Building Society or Bank?
By Derek Beese
What’s the difference you will probably say. They do the same thing. To some extent that is true but to say that they are the same is totally incorrect and the best way to understand the difference is to go back to the start for each.
The origin of banks has been seen in a previous post on this blog and the purpose of their formation was to act as middlemen to make trade easier. Their aim was to give credit, effectively temporary loans, to businesses so that trade could be done and these were then repaid when the whole deal was finished. This type of financing was essentially of a short term nature rarely extending beyond say, one year. They later became places which were trusted, so people and businesses who had surplus money used them as a safe place to keep it - that is to store their wealth. They were able to withdraw this at any time unless they had entered into an agreement to leave it there for an agreed time (term) for which they received a better rate of interest. If this was done then the bank could use this money to lend to businesses provided it was repaid before the bank had to pay it back to its owner and thereby the bank earned a higher rate of interest than it was paying. This process became known as “borrowing long and lending short”. That means lending for a time that is shorter than the borrowing time so that repayment can be made on the due date. Over the centuries as banks grew to the enormous size that they now are this principle has been diluted somewhat so that banks do in fact lend for longer times for a proportion of their business, but the basic rule of banking is, and must be, to “borrow long and lend short”.
There is one difficulty with this however and that is if a person wants to buy or build himself a house, he cannot borrow any money to do so, because that is a very long term affair. This was the situation in the mid 1700’s in the UK when people were starting to want their own homes rather than renting them from their employers. This was the early Industrial Revolution when money was becoming more plentiful and living standards were rising.
So in 1775 a group of workers banded together to form a self-help group with the aim of paying money into a fund which was used to build each of them a house, at the end of which the group would be disbanded. A very good idea and it worked so well that within 50 years there were hundreds of these groups. Then someone had the bright idea that these worked so well that they should be permanent, not temporary. This was the start of Building Societies trading as separate businesses, helping anyone who joined them, to obtain their own home. They paid interest to the people who deposited money with them and lent this to member borrowers at a higher rate and any surplus left over after paying their own expenses was kept in the business to build up additional funds to help members and to ensure that they were able to repay any withdrawals on demand. Lending members were happy to leave their money in the group for as long as possible because it kept them in the group with its associated benefits.
Now in theory this system should not work because the business is lending long term and borrowing short term, that is, it is “borrowing short and lending long”. That is the opposite of bank policy. But it was successful because it was a closed group of members who all had the same aim. Additional people could join but they must be like minded and with each year the society grew stronger and stronger because its funds were growing, built up by the annual surpluses. A basic rule was also laid down that a minimum cash “readiness” fund had to be kept to make sure that any sudden cash calls could be paid. Hundreds of the societies grew up and they banded together in an Association to help each other in times of difficulty and over time many of them merged to form much larger organisations. This Building Societies Association still controls the standards of the societies to ensure that they are sound financially.
Some important points emerge from this evolution:
1. Building Societies lend only to buy domestic properties ( with very few exceptions ).
2. They are “ring fenced” containing only their own members who all own a part of the society. (This is called a Mutual Society).
3. The raising of funds to lend is restricted to the members and the society cannot borrow from outside.
4. Each society has to keep a strict minimum level of ready cash to meet repayments to savers even if this is a restriction on the amount of mortgages they can offer.
5. The societies grew stronger each year because annual surpluses accumulated and created an ever increasing fund which could not be withdrawn by members on demand.
The only disadvantage was that the society could only grow relatively slowly and there was always a backlog of requests for mortgages for houses. Building Societies do not finance businesses and will not normally grant mortgages on business property,
Then in the 1980’s some bright spark had a “brilliant” idea - ” Why not allow Building Societies to convert to banks so that they could borrow money in the same way as banks and this would enable them to make far more loans on domestic mortgages?”. The necessary law was passed after sorting out the technicalities and a number of B Socs converted into banks. This however was a problem in the making because here was a bank that was now operating a principle of “borrowing short and lending long for all of its business”! Not a good idea! In fact a bomb waiting to explode!!
When the current housing bubble burst all of these “building society banks” failed, starting with Northern Rock and also spread to those smaller true banks who had bought up the larger B Soc Banks like ”Halifax”; in this case the Halifax Bank of Scotland. So all of the B Soc Banks have now gone leaving the situation back at square one – the true mutual building societies and the true banks. The latter have a hangover however because they have become far more involved in the domestic housing market as a result of all this disruption and now have a greater lend long element in their business.
The outcome of all this is that in the UK, (because building societies are a uniquely British creation that do not occur anywhere else) the situation has now returned to sanity with good Building Society principles and true Banks operating under the sound rules forged over hundreds of years. All of the hybrids have gone except where they have been taken over by true banks or have been nationalized by the government with the aim of winding them up in due course.
There is one fly in the ointment however. The law enabling building societies to convert to banks still exists and at some time in the far future when all of this present turmoil has died down and been forgotten, a “bright spark” is again going to erupt and think of this brilliant idea.
The basic problem is that in general people do not learn from history, or from other people’s mistakes, and politicians are unfortunately the foremost examples of this failing in the human race.
Tags: building society or bank, what is a building society
Money Matters | Derek Beese January 8, 2009
