Merging banks under duress

The government has become notorious for its foot dragging and, sometimes, even outright inaction with regard to the reform measures that are badly needed to generate a sustainable economic recovery.

The latest case in point is the consolidation of the private banks that were nationalized in 1999. The government has finally decided to merge five banks as four of them are not likely to be able to achieve the minimum capital adequacy ratio (capital against risk-weighted assets) of 8 percent by the December 31 deadline.

But why was that measure taken only two months before the deadline? Was the government's monitoring and supervisory ability so ineffective that it could not have known as early as June that those banks had no chance of achieving the minimum CAR level?

The consequence of the hurried measure is that the merger is now being completed under duress, rather than being a consolidation directed by market forces.The enforced process will certainly impose more costs on the government while its outcome is not likely to be as favorable as what a market-driven merger would produce.

Moreover, a merger process is never an easy and smooth exercise even though the five banks -- Bank Universal, Bank Bali, Bank Patriot, Bank Prima Express and Bank Artha Media -- are majority or entirely owned by the government and are all medium- size retail banks. Since a merger is by its nature a consolidation process, it requires massive layoffs and the closure of redundant branches to achieve maximum efficiency, not to mention the initial complications inflicted upon the clients of those banks.

Fortunately, though, the announcement of the merger did not cause any jitters among depositors because all five of the banks are either majority or entirely-owned by the government and, most importantly, the blanket guarantee for bank depositors and creditors is still effective.

In any case, since a merger, though rather late, is still much better and less shocking than outright closure, the government should make the most of the consolidation.

Even though some analysts initially estimated that the merger of the five banks, which had combined assets of Rp 28 trillion (US$2.6 billion), would create a new bank with a CAR of 10-11 percent, significantly higher than the minimum 8 percent, the government should see to it that the capital standard of the new bank is based on a strict asset classification.

Most crucial in ensuring high asset quality is the application of tough standards in loan classifications. The latest experiences with the closure of Unibank due to widespread bad loans and the second recapitalization of Bank International Indonesia that cost the government another Rp 2 trillion to Rp 3 trillion, point to the unreliability of the asset classification system applied in the banking industry.

Lenient loan classifications are able to conceal weak assets only for a short time, and these low-quality assets are like a time bomb that could explode even at the slightest downward shift in the economy. It is therefore most imperative to rid the new bank entirely of doubtful and bad loans so that its non- performing loans will be cut to a maximum 5 percent, as mandated by the end of next month.

In fact, given the persistently high risks to be encountered by banks in view of the weakening economy and the downward trend in the rupiah exchange rate, the government, if necessary, should inject additional capital to bring up its CAR to at least 12 percent, the level now applied in most Asian countries. Simply achieving the minimum 8 percent CAR, particularly if the asset classification system was based on questionable standards, would only put the new bank on the verge of again falling below acceptable standards. Moreover, a minimum capital standard will not make the bank attractive to private investors and this will certainly hinder its privatization, which should, after all, be the next compulsory stage of its consolidation.

No less important is the kind of corporate image to be created for the new bank, and this involves the selection of the surviving entity from among the five banks. But since Bank Bali and Bank Universal are the largest of the five, certainly one of them will eventually emerge as the surviving entity. That does not, however, mean that the highest CAR (Bank Bali with more than 15 percent) is the key prerequisite for becoming the merger leader, especially in view of the tarnished image of Bank Bali under the so-called Bank Bali scandal in 1999 that derailed its acquisition by Standard Chartered Bank.

Since the corporate image of the new bank should appeal to its market segment, that is small and medium-scale enterprises, Bank Universal, well known for its good corporate governance practices, and good track record in that sector, could emerge as the surviving entity.