Protecting small depositors

Protecting small depositors

The national banks, which have spent about US$75 billion in
taxpayers' money on restructuring and recapitalization, will face
their first real market test next year after the phasing out of
the current government blanket guarantee on bank deposits and
claims.

The government has yet to set the date for the establishment
of a bank deposit insurance scheme (DIS) to replace the blanket
guarantee program, which is currently managed by the Indonesian
Bank Restructuring Agency (IBRA). But the government decided at a
Cabinet meeting on Monday not to extend the IBRA mandate, which
will end in February.

Since the bill on bank deposit insurance scheme (DIS) was
proposed to the House of Representatives just two weeks ago, the
scheme may become effective only in the second half of next year,
given the time needed to educate the general public on the rules
and arrangements for the DIS. Hence, the blanket guarantee will
remain effective at least until July under the management of
another government institution within the Ministry of Finance.

Deposit insurance is one of two key components of the
financial safety net, which is vital to promote the stability of
the financial system by enhancing public confidence in the
banking industry.

The other key component -- the function of lender of last
resort -- will also be strengthened under the amendments of the
central bank act currently under deliberation at the House.

Unlike the present blanket guarantee program, which creates
moral hazards and doesn't allow the market mechanism to properly
screen out banks as it covers almost all deposits and bank
claims, the DIS is designed to enhance the market discipline of
bankers, yet helps safeguard the safety of the banking system.

The most outstanding difference will be in the extent of
coverage. The DIS will focus on the protection of small
depositors, who are assumed to be incapable of assessing the
conditions of their banks, by limiting the amount of deposits to
be insured under the scheme.

The current blanket guarantee, which was launched during the
height of the banking crisis in January, 1998, covers all
deposits, irrespective of their size, and almost all other claims
on banks, including those resulting from interbank transactions.

But such a program is now considered a significant
disincentive to sound competition within the banking industry
because both small and large depositors tend to focus more
attention to such factors as the level of deposit interest rate
and convenience offered by banks, rather than the condition of
their management, capital and ownership.

Such unlimited coverage is certainly unfair because large
depositors have the resources to monitor and assess the condition
of their banks. Banks should also be able keep themselves posted
on each other's soundness. Virtually unlimited coverage also
creates moral hazards and imposes large contingent liabilities on
the government, which runs the guarantee scheme.

Under the DIS the maximum deposit to be covered will be
decreased initially to Rp 5 billion ($588,000), then to Rp 1
billion and finally to only Rp 100 million. Such a gradual
decrease will be wise indeed, as it will prevent unnecessary
shocks.

The final ceiling is considered ideal for the country because,
according to Bank Indonesia reports, more than 90 percent of bank
depositors hold small accounts with less than Rp 100 million in
savings, even though they account for only around 20 percent of
the total of around Rp 850 trillion in third-party funds at banks
now. Protecting small depositors will increase household
confidence and help protect the payments system.

Large depositors will therefore have to be careful in
selecting the banks they deal with, but it is this selection
process that will unleash stronger market competition within the
industry.

Next year would be the right time to launch the DIS with
market-friendly incentives, because the bank restructuring
program has been completed. Further postponement of the phasing
out of the blanket guarantee would not only expose the government
(ie. taxpayers) to larger contingent liabilities but also hinder
the market screening of banks.

However, it will be extremely difficult to launch the DIS if
amendments to the central bank law have not been enacted, because
these changes will strengthen the central bank's function as
lender of last resort and its banking supervisory system, two of
the vital preconditions needed for effective functioning of a
deposit insurance scheme.

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