Next step of banking reform

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.