Ailing banking industry off the critical list

By Reiner S.

JAKARTA (JP): The financial condition of domestic banks has improved after the government completed its costly bank recapitalization program, but experts warn that the industry is not out of the woods yet as their internal condition is still weak and external factors can still become a danger.

According to Bank Indonesia, combined operational profits jumped to Rp 3.6 trillion (about US$387 million at the current rate) in the third quarter of this year, compared to Rp 8.1 trillion and Rp 500 billion respectively in losses in the previous two quarters.

The central bank said that the return to profitability was due to the increase in the net interest margin from Rp 4.8 trillion in the second quarter to Rp 6.3 trillion in the third quarter.

But banking experts say that external factors particularly the current weakening of the exchange rate of the rupiah against the U.S. dollar, and rising interest rates could spell trouble for the banks.

The weakening of the local currency would lead to rising domestic interest rates, both of which would create difficulties in the restructuring of non-performing loans (NPLs). The failure to resolve the huge NPLs would also then threaten the capital soundness of the banks as measured by the capital adequacy ratio (CAR).

Director for banking supervision at Bank Indonesia Djoko Sarwono said that the top agenda for domestic banks in 2001 is to achieve the minimum 8 percent CAR level and maximum 5 percent NPL level by the end of the year.

Djoko said that the central bank had conducted a "stress test" to measure how the banks would perform particularly in relation to achieving the CAR and NPL requirements when the rupiah weakens and the interest rate increases.

"Based on the stress test, some banks must improve their performance and operation to be able to meet the minimum 8 percent CAR requirement," Djoko said.

"We'll no longer bailout banks through another recapitalization program," he added, pointing out that banks which fail to meet the new CAR requirement would be put under the special surveillance for up to six months and if they still could not improve the CAR, the banks would be liquidated.

"The biggest challenge for the recapitalized banks is the weakening rupiah and the rising interest rates," said head of bank restructuring unit at the Indonesian Bank Restructuring Agency (IBRA) Soebowo Musa.

The government completed the bank recapitalization program in October by issuing more than Rp 430 trillion in bonds to help finance the program. Some Rp 283 trillion worth of bonds have been injected into the country's four state-owned banks, Rp 124.1 trillion to four nationalized banks, Rp 22.1 trillion to seven private banks, and Rp 1.2 trillion to 12 small provincial development banks.

The recapitalization program has brought the banks CAR level to above the minimum 4 percent requirement.

Djoko said that the CAR condition of the country's recapitalized banks varies from one bank to another, with some already above 8 percent while others were still below the 8 percent level but above 4 percent.

He declined to name the banks with the lower CAR level.

In addition to the group of recapitalized banks, there is another group of around 75 private banks which did not join the government recapitalization program because their CAR at the time the program was launched last year was already beyond the 4 percent level. But as the banking environment continues to remain uncertain, the CAR of this smaller group of banks may deteriorate and they may have to merge with the stronger banks to avoid closure at the end of 2001.

Difficult situation

As part of the recapitalization program, banks must clean up their balance sheets by transferring their bad debts to IBRA. Only loans below the bad debt category, which may still be non- performing, remain at the banks.

According to Bank Indonesia, as of end of September this year, around Rp 54.1 trillion of NPLs owed by nearly 17,000 debtors had been restructured.

It said that in the third quarter of this year, the NPL level of the banking sector had declined to 27.9 percent from 30 percent in the second quarter and 32.1 percent in the first quarter.

"According to my calculations, the NPL level in the banking sector is still around 34 percent, but even at 27 percent, the NPL level is still quite high," said banking analyst Elvyn Masassya.

"The weakening of the rupiah and higher interest rates will put the borrowers and bankers in a difficult position to reach a restructuring deal," Elvyn added.

The rupiah has weakened to around Rp 9,500 per U.S. dollar recently, which is more than a 25 percent drop from the level earlier in the year due to a combination of domestic political instability and the weakening of the other currencies in the region. The government had initially targeted an average exchange rate level of Rp 7,000 per dollar for this year, but so far the actual average level was at around Rp 8,500.

The lower exchange rate level and inflationary pressure has prompted the central bank to allow interest rates to further increase. The interest rate of Bank Indonesia one-month SBI promissory notes has been hovering at more than 14 percent compared to the government target of around 12 percent.

In addition to the high external risk, analysts also warned that domestic banks are still operating at a very low earning growth.

Analysts pointed out that around 70 percent of the banks assets were in the form of government bonds which carry both fixed and variable interest rates. They said that such an asset structure was not healthy because a banks earnings should normally comes from its lending operations.

"Although Bank Indonesia said that banks have returned to profitability, they're actually still running at a loss if you consider their financial intermediary operation," Elvyn said.

"The profit so far has only come from the interest rates of the government bonds they hold. So the improvement is only artificial," he added.

Indeed, new bank lending to the real sector has been relatively low. Out of the total third party funds of Rp 652 trillion raised as per end of September, outstanding credit was only Rp 280.6 trillion.

Bank Indonesia said that new lending only started in July, and until end of September, total new lending only reached Rp 15.1 trillion, mostly channeled to the industrial and trade sector.

"With such conditions, we can't say we're happy with the banking performance in 2000," Elvyn said.

Analysts have said that the relatively high risk associated with the real sector due to the huge NPLs was one factor discouraging banks from resuming lending particularly as banks have to meet the minimum requirement of 8 percent CAR by the end of 2001.

"Banks have now to be extra careful in channeling loans because the environment is still not yet conducive particularly with the high NPL level," said chairwoman of the national private banks association (Perbanas) Gunarni Soeworo, adding that it was difficult for banks with a minimum CAR level to expand their lending.

"It's also difficult to find good customers out there," she added.

The government and Bank Indonesia have recently allowed 14 banks to exchange their fixed rate bank recapitalization bonds with new government bonds carrying a higher fixed coupon rate to attract investors to purchase the bonds so that the banks can raise cash for financing lending activity. IBRA banks

The group of banks which are currently under the most scrutiny are the 11 recapitalized banks under IBRA which include the publicly listed Bank Central Asia (BCA), Bank Niaga, Bank Danamon, Bank Bali, Bank Lippo, Bank Internasional Indonesia (BII), Bank Universal, and non-listed Bank Artha Media, Bank Prima Express, Bank Bukopin and Bank Patriot.

The first four banks are the so-called nationalized banks in which the government via IBRA owns up to more than a 90 percent stake in the bank, while the government only owns between 50-80 percent in the remaining group of banks.

The CAR condition of the IBRA banks also varies, with BCA recording the highest CAR level of around 44 percent.

According to IBRA's Soebowo, BII and Bank Universal had to work harder to meet the 8 percent CAR requirement by the end of 2001.

In terms of NPL, BCA also has the lowest level, while Bank Niaga has the highest level of around 72 percent. "The debt restructuring process has been moving slowly. The NPL level is still at an average of 30-40 percent which is still very high according to international standards," Soebowo said.

"We can say that our bank restructuring program is not complete yet. We have just started by strengthening the capital condition, but we haven't moved into the core restructuring program," he added.

In terms of loan to deposit ratio (LDR) -- which reflects the aggressiveness in channeling loans -- BCA has the lowest level of 5-6 percent compared to its massive deposit base of more than Rp 100 trillion. BII has an LDR of 57.36 percent and Niaga around 45.24 percent.

Soebowo feared that some domestic banks including those outside IBRA might not be able to meet the new CAR requirement by the end of next year.

He suggested that the weaker banks with a low CAR be merged with the stronger banks with a higher CAR level. He said that once the banks merged, the resulting bigger bank could be sold to investors to improve its capital condition and financial soundness.

IBRA divestment

IBRA is planning to divest its remaining ownership in BCA and Bank Niaga in the first quarter of this year. The divestment program was supposed to be implemented at the end of 2000 but has been delayed due to unfavorable market conditions. The agency sold 22.5 percent of its ownership in BCA through an initial public offering in May this year.

Another major bank sale planned next year would be the privatization of state-owned giant Bank Mandiri sometime in the fourth quarter of 2001. Other agenda

Another important agenda for the government and Bank Indonesia next year is to complete the necessary preparations to create a new agency that would supervise the country's banking industry and other financial operations excluding the stock market.

But Bank Indonesia's Djoko said that the finance ministry, which represents the government, has so far not yet held any high level talks with the central bank over the plans.

"The talks so far are at the working committee level," he said.

The finance ministry and the central bank have been occupied this year in trying to resolve the dispute over the government's massive bank emergency loans channeled via Bank Indonesia to ailing banks between late 1997 and early 1999 during the height of the country's financial crisis.

According to the Supreme Audit Agency (BPK) around Rp 80 trillion of the Rp 144.5 trillion loan had been misused by the recipient banks and this was particularly due to the weak supervision of the central bank. Bank Indonesia finally agreed last month to be responsible for financing Rp 24.5 trillion of the emergency loan.

Djoko also said that the transfer of the supervisory role from the independent central bank to the new agency was not related to the weaknesses in Bank Indonesia's supervisory role.

"The transfer is a global trend, it is not because our supervision has been weak," he said.

The country's banking authority must also immediately complete the map for the country's new banking landscape. Since the financial and banking crisis hit the country in the middle of 1997, the government has closed down around 67 out of more than 200 banks.

There are currently more than 150 banks operating in the country's still crowded banking industry, which comprises 88 private banks (including nationalized banks), four state-owned banks, 39 foreign and joint venture banks and 26 provincial development banks.

The remaining number of banks is still huge. "We don't need so many banks, but what we need is an extensive network of branches that can efficiently cater to customers throughout the country," Elvyn said.

But the government and Bank Indonesia seem to have a different view on what the new banking landscape would be.

The government has said that it wanted to see only a number of core banks and some smaller focus banks by 2005. But Bank Indonesia has said that it wants to see a few huge domestic banks that can penetrate regional and international markets, and a number of banks that focus on the national market, and yet another group of banks that focus on rural areas.

There seems to be also no consensus on how the new banking landscape would be achieved. Some experts have said that banks must be forced into a merger process, but finance minister Prijadi Prapotosuhardjo has said that the merger process must be based on market forces.

Another crucial agenda for Bank Indonesia next year is the plan to gradually introduce the banking supervision system from the current compliance-based mechanism to the risk-based system.

Djoko said that the new measure would strengthen the country's banking supervision system.

"This is a change in paradigm," he said, pointing out that in the compliance based-system banks must meet Bank Indonesia's prudential requirements such as legal lending limit, net open position and minimum reserves requirement.

He said that in the new risk-based supervision system, banks would be forced to also calculate and manage the risk they were facing including the credit risk, and market risk.

But Djoko said that the compliance-based system would not be abandoned although the central bank had implemented the risk- based supervision system.

"Banks must still meet Bank Indonesia's prudential requirements," he said.