Current banking controls counterproductive: Analyst

Current banking controls counterproductive: Analyst

JAKARTA (JP): Indonesia's increasing control over the banking
sector and lesser control on accountability can be
counterproductive for the industry, a foreign banking analyst
said.

Ross H. McLeod, a research fellow for the Indonesian Project
at Australian National University, said that government
intervention has been making a strong comeback since 1991, three
years after the country liberalized the banking industry.

"Misunderstanding of the cause of inflation is leading to a
new proliferation of controls," McLeod said at a seminar
organized by the state-owned Bank Negara Indonesia 1946 here last
week.

Although inflation is relatively under control, its rate has
always been higher than the government's current five-year
development target of 5 percent per annum.

Thus, there is mounting pressure on Bank Indonesia, the
central bank, to curb inflation, especially by reducing the
supply of money. However, Bank Indonesia has taken a wrong
measure, controlling bank lending through what it calls "moral
suasion" instead of really reducing money supply.

McLeod contended that commercial banks do not create inflation
because their increased intermediations relocate, not add to the
total of, spending power.

In turn, he continued, inflation is the result of Indonesia's
exchange rate policy, which has generated balance of payments
surpluses throughout most of the last 25 years.

"As the result of the surpluses, Bank Indonesia is forced to
buy them with rupiah, which cause the supply of base money to
grow too fast. This causes inflation, which offsets
depreciation," McLeod said.

The market solution for the matter, McLeod suggested, is to
adopt a flexible exchange rate, instead of controlling bank
lending. He acknowledged that the central bank has been moving
towards that direction. However, its approach is not well-focused
as it tries to cut capital inflow to reduce the payments surplus.

"This is anti-protection. Domestic firms (banks) are not
permitted to compete with foreign firms (offshore banks) and it
ignores the fact that capital inflow is beneficial to growth and
incomes," he argued.

To increase demand for base money relative to supply, Bank
Indonesia has increased banks' reserve ratio to 3 percent from
the previous 2 percent. However, it has been reducing banks'
intermediation capability, McLeod said.

Although the increase seems to be trivial, only by one
percentage point, the real increase is much larger since the
definition of the reserve requirements is changed.

"I just don't see any reasons at all for Bank Indonesia to
increase the reserve requirements," McLeod said.

The alternative to increasing bank reserve requirements is to
issue central bank certificates. "But this is costly to Bank
Indonesia because it has to pay the interests," he said.

By contrast, the reserve ratio amounts to a tax collected by
Bank Indonesia, with a negative impact on intermediation. By
increasing reserve requirements, Bank Indonesia saves up to $260
million annually.

In addition to controlling lending and increasing reserve
ratio, Bank Indonesia has also imposed controls on banks'
involvement with commercial paper issues.

"It tries to hold back the spread of new financial
technologies, such as commercial paper. This is like holding back
the spread of savings deposits prior to 1988, by preventing bank
branching and restricting banks to Tabanas," McLeod said
referring to national development saving deposits.

Competition

Besides, Bank Indonesia has extended controls to non-bank
financing services and held back the expansion of different kinds
of financial institutions.

"Again, this ignores the obvious benefits of competition,"
McLeod said.

"To me, all of these backtracking steps are counterproductive.
They are in conflict with our understanding of the economics of
finance, and they ignore what we have learned from our experience
with deregulation," he continued.

He noted that the challenge now is to hold back the tendency
towards renewed counterproductive government intervention in the
banking industry.

He commended, however, that Indonesia has a very good
scorecard over an extended period, with only one bank failure
resulting in losses to depositors, Bank Summa. The bank went
bankrupt in 1992, with over $800 million in liabilities.

However, he noted that losses to the public caused by state
banks have vastly exceeded those of private banks. And prudential
regulation is probably not capable of solving the problem of
state banks.

McLeod suggested that the government expose the state banks
more to competition as there is now a lack of strong incentives
for state banks to improve their efficiency and profitability.

"As the Bapindo-Golden Key Group case suggests, they are still
subject to political interference in their management," McLeod
said, referring to the $430 million loan scandal at state-owned
Bank Pembangunan Indonesia (Bapindo), which involved the chairman
of the Golden Key Group, Eddy Tansil.

Therefore, he noted that moves to list state banks on stock
exchanges are to be welcomed because there is no real substitute
for private sector owners to put pressure on managers to perform
as prudential regulations cannot force them to do so.

Currently, the government is preparing state-owned Bank Negara
Indonesia to float shares on domestic stock markets.

Speaking on prudential regulations, McLeod mentioned rulings
in New Zealand, as a comparison with those in Indonesia.

In New Zealand, the regulators simply require that detailed
financial statements be posted in all branch offices -- and bank
officials face very severe penalties if they provide misleading
information.

The onus is on the public -- depositors and other creditors --
to monitor the risk of placing their funds with banks, and act
accordingly.

In contrast, Indonesian banks are required to publish highly
condensed financial statements, with very little information to
inform depositors and creditors about risks.

And the practice seems to give them the dispensation not to
publish when they are in trouble -- the only time at which the
financial statements would really be of interest to depositors
and creditors.

In effect, the public is asked to trust the central bank and
the bureaucracy to look after its interests.

"But problems at Bank Duta (because of a US$420 million
foreign-exchange scandal), Bank Summa and Bapindo -- not to
mention bank failures in other countries such as the United
States, Japan, France, Britain and Thailand -- suggest that
bureaucracy sometimes lets the public down," McLeod said.

Moreover, he continued, Bank Indonesia's present system for
evaluating bank soundness is poorly designed. Soundness is
measured as a composite of performance scores in a number of
areas, including some that have nothing to do with risk, such as
credit extended to small enterprises, and some that have very
little to do with it -- for instance, the loan to deposit ratio.
(rid)