Editorial: Insured up to $200,000

Thu, 10/16/2008 10:49 AM  |  Opinion

The government has kept reassuring us and the international market, even at the height of the financial crisis in the United States late last month, that our banking system is sound and our economic fundamentals are much stronger than those before our economic crisis in 1997.

Then the government made the bold move on Monday of putting its money where its mouth is by increasing the ceiling amount of bank deposits covered by the state-owned Deposit Insurance Agency by 20-fold, from Rp 100 million (US$10,000) to Rp 2 billion ($200,000). That is quite a generous guarantee, given our per capita income of only around $1,600.

As we are now facing the impact of the systemic banking crisis in the United States and Europe, such a wide, generous insurance coverage is key to preventing panic or sudden, irrational runs on banks.

As a vital component of the financial safety net, deposit insurance is pivotal to strengthening the stability of the financial system by enhancing public confidence in the banking industry, so people can rest assured their savings in banks are safe.

The government also strengthened the other pillar of our financial safety net -- the lender-of-last-resort function of the central bank -- by broadening the category of assets that banks facing severe liquidity problems can pledge as collateral for emergency credit from the central bank.

A deposit insurance scheme is effective in preventing problems at one bank from spreading to other healthier, stronger banks, thereby minimizing the possibility of contagion or a chain reaction within the banking system as a whole.

The government introduced the deposit insurance scheme for the first time in late January, 1998, soon after the collapse of almost all the major banks at the height of the financial and economic crisis.

The rationale was that, given the current complex structure of the financial industry, most depositors are presumed incapable of assessing and continuously monitoring the risks of banks even when their financial audits and reports are easily accessible.

According to data from Bank Indonesia, the 20-fold increase in the ceiling amount covered by the deposit insurance now means almost 97 percent of all third-party depositors at banks are guaranteed by the state-owned Deposit Insurance Agency.

A deposit insurance program also allows the central bank, as the supervisor of the banking industry, greater leeway to let problem banks fail without causing systemic risks.

Such orderly exits by distressed banks could even accelerate the consolidation process within the industry.

However, the drastic move to bring the maximum guaranteed deposit closer to the U.S. ceiling ($250,000) under its federal deposit insurance scheme could become a big gamble at the expense of taxpayers if the central bank (Bank Indonesia) does not steadily improve the integrity and competence of its bank supervision.

A conventional criticism of deposit insurance is that such a scheme can increase the risk of imprudent behavior by individual banks and hinder the market from screening out the unhealthier ones as people tend to overlook the soundness of banks.

In fact, there is now a greater need for effective oversight of deposit-taking institutions to contain the moral hazard, especially because banks covered by the Deposit Insurance Agency pay only flat, not risk-based, premiums.

The combination of moral hazard, ineffective bank governance and inadequate supervision could have the most lethal effect on the stability of the banking industry.

This is quite an uphill challenge for the central bank because there remain simply too many banks -- more than 130 city-based commercial banks, and hundreds of secondary banks that are all members of the Deposit Insurance Agency.

The central bank's banking architecture, which imposes tougher terms for commercial banks, seems ineffective in accelerating consolidation within the industry either through mergers or acquisitions.

Hence, one of the most important ways of minimizing moral hazard while maintaining the benefits of deposit insurance is to vigorously promote good governance for banks and see to it that there is a sound regulatory and supervisory framework in place to deal with excessive risk-taking by banks.

Put another way, effective bank oversight is the third key component of the financial safety net, in addition to the deposit insurance scheme and Bank Indonesia's strong lender-of-last-resort function.

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