Banking expected to improve, but slowly

Banking expected to improve, but slowly

Fauzi Ichsan

International investors and donors like to point out that
although Indonesia's economic growth is rising, investment in the
real sector of the economy, and therefore economic growth, are a
lot lower than their full potential. There are two reasons why
real investment is so low. First is legal uncertainty, which
hampers long-term investment like infrastructure and mining.

Second is a "malfunctioning" banking sector. Still traumatized by
corporate debt defaults in 1998/99, the banking sector prefers to
keep its assets in the form of government bonds, central bank
discount bills (SBI) and consumer loans to individuals, who are
better at repaying debt than corporations. But real sector
investment, the kind that accelerates economic growth and creates
employment by the millions, is driven by corporations, not
individuals.

The role of the banking sector remains smaller than before the
financial crisis. Bank lending now generates less than 25% of the
economy, compared to 60 percent in 1997. Bank loans now cover
only 38% of the total banking sector assets, compared to 71
percent in 1997. Banks' reluctance to lend to the real sector is
ironic since they have too much cash. In a recent parliamentary
hearing, Bank Indonesia (BI) Governor Burhanudin Abdullah even
said, "Indonesia is still in an economic crisis", as "excess
banking liquidity" has reached Rp 180 trillion - Rp 190 trillion
or around 10 percent of the economy. The banks spend around 85
percent of this excess liquidity to buy SBI notes and place the
rest in the overnight BI facility, which is annually costing the
central bank about Rp 14 trillion to 16 trillion in interest
expense and eating up its capital. Overall, the banking sector is
still dependent on the government, as almost 40 percent of their
interest income comes from government bonds and SBI. Given a weak
legal system, banks remain reluctant to lend to the real sector,
particularly the corporate sector. In addition to its "generic
problems", the banking sector has also been affected by "high-
profile" fraud cases at state-owned Bank Negara Indonesia (BNI)
and Bank Rakyat Indonesia (BRI). Given all these problems, it is
not surprising that bank lending for corporate investment remains
low.

Looking over the medium term, however, the banking sector is
now healthier than during the peak of the crisis. Between 1998
and 2003, non-performing loans (NPL) as a percentage of total
bank loans have sharply declined from 49 percent to about 7
percent. Over the same period, banks' net interest income has
increased from minus Rp 61.2 trillion to around Rp 27.8 trillion
and banks' capital adequacy ratio (CAR) has improved from minus
15.7 percent to around 23 percent. The Indonesian Bank
Restructuring Agency (IBRA) has sold most of the troubled banks
that it took over during the crisis, Including BCA, Danamon,
Niaga and BII, to strategic investors. The government has also
partially sold its non-IBRA banks, including Bank Mandiri,
Indonesia's largest, and BRI, a solid rural credit bank, through
successful initial public offerings (IPO). Meanwhile, the
international rating agencies, like Standard and Poor's and
Moody's, have been upgrading the risk rating of several banks.
So, there are good stories to tell about the banking sector and
further progress is expected, slowly but surely because of the
inherent problems the sector is facing.

Banking sector in 2003

In 2003 the banking sector experienced three major
developments. The first of these has been a continually falling
interest rate. BI has been willing to reduce SBI rates (the
benchmark for banking rates) because of falling inflation and
because of excess liquidity in the banking sector. The immediate
effect of falling interest rates is falling profitability, given
banks' dependence on government re-capitalization bonds and SBI.
Many banks hence try to protect their profits by maintaining high
interest rates on loans, inviting criticism from BI and the
business community. But the positive effect of a falling interest
rate is that banks are increasingly forced to look for
alternative sources of income, either through increased lending
or service fees, to reduce their dependence on the government and
BI debts.

The second development is domestic consumption growth. A
falling interest rate, stronger rupiah exchange rate and falling
inflation have all supported domestic consumption, which
generates 80 percent of the economy. If banks are reluctant to
lend to corporations, they are more than happy to lend to retail
consumers to buy cars, motorcycles and residential houses. While
this may not be a healthy strategy in the long run, the banks at
least are lending to the real sector of the economy.

And the third development is the emergence of the mutual fund
industry. The tax-free mutual fund industry has grown rapidly
from Rp 46.6 trillion at the end of 2002 to Rp 85.8 trillion by
September 2003. The growth of the industry has simply exceeded
the growth of the bank deposit market. Many banks used the
opportunity to rapidly sell their re-capitalization bonds to
mutual funds, both to book trading profits (because of rising
bond prices due to falling interest rates) and to reduce their
debts by persuading bank depositors to move their money from
deposits to mutual funds. The emergence of the mutual fund
industry allows the banking sector to slowly reduce its
dependence on government bonds.

All in all, in spite of the highly publicized bank fraud
cases, the banking sector in 2003 has become healthier, judged on
basic banking indicators, such as NPLs, CAR and loan-to-deposit
ratio (LDR). Falling interest rates are squeezing profits but
that has also reduces the government's interest expense (and
taxpayers' burden) on re-capitalization bonds while slowly
forcing banks to resume their capital intermediary role in the
economy.

Banking sector in 2004

In 2004, the banking sector can also expect three
developments. The first of these is the general election. The
elections will mean two things. First, that real investment is
likely to remain flat. And second, that political parties will be
spending money on their campaigns at the grass-roots level, which
will help consumer spending. This will support the bank consumer
lending business, as households will have more cash to repay
their loans and credit cards. Businesses, which "profit" from the
"spillover" of money politics, will also need working capital
financing from banks. All in all, unless it descends into a
political disaster, which is unlikely, the general election is
likely to be positive for the economy, including the banking
sector.

The second likely development is higher interest rates.
Interest rates are expected to rise, albeit slightly, because of
the general election, due to likely rupiah volatility during the
election and possible U.S. interest rate hikes. This would
prevent banks' interest income from falling further. Because
banks' are unlikely to raise their deposit rates (unless interest
rate goes up sharply - which is unlikely), the "spread" between
SBI rates and deposit rates could widen, improving banks'
profitability.

And the third likely major development is further bank
privatization and consolidation. The government is already
planning to sell Bank Permata and Bank Lippo to strategic
investors in 2004. The fraud cases at Bank BNI and BRI, as well
as the likelihood of higher non-performing loans at Bank Mandiri,
could increase public pressure on the government to divest state-
owned banks. This could both insulate the government from future
financial liabilities while improving the management and capital
base of the banks. On the regulatory side, further progress is
expected but mainly after the election. This would include the
removal of the blanket deposit guarantee scheme and the gradual
introduction of the financial services authority (FSA) that could
take over supervision and regulatory powers from BI.

All in all, 2004 is likely to be a year of further
privatization and consolidation for the banking sector. In spite
of all the structural problems it faces, the banking sector is
likely to continue to progress, surely albeit slowly. In the long
run, progress in the banking sector could only be accelerated by
a combination of factors. First, continual political stability.
Second, a better investment climate for investors. Third, a
stronger legal system, particularly in the bankruptcy court and
its legal enforcement. Fourth, improved bank internal risk
management, particularly on credit risks. And fifth, prudent
supervision by the government, particularly strong coordination
between the Ministry of Finance, Bank Indonesia and the Capital
Markets Supervisory Board - BAPEPAM.