RI needs deposit insurance system
By Sumitro
The government has pledged not to liquidate any more banks and when announcing the new economic measure last Thursday President Soeharto said that the government will set up a deposit insurance scheme if necessary. The following article deals with this topic deriving from the American experience. This is the first of two articles.
SINGAPORE (JP): Governments have long recognized that they have a responsibility to maintain stability and liquidity in the financial markets. A case in point is when the Bank of England played an essential "rescue" role by buying 4.2 million pounds sterling of the stock of the collapsed South Sea Company when speculative mania in that government-sponsored enterprise collapsed in the year 1720.
Fast forwarding to recent time in Indonesia, the closure of 16 commercial banks prompted professionals in the banking industry to voice their concern and hope for a formal structure and clear mechanism to be put in place for the resolving of domestic banking insolvencies. This concern is well understood because stability and public confidence in the nation's banking systems is of utmost important to finance economic growth.
Although the size and effects of the closure of the banks in Indonesia are not comparable to the banking collapse in the United States in the 1930s, it is worth noting the lessons learned from the U.S. experience so as to prevent future banking crises in Indonesia.
This article attempts to provide a flashback on the world's oldest system of national deposit insurance. Since the system was created in the United States, all of the examples here come from American experience.
I will start with bank liquidity problems as the root of a banking crisis and then will elaborate more on the deposit insurance system of the United States. Just like any other bank, the deposit insurance could itself become insolvent. The last portion of the article is dedicated to avoidance of such insolvencies.
A bank liquidity problem can arise on either the asset side or the liability side. A problem on the liability side arises whenever the holders of a bank's liability, such as the depositors, seek to cash in their financial claims immediately.
When this happens, the bank must either borrow additional funds or sell off assets to meet the withdrawals. The most liquid asset of all is cash. However, banks tend to minimize assets of cash reserve holdings because they pay no interest. To generate interest revenues, most banks invest in less liquid assets and in those with longer maturity.
While most assets can be turned into cash eventually, it will be very costly if they must be liquidated immediately. The price the holder of the assets has to accept may be far less than if there was little urgency in the sale and a longer period over which to negotiate it. Hence, the value of the assets may not be enough to cover the liability claims.
The second source of liquidity problems arises on the assets side as a result of lending commitments. A lending commitment allows a borrower to take down funds from a bank on demand. When the loan is taken down, the bank has to fund its balance sheets immediately; this creates a demand for liquidity. As with liability withdrawals, a bank can meet such liquidity either by running down its cash assets, selling off other liquid assets or borrowing additional funds.
Under normal conditions, net deposit withdrawals or the exercise of loan commitments pose few liquidity problems for banks because borrowed fund availability or excess cash reserves are adequate to meet anticipated needs. In America, for example, during December and the summer vacation season when deposit net withdrawals are high, banks anticipate these seasonal effects through holding larger than normal cash reserves or borrowing more than normal on the wholesale money markets.
Major liquidity problems can arise, however, if deposit drains are abnormally large and unexpected. As depositors begin withdrawing their cash in amounts larger than banks can sustain, bank operations are suspended and the country may declare a moratoria on bank transactions. Such deposit withdrawal shocks may occur for a number of reasons:
1. Concerns about a bank's solvency relative to other banks.
2. Failure of other banks leading to heightened depositor concerns about bank solvency generally (contagion effect).
3. Sudden changes in investor preferences regarding holding non-bank financial assets (such as T-bills) relative to deposits.
In the past, such behavior by depositors was not irrational. They had learned from hard experience that if they kept their money in a bank it might not be available when they needed it, and they could also lose a large portion of it. In general practice, depositors were treated in the same way as other creditors -- they received funds from the liquidation of the bank's assets after those assets were liquidated.
Before the creation of deposit insurance, the time taken to liquidate a failed bank's assets, pay the depositors, and close the books averaged about six years. Given the long delays in receiving any money and significant reduction in deposits when banks failed, it was understandable why anxious depositors would withdraw their savings at any hint of trouble.
The Great Depression of the late 1920s and early 1930s caused financial chaos in America. More than 9,000 banks closed between the stock market crash of October 1929 and March of 1933. For all practical purposes, the U.S. banking system shut down completely even before President Roosevelt declared a "banking holiday", and suspended all banking activities until stability could be restored.
Among the actions taken by Congress to bring order to the system was the creation of the Federal Deposit Insurance Corporation (FDIC) in June 1933. Congress created the FDIC with special powers to adjudicate failed banks. The government, through the FDIC, guarantees that customers' funds, within certain limits, are safe and available to them on demand.
Federal deposit insurance coverage is limited to deposits, and does not include securities, mutual funds or similar types of investments that may be offered for sale at FDIC-insured banks. The original level of individual insurance coverage at commercial banks was US$2,500 which in 1980 was increased to $100,000. Savings, checking and other deposit accounts, when combined, are generally insured up to $100,000 per depositor per bank or financial institution insured by the FDIC. Deposits held in different ownership categories, such as single or joint accounts, are separately insured.
Wealthy investors and institutions can employ deposit brokers to spread their funds over many banks up to the permitted cap of $100,000. To cover all their deposits in this way, they could hire a deposit broker such as Merrill Lynch to split $10 million into 100 parcels of $100,000 and deposit those funds at 100 different banks.
The writer works and resides in Singapore.
Window A: Under normal conditions, net deposit withdrawals or the exercise of loan commitments pose few liquidity problems for banks because borrowed fund availability or excess cash reserves are adequate to meet anticipated needs.
Window B: Given the long delays in receiving any money and significant reduction in deposits when banks failed, it was understandable why anxious depositors would withdraw their savings at any hint of trouble.