Banking crisis: Who's to blame?

Banking crisis: Who's to blame?

By Eddy Soeparno

JAKARTA (JP): Many Indonesians find it difficult to accept
that the economic crisis has changed their lifestyle -- as well
as their status, notably from being employed to unemployed -- in
a matter of months.

As late as July 1997, the World Bank announced that the
Indonesian economy was "performing very well" and had a chance to
maintain an annual growth of about 7.5 percent in coming years.
Now it says the nation is "near economic collapse" and is in a
"desperate" situation that "spells immense dangers and
difficulties" for its 202 million people.

Much of the blame is pointed at the banking sector, which over
the past three years had become a hotbed of speculation for
business owners -- including bank owners. Speculative bubbles,
especially in the real estate sector, were effectively nurtured
by continuous flows of bank credit which artificially lifted
asset prices as well as demand. As a result, the prices of these
assets soared, attracting even more investments into the sector.

Because Asia's economies were growing at a very fast pace, the
negative impact of this type of resource allocation was not
immediately apparent. However at the end of the day, these assets
became so inflated that a price correction was simply inevitable.
But it came too late -- forcing a full, immediate correction
rather than a gradual, less painful one.

When the market finally realized the actual value and demand
of these assets, a significant gap between the value of the loans
and the value of the real estate backing them had already
occurred. Soon after that, the entire house of cards came
tumbling down as property prices went into a free fall and
overdue bank portfolios began to swell, while the financial
system virtually malfunctioned.

Another form of speculation -- that is taking short-term loans
to finance long-term projects -- also contributed to the problems
now faced by troubled banks. The confidence crisis in the banking
sector further triggered huge withdrawals of public funds from
the banking system. Since most bank assets were tied up in
medium- to long-term projects, the government -- in an effort to
stabilize the banking system -- bailed out a number of banks by
providing immediate liquidity to meet depositor commitments.

To date, the government has poured approximately Rp 145
trillion (US$12 billion) into the banking sector to save it from
collapse.

To finance the move, however, the government actually printed
new money, resulting in skyrocketing inflation rates up to 80
percent (projected to reach 100 percent by year end of the year),
from a modest single digit figure in 1997. The task of rolling
back this inflation rate has further resulted in high interest
rates of between 60 percent and 70 percent. Lending rates are
currently hovering between 80 percent and 90 percent, making it
virtually impossible for banks to resume lending and disbursing
the much needed liquidity to restart the engines of Indonesia's
faltering economy.

When the government realized it would have to take on the task
of salvaging and rehabilitating more banks, it summoned a team of
international auditors to look into the books of several troubled
institutions. The result was astonishing. Intercompany lending
accounted for as much as 85 percent of total loan portfolios,
while the amount of doubtful and bad loans at some banks
reportedly accounted for 90 percent of total assets.

This comes as no surprise to anyone familiar with the
country's banking structure, mostly run and operated by owning
families who normally use the bank as a vehicle to gain cheap
funding to finance their own highly speculative projects other
banks have refused to finance.

The audit's findings prompted the government to pull the plug
on several faltering institutions, resulting in the closure of
three medium-sized banks. Another four banks, currently under the
Indonesian Bank Restructuring Agency's (IBRA) supervision, were
given until the third week of September to make good on all
obligations owed to the central bank.

The exercise of closing and liquidating banks, however,
appears to have come at a higher price tag than previously
anticipated. First, the resulting layoffs will further eat into
the government's pocket since it only increases the need to
maintain its "social safety net" in the form of subsidies.

Second, the move will result in tangible as well as intangible
losses, such as the loss of customer relationships, banking
networks and management information systems.

And finally, rehabilitating and selling off remaining assets
of liquidated banks is a long, cumbersome and complicated
process. Take French banking giant Credit Lyonnais, for instance,
which in 1994 set up an institution similar to the Resolution
Trust Corporation in the U.S. to sell off their non-performing
loans. To date, it has only managed to sell about 40 percent of
its total asset portfolio.

Another matter virtually ignored throughout the crisis is the
condition of the country's six state-owned banks. Frequently used
as a tool for politically motivated lending, the state banks were
known to have large single portfolios of non-performing accounts
even prior to the crisis. The only reason these banks did not
fall apart is because it had vast and almost certain access to
government liquidity.

In the past, if any of these banks suffered from mounting
pressure from non-performing assets or liquidity problems, the
government would normally step in and inject the necessary funds
needed.

In practice, should the banks then fail to service these
central bank loans, the government would normally decide to
increase its equity in the bank by converting its loans into
capital.

If economists fear that a government-led bailout of the
private sector would increase the problem of moral hazards, it
should be noted that continuous government bailouts in the public
sector has already created a special kind of moral hazard
problem, unfortunately carrying a much larger impact.

The fact is, state banks -- either by will or "invisible
force" -- have engaged in larger and riskier projects than any of
their private sector counterparts.

Worse still, no state bank has ever been allowed to collapse,
no matter how large its losses.

Therefore, while pointing the finger at the state of the
country's private banks, we should also assess the condition of
government-owned banks. The size of their portfolios is
significant and any problems resulting in their non-performing
loans could create another ripple in the economy.

Long before the crisis, Indonesia's banking sector had been
widely criticized as "highly regulated but poorly supervised".
The regulatory and supervision function of the central bank
should therefore share much of the blame for causing the banking
crisis, along with other factors.

Weak auditing by regulators has often resulted in inaccurate
bank reporting, which has misled the public over the actual
conditions of various banks.

Recent investigations on the misuse of liquidity facilities to
ailing banks by several former board members of the central bank
further indicates that corruption and collusion were partly
responsible for the current banking chaos.

Therefore, it is of paramount importance that the central bank
enhance its supervisory role to prevent future bankers from
outsmarting regulators in judging the health of their books.

Increased audit transparency should also be emphasized in the
wake of growing criticism from the public as well as the need to
restore confidence in the authorities' policymaking function.

In 1988, the liberalization of the financial sector and the
privatization of the banking system were central to the country's
structural reform programs.

This, together with the availability of more resources as a
result of fiscal consolidation and capital inflows, led to the
considerable growth of credit to the private sector. From 1989 to
1994, financing from private sector banks expanded at an annual
rate of 22 percent, which further prompted the central bank to
limit credit growth by allowing banks to expand their assets by
only 18 percent per annum in 1994.

Unfortunately, the credit explosion occurred at a time when
there was inadequate financial supervision and regulation by the
authorities and before the banks could establish the necessary
internal controls to ensure that credit would be granted
prudently.

The results of this are evident today with the collapse of
several medium to large financial institutions and the discovery
of more flaws in the entire banking system.

Salvaging the banking system has proven to be costly in the
past and it will not cost the public any less by shutting down
ailing and more ailing banks.

Therefore, the central bank should provide clear guidelines on
bank closures as well as increased transparency in their role as
lender of last resort to ailing banks.

On a final note, banks are institutions in which the public
put more than just pennies and dimes into. It is trust that a
small time depositor extends when placing his or her lifetime
savings into a bank. Bankers should realize this trust and reward
it with prudent policies.

The writer is a corporate finance director for American
Express Bank.

Window A: The exercise of closing and liquidating banks,
however, appears to have come at a higher price tag than
previously anticipated.

Window B: Weak auditing by regulators has often resulted in
inaccurate bank reporting, which has misled the public over the
actual conditions of various banks.