Prudence leading banks onto sound growth path

Prudence leading banks onto sound growth path

JAKARTA (JP): As part of Indonesia's economic revival of the
early 1980s, banking was the first sector to be deregulated. The
first deregulation package was introduced in June 1983, and
removed ceilings on credits, reduced liquidity credits and
allowed banks to set their own interest rates.

However, when the government decided that it could no longer
depend solely on the state banks and oil/gas revenues to fuel
economic growth, a major reform package called PAKTO was released
in 1988. The latter relaxed the restriction of new banks and
branches, reduced reserve requirements, allowed banks to be
listed on the capital market, and finally permitted state
enterprises to deposit their funds in non-state banks.

Consequently, the number of private national banks mushroomed.
Currently, there are over 250 private banks in the country, with
their operations generally divided into corporate and consumer/
retail banking. Of these, the bulk were established after the
enactment of PAKTO.

Between 1991 and 1992, the country suffered an over-heated
economy, which set interest rates rocketing above 30 percent. In
February 1991, a more prudent measure was introduced. The measure
required banks to achieve a minimum capital adequacy ratio (CAR)
of 8 percent, prompting banks to decelerate their lending and
reassess their loan quality, which had deteriorated due to
aggressive growth, and the high interest rate environment.

Between 1991 and 1992, Indonesian banks entered a
consolidation phase, with most of their funds channeled into Bank
Indonesia certificates (SBI). Later in 1993 the central bank
issued a stimulation package called PAKMEI, in which the
calculation of LDR and CAR were eased, while provision for risk
assets was halved to 0.5 percent, from the previous 1.0 percent.

This has boosted lending in 1993, which grew by 19.9 percent
against 8.9 percent the year before. Private banks recorded the
strongest loan growth, with lending rising by 42.7 percent,
compared to 5.9 percent for state banks. The 1993 reform measures
provided banks with greater room for expansion, which was mostly
enjoyed by the private banks.

In its latest move, the central bank, in January 1995, issued
four new regulations to promote a healthier and more reliable
banking sector. The first regulation required banks to set out an
annual working program, including projections on savings,
deposits, lendings, fee-based services and net-work expansion.

Reports regarding credit disbursements is required to include
information on the project, the financing, collateral, terms of
payment and the portion to total outstanding loans. The second
regulation defines the people who should be barred from owning
and working in a bank. These are black-listed shareholders,
executives and other employees, who have been involved in fraud,
false transaction or colluding with a third party.

Under the second regulation, former executives or affiliated
parties involved in the downfall of their banks during their
terms of office are also black-listed. The third regulation sets
out the restrictions on exchange of information between banks, on
information of their active borrowers. The fourth regulation
provides standardization on accounting system. This includes
financial reports which should be published at least twice a year
and show the position the year before (June and December
financial report), financial audit by an auditor registered with
the central bank and for listed banks to follow regulations set
by the capital market supervisory board (Bapepam).

Credibility

The regulations will be strictly enforced by Bank Indonesia,
and should improve the overall credibility on the banking sector,
which have been blemished on several occasions by such acts as
fraud and false transactions. The new regulation, should also
reduce unfair competition as operations will be closely monitored
by the central bank.

The listed banks within our coverage posted a 78.2 percent yoy
(year-on-year) increase in pre-tax profits in the third quarter
of 1994. The impressive earnings growth were within our
expectations, and was due to a significant improvement in
loan-to-deposit ratio (91.8 percent in 3rd quarter of 1993 to
101.4 percent in 3rd quarter of 1994), capital raising in the 2nd
quarter of 1993 and 1st quarter of 1994, and banks' successful
effort in boosting fee-based income, to compensate for the rise
in deposit rates.

Largely due to the strong credit demand and a better
investment climate, compared to the previous years, the banks'
loan book expanded by 47.2 percent yoy, while year-to-date (ytd)
loan grew by 32.3 percent, surpassing the industry's loan growth
of 18.2 percent for the same period.

Most of the growth occurred in 2nd Quarter of 1994 and 3rd
Quarter of 1994. This is expected to continue which should
contribute to strong earnings in 1995.

On the funding side, deposit growth fell short of loan
expansions, at 39.7 percent yoy and 19.2 percent ytd, as they
were partly funding their loan expansion through strong equity
financing. This was a deliberate strategy, as the covered banks
were trying to limit funding cost amid rising pressure to
increase local deposit rates.

Consequently, net interest margin of the banks widened to 4.8
percent in 3rd Quarter of 1994, from 4.4 percent in the beginning
of the year. The increase in the yield of its earning assets was
also reflected in the banks' average loan-to-earning asset ratio
which stood at 75.4 percent in 3rd Quarter of 1994, versus 65.9
percent in the beginning of 1994.

Bank lendings

Total bank lending as of April, 1995 stood at Rp 200.43
trillion (US$91.1 billion), a 6.3 percent increase from the end
of 1994. Lending over ten months of 1994 outpaced the previous
year's 12-month growth of 19.9 percent (1993), 8.9 percent (1992)
and 16.3 percent (1991). This was attributed to private national
banks, which posted a growth of 34.5 percent during the period,
against 21.1 percent for foreign banks and 9.9 percent for state-
owned banks.

State-owned banks are still struggling with bad or doubtful
loans which reached around 20-25 percent of its outstanding
loans. Consequently, private banks' share of the credit market
has substantially expanded.

In 1988, state-owned banks, including provincial development
banks dominated the credit market accounting for just over 71
percent of the total domestic outstanding loans. Since then, its
market share has steadily declined to below 47.2 percent as of
3rd Quarter 1994, with the balance attributed to private banks
(52.8 percent).

The chunk of the domestic lending growth will come from the
manufacturing, trade and service sectors. As of the third quarter
of 1994 the manufacturing sector accounted for 31 percent of the
outstanding domestic loans, followed by the trade and service
sector which accounted for 26 percent and 24 percent
respectively.

With the central bank's advice to reduce loan expansion to
around 20 percent, the reduction is most likely to come from loan
restriction to the over-heated property sector. Loan disbursement
to this sector in 1994 was estimated to have doubled that of the
total banking sector's loan expansion.

Deposit rates

Upward pressures on domestic interest rates, emanating from
the uptick in U.S interest rates throughout 1994, have led banks
to increase deposit rates. The average three-month deposit rate
which has been declining throughout 1993 and 1st Quarter of 1994
(-492 basis points), began to rise in April 1994, up by an
average 307 basis points to 14.5 percent as at the end of 1994.

Compared to the increase in the U.S interest rate of 250 basis
points for 1994, the rupiah three-month deposit rate rose higher
at 285 basis points. This was necessary to maintain the
attractiveness of the rupiah and to prevent capital flight. It
also appeared that there was a strong need to contain
inflationary pressures in 1994 with inflation reaching 9.2
percent by the year-end, above the 8.5 percent most expected in
1st quarter of 1994 and the initial government projection of 7
percent at the beginning of 1994.

Looking at the medium-term, the average three-month deposit
rate and prime lending rate over the next twelve months are still
expected to rise by 100-150 basis points, despite indications
that U.S interest rate has already reached its peak. In June,
1995, the average three-month deposit rate stood at 16.5 percent.

To prevent capital flight and encourage capital inflow, the
government imposed two policies which is the managed rupiah
depreciation against the greenback (ideally should equal the
inflation gap between the two countries) and maintaining an
attractive spread between the rates of both countries.

The reversal in the interest rate curve has caused the average
bank's spread to constrict. Deposit rates which have been falling
at a faster rate than lending rates over 1992 and 1993, are now
rising ahead of lending rates. The average nominal spread
between the three-month deposit rate and working capital loan has
declined from 600 basis points at the beginning of 1994 to its
low of 366 basis points in October 1994.

Credit expansion

The outlook of higher interest rate has prompted the central
bank to advice banks to limit their credit expansion to around
20 percent in 1995. The central bank has also been tightening the
policy through the use of its money market instruments, namely,
the Bank Indonesia Certificates (SBI) and money market commercial
papers (SPBU).

The monetary contraction is led by the decline in the value of
outstanding SBI from Rp 24.8 trillion in January 1994 to Rp 14.7
trillion as of the third week of November 1994 and Rp 10.4
trillion as of June, 1995. This is also reflected in the value of
net outstanding SBI, which is the value of outstanding SBI,
deducted by the value of outstanding SPBU.

The value of net outstanding SBI over the same period has
declined from Rp 23.5 trillion to Rp 12.4 trillion and Rp 5.4
trillion. With liquidity expected to deteriorate in 1995, we
expect banks to maintain their margins by adjusting lending rates
to prevent erosion of earnings.

The average deposit growth at 3rd Quarter of 1994 stood at
15.6 percent yoy, lagging behind loans which grew by 22.8
percent yoy. Consequently, the industry's loan-to-deposit ratio
has risen to a high of 111.6 percent in 3rd Quarter of 1994,
against 105 percent the year before.

However, using the Bank Indonesia loan-to-deposit calculation,
the average bank's regulatory LDR is estimated at around 90
percent, still well below the 110 percent ceiling.

In addition, lending rates will still be on the lower end of
its historic scale, and given demand for credit remains strong,
there is a good possibility that the average loan expansion will
surpass the limit advised by the central bank.

This should also be supported by the lower expected inflation
rate in 1995 and strong economic growth and a jump in domestic
and foreign investment approval throughout 1994.

Banking stocks are currently trading at a 1995 price earning
ratio of 10.6 times, compared to the market average of 13.5
times.

We believe investors should focus on the more liquid banks,
which have either raised funds through a rights issue or offered
their shares over the last twelve months. These banks should be
able to post healthy earnings growth. Further, second-tier listed
banks should be able to expand their loan book at a faster rate,
and at higher margins.

-- Sigma Batara Research