Rescuing banks

Rescuing banks

The banking industry, which lies at the root of Indonesia's
economic crisis, and the central bank are now mired in a vicious
circle.

The government's blanket guarantee for foreign exchange and
rupiah depositor and creditor claims on locally incorporated
banks has been causing moral hazards not only throughout the
industry but also for the bank supervisory mechanism and
depositors. The guarantee, provided in late January to prevent
banking panics and runs, has overtaxed the role of the central
bank, Bank Indonesia, as the lender of last resort. It has
unintentionally forced the central bank to provide liquidity
support not only to illiquid but solvent banks, but also to
outright insolvent ones.

We expected the central bank and the Indonesian Bank
Restructuring Agency (IBRA) to act quickly and firmly on
insolvent banks as soon its across-the-board guarantee was put in
place because the risk of massive panics would be minimized.

But it is now painfully apparent that it is the central bank
that is now in a panic, making huge liquidity injections into
banks without proper evaluations of their assets and operational
viability. The latest official reports show that as of June 5,
Bank Indonesia has pumped Rp 132 trillion (US$12 billion) in
liquidity credits into problem banks, up from Rp 101 trillion
early last month. The total does not include liquidity injections
to illiquid banks which are still sound enough to evade the IBRA
hospital.

This anomaly is eroding market discipline among banks and
cutting into the profitability of the banking industry as
insolvent institutions are allowed to remain afloat to compete
with solvent ones.

Likewise, large depositors and creditors, who are supposed to
have more resources and are better informed of bank conditions,
also seem affected by the moral hazard. They have become lax in
enforcing market discipline on weaker banks because they feel
secure that the guarantee scheme will bail them out of any
trouble.

Worse still, the establishment of IBRA in late January, when
the blanket guarantee was announced, has caused both a moral
hazard at the central bank and dualism in bank supervision. IBRA
is in charge of supervising and managing problem banks, while the
central bank is to handle what are classified as sound banks.
But the intensity and quality of the central bank's supervision
of banks under its purview seems to have declined since it can
now simply dump problem banks onto IBRA.

As the amount of bad credit steadily increases due to the
battered economy and punitive lending rates as high as 70
percent, the quality of most bank assets has been deteriorating
as well. This has raised concerns that the central bank or IBRA
might not be able to recoup the huge liquidity credits already
pumped into the banking system.

Contrary to official optimism, most analysts do not expect, at
least until political uncertainty is removed, any significant
strengthening of the beleaguered rupiah. Without a stronger
rupiah, the high interest rates will most likely be maintained
with devastating effects on both businesses and banks.

Recapitalization seems now the most effective and quickest way
of restructuring the ailing banks. But not a single domestic
investor is capable or likely willing to invest in the crippled
banking industry since most large business groups, which are
themselves major shareholders in most banks, are being
overburdened with foreign debts. Foreign capital inflow or a
return of Indonesian capital, which fled overseas after the
recent riots in Jakarta and other areas, is not a prospect
either.

The outlook is quite grim indeed. As the capital base of most
banks erodes and with a virtual stop in new lending, more banks
will eventually be forced to enter IBRA care, which is now
tending to more than 45 distressed banks.

Given the severe banking crisis and the blunt fact that its
resolution is crucial for the stabilization of the rupiah at a
reasonable level, it is high time for both the central bank and
IBRA to act firmly and quickly on insolvent banks. Allowing them
to stay afloat with additional liquidity credits not only makes
it more difficult to strengthen the whole banking industry but
also risks wasting a huge sum of public funds and further
hyperinflation.