The retail deposit scheme

Vernon Small at Stuff reports:

Treasury failed to stem the flow of millions of dollars into risky finance companies, including failed South Canterbury Finance, after the Government guaranteed their deposits, a report highly critical of the management of the scheme reveals.

The report, by Auditor-General Lyn Provost, reveals deposits in South Canterbury Finance jumped 25 per cent and another finance company saw more than $7million flow into its coffers as investors chased higher returns once they realised the Government was there to pick up the tab when riskier finance companies fell over.

Ms Provost says Treasury knew from the start that depositors would chase the guarantee and that that carried significant risk, but did not take sufficient steps to minimise that risk.

“We saw one example where a finance company’s deposits grew from $800,000 to $8.3 million after its deposits were guaranteed. At South Canterbury Finance Limited, the deposits grew by 25 per cent after the guarantee was put in place,” the report found.

“Once deposits with these companies were guaranteed, depositors could safely move investments to where they would get the highest return, irrespective of the risk of company failure. The finance companies also had less reason to minimise risk in their investment activity. The Crown was carrying much of this risk.”

From mid-2009, Treasury was closely monitoring these changes and the companies that were identified as being at risk.

“However, it was largely doing so to prepare for potential payouts. It did not see itself as able to interact with a finance company to attempt to moderate that behaviour, even when it could see the Crown’s potential liability increasing markedly. The view appeared to be that it was better to recover what funds it could after an institution failed, than try to influence events before a failure.”

So the criticism is that having guaranteed the deposits, Treasury should have told some finance companies to pull their heads in, presumably with an implicit threat to revoke the guarantee if they don’t.

Treasury Secretary Gabriel Makhlouf said yesterday that Treasury disagreed with the assertion that more intervention in finance companies might have reduced the fiscal risks that were an inevitable consequence of the scheme.

I suspect it would have reduced the fiscal risks. However it may have increased other risks such as reputational risks. If Treasury was acting as a sort of implicit director of a finance company and it then crashed, the company might blame Treasury for interfering and say that without the interference they would have been fine.