Can RI end the prolonged national banking crisis?

Ross H. McLeod, Editor, Bulletin of Indonesian, Economic Studies, Acting Head, Indonesia Project, Australian National University, Canberra

In 1998 and 1999 the banking sector was recapitalized and drastically restructured. Four of the state banks were merged into one. Many of the private banks were closed, several were temporarily nationalized, and the government took a majority stake in several more. The government has guaranteed the liabilities of all of these banks since early in 1998 and, because so many of them became insolvent, this guarantee has generated enormous losses to the government amounting to at least 40 percent of annual output of the economy.

Unhappily, it is now obvious that these actions have not succeeded in restoring the banking system to good health. On the contrary. It now a distinct possibility that a further collapse of the banking system will occur in the near future. Another of the private banks has been closed in recent weeks. One of the jointly recapitalized banks has had to have a further large injection of funds from the government. And, most recently, it has been announced that several of the private banks are to be merged, since they will not be able to increase their capital adequacy ratios to the required 8 percent target by the end of this year.

It is important for the government to plan now for the eventuality of further bank failures. Such planning should be based on an objective reappraisal of the strategies that were followed in the first instance. There were two major shortcomings with these strategies.

First, the capital adequacy standard was very greatly weakened early in the process. Just prior to the crisis, the minimum capital adequacy ratio (CAR) requirement was 9 percent. This was almost the same as the international convention for capital adequacy, but this convention is much more suited to the highly developed countries where the level of uncertainty is much less than it is in Indonesia.

A much higher CAR is appropriate here -- perhaps of the order of 16 to 20 percent. The low standard that existed prior to the crisis was a main contributing factor to the collapse of the banking system. Despite this, the authorities lowered the minimum standard to only 4 percent, and later relaxed the definition of capital for the purpose of calculating this ratio to such an extent that the requirement became virtually negligible.

Worse still, despite the authorities' rhetoric about the importance of enforcement of prudential regulations such as the CAR, in reality this is still not taken seriously. There is no point in having a minimum CAR requirement if capital is not measured accurately. Yet the prudential regulator is allowing the banks to carry one of their major assets -- the recapitalisation bonds -- at book values considerably in excess of market values.

Thus, not only has the CAR requirement been set at far too low a level, and the definition of capital made far too broad, but there has been little or no insistence on marking assets to market values. In consequence, although many banks may report CARs of 8 percent by the end of this year, their true capital adequacy will be much less-and their vulnerability to failure correspondingly greater.

Second, the whole approach to restructuring relied very heavily on the bureaucracy rather than making use of market forces. Rather than closing troubled banks or taking over their ownership, the government should have kept them in the private sector -- although not necessarily under their original owners.

In every case, banks that had become insolvent should have been offered for sale. And, if there had been no offer to purchase them, the government should have called for tenders to take them over. In this manner, the cost the government incurred by virtue of guaranteeing banks' liabilities would have been reduced, because private sector entities are much better able to manage banks -- or, if necessary, to manage their liquidation.

The strategy of bringing such a large part of the private banking sector under government control flew in the face of the accumulated history of the state banks and other financial institutions owned by the government, which is a history of inefficiency and repeated insolvencies. Thus it comes as no surprise that at least some of these banks have deteriorated even further after coming under government control.

What needs to be done now is for the authorities to reinstate the original plan to increase the minimum CAR to 12 percent by, say, the end of 2002, and to move even further by setting a target CAR of 16 percent by the end of 2003. The definition of capital should be significantly tightened to exclude loss reserves and all exposures to entities affiliated with the bank.

At the same time, the government should immediately put all of the banks under its control up for sale, along with all of its shares in the jointly recapitalized banks, under a transparent bidding process. In order to maximize its revenues from these sales, bidding should be open to any entity capable of passing a fit and proper test. These auctions should be two-sided, in the sense that payment can go in either direction.

In cases where bidders perceive the banks to have negative capital, the government should be prepared to pay to have the implied liabilities to depositors (net of assets) taken off its hands. In all cases, the successful bidders should have the option either of continuing to operate the bank-subject to an immediate injection of new capital to bring the CAR up to 12 percent -- or liquidating it.

The above article was delivered by the writer at a seminar held Thursday by the Centre for Strategic and International Studies.