Can RI end the prolonged national banking crisis?

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.