Banks' dominance in financing dangerous

JAKARTA (JP): The continuing dominance of the banking system in the country's commercial finances poses great risks of credit crunches that may inhibit economic growth, an economist said over the weekend.

John D. Montgomery, an economist from the International Monetary Fund (IMF), said Indonesia's finance was dominated by banks, while the role of capital markets was still minimal.

He said banks' dominance had negative implications because enterprises had fewer alternative sources of finance than their foreign competitors.

"The dependence of firms on bank finance increases the risk of a credit crunch that could magnify the effect of an economic downturn," Montgomery said in a paper prepared for a conference, organized by the IMF and Bank Indonesia which ended on Friday.

Official data shows banks have provided almost two-thirds of total commercial finance, while stock markets have provided the other one third.

Montgomery, however, said banks actually dominated Indonesia's commercial finance by providing 85 percent of the business sector's commercial finance needs while stock markets put up only about 15 percent.

He argued the government's figures substantially overstated the stock markets' roles because the market capitalization of listed shares included shares which have never been sold on the stock exchanges.

The founding shareholders of most listed companies on the Jakarta Stock Exchange have sold only between 15 to 30 percent of their shares.

In addition, Indonesia's bond market was still very small compared to other countries, he said.

Debt contract

Montgomery said the legal environment to enforce debt contracts in Indonesia was relatively weak. The weakness of laws protecting collaterals and governing corporate bankruptcy make even collateralized bonds risky and costly, he said.

To the extent that bonds are not collateralized, they are de facto required to have a guarantor, usually a bank. Bonds, therefore are indirectly obligations of a bank as well.

"For the bond market to grow, the legal system must reach the point where the abilities of creditors to protect their claims are strengthened," Montgomery suggested.

Meanwhile, the role of financial intermediaries, including insurance companies and non-banking financial institutions, in Indonesia's finance is small, compared with banks. Banks own over 85 percent of the total assets of this group of intermediaries, excluding pension funds.

Montgomery acknowledged the dominance of bank debts over other forms of finance could facilitate the operation of monetary policy. This makes the transmission from Bank Indonesia's monetary policy to economic activity more direct and potentially more precise and predictable.

However, he said there were indications that a significant number of banks were undercapitalized and had not yet complied with some important prudential rules, although compliance appears to be improving.

According to the central bank, 15 banks did not meet the required 8 percent capital adequacy ratio in April 1996, down from 21 banks in December 1995. Twelve out of the 77 licensed foreign exchange banks did not meet the rules on net open foreign exchange exposure.

In Indonesia, where the government stands ready to bail out failed banks, poorly capitalized banks tend to make economically sub-optimal lending decisions, Montgomery said.

"The issue of undercapitalized banks should be resolved quickly," Montgomery said.

The presence of undercapitalized banks reduced economic efficiency because banks had a safety net so undertook risky lending.

Similar criticism was expressed by John Hicklin, assistant director of the IMF's Southeast Asia and Pacific Department. He said the management of banks in Indonesia took excessive risks in extending credit.

Montgomery noted that Indonesian banks' ownership structures also influenced the efficiency of asset allocation. As many private banks are owned by affiliates of large corporate groups, there is a risk the banks will make lending decisions in the interest of the group's owners rather than those that maximize the bank's returns. Therefore, the legal lending limit is not observed.

Bank Indonesia has revealed that as of last April, 41 banks did not comply with the legal lending limit, although it was an improvement from the 70 banks in December 1995.

As for state banks, Montgomery said they might not be required to make lending decisions on a commercial basis. This is evident from their problem loan ratios which are much higher at state banks.

Official figures indicate non-performing loans comprised about 17 percent of total credits extended by state banks at the end of 1995, against only 5 percent of private banks' credits.

Montgomery said there was a possibility that some non- performing loans had been restructured into performing loans, but "these technical restructurings may hide poor quality assets."

He also pointed out here had been less focus by the monetary authority to ensure a level of competition among banks adequate to produce competitive pricing on loans and deposits.

Competition induces marginal cost pricing in both lending and deposit market, and efficient use of resources to produce banking service.

"Direct evidence on this issue is absent in Indonesia," Montgomery said.

He suggested the government restructure the country's banking system to provide competitive and efficient banking services. (rid)