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.