Downgrading the bank blanket guarantee system

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.