Part 2 of 2: Lessons from crisis management

Part 2 of 2: Lessons from crisis management

Ross H. McLeod, Indonesia Project,
Australian National University, Canberra

In Part I of this series, I drew attention to the huge cost of
the collapse of the banking system in 1997-1998, and canvassed
some ideas as to how the government might recoup some of its
losses.

In this second part, I turn my attention to the very real
possibility of a recurrence of a similar financial disaster. No
significant progress appears to have been made on this front as
yet, and nothing in current discussions of the proposed
"Financial Safety Net" provides any cause for optimism in this
regard.

One of the reasons why the recent banking collapse was so
costly was that the authorities were willing to pay almost any
price to avoid widespread banking insolvencies resulting in
damage to the payments system provided by the banks. In this it
was certainly successful, but it is surely incumbent upon
policymakers to find some way of ensuring the integrity of the
payments mechanism that does not run the risk of incurring such
enormous costs.

As former Bank Indonesia governor Soedradjad Djiwandono argues
in the newly published special issue of the Bulletin of
Indonesian Economic Studies, the banking law provided no explicit
guidance on how the authorities should deal with a system-wide
meltdown. We should not forget that the $60 billion cost incurred
by the government is ultimately borne by "innocent bystanders" --
members of the general public who may even have had no direct
relationship with the banking system.

I have set out a proposal for modifying the banking law with
these concerns in mind in the special issue of BIES. The key to
dealing with any future system-wide insolvency among banks, in a
way that keeps the banking system operational while avoiding huge
costs to the general public, is to ensure that such insolvencies
are handled in more or less the same way that insolvency of a
non-bank corporation is handled. The intention of a well-designed
bankruptcy law is to minimize aggregate (as distinct from
individual) losses resulting from the failure of any corporate
entity.

A fundamental insight here is that these losses may well be
smaller if the corporation can be kept in operation rather than
closed down -- a point ignored in Indonesia's recent banking
debacle, in which scores of banks were summarily liquidated.
Closure of any firm implies losing the value of all assets that
are specific to that firm, such as brand recognition, the
customer base, management information systems, corporate know-how
and so on.

Keeping the firm in business does not require any handout to
its owners (the absurdly generous treatment of the infamous
Texmaco conglomerate by successive governments notwithstanding).
On the contrary, the logic of the capitalist system is that
failure to manage businesses carefully results in the loss of the
owners' equity in the firm.

If this equity is fully exhausted, further losses are borne by
the firm's creditors, which gives them, also, a strong incentive
to lend wisely. I argue that there is no reason to treat banks
any differently.

The way this works in the non-bank corporate sector (providing
the legal system operates effectively, and in the absence of
government interference) is that, if creditors come to believe
that a firm is likely insolvent, they arrange to appoint an
administrator to take over the management until the firm's future
can be resolved.

In the interim, creditors are prevented from withdrawing their
loans in order to conserve its cash resources. In effect, if the
firm is indeed insolvent, the creditors become its new
shareholders, and they are entitled to ownership of its remaining
assets in proportion to their share in total liabilities.

In the case of banks, the major creditor class is the
depositors. My proposal is that the banking law should be
modified such that, if the supervisory authority comes to the
view that a bank is actually or nearly insolvent, it
automatically freezes deposit withdrawals and draw-downs of
loans, and appoints a temporary administrator to take over the
management. The only real difference here is that it is the
regulator, rather than the creditors, who initiates this action.

In addition, in view of the importance of maintaining the
operation of the payments mechanism, the administrator arranges
for a quick, conservative audit of the bank's financial
condition.

Once a new balance sheet has been drawn up on this basis, he
then immediately imposes a debt-equity swap, the purpose of which
is to write down the value of deposits and other liabilities by
an amount sufficient to build up the bank's capital to a healthy
level. As soon as this had been accomplished, depositors would be
permitted to draw on whatever remained in their accounts.

The proposed revision to the banking law would specify that
demand deposits would rank more highly than other kinds of
deposits and non-deposit liabilities, with the intention of
keeping deposits used for transactions purposes intact, so far as
this is possible, thus minimizing disruption to the payments
system.

Since the true value of the bank's assets cannot be known with
certainty, and since the auditor would be required to err on the
side of conservatism, the market value of new shares acquired
through the debt-equity swap by the bank's depositors and other
creditors would be expected to exceed the value indicated by the
balance sheet.

These shares could be sold in a market (facilitated by the
administrator), either to other depositor/shareholders or to new
investors. When any single investor or group of investors
acquired a large enough shareholding to warrant taking management
control, the administrator would call a shareholders' meeting for
this purpose. A newly formed board of commissioners would then
appoint a board of managing directors, thus allowing the bank to
emerge from administration and to return to normal activity.

One advantage of this proposed set of arrangements is that
ownership of the banks would stay with the private sector, thus
avoiding the kind of looting witnessed after the government took
over private banks, in whole or in part, in 1998-1999, and placed
them in IBRA's portfolio.

Disruption to the payments mechanism would be limited to the
level of minor inconvenience and, perhaps most important of all,
the losses of the banking system would be confined to its owners
and creditors, thus avoiding the transfer of these losses to the
blameless general public.