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