Preparing Better For Crisis, Also For Smaller Banks

Preparing Better For Crisis, Also For Smaller Banks

Preparing Better For Crisis, Also For Smaller Banks

The Financial Services Authority (OJK) recently announced that it planned to issue a guideline on internal recovery planning for 12 systemic banks as part of its efforts to shield the economy from a major bank failure.

A recovery plan sets out actions that a bank will take to restore its viability in the case of significant deterioration of its financial condition. The OJK rule on this subject — expected to be issued in April — is a supporting regulation mandated by the 2016 Financial System Crisis Prevention and Mitigation (PPKSK) Law.

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

To reduce the likelihood of intervention by the authorities being called for, a clear and credible recovery plan is necessary: When near-default scenarios happen, what actions will a bank take? Where will it raise capital and liquidity? What businesses would it rein in or sell? How does it test its recovery options and does it set and monitor early warning signs? What are the triggers to invoke certain recovery actions? How and when will the bank’s management communicate to key stakeholders?

Preparing Better For Crisis, Also For Smaller Banks
Preparing Better For Crisis, Also For Smaller Banks

Preparing better for crisis, also for smaller banks

A recovery plan contains special case contingency plans, such as funding contingency plans, a business continuity plan and disaster recovery. A recovery plan differs from these plans in that it focuses on severe scenarios when the bank is at the near default zone, just before the point where a resolution tool like bail-in bonds is activated. Bail-in bonds are a debt instrument converted to equity when the capital ratio falls to a certain threshold.

Obviously, to support the recovery planning process, the banks’ directors and top management should deploy dedicated resources. In some countries, the banks’ chief executives, main commissioners and controlling shareholders must sign the recovery plan to demonstrate their commitment to it.

Hence, the initiative might cause apprehension in bank executives 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 the profitability of its biggest players is among the highest in the world.

If anything, some bankers might argue that 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 the OJK, perhaps after two or three rounds of supervisory revision. The iterative process is necessary because in the first submission, most banks are unlikely to come up with a credible document that is considered by supervisors as a useful playbook during a crisis.

That being said, according to our observations in other countries (e.g. European Union member states), managements and shareholders will find the exercise highly beneficial.

Recovery planning actually draws together weak parts of risk management that might currently be ineffective.

At any rate, the supervisory authority will likely tell banks to shore up their stress testing practices and integrate them into the risk management framework when preparing a recovery plan.

A particularly helpful approach is for banks to use reverse stress testing as a starting point in the process.

This means that a bank will first define a point or magnitude of shock that would lead to its failure and then explore plausible scenarios that could cause this. As an end result, the bank will not only get insights about its (hidden) vulnerabilities but also test possible measures that could effectively avert a breakdown of its business model.

Because of the 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 crises are a constant, only the timing is variable.

Sometimes, the failure of smaller player, say bank number 13 in the size ranking, can trigger a full-blown crisis. By the same token, the imminent failure of a small player might be considered a systemic threat and a decision be 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 to having a banking industry that is strong on average and does not have contagious weakest chains at the same time.

The existence of weak players could unduly prevent Bank Indonesia from applying countercyclical macroprudential measures because banks with weak financials and poor business models cannot keep up. For the same reason, they could also prevent the OJK from imposing stronger prudential standards, or allowing fiercer competition that benefits banking customers, e.g. lower lending rates.

Preparing Better For Crisis, Also For Smaller Banks

Preparing Better For Crisis, Also For Smaller Banks
Preparing Better For Crisis, Also For Smaller Banks

The concern with the weakest links in the banking system is a key reason why all banks, unlike players in other sectors, face socalled minimum requirements for capital and liquidity. This being said, the minimum requirement has 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 recovery plan regulation will further strengthen Indonesia’s banking sector.

It could lead to early management and/or supervisory actions to deal with the significant threat of default and, as necessary, trigger faster consolidation in the industry.

This initiative is so relevant to bank risk management that it should be applied to smaller players in the near future as well.