JP/6/ED26

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.