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.