Solving the low loan-to-deposit ratio syndrome

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.