Bailing out BII

However the government defines it, state Bank Mandiri's plan to acquire state-controlled Bank International Indonesia (BII) is nothing but second-stage recapitalization using taxpayers' money. The term "acquisition" is being trumpeted only to create the perception that the process of bailing out debt-ridden BII is simply a deal between two banks designed to build up strategic synergy. It is also designed to circumvent the requirement of having to obtain prior approval from the House of Representatives in the case of outright recapitalization having to be made.

But as the acquisition will be made possible only after the Indonesian Bank Restructuring Agency (IBRA) takes over US$1.2 billion (Rp 13.6 trillion) worth of BII's bad debts by using government bonds, the direct cost of the transaction will be borne by the state budget.

Acquisition by Bank Mandiri seems to be the least-cost alternative to save BII from bankruptcy. Liquidation will not only inflict tremendous costs as the government would have to reimburse third-party deposits, estimated at about Rp 24 trillion, under the blanket guarantee scheme. Such a drastic measure would also have a devastating impact on public confidence in six other recapitalized banks, not to mention the systemic risks to other solvent banks and the moral hazard of being "too big to fail".

The financial distress currently faced by BII was caused by the forbearing attitude adopted by the government in 1999 when it went ahead with recapitalizing the bank even though it was found to have violated the ruling on lending to affiliated parties. True, the $1.2 billion in BII loans to the Sinar Mas Group, formerly the controlling owner of the bank, was still current at that time.

But it was simply mind-boggling to note how the government could have overlooked such a blatant violation of the legal lending limit that had placed the bank at such huge risk. The lending to the Sinar Mas Group alone accounted for more than 60 percent of its total loans. Tolerating such a breach of prudential regulations has now turned out to be a time bomb that the government has to defuse by using taxpayers' money.

True, part of the woes that have been responsible for the predicament of BII and most other banks should be blamed on the political uncertainty, which has increased overall economic risks and made the condition inimical to banking operations.

Bank Indonesia disclosed last week that BII was only one of nine banks that had yet to meet the minimum 8 percent capital adequacy ratio -- the ratio between capital and risk-weighted assets -- by December, warning that they may have to be closed if they fail to meet the requirement either by merger or private placement.

It is simply because of the government blanket guarantee on bank deposits and claims that the nine banks, including BII, have not encountered massive runs despite such negative publicity.

The question, though, is whether the government, already burdened with Rp 61.2 trillion in interest costs of bank recapitalization bonds this year alone, could still afford to reimburse depositors in case of another major bank failure. There is now major concern that big depositors of a failed bank would be reimbursed only with government bonds, which, like the Rp 650 trillion in recapitalization bonds, are entirely illiquid and have no secondary market.

This concern has now markedly distinguished, at least in the public perception, two groups of banks with strikingly different conditions: One group consists of domestic banks perceived to be fragile and highly risky, and the other made up of foreign bank branches seen to be sound and strong as a safe haven for financial assets.

The wide difference in the risk factor has certainly placed domestic banks at a great disadvantage in raising funds and attracting prime customers. It is this hostile environment that has caused domestic banks to remain fragile.

Set against this inimical condition, the plan by Bank Mandiri to acquire BII may put the state bank in great danger of financial distress. It would not solve but only transfer the problems of BII to the books of Bank Mandiri, and these problems could become another time bomb within the state bank.

This is the big risk that the government has to thoroughly assess in the due diligence process, especially because Bank Mandiri, which is now the largest bank resulting from the merger of four state banks in late 1999, is designed to become a core domestic bank, the anchor of the banking sector.