Bad loans: A sperate affairs

By Andrew Cainey & Andrew Clark

JAKARTA (JP): Banks need to separate their current operations from the resolution of problem loans. Without this clarity, ongoing business will be neglected and a work out will suffer from lack of concentrated effort appropriate expertise. Clear separation is important because the objectives, pace, type of personnel required and measures of success are all so different.

Speed is of the essence in the work out: success rates in recovery drop off steeply as every week goes by. Believing that you will get 100 cents on the dollar is unproductive, which is why you need different people working on the bad credits. Those who were involved in extending the original loan are less willing to settle quickly and move on to the next case.

"Bad bank" executives must be given clear negotiating authority, and staff should be added up to where marginal cost can no longer drive marginal revenue. It is also advantageous that customers view this group as separate from their regular account executives. On the other hand, prudence must be the watchword for the ongoing "good bank" operations; credit decisions must be carefully studied, costs controlled and customer service delivered to a high standard.

Over the past few months, the Boston Consulting Group has seen a number of Asian banks involve every one of their talented executives in bad loan resolution, which soaks up all their time and leaves none for maintaining ongoing business. The risk of this approach is that there is no underlying business to return to when the nonperforming loans are resolved.

To further protect the ongoing business, banks that have not done so already, need to revamp their credit processes and tools, moving from asset-based to cash-flow lending. In addition, they need to free themselves of the type of top-level relationship -- or government -- directed lending demonstrated across Asia.

An effective recovery process is the biggest lever a bank has in a crisis economy. Once bad loans have been reserved, any incremental recovery goes directly to the bottom line. Even the healthiest Mexican banks, which sold U$19 billion of bad loans to the government, are still focusing on the recovery process; under the terms of the bailout, banks continue to hold a 25 percent stake in all loans they have sold.

To deal with profit pressure, banks need to reengineer and restructure to reduce costs. Banamex and Bancomer, two of the most profitable banks in Mexico, have such programs underway. Banamex is preparing to lay off 10,000 of its 31,383 workforce. Bancomer has announced an additional 8 percent reduction in its workforce in 1998. Bital has sacked nearly 4,000 of the 4,389 employees that came with its acquisition of Banco Altantico.

While many Asian banks have undertaken similar efforts, they have not usually included cost cutting. Staff lay offs, typically the major source of cost reduction, are anathema in this region given the absence of social safety nets and have been avoided by leveraging rapid growth instead.

Most Indonesian banks have not actively played the key roles of a banking system: the filtering and selection of investment opportunities, attracting customers and profitable lending activities.

In the future, Indonesian banks need to aggressively build the capability to filter the good risks from the bad risks. This means better collection and analysis of customer information. It means banks need to conduct probing industry analysis. As the judgment and experience is scarce today, banks will initially need to centralize loan decisions in the hands of those with the most experience. As capabilities grow, branches can play a more active role again.

Above all, success requires a new mind-set and the courage and ability to say "no" to unattractive but large lending opportunities.

Banking crises usually create a high interest rate environment. In Sweden, the interbank overnight rates went as high as 500 percent, while in Mexico, the interbank overnight rate leapt to 109 percent at one stage. Similar developments have occurred in Indonesia, where the interbank overnight rate reached 150 percent for some smaller banks.

This causes problems for banks without local deposit bases. Foreign-sourced funds dry up due to risk aversion and the central bank becomes the primary source of liquidity. But increased cost of funds often cannot be passed on, either due to preagreed loan pricing or client inability to pay. Thus, banks that fund themselves on a wholesale basis find their margins dramatically squeezed, if not negative. In Mexico, all lending businesses were pushed into the red, even before considering bad debt losses because banks were unable to reprice loans fast enough to keep up with the increasing cost of funds.

Banks that already have strong retail networks in the right locations can leverage these with higher rates and focused marketing. Banks with poorly placed branches or few branches at all should consider strengthening their retail network through acquisition.

According to the Boston Consulting Group, there are two areas for domestic mergers and acquisitions. Banks need to think beyond price/value and consider complementarity or overlap. In the first, a bank with a strong presence in Jakarta may want to capture a nationwide retail operation by acquiring banks which focus on other regions.

In the second, a merger of two banks creates opportunities for cost reduction and branch closure. For foreign capital injections, domestic banks can benefit from thinking through their preferred source of capital and positioning themselves appropriately. Foreign players will typically want to invest in the stronger banks, not the weaker ones.

In Mexico, Bital has emerged successful from the crisis. While relatively small, it is considered to be one of the leading banks, particularly in terms of new product innovation and marketing. With the marketing experience of its international partners, Banco Central Hispano and Banco Commercial Portugues, it has created a small revolution in the retail banking segment.

It was the first bank to open afternoons and weekends, forcing the rest of the sector to follow to defend their share. It rolled out an impressive array of new products for the consumer, ranging from credit for small appliances (BitaBonos) to innovative savings products modeled on the informal economy (Tandas). Bital also leads the sector in new branch openings, going from 450 in 1994 to 1,218 in 1997. All of this has been supported by an aggressive advertising campaign poking fun at the rest of the traditionally staid banks.

Finally, whatever merger and acquisition decisions are made, they must be executed well. To realize the benefits -- greater market penetration, increased scale in asset management, cost reduction -- integration must be handled as a discrete, explicit process. Strategic objectives must be clear and decisions must be made quickly, communicated openly and executed relentlessly. Many mergers actually destroy value because they are not properly integrated.

Banks that waver, risk losing key personnel, high-value customers and the momentum to make drastic cost reductions.

The main value of in-market mergers comes from growing the customer base while reducing costs. If, however, customer attrition is not carefully managed, the value is lost. In one recent Mexican example, the acquiring bank should have boosted deposits by 30 percent, yet one year later, its market share was actually below the premerger level. In a different Mexican example, disgruntled former employees of an acquired institution who felt they were treated unfairly took their customer lists to competitors.

Times are hard, and there are many urgent issues to distract senior managements. Only the institutions that focus on the five key success factors will emerge as strong competitors in the new environment; banks which can honestly say that:

* their ongoing business and work out problems are being run separately by focused groups of experts,

* intensive cost restructuring is underway,

* they have a program to build risk management capabilities,

* they have a secure and expanding deposit base, and

* senior management has clear views on complementary mergers and acquisitions, as well as concrete plans for execution

Should be comfortable that they are on the right path.

Andrew Cainey is a vice president of the Boston Consulting Group and Andrew Clark is a manager of PT Boston Consulting Indonesia.

Window: Most Indonesian banks have not actively played the key roles of a banking system: the filtering and selection of investment opportunities, attracting customers and profitable lending activities.