Solving the low loan-to-deposit ratio syndrome

Lin Che Wei, Director, Founder, Independent Research and Advisory, Jakarta

For the past five years since the crisis, Indonesia has continued to suffer from a "low loan-to-deposit ratio (LDR) syndrome," as the level of LDR among Indonesian banks continues to be very low. The low LDR has resulted in the criticism that the banks are not lending out to the real sector.

We also hear complaints that the banking system here is not working hard enough to resume its financial intermediary function as they prefer to put their money in Bank Indonesia certificates.

This has created a vicious cycle or, to quote Bank Indonesia Governor Burhanuddin Abdullah, it is like a dog chasing its own tail.

But wait a minute -- the amount of third-party deposits rose from Rp 358 trillion (US$42 billion) in December 1997 to Rp 838 trillion in May 2003, or a growth of 134 percent over the last five years. Loans grew by only 13 percent, from Rp 378 trillion to Rp 428 trillion in the same period.

What do these numbers mean? One reason for the low LDR may be that loan disbursement is too low compared with its full potential. The second is that deposits collected by banks may far exceed the real needs of the banking system.

Politicians and central bank figures all seem to conclude that there is nothing wrong with too much deposits. They assume that the problem lies with loan disbursements that were too small and too slow. They complain that banks are not doing their hardest to lower lending rates. Numerous statements question continued high lending rates while funding rates continue to fall. Why aren't banks trying harder to lend to the real sector to revive the economy?

Let's suppose that the banks boost their loan growth as fast as possible to increase LDR. Who would bear the risk for such rapid growth in loans: politicians or the government, the central bank or the banking sector itself?

Those likeliest to suffer the most would be the banking system and taxpayers, who would ultimately have to bear the cost in the event of another huge banking bailout. I do not believe in a financial system where the true level of loans and deposits is determined by politicians.

I believe in a banking system that operates on a profit- maximizing principle and a resource-allocating principle based on risk-reward consideration. The banks should operate freely without "instruction" or "command" from politicians or the central bank.

The most that BI can do is to set up a regulatory environment and regulations to encourage banks to resume their financial intermediation role.

A low loan level could indeed mean that banks are "lazy" in financing the real sector and prefer to lodge their money with the government, which has a better risk-return profile. The low loan level could also mean that most banks are still haunted by the trauma of lending to corporates, due to a weak foreclosure environment and legal infrastructure.

This is understandable, given the very low average recovery rates of loans transferred to the Indonesian Bank Restructuring Agency during the crisis.

The low loan level could also reflect that not only banks do not trust their customers, but also that banks do not believe in themselves -- especially as the old banking culture has hardly changed, despite the crisis.

Given that lending practices and risk management have hardly changed, perhaps it is better that banks grow slowly rather than rapidly.

However, another likely possibility is that real demand from viable business ventures has reached its optimum level; hence it would be quite difficult for banks to grow their loan books further without compromising asset quality.

If we assume the loan level has reached its optimum level, the "too high" deposit level could explain the low LDR level. A high level of deposits could mean that first, public confidence toward the banking system has been restored -- otherwise why would people deposit as much as Rp 838 trillion in the banking system?

However, this does not mean that the public has complete trust in the viability and the health of our banks. The blanket guarantee, which provides protection for depositors in the case of bank failure, may explain this high confidence. More importantly, Indonesians still prefer to keep their money in banks, so this is also why deposits have reached such high levels.

But the most plausible explanation for high deposits is probably due to the very limited viable alternatives for people to put their money into, such as rudimentary capital market instruments like bonds and the equity market.

Therefore, low LDR may be more attributable to a high level of deposits rather than a low level of loans.

As the crisis has resulted in an overall lower growth of gross domestic product, this also means that Indonesia is suffering from a permanent output loss, which has ultimately resulted in lower demand for loans.

If this scenario were true, it would be better to let the banks grow at a prudent pace rather than push them to grow their loan book just to meet a normal LDR level. Consequently, we should focus efforts on providing alternative financing (other than through banks) to allow the real sector access to financing.

The important factor to resolve the problem of a high level of deposits is to create an alternative investment into which people can put their money, without having to go to the banking system. This means the creation of depth and liquidity in the capital market. At the moment, the Indonesian capital market lacks liquidity and depth and relies too much on banks for its funding requirements.

Contrary to the perception that the withdrawal of funds from the capital market (or "hot money") during the crisis was the main cause of the liquidity crunch in Indonesia and the region, deposit withdrawal from banks was the main cause for the Asian economic crisis.

Funding from banks often creates maturity mismatch between assets and liabilities. Banks use short-term funds such as deposits and savings, which are prone to sudden withdrawal, to finance long-term projects. Development of capital markets would lead to a healthier financial system, foster more market discipline and improve corporate governance and disclosure.

Focusing on a specified level of LDR is meaningless, let alone following instructions from politicians or the central bank, without considering the risk-return profile of business lending. Pushing the banks to lend too fast will never succeed and might even backfire.

The important thing for Indonesia is to allow corporates to obtain much-needed financing to enable them to revive the real sector. This could be achieved either with or without the banks, as long as there is a healthy capital market.

A cure for "low LDR syndrome" is thus the creation of a vibrant capital market; not pushing banks to loan recklessly, simply to meet an LDR target.