The rethink by finance academic Kevin Davis of the financial guarantees regime deserves a detailed read.This article presents a condensed version of the conclusion to a paper submitted by the wealth manager and life insurer Challenger last month to Treasury during the consultation phase deciding the terms of reference for the financial system inquiry.By Kevin DavisIt is apparent that the Financial Claims Scheme is distorting the structure of household financial decision-making in regard to the relative competitive position of authorised deposit-taking institutions versus other financial market participants in the savings, lending and investment markets. The following questions can be posed about whether the current design of the FCS is optimal. Suggested options for policy changes are also made. Given the distortions caused by the FCS, one policy option could be to remove it altogether. As argued in the 2004 Davis Report, the case for a deposit insurance scheme in Australia was finely balanced because of the existence of depositor preference arrangements, which provide protection to depositors by virtue of seniority of claims in liquidation. This remains the case, and depositor preference arrangements could be further strengthened to provide priority for particular types or amounts, or holders of deposits, even in the absence of the FCS. In practice, there are several impediments to removing the FCS. First, the international pervasiveness of deposit insurance, and agreement regarding its role as part of the core financial infrastructure, could make any non-conformity with international norms an issue. Second, the GFC experience reinforced perceptions of the existence of implicit guarantees, which would become explicit in situations of stress. It is unlikely that depositors would treat a repeal of the FCS as a removal of guarantees, and thus retention of an explicit scheme may be preferable. Nevertheless, removal is an option - although other provisions of the scheme, including a strengthening of the Australian Prudential Regulation Authority's powers and its ability to effect open resolution of troubled ADIs' problems (by merger etc), rather than liquidation, are valuable changes to failure resolution solutions in Australia. Increased guarantee fee another option An alternative approach could be to increase the size of the guarantee fee charged, to banks to reflect the benefits obtained from the perceived lower risk of deposits, thereby restoring some measure of competitive neutrality for institutions not covered by the FCS. Unfortunately, determining an appropriate fee is complicated by two factors. First, information on perceived bank credit risk on non-covered products, such as credit spreads on bank debt, relates to bonds and other securities, which are lower in the preference ordering than deposits. Identifying what would have been the credit spread on uninsured deposits (and thus the interest rate benefit to insured deposits) is thus more complicated than would be the (already difficult) case were deposits ranked equally with debt. Second, spreads on bank bond instruments would be partially affected by perceptions of the existence of implicit guarantees (or the likelihood of government-assisted open resolution of troubled institutions) and the likelihood that bond-holders would suffer loss