Banks' dominance in financing dangerous

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)