RI banking system: Rewarding the bad guys

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.