Sector could face run on deposits despite changes made in wake of Co-op Bank saga

Digital banking has put smaller lenders at risk of a run on their deposits that could spread across the financial system, despite changes meant to avoid further UK bailouts, a government report has warned.

The alert was included in an inquiry commissioned by the Treasury into how UK watchdogs – the Bank of England’s Prudential Regulation Authority (PRA) and defunct Financial Services Authority – handled the Co-op Bank’s supervision in the five years prior to its near-collapse in 2013.

The report acknowledged that banking regulators had undergone many changes in the wake of the Co-op Bank saga but outlined a number of lessons to be learned. It includes warnings over how the growth of digital and open banking could affect the stability of smaller lenders in the future.

Mark Zelmer, who spearheaded the review, questioned whether changes to resolution rules – meant to safely wind down banks without the need for a government bailout – were adequate to cover smaller, more digitally connected, lenders.

Zelmer said: “Past experience has shown that runs on deposits can happen fast in a digital world, and this risk may continue to grow.” He pointed to new open banking rules that allow third parties to access account data. Those third parties could move money from a troubled institution “at the first hint of any problems”.

He added: “I would not be surprised if smaller institutions find their deposit bases become less sticky over time and more likely to run at the first hint of troubles. Contagion risk … may well be higher in the future than has been the case up to now.”

The review, which has so far cost the Bank of England’s PRA £1.8m, also urges the financial supervisor to consider hiring external auditors to help it review regulatory information being handed in by UK banks.

The five-year period covered by the review accounted for the most tumultuous period for the Co-op Bank, marked by its failed bid for more than 600 Lloyds branches and the discovery of a £1.5bn black hole in its accounts, which nearly led to its collapse.

The lender was chaired by disgraced former Methodist minister Paul Flowers. The chairman, who earned £132,000 a year, stepped down in 2013 as the bank’s financial troubles worsened. Flowers was dubbed “the crystal methodist” after secret footage emerged that led to him pleading guilty to cocaine, crystal meth and ketamine possession in 2014.

Last year, Flowers was banned from the financial services industry by the City regulator for inappropriate use of the bank’s phone and computer systems to access premium-rate chat lines and trade sexually explicit messages.