Clean sweep of banks

The clean up of the banking industry the government has pledged to complete later next week should be a sweeping one, undertaken with the highest transparency and consistency possible in line with the prescribed requirements. Anything short of these qualities would not help domestic banks to jumpstart the process of regaining domestic and foreign confidence. Without public confidence, the banking sector will remain crippled, unable to resume lending, the lifeblood of businesses.

We have been apprehensive about the clumsy way the government has handled the banking crisis since November, 1997. But as more information is made available about the preparations for the massive banking realignment, we see a more encouraging signal. The central bank (Bank Indonesia), which in the first place is partly responsible for the banking crisis, has provided a clearer indication of what kind of banks will escape the clean-up drive by disclosing what we reckon should be the most vital element of good bank governance.

Bank Indonesia has asserted that banks must pass a 'fit and proper' test in order to qualify for the government-sponsored recapitalization program. This means that the management of banks to be recapitalized should have integrity and be honest, competent and technically qualified, and their shareholders should also demonstrate high integrity.

Previously, the monetary authorities seemed to put more emphasis on money issues -- the capital adequacy ratio and the settlement of bad credits and liquidity support from the central bank. Only one requirement, a viable business plan, is not related directly to the funding issue. Though these requirements are certainly necessary, as basically banking is all about the business of money, they are not enough and, in fact, not the most important determinant of a sound bank. After all, owners are required to put up only 4 percent of their total bank assets with the remaining 96 percent being provided by the public. Likewise, a valid, viable business plan is not absolutely crucial for ensuring sound bank operations. One can simply hire a bank consultant to prepare an excellent business plan in order to impress the central bank.

It is precisely because bank management and shareholders deal mostly with other people's money that their integrity, honesty and technical competence should be made the ultimate criteria. Good bank governance starts with the owners and management.

Owners with high integrity and honesty will obviously insist on the same characteristics and moral standards in the personnel they want to appoint to manage their banks. Good management will demand prudential banking practices from their staff and insist on having an effective internal audit system and controls. No amount of external supervision by the central bank would be effective in preventing bank failures or scandals if the internal audit system and controls are weak.

Case studies of bank failures in most countries have concluded that poor management or shareholders with a crooked mentality have been the main reason behind banks going bust. Very rarely did a bank fold because of fierce competition.

Bank Indonesia itself has discovered that almost all the banks that have now to undergo recapitalization either violated the legal lending limits or engaged in unsound lending sprees. In fact, it was unsound lending practices that led most banks into their present crisis. The financial meltdown (rupiah depreciation) acted only to trigger the outbreak of the crisis.

Hence, following this line of thought, the management and shareholders of banks which were found to have committed egregious violations of the legal lending limits (excessive connected lending) should fail the 'fit and proper' test. Retaining them in their positions only because they have fulfilled the other requirements will only plant a time bomb under their foundations which sooner or later will explode to shock the industry.

Given the perception that the government has often been politically motivated and clumsy in its approach to bank restructuring, it should have acted in a spirit of great transparency in conducting the 'fit and proper' tests of bank management and shareholders, especially because recapitalization will be funded mostly by the taxpayers.

Transparency and disclosures are especially important for the financial market because of its high sensitivity to information. It is most imperative therefore that the announcement of the wholesale bank clean up scheduled to be made on Feb. 27 provides detailed information on the management and shareholders of recapitalized banks, on how they have settled or will settle their bad loans and liquidity support from the central bank and on what the basic elements are of their respective business plans.