NPL requirement eased

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.