Relevance of Basel III and quality of implementation

The Basel Committee’s latest semiannual report shows progress by majority of Basel members in implementing new capital standards (4 April 2013).

However, timely implementation does not mean quality implementation.

Quality concerns can arise from lack of interest as well as from deficient institutional capabilities. In some rapidly growing emerging countries, the Basel III accords as well as other related prudential initiatives (e.g. on compensation, Living Wills, SIFIs charge, etc.) are not (yet) considered attractive or relevant by bankers & regulators alike. That Basel III is not a live agenda has also impacted negatively the necessary (operational) capacity building with regard to policy making and execution.

As stressed in many preceding posts, there is no better time than now to adopt the various global regulatory reforms in Indonesia (and in some other large emerging countries). For example, it is an opportune time for Indonesia's micro and macro prudential authorities to introduce higher capital and liquidity requirements when the profitability of the banking sector is being strong, in the backdrop of high loan growth, robust domestic demands and relatively favorable commoditiy export markets.

Even in 'bad' times, banks have ability to adapt to more demanding regulations without harming the wider economy according to this IMF study.

...but also a quality issue with the Basel III rule itself
One of Basel III's most relevant components is related to the the liquidity standards. Unfortunately, in January 2013 the liquidity rule (e.g. LCR) is made less rigorous with respect to retail funding.  The new rule says liquidity must be enough to cover a 30-day run on insured retail ("stable") saving deposits of 3 percent, instead of 5 percent.

Basel III's LCR is introduced to improve the short-term resilience of banks' liquidity risk profile under the assumption of a combined idiosyncratic and market-wide stress scenario. A higher run-off factor would force banks to hold high quality, but low yielding, liquid assets; or to reduce the share of demandeable deposits in the total retail funding in favor of more expensive time deposits.

In developing countries, if a medium-size bank is rumored to face solvency or liquidity problems, deposit run-off rate is likely to be very high, much higher than 5%; not in a 30-day horizon, but perhaps already in the first week. The run-off rate is even higher when more banks are said to be in trouble.

Frankly speaking, even a 30-day run-off factor of 10% for “stable” saving deposits is too low in many jurisdictions.

We have learned from the recent Cyprus crisis that the value of the deposit guarantee scheme is linked to creditworthiness of the government that is implicitly or explicitly backing it. Deposit guarantees would lose credibility when the government capacity to meet its obligations is in doubt.

The Basel III committee has actually anticipated the importance of idiosyncratic differences among member countries as it underscores the 'quality' aspects of implementation, for example from paragraph (77):

"Jurisdictions applying the 3% run-off rate to stable deposits with deposit insurance arrangements that meet the above criteria should be able to provide evidence of run-off rates for stable deposits within the banking system below 3% during any periods of stress experienced that are consistent with the conditions within the LCR."

That said, empirical evidence on the customer deposit run-off during stress conditions (e.g. IMF, 2012) and experience in recent months indicates that the 3% run-off rate as an anchor is rather optimistic, if not misleading.

Some emerging countries should really subject 'stable' deposits to much higher outflows to capture sovereign risks and weak legal enforcements, transparency, public awareness of deposit insurance etc. It underlines the importance of quality reviews and regulatory consistency assessments also with regard to the implementation of the liquidity standards.

The unique case of Indonesia

Because of its particular features of its deposit guarantee scheme, Indonesian banks continue to accumulate retail saving deposits at the expense of more stable time deposits. Due to the very low saving interest rates, Indonesian banks have increasingly used CASA (current account and saving account) ratio as a key performance indicator. The chart shows the rising share of CASA ratio especially in the last three years.

                          Source: Bank Indonesia, Basel2risk.org

From an individual bank’s point of view, higher CASA is good for its profitability. But from the public interests’ point of view, the race for CASA will amplify the systemic liquidity risk because CASA is off course comprised of deposits that can be drawn down on demand.

The development shown in the chart is a form of maturity rat race as banks do not commit to limiting maturity mismatch (without government intervention). It is also a classic example of a collective moral hazard as banks do not fully internalize the social costs of systemic funding risks. The Basel III liquidity rule is expected to mitigate the collective moral hazard by giving more incentives for longer term time deposits.

For this reason, the liquidity rule is particularly relevant for the case of Indonesia because it reminds both bankers and regulators of the need to manage funding risks and to pursue the macro-prudential supervision, respectively.

To align the liquidity rule with the conditions of Indonesia's banking sector, I would suggest (at least) a 20% run-off factor for “stable” deposit and 30% for "unstable" deposits. The rates might be decreased upon sound regulatory arguments supported by proper empirical evidence as well as after fixing the deposit guarantee scheme.

Compare this with outflow rates now being pondered by the EBA for the EU.

Implementation of Basel capital standards in Indonesia and (dis-) incentives for better risk management

Just a few days before the closing of 2012, Bank Indonesia supplemented its capital regulation with further guidance on the Pillar 2 processes.
In doing so, it marked the completion of the Basel II adoption in Indonesia. This is good, isn't it?

The Pillar 2 process is essentially the second phase of Basel II and involves an assessment of the additional capital that is required to mitigate those risks that are not adequately covered in Pillar 1.

The following table shows the new minimum capital ratios within the Pillar 2 framework:

Risk-based composite rating (composite of risk, profitability, capitalization and governance scores)	Required capital  (the minimum 8% + % add-on)
1	8%
2	9%
3	10%
4 – 5	11% - 14%

According to this new regulation, capital add-on is linked to a composite rating of inter alia: risk profile, profitability, capitalization and quality of governance. Hence institutions with a composite rating “4” should have a higher capital ratio than institutions with a composite rating "3" et cetera.

Is it a sound approach?

When this blog was launched over four years ago, the idea then envisaged was to share resources and experience about implementation of the Basel II accord with an emphasis on its Pillar 2. One of the thoughts or concerns was that Pillar 2 practices had been widely varying among early adopters- especially for the internal capital adequacy assessment process (ICAAP). The ambiguities and lack of standards would not help later adopters to interpret the depth and implication of Pillar 2 requirements, leading them to adopt a less robust approach instead.

The issues that I want to highlight now are related to the problematic use of the risk-based bank rating (RBBR) as determinant of the minimum capital adequacy ratio (CAR) and the inadequacy of the new rule to advance risk management practices and encourage sufficient capital buffers over the minimum requirements.

I also argue at the end of this post, that the minimum ratio for Indonesian banks should be much higher if the industry wishes to apply fully and thoroughly Pillar 2 of Basel II and all capital buffers under Basel III. After all, the regulatory minimum in good times must substantially exceed the minimum standard in bad times.

But first of all, I turn now to the use of BI's composite rating approach as key part of the new capital regime.

Drawbacks of the risk-based composite rating approach

The main concern with the use of the composite rating is that it is less useful for capital adequacy assessment because in practice, it unlikely becomes an integral part of banks´ risk management system and day-to-day decision making process. Such a scoring card system has been used in the Netherlands for example, basically as a first input to perform peer comparison and prioritize supervisory efforts (see APRA or Bank of Spain for a similar approach). Such a model is also used for strengthening the ability of supervisors to make better judgment and take effective actions.

Even as a supervisory tool, BI's composite rating model needs to be improved in a number of areas.

Firstly, it should explicitly account for interest rate risks in the banking book, which is one of key Pillar 2 risks, and also liquidity risks.

Secondly, the model should rely less on historical financial ratios. The current approach would not be responsive to changes in risk conditions and is not very forward looking. Today's banking supervision has drawn lessons from the financial crisis by paying more attention to the story of the future, i.e. business models, strategic choices, behavior and culture of a bank. Traditional financial ratios are deficient because they tell an old story.

The use of profitability ratios for example as an important determinant of the rating is suspect as long as the front-loading of banking earnings is enabled by the current accounting regime. The current global financial crisis shows how higher profitability in the banking industry is often obtained by relaxing underwriting standards, taking liquidity risks or levering up.
Even the forward looking provisioning regime currently in consultation could only partially mitigate the short-run orientation of the profitability ratios.

Last but not least, the composite rating as a basis to calculate capital add-on provides reduced incentives for advanced risk and capital management, to which we now turn.

Need of more direct links between specific risks and capital coverage

The objective of risk sensitivity championed by the Basel II accord could be better achieved by banks specifically establishing for which risks a quantitative measurement is warranted, and for which risks qualitative factors are dominant and to be mitigated using risk management tools. A lesson from the recent financial crisis is that a bank failed especially due to its overweight exposure to idiosyncratic material risk (eg. liquidity risk, concentration risk in real estates and excess credit growth).

As we all know, Basel II identifies three major risks to be covered by Pillar 1 capital: credit, market and operational risks. Accordingly, for the Pillar 2 framework, assessment and capital coverage of non-Pillar 1 risks should continue to be direct and transparent just like under Pillar 1.

Pillar 2 risk types need to be identified as relevant and material for a given bank. Subsequently, the material risks need to be quantified and backed with an adequate amount of economic (or ICAAP) capital, according to models that are appropriate for the size and complexity of the bank (ie. risk based, bottom-up assessment).

The following figure shows an example of how each relevant material risk type is accounted for in an ICAAP:

Source: The Austrian guidelines on ICAAP (chart 15)

The key point is that bespoke methodologies to determine capital needs for each risk type, as illustrated in the chart, would incentivize banks to link risk models and capital management more closely, leading to a better risk capture.

Furthermore, such ICAAP can be used operationally to set risk limits, capital allocation over business units, performance evaluation (eg. risk adjusted performance measurement, RAPM) and other risk management applications.

Highlights of alternative steps to calculate risk capital can also be found in e.g. papers by EBA/CEBS, Bank of Finland and Bank of Spain. For the European banks perspective, see here.

Explicit capital targeting above the minimum capital ratio should be part of the ICAAP

The rule stipulating the minimum capital requirement can lose its relevance as prudential measure because available capital to meet the minimum capital ratio cannot be used to absorb losses (Goodhart 2010).

Therefore, a sensible institution would maintain capital buffers over and above the regulatory minimum to be consistent with banks’ risk appetite, growth ambition, external factors or reputation enhancing objectives (such as high credit rating). In the case that capital ratio falls below the internal capital target due to rapid growth, etc., a sound bank would consider in its ICAAP document a realistic and prudent plan for returning to their capital target.

In many jurisdictions, the UK for instance, capital buffer above a total of Pillar 1 and Pillar 2 capital should also be in place so that regulatory capital requirements continue to be met even in economic downturns.

Link to Basel III

Basel III is essentially a reform on the Pillar I of the Basel II framework. Hence, pillar 2 process will continue to embody the spirit of Basel II/III. 

In the ICAAP, capital target ratios should also be calculated using Basel III parameters, at least within the context of migration to the Basel III end-states in 2019. By doing so, the ICAAP could help pave the way for implementing Basel III before its implementation is formally effected (between 2014 - 2018).

The rationales and ramifications of Basel III will be better understood by the banking sector if they have performed a sound ICAAP and established appropriate capital targets to cover their specific risk exposures, external factors, business plan, and stress testing. In fact, capital targeting and capital planning have been partially formalized in Basel III’s capital conservation measures that generate buffers for bad times (see further in the last part).

Summary

The central tenet in the above commentary is that even a bank perceived to have the lowest risk profile according to the composite rating model still needs to perform capital attribution per risk type, comply with its own internal capital target over the minimum capital ratios and demonstrate that its own fund is adequate according to supervisor's and its own firm-specific stress tests.

Sound implementation of Pillar 2 could foster risk management standards, as banks would make important strides in developing their capital adequacy procedures.

The use of composite rating to determine capital add-on could hold back the necessary transformation in the banking sector, which is desired by the Basel II/III accords: to improve risk management, to better align risk with capital needs - and although emphasized only recently - to strengthen financial stability and reduce moral hazard.

A more direct, specific and transparent framework approach for risk capture along with respective capital attribution as mentioned above would compel banks to understand their risk drivers and further intensify their risk management efforts.

Within the interim period up to 2019 when Basel III reaches its end-state, a full and sound Pillar 2 process is suitable to tackle possible gaps in capital and liquidity adequacy in the Indonesia banking sector.

Future direction of capital regulation in 2013 and beyond

So it seems obvious that we need to have a more risk-sensitive capital regime and thereby incentivizing the adoption of state of the art risk models, when applicable.

A more fundamental requirement eventually however is to ensure that Indonesia banks remain adequately capitalized also during difficult economic conditions. 

The banking sector is currently highly profitable. In particular, domestic systemically important institutions (D-SIFIs) have managed to sustain profitability - staggering by international standard - on the back of implicit government support and rapid loan growth. In my view, the high profitability is providing an ample incentive for banks to maintain a high level of capitalization in order to protect their franchise, thus even without minimum capital standards.

This highly profitable episode that has been aligning interests of shareholders, bankers and taxpayers could end in face of less conducive economic, regulatory, funding/liquidity and competitive environments. The potential for a misalignment of interests among stakeholders is also a feature of financial stability risks. Unfortunately, despite this being a central theme of the global regulatory reforms, you do not hear much in Indonesia about the risk of moral hazard from the rise and fall of banks.

That is why, future revisions of the capital adequacy regime should ensure that the required Pillar 2 capital add-on can capture:

a. Country specific risk  (2% point) associated with Indonesia being an emerging economy, etc.;

b. Institution specific risk capital add-on based on a proper Pillar 2 process (say 5% point). This will foster the link between day-to-day risk and capital management;

c. Specific capital add-on for systemically important bank (eg. add 1.5% point). See for a Swiss example here and for why bigger banks should hold a greater capital buffer here ;

d. Basel III's capital conservation buffer (2.5%);

e. Basel III's countercyclical buffer (0% - 2.5%).

In this case, the 8% minimum capital is amplified by a summation of: 2% (systemic risk) + 5% (individual Pillar 2 charge) + 1.5% (in case of systemic banks) + 2.5% (capital conservation buffer). Hence, 19% in total.

Such an enhanced capital regime would have combined the intents and insights of the global financial reforms comprising of a proper implementation of Basel II Pillar 2 and full implementation of Basel III. 
For international comparison of add-on percentages over the regulatory minimum, see here and here.

Under this enhanced capital regime, a normally profitable, most robust, systematically important Indonesian bank which is currently operating in an average credit growth environment could face a minimum CAR of 14% (i.e. 8% + 2% (country specific) + 2.5% (conservation buffer) + 1.5% (systemic buffer)). 

In a scenario that the same bank turns reckless during a credit boom period, the minimum CAR could rise from 14% to 21.5% due to:

* deployment of the countercyclical buffer of 2.5%;
* additional capital charge of 5% - for example because it is running a highly concentrated credit portfolio combined with material interest rate and liquidity risks.

If the capital regime just announced turns out to be too meager, is a considerably more prudential capital framework achievable and sensible?
The answer is yes because average commercial banks CAR has already exceeded 17% for some time (CEIC).

In good times like now, why not just seize the global momentum to introduce a capital rule that also arrests incentive distortions and moral hazard risks? 
After all, profitable banks will welcome a more risk sensitive and conservative capital regime because they want to keep their banking franchise sustainable.

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)

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...

Consultative Paper Basel III in Indonesia: Preliminary inputs

The consultation period is closed but the commentary is available on request.

Beware of 'addiction' to thumping returns on equity in the banking industry

Top Indonesia’s banks continue to get stiff valuation after posting strong profits in H1 2011. To illustrate its exceptionality, I gathered price to book ratios (PBV) and returns on equity (ROE) of three largest Indonesian banks (total market share > 35%) and largest banks from emerging G20 countries experiencing strong economic growth: Brazil, India and Turkey. I also added data from three largest Malaysian banks (Malaysia being Indonesia’s peer despite having much larger financial sector) and data from several world’s largest banks.

The ratios are widely used in analysis because the book value of equity in a bank is given more weight than in other sectors due to market-to-market and regulatory capital rules. Book value as the denominator in PBV is also much less affected by the economic cycle than earnings as the denominator in price/earnings ratio.

The upper graph below clearly shows that the three largest Indonesian banks' PBVs are much higher than banks in some of today’s hottest banking sectors.

PBV of “1” means that you can buy banks close to its liquidation value, which is not bad. Historically, top banks were considered cheap when they were priced around book value, and expensive when they trade for two times of the book value and higher.
With PBV lower than 1 (except JP Morgan), world’s largest banks are still being penalized either for credit quality trouble or low returns. Some investors out there might also hold skepticism over their business model, or accounting used to arrive at book value.

The Indonesian bank stocks in this comparison hence look very expensive indeed and probably not priced for any disappointment like inflation or problem loans being much higher than expected.

The lower graph shows high ROE of Brazil's and Indonesia's top banks with Bank Rakyat Indonesia (BRI, the second largest Indonesian bank) handing down a walloping return on equity of nearly 39%. Note that high returns have been around for sometime in these countries (not shown in this occassion).

To put the exceptional profitability of Indonesia’s largest banks in an economic cycle context, consider the following excerpt showing shareholder returns of largest banks in the euro area. Average return on equity of largest banks in euro area was ‘only’ about 15% during the credit boom years.

                            Notes: * Based on available figures for 20 IFRS-reporting large and complex banking groups in the euro area
                                            * See European Central Bank, Financial stability Review, June 2011, table S5.

Profitability under upcoming regulations 
The central bank (BI) has recently introduced a Prime Lending Rate disclosure requirement. This is a welcome initiative (though not yet a game changer) that would improve transparency and market competition.

As is well-known, high NIM has been a key driver of Indonesian banking sector's profitability. Despite a relatively competitive market structure (btw, not necessarily competitive behaviour), the NIM of large banks, in particular, has stayed high thanks to low-cost current and savings accounts, or CASA, which make up a large portion of banks' core funding. 

Unlike (big) debtors and depositors, savers have a limited price awareness and likely put up with low saving yields. While lending rates might fall thanks to improved disclosures, compensation to saving public remains low, or might be pressed further down as banks attempt to retain their high NIM. Lack of saving rates transparency and obstacles to switching accounts do not help to raise responsiveness to saving returns.

Enhanced consumer education and protection can counter some of the forces behind the high returns on equity obtained at the expense of other stakeholders, i.e. savers/depositors.
Future regulatory landscape would also erode the advantage of CASA. For example, under the new liquidity standards of Basel 3 - CASA will receive less favorable weight as compared to time deposits. This means that cost of fundings is going to rise provided a proper implementation of the Basel 3 standards.

What goes up must come down
The supercharged profits and valuation in Indonesia are partially for the right reasons. Growth data looks healthy and inflation has dropped for six months. On the other hand, the stellar performance in the financial industry has been enabled by short-term capital inflows, commodities export boom and also, loose regulations permitting banks to take on more asset and liquidity risks. The issue being flagged here is the danger of taking unnecessary risks due to an 'addiction' to unusual returns on equity.

Business conditions can be less benign or hit by unexpected event as such that without a closer supervision, bank managers may choose to load up on riskier, high-profit margin loans to dodge downward pressures on the return on equity. Other scenarios are possible as well. When lending rates decline due to lower risk premium and optimism, lenders might also increase risk taking in 'search for yield', which can cause trouble if they search too hard for it.

A very insightful case study on the failure of Northern Rock shows among others how the bank sustained its high return on equity by increasing leverage, employing a more aggressive funding model and resorting to a higher overall risk profile as credit margin fell and regulators were getting complacent.

A small case study on failure to grasp the basics of value creation

The huge profit growth does not only belong to large Indonesian banks. One small bank, Bank Mutiara (yes, formerly known as Bank Century that was rescued by Indonesia’s Deposit Insurance Corporation - LPS) has recently released dazzling figures, posting a 247.8% profit surge. Its company website reports ROE of over 58% in H1. On the other hand, its capital adequacy ratio fell to 9.3% (very low) from 12.8% (low) a year before while its breach with the central bank’s large exposure rule was reportedly much higher over the same period, indicating higher concentration risks.

The owner, the aforementioned LPS, seeks to sell the bank in August 2011 at more than 8 times book value of equity!

With that last minute credit acceleration, the bank has tried too hard to impress would-be investors. The rapid credit expansion before the target date of divestment is planting the seeds for failure down the track. I believe Bank Mutiara and LPS should come up with a more credible, longer-term divestment strategy instead, since the talking of sale target this year and the hiring of financial advisors are actually quite a waste of time and money. 

The flawed focus on short-term performance measures reminds us of the famous interview with Jack Welch, who is regarded as the father of the “shareholder value”. Mr. Welch said that “…short-term profits should be allied with an increase in the long-term value of a company. On the face of it, shareholder value is the dumbest idea in the world,”. Furthermore, “Shareholder value is a result, not a strategy .. . Your main constituencies are your employees, your customers and your products".

In a nutshell, Bank Mutiara should have no delusion of being capable of creating shareholder value in a short period of time by bolstering income through overextended credit growth.

Concluding remarks

Following the bail-outs in response to the 2008 financial crisis, the public in the U.S and Europe has questioned if the supranormal return on equity was really something bankers should be proud of, if it had been obtained by repressing deposit rates, charging elevated lending rates and service fees, or just exploiting expectations of government support through excessive risk taking and size expansion.

Valuation and profitability of several Indonesian banks are staggering. Based on early warning signals, the regulator should be alert on the sector's drives to sustain the excess profitability by engaging in highly risky entrepreneurial activities on the back of perverse incentive schemes that include excessive bonuses and compensations.

Especially the pursuit of a profit in the short run is not consistent with the stability that especially systemic banks should be about. We know that de facto, large banks will be protected by the government since the damage to the economy caused by their failure would be too great. Even a bank as small as Bank Mutiara might be supported again by public funds in case of another failure.

The banking sector's excess profitability or an appearance thereof can also lead to misallocation of scarce resources.

Think of the latter in terms of high-talented young engineering graduates going into the financial sector as it pays much higher salary than engineering and manufacturing sectors.
The importance of fostering employment in production-oriented sector and new economic activities is substantiated by Dani Rodrik (2011) here.

Closer supervision and adoption of sound regulatory standards might make Indonesia’s banking sector less lucrative eventually, but the country will have the benefit from having fewer bank failures and more sustainable economic growth.

Regulators can't be complacent, especially now

Former Fed chairman Alan Greenspan recommends that "regulators must risk more to spur growth" (FT 26 July 2011). Still calling for loose regulation, Greenspan does not appear to have changed his minds after all....

Weighing growh and financial stability risk trade-off
In emerging economies, financial sector deepening through deregulations is an important growth strategy. Greater financial intermediation is expected to improve economic allocations and enhance central banks’ monetary policy transmission mechanism, among others. 
Nonetheless, financial deepening causes economic growth as long as the relationship is not exploited (Rousseau and Wachtel, 2007). Too rapid credit growth would actually weaken banking system.


In Indonesia, the main cheerleader for the currently above average credit growth is the central bank itself through its loan-to-deposit (LDR) regulation, where banks with LDRs falling outside a targeted range face higher reserve requirements. As noted elsewhere in the blog, such jawboning would easily tempt banks to relax their underwriting standards or saddle (smaller) banks with liquidity constraints.

Having been exposed to several headline economic and banking crises, I support the premise that closer regulation and supervision of banks will do more good than harm. A loose or exceedingly pro-growth financial sector policy tends to inspire perverse behavior. The consequences of greed on judgment of bankers, informational asymmetries and the asymmetry between private gains and socialized losses are among many good reasons for a close regulatory supervision of banking and finance.

Indicative of pervading complacency in Indonesia is the sector's refusal to adopt the Financial Stability Board (FSB) recommendation on sound compensation practices. Both the banking sector and the regulator underplay its relevance arguing that compensation level hinges on market conditions and should be up to shareholders to decide.
That is exactly the misplaced view that had prevailed before the 2008 crisis. While the concerns about the cost of salaries to the banks are for shareholders to sort out, the bonuses tend to reward short term payback and do not sufficiently penalize long run losses. It is squarely the business of the regulator when there are concerns that bankers have incentive schemes that lead to unnecessary risk taking with the public money. It seems for now Indonesia's regulator passes the opportunity to promptly benefit from the global momentum of reform in this area.
To give idea of executives' compensation level and bonus structure in these days, here. FSB is currently finalizing its second peer review on remuneration practices in the G24 group as reported here.

Need for narrowing the regulatory gap
Strong profitability of Indonesia's banks and confidence gained out of the success to escape from the financial crisis might account for the delayed adoption rate of the global regulatory initiatives including Basel II.  This is not unique to Indonesia since delayed implementations are more of the rule than the exception in the case of developing countries. With the introduction of Basel III - with Europe leading the pack based on the recent opening for the CRD IV consultation - the regulatory gap is set to widen even more.
For a survey of the regulatory gap between developed and developing economies, see Young Cho (2010) paper published in the ICFR website. For a summary of CRD IV by Cicero-Group, here.

Different pace of adoptions will create an unlevel playing field but could also form a regulatory arbitrage risk that may destabilize regional or global financial systems. One might argue that emerging economies’ financial sector is relatively small and domestically oriented, mitigating the risk concern. Again, the point is that financial sector is different from other sectors. Due to the ease with which losses can spread through the financial system in increasingly interlocking economies, regulatory developments should be subject to certain standardization and harmonization.

Vigilance called for (especially now)
Contrary to Mr. Greenspan’s emphasis on the primacy of unfettered markets and self-regulation in the financial sector, tight banking regulation and supervision must be sustained instead.

Indonesia's banking sector is presently having a good time, evidenced by high profitability, very easy financing conditions and bullish stock valuation - probably among the highest in the G20 countries! 
Under Basel III, regulators can solicit to operate the countercyclical buffer to discourage credit excesses at this point of economic cycle. Without Basel III, Bank Indonesia (BI) could fall back to other prudential measures on the menu (e.g. lower loan-to-value ratio, higher reserve requirement, remuneration policy).

Above all, BI should be prepared to ‘take away the punch bowl just as the party gets going’ (William McChesney Martin about the art of central banking).