and employed 50,000 people, illustrates that no bank is totally risk-free.
Situs Taxes
Taxation on overseas investments is a real issue to consider for South African residents. Situs taxes are payable in many countries, including the UK and US, upon the death of the owner of assets which are deemed to be located in those countries. Typical investments that fall under Situs legislation include bank accounts, properties, and equities.
For instance, if you own a property, a share portfolio, or a bank account overseas at the time of your death, you could be liable for situs taxes of up to 40% in addition to normal SA estate duties.
Your estate would usually also need to go through the delays and expenses of overseas legal fees to wind up the overseas portion of your estate. The threshold for these taxes in the US is only $60,000, while in the UK it is £325,000.
The good news is that it is possible to quite easily avoid these costly taxes if your overseas investments are properly structured, typically through offshore endowment policies.
Cash in the bank is an essential part of everyone’s portfolio, but it is important to understand that nothing is risk-free.