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.