Sunday, October 7, 2012

Fixing distortionary features of the deposit insurance scheme

The Indonesian Deposit Insurance Corporation (“LPS”) recently announced a plan to calculate deposit insurance premiums based on a rating model.

Many countries have applied differential premium systems successfully (eg. here, or here). So the plan to adopt this good practice is a move in the right direction.

The issue that I want to raise now is that LPS needs to improve not only the way it charges premium but also to remedy other distortionary features of its deposit insurance scheme.

Brief comment on the plan

A risk-adjusted premium setting would help strengthen the banking sector and reduce moral hazard as it encourages Indonesian banks to behave well to avoid paying higher fees to LPS.

Moral hazard is defined here as a situation when a stakeholder makes less effort to avoid misfortune, or tends to take risk as other stakeholders (also) bear the costs of failure.

LPS' rating is ideally robust from gaming. There is a saying (roughly describing Goodhart's Law): "when a measure becomes a target, it ceases to be a good measure".
Designing a risk model to determine insurance premium charges would necessarily involve a lot of thinking about economics of it and its impacts on behavior of stakeholders.

Some questions need to be asked, for examples, will LPS measure and quantify systemic risk? This means that all else being equal, larger banks or highly interconnected banks should pay higher premiums per insured deposits than smaller banks. Will the scoring model account for pro-cyclicality as banks tend to be better rated in good times? How important are qualitative and override factors in the rating model?
These are strategic and technical points that LPS would hopefully consider when designing a differential premium system.

Above all, the project should  not distract LPS from recognizing and remedying even more crucial flaws in the current deposit insurance scheme. These flaws, to which we now turn, have contributed to the build up of systemic liquidity risks in the Indonesian banking sector.

More distortionary features

Key and unique features of Indonesia’s deposit insurance scheme that are questionable include a very high coverage amount, the world’s highest in per capita GDP (see the chart below), and the use of so called "guarantee rate", or "insured interest rate", to define coverage.
The latter means that LPS’ insurance does not cover deposit accounts with an interest rate exceeding LPS’ guarantee rate, which is reset periodically.

In response to the financial crisis in October 2008, LPS raised its deposit coverage by 20 times to IDR 2 billion and kept it unchanged since then. Neighboring countries have slashed their deposit insurance coverage to a level that is consistent with the main mission of any deposit insurance corporation: to protect savings of average depositors without substantially undermining market discipline.


Source: http://www.fsb.org/wp-content/uploads/r_120208.pdf?page_moved=1


The generous coverage in Indonesia may lead to LPS's funding shortfall when one or two small-medium sized Indonesian banks fall. In addition, the outsized deposit insurance coverage will likely spur the whole banking sector to take greater liquidity mismatches as they assume LPS will cover the downward risk for the retail funding. This is a kind of moral hazard on the part of the banking sector as evidenced by the growing share of CASA (current account and saving account) deposits (of which cheap sight savings deposit is a major component), especially among larger Indonesian banks.

One might argue that the moral hazard is limited since the insurance coverage is only intended for deposits with interests below the guarantee rate. Under this term and condition, LPS could prevent unbriddled competition in deposit markets and overcome the moral hazard on the part of depositors since they cannot accept high interest rates while expecting LPS or government to bail them out in case of need.
In other words, depositors accepting high interest rates will still be incentivized to monitor their banks and promote the desired market discipline.

Nonetheless, the case for the guarantee rate feature is contestable. It can for instance distort the effectiveness of central bank’s interest rate policy decisions or undermine the transmission of monetary policy as deposit rates would not promptly move in tandem with the policy rates. Given the shallowness of interbank and debt markets, the responsiveness of retail deposit sectors is pivotal and should not be inhibited by a rate ceiling.

It is also dilemmatic. If the guarantee rate is too high, LPS will have to insure  more deposits base, hence perpetuating moral hazard.

If the rate cap is too low, then it could cause interest rate repression that favors financial intermediaries at the expense of depositors. If real deposit rate (deposit rate - inflation) is too low or even negative for too long, saving will be discouraged, weakening Indonesia's economic fundamentals.

(For a counter argument about the impact of low savings rate on propensity to save here)

Furthermore, the effect of the deposit insurance design on bank competition is a big omission in current discussions (if any). In my view, a low guarantee rate would distort competition in deposits market.
A bank may be able and willing to offer attractive deposit rates because they are operating in a profitable niche segment and at a lower cost - or may be willing to pursue lower returns on equity while growing market share. So it does not mean that gaining market share by offering higher saving rates represents unjustified risk taking.

The existence of the guarantee rate makes it impossible especially for promising smaller banks to challenge bigger banks.

Paradoxically, for smaller banks with weak business models, (low) guarantee  rates may help keep them alive as they benefit from a cheap access to retail funding despite their poor rating.

In a nutshell, the rate ceiling, which effectively weakens competition in deposit taking business and disadvantages savers, should not be used as a tool to discourage excessive risk-taking. The solution to the problem of  undue risk taking is more demanding capital and liquidity requirements!

What to do

If the moral hazard is to be minimized, LPS can attempt the following measures, ideally to be introduced as an integrated reform package:

a. Lower coverage
Insured deposit should be reduced to a level comparable to neighboring, peer countries (e.g. Malaysia, the Philippines, Thailand). The reduction should have a phase-in and credible timeline to allow both banks and depositors to adjust their strategies and behavior accordingly.

b. Use a range of time-varying guaranteed rates
In combination with the outsized deposit coverage, the presence of a single ceiling rate (guarantee rate) has led to a highly skewed distribution of deposits around shorter maturities as the guarantee rate is, in reality, benchmarked against the central bank rate (BI rate).

If a guarantee rate is still desired, instead of setting a single ceiling rate, LPS could issue a range of insured deposit rates (i.e. with minimum and maximum interest rates).

Alternatively thus, guarantee rates could include a spread above certain benchmarks that might reflect averages of deposit rates offered by the sector over various maturities (e.g. sight saving, 1M TD, 3M TD etc). The spread could be capped at, for example, 25% of the averages, or more.

Time-varying guarantee rates will help establish a more market-based time structure of deposit rates. Such reference rates will reflect the fact that liquidity is a scarce resource and will help Indonesian banks to develop a fund transfer pricing (FTP) system.

A key lesson from the recent banking crisis is that banks should have an FTP system as part of the effective risk management framework to allocate risks, costs and benefits of liquidity.

Let us dwell on the time aspect a bit further.

As you can see from the chart below, the guarantee rate tracks the BI rate quite closely. To demonstrate the influence of guarantee rates to deposit rates setting, I then selected time deposit rates offered by state banks because they are not only market leaders as a group, but also enjoy an implicit state guarantee. My premise is that state banks should be able to sell longer-term deposit products easily at rates above the guarantee rate as their depositors could rely on the implicit state guarantee instead of explicit guarantee from LPS.

Therefore, I find it remarkable that even state banks strive to price their longer term deposit below the guarantee rate. Only during the highly uncertain conditions (October 2008 - end-2009), the banks attempted to attract longer term deposit (6M or longer) by offering interest rates markedly above the ceiling rate.

                  Source: Bank Indonesia banking statistics

As a remedy, we could introduce time-varying guarantee rates as illustrated in the table below. This is not a novel idea. For a similar application/example of such interest rate restrictions, see the FDIC.


In a nutshell, the absence of time-varying guarantee rates had incentivized Indonesian banks to rely on liquid retail deposit, thereby ignoring the basics of liquidity risk management and contributing to the systemic liquidity risk build-up that I mentioned in the previous blogs.

I would like to refer to the Basel III accord again to underscore the concern on this matter. It too gives a clear signal that a higher share of time deposits (i.e. with remaining maturity longer than 30 days) is desirable.

In emerging economies with largely confidence-sensitive depositors, where deposit run-off rates could be very high, timely adoption of the Basel III liquidity risk framework is expected to raise systemic risk awareness as policy makers would likely be compelled to introduce higher run-off parameters for sight saving deposits to calculate the liquidity ratios.

Indonesian bank regulators are still silent about the systemic liquidity risks spurred by the flaws in the deposit insurance scheme. But timely adoption of Basel III in Indonesia could hopefully set off a debate about this subject and other missing prudential policies that would align incentives of key stakeholders with the long-run health of the banking sector (see also my previous posts here and here).

c. Optimize design and use of risk rating
A rating system that is reportedly being studied should account for a bank's contribution to systemic risk and makes considerable use of assessment scores produced by its direct bank supervisors. In my view, bank supervisors (BI or OJK) will know the bank under their oversight well enough thanks to years of examination and their insight cannot be replaced by any rating model.

In relation to point (b) above, LPS’ rating combined with supervisors' rating opinion could also be used as a basis to prohibit banks that have poor ratings to offer interests in excess of the above mentioned averages.
This is because poorly rated banks are likely in dire need of some liquidity and may attempt to increase their deposit base by offering unreasonably high rates.

d. Consider ex-ante and ex-post financing scheme
The banking sector currently finances the insurance scheme at 20bps of the deposit base per annum, which is quite low compared to Thailand for example. The planned differential premiums system could give a timely opportunity to set a range of premiums with a relatively high upper bound for most (systematically) risky banks. Consider for instance a range between 15bps up to 50bps per annum, at least until LPS' fund has reached at least 2.5% of the sector's deposit base.

Furthermore, to stimulate banking sector’s self-regulation, lawmakers could also introduce ex-post insurance financing. In this case, when capital of LPS falls below a threshold due to bank failures and resolution costs, the banking sector will be asked to make a greater contribution in one lump sum, or over a number of years.

An example of the deposit insurance scheme that combines ex-ante and and ex-post financing will be implemented in the Netherlands as of June 2013.

Concluding remarks

The banking sector is different from other sectors because it has many more relevant stakeholders to deal with: national regulators, international regulators, depositors, creditors, borrowers, tax payers, shareholders, management and so forth.

The distortionary features of LPS' deposit insurance scheme could decrease competition in the banking sector and might unfairly favor one stakeholder (e.g. shareholder, management) at the expense of other stakeholders (e.g. depositors, tax payers). The design flaws have also caused short-term maturity concentration and underpricing of retail funding in view of the generous insurance coverage backed by an implicit guarantee of the government/tax payers. Such government support could thus allow banks to persist in undue risk taking mode far longer than normal businesses could.

Some of the above ideas look drastic to many, in part because of limited interests in the media, or omission in the public discussion about the systemic threats stemming from misaligned incentives driven by suboptimally designed safety nets.

Therefore, the regulators ought to initiate the safety-net reforms to promote long-term financial stability and limit fiscal costs of future banking crises.

Each of the above action points clearly requires a further work-out, time and resources. But one of the lessons from the Euro crisis is that the best time to introduce reforms is when the economy is doing well. And the best time to press ahead with deposit insurance reforms is when the banking sector is highly profitable and the chance for bank runs is low.

"The time to repair the roof is when the sun is shining..." (John F. Kennedy, 1962)

Sunday, August 19, 2012

Application of Basel III liquidity rule and its monetary policy imperative

It has been argued before that the Basel III liquidity standards are expected to be more consequential in many emerging countries. The new liquidity framework entails the Liquidity Coverage Ratio (LCR), which indicates banks’ ability to withstand a short-term liquidity crisis and the Net Stable Funding Ratio (NSFR),  which measures the long-term, structural funding mismatches in a bank.

Until now however, Basel III does not seem to be an agenda really influencing Indonesia's policy making and the liquidty rule has interested stakeholders even less. Publication of a separate consultation paper (CP) on the application of the new liquidity standards would be a remedial step. A CP on the liquidity standards needs to display sufficient details and concrete proposals supported by impact assessment on the banking sector and national regulations. As an encouragement, this article might serve as a background analysis of Indonesia's banking environment relevant for the application of the Basel III liquidity rule...

The liquidity rule was introduced because during the global financial crisis started in 2007, banks became overexposed to liquidity shocks due to excessive maturity transformation in their balance sheets. A number of banks which failed had high reliance on very short-term (wholesale) funding.

Financial intermediaries in Indonesia are still dependent on retail deposits to finance their lending business. Because retail deposit is widely seen as more stable than wholesale and interbank funding, systemic liquidity risk is not a pressing issue given the high deposit guarantee provided by the Indonesian Deposit Insurance Corporations ('LPS'). This is however true only for the short or medium term. I have mentioned before that the deposit guarantee scheme in Indonesia, by far the highest in terms of per capita income, would have negative ramifications for banks' risk taking and fiscal risks.

As if taking advantage of the generous explicit guarantee by the LPS and implicit guarantee by the government, Indonesian banks have been boosting current and saving accounts (CASA), or the non-maturity deposits, because they are much cheaper than time deposits (TD). Saving interest rates centered around 1% - 2% versus 4% - 5.5% on time deposits (6 month).
The data of TD ratio and CASA ratio in Indonesia's banking system span from Jan 2003 to June 2012. As you can see in the chart below, TD and CASA ratios went up and down around the 50% line. The recent delay, or absence,  of reversal to the mid-line can indicate a build-up of systemic liquidity risks since the inception of the high deposit guarantee coverage around the end of 2008.


                    Source: Bank Indonesia banking statistics

Put differently, high reliance on CASA is risky and can expose the country  to a systemic liquidity risk as depositors withdraw their money from banks at a large scale at the same time, for any reason, despite the deposit guarantee scheme.

At least, that learning point is what is implied from the parametrization of the liquidity rule. For example, in calculating the LCR, CASA and TD with a remaining maturity less than 30 days have to be backed by highly liquid assets as they face a run-off factor between 5%  - 10% depending on the nature of account characteristics. These are minimum percentages as national jurisdiction may impose more conservative parameters. It is notable that a lion share of TD offered by Indonesian banks clearly has remaining maturity of less than one month. The CASA ratio as charted above is hence understated according to Basel III.

Upon implementation of the LCR, Indonesian banks might have to increase their stock of qualifying liquid assets in view of the high CASA ratio. In many countries, say in the core euro zone, increased liquidity buffer requirement is a drag on profitability since the yield on government papers is generally very low, often much lower than sight saving interest rates. The implication is consistent with the intention of Basel III to give banks incentives to collect more TD.

But Basel III implementation in Indonesia will not necessarily reverse the CASA upward trend.

In contrast to many other countries, Bank Indonesia's securities (SBI) and its deposit facilities offer interest rates that are materially higher than CASA interest rates, as a consequence of Bank Indonesia's need to finance growing international reserves.
As long as Bank Indonesia maintains a monetary policy regime that requires it to continue absorbing excess liquidity in the banking system via open market operations, application of the Basel III liquidity rule shall not diminish the banks' reliance on short-term retail funding. As profit maximizing agents, banks will continue increasing the CASA ratio, and use part (or all) of the collected deposits to further accumulate 'risk-free' governement or central bank debt securities.
There exist a free lunch here, especially for bigger banks, since retail deposits are underpriced due to the presence of the generous deposit guarantee scheme and BI continues to rely on SBI and time deposit facilities as the main instrument to withdraw a structural excess liquidity.

Need of monetary policy adjustment
Application of the Basel III liquidity rule in Indonesia should be considered within the context of both macro prudential and monetary policy making. Its effectiveness will also be eroded without an amendment to the current deposit guarantee scheme.

Better understanding of Basel III implementation would help the search of appropriate monetary policy initiatives to address risk issues and dilemma mentioned above or elsewhere in this blog. We have the issues that are curiously enough least mentioned in the media: rising CASA share, excess credit growth and (big) banks' excess profitability that might have impeded an emergence of strong competition. On the other hand, we have another issue that is being underestimated concerning large financial losses of Bank Indonesia arising from significant carrying cost of international reserves (represented by the difference between the yield on the reserves and BI's funding cost).

There is no such thing as a perfect mix of prudential and monetary policy. That being said, one such policy initiative that can lead to lower monetary policy costs, and bolster the prudential impact of Basel III on liquidity risk management is higher reserve requirement (RR), targeted to reduce maturity and currency mismatch. Such RR is both a monetary and prudential policy instrument and, while not simpler, can be deployed quite readily. See this IMF study about various designs of RR (page 70).

Higher and targeted RR would also strengthen the stability of the financial system, can improve the transmission mechanism and support the inflation targeting regime pursued by BI. Similar point is made in this paper (Montoro, 2011) in the context of a general equilibrium model.

RR is indeed a tax on financial intermediation and may curb credit activities. Nonetheless, amid excess credit and profitability growth as well as worsening external balance, there is no better time to at least prepare for it. After all, higher RR will help eliminate or lessen BI's financial loss which would undermine its independence if not addressed timely.

I believe Bank Indonesia should consider finetuning its monetary policy instruments. Reducing the yield on the FASBI deposit facility, and employing RRs that differ by deposits maturity are the monetary tools that have been missing until now. Its cost and benefits along with the implementation of Basel III's liquidity requirement are worth pondering. I hope to address them in another occassion...