Downgrading the bank blanket guarantee system

Nawa Thalo, Jakarta

Starting from March 2007, money depositors or owners of bank accounts will only be able to recoup at most Rp 100 million (US$10,000) if their bank collapses. Under the current blanket guarantee system, Bank Indonesia guarantees the return of all depositor funds in the case of a collapse.

The government has established the state-owned Insurance Deposit Agency (LPS) to cover the risks, including paying depositors a maximum of Rp 100 million. The existence of the LPS obviously will have implications on how depositors choose their banks.

The limitation on the deposits insured by the agency will consequently encourage a massive migration of third-party deposits valued at more than Rp 100 million from one bank to another. Logically, these deposits will be relocated to well- managed and well-capitalized banks, i.e. healthy banks, with high-rated profitability and capital adequacy ratios (CARs), and low-rated nonperforming loans. But above all, since interest rates are the most visible indicators of a bank's soundness, a sound bank will offer interest rates that are on a par with market rates.

On one hand, it is very important for banks to obtain a part of the migrating funds, in order to enhance their liquidity and profitability.

The competition to attract depositors however will likely be very tough. Totally different from the current practice, within the next two years banks will no longer be able to change their deposit interest rates arbitrarily as instruments to win the hearts of the public. This will not only be forbidden by the agency's rules, but would also void any insurance claims on the funds in the case of the bank's collapse.

Besides, above-market interest rates offered by banks would worsen the banks' risk perception on banking failure. Eventually the banks would face a dilemmatic situation when using interest rates in trying to win the competition.

The vanishing of the blanket guarantee system will therefore stimulate a non-interest rate competition among banks. This will force the industry to be more creative in attracting future costumers without offering higher interest rates.

Augmenting banking products to accommodate people's tastes, for instance, can be done to win target markets. This could be done in collaboration with other businesses in the same sector, such as mutual funds, insurance or investment banks.

The competition could also take the form of providing a greater amount and more sophisticated ATM, internet or phone banking services, and advancing human capital capacity. Meanwhile, promotional tactics could be accomplished through media advertisements and prizes offerings.

Marketing expenses, like corporate image campaigns and non- interest rate incentives, would definitely be a costly effort for some national banks, particularly state banks.

Conversely, this would not be that difficult for some banks with solid images, such as foreign-owned banks that are positioned as safe and sound banks protected from political intervention. It therefore would be superfluous for foreign banks to carry out extra efforts to promote their positioning strategies.

Sky-scraping promotional budgets would certainly press some banks' profitability. Particularly when economic conditions are severe, the thinning of the spread between lending and borrowing rates, and the increasing of minimum obligatory demand deposits imposed by the central bank, would deteriorate the industry's potential profit.

This helps to explain the recent fall of banking shares on the Jakarta Stock Exchange. Unless the policy formulation significantly changes, these difficulties will be persistent in years to come.

High-cost promotional activities will also deteriorate the capability of unhealthy banks to maintain customers and to take a piece of the migrating funds competition.

These unhealthy banks would suffer from liquidity stagnation, which would eventually worsen their profitability and ultimately threaten their CAR rates.

They could then become the earliest preys in the consolidation process, merging with other banks or being acquired by stronger banks for their failure to grow organically.

A more progressive regulation is therefore urgently needed: acquiring banks must have excellent CARs and loan to deposit ratios (LDRs) by the preacquisition period.

The writer is an economic researcher at The Indonesian Institute, Center for Public Policy Research. He can be reached at nawa@theindonesianinstitute.com.