Sunday, November 24, 2013

Indonesia's next banking sector reforms (part 1)

Gauged by the significance of the rupiah depreciation compared to other fragile currencies, the current market turbulence has particularly informed us about Indonesia's internal growth constraints.

The country is being saddled with structural problems from its import-dependent consumption and investment growth combined with an undiversified export mix. More rupiah depreciation and/or significantly lower growth rates would appear necessary to restore the external balance in the short-medium term.

As the government is deliberating some structural reforms, the immediate question is whether we need reforms in the banking sector as well? Is finance part of the story here? And what has the banking sector to do with the quality and sustainability of economic developments?

It might sound odd to question the banking state of affairs when profitability, asset quality and solvency of Indonesian banks look strong. Average solvency of the banks is high and profit margins of Indonesia’s systemic banks are the highest among the G-20 countries.

The good average, however, can lead to complacency about the dangers coming from pockets of vulnerability in the banking sector.
In analogy to an ecosystem, the strength of the banking sector is significantly determined by its weakest member. A small Indonesian bank was distressed in 2008 and perceived - rightly or falsely - too big to fail and therefore rescued essentially to bail-out the whole banking sector.

A lesson from the experience is that minimum capital and liquidity standards should be raised in good time to ensure that all banks are better prepared for stress environment.The high average of Indonesian banks' performance indicators that I mentioned will turn out to have little value in adverse scenarios.

Major reforms tend to be pursued in a shadow of a crisis, which might be not (yet) the case today. This said, there is an urgent need for rebalancing of policy priorities in favor of long-term saving and lending, diversified economy, market discipline, competition, financial inclusion and truly risk-based regulatory regimes at individual entities as well as at macro levels.

My main references in formulating reforms objectives are the latest global regulatory initiatives such as Basel III and discussions in relation to a.o. safety nets, recovery & resolution mechanisms, future of banking and even the chicago plan. I believe they provide valuable insights that are relevant for Indonesia as well as for other emerging economies.

Formulation of reforms goals

Now that the time has come that less capitalized and more vulnerable banks are facing increased downside risks, a part of the reform initiatives has gained relevance for adoption sooner rather than later.

The reform calls could mean small steps from the current policy frameworks. Some unfortunately might implicate a change of paradigm in regulatory supervision and structures as well as in banking culture/philosophy.

The next reforms package is expected to be ambitious and aims to:

a. Decrease the likelihood of bank failures as well as the impact on the economy given bank failures;
b. Induce responsible lending to limit economic inefficiencies associated with defaults and over pessimism in downturns;
c. Support diversity that facilitates the poors' access to (basic) banking products and improve customer care;
d. Foster competition that broadens the access to credit and raises incentives to save long term;
e. Align interests of bankers more with those of their customers and the public;
f. Promote market discipline by fixing distortionary features of the current deposit insurance scheme and pricing systemic risks fully;
g. Encourage deepening of interbank & capital markets by strengthening market infrastructure like rating agencies and monetary policy frameworks;
h. Incentivize banks to finance new drivers of growth, away from consumption towards productive investment.

Any measure taken to achieve the above goals would not necessarily slow down the rupiah depreciation or accelerate growth in the short run.

Having said that, the deterioration of the Indonesian current account deficit might have been reinforced by the kind of developments seen in the banking sector over the last years. It has been coinciding with rapid growth in low productivity (e.g. consumers) or high collateral sectors (e.g. property). It has been coinciding with exceeding attractiveness of the financial sector for top talents, notably compared to employment in innovative, export-oriented sectors. And the overall credit expansion has spurred demand for imported goods too.

Several reform components above aim to improve the transmission of the central bank's monetary policy actions. BI's interest rates policy (this time in rate-hike biases) is lacking effectiveness due to distortive deposit guarantee scheme and reliance on the standing deposit facility - instead of reverse repos - to absorb liquidity (more on this in later posts). With robust macroprudential measures being absent (e.g.  debt-service to income limit & much greater reserve requirements), current account deficits and loan growth could remain high despite increases of the BI reference rate.

When envisioning next generation of reforms, one would focus on reforms agenda that is presently facing resistance, still being neglected or misconceived.

A competition policy, for example, needs to be introduced to allow for customer mobility and to bolster confidence in the ease of [account] switching. The policy also needs to be bold in incentivizing or forcing weak, smaller banks to merge into a strong challenger to bigger banks.

Another example may be useful.
On reform (a): While decreasing the likelihood of a bank failure is obviously the goal of the current regulatory regime, it is not clear if the current laws have a thought about limiting the impact on the economy given a bank failure .

The OJK law authorizes the parliament to ask the deposit insurance corporation to take over a problem bank when it is a systemic bank. The parliamentary decision must be made within 24 hours after receiving recommendations from the financial system stability forum coordinated by the finance minister.

This part of the law is a strong impetus for banks to compete on becoming big to seek a protected status. This is a form of moral hazard risks that can be mitigated, under reform (a), by instituting higher capital requirements for systemic banks, bail-in (i.e. conversion of debt to equity) provisions, resolution mechanisms (i.e. to make systemic banks easier to shut down in a crisis) and reduction of implicit too-big-to-fail subsidy.

Concrete measures to be taken:

This is a first in reform series to address several fault lines in the Indonesian banking sector.  As bad times make good policy, there is a chance that the missing prudential insights get their due attention now that the economy is starting to take a beating.

We begin with addressing the current capital regulation, followed in next posts by the implementation of the liquidity standards, the role of the deposit insurance scheme, the monetary policy framework, the development of financial (data) infrastructures, remuneration in banking, themes surrounding financial inclusion, the functioning of the regulatory institutions, etc. The discussion will be short when the subject matters were covered in previous posts.

1. More robust capital framework

Key emerging markets escaped from the global financial crisis (GFC) of 2008 largely unscathed because of their focus on relationship banking and reliance on traditional funding model.

There are nonetheless valuable lessons from the GFC as well as its regulatory reactions (or over-reactions for some of us) for many developing economies.

One of the regulatory initiatives that should be seen as a minimum is the Basel III capital accords to raise loss absorption capacity and to align interest of bankers & shareholders with other stakeholders.
This means that Indonesian banks should face higher minimum capital requirements commensurate to their risks and macroeconomic environment. This seems an obvious rule of the game every risk manager knows.

However, it applies only to an extent because the range of minimum solvency for riskiest banks are capped at 14% by the current regulation. A bank with worst supervisory risk rating ('four' or 'five') might keep its license as long as this 14% minimum ratio is met.

Although the regulation says that minimum ratio can also be set above 14% if potential loss warrants a higher solvency ratio, the 14% threshold remains a sort of regulatory forbearance for weaker Indonesian banks. For example, reserve requirements are not raised when a bank's LDR is higher than 92% if its capital adequacy ratio (CAR) is at least 14%. It means that a higly risky bank can also allow itself to hold an aggressive maturity transformation as indicated by a high LDR.

In my view, the Indonesian Basel II’s Pillar 2 framework has to be repaired to warrant a more direct link between risk profile and capital requirement. A bank should hold capital as much as it needs to cover its risks based on a so-called bottom-up assessment embodied in its internal capital adequacy assessment process (ICAAP).

Investment and enthusiasms in risk management to adopt best practices would stall if Basel II & III are not implemented wholeheartedly. To my experience, introduction of appropriate Pillar 2 frameworks for capital (and liquidity as discussed in the next post) can greatly encourage banks to strengthen their risk system and methodology.

Supplementary to the bottom-up, risk-based calculation of capital requirement, banks also hold capital buffers to support business growth and to cope with their inherent cyclicality. In the context of Basel III, the buffers are pushed up during economic upturns and drawn down during downturns.

Additional buffers should also be imposed as part of macroprudential supervisions on systemically important domestic institutions, or on exposures in certain sectors/regions (eg. real estate, consumers, vehicles financing). Extra buffers now would prepare Indonesian banks to cope with impending reversals of the US monetary policy, or more seriously, China's hard landing, or rebalancing of the Chinese domestic demand away from Indonesia’s traded commodities as it becomes older and richer.

In sum then, risk-based capital requirements should not be capped with an explicit upper target (i.e. 14%) for the capital regulation to be effective. Including the impacts of risk-based capital add-on and buffer provisions, average CAR  in the industry would increase to about 20%! from just over 17% as at end-2012.

Most Indonesian banks would likely be able to meet the reasonable increase of capital requirements coming from the risk-based and macro-based assessments.

One might worry about the implications of a more demanding capital regime for credit and economic growth. Again here, unleashing sustained growth can be best achieved by stimulating investment and increasing productivity. The emphasis is thus on quality of financial developments, not on merely sustaining economic growth by credit expansion.

Asking a bank to meet additional capital requirements is an ultimate stress test to check who is the weakest link in the financial system. Those with weaker business model might find it difficult to meet a higher capital requirement.

Hence, a more credible capital regulation would improve prospects for especially smaller banks to become formidable and effective challengers of larger banks. This underscores the mutually reinforcing nature of financial stability and competition that will be revisited several times in next posts.

Final remarks

Implementing a robust risk-based capital regime would help reduce excessive risk taking and better align the interest of short-term profitability and sustainability. This is essentially the task of a banking supervisory authority that is supposed to be assumed by the OJK (Indonesia’s financial services authority) starting from January 2014.

On the other hand, the buffer requirements are basically macroprudential tools that would address systemic risks and inefficiency associated with financial instability. The latter task is assumed by Bank Indonesia.

Indeed, the adoption of Basel III would help define more clearly the role of supervisory authority vs the central bank, which is still vague at this point of time (e.g. see page 21).