The House of Representatives’ special inquiry committee has had its say on the Bank Century bailout, essentially saying it was flawed.
Alas, this verdict does not have strong economic rationale.
The irony is that the Century bailout is from the very get-go an economic issue. The brouhaha, after all, just shows that our lawmakers badly need to improve their economic literacy, while some self-professed experts and pundits should refresh their reading list, and the press is seriously ill-informed.
This mix of unfortunate features has promoted to the public skewed “economics”. This article attempts to fix some damage made by such economic populism.
First, most people think the Century bailout was akin to a business investment. It was not. Thus, when the Deposit Insurance Agency (LPS) injected Rp 6.76 trillion (US$716 million) into Century, one cannot use a return-on-investment indicator to judge whether the move was wise.
Instead, as the name suggests, it is an insurance operation where the insurer (LPS) prevents the insured’s (Century depositors) losses, by injecting capital into Century. Yes, the government has share in the LPS’s initial capital, but the agency’s operational fund comes mostly from the premium paid by banks, just as with any other insurance company.
As such, one cannot say that instead of bailing out Century, the money could have gone to building schools or helping small-scale farmers, for instance. This fallacy is like saying that rather than paying for your damaged house, your insurance company will instead build a public elementary school.
What is at stake, in fact, is much higher: saving the Indonesian economy. This is why the government, by way of the LPS, decided to bail out Century. To prevent a run on banks, they deliberately propped up Century – a riskier option that still cost the LPS Rp 6.4 trillion to repay the failed bank’s depositors’ money.
Second, the populace has come to believe that the notion of a “systemic risk” is just jargon invented by Finance Minister Sri Mulyani Indrawati and then Bank Indonesia governor Boediono to justify their policies.
No. A systemic risk is a real and well-known idea in banking and monetary economics to illustrate the link between a bank run, a banking crisis and economic collapse. It all boils down to the problem of inherent asymmetric information – that is, banks, depositors and borrowers cannot fully observe each other’s use of the money in the system.
Let us be a bit thorough here. Banks, by nature, must set up an optimum liquidity, taking into account the need to fulfill normal short-term depositor’s fund withdrawals and higher returns from long-term investments.
The depositor, as demonstrated by Douglas W. Diamond and Philip H. Dybvig (1983), has two options for optimal behavior.
They draw their deposit only according to their need for liquidity, if other depositors do the same; or they draw their money beyond their need for liquidity, if others also do the same – because some depositors panic, for instance. In short, they do not want to miss the boat and lose their money.
Now back to the Century case. Suppose in the late 2008 the government had let Century collapse and announced that the bank’s owners had misused the depositors’ money and been hit by the global financial crisis. Depositors at other banks would then wonder if the owners of their bank had perhaps not done the same.
Alas, due to the problem of asymmetric information, this question cannot be fully addressed. As a result, some wary depositors might have withdrawn their money regardless of their liquidity need.
Others, seeing these people bail, would probably have joined the fray. Panic looms. Banks, healthy ones included, would suddenly become illiquid, leaving some depositors unable to get their money.
In this case, a self-fulfilling prophecy would have unfolded we would have had a banking crisis on our hands.
Was the panic argument relevant at that time? Yes.
A colleague of mine from the University of Indonesia’s School of Economics, Arianto Patunru, demonstrated this year that if Century had been allowed to collapse, then by mid-November 2008, the rupiah would have plunged to around Rp 12,500 to the US dollar, and reserve assets would have dropped from $57.1 billion in September to $50.2 billion in November.
The Danareksa Research Institute points out that banking system pressure index that month was higher than in March 1997, the antecedent of the 1998 economic crisis.
Third, the populace suggests that the banking crisis would have no effect on the economy; or if it did, it would only be limited to the banking sector.
Wrong again. If the panic was not tamed, we would have had a really big problem.
Massive deposit withdrawals would force banks to sell their long-term assets at fire-sale prices, destroy bank balance sheets and send the capital adequacy ratio into negative territory. In other words, bankruptcies. In addition, information between banks, depositors and borrowers would also be gone.
This, following Joseph E. Stiglitz and Andrew Weiss (1981), would exacerbate the problem of asymmetric information. Bank would be more selective in giving credit and lending at below market-clearing quantity, technically known as credit rationing.
Also, once the economy experiences an adverse shock, as Ben Bernanke, Mark Gertler, Simon Gilchrist (1999) and Nobuhiro Kiyotaki and John Moore (1997) demonstrate, it would decrease firms’ net worth and the value of firms, as collateral would go down as well.
Again, banks would be more reluctant to lend, right when the firms would need more external financing. As a result, investment and production decline would eventually suppress firm’s net worth even more.
Welcome to a spiral effect that would bring the economy to its knees.
The empirical evidence for this ill omen abounds. The latest research by Kenneth Rogoff and Carmen Reinhart (2009) suggests that, among others, a banking crisis would raise unemployment by 7 percent annually for up to five years. Output would decline by 9.3 percent a year for almost two years.
Indonesia’s own experience shows that in the 1997/1998 crisis, the economy shrank by 13 percent and stayed negative for two years.
Fourth, what do all these numbers have to do with the cost-benefit calculation of the Century bailout? Here’s the idea: First, you need to estimate the probability for an economy-wide crisis, plus the loss from banking practice moral hazard caused by the bailout. Then, you compare it with the Rp 6.76 trillion of LPS money placed in Century, and ask yourself if it still comes out positive.
Surely you may disagree on the probability of crisis and come out with your own figure. However, you cannot say that Mulyani and Boediono’s argument is based on flawed economics.
On top of that, consider these facts: First, we did not experience an economic crisis in 2009. Second, Mulyani and Boediono argued that averting the crisis was the very purpose of the bailout. You may not believe that they succeeded in doing so, but, alas, this is the least speculative proposition we have.
So what did the House miss in its findings? It’s the economy, stupid.
The brouhaha, after all, just shows that our lawmakers badly need to improve their economic literacy,
The writer is a PhD candidate in economics at George Mason University, Fairfax, Virginia.
