This article by me was first published in Retail Banking Review. It is correct as at 16 November. The legislative package is here.

Can you regulate fear and panic in the banking sector? Kevin Rudd and Wayne Swan think so.

As a result of the global financial crisis, on 12 October 2008 the Prime Minister announced the Australian Government will guarantee all deposits of Australian banks, building societies and credit unions, Australian subsidiaries of foreign-owned banks and other authorized deposit-taking institutions (ADI’s) and would make available to those institutions a guarantee of their wholesale term funding.

The Treasurer announced on 24 October that the Government has decided that from 28 November 2008 a threshold of $1 million will be implemented, over which a fee will be charged to financial institutions to receive the benefits of the deposit and wholesale funding guarantees. After 28 November 2008, deposits over the $1 million threshold and wholesale funding will only be guaranteed if an application has been made to the RBA and the relevant fee has been paid.

The Government will offer the guarantee in return for a fee between 0.7% and 1.5% per annum depending on the ratings of the institution.

Also on 24 October the Treasurer announced that foreign bank branches will be able to access the guarantee for short-term wholesale funding raised from Australian residents at the same premium that applies to other ADIs. Foreign bank branches will also be able to access the deposit guarantee in respect of domestic deposits held by Australian residents on the basis of the fee schedule, but with no fee-free threshold. This arrangement will be subject to strict limits and requirements to ensure the funding is used only for their Australian operations.

Further clarification was made by Treasury on 28 October.

These changes represent a major restructure of Australia’s financial system and approach to depositor risk.

Guarantee of deposits

The guarantee is not a guarantee that the financial institutions will not fail. But if they do fail the Government will make available deposits to customers early on the basis that the Government will recover the funds when the institution is wound up.

Eligible ADIs would choose whether to 'opt in' to the guarantee for their deposits above the threshold of $1 million. For example, if a person holds $1.5 million in deposit accounts in an ADI, the first $1 million would be guaranteed for free and a fee would be payable to obtain the guarantee for the remaining $500,000.

The threshold applies per depositor per institution. That is, the threshold applies to the total amount of funds held by a depositor in (separate) deposit accounts with an ADI.

If an ADI agrees to opt in, they would be required to pay the relevant fee to the Reserve Bank. The fee would be payable on the value of the depositor’s account over the fee threshold. It is expected that an ADI will pass on the costs of the guarantee to depositors either in the form of a fee or a reduced interest rate.

The fees will be levied on a monthly or quarterly basis depending on the liability.

The guarantee applies to all types of deposits, regardless of the type of account through which the deposit is made. For example, it includes savings accounts, passbook accounts, cheque accounts, pensioner deeming accounts, term deposits, mortgage offset-accounts, farm management accounts, first home savers accounts and retirement savings accounts. Both retail and wholesale deposits are covered by the guarantee.

The guarantee applies to deposits held by all types of legal entities in Australia, including individuals (including joint accounts), partnerships, businesses, trusts and government entities.

For the first 3 years, the guarantee applies to deposits denominated in any currency. After three years the guarantee will be limited to Australian denominated currency deposits. The guarantee  will apply to deposits held in eligible institutions, regardless of where the depositor resides.

The guarantee does not apply to money invested in cash management trusts, superannuation funds or mortgage and property trusts which are not prudentially regulated by the government.

The guarantee will operate for a period of three years from 12 October 2008 without a cap on the guarantee. For ADI’s wound up after 12 October 2011 there will be a guarantee cap of $20 billion.

Guarantee of term funding for institutions

The Australian Government will also guarantee, if the fee is paid, eligible wholesale term funding of Australian-owned banks, building societies and credit unions, Australian subsidiaries of foreign owned banks and foreign bank branches.

The guarantee on wholesale borrowing will be made available, on application, for new and existing term debt issuance out to 5 years (60 months). The guarantee will be available for eligible debt instruments issued in all major currencies.

The facility will be withdrawn once market conditions have normalised.

General insurance claims

In the case of a general insurance failure, eligible policyholders with a valid claim against the failed insurer will receive a payment under the scheme equivalent to the value of their claims, less any excess or deductible amounts.

Eligibility for coverage for general insurance policyholders will be limited to individuals, small businesses and not-for-profit organisations.

Investment products, such as superannuation, life insurance, and managed funds and products offered by institutions which are not regulated by APRA will not be covered by the scheme.

How the Financial Claims Scheme works

The Financial Claims Scheme (FCS) legislation package consists of the Financial System Legislation Amendment (Financial Claims Scheme and Other Measures) Act 2008, the Financial Claims Scheme (ADIs) Levy Act 2008 and the Financial Claims Scheme (General Insurers) Levy Act 2008.

The Scheme legislation establishes an Early Access Facility for Depositors to ensure that depositors in a failed ADI have timely access to their deposit funds, which they would otherwise have to wait to receive through the liquidation process.

A depositor‘s rights are automatically assigned to APRA for the amount of the depositor‘s entitlement under the scheme. APRA’s recovery of payments made to depositors will have first priority in the liquidation. If the funds are not recovered in full through the liquidation of the failed institution, then the legislation allows for APRA to impose a levy to be imposed on ADIs to help fund the scheme.

The levy paid by an ADI cannot exceed 0.5 per cent of the ADI's liabilities to its depositors.

Further changes possible

The initial announcement of the deposit guarantee was followed by claims of unintended consequences. This was followed by the announcement of a fee for guarantees of deposits over $1 million.

Treasury has subsequently announced administrative clarification.

The Treasurer has announced six-monthly reviews at which it is possible further adjustments will be made.