In order to ensure banking stability, regulators throughout the world have implemented minimum capital adequacy ratio (CAR) regulations. In Indonesia, CARs were only implemented and enforced in the aftermath of 1997 crisis. Learning from this, the Central Bank (BI) became aware of the consequences of such an economic downturn. Hence, CAR forbearance from 8 percent to 4 percent was adopted to provide "breathing space" for the bank and the borrower.
The global financial crisis has not led to any policy change on the minimum CAR requirements for Indonesian banks; they must still hold capital in excess more than 8 percent to avoid penalties from BI.
At the end of 2008, CAR in Bank Mandiri recently reached 17 percent, while BRI, BCA, BNI and Bank Danamon had more than 15 percent each. Yet Bank Panin has a higher CAR of 20 percent, while small banks have average CARs of 40 percent. In general, the overall average of CARs in Indonesian banks lies at 16.2 percent.
Does a higher CAR really enhance overall banking stability? As a matter of fact, higher CARs are not always associated with banking stability. Holding capital (CAR) is costly and can erode profitability. This affects big banks with complex organizational structures and products. This is why Lehman Brothers, Merril Lynch, Morgan Stanley, etc, prefer debt to equity capital when financing their projects.
Unfortunately, imprudent debt policy led them to bankruptcy, triggering the global financial crisis.
Since capital is more costly than debt, holding excess capital may induce banks to take excessive risks. Their purpose is to compensate the cost of capital as well as to maintain profitability. Simply said, excess capital has the potential to erode a bank's stability due to risk-taking.
What is the indicator of excessive risk-taking in Indonesian banks? It can be directly tracked from low loan to deposit ratios (LDR) and high ratios of allowance for loss to total loans (loan loss provisions/LLP). A lower LDR is associated with lower intermediation activity, while a higher LLP ratio is associated with a higher (ex-post) credit risk.
Earlier this year, Bank Mandiri had a LLP ratio of 153.3 percent, while its LDR was only 66.4 percent. BRI had a LLP ratio of 192.2 percent, but a LDR of about 86 percent. BCA had a LLP ratio of 351.8 percent with a LDR of only 54.7 percent. Yet BNI and Bank Danamon had a LLP ratio of 105.3 percent and 129.3 percent, respectively. It can thus be summized that those banks increase risk-taking. The amount of loans distributed is relatively small but accompanied by high prospective credit risk.
Unfortunately, excessive risk-taking is not accompanied by an increase in profitability but instead by an increase in the ratio of operating expenses, particularly in state-owned banks. The ratio of operating expenses to operating income in state-owned banks increased from 99.85 percent in January 2008 to 121.14 percent at the beginning of 2009. The amount of operational losses in state-owned banks currently stands at Rp 1.91 trillion (US$189 million).
If holding excess capital erodes profitability and increases risk, why do banks hold more than the required 8 percent? And what is the impact of this on economic growth?
The reason is that we are in the midst of an economic downturn due to the global financial crisis - our banks are too worried about non-performing loans. Consequently, loan availability decreases but excess capital as an indicator of "charter value" increases. Charter value reflects the opportunity measure of a bank, or its ability to continue to do business in the future. Despite an increase in charter value, holding excess capital is unfortunately unproductive. This is why our banks do not reduce interest rates on loans, although BI has decreased its rate to 7.75 with the objective of maintaining bank profitability.
Meanwhile, holding excess capital in this downturn period surely worsens the chances for economic growth, since loan availability is too small to be distributed to the real sector. This is what we call the pro-cyclicality effect of bank capital.
Moreover, tight minimum capital requirements imposed by Bank Indonesia reaching 8 percent drive bank's CARs higher. This, combined with the continuous decline in bank's profitability in 2009, will induce banks to shift their intermediation to non-interest income generating activities, such as fee-based and trading incomes, in order to remain profitable. This behaviour tremendously erodes the availability of loans for the real sector.
Regarding the dark side of excess capital and tight minimum capital requirements, BI needs to lower the 8 percent CAR regulation. Hence, more capital can be distributed as credit to help the economy recover. How do we maintain banking stability if CAR diminishes?
Basel II has been initiated in Indonesia as of May 2008. It needs to be enforced, notably on the third pillar (market discipline). Banking stability can be maintained if the market pressures the banks to behave prudently. Indeed, this mechanism requires banks to be willing to reveal their financial condition to the public. Efficient supervision as well as smooth disclosure policy, minority shareholder protection, credible depositor guarantees, bank rating agency enforcement and so on are also important.
A study of 17 European countries found that banks heavily involved in market activities have relatively low bankruptcy risks. One example of market activities is the high portion of funding from money markets such as subordinated debt. Yet, those banks behave prudently by increasing excess capital in the upturn periods (boom), but decrease it in downturn periods.
Finally, market discipline is obviously a creative intervention. It combines market pressure and the (indirect) role of government. So, why do we wait to enhance the infrastructure of market discipline?
The writer is a PhD candidate in Economics, specialized in Banking & Finance,at the University of Limoges-France and a lecturer at the School of Economics, the Sebelas Maret National University, Solo.
