Urgent: Bank consolidation

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.