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.