Closing bad banks

Fostering a sound banking sector through orderly financial conditions and a good monetary system has always been a core component of IMF-supported programs in its member countries, as again amply evidenced by Indonesia's latest reform package. The rationale is that banking problems can be costly for and disruptive to economic performance. Moreover, in the current era of integrated financial markets, one country's banking crisis could result in regional and even international repercussions.

A recent study by the International Monetary Fund showed that during the past 15 years, 133 of its 181 members have experienced significant banking problems, with financial costs often exceeding 10 percent of gross domestic product.

Nonetheless, the government decision over the weekend to close down 16 bad banks, in a bold move to strengthen the financial sector, revealed several worrisome tendencies.

The most troublesome of these is that the move served to strengthen the market perception that the central bank (Bank Indonesia) is often held hostage to political pressures, is short of skilled supervisors and that the integrity of a number of its supervisors is not high enough to guarantee reliable bank assessments.

The problem has been exacerbated by the fact that information and reports published by many banks have not been reliable or comprehensive enough to enable a viable bank assessment. Moreover, many bankers seem to hold the misperception that capital, and not good management and prudential practices, is the most important asset for a sound bank.

The market has long suspected that the central bank, as the supervisory authority for the banking industry, does not have adequate autonomy and freedom from political influences to enforce all the prudential regulations it has imposed. The last minute haggling to save a number of banks which the central bank had recommended for closure clearly showed how vulnerable the central bank has been to political pressures.

As the number and names of the 16 banks closed differ widely from long-running market speculation, there is now also a strong suspicion that the content of bank reports is often misleading. As recently as June, for example, the trade magazine InfoBank, which specializes in the banking industry, announced the rating of all commercial banks on the basis of the parameters set by the central bank to assess bank soundness. Six of the 16 banks which were closed on Saturday were rated as fairly good or good. The magazine did not give any rating for another 19 banks as they had not issued quarterly or annual reports for years, some of them since 1993. Yet, only seven of these 19 banks fell to the liquidation axe.

The grim consequence of these developments is that the central bank should prepare a huge financial safety net to prevent another chain of bank liquidations in the near future, otherwise systemic risk and panic will hit the whole industry.

We are confident, nevertheless, that the central bank and related agencies, with technical and financial assistance from the IMF, the World Bank and the Asian Development Bank, will become more capable of and have broader political freedom to strictly enforce market discipline and stronger prudential regulations on the remaining banks. We anticipate that the central bank will be tougher in forcing weak banks to merge or obtain new investors.

Stronger enforcement of prudential banking regulations is even more crucial now given the difficult economic situation, with very slow growth or perhaps even recession predicted for the next two years. In such a situation, banks are facing greater risks related to market competition as well as credit, interest rate and exchange rate risks.

But the central bank's supervision could be made more effective, and preventive measures against new bank failures can have stronger teeth only if the government fully enforces the 1992 Banking Law and Law No.68/1996 on bank liquidation upon the 16 closed banks.

Both laws stipulate that bank directors, supervisors and shareholders who are responsible for leading their bank into bankruptcy are liable for up to 15 years imprisonment and fines of up to Rp 10 billion. On top of these penalties, they are also held fully responsible for settling the debts of the liquidated bank, meaning that their personal assets can also be confiscated whenever the assets of the liquidated bank are insufficient to settle its debts.

This is both a great challenge and opportunity for the central bank to strengthen its integrity and political freedom. It must conduct its investigation of the liquidated banks in a fair and transparent manner because the owners or directors of the liquidated banks include politically well-connected personalities.