To promote a more sound financial sector, Indonesia needs to strengthen its deposit guarantee institution, currently assumed by the Indonesian Deposit Insurance Corporation (LPS).
According to the Basel Committee, which consists of governors of central banks including Bank Indonesia, an authority of deposits guarantors plays an important role in limiting the scope for discretionary decisions, promoting public confidence, helping to contain the costs of resolving failed banks and mitigating moral hazard.
Moral hazard occur when a party insulated from risk may behave differently than it would if it were fully exposed to it. Moral hazard dominates the banking sector because of the privatization of profits and nationalizing losses. If a bank makes a profit by taking inappropriate higher risk, executives and the owners get an extra bonus, while the LPS and the state-bailout bear the loss in the event of default.
There are criticisms about the setup of the LPS. The first is the establishment of “fixed” premium for all banks, without taking into account that each bank is unique in terms of risk. Consequently, conservative banks and adventurous banks pay the same premium price. The premium is paid by banks to the LPS once every six months, equaling 0.1 percent from the average monthly deposit balances.
The funds collected are used to handle the collapse of banks, such as the recent case of Bank Century.
In advanced finance industries risk-adjusted pricing is adopted in determining premiums. These premiums are based on the riskiness of business. A justified risk-based premium scheme would have avoided moral hazard excesses.
One of the principles designed by the Basel Committee reads: “Moral hazard should be mitigated by ensuring that the deposit insurance system contains appropriate design features and through other elements of the financial system safety. According to the Committee, risk-adjusted premium approaches can mitigate moral hazard, which will also strengthen the prudential supervision instruments of Bank Indonesia.
The second criticism concerns the organization of the LPS. The board of commissioners and board of directors consist of “state-oriented” professionals from government agencies.
This does not promote the proper functioning of the LPS. According to the Basel Committee, a deposit insurer should be operationally independent, transparent, accountable and insulated from undue political and industry influence.
It is a question mark, whether the LPS founded by its “state spirit” is able to re-model a collapsed bank into a healthy bank and implement risk-adjusted pricing as recommended by the Basel Committee.
In early 2010 the LPS informed the House of Representatives’ Special Committee (Pansus) at public hearing the then book equity value of Bank Century (now Bank Mutiara) amounted to Rp 565 billion (US$63.11 million).
The LPS convinced the Committee that the future sale of the bank would reach the national bailout cost within five years.
In other words, the LPS is going to re-create a franchising value for the new Bank Mutiara and increase the equity value by 11.86 times from Rp 565 billion to Rp 6.7 trillion. Let’s examine the LPS’s plan.
Bank Mandiri has built its franchising values for more than a century.
In the period of 2003 - 2009 the share price of Bank Mandiri hit the highest at Rp 5,150 per share on Oct. 6, 2009, in comparison to Rp 850 per share on July 14, 2003. It took Bank Mandiri more than six years from the beginning period after its giant mergers — struggling with building up a new identity — to escalate its equity value by 6.06 times, which is about half of the LPS target for Bank Mutiara.
It is a question mark whether Bank Mutiara, with its background, will be able to perform better. Creating a new identity for Bank Mutiara is not a simple task.
And in order to build shareholder value that quickly, one should have not only be skilled in finance, but should have a unique entrepreneurship in business and in the struggle of competition with other banks to win customers. It is wondered whether the LPS has the infrastructure, skills and a sufficient authority to approach the target.
A better alternative that the LPS could apply is to determine premium, which is based on the score criteria: Solvency, Asset Quality, Management, Profitability and Liquidity (CAMEL). According to some studies, CAMEL and credit ratings are correlated positively. For example, the Federal Deposit Insurance Corporation (the US equivalent of the LPS) adopts CAMEL in determining risk-adjusted pricing by applying appropriate weights in each component of CAMEL.
Each component’s ratio and weight is multiplied by a pricing multiplier. Management and capital gets weighed 25 percent, Asset Quality 20 percent and 10 percent for Profitability and Liquidity. US banks with assets of under US$10 billion pay a base premium of between 0.07 percent - 0.24 percent of deposits.
Pricing for the Management component is imperative and should not be only given by assessing the effectiveness of the Management, but also the quality of corporate governance. In the Journal of Business Volume 76, it is mentioned that the correlation between Corporate Governance and bond ratings is positive.
The same conclusion is drawn by Collins and LaFond by using ratings data from Standard & Poor’s. Companies that have strong Corporate Governance obtain a higher credit rating. Therefore, banks with sustainable Corporate Governance have the right to pay lower premiums.
By using risk-adjusted pricing, the moral hazard can be mitigated earlier before the excesses, causing a greater crisis in the future, where costs triple compared to small banks like Bank Century. For this idea, the LPS should be a brilliant institution like well-known insurance companies and have excellent quality human capital.
Lenny H. Pattikawa works at ING Bank Rotterdam as an actuary. Harry Pattikawa, who has worked at the Dutch banking sector since 1998 as a credit analyst and accountant, is now a credit risk portfolio analyst at DHB Bank in Rotterdam.
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