BI should stop remunerating the statutory reserves

Bank Indonesia (BI) will gradually increase the statutory Reserves Requirement Ratio (RRR) to 6.5 percent in September. The critical point to note here is that BI provides remuneration to banks in the form of 1.5 percent interest on the RRR.

The RRR is an obligation for banks set by BI first to foster the health of banks for financial stability and strengthen the resilience of financial institutions against external risks. The second objective is monetary control, such as to offset below-trend output growth. The third is liquidity management, which seeks to influence the liquidity of the banking system to reduce pressure on inflation, exchange rates and interest rates. The third is the BI’s main objective in this regard.

What are the economic benefits of BI’s strategy of giving remuneration to banks, while the RRR is an obligation based on law? Helping boost profitability for banks is not BI’s mission. On the other hand, the profitability of Indonesian banks amid COVID-19 remains the highest in Asia Pacific during 2020 and remained profitable in 2021.

There are at least four points that need to be addressed about the setup of this remuneration on the RRR.

First, according to the Organization for Economic Cooperation and Development (OECD), most countries do not remunerate the RRR and the RRR is de facto a tax in the banking sector. The OECD is of the opinion that the remuneration of RRR could have a negative impact on a central bank’s financial position, which could eventually have a negative impact on a central bank’s effectiveness in my view.

Second, looking at it from a general prudent perspective, remuneration practice of the RRR in countries where the central bank is not a bank supervisor such as in Indonesia is questionable according to the International Monetary Fund. Remuneration of the RRR provides an incentive for banks to keep reserves at the central banks, but may not be the right way to motivate keeping cash balances for the intended purpose of prudence, as the central banks are not the banking supervisors.

The IMF then argues that the RRR remuneration weakens or eliminates the impact of the RRR on interest rate spreads in the market, and in my view, it can have negative effects on central banks’ effectiveness.

Third, the RRR is an obligation by law. It sounds asymmetrical, providing a lure in exchange for something that is already mandatory. BI’s remuneration practice on the RRR fits the definition of subsidy or the provision of state from the state for banks. For instance, the provision of state aid to a sector is prohibited in principle in the European Union because it can distort competition in the European market. The provision of the state is present if the (local) government provides economic benefits to companies that are obtained from state resources.

Fourth, BI’s policy to provide remuneration on the RRR sharpens inequality in Indonesia. It is well known that the Indonesian banking sector has been profitable in this COVID-19 era. The remuneration on the RRR will most probably lift the overall remuneration in the banking sector for their stakeholder’s exceeding reasonableness compared with other sectors that are experiencing difficulties due to COVID-19.

Thomas Piketty, a Nobel laureate in economics, argues in his book Capital in the Twenty-First Century, which focuses on wealth and income inequality, that inequality increases when returns on capital exceed economic growth. Granting remuneration on the RRR to a banking sector that has already been profitable enough will boost returns on capital in the banking sector, outpacing the economic growth. Consequently, inequality continues to grow.

The RRR is a part of public savings that banks must keep in BI. With this RRR deposit, BI as the lender of this last resort is able to inject liquidity into the financial system in the event of a financial crisis. This then becomes an opportunity cost for the banking sector, yet on the other hand, the Indonesian banking sector gets a kind of remuneration insurance.

Last but not least, the RRR will be more flexible and effective as a monetary policy tool if the RRR is purely interest-free.