Deposit Insurance Where The Insurer Has No Money To Pay
Australians with bank deposits who believe their deposit is insured by the Federal Government via the Financial Claims Scheme (FCS) may be in for a rude shock.
In the aftermath of the collapse of Lehmann Brothers in September and October 2008, Australia experienced a fall in domestic economic confidence and even panic in some quarters.
This led to rumours on the weekend of 11th and 12th October 2008, following an 8 per cent fall in the Australia share market the preceding Friday, that a run on Australia’s banks could occur on the following Monday, i.e. 13 October 2008.
During this weekend, in order to stem the collapse of confidence and sense of panic, the Rudd Government introduced deposit insurance for all personal (non-commercial) deposits up to $AUD 1 million per institution as part of a scheme called the Financial Claims Scheme (FCS) as well as a guarantee scheme for Large Deposits and Wholesale Funding.
The FCS was formally introduced via the Financial System Legislation Amendment (Financial Claims Scheme and Other Measures) Act 2008 and provided insurance for up to $AUD 20 billion for each institution with an additional $AUD 100 million per institution in administration costs.
The details of the FCS were as follows:
- the insurance payable would be not automatic and from a legal stand point the FCS would need be ‘activated’ by the Federal Government;
- the FCS would be based on an ‘ex-post’ funding model meaning that if the FCS were activated, the Federal Government would need to pay the deposit insurance payable up front and then subsequently seek to recoup the funds through an imposed bank levy; and
- the Federal Government’s estimated total financial exposure to the FCS was estimated initial at $AUD 650 billion in October 2008.
Despite these fine print details, the announcement of the FCS proved successful in maintaining confidence in Australia’s banking system and therefore prevented a run on Australia’s banks and any further significant deposits being withdrawn.
In the years subsequent to the GFC when the global economy and international financial system returned to stable normality, key changes were made by the Rudd and Gillard Governments to the deposit insurance and wholesale funding guarantees, including:
- a withdraw of the guarantee for Large Deposits and Wholesale Funding in March 2010 ; and
- a reduction in the amount of deposit insurance available under the FCS from $AUD 1 million to $AUD 250,000 per institution in September 2011 .
This latter change was driven by analysis and a recommendation by Australia’s Council of Financial Regulators that the provision of insurance coverage per institution (i.e. $AUD 20 billion) was insufficient to insure Australian personal (non-commercial) deposits up to $AUD 1 million per customer, per institution.
This change reduced the Federal Government’s overall financial exposure to the FCS from $AUD 780.1 billion in 30 June 2011 to $AUD 623.1 billion in 29 February 2012.
Despite these changes, the FCS came into criticism by the International Monetary Fund (IMF) in 2012 during its ‘Financial Stability Review Assessment’ of Australia and New Zealand.
In their report, the IMF expressed concern over the FCS’ existing ‘ex post’ funding model and recommended that Australia should adopt an a ‘ex-ante’ funding model (i.e. a funding model which collects and retains a pool of funds upfront for the express use of the FCS).
Specifically, the IMF noted:
“However, ex post funding and the levy’s optional feature are not consistent with international best practices requiring banks to bear the cost of their own failure.
“An ex ante funded deposit insurance scheme is one of several methods that are available to mitigate the moral hazard by imposing costs on the industry. An ex ante deposit insurance scheme should have a credible and adequate reserve fund built up from periodic flat-rate assessments on ADIs’ deposits initially but changing to risk-based assessments over time, and the fund’s investment objective should emphasize liquidity and safety over return.
“An ex ante funded deposit guarantee scheme, together with higher loss absorbency requirements (as discussed above), appear to represent the best option for Australia since the infrastructure is already in place.” 
The IMF recommendation for an ‘ex ante’ funding model was adopted by the Rudd Government and a $AUD 733 million bank levy was announced by the then Treasurer Chris Bowen on 1 August 2013 , despite opposition from the banking industry.
Following the 2013 election, the Abbott Government accepted the Bowen-Wong policy as an interim policy position in its 2013 Mid-Year Fiscal and Economic Outlook (MYEFO) , but referred the matter to the Government’s Financial Services Inquiry (FSI) for further examination.
Upon review, the FSI, led by former Commonwealth Bank Chief Executive Officer David Murray, stated in its November 2014 final report (p37) that:
“The Inquiry recommends maintaining the current ex post funding model for the FCS, while noting that the cap of $250,000 is relatively high compared to other countries.”
The FSI, thus rejected the IMF recommendation.
The FSI status-quo advocacy of the ex-post FCS funding model was accepted by the Abbott Government in 2015 and remains the policy of the Federal Government till today.
Importantly, this position, coupled with the current design of the FCS, carries significant implications which Australians need to consider, especially those Australians with significant cash deposits within an Australian bank.
The major implications that should be considered include that:
(a) the FCS is not a ‘live’ scheme and must be consciously ‘activated’ by the Federal Government for the insurance to be paid and therefore depositors need to consider under what circumstances would the Federal Government not ‘activate’ the scheme and pay deposit insurance;
(b) the Federal Government’s total financial exposure has grown to $AUD 890 billion as of 31 December 2018, up from $AUD 623.1 billion on 29 February 2012, meaning that the FCS may face risks of ‘under insurance’ at the institutional level given that the institutional level of deposit insurance has not been raised from its $AUD 20 billion ceiling;
(c) there are no pre-existing funds for the Federal Government to pay deposit insurance if the FCS is activated and therefore depositors need to consider under what conditions would the Federal Government not be able to meet its financial obligations under the scheme, even if it wanted to; and
(d) if claims were paid under the FCS, ultimately bank customers and shareholders would be required to meet the costs of the paid insurance via an imposed bank levy.
These are important questions that each Australian with a bank deposit needs to consider, especially given the current ambiguity over whether bank deposits can be ‘bailed in’ similar to the experience of the Bank of Cyprus in 2012.
Moreover, depositors need to consider how the FCS is likely operate if multiple banks fail during an international financial and economic crisis resulting from record levels of global debt (especially relative to global gross domestic product).
In such a crisis, the FCS claims on the Federal Government may be in excess of $AUD 20 billion and may range from $AUD 40 billion to $60 billion if two or three banks were to go fail simultaneously.
Under such conditions, the ability of the Federal Government to financially meet such FCS claims when the government’s gross liabilities are currently in excess of $AUD 900 billion at the same time as when the federal budget deficit would be exploding in the tens of billions of dollars due to collapsing tax revenue is highly questionable.
If sufficient funds could not be borrowed from either domestic or international credit markets when the financial demands on the government are acute, the Federal Government would either:
- be forced to default on its obligations under the FCS; or
- seek the Reserve Bank of Australia to inflate the money supply thereby allowing the government to borrow and meet its financial commitments, albeit with Australian dollars that hold less purchasing power.
Ultimately, depositors will need to assess whether the FCS will remain functional during a systemic economic crisis, the safety of their deposit and what value will their deposit retain.