Why banks are cutting savings rates and what you can do about it

Just as the country is saving more, banks are paying much less interest.

Why? Well before we get into the current environment, let's look at how banks ‘usually' set their savings rates, and then what's changed.

This article isn't personal advice. It's aimed at those who are comfortable with making their own decisions.

Why do banks need people to save with them? To put it simply, it's to fund their lending.

Banks, like other companies, are set up to make a profit. They make money by lending out at a higher rate than they pay to get it in. The difference is called a net interest margin.

So their demand for savings deposits will be driven by the amount of money they can lend, without taking on too much risk. They don't want an unlimited amount of money if they can't lend it out. There's a fine balance.

Savings rates can be thought of as the price that banks need to pay to attract the amount of money it needs from savers.

Some banks will need to work harder than others to attract money. High street banks benefit from an established brand and existing relationships with millions of customers, so they don't always need to offer the top rates.

This is why you'll usually find smaller ‘challenger' banks at the top of the rate tables. They won't have a large customer base behind them, so they need to offer headline rates to bring the money in.

But savers aren't the only place that banks can go to get this money. They can also borrow it from the Bank of England (BoE).

What's the base rate and why does it matter?

It's the rate of interest the BoE charges to lend money to banks, and will tend to be used as a reference for the rate at which those banks lend money in the economy.

The BoE uses this rate as part of its monetary policy tool box to influence the economy. Generally speaking, raising the base rate will pump the brakes on a growing economy, and lowering it will fuel a faltering economy.

The economic theory behind these policies is that by lowering the cost of borrowing people have lower mortgage and personal loan payments. This puts more money in their pockets, which then hopefully gets spent. The same also applies for companies, who have lower debt costs, and therefore invest more and pay more dividends. This is why equity markets will tend to rally when rates are cut (unless it was already expected and priced in).

A lower base rate also encourages banks to be more efficient with their money. Rather than leave huge reserves in their accounts with the BoE, earning a low rate, they can get it out in the economy through loans.

In practice, the real world is far more complicated than simple economic models. The impacts can be unpredictable and take a long time to trickle through. It does however usually hit the savings market fairly fast.

Coronavirus has hit the savings market hard

In March the BoE took extraordinary measures to cut the base rate from 0.75% to 0.10% in response to the escalating coronavirus pandemic. This is now the lowest rate in history.

BoE base rate

Source: Bank of England, 30 June 2020.

Crucially, it also announced a new funding programme for banks called the Term Funding Scheme.

When interest rates are brought close to 0%, the banks' net interest margin is put under pressure. It gets harder for banks to operate profitably and maintain a stable deposit base. To help banks pass on most of the base rate cut so that it benefits the economy through lower lending rates, the BoE needs to also provide funding support.

The BoE can't encourage individuals or companies to save at lower rates, so it essentially becomes a saver itself. It provides the banks with money at the base rate, on the basis that the individual banks lowers their lending rates and actually lends the money. They did this in 2008, 2012 and 2016. The current scheme has a special focus towards lending to small and medium-sized enterprises (SMEs).

This means that for most banks in the UK, savers are less attractive at the moment. They can get money from the BoE and only have to pay 0.10%. And they don't need to deal with millions of customers to get it.

Remember that savings rates reflect the price banks need to pay to attract money. The Term Funding Scheme reduces their demand for savings, so the price they're willing to pay falls.

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How the banks have reacted

Banks have to keep a certain amount of money aside, known as a liquidity ratio. They must hold enough in reserves to cover 30 days of withdrawals in a ‘stress' period.

Initially most banks chose to be cautious in the face of a crisis with so many unknowns. They fought to get deposits on board to get their liquidity ratios up and make sure they had plenty of money to hand. Savings rates held steady and in some cases went up, as banks bid for customers' money.

As more light has been shed on the situation and likely outcomes, banks have reined this back in. They're preparing for a slowing economy, higher loan defaults, and they've been getting lots of cheap support from the BoE.

The property market also ground to a halt through lockdown as government measures made viewings all but impossible. This meant the mortgage market and many other forms of lending practically stalled overnight.

Mortgage approvals for house purchases

Source: Bank of England, 30 June 2020.

If banks are lending less, there's less demand to bring money in from savers, which reduces the rate they offer.

All of this has caused some pretty sharp declines in savings rates. At the start of the year the average instant access account paid 0.41%, but it's now down to nearly half that at 0.22%. A 1 year fix is down from 0.97% to 0.60%.

Average savings rates (including unconditional bonuses)

Source: Bank of England 30 June 2020.

But, that's not the full picture

There are lots of other things on the periphery that will have an impact on savings rates. These are some of the main points, but it isn't an exhaustive list.

Mortgage price war – rules were recently introduced that forced banks to separate their retail and wholesale banking businesses. The idea was that this would mean retail deposits would only be used for retail lending rather than risky investment banking, and the banks would be safer for the UK public.

But there were some unintended consequences. Most of these banks found themselves with excess retail deposits compared to retail loans. They've tried to balance this out by lowering their prices on mortgages to get the excess deposits out the other side as home loans, forcing all other banks to follow. Remember that banks need to earn more on the money they lend out than they do to bring it in – so if their lending rates are reducing, so will savings rates.

Each other – banks tend to use each other as pricing guides. After the base rate cut it seemed to be a game of ‘who would blink first' on easy access rate cuts.

The bank sitting at the top of the rate table will take in a lot of money. If they cut their rate, the money goes to the next best. But not all banks will be lending enough to be able to cope with the amount of money flowing in. So they cut their rates and you end up with a domino effect.

National Savings & Investments – NS&I have now, perhaps unwittingly, ended up as the anchor for the market for instant access. But remember, they aren't like a normal bank – they're backed by the government.

But similar rules apply. The government can also borrow money at rock-bottom rates now, so don't really need to pay the public a top rate to get it. If they move, we could see another series of rate cuts as the market tries to rebalance itself.

Products available through Active Savings can be added or withdrawn at any time. Minimum deposit requirements apply to individual products. Instant access products allow immediate cash withdrawals, Active Savings offers easy access products where withdrawals usually take one working day. Inflation can reduce the spending power of money.

*AER (Annual Equivalent Rate) shows what the interest rate would be if interest was paid and compounded once each year. It helps you compare the interest rates on different savings products.

Gross means the interest rate without any tax deducted. Interest is paid gross. You're responsible for paying any tax due on interest that exceeds your Personal Savings Allowance to HM Revenue & Customs. Tax treatment can change.

The Active Savings service is provided by Hargreaves Lansdown Savings Limited (company number 8355960). Hargreaves Lansdown Savings Limited is authorised by the Financial Conduct Authority under the Electronic Money Regulations 2011 with firm reference 901007 for the issuing of electronic money.

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