Between a rock and a hard place

With financial institutions being shaken by poor trading performance and bad debts, is there anything that private investors can do to protect their money? Stuart Langridge looks for clues at the plight of Northern Rock.

The unfolding drama in the UK with the Northern Rock bank brings to mind an old financial saying: "The return of your money is more important than the return on your money." Another of these maxims is that, "capital is scared". The value of both of these investment truisms has been amply borne out the the experience of Northern Rock over the past several months.

From the perspective of the average private investor with savings in the bank, confidence had clearly been lost and this was enough to start the run. Some of this anxiousness was clearly led by emotion rather than logic. Bank deposits are protected in the UK within set limits and yet many of those in a rush to withdraw their savings were well within that protection.

If government worked in the same way, then the UK finance ministry - or Her Majesty's Treasury as it is quaintly styled - would have had queues at the door for weeks, the vast majority of taxpayers will have lent more via the government to rescue the bank than they personally had invested in it. In a recent Treasury and market report, it was suggested that the potential full cost of bailing out the bank could be as high as £90.7 billion (Û120bn), which would equate to £3,600 (Û4,770) per taxpayer.

Clearly, in financial services - wherever they may be located - confidence is vitally important. Any investor, in a fund, savings account or share ownership, wants to be certain that his or her money is safe.

In the current climate, this certainty of safety is difficult to find. Around the world - but most noticeably in the US - long-established banking and financial institutions have found themselves in trouble.

The real problem for private savers at the moment is that the banks have been either unable to value the bad debts on their books or unwilling to announce them publicly. There are, of course, good reasons for both.

It might normally be possible to pick the weak from the strong by looking at the interest rates being offered in the market to savers. Smaller institutions would generally need to offer higher returns to attract funds. This 'risk premium' would compensate investors for the small but increased potential for default.

But, this is not a sure-fire way to select a provider. While smaller companies might try to compete with higher rates, the larger firms can use economies of scale to offer equally tempting rates to attract business.

Shareholders have also felt the financial winds of change. Only 12 months ago, a Northern Rock share was worth more than £12 (Û16), but after a near terminal plummet, they have finally been suspended at £0.90. Since it was a FTSE 100 company, it seems reasonable to suggest that many unit trust and pension fund managers had also invested and failed to spot the risks.

Since a large merchant bank or pension fund employs very bright fund managers, analysts, accountants, traders and even has access to the company boardroom, they should surely have been bailing out in advance.

It could also be argued that the regulator - the Financial Services Authority - was not able accurately to understand the risks being taken in Northern Rock's business model either. In the modern, globalised and highly complex capital markets, can this be a surprise?

If other banks, money managers and regulators find it near impossible to decide who is safe to lend to, how is a private investor to judge?

Unfortunately, the rather unpalatable answer to that question is that we cannot. Instead, what private savers and investors can do is be watchful of financial news and move fast in the event of it being bad. A flexible attitude and willingness to act quickly if required are all we can realistically manage.

As simplistic as this advice may sound, the alternative may involve waiting months for compensation with your account frozen and access to funds denied. A government guarantee may be better than nothing, but it is up to the individual to decide what it is really worth.

With financial institutions being shaken by poor trading performance and bad debts, is there anything that private investors can do to protect their money? Stuart Langridge looks for clues at the plight of Northern Rock.