Another emergency GFC policy — the federal government’s decision to “guarantee” bank deposits of up to $1 million — is expected to be lowered in the next few months. As Adam Creighton observed in Crikey yesterday, while guarantee (along with other policies such as the purchase of RMBS’ and wholesale funding guarantees) represented an almighty moral hazard, its reduction to between $100,000 and $250,000 could place small and medium size lenders in a difficult position.

In October 2008, with the financial crisis raging across the world, the panicked federal government followed the lead of the Irish in guaranteeing all cash and term deposits of up to $1 million. This had the direct effect (along with the other assistance given to the finance sector) of, temporarily at least, ensuring Australian banks, building societies and credit unions were in one sense too big too fail. It also meant that depositors could make a deposit, instead of analysing the credit-worthiness of the institution, knowing the Australian taxpayer will stand behind any loss.

After almost three years, the key Australian regulators, including the RBA, Treasury and APRA, have told the government to lower the guarantee to between $100,000 and $250,000. While this would cover the vast majority of accounts by number, it may have a substantial effect on smaller financial institutions, like credit unions and building societies.

The irony is of course, while credit unions and building societies have far greater challenges in raising money, they are in essence now less “risky” businesses than the large banks (and tend to be more responsibly run).

Take CUA, one of Australia’s largest credit unions. CUA last year reported loans (an asset) made up $6.5 billion. It funded those loans largely through deposits (of $5.3 billion) and borrowings ($2.5 billion). It leveraged its equity base of $591 million by around 14 times.

By contrast, Commonwealth Bank stated in February that it had assets of $650 billion. Of this, $335 billion was funded by customer deposits and the remainder by borrowing from a mix of sources like overseas sourced wholesale borrowing. Around 51% of CBA’s funding needs came from its depositors (compared to 82% for CUA). Commonwealth Bank is also far more leveraged, with its equity base being only $35 billion — so it has leveraged its shareholders equity almost 19 times.

The problem for CUA is that almost all its borrowings need to be rolled over within a year. And around more than half of its deposits are on-call ($2.5 billion), or are due in less than three months ($531 million). So while CUA is being (relatively) conservatively run compared to the big banks, it faces serious liquidity risks in the event that depositors are spooked by the removal of the government guarantee.

Australia’s largest building society, Heritage, faces a more dire predicament. While more responsibly managed than the big banks — Heritage has reported increasing profits over the past five years, while reducing the value of loan approvals from $2.03 billion in 06.07 to $1.3 billion last year — it has members’ deposits of $3.9 billion and borrowings of $2.1 billion. Almost all deposits are on-call within three months. Heritage has a small equity base of only $235 million, which has been leveraged almost 30 times into its asset base of $7 billion.

By not utilising borrowed wholesale monies, credit unions and building societies are at greater risk following the removal of the larger deposit guarantee as they rely more substantially on customer deposits.

Perhaps one solution is a trade-off. The government could allow the larger guarantee to remain for some financial institutions, in exchange for a far higher capital adequacy ratio (and, heaven forbid, lower executive remuneration). The institution can choose to reject the offer and raise deposits in the market, or reduce the size of its loan book. But should the government continue to provide any sort of assistance to financial institutions, it should demand lower leverage to protect against that guarantee from ever being utilised.