Mon, 31 Jul 2000

Next step of banking reform

The political process for the restructuring of the banking sector was completed on July 22 after the House of Representatives approved the recapitalization of state Bank Rakyat Indonesia and Bank Tabungan Negara and publicly-listed Bank Bali with Rp 48.4 trillion (US$5.3 billion) in government treasury bonds. They were the last batch of state and private banks that required massive recapitalization to meet the mandated minimum capital adequacy ratio of 4 percent.

The additional bonds will bring the total recapitalization cost of the banking sector to more than Rp 430 trillion. However, including the hundreds of trillions of rupiah spent to reimburse depositors and creditors of closed banks under the government blanket guarantee on bank deposits, the total restructuring cost is estimated to be about Rp 650 trillion, the largest ever spent by any country in the world to bail out its banks.

But the recapitalization actually means nationalization because more than 80 percent of the additional capital has been put up by the government in the form of treasury bonds and the recapitalized banks together account for more than 90 percent of the banking industry's assets. Hence, the whole banking sector is now majority owned by the government.

But even the massive recapitalization is only an initial step within the restructuring program to restore the ailing banking sector to a sound, strong footing. And this step is still vulnerable to failure because the recapitalization (bond issuance) does not bring in fresh equity, nor new funds to the banks. It is in fact mostly an accounting maneuver that replaces non-performing loans with treasury bonds. Depositors have not deserted the recapitalized banks simply out of their sense of security that the banks are now majority owned by the government.

The next step is much more difficult and will take a much longer time as it involves the restructuring of bank operations, which is an uphill task, given the weak economic condition, fluctuating rupiah and the fragile political situation, which adds sovereign risk to the already high economic risks. Even liquidity-soaked banks would find it extremely difficult to operate in the current situation, let alone the recapitalized banks whose financial capital consists mainly of a debt instrument (treasury bonds). Banking by its nature entails taking an array of risks even under favorable economic condition, let alone amid the economic woes at present.

One can easily reckon how big the risks are in relation to market competition, credit, interest rate, liquidity and foreign exchange encountered by the recapitalized banks. As most medium and large-scale businesses are still either being treated at the debt restructuring "hospital" of the Indonesian Bank Restructuring Agency (IBRA) or held hostage to foreign debts, major corporate lending now is still rare. As of March, for example, only about 30 percent of the funds raised by banks was ploughed into loans to small enterprises and consumers as most banks still invested their funds either in the interbank market or the central bank debt instrument (SBI).

This is worrisome, especially for domestic banks, because they still rely mostly on the net interest margin for their income, unlike foreign banks, which have developed a significant source of fee-based income. As private and government consumption will likely remain the main locomotive of the economy, at least until 2001, most domestic banks therefore compete mainly on the retail market, notably consumer loans.

Hence, the central bank's decision to assign permanent supervisory staff, initially at recapitalized banks and eventually at all major banks, is a strategic move to ensure that banks wholly operate according to prudential regulations. On-site inspection is much more effective than off-site, which depends only on monthly reports from banks, to detect problems as early as possible. And an early warning system is sorely needed under the fragile economic situation, where the condition of a bank could rapidly worsen.

Moreover, as the government is conspicuously known as a poor banker, the permanent presence of on-site supervisors from the politically independent central bank would help ensure that the restructuring process will continue on the right path so that the government can divest itself of the banks and return them to the private sector within one year and recoup its investment or taxpayers' money.