Bad, good bankers

The arguments put forward by several bankers in opposition to the finance minister's Nov.1 decision to close down their banks bore signs of a significant misperception about the core requirements for operating a sound bank. Their points of view focused mainly on capital, as if money was virtually all things to a bank's soundness. They played down connected lending, which in the past has been cited as the main cause of most bank failures, as a minor violation.

On the contrary, the experiences of most countries facing serious banking problems, and the cases of several bank failures in Indonesia itself, have shown that mismanagement, and not market competition nor temporary illiquidity, was the main reason behind bank insolvency. In fact, connected, politically-motivated and heavily-concentrated, lendings by poor managers have often been found as the main cause of bad credits which lead into insolvency.

Mismanagement means that a bank is not operated properly under the prudential rulings set out by the central bank as the supervisory authority. Outstanding among the rulings are those related to the integrity and competence of management, internal control mechanisms, tough disclosure requirements and connected (intra-group) lending.

In addition to these components -- which are main yardsticks for qualitative assessment -- bank performance is also assessed qualitatively based on financial ratios, such as the ratio of capital against assets, return against assets and equity capital, liquidity, net interest margin and provisions against bad credits.

Nonetheless, given the increasing complexity of the financial sector, qualitative assessment has been assuming an important role because rules, notably those based on quantitative parameters, may become easier to circumvent.

The rationale of all these prudential rulings and stringent disclosure requirements is that banks, because of their fiduciary responsibility, are different in many substantial aspects from non-financial enterprises in that they act as the repository of private savings. Banks, at the most, own only between 9 percent to 12 percent of their total assets, the remainder belongs to the general public. No wonder banks are governed by a special law (the Banking Act) while all other corporations are subject to Company Law.

One could imagine if a bank with bad management, or controlled by owners with criminal mentality, were allowed to continue operations. That would amount to licensing a crook to work among the public on a massive scale. So crucial is the factor of management and owners, with regard to their integrity, honesty and competence, that the law empowers the central bank to order their replacement whenever deemed necessary to return a bank to prudential operations.

Qualitative assessment is also essential because of the special characteristics of banking operations. Different from non-financial firms, the symptoms of insolvent banks can often be deferred because most bank products include a promise to pay in the future. It thus can take some time before a bank's inability to fulfill its contracts becomes evident.

Banks can conceal problems by rolling over bad loans or by raising more deposits and increasing the size of their balance sheet. Banks also can attract new depositors with the promise of high interest rates so as to maintain big depositors and attract new ones. We noticed, for example, how some of the closed banks had offered interest rates of up to 40 percent.

It was because of this time lag that the real magnitude of banking problems began to appear only in July, after the currency crisis forced the monetary authorities to tighten liquidity. In a booming economy, like the one the nation had experienced until early this year, strong growth, high earnings and continued capital flow could hide mistakes and gross inefficiency in the business sector. But a downturn like the situation we are in now exposes the results of poor management and all the excesses of inefficiency.

Past experience has also shown that the costs of banking failures to the taxpayers are often very great. We are afraid of how the Rp 2.3 trillion the government has set aside for the repayment of small depositors of the 16 closed banks will be recouped. The problem with liquidation is that the bank assets will be harder to sell, especially given the dire economic conditions now.

Given the high costs and the great risks imposed by unsound banks on the financial system, the government, businesspeople and even the general public should gain a beneficial lesson from the closure of the 16 insolvent banks. For that, it is necessary for the central bank to announce -- obviously the closed banks are no longer protected by banking secrecy provisions -- the mistakes and other "sins" which have driven those banks into insolvency.