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.