Reforming the banking system

The following is the first of two articles by I Putu Gede Ary Suta, the former chairman of the Indonesian Capital Market Supervisory Agency. It is based on his presentation at the launching of his two new books Foundations of our Capital Market and Menuju Pasar Modal Modern (Toward a Modern Capital Market) on June 22 in Jakarta.

JAKARTA: We are in the 35th month of a serious crisis. Those with resources still visit luxury shops in Senayan Plaza, but ordinary people are facing hard times. Teachers, factory workers and soldiers, among others, must support families on an income depleted by inflation. Millions are jobless. Sectarian violence and strikes have become routine. College graduates are entering the ranks of the unemployed.

It would be nice to be able to say that there is a light at the end of the tunnel and that foreign investment, which is so necessary to growth, is returning. Some believe that with positive statements, our troubles will vanish. If only it were so. Road shows, seminars and optimistic forecasts cannot change reality. Words may fool some -- for a while -- but permanent money flows depend on convincing those whose job it is to be skeptical.

It is fashionable to blame the crisis on the International Monetary Fund (IMF). The IMF has prescribed medication that seems to have done more harm than good. However, let us not forget that every letter of intent signed with the IMF has had two parties. Certainly, as a sovereign nation, those who have accepted these policies on behalf of Indonesia are as responsible as the IMF.

Many suggest that the situation will improve when civil violence stops and political stability returns. But this confuses cause with effect. Riots and political upheavals followed -- not preceded -- the banking crisis. A defective banking policy was the cause. Violence and political turmoil were the effect.

The international media tells us that foreign investors have turned away from Indonesia. Some funds will flow into the country, even in the worst of times. However, the amount of the investment falls short of what is needed to sustain growth and provide jobs for our people. A recent economic report of a major international bank has characterized our nation as "teetering on the brink" and is representative of current opinion.

Nevertheless, there are still optimists that consider any fractional improvement in economic statistics is a sign of recovery.

Some say that unless the problems which caused the crisis are fixed, the country is in for even worse times. Whether or not this is so, the country cannot risk a wait-and-see policy. We cannot afford the luxury of a learning curve for economic policy. A rethinking of some economic planning is now necessary. Some policies, especially with respect to banking reform, are not working.

There is no mystery as to the cause of our current troubles. The economic system collapsed because of a corrupt and inefficient banking system. Government-controlled banks distributed people's money in massive amounts to financially unsound schemes of cronies and relatives of those in power.

Private banks, owned by economic conglomerates, used depositors' funds for personal benefit, ignoring the fiduciary responsibility of sound banking and exhibiting deplorable business ethics. Foreign creditors and bankers channeled billions of dollars of short-term hard currency loans to dubious, long- term, rupiah-based projects that could not be repaid.

In August 1997, the house of cards collapsed. The government announced the end of support for the rupiah. Foreign debts were not repaid and foreign investment ceased. There were runs on banks, causing the government to guarantee deposits, thereby indirectly assuming the burden of bad loans which were the result of unethical conduct by the nation's bankers.

It was clear at the time, as it is today, that a defective banking system was to blame for our woes. The cause was not just a few bad banks or bad bankers, but a whole system based on flawed policies.

However, the remedies prescribed by our economic advisors have been directed to secondary problems -- the effects rather than the causes. We have yet to build the clean and sound banking system that is needed. Let's look at the facts.

First, instead of privatizing state banks, thereby removing the temptation of corrupt lending for political purposes, we have increased the number of government-controlled banks, insuring the continuation of practices that brought about the crisis.

If money is the mother's milk of politics, state banks are the cash cows that feed our political system. Most government officials and politicians cannot even conceive of a nation without state banks. Does anyone really believe that it was the IMF and not our own officials that insisted on recapitalization, rather than privatization of state banks?

Second, instead of rigorously separating ownership of private banks from borrowers and putting banks on a professional basis, there is an eagerness to return banks to their original owners -- as long as they raise the capital to repay government loans.

Bankers should stick to the banking business and should not be preoccupied with channeling depositors' funds to their own enterprises. When bankers approve loans based on impartial and skeptical analysis of credit, the overall quality of loan portfolios will improve.

In the United States, which has one of the most successful economic systems, laws rigorously separate bankers from borrowers. The cost to our nation for not making this separation has been severe, and the price may even be greater if we do not exercise wisdom in making the necessary reforms.

Third, instead of recapitalizing sick banks with real money which could be loaned to businesses and provide people with jobs, we have performed cosmetic surgery by artificially writing up the capital accounts of banks with overvalued, nonmarketable government bonds.

It is obvious that these government bonds must be redesigned if they are to be sold, but Bank Indonesia has fiddled and delayed for over a year and still shows no sign of understanding how to solve a problem that would be routine to any competent investment banker.

Of course, foreign bankers and investors can see what is happening. It is possible to fool some people with misleading statistics and half-truths, but we cannot fool the market for long. If optimistic statements were the solution, we would be in prosperous times. The banking system is broken, and effective measures have not yet been taken for true reform.