Status Quo (continued)

Costs of exiting DGS

21. The current DGS was put in place for a period of two years, expiring on 12 October 2010 to provide time to see how well international financial markets stabilise.

22. This is one year shorter than the Australian scheme. [Withheld – prejudicial to our international relations ]

23. Decisions need to be taken as to what will happen after October 2010 so that firms and depositors can make informed reinvestment and business decisions. A prompt announcement about the future of the Scheme will:

• Provide greater certainty to investors, and enable them to make sensible reinvestment decisions.

• Enable NBDTs to make more rational decisions in terms of strategy, pricing and lending. Due to uncertainty, NBDTs are increasing their holding of liquid assets, which in turn is having an impact on profitability, the efficient allocation of resources, and the ability to strengthen capital levels. NBDTs are also reluctant lend for term beyond October 2010. We expect banks to also want certainty about future arrangements sooner rather than later.

24. To provide this certainty these decisions need to be taken as soon as possible; at the latest one year out from the expiry of the Scheme - that is, before October 2009.

25. As assessment of the pros and cons of letting the DGS cease in October 2010 to achieving the objectives (economic efficiency, stability and fiscal) are provided below.

Pros

Economic efficiency

26. Blanket retail deposit guarantees are generally undesirable because of the economic distortions they create. Economic distortions include encouraging guaranteed depositors and deposit taking institutions to make riskier investment decisions since gains are privatized and losses are socialised (referred to as a “moral hazard” problem); lessening the market incentives on firms to restructure, merge, exit the industry etc; and creating an artificial shortening of terms offered by firms if depositors are not willing to invest beyond the guarantee period. Allowing the DGS to lapse avoids the additional period of economic distortion. Moreover, the DGS ceasing in October 2010 would avoid the possibility of firms using the longer DGS period to imprudently growth their retail deposit books, increasing the Crown’s exposure.

Stability

27. Stability is aided to the extent that moral hazard is reduced, thus decreasing the likelihood of more failure in the long run through imprudent lending. However, there are more likely short term stability detriments, which are considered in the cons section. It can be expected that individuals would take actions that would reduce their own risks, which would also have systemic benefits, but in aggregate may not be sufficient.

Fiscal

28. Letting the DGS cease in October 2010 would avoid the direct costs associated with the Treasury continuing to operate the DGS for an additional period, but forgo the fees currently collected. Also, retail guarantees expose taxpayers to risks of default. Allowing the scheme to lapse removes this risk. However, in the transition it could create larger expected fiscal costs if it causes institutions to fail at a time when asset markets are still weak. This is covered in the cons section.

Cons

Economic efficiency

29. Despite its relatively small size, a viable non-bank sector provides competition and domestic capability in the financial sector, particularly in regional New Zealand, where larger banks are less active, and for certain specialised forms of lending, such as SME, vehicle, consumer and property financing. The Scheme lapsing could come at the expense of the longer term viability of the non-bank sector, which may take some time to recover, but generally economic efficiency is enhanced, hence the discussion in the pros.

Stability

30. The current DGS appears to have achieved the objective of promoting depositor confidence in New Zealand deposit taking institutions during a period of financial turmoil, although the counterfactual is difficult to determine. Funding sources have stabilized for banks since the DGS was introduced, although they remain reliant on the wholesale funding guarantee facility in international markets. Funding sources remain vulnerable for non-banks due, in part, to the impact of the recession on their asset quality.

31. While confidence in international and domestic financial institutions has improved substantially from late 2008, and individuals are likely to respond in the absence of the Scheme by taking risk mitigation actions, it would be imprudent to assume that a full return to ‘normal times’ has occurred and the stability gains from the Scheme are insignificant.

32. While it is difficult to be precise about the extent to which a loss of deposit confidence will impact significantly on financial system stability, it is worth bearing in mind that:

• The Australian guarantee remains in place until October 2011. Although ex ante we cannot be certain about the size of the flow to Australian guaranteed banks if the New Zealand Scheme ceases in October 2010, anecdotal evidence from the period around October 2008 suggests some flow could occur, particularly by corporate and high net worth individuals. However, a large flow of retail funds is not expected.

• [Withheld - to avoid prejudice ].

• Relatively high levels of non-performing loans are currently affecting the profitability of some deposit takers. This situation is not expected to improve in the near term and will impact on the ability of affected institutions to absorb any additional unexpected pressures.

33. While these risks are low, it would be imprudent to rule them out or to assume international markets are no longer an area of risk. Extending the DGS could avoid the downside risks of a loss of depositor confidence on system-wide financial stability by allowing more time for financial markets to stabilise and aligning the end of the Scheme better with that of Australia’s.

34. Moreover, the impending expiry of the current DGS has resulted in short-term “hot money” seeking higher returns, and a dramatic “wall” of maturities is building up for many NBDTs as investors wait to see if the guarantee will be extended post October 2010 (see figure 1 showing the funding wall affecting finance companies). In general this wall of maturities is making it difficult for NBDTs (includes finance companies) to lend for term, and could result in liquidity problems for some NBDTs if they find it difficult to attract retail funding after the guarantee expires.

Figure 1: Funding maturity profile for active finance companies

Source: RBNZ estimates based on returns from financial institutions. Data as at 31 March 2009.

35. Failures particularly of significant entities could also result in the disruption of financial services and credit markets, particularly in regions and sectors where the entities operate.

Fiscal

36. Calls on the DGS remain a possibility throughout the remainder of the current DGS due to devaluation of assets, liquidity issues and the foreseeable removal of the guarantee which has enabled some deposits to be attracted or retained when they might not have been otherwise. The government is monitoring this risk closely to assess the likelihood of further defaults by any individual deposit-takers and the Crown’s likely loss given a default^[3]. [Withheld - to avoid prejudice ].

37. If the DGS ceases in October 2010 some non-bank entities may find it difficult to find new equity investors and depositors which could lead to both capital and liquidity shortfalls. [Withheld – commercially sensitive ] It still remains possible that firms will default during either the current guarantee or extension period. A number of firms are beginning to change their strategies by looking to raise additional equity, focusing on their core business, exiting property development and working out ailing assets, in preparation for the end of the guarantee period.

38. If the DGS ceasing in October 2010 resulted in concentration of defaults in the lead up to the end of the guarantee period, then that could also lead to assets being realized over a short period, depressing asset prices and reducing recovery rates and so increasing the net cost to the Crown of the default event. This is because the gross payments to deposit-holders, less net assets subsequently recovered from the deposit-taker could be expected to be higher, than if the default event occurred when asset prices had stabilised, or were recovering. However, this would be offset to some extent by the additional fee revenue that would be collected during the additional period, from firms in the DGS.

39. [Withheld – under active consideration ].