9th October 2008: Article for The Times by Jesse Norman

As the financial crisis worsens, the numbers get steadily more eye-popping. But it's worth keeping an eye on the fundamentals. One fundamental rule is this: free lunches can cost. Deposit insurance protects savers, but it can also encourage markets - and banks - to fail.

Take Iceland, whose second- biggest bank Landsbanki, which owns the online UK banking brand Icesave, was nationalised on Tuesday.

Together with its sister brand, Heritable Bank, Icesave has about 300,000 customers in Britain, with more than £4 billion in savings.

Under the “European passport scheme”, Icesave savers can claim compensation for the first £16,200 or so of losses from Iceland's deposit insurance scheme. After that, the UK Financial Services Compensation Scheme reimburses up to £50,000.

If Iceland itself became insolvent - its GDP is less than £8 billion - Alistair Darling would be under huge pressure to make up the difference. He has repeatedly promised to do “whatever it takes” to protect UK savers and these are UK savers, albeit in an Icelandic bank. Either way, a large chunk of £4 billion compensation would be paid by British taxpayers. That's you and me.

Now imagine what Augustus Melmotte, the swindler in Anthony Trollope's great novel The Way We Live Now, would make of this.

He obtains a UK licence for his foreign bank. He puts up a bare minimum of capital, spends a few million on a secure online website to take deposits, on advertising and on wining and dining pundits. He offers 0.25 percentage points more interest than rivals, and quickly scoops up £4 billion of deposits from online investors keen to combine maximum security with added financial reward.

Melmotte now lends the money to his friends, who use it for speculative “double or quits” investments. If they double their money, they split the gain down the middle, and Melmotte makes £2 billion. But say they fail. Then the corporate borrowers fold, with their liabilities strictly limited by law. The bank's assets are sold at fire sale prices.

But the bank's home country has a population the size of Coventry. Maybe it can pay £1.5 billion to UK savers, in which case British taxpayers - still you and me - are in the hole only for £2.5 billion. Or it can't. Then it's the full £4 billion.

This sounds like a fantasy. But it's very serious. Take responsibility away from savers, and you end up with gigantic losses for the taxpayer. Take responsibility away from bankers, and you put the whole system at risk.