Preparing for future banking crises

"An overhaul of financial regulation .... will be a failure if we could not contemplate the failure of a firm such as Goldman Sachs" (said Federal Reserve Chairman Ben Bernanke). “That is, there needs to be a system by which Goldman Sachs will go bankrupt and Goldman Sachs’ creditors could lose money" (15 Feb 2011 Bloomberg).

While the intention to design such a system (a.o. living wills, bail-in mechanism) deserves supports, in practice, hurting creditors or permitting a bank to bust outrightly, let alone a big one, will remain a very rare decision. I still believe the current financial crisis was immediately set off by the collapse of Lehman Brothers and that the potential cost of its rescue would have been much less than the cost of the global financial crisis that followed, in terms of economic activity and public finance.


This said, rescuing a bank using public money would always be controversial. In Indonesia, we know the case of Bank Century, which, probably by hindsight, should have been liquidated instead because it was too small to trigger a systemic crisis, especially when the coverage of the deposit insurance was high enough to ease depositors' worry at that time.

Revisiting the lessons to be learned
A banking crisis can arrive anytime anywhere in current environments.  
In the last few days, South Korea's financial regulator has temporarily suspended seven savings banks to avert an overall systemic crisis (WSJ, 22 February 2011). 
Those banks have insufficient liquidity to meet a surge of withdrawals and inadequate solvency due to their exposures to the weak South Korean real estate market. The embattled saving banks have to solve their problems on their own or seek to be acquired by large commercial banks.


In preventing it from developing into a systemic crisis, the Korean regulator has acted early enough and found no need to involve public money. Though in a different stage and extent of savings banks crisis, similar responsiveness and decisiveness have been demonstrated by Spain's government in dealing with beleaguered  savings banks, 'Cajas' (FT) that are excessively exposed to the distressed property sector.

Spain's regulatory regime had received recognition for its prudence before the 2008 crisis (e.g. application of forward looking loan provisioning) - at least until recently - and I think its banking sector has defied additional pressures in the last few months relatively ok.

Of course, the Spanish case is not necessarily an ideal reference for the point that is being made here. For instance, the government may still need to nationalize Cajas if they fail to timely raise fresh capital. Or losses could turn out to be much greater than expected due to the severity of the real estate crisis.

On that note, allow me to underscore the lessons from the past and the recent experiences when contemplating possible banking crises in the future:


1. When bail-out decision is called upon, then it is two to midnight. The correct decision is most likely to approve the bail-out because the economic cost is likely to be lower and very often, the beleaguered banks tend to be deemed 'more systemic' in turmoil than in normal economic condition. Rating agencies (e.g. S&Ps) seem to have understood this rationale by planning to modify its rating methodology in order to give more weights to the state support rating component.
2.  But 'systemic' banks can also be too big to rescue. Irish banks for example turn out to be too-big-to-save for the nation's indebtedness capacity.

It follows from the above that any meaningfully sizeable bank (incl. small-medium size) in any country will likely be considered too big too fail, or too inteconnected to fail. But they can also tend to be too big to save, yes also in Indonesia. For guidance to assess systemic importance of banks, here.

The road ahead to find a system, such as the one desired by the Fed Chairman to avoid a Lehman Brothers redux is daunting. Although a resolution that imposes losses on non-common capital instruments is better than a bail-out that uses public funds, establishing living wills for the largest institutions, for instance, is a complex and multi-faceted undertaking (for a discussion on living will see here). We need more time and study to ensure that the wind down plans will work from the cost-versus-benefit perspective.

That is why, it is of paramount importance that regulatory institutions and policy makers employ robust early warning signals, promote prompt corrective actions,  and minimize sources of moral hazard in the financial system while they still can.... Because one cannot fight moral hazard when the financial sector is in turmoil.


In continuation to the points stressed in the previous posts, moral hazard and adverse selections should be addressed by appropriate institutional designs and policies. For example (no particular order), by an independent supervisory and monetary policy making body,  smaller coverage of deposit insurance & risk based deposit insurance premium setting, high quality of risk disclosures, sound corporate governance and remuneration schemes....


For a range of possible approaches the Fed Chairman might have in mind to offset moral hazard created by systemic banks, see an FSA's paper here

Deposit insurance scheme and hidden risks to fiscal and financial stability

Indonesia has a track record of prudent fiscal management prior to the global financial crisis and only introduced a modest stimulus in 2009 and 2010. With its fiscal position among the strongest in ASEAN (see below) and perhaps among emerging economies, Indonesian fiscal outlook is arguably not a hot topic today.

Source: Budina and Tuladhar (2010)

Yesterday's parliamentary briefing by LPS (Indonesia's Deposit Insurance Corporation), however, reminded us of potential fiscal risks arising from the curent deposit insurance arrangement, which were unfortunately left undiscussed. It appears that merely the case of Bank Century (the fallen bank controversially taken over by LPS in 2008) has fascinated the lawmakers and the media....

I am quite puzzled by, first of all, the still very high level of the current deposit insurance coverage. And it seems that the Ministry of Finance has voiced no plan to cut back the scope of the scheme and to refocus on protecting smaller depositors as intended by the 2004 LPS law (see its enclosed notes).

Assuming USD 1 = IDR 10,000 for convenience sake - today’s rate is about 9000 rupiah per US dollar - the insured amount is USD 200,000 since end-2008. This figure is high in relation to the Indonesian per capita income (now almost USD 5000 per annum) and also, compared to the median size of guaranteed customer deposits in developed countries (i.e. USD 130,000).

LPS and the state are close to offering a blanket coverage of retail deposits, which will eventually damp the risk senses of depositors and diminish incentives for banks to remain prudent.

Secondly, I am afraid LPS’ capital needs to be beefed up as a result of the expanded guarantee (from USD 10,000 to USD 200,000!) and considering that the fair value of its equity stake in the rescued and closed banks is less than the book value.

Note that according to the LPS law (2004), it is the Ministry of Finance that will provide liquidity assistance and/or equity injection should the LPS asset - reportedly about USD 2.25 billion as per end November 2010 - fall below its original equity amount (i.e. USD 400 million). With total insured deposits amounting to approximately USD 130 billion (about 76% of GDP), use of tax money would inevitably be solicited IF one or two small-mid sized banks collapses.

Moral hazard

The first issue concerning the large insurance coverage per customer gives rise to moral hazard. Moral hazard here arises when bankers run high risks, notably liquidity risks, and reap profits as they think the government will help if things go wrong.

The current financial crisis has taught us how the moral hazard problem is seriously damaging. The implicit guarantee and, very often, the underpriced funding (through its access to central bank borrowing facilities in combination with easy monetary policy) enabled banks in industrial countries to pursue above-average profitability targets and create conditions for excessive remunerations. See among other this BIS/Bank of England article surrounding the implications of the banking safety net.

The close relationship between the generous deposit insurance and banking sector profitability might also apply in Indonesia. A rigorous analysis on the topic is yet to be made but this news article says that Indonesian banks would book staggering profits for 2010.

Possible underfunding

Indonesia is recognized by the IMF as one of the pioneers in fiscal risk analysis among emerging market economies.

Nonetheless, banking crises (see the IMF new database) caused some of the largest fiscal costs arising from contingent liabilities and therefore should take a more central stage in the Ministry of Finance' fiscal risk statements. Implicit or explicit guarantees usually do not cost much. But when the guarantees are called upon, what they cost often come out as an ugly suprise.

Recall again the current Irish saga. Ireland is an exemplary story of rapid growth with high scores on competitiveness and macroeconomic policies, but now being overwhelmed by sovereign default threats since the government was (or felt) obliged to nationalize the banking sector, whose size was much larger than Ireland's economy.

If LPS is indeed underfunded, it is only fair and logical that the banking sector raises its contribution to LPS. It will not only trim down the fiscal risk but also the hidden risks to financial stability inherent in a banking sector that enjoys an implicit state guarantee, and low interest rates environment thanks to LPS' implicit customer deposit rate ceiling and central bank's stimulative monetary stance (see my previous post).

Furthermore, I believe that in order to moderate the identified moral hazard problem, LPS' insurance premium soon has to be set on risk-sensitive bases where lower rated banks pay more and banks perceived to be safer pay less.

On BI independence and Indonesia's natural rate of GDP growth

On 5 January 2010, Bank Indonesia decided to keep its main interest rate reference (the BI rate) at 6.5% because inflationary threats are deemed to come from supply fronts as reflected by surges of (volatile) commodity and food prices. BI believes and hopes (see the last paragraph of its published statement) that the government will address the supply side issues (e.g. production capacity and distribution system) to combat rising prices.

This line of reasoning needs to be checked once and again since BI might be overrating supply side issues and the importance to further enhance policy coordination with government in addressing them. I believe, in the long run, inflationary effects of supply shocks depend on propagation through expectations and inflationary inertia. If implemention of its inflation targeting is credible, this propagation can be limited. Getting involved too far in addressing supply side issues could weaken BI's focus and accountability.

BI should also retain its independence. In my view, holding up the economy via easy monetary policy now is not opportune and could discourage productive investment in sectors where productivity gains are high (industry, education, innovation) in favor of activities linked to credit (real estate, finance).

BI should employ instruments to tackle inflationary pressures at an early stage and guide inflation expectations. It also needs to look at its macroprudential tools chest to prevent (future) asset bubbles, which are currently indicated by surging real estate and stock prices. Raising rates rapidly later to contain inflation in a "leaning against the wind" mode can be detrimental to output and financial stability. To prevent expectations of higher inflation and bigger problems in the future, BI should send strong signal to investors. See for those interested, a review discussion on the timing of monetary policy measures here. Or a cautious view of monetary policy possibilities to prick bubbles here

The fact that the GDP growth rate is 'only 6%' in 2010 does not mean BI has a room to further boost economic growth by essentially over-encouraging banks to expand credits.

Though Indonesia's credit-to-GDP ratio is lower than neighbouring countries, it is the rise of the ratio above the trend (read: too high loan growth) that precipitates the most serious episodes of banking sector problems in the world. That is why the Basel Committee recommends using the trend in credit-to-GDP ratio as a major determinant of required countercyclical capital buffer in the future (under the Basel 3 Accord).

Given its institutional constraints, underdeveloped infrastructure and other supply related challenges, 6% maybe the natural rate of GDP growth for Indonesia at the present moment. Stimulating demand to achieve growth above that rate would only be inflationary and lead to external imbalances.

The central bank of Indonesia needs to focus on its principal objectives to maintain price stability and the stability of the banking sector. Trying too hard to alleviate long-term constraints with purportedly 'pro-growth' policies means planting the seeds of future financial crashes.

By pursuing a more credible inflation targeting, BI will give incentives to the government to focus more on its investment in infrastructure and institutional capabilities, shore up the fight against corruptions and facilitate technological innovations. For in the long run, all of that are positive for productivity growth (hence the supply side!) and will likely be associated with lower inflation (see e.g Mt. Kiley, 2003)

Challenges of Basel II implementation in Indonesia

After previous talks about the grand institutional and regulatory set up (re: discussion on OJK), lets step back for a minute and think about the challenges faced by the Indonesian regulator when Basel II is implemented (planned 2011 for Pillar 1). One way is to learn from experience in other countries having comparable conditions as Indonesia. The article describes the discussion before the Basel II era in India and several implementation challenges.

One of the pitfalls mentioned is related to the very limited rating penetration by external rating agencies. Moreover, ratings are often restricted to issues, not issuers.

Encouraging banks to adopt Internal Rating Based Approach is neither practical nor prudent, even for larger banks, which perhaps have staffs and infrastructure to carry out the program. If the banks are able, the question still is if the regulator has adequate capacity to supervise and validate rating models in the first place.

So, it will be sensible like in many other countries to require all banks to first adopt the standardized approach for credit risks and allow them to migrate to the IRB approach after several years.

This being perfectly understandable, implementation of Basel II will only be worth doing (in the Indonesian case after a delay of multiple years ...), if, among others, rating activities of external rating agencies are thriving and their quality of works is well overseen.

Today, Committee of European Banking Supervisors (CEBS) issues a guideline on the recognition of external credit assessment institutions. You know..., the track record and practices of ratings agencies have been heavily under attack. It is only proper that the supervisor starts to subject them to inspection mechanisms and better oversight.

While the need of more regulatory support for rating agencies sector is the main message of today's post, I find it equally important that Bank Indonesia has a framework to build national rating institutions according to good standards. Here is the mentioned CEBS publication.

Applying for Basel III without Basel II experience?

The final Basel III proposal, pending ratification in G-20 meeting in Seoul next November 2010 is expected to pose no problem for the Indonesian banking sector.

How true is this claim?

Unlike Basel II, which is more a substitute for Basel I, Basel III refers to a combination of the (revised) Basel II capital framework and the new global capital standards . For instance, the Pillar 2 supervisory process and the banks' own assessment of capital adequacy (ICAAP) will remain key elements of the Basel III framework. As indicated in a summary below, increased capital requirements under Basel III are still expressed in term of the risk weighted assets (RWAs) calculated according to the (revised) Basel II parameters.

Implementation of Basel III is aimed to considerably increase the quality of banks' capital and level of their capital. It is also intended to reduce systemic risks. Another important aspect is the introduction of new global minimum liquidity standards that promote banks' short-term resilience to potential liquidity disruptions. It also provides incentives for banks to use stable sources to fund their activities and thus address funding mistmatches. New because no such international standards currently exist.

According to the IMF's Financial System Assessment (September 2010, see my previous post), a full implementation of Basel II in Indonesia is expected from January 2014 and Pillar I from 2011.

It seems obvious to me that a full adoption of Basel II should precede the claim of 'compliance' with Basel III!

Unfortunately thus, key regulatory initiatives (such as Basel II/III) are often communicated as a matter of application of formulae and compliance with, for example, a minimum capital adequacy ratio (CAR). However, high CAR would mean much less for financial soundness of banks without adequate risk management standards including sufficient loan provisionings, sound valuation and proper disclosures. All of these elements would normally be inherent parts of banks' implementation of Basel II's Pillar 2 and Pillar 3 requirements.

Stated differently, we cannot jump into the Basel 3 world without Basel 2 experience...

The Basel Committee broadens its membership

On June 10, 2009, the Basel Commitee released the news that it decided to invite some key emerging economies to become members. Considering the extended delay of implementation of Basel II in many emerging economies esp. Indonesia, this news can be a boost to productivity for the central bank to release more implementation guidelines up to the standards of other (peer) regulators, in terms of quantity and quality of issued regulatory papers.

http://www.bis.org/press/p090610.htm

More sources on ICAAP implementation

Hi,
Some of Basel II team members/consultants will likely still be in constant search for variety of methods in dealing with Pillar 2 requirements.
Fortunately, more and more banking regulators are coming up with their own versions of the high level Pillar 2 guidance provided under Basel 2. Leaders of the pack are still the European regulators, (the British, Dutch, Austrian, Hungarian etc). In particular, Bank of Spain has come up with a more specific ICAAP guideline (2008). Another source is APRA, who issued specific guideline for interest rate risk in the banking book at end 2007. Most elaborate regulatory paper on interest rate risk in the banking book is issued by the Austrian Regulators here. Central Bank of Bahrain and the Reserve Bank of India are examples of regulators in developing countries who have issued their Pillar 2 directive in 2008.