Part 1 of 2: Banking system amid the risk of currency crisis

Ross H. McLeod, Canberra

The government bailout of the banking system during the economic crisis of 1997-1999 burdened the Indonesian people with additional net debt of around US$50 billion, which will take decades to repay. With the sudden and disturbing gyrations of the rupiah in recent days it seems timely to ask whether the banking system is now capable of withstanding a similar currency crisis.

In the last month of the Megawati Soekarnoputri government in July, 2001, the House of Representatives (DPR) enacted Law 24/2004 on the Deposit Guarantee Institution, commonly known by its Indonesian acronym, LPS (Lembaga Penjamin Simpanan). The law provides the basis for establishment of the LPS, the function of which is to guarantee bank customers' deposits, and actively to protect the stability of the banking system.

Rather than seeking to avoid the policy mistakes that generated the last financial disaster, however, the new legislation writes almost identical responses into law.

The institution is intended to fulfill its functions in either of two ways: By reimbursing depositors up to a certain monetary limit if their bank fails and is liquidated, or alternatively, by injecting new capital into troubled banks in order to rehabilitate, rather than liquidate, them.

Beyond the residual value of failed banks' assets, the funds needed by LPS in order to reimburse depositors or to inject new capital are drawn from three sources: First, a reserve that is built up from premium payments by the banks; then, if necessary, from its own capital; and ultimately -- if the LPS itself becomes insolvent -- from new injections of capital to its own balance sheet by the government.

These new arrangements are intended to replace the existing blanket guarantee of bank liabilities that was introduced in January 1998, at the peak of the last economic and financial crisis. It took almost seven years to enact this new legislation, and it will be March next year before the blanket guarantee will begin to be wound back. Even then, this will be done in stages at six monthly intervals -- at first reducing the guarantee from 100 percent of all deposits to a limit of Rp 5 billion, then to Rp 1 billion, and finally to Rp 100 million.

The size of deposits guaranteed can be increased in the future in certain circumstances, however. First, the limiting amount can be adjusted from time to time in line with inflation. Second, the limit can be reset at any time in order that it will allow for 100 percent guarantee cover to at least 90 percent of all bank depositors. Third, and most importantly, the size limit for 100 percent coverage can be increased if there is a rush to withdraw funds from the banking system.

The scheme is quite straightforward in the case of the failure of individual, small banks -- that is, banks that are a negligibly small component of the banking system overall. In this case, upon being notified by Bank Indonesia (which is responsible for bank supervision) of the likely failure of the bank in question, the LPS is required to choose between rehabilitation or liquidation, with this choice determined by which option involves the least cost to itself.

Rehabilitation will involve the injection of sufficient equity to cover accumulated losses (in excess of shareholders' funds) and restore at least the minimum capital adequacy ratio (CAR) requirement, making the LPS the new owner of the bank, which it is obliged to sell within a period of six years.

Liquidation, on the other hand, involves immediate closure of the bank, followed by the sale of its assets, the proceeds of which are used to cover as much as possible of the expense of reimbursing the small depositors. The LPS then meets any deficiency. If there are funds left over after meeting these costs and meeting the claims of the former employees of the bank for unpaid salaries and severance entitlements, the remainder is returned to other depositors in proportion to their share of total non-guaranteed deposits at the time the bank was closed.

Provided the losses accumulated by these banks are small enough, the LPS will be able to meet such expenses out of its accumulated premium income and investment earnings. Indeed, if there are sufficient non-guaranteed deposits to absorb the bank's entire losses, the LPS will incur no expense at all -- in sharp contrast to the rehabilitation option, in which the bank's accumulated losses are transferred to LPS. The guarantee institution will therefore have a strong incentive to close rather than rehabilitate banks, with all the social costs of job losses and wastage of bank-specific investments this implies.

The more important case, however, is that of the failure of large banks or multiple banks, to which we shall return in Part II. Is the banking system ready for the next currency crisis?

The writer is Editor, Bulletin of Indonesian Economic Studies, Australian National University, Canberra.