Bad bank governance

Bad bank governance

Lending irregularities at state-controlled Bank Mandiri, which
led to the dismissal and arrest of its president and two vice
presidents last week, once again shows how fragile the banking
industry is, how vulnerable it is to fraud and how deficient the
central bank is in its supervisory capacity.

The alleged banking crimes in the largest domestic bank follow
on the heels of a huge scams at Bank Global, which was closed
down last December, and lending scandals at Bank Dagang Bali and
Bank Asiatic, which were given the axe in April 2004.

It is too early to ascertain as to whether the criminal
charges being investigated by the Attorney General's Office (AGO)
against Mandiri's executives and several of its borrowers will
hold up in a court of law here. But the fact that the arrests of
the bankers and borrowers was made after just two months of
investigations could, in itself, be seen as a strong indicator
that there was some solid evidence of serious banking crimes.

We do not think the AGO would stake its reputation on weak
cases, especially because the investigations were led by the
Deputy Attorney General for Special Crimes, Hendarman Supanji,
the leader of President Susilo Bambang Yudhoyono's special
corruption combat team. Moreover, the investigations were made to
follow up on the findings of some "28 lending irregularities"
made last year by the Supreme Audit Agency's (BPK) audit of the
bank.

Since Bank Mandiri is the largest domestic bank in terms of
assets -- and thus has the sheer size to create systemic risks
within the whole banking industry -- the bank must have been
under special scrutiny from Bank Indonesia's supervisors.
Furthermore, as the bank is also listed on the Jakarta Stock
Exchange its financial reports are supposed to be much more
credible and reliable than private companies, in view of the
stringent disclosure requirements and audit standards supposedly
imposed on publicly traded companies.

However, if a such a large and blatant lending scandal could
still occur at Bank Mandiri, that should raise greater concerns
over the condition of all state-controlled banks -- more than 40
across the country. That also raises great doubts about the
integrity and technical competence of the central bank's
supervision department.

A bank is not simply a business entity in an ordinary sense,
given its fiduciary responsibility, the multiplicity of
transactions it is involved in and its key function within the
economy. That is why the principles for good corporate governance
for banks are much more elaborate than those for other commercial
entities. That is why not everybody who can merely put up the
capital is able to have a controlling ownership in a bank. Those
who want to become controlling owners and commissioners of a bank
have to pass a series of "fit-and-proper tests" carried out by
the central bank to assess their technical competence and
integrity.

Given the special role and characteristics of their
activities, banks are put under a multi-layer supervision
mechanism. And on top of that, banks also are subject to the
Indonesian Banking Sector Code of Corporate Governance.

This code requires banks to set up audit, nomination,
remuneration and risk policy committees. The internal auditor of
a bank must be approved by its commissioners and have functional
coordination with the board of commissioners and the audit
committee. The audit committee has to ensure adequacy and
effectiveness of internal control systems for prudential banking
practices and comply with all auditing standards.

On top of all this, a bank must still have a director
specifically in charge of ensuring that all bank activities
comply with laws and regulations, internal procedures and
directives from the central bank.

The government last week replaced the boards of directors and
commissioners of Bank Mandiri and Bank Rakyat Indonesia and
similar management shake ups and are expected to do the same at
two other state banks -- Bank BNI and Bank Tabungan Negara.

The screening of candidates for the posts of director or
commissioner of state companies, including state banks, has now
been put under a special inter-ministerial team directly chaired
by the President. That was different from the previous system
whereby the appointment of state company directors was almost
entirely under the jurisdiction of the minister for state
enterprises.

This new system would help secure the appointment of directors
and commissioners with high technical competence and impeccable
integrity. This alone would not, however, prevent a recurrence of
banking crimes, unless and until Bank Indonesia improves the
capacity and integrity of its bank supervisors and the government
acts decisively to establish a strong system of good governance
at all state companies, particularly the banks.

Good governance and corporate responsibility are absolute
prerequisites for the integrity and credibility of market
institutions. By building confidence and trust, good governance
allows banks to have access to external finance and to make
reliable commitments to creditors, employees and shareholders.
But when this trust is undermined, lenders and investors lose
their appetite for risk, and shareholders unload their equity.