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)