NPL requirement eased

Bank Indonesia (the central bank) is correct in postponing the requirement for banks to clean up their non-performing loans (NPLs) to a maximum of 5 percent of credits outstanding originally scheduled to be completed by the end of this year.

Persistently enforcing the NPL ruling after the Oct. 12 bomb attack in Bali would not have only been rather impossible but could also unnecessarily cause a new shock in the fragile banking industry and force banks to resort to acts of deception by artificially classifying their loan assets.

It is indeed more realistic to postpone the requirement but under tight supervision to ensure that banks categorize their liabilities fully according to the central bank's standards and set aside adequate provisions for their NPLs.

Enforcing the minimum 5 percent NPL level under more stringent rules should indeed be necessary to develop a sound banking industry, especially after the massive cleansing of the industry of bad loans in 1998 and 1999 when all the largest national banks had to be recapitalized by the government with bonds.

It is of equal importance to minimize NPLs at banks to allow them to devote more resources to viably marketing loans to the corporate sector, developing more reliable information systems to determine creditworthy borrowers and rebuild trust between borrowers and the banking industry.

But the NPL target became infeasible after the Bali bomb blast, which has increased business risks and consequently put more loans in a state of vulnerability to default. Bank Indonesia Governor Sjahril Sabirin himself acknowledged last week that the Bali tragedy could significantly increase the incidence of bad loans as companies were struggling with higher business costs.

The increased security and business risks have certainly had an adverse affect on the business plans on which loans were assessed. Cash-flow estimates which were earlier assessed as adequate to sustain debt service payments were upset, as costs rose and the international market confidence in Indonesia decreased.

Latest Bank Indonesia data showed that industry-wide, NPLs still averaged 12 percent as of September. Some 64 of the 144 banks operating in the country are still burdened with NPLs far higher than 5 percent.

Enforcing the maximum 5 percent NPL could unnecessarily put the yet weak banking industry into another shock, especially in light of the government decision to phase out its blanket guarantee on bank deposits and claims starting in January.

The blanket guarantee that was launched in February, 1998 at the height of the banking crisis is surely the most important factor in maintaining public trust in national banks, despite their fragile condition and their heavy reliance on government bonds for their incomes.

The phasing out of the guarantee, which will start in January 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.

The postponement of the NPL requirement should, however, be supplemented by the central bank with closer monitoring and more effective supervision to ensure that banks would not relax the efforts to clean up their portfolios from bad assets and that they fully abide by Bank Indonesia standards in classifying the quality of their loans.

Yet more important is that central bank should see to it that banks adequately cover their bad loans with provisions.

Bank Indonesia also removed another source of worry among the banking industry by wisely reaffirming on Friday that Indonesia will not blindly follow the time table for the enforcement of the minimum 12 percent capital adequacy ratio (CAR) according to the new Basel Capital Accord being developed by the Bank for International Settlement.

In the present circumstances whereby all the largest national banks are still weak, insisting on adopting the new capital standard accords which will revise the internal ratings-based (IRB) approaches to credit risks to include operational and market risks might force banks to resort to artificial risk- weighting of their transactions.

This is, however, not to suggest that banks should be allowed to operate with weak capital ratios. But it is more effective to secure sound banks by holding to the minimum 8 percent CAR currently enforced, rather than a cosmetic 12 percent CAR, provided the former capital standard is the real ratio resulting from true risk-weighting of assets.

It is therefore most imperative 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 frauds that were uncovered recently in the United States, requires the central bank to put more emphasis into qualitative supervisory oversight.