«Burhanuddin Abdullah and Wimboh Santoso 1. Introduction A banking crisis occurred in Indonesia following the persistent depreciation of the ...»
The Indonesian banking industry:
competition, consolidation and systemic stability
Burhanuddin Abdullah and Wimboh Santoso
A banking crisis occurred in Indonesia following the persistent depreciation of the Indonesian rupiah
(IDR) from mid-1997. A number of banks experienced illiquidity and insolvency during the crisis due to
a lack of public confidence in the banking system that forced Bank Indonesia (BI) to bail out several
systemically important banks. To restore the solvency and the stability of the banking system, the government embarked on a restructuring programme in 1998. However, the government only recapitalised and restructured viable banks. As a consequence, several banks were frozen out of operation or closed in 1998-99 to prevent the financial system and the economy from further disruption.
The restructuring programme has involved:
· the injection of government capital into viable banks through the issuance of recap bonds;
· the introduction of a blanket guarantee;
· the establishment of the Indonesian Bank Restructuring Agency (IBRA);
· corporate restructuring;
· improvement of corporate governance; and · bringing supervisory and regulatory practices closer to international standards.
The government also encouraged the merger of several small banks into a stronger bank in 2000 and that of four state banks into a new large bank - Bank Mandiri - in 1999. Bank Mandiri is now the largest bank in Indonesia with total assets of IDR 290 trillion (29% of the market) in Indonesia in August 2000.
This consolidation strategy, as well as the closure of frozen banks, significantly reduced the number of banks from 241 in 1997 to 153 in October 2000. Nevertheless, the present banking industry remains vulnerable, such that strengthening of the restructuring programme is of the utmost importance.
This paper analyses the dynamics of competition, and consolidation of the Indonesian banking industry before, during and after the crisis, as a basis for policy recommendations. It is organised as follows: Section 2 outlines the forces for change in the Indonesian banking industry after the crisis;
Section 3 examines the privatisation of state banks; Section 4 discusses domestic mergers between local banks; Section 5 analyses the role of foreign banks; Section 6 discusses systemic stability in the banking industry; and Section 7 provides a summary and conclusion.
2. The forces for change The weaknesses in the banking sector could be identified long before the crisis occurred. This section tries to explore the crucial aspects of the banking industry in the period prior to, and after, the crisis.
The findings of this discussion will be used as a basis for improving the stability of the banking system in the future.
2.1 History of the banking crisis The weaknesses that might have led to the banking crisis had been recognised from the late 1980s to the early 1990s. For the sake of a better overview of specific problems, the evolution of the banking industry may be split into three periods: 1970-83, 1983-88 and 1988-97. The periodisation itself can be attributed to the characteristics of banking business, which moved from a distressed financial situation BIS Papers No 4 resulting from heavy regulation and limitation, to a more “optimistic” atmosphere due to deregulatory measures adopted by the government.
In the period 1970-83, the economy benefited from the oil boom as the government budget relied heavily on the revenues from oil and gas. BI applied credit ceilings and interest rate controls, and limits on prefinancing credit to contain the inflationary pressures. Under the liquidity support scheme, banks obtained a certain margin of interest for credit extended to borrowers. This incentive, which was given only to state banks and selected private banks which met minimum criteria regarding soundness, became the motivation for banks to mobilise public funds.
In the period 1983-88, initiated by the fall in oil prices in the early 1980s, the government could no longer provide resources at subsidised interest rates. Hence it introduced a number of reform packages, including one covering monetary and banking policy in 1983. Under the June 1983 reform, the government decided to reduce the interest rate subsidies and prefinancing credit except for small and medium-sized enterprises, and simultaneously introduced discount window facilities, Bank Indonesia Certificates (SBI) and Money Market Commercial Paper (SBPU). The SBI was designed to absorb banks’ excess liquidity, while SBPU was to provide an instrument for money market operations and liquidity management for banks. The discount window was intended as a facility for banks to borrow funds from BI in case of liquidity mismatch. Such big changes necessitated banks adjusting to a new policy environment. Due to lack of expertise, in the initial phase, banks mostly relied on funds from the money market to finance their loans; therefore, banks’ profits were very sensitive to the volatility of interest rates.
In the period 1988-97, the government continued to roll out a series of reform packages. These were aimed at improving the effectiveness of banks as financial intermediaries and the stability of the
banking system. In general, the reform packages covered the following areas:
· promoting fair competition among banks by allowing new entry, widening the network, reducing segmentation between state banks and private banks, and allowing more independence in decision-making;
· promoting more prudent regulation, such as the adoption of net open position limits, use of the Basel Capital Accord of 1988 to assess the adequacy of capital, and statutory lending limits;
· promoting the effectiveness of money market instruments; and · shifting from relatively fixed to more floating interest and exchange rates.
These reform packages were issued in October and December 1988, March 1989, and January 1990.
Prior to the adoption of this series of reform packages, the banking industry had been very restricted and the financial market, in general, depressed. Lifting the barriers to entry encouraged banks to mobilise deposits and hence reduce their reliance on the government. The dominance of state banks also began to decline due to, inter alia, the abolition of the guideline for state enterprises to place deposits with state banks and to borrow from them. Graph 1 shows the evolution of market shares of loans from 1980 to 1999.
After the implementation of those reform packages, applications for new bank licences were soaring, submitted mostly by groups of companies. In just two years, BI granted 73 licences for new commercial banks and 301 for new branches. The rapid growth of banks and branches encouraged banks to be more aggressive in tapping the deposit market, without a clear view of to whom they would lend. Private banks intentionally started to lend their money extensively to related companies without sound credit analysis. These practices led to a high level of non-performing loans (NPLs), which was the root of the worst banking crisis in Indonesian history. The following sub-sections discuss the key issues facing Indonesian banking before the crisis.
Sources: Bank Indonesia annual reports, various issues.
Problem loans Problem loans had been quite worrisome for many years prior to the crisis. Lack of credit analysis was the main problem for state banks because most of the credit policies were intervened by the government and/or top government officials. NPLs within private banks were normally related to loans within the group, violating the statutory lending limit, which was only minimally enforced by a dependent central bank (the Governor of BI was a member of the cabinet).
In February 1993, Booz Allen & Hamilton forecast that the problem loans of Indonesian banks would be around 5 to 20% of total outstanding credits. The problem loans, which increased gradually from 6% in 1990 to 11% in 1991 and 17% in 1992, were the main sources of bank failure in the 1990s.
Annex 1 shows the growth of NPLs from January 1995 to December 1999.
Banking regulation and supervision Under the existing regulations, the authorities have experienced difficulties in detecting problem banks at an early stage. In our view, banking regulation in Indonesia needs further improvements.
First, risk-based capital requirements, which rely solely on credit risk, fail to assess the true risk borne by banks. Theoretically, bank risks comprise not only credit risk, but also interest rate risk, foreign exchange risk and other risks. Therefore, there is a clear danger of banks failing to pay due regard to those risks not covered in the capital requirements.
Second, BI adopted the “gross approach” to these capital regulations, incorporating the portion of loans which have been covered by provisions for expected losses in the calculation of risk-weighted assets. This approach may discourage banks from monitoring their loans as good-quality loans attract the same risk weights as bad loans in the assessment. The gross system was replaced by a net system in June 2000.
Third, the risk assessment methodology fails to capture the actual performance of management. While other criticisms may be levelled against the BIS proposal (BIS, 1988), we have identified some weaknesses in the current capital adequacy regulations. Therefore, banking regulation in Indonesia calls for further improvement. Nasution (1998) criticised the October 1998 reform for requiring strong legal and accounting systems, which could not be established promptly. Disclosure was poor due to weak implementation of accounting standards. It was reasonable to suspect there were loopholes for BIS Papers No 4 bribery and corruption. The government could easily be tempted to intervene in the selection process of lending.
As we have already mentioned, the rapid growth in the number of banks’ offices, together with their exposures, on the one hand, and the shortage of professional managers and weaknesses in bank supervision, on the other, were the factors contributing to the banking crisis. In fact, a number of banks had suffered financial problems before the crisis.
Exchange rate environment The crisis in 1997-98 caused a sharp fall in banks’ capital as a consequence of huge losses. The banking crisis in 1997 was triggered by the persistent fall in the IDR exchange rate from July 1997.
The USD/IDR exchange rate dropped from IDR 2,450 per USD in July 1997 to IDR 11,000 in March
1998. In response, BI initially widened the spread of its intervention band (ie the difference between BI’s buying and selling rate) from 8% to 12% to curb speculation on the IDR. However, this strategy was no longer adequate and finally BI abandoned the band in August 1997. See the plot of the IDR/USD exchange rate in Graph 2 below.
2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 Source: Bloomberg.
The managed floating exchange rate policy was an implicit guarantee given to the market by the government. From time to time, the government publicly announced the USD/IDR rate that it envisioned. The players, therefore, could make an accurate estimate of the exchange rate for the forthcoming period. Given this exchange rate policy, market participants prefer borrowing funds from overseas without hedging. However, when the government was unable to maintain the intervention band, the exchange rate plunged and the players, including banks, suffered huge losses.
The exchange rate turmoil negatively affected the weak banks, which had suffered financial problems even before the crisis. Consequently, the government revoked the licences of 16 private national banks on 1 November 1997, and closed seven banks in April 1998 and 38 in March 1999. The level of NPLs reflected the worsening of banks’ performance during 1995-99, as shown in Annex 1.
BIS Papers No 4 83 2.2 The structure and the regulatory and supervisory frameworks of the banking system To address the banking crisis, the government in 1999 introduced the banking restructuring programme, which led to considerable changes in the banking industry in Indonesia.
The Government also formed the Indonesian Bank Restructuring Agency (IBRA) at the end of January 1998 to: (i) verify customer claims under the blanket guarantee scheme; (ii) dispose of assets from banks taken over; (iii) restructure and sell loans transferred from banks; and (iv) divest ownership of recapitalised banks.
The following discussion shows the current structure and the regulatory and supervisory frameworks of the banking system.
The structure of the banking system The number of banks in Indonesia has shrunk from 239 to 153 comprising five state banks, 38 private national foreign exchange banks, 45 private national non-foreign exchange banks, 26 regional banks, 29 joint banks and 10 foreign banks. By the end of 1999, the top 20 banks, which included five state banks, accounted for almost 80% of total assets, loans and deposits as shown by Graph 3. The remaining 20% share was shared by 133 small banks.
Sources: BI Call Reports, various issues.
Since the regulatory authority (BI) treats all banks equally, large banks with national branch networks have competitive advantages. However, when the crisis struck, these large banks suffered the most while small banks were generally immune. Most of the problem banks were large banks with wide networks because the banks were highly exposed to credit and market risks. One may then infer that the future structure of the banking system may comprise a small number of large banks with wide networks and small unit banks at the regional and district level. However, BI has no plan to intervene by directly reducing the number of banks. Instead, BI will only impose tight requirements on establishing new banks and opening branches, in addition to enforcing the exit policy regulation for insolvent banks.
BIS Papers No 4 The regulatory and supervisory frameworks of the banking system Under the existing regulations, the authorities have encountered difficulties in detecting problem banks
at an early stage due to, inter alia, the following factors: