Credit default swap (CDS) spreads to the risk-free interest rate that a bank can expect to pay in the market for 5-year loans.

Riskiest of all the major banks is HBOS, with a senior 5-year debt premium of 78 basis points (0.78% above the 5-year gilt yield of 4.3%, i.e. 5.1%). 5.1% is therefore what they have to pay the market for funds. (If they’re paying you much less that’s not a good risk/reward). RBS, Santander (Abbey National) and Barclays aren’t much better but HSBC and Lloyds are considered by the market to be the safest. If you can get a good rate from either of these banks, then given the risks the market thinks you’re taking, that’s a good deal and you should be able to sleep well at night.
I haven’t mentioned the ex-building societies yes just because they are in a group of their own. Alliance & Leicester and Bradford & Bingley both have 5-year CDS spreads that are flashing major warning signs. When these banks give you a higher savings rate, it’s not because they’re being generous, it’s because they have to compete for funds with rather more secure institutions.
Alliance & Leicester is being made to pay 200 basis points (2%) over the odds for 5-year money (i.e. about 6.33%) so no wonder they are offering savers in excess of 6% - they have to in order to get any funds at all. The implication is that a high savings rate from Alliance & Leicester reflects a higher risk that you won’t get your money back. Such fears obviously only apply to people with very large sums because the system insures savers up to a certain amount (£35,000). Still, I don’t think you want to have your life savings in a bank that the bond market views with such suspicion. The same goes for Bradford & Bingley.
Here too, the spread over risk-free 5-year money is very nearly 2%. The credit market won’t lend to BB/ over 5 years unless BB/ pays nearly 6.3%.
The question you have to ask yourself is: should you accept anything less?
Then, there are the foreign banks who are offering us internet savings accounts. The basic rule of thumb here is: if they’re ING, they’re no worse a risk than a UK high Street bank. If they’re Irish, they’re likely to be over leveraged and a bit more of a worry(especially Anglo Irish Bank). But if they’re Icelandic, then be afraid; these banks are starting to be priced for bankruptcy risk and it’s not clear what protection UK savers might have with these foreign accounts.
Kaupthing is now having to pay almost 6% more than 5-year government bond yields (i.e. 10.2%) to raise funds. Kaupthing’s savings account pays just 6.5% AER, which doesn’t even come close to compensating us for the risk I’d say. The markets seem to be telling us that there is a very real default risk here. Glitnir Bank is not much better and even Landsbanki (owner of the popular Icesave internet banking business) has to pay the credit markets 3.2% more than risk-free rates and 2.45% more than ING does, for funds.
Given that Icesave pays 6.3% on their easy access internet savings account and ING pays 5.15%, perhaps shopping around for the highest savings rate right now is not actually the best thing to do. Perhaps, just perhaps, we should pay more attention to the risk side of the equation too.
So who’s best on the risk/reward basis? Lloyds TSB has the lowest current CDS spread (0.6%) of any UK bank and the third lowest of any European bank (after Fortis and BNP). For one year, Lloyds’ internet account is paying 5.75% (dropping to 4.75% after one year is up) as long as you have £100,000 to save. This looks like the safest place to park your savings for the time being if the credit markets are anything to go by.