Part 2 of 2: Is the banking system ready for next crisis?

Ross H. McLeod, Canberra

By contrast with the failure of small, individual banks, the more interesting and much more important case involves the failure of large banks, especially if several of them fail simultaneously. By "large" is meant banks that are considered by the authorities to be systemically important. In these cases the law does not allow for closure. Rather, such banks are required to be "saved", or bailed out, by the LPS, by building up their equity to reach at least the minimum CAR requirement.

There is provision for the existing shareholders to retain partial ownership, provided they are prepared to subscribe at least 20 percent of the new capital needed. Otherwise, the entire new capital amount is subscribed by the LPS. Again, it is required that the bank be divested within a period of six years.

The bulk of banking system deposits are held by a small number of relatively large banks (recalling that there are well over a hundred banks in Indonesia, most of them very small). It seems entirely possible that any of these large banks could be construed to be "systemically important", especially given that the new law neglects (deliberately, I am told) to define what is meant by "systemically important".

Once a bank has been given this status, it cannot be closed down under this legislation: It must be bailed out. And of course, if several of these large banks were to experience a rush on their deposits simultaneously, they would almost undoubtedly be given the status of systemically important banks. The implication is that all depositors in these large banks are almost certainly still protected by a 100 percent guarantee, regardless of how large their deposits: big banks will never be closed down, so there will never be any losses to any of their depositors.

The requirement to bail out systemically important banks, and the provision for unlimited increases in the proportion of deposits guaranteed, means that the law exposes the government to an open-ended contingent liability, almost exactly as was the case in the banking collapse of 1997-1999.

It will be recalled that this began with the closure of 16 small banks, the total deposits of which accounted for only about 3 percent of total bank system deposits. The government announced that deposits of up to Rp 20 million would be guaranteed, but a very large proportion of deposits in the banking system as a whole was in amounts far greater than this. Large depositors immediately drew the conclusion that they were exposed to the risk of loss if their banks were also closed at some time in the future, which seemed quite a strong possibility at the time.

Hence there was a rush to withdraw funds from the private banks, and the government responded in panic by removing the Rp 20 million ceiling on its guarantee altogether. Without going into detail, all the large banks and many of the small ones collapsed, causing the Habibie government to run an unreported budget deficit equivalent to about 40 percent of GDP.

Whether by accident or by design, the new law gives the impression that it is only relatively small deposits that are guaranteed. The reality, however, is that most large deposits are also fully guaranteed in practice, except those of depositors who are not smart enough to realize that their funds are much less safe if they put them with small banks.

Thus, rather than learning from Indonesia's bitter experience of banking collapse in 1997-1999, the new legislation appears to provide a strong legal basis for such a collapse to occur again. It is surprising, to say the least, that the ministry of finance would have approved this legislation, given the enormous financial burden it incurred in this previous episode.

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