Reforming the Indonesian banking system

The following is the second of two articles by I Putu Gede Ary Suta, 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 (Towards a modern capital market) on June 22 in Jakarta.

JAKARTA: Not only have the remedies prescribed for the banking problem been ineffective, the medicine actually contains a slow poison that makes the situation worse. This slow poison is the cost of interest on the government bonds that have been used for the superficial repairs of bank balance sheets.

These bonds require interest payments that now absorb most of the income taxes collected by the government. As the ineffectual plan to recapitalize the banks moves forward, even more bonds will be issued for the same doubtful purpose, increasing the drain on our resources.

Not only do these over-valued government bonds fail to provide funds for recovery, but the interest diverts money that could be used to pay fair salaries to teachers, soldiers, public health workers and others on whom we depend for safety and well-being.

The problem with the bank restructuring program is that there is no end game strategy. The illiquid government bonds will eventually come due. Unless interest rates are increased so that the bonds are marketable, perpetual rollover of these bonds is the logical outcome, permanently burdening the budget and postponing recovery.

There are many things wrong with the political and economic environment. However, it is necessary to separate prime causes from secondary problems. Does anyone doubt that civil disturbance and violence would decrease if employment were to recover? Is it not obvious that dealing with the debilitated banking system is the most urgent matter?

Sometimes in the affairs of nations, policies become entrapped in what seems to be "political reality". Even though many realize that a certain course leads to disaster, no one is able to take the necessary corrective action in time. Empires and generations are lost due to temporizing, uncertainty and the fatal assumption that "nothing can be done". Let us hope that this is not the case in Indonesia.

Our banking policies were cast in the early 1980s and were already obsolete at that time. Economic policy makers gave little consideration to securitization. Attention to capital market development was restricted to a state-owned securities company. Almost no incentives were provided for long-term capital formation. The focus was almost entirely on banking.

Privatization of state banks and separation of borrowers from lenders were already recognized as prudent policies in the 1980s. Nevertheless, the temptation to keep control of funds in the hands of government officials and cronies was too great to be resisted.

The tragedy that we now face is that when the banks collapsed in 1997-1998, instead of realizing the errors of the past, we listened to the same advisors who had designed the flawed system in the first place.

The result, predictably, has been an attempt to reconstruct an obsolete and defective structure, rather than the prudent option of seizing the opportunity to establish a modern financial system of which the country could be proud.

As the cost of nonproductive interest on government bonds continues to erode the state budget and lackluster economic policies discourage foreign investment, we are moving into an area in which even funds from the International Monetary Fund (IMF) may be insufficient. No one will be safe if the social structure falls apart.

Strong economic leadership, courageous policies and a credible program for implementation could turn the course of the economy strongly upwards in a relatively short time, even though it will take longer to repair the damage.

The world will recognize the difference between credible reforms and cosmetic patching. Rather than halfhearted repairs of a financial system that is already corrupt, it would be better to move forward with true reform: * Privatize government banks, * Separate bank owners from borrowers, and * Redesign government bonds so that money is raised to finance recovery rather than just incurring interest that will further drag down the economy.

Technically, it is not as difficult to reform the banking system as is sometimes suggested. First, competent bankers are needed, but the world has an ample supply of those who can do the job. The reform of government bond issues can be accomplished by redesign, using techniques proven in other markets.

The difficulty is not technical, nor market-related, but political. Many seemingly technical arguments are only excuses to maintain the status quo. Some will even say, "It is too late for true banking reform -- we have already signed a letter of intent with the IMF."

But would the IMF oppose privatization of the state banks? Would they be against the separation of bank ownership from borrowers? Does the IMF prefer cosmetic restructuring with illiquid bonds over funding that puts money into the system? It is clear that opposition to reform comes not from abroad, but rather from within.

The capital market was not the cause, but rather a victim of the current crisis.

The future of our capital market now depends on the modernization of banking. If the banking system is not reformed, and if economic recovery is delayed five years or more, not only will we experience unpredictable social and political turmoil, but we may also find that our capital market has moved offshore.

Already, our stock exchange is badly out-of-date, hanging on to inefficient, floor-based trading. Most broker-dealers do not have safe operational procedures to support scripless trading. As the income of market institutions declines, it will be less feasible to raise funds to build a strong securities industry.

Continued development of our capital market depends on economic recovery and reform of the banking system. Due to inevitable technological change and advances in other countries, delayed recovery may have irreversible long-term implications on the ability of Indonesia to take the lead in regional markets.

Every month that the crisis is prolonged represents a setback to our dream of creating a major regional capital market by 2020.

Misuse of the banking system and lack of attention to the capital market are characteristics of the current crisis. Resolution of the crisis calls for the introduction of banking reform and the provision of incentives for capital market development.