JP/6/ED26

May 26, 2003

Continuing bank divestment

Buoyed by the smooth and successful sale of its 51 percent stake in Bank Danamon to Asian Finance Indonesia Pte. Ltd, a consortium of Singapore Temasek Holdings and Deutsche Bank of Germany, last week, the Indonesian Bank Restructuring Agency (IBRA) is now finalizing preparations for government divestment of publicly listed Bank Lippo, state Bank Mandiri and Bank Internasional Indonesia (BII).

While divestment of Bank Mandiri will be conducted through an initial public offering (IPO) at the Jakarta Stock Exchange within the next few weeks, the other two nationalized banks will most likely be offered to strategic investors through competitive bids.

Narrow-minded nationalists may oppose the divestment program, expressing great concern that the country's largest banks will eventually be controlled by foreign investors and criticizing the fact that bank sales thus far have failed to gain high prices due to weak market response.

True, given the financial distress of all large domestic investors, it is likely that both Bank Lippo and BII will eventually end up under the controlling ownership of foreign investors.

But the probability of foreign control is nothing to worry about as long as the new investors are finance institutions that are able to bring in synergy, credibility, fresh capital and better management to the acquired banks as the new controlling owners of Bank Central Asia (BCA), Bank Niaga and Bank Danamon are.

But the government is also wise for selling Bank Mandiri, the country's largest bank, not through a strategic sale but through an IPO that will initially offer only 15 percent. It is still simply politically unfeasible to let this state bank fall under foreign control.

It is also unrealistic to expect very high prices for the banks, let alone to recoup the investment the government made to recapitalize those banks in 1999 and 2000. Investment in domestic banks is still highly risky given their fragile condition.

Moreover, it is not logical to compare the prices of banks here with, say, those in Thailand and South Korea because the condition of domestic banks is simply the reflection of the overall economic condition.

The dilemma here is that the longer the government divestment of the banks is postponed, the more vulnerable they will be to another wave of financial distress, especially in light of the government policy of phasing out its blanket guarantee of bank deposits and claims early next year.

The phasing out of the guarantee, which will start with the lifting of bonds, direct loans, letters of credit and derivative transactions from the scheme, will certainly force a tougher consolidation of banks as market forces will be more stringent in screening viable banks.

It would therefore be misguided to assess the strategic sale of the banks simply from the prices to be gained. Much more important is the synergy, credibility and improved management that will be brought in by the new majority owners.

Strategic investors with a good reputation will be able to jump-start the banks' operational restructuring and create a virtuous cycle within the banks. Operational restructuring is most imperative now to enable banks to devote more resources to viably market loans to the corporate sector, develop a more reliable information system on creditworthy borrowers and rebuild trust with borrowers.

Just witness how the loan-to-deposit ratio within the banking industry has remained below 50 percent, while most businesses are suffering from a credit crunch, and a loan-to-deposit ratio of almost 100 percent is needed to spur high economic growth. But again foreign control of major domestic banks does not ensure the development of a sound, strong banking industry. Neither should divestment of state-controlled banks be considered an end in itself, but rather an important stepping stone to creating a sound financial system.

But experience in most other countries points to the need for the government to take a multifaceted approach to deepen the financial sector and increase access to credit. Key elements of this approach include strengthening the legal and regulatory framework for the financial industry and improving the investment environment to reduce business risks and consequently the risk of loans turning sour.

It is similarly vital for the central bank to steadily improve the effectiveness of its bank supervisory mechanism to ensure 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.