The Latent Dangers of Tight Liquidity
Liquidity is palpably tightening in markets. Interest rates are being increased to attract liquidity into banks. A war of high interest rates will involve big banks at first and then spread to smaller ones.
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Liquidity is palpably tightening in markets. Interest rates are being increased to attract liquidity into banks. A war of high interest rates will involve big banks at first and then spread to smaller ones.
Banks will then engage each other in an open guerilla fight for third party funding (DPK) with higher interest rates.
Will there be banks that deplete all of their liquidity end up being abandoned by their clients and shut down? It is not be easy to predict such outcomes. However, experience teaches us that bank closures always begin with liquidity drying up and their clients abandoning them. The trigger is an outflow of foreign funds, leading to a sharp interest rate hike to prevent further capital outflows.
Word of mouth spreads quickly about banks that lack liquidity – and this will immediately affect client trust. Customer psychology will then prevail and all formulas on pride-inducing macro indicators will soon be nothing more than sweet words. Based on the Indonesian experience in the 1998 crisis, all economic indicators were healthy in 1997. Even the World Bank deemed our economy stable back then.
Hard times in Indonesian banking always begin with liquidity troubles. In 1997, the Indonesian government took International Monetary Fund (IMF) advice to close down 16 banks. This closure of 16 banks without any guarantee program triggered widespread panic. Frightening rumors about which banks the government would close next loomed large. In such conditions were the Rp 144 trillion (US$9.67 billion) of Bank Indonesia Liquidity Support (BLBI) funds distributed.
Conditions were similar in 2008. InfoBank Research Bureau record showed 23 banks with tight liquidity of Rp 18 trillion in DPK. Based on the 1998 experience, the government decided to rescue Bank Century with a fund injection of Rp 6.7 trillion to prevent any chain reaction leading to widespread financial difficulties. As it turned out, the fund injection was a success.
However, things are not as easy this time around, as banks with liquidity troubles could not automatically obtain short-term loans from Bank Indonesia (BI) as the lender of last resort. Currently, banks with liquidity troubles are required to secure funding on their own.
The government and state-owned banks and enterprises (SOEs) that have always put their money in such banks may withdraw their money at any time. Such immediate withdrawals of SOE money could accelerate the demise of banks. SOEs may decide to withdraw their funds as, if anything is to happen with these banks, the SOEs will have to face questioning by the legislature. What’s more, ahead of next year’s legislative election, lawmakers are always looking for their “time to shine”.
This also happened in the Bank Century case, which kept a lot of dormant SOE money that generated huge interest. When the bank was declared at risk, the SOEs withdrew their money immediately. Such an experience happened again recently, when a bank was declared at risk. The bank owners ended up asking for help from a “private central bank” – which has always served as a savior for private banks having liquidity troubles, surely with interest rates higher than the market rate.
On the one hand, this is helpful. On the other hand, it is burdensome. However, it is the only choice for banks with liquidity troubles. Tight liquidity is also marked by a loan-to-funding ratio (LFR) nearing its ceiling. This means that the bank can no longer expand its credit as it can no longer obtain liquidity. Credit expansion faster than funding will only serve as a hurdle at a time when the environment is rapidly changing.
Source of the problem
Currently, the Indonesian economy is not that bad with growth of 5.27 in this year’s second quarter. This is quite strong. The rupiah is weakening but it is not like in 1998. Scores of analysts believe that, based on economic indicators, Indonesia is far from a crisis. However, the current account balance is in a 3.04-percent deficit compared to the gross domestic product. This is bigger than Thailand and Malaysia. Despite being far from a crisis, we should not be overly confident and weaken our defenses without preparing ourselves.
We need to realize that a storm is coming, with the crises in Venezuela, Turkey, Argentina and Pakistan serving as warning signs. The weather is worsening and strong winds are arriving, as shown in the drying-up of liquidity and the capital outflow in line with interest rate rises in the US. Amid the current tumults triggered by US interest rate hikes, capital outflow reached Rp 54.1 trillion. Compare this to the capital inflow of Rp 107 trillion in 2016 and Rp 170.3 trillion in 2017. Such a situation signifies scarce liquidity. Geopolitics and the US-China trade war also put pressure on global financial markets, which affect currencies’ exchange rates.
Tight liquidity is expected to continue until 2019, especially due to global factors including expectation of the US Federal Reserve’s federal fund rate (FFR) increase, which is triggering an interest rate war among banks.
Acute problem
InfoBank Research Bureau records show that, throughout Indonesia’s banking history, acute banking problems are always centered on liquidity. Every time there is turmoil, the first shock is always centered on liquidity. Among the liquidity troubles is that long-term loans are funded by short-term funds. Savings on deposit for up to 12 months, but mostly for only one or three months, are used to fund five-year loans or even 15-year housing loans. It is unsurprising that banks often suffer from mismatches. During market shocks, such as from an interest rate hike, banks will get “sick” quickly. Interest rate wars take place and, eventually, credit quality decreases as credit interest rates increase. Such patterns are embedded into Indonesia’s banking system, both before and after the 1998 crisis. It became deeper since the Pakto 88 with the 1991 tight money policy (TMP). Liquidity is an acute problem for Indonesia’s banks.
On the other hand, lending per gross domestic product is very low, at only 36-40 percent. More lending is needed for better credit deepening. However, banks have a high loan-to-deposit ratio (LDR) at 90-92 percent. Therefore, credit expansion requires more funding.
When the government plans higher economic growth through bank lending, the economic engine will get heated easily from interest rate hikes as funding runs out. InfoBank Research Bureau data shows that banks have been expanding in the past year as a result of the government’s infrastructure push.
State-owned banks have readily distributed credit and their LDR reached 94.3 percent in July. Signs of tightening liquidity are also found in private non-foreign exchange banks, the LDR of which reached 94.4 percent. Private foreign exchange banks, most of which are in the BUKU III and BUKU IV categories, are relatively healthy with an LDR of 90.3 percent. Regional development banks (BPD) have an LDR of 81.2 percent.
LDR conditions signify when banks require more liquidity, which may trigger an interest rate war. Like all wars, there is the strong and the weak. Nationwide, our banks’ conditions seem healthy, if we look at their capital adequacy ratio (CAR), non-performing loans (NPL), net interest margin (NIM) and return on asset (ROA). However, individually, each bank is surely different from one another. Some may win the competition and others may only be able to resolve their NPL while putting their hopes in the “private central bank” for an on-call deposit placement, which is costly and can be withdrawn at any time. Liquidity is fast-moving and the “flight to quality” law applies to banks. Under this law, clients will always move to better-quality banks.
Based on our experience in the 1998 and 2008 crises, anticipatory measures are important to face banks’ tightened liquidity. First, cease all loans until liquidity improves. This will immediately affect multifinance companies without group funding access. Currently, multifinance companies get their funds from banks and, as such, a loan cessation will cause difficulties. Second, continuously seek liquidity in order to maintain position and to be able to expand credit soon after the difficult times end.
Third, maintain an improving trend in loan quality, which has deteriorated in the past year. As of June this year, low-quality loans accounted for 8.33 percent of all loans. This was worse than the 7.33 percent in late 2017. Was this because of the blind expansion of 11.34 percent in 2018, with funding growth being only 6.89 percent? Fourth, if loans continue to worsen, banks should resolve this quickly, including by selling them to turn them into liquidity.
Fifth, banks should immediately improve themselves with regard to compliance. Experience shows that banks often disregard principles of governance. In times of crisis, this poor management will be exposed to the public, which will abandon these banks. Here lies the beginning of acute liquidity troubles.
Eko B. Supriyanto
Currently, a war for DPK using the most primitive of weapons, namely high interest rates, is taking place. The Deposit Insurance Corporation (LPS) has increased the guaranteed interest rate and banks have also increased their savings interest rates. Banks are currently in the “cash is king” era. Liquidity has yet to completely dry up, but seeking more liquidity will not be easy up to next year. Liquidity is becoming a latent danger for Indonesian banks.
These days, we are in an era of tight monetary policy. If the rupiah decreases further, some banks may encounter difficulties.
Everyone should maintain conducive conditions in line with the strengthening of our foreign exchange reserves, which are currently at US$118 billion, or 6.5 times our import needs. National banks are strong enough to weather this heating-up of the economic temperature, as banking conditions today are much better in terms of governance compared to how it was in 1997-1998. Despite the poor governance of some banks, in general Indonesian banks have sound business practices. Nevertheless, we should monitor the tightening liquidity as it is liquidity that is closely linked to banking clients’ psychology and expectations.
Eko B. Supriyanto, Director, InfoBank Research Bureau
