Taking a closer look at the deposit guarantee

Details of the Federal Government’s deposit guarantee have been widelydiscussed, but the implications for investors are still not widelyunderstood.

This is unfortunate because the guarantee fundamentally changes theappropriate investment strategy for cash deposits, which comprise anincreasing proportion of most investment portfolios.

By way of background, the basic facts are as follows:

• Eligible deposits of up to $1 million will be government guaranteed until October 12, 2011, free of charge.
• Authorised deposit-taking institutions (ADIs) need to pay a feeto the Government to cover deposits in excess of $1 million if theywant to maintain the guarantee on behalf of their clients. This fee inmost instances is passed onto clients via a reduction in rates.
• The fee charged is based on the credit rating of the ADI and is70 basis points for ADIs rated AA- and above, 100 basis points forthose rated A- to A+, and 150 basis points for those rated BBB+ andbelow or not rated.
• The ‘free’ government guarantee is $1 million per investor (orentity) per institution, which allows investors to spread their fundsacross multiple institutions and/or account names, each with up to $1million, and still receive the ‘free’ guarantee.
• Non-guaranteed deposit holders are effectively subordinated by anew class of creditor, the Federal Government (ie, the AustralianPrudential Regulation Authority (APRA)), which will recoup certainamounts paid out under the $1 million deposit guarantee before ordinarydepositors and other creditors are able to make a claim in aliquidation scenario. This will lead to lower recovery rates fornon-guaranteed deposit holders and ordinary unsecured creditors in thecase of an ADI failure.

Taken together, these facts suggest that investors with less than $1million should look for the highest yielding deposit with an ADIcovered by the automatic government guarantee that matures on or beforeOctober 11, 2011.

On the other hand, investors with more than $1 million should obtainthe highest possible return from a guaranteed deposit. If a single ADIis prepared to offer a high return and ‘wear’ the deposit guaranteecost for amounts over $1 million, this is the best option.

However, it is more likely that term deposit rates for amounts lessthan $1 million will be superior. In this case, investors should splitthe amount into parcels of $1 million and spread it across the highestyielding eligible ADIs, all of which automatically receive the ‘free’government guarantee. This will ensure a high rate of return as noguarantee fee will be deducted from the interest rate offered whilemaintaining the AAA Australian government guarantee for all principalwithout the risk of subordination in the case of liquidation.

In order to guarantee all principal and interest, the optimal initialinvestment size can be calculated by discounting a redemption value of$1 million over the term to maturity using the applicable interest rateand payment frequency. This will ensure that at maturity, the principaland accrued interest is exactly $1 million and that the entire amountis covered by the ‘free’ government guarantee.

Risks of non-guaranteed deposits

For investors with over $1 million, the risk of not obtaining aguarantee for the amount in excess of $1 million can be considered intwo ways:

• lower return for the same risk — if the investor chooses to placeall funds with the one ADI in a guaranteed deposit, it is expected thatin most cases the ADI will pass on some or all of the guarantee fee (of70 basis points to 150 basis points) for an amount over $1 million vialower deposit rates, reducing the overall return but retainingAustralian government AAA risk; and
• similar return for higher risk — if the investor decides not toguarantee the amount over $1 million, it is expected they could achievea deposit rate approximately the same as that offered for amounts under$1 million for which there is no guarantee payable, but the risk issignificantly higher, as the investor is exposed to the underlyingcredit risk of the ADI (many of which are unrated and would likely besub-investment grade).

In addition, the recovery rate or return on non-guaranteed deposits ina liquidation scenario would be materially lower due to ‘structuralsubordination’, with the Government via APRA receiving priority paymentfor certain amounts paid out under the guarantee scheme, leaving lessfor remaining creditors, including non-guaranteed deposit holders.

By splitting investments between institutions your capital will beprotected while your return will be maximised. This presents a rareopportunity to maximise returns while achieving AAA-rated Australiangovernment backing.

Structural subordination

One of the most important implications (or risks) with the governmentguarantee as it currently stands is that it will create a new class ofcreditor.

If an ADI were to fail and was placed into liquidation, the Government(via APRA) would claim the amount paid out to investors under the $1million deposit guarantee scheme ahead of any payments made to ordinaryunsecured creditors, including non-guaranteed deposits andnon-guaranteed wholesale funding. This has the effect of potentiallyreducing the amount that non-guaranteed depositors would receive.

Note that for amounts paid out in respect of the wholesale fundingguarantee (ie, for government guaranteed bonds and deposits over $1million), the Government will rank as an ordinary unsecured creditorafter all non-guaranteed deposit holders and equally with othernon-guaranteed senior debt holders.

The illustration below highlights how this ‘structural subordination’ of non-guaranteed creditors will lead to a lower return.

Two scenarios have been considered to compare the recovery rate oractual return that could be expected for non-guaranteed deposits andother unsecured creditors in the case of an ADI failing and beingplaced into liquidation.

Scenario 1 is the case that existed before the government guarantee wasenacted. Scenario 2 shows the new order of repayment following thepassing of the Financial System Legislation Amendment (Financial ClaimsScheme and Other Measures) Act 2008, which states that APRA willreceive priority for all payments made in respect of depositsguaranteed up to $1 million (including costs in administering thisprocess).

In both scenarios, the hypothetical ADI is assumed to have the samebalance sheet structure, with $100 of assets, $90 of liabilities(breakdown shown in the table) and $10 of equity. In each case it isassumed that $40 of assets are realised in total and are available fordistribution to the various creditors. No funds would be available forshareholders. (The following is a simplified version for illustrationpurposes only.)

In many cases there would be senior secured debt that would rank inpriority to unsecured creditors and there would also be subordinateddebt, hybrid issues, preference shares and other types of capital thatwould rank below ordinary unsecured creditors.

The recovery rate of $40 is used for the benefit of example only. Inreality, the recovery rate of an ADI could be significantly more orless than this proportion. Recent global bank failures have seenrecovery rates materially lower than this level, particularly wherethere have been large amounts of off-balance sheet liabilities andcontingent credit derivative exposures that have ‘crystallised’ assenior unsecured debt upon an insolvency event.

Unsecured liability breakdown

Structural subordination has a significant impact on the recovery rateof non-guaranteed deposits in the liquidation of an ADI. By virtue ofAPRA ranking above non-guaranteed depositors under the new legislation,the recovery rate has fallen from 73 per cent to nil for thosenon-guaranteed deposit holders using the example above.

This presents a compelling case for obtaining the government guaranteefor all funds on deposit, particularly if this can be obtained at a lowcost or even no additional cost. The impact on the non-guaranteeddeposit recovery rate will be more pronounced if one or more of thefollowing factors are present:

• the realisation of assets is low;
• there is a large amount of ‘off-balance sheet’ liabilities suchas credit derivatives. These contingent liabilities would ‘crystalise’and rank as ordinary unsecured creditors in a wind-up scenario, furtherdiluting non-guaranteed depositors and debt holders; and\or
• a large portion of liabilities are guaranteed deposits under $1 million.

Many smaller ADIs, where the vast majority of funding is via depositswith balances under $1 million, are likely to see significantstructural subordination, as the percentage of liabilities covered bythe government guarantee will represent a much higher proportion oftheir overall liability mix.

Justin McCarthy is the head of research at fixed-interest specialist FIIG Securities and its online division, termdeposit.com.au.