Cleaning up the banks

Cleaning up the banks

Bank Indonesia (the central bank) is right in persistently
pushing ahead with its efforts to reduce the number of non-
performing loans (NPls) in the banking industry to a maximum of 5
percent of outstanding loans by the end of 2002.

But the central bank is also wise in not blindly following the
timetable for the enforcement of the minimum 12 percent capital
adequacy ratio (CAR) requirement based on the new Basel Capital
Accord being developed by the Bank for International Settlements.
After all, even the developed economies with already well-
established banking industries will only begin applying the new
capital adequacy standards in 2006.

In the present circumstances where all large domestic banks
are still weak and dependent on interest income from government
bonds for almost 50 percent of their revenues, the central bank
should be realistic.

Insisting on adopting the new capital standard accords, which
revise the internal ratings-based (IRB) approach to credit risks
to include operational and market risks, might force banks to
resort to artificial risk-weighting of their transactions. What
is the use of trying to show the international financial markets
that our banks have met the international guidelines if in
reality their capital adequacy ratios are merely cosmetic?

This is, however, not to suggest that banks should be allowed
to operate with weak capital ratios. But the minimum 8 percent
CAR requirement currently being enforced could well be adequate,
given the present circumstances, if real ratios are revealed that
result from true risk-weighting of assets and are then tightly
monitored under an effective supervisory mechanism.

Moreover, even within the Basel Committee of the Bank for
International Settlements, the debate is still going on about the
definition of market and operational risks in view of the unique
characteristics of national markets.

But enforcing the minimum 5 percent NPL level under more
stringent rules is a must in light of the need to develop a sound
banking industry. Even achieving this target has proved to be an
uphill task in spite of the massive cleansing of the industry of
bad loans in 1998 and 1999, when all the largest national banks
had to be recapitalized by the government with bonds.

Latest Bank Indonesia data shows that industry-wide, NPLs
still averaged 12.4 percent as of June. More than 33 banks were
burdened with NPLs as high as 35 percent, and there is a high
risk that more than 40 percent of the 148 banks in the country
may not be able to achieve the maximum 5 percent NPL target later
this year.

It is indeed most imperative now to minimize NPLs to allow
banks to devote more resources to viably marketing loans to the
corporate sector. The 1997/1998 banking crisis destroyed highly
valuable bank assets in the form of reliable data banks on
creditworthy borrowers, as well as the trust between the
corporate sector and the banking industry.

It is now high time for banks to allocate more resources to
rebuilding this trust and to developing a more reliable credit
information system. Otherwise, banks will never be able to resume
a full-fledged intermediation role.

The conditions now are more conducive for restructuring bad
loans and extending new credits since overall economic risks have
been decreasing as a result of the relative stability in the
political situation and rupiah exchange rate, as well as reduced
inflationary pressures. Previously, instability in almost all
sectors made it virtually impossible to reasonably assess
business plans in the light of loan restructuring or new credit
assessment.

However, under more flexible CAR rules, it is most imperative
for the central bank to steadily improve the effectiveness of its
bank supervisory mechanism to ensure the sort of high-quality
financial reporting that is essential for the efficiency and
stability of the financial system.

The growing capacity for financial engineering and innovation,
as revealed in several cases of aggressive accounting and
corporate fraud that were uncovered recently in the United
States, requires the central bank to put more emphasis on
qualitative supervisory oversight.

But this is possible only if banks are subject to stringent
disclosure requirements that force them to always issue
meaningful and reliable financial and operational reporting.

It goes without saying that the financial information issued
by banks and other corporations has a signaling function in that
it facilitates the identification of the most productive use of
economic resources, thereby enabling reliable assessment of
prospective returns and risks.