Foreseeing the end of blanket bank guarantee

Foreseeing the end of blanket bank guarantee

Fajar Hidayat, Jakarta

Starting in February 2007, the government's blanket guarantee
on bank deposits and claims will phase out and be replaced with a
deposit insurance scheme with a maximum coverage of Rp 100
million (US$10,750) per account.

The scheme will be run by a Deposit Insurance Agency, to be
established under a bill approved by the House of Representatives
late last month.

The rationale behind the scheme is that large depositors are
better informed and more knowledgeable in assessing the soundness
of banks and hence, are in a better position to protect their
deposits from risks.

Mandatory for all banks, the insurance agency will initially
charge a flat 0.2 percent uniform premium of a bank's third-party
funds. Only when the prerequisites are met will the agency impose
a risk-based premium on banks.

A uniform premium on deposit insurance is a simple pricing
system aimed to maintain adequate financial capacity for the
insurer, and leaving the task of controlling moral hazards to the
banking supervisory process and the market.

Moral hazards are related to the incentive for banks to take
excessive risks, because insured depositors are unlikely to
assess the healthiness of a bank when placing their deposits. The
bank management, being aware of this general lack of attention
among depositors, may adopt riskier strategies. They gain higher
returns if the strategies are successful, while losses from
failure can be shared with healthier banks under the uniform
premium of a deposit insurance scheme.

For example, both bank X and bank Y have third-party funds
outstanding Rp 5 trillion, so the two banks must pay the same
premium of Rp 10 billion annually. But 90 percent of bank X's
deposit portfolio and only 50 percent of bank Y's portfolio is
under Rp 100 million.

Secured by a 90 percent deposit insurance, bank X conducts
excessive risk-taking, as indicated by a rapid growth in lending
without prudent practices that results in soaring non-performing
loans (NPL) of 25 percent. Meanwhile, bank Y has a much lower NPL
at only 3 percent. With the same insurance premium, this means
the healthier bank Y also provides a subsidy for the weaker bank
X's high risk-taking behavior.

Charging different insurance premiums for each bank based on
their healthiness is a fundamental solution to mitigate the moral
hazard problem. It can also rectify the contradiction of the
cross-subsidy effect for high-risk banks and force banks to
manage their risk-taking activities prudently.

Determining different insurance premiums for different banks
can be done by setting the premium against the bank's
healthiness. One such feasible method is CAMELS -- Capital
adequacy, Assets quality, Management quality, Earnings, Liquidity
and Sensitivity to market risk -- which assesses the financial
and managerial conditions, and specific risks to evaluate a
bank's healthiness.

To break down CAMELS further, Capital recognizes a bank's
ability to maintain capital commensurate with all types of risks,
cushioning the volatility of earnings, controlling growth and
lowering the probability of bank failure. Asset quality indicates
the credit risk associated with loan and investment portfolios as
well as off-balance sheet activities. Management reflects the
ability of the board of directors and senior management to
identify, measure, monitor and control risks.

Earning reveals not only the quantity and trend in earnings,
but also the factors that may affect the sustainability or
quality of earnings, while Liquidity reflects the adequacy of a
bank's current and prospective sources of liquidity and funds
management practices. Finally, Sensitivity to market risk
reflects the degree to which changes in interest rates, foreign
exchange rates and equity prices can adversely affect earnings or
economic capital.

A CAMELS composite rating is assigned to a bank's overall
operation, ranging from one, the highest or best rating, to five,
the worst or lowest rating. A composite rating of one or two
indicates a fundamentally healthy bank, three indicates that a
bank shows some underlying weakness that should be corrected,
while a four or five indicates a problem bank with some near-term
potential to failure.

Determining risk-based deposit insurance premiums can then be
executed by basically charging the premium differentially to
match a bank's CAMELS composite rating, and the healthier the
bank, the lower the premium.

The Deposit Insurance Agency can team up with the banking
supervisor to establish a risk-based deposit insurance based on
the CAMELS rating system. As the banking supervisor, Bank
Indonesia (BI) -- or perhaps the Financial Services Authority,
which might replace BI in the future -- can conduct the CAMELS
analysis, which will then be utilized to determine insurance
premiums for each bank according to their CAMELS rating.

BI is in the process of applying CAMELS for supervisory
purposes, to evaluate commercial banks' healthiness. According to
BI Regulation No. 6/10/PBI/2004 and BI Circulate Letter No.
6/23/DPNP, CAMELS will be implemented by the end of this year,
and CAMELS calculations and analyses will be carried out
quarterly by the banks themselves. BI will regularly -- or
whenever necessary -- examine the accuracy and adequacy of the
banks' CAMELS analysis.

Under the mechanism, if a bank has a rating of four or five,
BI could demand the bank's management and shareholders to provide
an action plan with a target time frame for improving the bank's
health. The plan will identify and offer a solution to the bank's
crucial problems, such as by injecting fresh capital to improve
its capital adequacy ratio, implementing effective NPL solutions,
improving internal audit, increasing operational efficiency for
better profitability, heightening access to financial markets to
resolve a liquidity problem, and adding capital or restructuring
financial portfolio to reduce the risk of interest rate exposure.

When the CAMELS rating is used to determine deposit insurance
premiums, charging a higher premium will then impose an
additional penalty on weak and risky banks. At the very least,
the system is expected to offer a strong incentive for banks to
be more prudent and deter banks from taking excessive risks.

However, the effectiveness of the premium-pricing system
depends heavily on the accuracy of CAMELS in reflecting banks'
healthiness and riskiness. Consequently, before the system can be
implemented in the deposit insurance scheme, BI must prove its
ability to provide accurate CAMELS ratings, free from any unfair
practices in the assessment process.

The writer, a financial market analyst, can be reached at
fajarhidayat@lycos.co.uk