Monday, April 21, 2014

Reviving systemic liquidity risk awareness

In this banking reform series, we shed further light on systemic liquidity risks arising from reliance on demandable retail deposits, known as current and saving accounts (CASA).

Indonesian banks are fiercely competing for market share in CASA. Overall, they are quite successful too as shown below by the rising trend of CASA since 2008/2009.

                                Source: BI banking statistics

Savers appear to accept a poor return of barely 2% (average). Compare it to current rates of inflation (6% – 8%), or consumer loan of 13% per annum (at least) .

Remarkably, banks can hoard their excess cash in the central bank’s overnight deposit facility (FASBI) to get 5.75%. The graph below shows a considerable 3% of spread  between FASBI and saving yield since the expansion of the deposit insurance coverage at end-2008.

                                     Source: BI banking statistics

Combined with the rising CASA share, the repressed saving interest rates and the profitable access to FASBI have enabled Indonesian banks to have a high-risk adjusted return on deposit taking business. 

Is there a free lunch here?
Perhaps for the banks, but not for the nation. The public/government will have to foot the lunch bill when medium-size or larger banks collapse due to an aggressive maturity transformation. This is because insurance fees accumulated so far by the deposit insurance corporation (LPS) would not be sufficient to cope with a loss of more than LPS' free capital of around 30 – 40 trillion Indonesian rupiah (IDR).

Why are savers accepting such a low yield? This is quite a puzzle, isn't it?
I think weak interest rate competition in CASA has played a role. In the case of time deposits, interest rate competition is more prevalent since (better endowed) clients are more price-elastic and better served. By contrast, small saving accounts holders pay less attention to saving interest rates; do not shop around for better deals, or would find accounts switching to other banks rather onerous. The different behaviour and treatment of saving and time deposit accounts holders could weaken the upward mobility of median-income households, and eventually cast doubt on the integrity of financial inclusion programs.

Another possible explanation is that savers accept the low returns since their saving is safe under the LPS' insurance coverage. 

Historically, however, confidence of retail depositors has never been really tested since the establishment of LPS in 2005. In my view, key shortcomings of LPS’ deposit insurance scheme need to be repaired in order to make it credible (i.e. low repudiation risks) and effective (e.g. shorter pay-out period, clarity of coverage terms, etc).

One of next articles in the banking reform series will revisit the distortionary features of the current scheme at greater length. For the moment, the following quote would suffice to underscore some criteria for a better deposit insurance arrangement: “effective deposit insurance scheme” refers to a scheme (i) that guarantees that it has the ability to make prompt payouts, (ii) for which the coverage is clearly defined and (iii) of which public awareness is high. The deposit insurer in an effective deposit insurance scheme has formal legal powers to fulfill its mandate and is operationally independent, transparent and accountable… “ (paragraph 76 of the BIS’ LCR text).

Underpricing of systemic liquidity risk

The increasing popularity of CASA implies rising systemic liquidity risks. Should confidence in the banking sector fall apart, banks with larger demandable deposit balance would suffer most from sudden withdrawals. 

The existence of (generous) deposit insurance relaxes a pivotal risk management challenge in banking and help to create banks to become risk immune. Negative externalities (spillovers) will worsen when bank executives increasingly believe that the deposit insurance generates smaller odds for fatal deposit outflows during financial distress. 

It is not coincidental that the Indonesian CASA boom started in 2008/2009 when the deposit insurance coverage was raised from IDR 100 million to IDR 2 billion. With a more limited deposit guarantee scheme, I think banks would have sufficient incentives to acquire time deposits (TD).

The rising CASA reflects an underpricing of systemic liquidity risk. It means that systemic-risk costs do not get internalized by individual banks since they lack impetus to contain the externalities and associated market failure.

Policy prescriptions

What is unique about a bank is that, when it fails, it drags down the rest of the financial sector and the broader economy. Therefore, even a very small bank was rescued in 2008 in order to prevent bank runs despite the existence of a generous deposit guarantee scheme (the world’s highest in per capita terms).

In economic theory, regulation is called for where there is negative externality or market failure. Recent regulatory initiatives like the Basel III accords focus on the market failure of systemic (liquidity) risks as well as enhancement of banks'risk management quality.

Implementing international standards such as Basel III could give Indonesian bank regulators opportunity to fix such a market failure. Having said this, however, more than a mere implementation of Basel III is needed.

First, the liquidity framework should be implemented properly. It means that regulators should embrace qualitative parts of the standards advocating e.g. sound risk management governance, implementation of funds transfer pricing and continual improvement of stress tests. It also means that outflow assumptions for retail deposits in the calculation of the liquidity ratios (i.e. LCD & NSFR) should be significantly higher than percentages applied in developed countries with established safety network institutions. The higher outflows assumption will raise banks' liquidity buffer requirements.

In particular, application of higher outflow (i.e. around 25%, instead of Basel III’s 5% - 10%) would make Basel III accords even more relevant for banks in Indonesia and in other emerging countries.

Second, Bank Indonesia should increase minimum reserve requirements on CASA in order to arrest the externalities from accumulation of short-term retail fundings. Simultaneously, it also needs to decrease reliance on central bank’s standing deposit facility - hence lower FASBI rate! - in favor of more active open market operations (OMO) to siphon off excess domestic liquidity. The OMO would involve using central bank or government debt papers in repo (in case of liquidity injection) and reverse repo (liquidity absorption) transactions. 

Lower FASBI rate (or equivalently, wider standing facilities corridor) as well as more active deployments of reserve requirement and OMO tools will create a more conducive environment for money market developments, thereby enhancing monetary transmission, market discipline and liquidity.

Capital markets development would also get a boost from the above initiatives. Greater liquidity buffer and corresponding increase of IDR government bonds held by domestic banks will lead to moderation of foreign investors holdings. As per Dec 2013, foreign holdings account for  32.54% of total rupiah government bonds, higher compared to countries selected below (perhaps highest in the region). 

The recent experience has shown that decline in foreign ownerships - partially due to uncertainties concerning the US Federal Reserve’s tapering to its asset purchase program - has contributed to domestic liquidity squeeze. 

In short, greater holdings of the IDR government bonds by Indonesian banks - due to Basel III requirement and, perhaps, reduced attractiveness of the FASBI - could raise the resilience of the government bond yields and local currency.

Concluding remarks

I believe banking reforms in liquidity risk policies are necessary not only for reducing negative externalities but also for stimulating long-term saving; revamping competition; improving income distribution, monetary policy and financial markets depth.

Proper adoption of global regulatory initiatives would likely result in either higher saving interest rates, or a greater share of time deposit in total funding. In either case, banks' cost of funds will inch up, but the quality of liquidity risk management at firm and macro levels will rise up to the global standards.