Improving bank efficiency through competition

Nurkholisoh Ibnu Aman , Surabaya | Mon, 07/13/2009 9:42 AM | Opinion

Banks in Indonesia are being heavily criticized for being too slow to respond to monetary policy and for showing inefficiency in intermediation roles. Despite the aggressive cuts of the Bank Indonesia (BI)-rate in the past five months, banks remain reluctant to adjust lending rates.

In comparison to December 2008, the BI-rate has been lowered by 225 basis points (bps), while the deposit and lending rates of banks went down only by 135 bps and 20 bps respectively.

As a result, the gap between the deposit rate and the lending rate is increasing. Banks are now actually collecting higher revenue from wider discrepancies.

To explain the behavior of such banks, we need to understand the cost structure of loanable funds.
The first component is what is usually termed as the “cost of fund”, i.e. the interest paid to deposit customers for third party funds placed in banks.

The second component is the overhead cost, such as personnel and general administration expenses. Next in the cost structure is “risk premium”, and the final component is the expected profit. The challenge is that it is difficult for banks to cut these cost drivers in times of financial crises.

Deposit customers insist on getting fat interest from their money despite the declining trend of policy rates. These customers might be small in number, but usually hold the majority of the third party funds in banks. To maintain liquidity and avoid the flight of funds, banks are forced to offer high interest rates to these “prime customers” even if it means higher cost of funds.

At the same time, banks themselves demand a higher “risk premium” to compensate for higher risks in the economy as the crisis unfolds. Debtors begin to miss their repayment schedule and the future still looks uncertain. Banks decide that they need to accumulate more revenue to “cushion” the turbulent period ahead.

Another challenge comes from bank shareholders who are reluctant to take a cut in their dividends. A stark contrast to the real sector, the economic crisis has not stopped banks from making a profit. In the first quarter of 2009, the overall banking sector managed to post 28 percent of a profit increase compared to the same period last year.

However, a more fundamental explanation of the behavior of such banks is the lack of competition in the financial market. Compared to the region, the Indonesian financial sector is relatively underdeveloped and highly bank-dominated. Almost 80 percent of financial assets in the country are managed by commercial banks.

A deep and broad financial market is desperately needed to provide additional and alternative financial services. A strong capital market, for instance, will act as a competitor for banks and help create a more efficient mobilization of funds between savers and borrowers.

Capital markets can offer a more attractive placement of funds for savers and thus relieve some pressures from banks. It provides an alternative for long-term savers such as corporates, insurance companies, and pension funds, who are seeking higher returns than what is normally offered by bank deposits. Banks will be freed from the demands of paying high interest and will therefore have a more efficient cost structure.

A well-developed financial market will also allow for better risk management through the aggregation of resources, allocation of risk to those more willing to bear it, and the application of portfolio management techniques that spread risk across diversified parts of the financial system. Again, this will help banks become more efficient by sharing the risks emanated from fluctuations in the economy.

A healthy competition in financial markets will also rationalize shareholder expectations. When banks no longer hold the dominant position in the market, they will become more flexible with changes in the business cycle. Shareholders must welcome both profit and loss as part of a natural business operation.

It is true that the on-going crisis is a result of financial innovation. But a deep and broad financial market apparently matters even more today. Both banks and non-bank financial intermediation need to be developed concurrently as they offer important synergies.


The author is an economist at Bank Indonesia. This article is his personal opinion.