Rating bank soundness

The new rules enacted by Bank Indonesia last week on the rating of the soundness of commercial banks are designed to strengthen the foundation of the banking system, even to the extent of banishing a number of the 239 banks now operating.

The tougher requirements for achieving a sound rating will force bank owners to increase their equity capital, thereby staking out more of their own assets. If the bankers are not willing or not able to do so they will have to merge their banks to survive in the market. The new rulings also put stronger pressure on bank managements to hold firmly to prudential operations.

Banks which fail to achieve a sound rating will eventually be edged out of the market because they will be shunned by the public and the central bank will deny them the permits to expand branches and upgrade to foreign exchange banking operations. But a quicker process of getting rid of unsound banks, irrespective of the political backing of their owners, is still needed to give stronger teeth to the recent government regulation on the procedures for bank liquidation.

Bank Indonesia apparently believes there are now too many small and weak banks which, if allowed to operate in their current condition, could affect the public's trust in the banking industry. Unlike other kinds of businesses, a bank failure can set off systemic risks with far-reaching repercussions on monetary stability. In fact, the central bank is now coping with a number of problem banks.

The new rating rules should be seen as part of an ongoing reform process conducted by the central bank to further consolidate the banking industry and remove the excesses of the 1988 massive banking deregulation which has almost doubled the number of banks to 240 at present.

The rating remains based on international standards such as capital adequacy, asset quality, management, liquidity, legal lending limits and net open position in foreign exchange but realigns the emphasis on several indicators to obtain a more reliable assessment of soundness.

For example, the yardsticks to assess the quality of assets were amended to prevent banks from carrying assets of a questionable quality. The objective is quite obvious. It is not only misleading to the general public but also meaningless for assessing soundness if banks are allowed to book loans or investment in securities which are not backed up with sufficient provisions. Further down the line, the capital standards of a bank are also influenced by the quality of its assets. A capital adequacy ratio will have no meaning at all if the ratio is based on assets whose quality is doubtful.

Legal lending limits or related-party lending -- lending directly or indirectly to borrowers associated with the shareholders -- have been given stronger scrutiny. This apparently has been prompted by the central bank's experiences with problem banks. Most of the problem banks have been driven to financial distress not by fiercer competition but by plundering by their own majority shareholders who made or countenanced unwise lendings to their own business group.

The latest case in point is the almost bankrupt Bank Pacific which is still in the process of being bailed out by the central bank through a merger or acquisition by new investors. The new rules also pay more attention to the quality of financial reports by downgrading the rating of banks found to make window dressing to embellish their bottom line.

The new rules therefore should not be seen as restrictive regulations amid the current era of deregulation but as much- needed prudential principles to improve the international competitiveness of the banking industry. With economies increasingly interdependent and huge capital flows, disruption to a national banking system poses a risk to the entire international financial system.