Thursday, March 2, 2017

Preparing for crisis, also for smaller banks!

A version of this article is published in the Jakarta Post on 14 March 2017

The OJK recently announced that it will issue a guideline on internal recovery planning for 12 systemic banks as part of efforts to shield the economy from a major bank failure. A recovery plan sets out the actions that a bank will take to restore its viability in cases of significant deterioration of its financial condition. The OJK rule on this subject - expected to be issue in April 2017 - is a supporting regulation mandated by the 2016 Law on Financial System Crisis Prevention and Mitigation (PPKSK).

The law effectively gives clarity and space to authorities when handling a banking crisis or a threat of it. Nonetheless, despite the better legal protection and clearer protocols, the PPKSK committee will unlikely have a comfortable time when a situation calls for their resolution authorities to be exercised.

To reduce the likelihood that intervention of authorities is called for, a comprehensive recovery plan is necessary: When near-default scenarios happened, what actions would a bank take? Where would it raise capital and liquidity? What businesses would it curtail or sell? How does it test its recovery options and if it sets and monitors early warning signs? What are the triggers to invocate certain recovery actions? How and when would the bank’s management communicate to key stakeholders?

Recovery plan is a special case of contingency plans such as funding contingency plans, business continuity plan, and disaster recovery plan. Recovery plan differs from those plans, as it focuses on severe scenarios when the bank is situated in the near default zone just before the point where resolution tool like bail-in bonds is activated. Bail-in bond is a debt instrument that is converted to equity when capital ratios fall to a certain threshold.

Obviously, to support the recovery planning process, the banks’ directors and top management should deploy dedicated resources. In some countries, banks’ chief executive, main commissioner and controlling shareholder must sign the recovery plan to show their commitment to it.
Hence, the initiative might cause bank executives’ apprehension as many concurrent and related regulations are already at work for example in relation to required submissions of annual business plans, risk based bank rating and stress testing results. After all, Indonesia’s banking sector is widely considered solid with its average capital ratio and profitability of the biggest players being among the highest in the world. If anything, the industry’s priority should be further directed for the handling of non-performing loans, for example.

Being a derivative of the PPKSK Law, recovery planning is indeed a compliance project as the plan will eventually have to be approved by OJK, perhaps after two or three rounds of supervisory revisions. The iterative process is necessary because in their first submission, most banks might not come up with a credible document that is considered by their supervisor as a useful playbook during a crisis.

That being said, according to our observation in other countries (i.e. EU member states), management and shareholder will find the exercise highly beneficial. Recovery planning had drawn together weak parts of their risk management that might currently be ineffective.

For example, we know that stress testing is an important tool to assess vulnerabilities at bank as well as at macro levels. However, its benefit for top management in providing insights and base for concrete actions is often found to be limited, partially due to its complexity and academic aroma. Recovery scenario testing will likely use the same methodology and resources for ordinary stress testing. In banks where integrated stress testing capability is already in place, the recovery plan requirement has not led to additional investment in automation and staffing. But the gain can be significant as stress scenarios in recovery planning have concrete benefits as a basis for improving components of the plan and existing risk management framework.

At any rate, the supervisory authority will likely tell banks to shore up their stress testing practices and integration into their risk management framework when preparing the recovery plan. A particularly helpful approach is for banks to use reverse stress testing as a starting point in recovery planning. This means that a bank will first define a point or magnitude of shocks that would lead to its failure, and then explore plausible scenarios that can cause it. In the process, the bank will not only draw insights about its (hidden) vulnerabilities but also possible measures that could effectively avert a breakdown of its business model.

Because of its considerable virtues, I think smaller banks should also prepare recovery plans - while appropriately taking into account their size, complexity, and nature of business. A lesson from centuries of financial history is that banking crisis is a constant, only its timing is variable. Sometimes, a failure of smaller player, say bank number 13 in the size ranking, can trigger a full-blown crisis. By the same token, an imminent failure of a small player might be considered having a systemic threat that a decision is made in support of a rescue using public funds.

While it is true that the state of the banking industry is stronger than ever, that conclusion is often based on average profitability and capital indicators. In an industry where confidence and interconnectivity are prominent, downward surprises can come from any (smaller) bank. There is a considerable advantage of having a banking industry that is strong on average and does not have contagious weakest chains at the same time. The existence of too weak players could unduly prevent the central Bank of Indonesia to apply a countercyclical macroprudential measure because otherwise, banks with weak financials and poor business models cannot keep up. They could also prevent the OJK from imposing greater prudential standards, or allowing a fiercer competition that benefits banking customers, e.g. lower lending rates.

Concern with the weakest links in the banking system is a key reason why all banks, unlike players in other sectors, face so-called minimum requirements for capital and liquidity. This being said, the ‘minimum’ requirements have an inherent problem in that it is sometimes too little and too late. The capital requirement for example is largely calculated from past snapshots such as last quarter’s risk positions.

That is why, with its strong forward-looking orientation, the upcoming OJK's recovery plan regulation will further strengthen Indonesia's banking sector. It can lead to early management and/or supervisory actions to deal with a significant threat of default and, as necessary, can trigger faster consolidation in the industry.

The initiative is so relevant for banks’ risk management that it should be applied to smaller players as well.

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