Does RI need a deposit insurance system?

Does RI need a deposit insurance system?

By Sumitro

This is the second of two articles on deposit insurance system
based on the United States' experience.

SINGAPORE (JP): What happens when an insured bank fails?

The United States' Federal Deposit Insurance Corporation
(FDIC) uses one of three techniques in adjudicating a failed
bank, but by law it must use the least costly approach in each
case.

The first technique is called the "pay off/liquidation"
method. This method is mostly used for small banks. The FDIC pays
the depositors their insured deposits using money from insurance
reserves. It then liquidates the failed institution's assets and
replenishes the insurance funds with the proceeds.

Before the Group of Thirty Conference on International
Insolvency in the Financial Sector in London, May 1997, Ricki
Helfer -- Chairman of the FDIC -- guaranteed that the FDIC would
issue checks to depositors for the amount of their insured
deposits within three days of a bank's failure. The FDIC's rapid
response to bank failures, according to Mr. Helfer, encouraged
greater market discipline and allowed the economy to recover more
quickly than would otherwise have been possible.

The second technique is called "purchase and assumption". This
method is used for medium-sized banks. A stronger bank purchases
and assumes both the insured and uninsured deposits of the failed
bank, as well as its remaining good assets. The difference
between the total deposits of the failed bank and the market
value of the failed bank's good assets is met by a cash infusion
from the FDIC minus any takeover premium the acquiring bank is
willing to pay.

However, when a very large bank fails, it is often difficult,
if not impossible to find a bank sound enough and big enough to
engage in "purchase and assumption". Furthermore, big depositors
and investors might lose confidence in the large banks if the
"pay off/liquidation" method is used.

The third technique "open assistance" then comes into the
picture. The FDIC provides financial assistance to keep an
institution open and serving its community. An example of open
assistance is the commitment of $870 million by the FDIC to an
investor group headed by Robert Abboud to take over First City
Bancorporation in September 1987.

If the deposit insurance program is fundamentally good, why
and how would it be possible to lose money then?

Although deposit insurance has deterred depositors and other
liability holders from engaging in runs, in so doing it has also
removed or reduced the discipline of depositors and stockholders.

Thanks to the insurance, the banks can borrow at close to
risk-free rate and, if they choose, undertake high-risk asset
investments in anticipation of higher returns. Faced with
shrinking margins to high quality borrowers, many banks are
pursuing sub-prime lending to the auto, home-equity and mortgage
market. Increasing competition may compel some sub-prime lenders
to compromise underwriting standards and lower pricing in order
to protect market share.

Since the deposits are fully insured by the FDIC, depositors
have little incentive to discipline the banks. They do not
withdraw their funds when the bank engages in more risk-taking
ventures nor do they require risk premia on the deposits. With
the lack of transparency, how would they know about the bank
activities after all?

This scenario, plus the losses on oil, gas and real estate
loans in the 1980s are viewed as the outcome of bankers
exploiting underpriced or mispriced risks under the deposit
insurance contract. It has created a moral hazard. The provision
of FDIC insurance encourages rather than discourages risk taking.
The banks put a high stake into risky asset investments and when
it pays off the bank owners make windfall gains in profits.
Should they fail, however, the FDIC, as the insurer, bears most
of the cost.

To control risk taking, several avenues can be pursued. First
is to require higher capital ratios so that stock holders have
more stake in making risky investments. They would have to use
more of their own money to make big bets on risky investments.
Another way is for the regulator to impose stricter discipline on
banks by increasing the frequency and thoroughness of bank
examinations.

Another is that a riskier bank must pay a higher premium than
its less risky counterparts. At the end of 1991, the U.S.
Congress passed the FDIC Improvement Act (FDICIA) to deal with
large numbers of bank failures and the threatened insolvencies of
deposit insurance funds.

One of the highlights of FDICIA is the introduction of a risk-
based deposit insurance premium. For example, consider an extreme
example of two banks (A and B) which have equal deposits of $1
billion. Bank A has all of its assets in real estate loans, while
Bank B has all its assets in T-bills. Being more risky, Bank A
must pay a higher insurance premium.

A strongly capitalized deposit insurance fund has been proven
to be essential in (1) effective bank supervision so that
problems in institutions can be addressed quickly, (2) assuring
liquidity in times of financial stress and preventing bank runs,
and (3) facilitating economic recovery by returning the assets of
failed financial institutions to the private sector as soon as
possible.

Given the current economic picture, it may be the right time
for Indonesia to consider setting up a similar deposit insurance
fund. It will increase public confidence in the domestic banking
system as well as preventing bank runs. Nevertheless, the fund
must be prudently managed to avoid its collapse.

The writer works and resides in Singapore.