RI needs deposit insurance system

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.