Urgent: Bank consolidation

The government should be commended for its well-designed program to phase out the blanket guarantee on bank deposits and claims within the next 20 months.

The manner and the period of time in which the extent and amount of coverage under the guarantee program will gradually be decreased will allow for a smooth a transition to a deposit insurance scheme that will only cover deposits to a maximum of Rp 100 million (US$11,000).

Certainly, there will be movements of funds from weak banks to stronger ones. People will be more careful in selecting the banks they deal with, but this will speed up the consolidation of the banking industry.

But unlike the period from 1997 to 1999 when funds seeking safer repositories mostly ended up at foreign banks in Jakarta or banks overseas, by February, 2004, quite a number of national banks should be strong and competitive enough to attract large depositors without the protection of a blanket guarantee.

The blanket guarantee, launched in late January, 1998, at the height of the banking crisis, to prevent massive runs on banks has indeed been successful in maintaining a reasonable degree of public confidence in the fragile banking industry.

However, the scheme has not only cost a huge amount of taxpayers money but also has caused "moral hazards" within the banking industry as market forces cannot function properly to regulate banks.

As of this year, the program has cost the taxpayers about Rp 50 trillion (US$5.5 billion), and another Rp 40 trillion in government bonds have been issued to replenish the guarantee fund.

Moreover, since the types of transactions and amounts of deposits covered by the guarantee are virtually unlimited, even bankers, businesspeople and large depositors do not always feel compelled to assess the banks they deal with as they rest assured that whatever may happen to the banks, their money will be reimbursed by the government.

It is quite rational to select import-related and derivative transactions, bonds, loans, letters of credit and other off- balance-sheet transactions as the first to be the lifted out of the guarantee scheme next January. Companies or people involved in such transactions are supposed to be resourceful and intelligent enough to judge the soundness of banks they deal with.

Likewise, the phasing out of inter-bank loans and deposits in excess of Rp 5 billion from the program in August, 2003, is quite sensible. It is entirely unfair to use taxpayer money to protect banks or large depositors who are careless or cannot exercise market judgment of the banks they deal with. Let them lose their shirts in any bank failure.

The phasing out of large deposits and most other financial transactions from the guaranteed coverage will unleash market forces to regulate banks so that only the fittest will survive. This will also remove the government's contingent liabilities.

The Rp 100 million ceiling on deposits to be covered by the deposit insurance scheme, which will be set up in February, 2004, seems reasonable. A deposit insurance program is supposed to protect only small depositors who may not have the means to analyze the soundness of banks.

After all, even though most depositors at national banks are small savers, more than 75 percent of the estimated Rp 850 trillion in third party deposits currently held by the banks are owned by those of middle and top-income earners and institutions which do have the means to assess banking risks.

The most difficult part of the program will be setting the premiums to be collected from banks to fund the deposit insurance scheme. Given the complexity of calculating risk-adjusted premiums, the government may simply impose a flat-rate premium on banks as most of the 80 or so countries, which have established a similar scheme, have done.

It is worth noting though, that a deposit insurance scheme is only one of the financial safety nets needed to prevent the financial system from breaking down and to minimize the costs of bank failure.

Other financial safety instruments such as the central bank's function as a last-resort lender and bank supervisor need to be strengthened and the procedures for the resolution of insolvent banks have to be expedited.

The market cannot function properly to regulate banks and people cannot make reasonable assessments of a bank's condition if the banks are not subject to stringent disclosure requirements and higher standards of accountability, and if the central bank does not have an effective bank supervision mechanism.