RI banking system: Rewarding the bad guys

Marzuki Usman, Former Head Capital Market Supervisory Agency (Bapepam), Jakarta

If you put your money in the bank, then you expect it to be there when you want to draw it out. However, as the people of Argentina have found in recent months, when a country gets into dire financial straits and becomes technically bankrupt, it is just not possible to pay on demand all the money that has been deposited in banks.

There is no doubt that banks are crucial to a nation's economy, acting as the center point of exchange throughout the whole economy. They gather savings from small and large depositors, make loans, run the payments system and coordinate financial transactions. In developing countries like Indonesia they are at the very core of the financial market. In short, banks are indispensable for the smooth running of any economy.

Yet it should not be forgotten that banks are also businesses in their own right, dedicated to making a profit in an often uncertain market. As such they are no different from businesses in any other sector, in that through imprudent actions they too can occasionally fail. Yet, because of the place banks hold in society, the failure of even a single bank can have far reaching effects on the whole economy, causing negative sentiment that can turn into social unrest.

This is why with crises in the banking system affecting more than three quarters of IMF member countries over the past 15 years or so, the idea that deposit insurance protects financial systems from the impact of bank failures has grown in popularity. Yet deposit insurance is not without its pitfalls and badly conceived deposit insurance schemes can actually do harm to a nation's economy.

One can sympathize with the concept that some form of guarantee of bank deposits should be put in place, particularly to protect the small depositors. Yet the question arises as to whether society, as a whole, should be unconditionally responsible for underwriting banking decisions, even those haphazardly taken.

For, by so doing, are we not merely underwriting folly, rewarding mismanagement and condoning intemperance? Why should those who do not even own a bank account -- a sizable majority in Indonesia -- bear the ultimate brunt for those who do? Make no mistake about it, it's the man in the kampong that finally pays the piper, one way or another.

The problem with an all-inclusive guarantee on bank deposits is that it encourages sloth; nobody really cares about whether they cut corners or not, because Joe Public will always bail them out if things do not turn out as rosily as expected. It also fosters coziness between politicians and bankers, the latter willing to loan large sums for dubious projects by political backers in the knowledge that they are most unlikely to be closed down.

This was the root of much of Japan's banking woes. Banks financing roads and bridges to nowhere, and construction companies contributing heavily to political campaigns. Yet when the blanket guarantees on bank deposits were dropped in April this year, there was not an overnight collapse of the banking system as some had predicted, raising some curious questions as to the motives of those Japanese politicians who are now screaming for blanket guarantees to be restored.

Opponents of deposit insurance maintain that a deregulated financial system is best for a country's economy and that deposit insurance in the long run upsets the system by weakening the incentives for bank managers, depositors, borrowers, economic policymakers and political leaders to act efficiently. In theory, an unregulated banking system could function without deposit insurance and be kept sound purely through market discipline. Just as a nation's debt is regulated by the market's perception of its ability to honor its liabilities, so too would banks be regulated by market forces, the amount of risk taken being commensurate with the variance in interest rates.

Such a scheme would only work in a perfect world however, as even countries like South Africa and New Zealand with the most unregulated of banking systems would feel bound to intervene if bank failures threatened a systematic collapse. Indeed, over the past half century, even those countries without insurance schemes have had to bail out their banks in times of trouble, rather than face the ire of dispossessed depositors.

For a nation such as Indonesia, which is in the process of rebuilding the banking sector however, this is a golden opportunity to put in place a system that provides incentives for self-discipline and prudent money management for all concerned - - bankers, large and small depositors, borrowers, policy formulators and government ministers. It is certainly time to scrap the total guarantee on all bank deposits, which only perpetuates bailouts due to poor management.

As small depositors lack the resources to monitor the condition of their bank, some level of guarantee must be put in place to set their minds at rest. This will encourage them and small business depositors to save and thus safeguard the retail payments system. Large depositors, on the other hand, do have the resources to monitor the condition of the bank. It is their responsibility to do so and thus the guarantee on their deposits should be capped.

Deposit insurance is meant to protect the banking system, not poorly run banks, so bank managers and owners must ensure that loans are accurately classified, that adequate provision is made for loan losses and that the bank is sufficiently capitalized. They should realize that not only are their reputations at stake in ensuring the bank is properly managed, but their livelihood.

Regulators must be free from impediments in immediately closing suspect banks, which means that political leaders must not seek to make political capital or to repay past favors by procrastination. It is also important that all banks are subject to the same treatment whether state or privately owned.

Thus, the policymakers who seek to design the system have much to consider, and must also must decide what steps to take in case of a future financial crisis. If they have learned the lessons of the past, they will now realize that guaranteeing every rupiah deposited in every Indonesian bank account is not the way to go.

That only makes winners out of losers while the little guy settles the bill and national poverty continues in perpetuity. And as a result, rich will get even richer while the country gets poorer.