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

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.