The pitfalls of guarantee

The pitfalls of guarantee

The guarantee provided by the Indonesian government to all
depositors and creditors at locally incorporated commercial banks
since late January 1998 should be hailed as the government's most
strategic move to restore public confidence in the banking
system. Without the blanket guarantee for both rupiah and foreign
currency claims, runs on banks set off by the closure of 16 banks
in November 1997 would have destroyed the industry.

We only can imagine the chaos and panic which would have
erupted after the closure of 38 insolvent banks on March 13 if
there was no government assurance that all depositors and
creditors at the liquidated banks would be fully reimbursed.

Even now, it is this guarantee that provides people the
confidence to continue to deposit their money in domestic banks,
even though most banks -- and all the largest banks -- are
operating with negative capital.

However, more than one year after the introduction of the
guarantee, we can see how costly the scheme has been to
taxpayers. The recent closure of the 38 banks will cost taxpayers
at least Rp 50 trillion (US$5.8 billion), the estimated amount
needed to reimburse the liquidated banks' depositors and
creditors. Several trillion rupiah more is needed for severance
pay for laid-off bank employees. Given the poor quality of the
liquidated banks' assets and the dire economic condition the
country faces until at least 2000, only a fraction of taxpayers'
money will eventually be recouped from the sale of the liquidated
banks' assets. An additional Rp 21 trillion also will have to be
spent bailing out nine major private banks, plus some Rp 150
trillion will be needed to revive state banks. And another
several trillion rupiah will be spent recapitalizing the seven
insolvent private banks the government decided to take over.

One could argue that the cost is justified because an economy
cannot run without a functioning banking system. Moreover, the
banking problem should not be blamed entirely on banks'
management and owners, but also on the country's economic woes,
particularly the meltdown of the rupiah.

Nonetheless, we wonder whether the government's guarantee,
with its overall coverage for both depositors and creditors, can
be sustained without entirely destroying market discipline and
providing more leeway for crooks to plunder state funds.

To our knowledge, no other government in the world provides a
blanket guarantee for claims on banks without any ceiling on the
amount of deposits and without restricting the classes of
creditors covered by the guarantee.

Financial data from the 38 liquidated banks show the pitfalls
produced by the blanket guarantee have not only enhanced moral
hazards in the industry, but also have led to the wastage of
taxpayers' money because insolvent banks left behind mostly
worthless assets.

Perusing financial data from the 38 liquidated banks, one can
see, for example, several banks lent up to several hundred
percent more than their third-party deposits, while prudence
dictates limiting total lendings to a maximum of 110 percent of
deposits. Several other banks owed the central bank as much as 20
percent more than their total gross assets. A number of banks
owed other banks (interbank debts) as much as 45 percent of their
total assets. Numerous other anomalies can be found in the
financial sheets of the liquidated banks. We believe these
anomalies could have occurred only because of the moral hazards
created by the government's blanket guarantee and the inadequate
technical competence and questionable integrity of the central
bank's supervisors.

Our point is that by maintaining the blanket guarantee without
any ceiling on the amount of deposits and without restricting the
class of creditors covered by the guarantee, the government risks
wasting more of the taxpayers' money at the expense of market
discipline, which is needed to force banks to remain prudent and
competitive.

It is therefore time to rework the guarantee. True, setting a
ceiling on deposits covered by the guarantee now, when the
public's trust in the banking system is still shaky, could be
counterproductive, at least until a self-financing deposit
insurance scheme is in place. But we do not see any risks in
immediately eliminating the guarantee's coverage of interbank
credits. After all, bankers should be qualified to assess the
condition of other banks -- their competitors. If bankers are not
able to assess which banks are sound enough to receive interbank
loans, let them lose their shirts. Excluding interbank loans from
the guarantee will force tough market discipline on banks,
thereby making bank closures more expeditious. Such a measure
also will sharply cut the potential loss of taxpayers' money in
future bank closures, which we believe are highly probable.