Reform the banks or perish

By Eddy Soeparno

JAKARTA (JP): Developments in the past few months indicate that despite a stronger rupiah exchange rate and lower inflation, the economy continues to remain dormant as a result of a banking system that is rotten to the core.

Indonesian banks are notorious for their high level of nonperforming loans, bad management and lending practices, while the system lacks the credibility which comes from sound regulatory and supervisory standards.

Clearly, for all of Asia's distressed economies, a stable exchange rate alone remains insufficient for sustained recovery, especially if the financial system lacks the capital to extend its balance sheets.

In overcoming this critical issue, the government has recently announced a major bank restructuring and recapitalization program for economic revival by way of "fueling up" the banking sector with new capital.

Unfortunately, in announcing the proposed Rp 257 trillion (US$28.5 billion) recapitalization program, the government failed to stress the importance of critical elements in a successful restructuring program, namely political and practical elements of a financial reform package.

If the former is closely associated with the political consensus to tackle a banking crisis, the latter appeals to the necessary tools required to achieve successful reforms.

Although the political will to push through with financial reforms is a key factor in determining the speed and results of the entire restructuring process, finding a political consensus always takes time, even under favorable circumstances.

As experienced by almost every nation with past banking problems, developing the political will to handle banking problems is a tough obstacle, given the unavoidable wealth and income distribution consequences.

Instead, maintaining a status quo could be more convenient, especially if low interest rates and fiscal outlays are used to prevent a total meltdown, as in the case of Japan. As for Indonesia, the loss and distribution of wealth seems to top the list of factors hindering a speedy reform process.

Although the government is currently pressing hard to completing a restructuring and recapitalization program over the next couple of months, it normally takes a few months itself to reach a much needed consensus.

Strong resistance from bank owners and "rock bottom" asset hunters make the process long and sometimes painful. And complicating what is already an obscure situation is the fact that other parties interested in receiving handouts (be it in the name of a "people's economy") are also trying to get their hands on these assets, thus prolonging an already lengthy process.

Consequently, even if there is enough political will to push through financial reforms, practical constrains -- ranging from a lack of expertise and qualified manpower to weak legal, accounting and supervisory standards along with limited financial resources -- are likely to thwart reform.

Notwithstanding the importance of other practical elements, the critical factor in Indonesia's financial reform program is undoubtedly the availability, or lack thereof, of funds to meet the objectives of the program.

Where will Indonesia raise such cash?

Well, be prepared for some bad news: the ability to run a larger budget deficit seems out of the question, especially since Indonesia is subject to strict deficit targets imposed by the International Monetary Fund. Room for spending cuts and tax increases is also limited, given the poor cyclical conditions and the fact that most of it has already been largely exhausted.

As such, with government's fiscal resources limited and private domestic resources largely depressed, foreign capital will play have to a key role in funding the recapitalization of banks and acquiring troubled assets. Therefore, the government has to ensure that disclosure and transparency of information are put up to international standards to meet investors' requirements.

In addition, grassroots resistance needs to be put aside in favor of new cash, technical know-how and the ability to survive the crisis intact.

The above funding issue also addresses the topic of using taxpayer's money to bail out ill-fated banks. As we all know, the huge recapitalization needs already imply an enormous burden on the public purse.

Should the public then be responsible for the mistakes of bank owners (many who are not bankers to start with) who practically misused public funds for their high risk ventures?

To be sure, it is morally unjust for the public to bear the full cost of the recapitalization process. However, under current circumstances, public help is at least needed as a "booster" to jump-start the recapitalization process.

Ideally, fiscal resources from the public should be recovered (sooner rather than later) through the sale of nationalized banks or other acquired financial assets, such as problem loan portfolios. This scheme will likely minimize the burden shared by the public while getting the recapitalization program off the ground.

Whether Indonesia's economy will return to robust growth over the next few years or simply drag its feet forward will largely depend on efforts in recapitalizing and restructuring the banking system.

There is enough evidence, earlier in Latin America and presently in Japan, to prove this statement right. Japan's long period of economic stagnation and its recent plunge into recession highlight that a sustained recovery is unattainable if problems in the financial sector are not well addressed.

Even next-to-nothing interest rates and series of fiscal stimulus packages will be useless in pulling the country out of its current economic slump. With high exposure in the property sector, Japan's private domestic banking and financial industry seem to be loaded with nonperforming loans and several banks are already suffering from negative capital.

In other words, more than a handful of Japanese banks are technically insolvent, with lack of serious efforts undertaken to overcome this problem. Another mixture to this deadly cocktail is the fact that Japan's banking sector consist of more than 900 private domestic banks, and 3,500 financial institutions, therefore intensifying the magnitude of the problem.

Thus Japan's message for Indonesia is simple: Failure to clean up the banking mess will result in more economic suffering, especially now that Indonesia's financial institutions are in a deeper mess than Japan's.

Coming back to financial reforms, these efforts should not be limited to only injecting fresh money into troubled banks. Bank restructuring should also leave the window of "bank closure and liquidation" wide open. Preventing panic and chaos in the banking sector should not hinder the government from closing down clearly ill-conceived banks.

Past experiences taught us that the cost and consequences of rescuing ailing banks in the long run could prove more costly and severe rather than closing them down immediately. Moreover, the fact that the government has already acted as de facto deposit insurance institution will in fact, minimize the risk of a run on the domestic banking system in the event of further bank closures.

Finally, let us not forget the ultimate goal of Indonesia's financial reform, namely to build a sound and stronger financial system. As such, efforts undertaken should not cease at merging, acquiring and injecting fresh capital into the domestic banking system, but continue by improving accounting, supervisory and legal standards in general. Banks, especially government owned, should not be treated as tools of state industrial policy, having them finance uncreditworthy borrowers and ventures.

Furthermore, the central bank's function as "savior of last resort" should also be replaced by a well secured and well funded depository insurance scheme, responsible for stabilizing the industry during in the event of crises. Last but not least, the traditional role of banks channeling public deposits to the business sector should gradually be reduced.

A bank's intermediary function should, in the future, be transformed into one that raises public funds to finance business growth, thus a move towards securitized funding. Depositors money will be invested in less riskier ventures, while business in general will be financed using public funding with the public determining their own risk-reward scheme.

The road to reform the banking sector is undoubtedly long and most likely rough. It is hardly a Sunday ride in the park. But, rest assured; once you reap the reward, it sure feels like one.

The writer is a director in a foreign bank in Jakarta. This article represents the writer's personal opinion.

Window: Consequently, even if there is enough political will to push through financial reforms, practical constrains -- ranging from a lack of expertise and qualified manpower to weak legal, accounting and supervisory standards along with limited financial resources -- are likely to thwart reform.