Annex 2: Change in fee structure, eligibility and coverage

Detailed design features of DGS extension

This section summarises the design of the extended DGS and the judgements used in making these amendments:

• Extended the Scheme until 31 December 2011, with a clear end date;

• Tougher eligibility criteria (firms rated BB- or below, or unrated are ineligible; CISs not eligible);

• Voluntary scheme (institutions will need to apply);

• More risk sensitive fees, paid on the whole deposit book; and

• Reduced and differential coverage for banks and non-banks (up to $500,000 for banks, and up to $250,000 for non-banks, per depositor, per institution).

Length of extension - extend until 31 December 2011, with a clear expectation it will be removed

The current DGS runs for a total of two years until 12 October 2010. The extended DGS is proposed to run for an additional fourteen and a half months and expire on 31 December 2011. This provides time for organisations to improve their business in advance of the withdrawal of the guarantee while not allowing the market to become dependent on the guarantee. Expiry in December 2011 will align more with Australia's guarantee, which expires in October 2011. An expiry date at the end of the quarter will assist firms to manage their liquidity, since many firms take deposits that expire at the end of the quarter.

It is critical that the market views the expiry date as certain and credible. This is essential to ensure that institutions take the actions needed to ensure their long-term viability following the removal of the guarantee. For example, some institutions may need to merge, owners may need to inject additional equity, and some institutions will need to offer higher return deposits past the end of the guarantee to prevent the build-up of another deposit maturity wall. If the market is not provided with absolute certainty then there is the risk that the necessary adjustment does not occur and there is pressure to extend the scheme further.

Institutional eligibility - minimum quality-based eligibility criteria for all institutions

Under the current DGS, deposit taking institutions were eligible for the guarantee if they met general eligibility criteria. New entrants after a certain date were required to have a credit rating of BBB- or above to be eligible to join the DGS.[8] To be eligible for the WFGF consideration is given as to whether, if the institution takes deposits, the institution is a member of the retail scheme.

The extended DGS would have a higher eligibility threshold than the current DGS by only being available to institutions covered by the current guarantee which have a credit rating of BB or higher[9]. Tighter eligibility criteria are proposed to help to meet the transitional objectives of the DGS. Credit ratings are simple and objective criteria. However, it will take time and cost for entities to obtain ratings, especially smaller entities. However, under the new prudential requirements for NBDTs, entities are required to have ratings by 1 March 2010, unless they have liabilities less than $20 million. [Withheld - commercially sensitive ].

The extended DGS would again be voluntary for all institutions. Access to the WFGF will not be conditional on also being in the extended DGS after October 2010. This will reduce the incentives for institutions to join the extended DGS. This is in order to encourage firms to opt out of the scheme to encourage transition. However, firms are likely to gain a competitive advantage from being in the scheme, if their depositors value the government guarantee, and so it is not clear that all banks (say) would chose to opt out.

The Crown would have the discretion to allow new institutions into the DGS where it is a newly merged entity and its inclusion lowers Crown risk by improving the long-term viability of guaranteed institutions, or it is a newly registered bank[10].

Collective investment schemes (CISs) are currently covered by the DGS to the extent that they solely invest in guaranteed retail deposits and/or Government stock. This is to recognise that the risk characteristic and substance of these investments is no different to a retail deposit that would be guaranteed if made by an eligible institution. However, CISs are legally different from deposits covered by the DGS in that units in these funds do not represent deposits or other liabilities, and are subject to investment risk, including possible delays in repayment and loss of income and principal invested.

As the CISs covered by the DGS invest solely in guaranteed institutions and/or Government stock, they do not pay fees as they invest in institutions already paying fees on eligible deposits.

Removing this limited category of CISs from the extended DGS's coverage would be consistent with the core coverage of the DGS. It would also reduce one of the boundary issues that has arisen between CISs and other institutions (such as mortgage trusts) with similar legal structures (but different investment approaches) that are not covered by the present DGS, and result in slightly reduced administration costs associated with managing separate deeds of guarantee. There may be some shifting of investors from CISs to guaranteed deposits, but this would be minimal.

Retaining CISs in an extended DGS would not cause any particular issues, other than potentially raising again the boundary issues with non-guaranteed schemes. The extended DGS proposes excluding CISs, in order to assist with moving toward tighter and more limited coverage.

Fees - pricing to reflect probability of default and likely loss

Fees in the current DGS involve a strong element of subsidy from taxpayers to shareholders and depositors, as fees are only charged on growth in guaranteed deposits of more than 10% or in excess of $5 billion^[11]. All classes of institutions are charged on a less than expected cost recovery basis. Subsidised fees have lead to economic distortions. For example finance companies have substituted bank funding with a growth in guaranteed deposits of $880 million since October 2008.

The extended DGS attempts to reduce economic distortions with pricing that reflects risk as much as possible. This will help to reduce moral hazard, minimizes distortions of investment decisions between equity, bonds, non-guaranteed and guaranteed deposits, and to ease the transition out of the guarantee.

The proposed fee schedule (see table 3) would apply to all guaranteed deposits and better reflect risk (based on credit ratings) and likely loss given default. The proposed fee structure is based on average US market spreads during the 20 years prior to the financial crisis. Current market spreads are higher than this, and so depending on how markets stabilise, it is possible that firms could exit into an environment where they have to pay higher rates to attract market funding than they do under the DGS.

The proposed fees will aid transition off the guarantee by providing less of a subsidy to guaranteed institutions which will help to ensure institutions have a real choice about whether to opt into the Scheme, or to opt out of the Scheme and offer higher, but unguaranteed deposit accounts. The fees may also encourage firms to undertake measures to improve their credit ratings where they think that it is possible over the next two years. This will also improve their chance of long-term survival.

Higher fees are expected to lead to some market adjustments with guaranteed depositors offered lower interest rates, borrowers charged higher interest rates, and a decrease in the return to the firms' equity where the fee cannot be passed on to depositors or borrowers.

A comparatively lower fee structure is recommended for banks, credit unions and building societies compared to finance companies as generally, finance companies with the same credit rating (reflecting the same probability of default) have a higher loss given default than other institutional types.

In determining the fees, some consideration has also been given to affordability issues for non-bank deposit takers (although the primary consideration was to reduce economic distortions). A risk here is that non-bank deposit takers are unable to afford the fees (or attract and retain deposits without the guarantee). While viable in the long-run, some institutions may struggle to be viable in the short run as they adjust to the new prudential requirements and are subject to the more commercial fees schedule. The proposed fee structure takes this concern into account, but the risk that some institutions that are viable in the long-run will experience considerable difficulties in the short-run remains, particularly in respect of building societies.