BANKING SYSTEM SOUNDNESS AND MACROECONOMIC MANAGEMENT: THE RECENT INDONESIAN EXPERIENCE

by J. Soedradjad Djiwandono


A dinner speech on the occasion of a symposium, "Towards the Restoration of Sound Banking Systems in Japan-Its Global Implication" held jointly by the IMF's Regional office for Asia and the Pacific and Kobe University's Research Institute for Economic and Business Administration, Kobe, July 14, 1998

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INTRODUCTION

It is a great honor and privilege for me to speak to all of you, such a distinctive group, to address topical issues of the day, problems related to the restoration of banking system soundness in Japan. Since I do not know much about them, I am not in the position to be able to add or to dispute arguments raised or analyses presented by the distinguished presenters and participants during the discussions in the morning as well as the afternoon sessions.

Instead, I would like to share with you my experience as governor of Bank Indonesia, the central bank of Indonesia, in managing the steps taken to cope with problems related to the restructuring of the banking system and maintaining monetary stability. It is my hope that some lessons could be drawn from understanding the problems that our economy is facing and the efforts and policies that Indonesia has been exercising so far.

BANKING SOUNDNESS AND MACROECONOMIC POLICY

Many studies have clearly shown the close link between the soundness of the banking system, which is the subject of microeconomic analyses, and monetary policy, which belongs to macroeconomics. Good monetary policy to achieving monetary stability or well managed macroeconomic policy to achieving growth and stability, cannot be sustainable without the existence of sound banking system. It is further argued that banking soundness should be treated as an objective for monetary policy, together with price - and exchange rate - stability. Manuel Guitian wrote that "Systemic bank soundness is now seen as a component of monetary management, as a complement to macroeconomic policy in general, and as a policy objective in its own right for the pursuit of economic balance and stability".

My comments about issues and problems associated with banking restructuring in Indonesia will have some bearing on my conviction on the validity of the above argument. However, I would look at the close link between soundness of banking system and monetary policy in a broader context of macro-economic management.

It has been documented that since 1980 up till before the Asian crisis broke out in July last year, over 130 countries had been experiencing banking problems, both in the nature of significant banking problems or banking distress and banking crisis. It seems also the fact that more problems had been observed in the latter part of the period, and that both the nature and the intensity of the problems as well as their ramifications had been increasingly severe. This seems to indicate that, despite increasing awareness about the close link between the micro and macro aspects of monetary policy, over time more countries have been experiencing banking problems and the problems are becoming more serious while the impacts are worsening.

The above development has been contributing to the many studies being conducted and resolutions and policy proposals to cope with the problems being made. The latter came notably from G-7 communiqué after the Lyon Summit in June 1996 and the Interim Committee's Declaration, Partnership for Sustainable Growth, in September 1996.

It may be important to reiterate at the outset the proposition that, "an appropriate macroeconomic policy stance is unlikely to be sufficient to maintain balance in the economy unless it is supported by sound underlying microeconomic conditions". This is true on the fiscal front as well as in the monetary policy area, be it in the exchange rate management, external debt-management, as well as the focus of our discussion in this symposium, the monetary policy and banking soundness. These propositions have been recognized and widely accepted . As I mentioned, they came out from past experiences in many Latin American countries in the early eighties, savings and loans associations' problems in the United States, exchange rates problems in Europe with the Exchange Rate Mechanisms (ERM) experiment, the Mexican crisis, and several others.

It is a bit of an irony that Managing Director Camdessus, in his closing speech of the International Monetary Fund (IMF) seminar on central banking at the beginning of 1997 said that "Last year I said that I suspected the next international economic crisis would begin with a banking crisis or almost certainly be compounded by one. Let us hope that all of our efforts to increase the awareness of financial sector problems and to seek solutions to them will lead to serious reforms - both nationally and internationally - that promote sound banking and market discipline. Through these efforts, including events such as this seminar, we can substantially reduce the possibility of my suspicions becoming reality." Questions arise, like why, despite this new awareness, did the Asian crisis actually happen? And how ? This would lead me to make an assessment on how and why the crisis did happen in Indonesia, in the hope that some lessons could be drawn, from the perspective of policy management as well as baking operation, and international cooperation.

THE CHRONOLOGY OF THE INDONESIAN CRISIS

It has been said by many that the Asian crisis stands out as one of the major crisis of the century, especially for those countries which are experiencing the turmoil. The impact of the crisis has been so devastating that, even pessimists acknowledge that it is worse than expected. Indonesia, together with Thailand and South Korea, have been suffering more than others. It is certainly indisputable to argue that, among the three, Indonesia is the worst hit.

If one looks at the process of how events in the Indonesian economy evolved to become an economic and political crisis, it is clear that the Indonesian crisis originated from an ordinary currency problem, when the rupiah suffered from a sudden pressure in July of last year, following the weakening and the floatation of the Thai baht, a little over a year ago. However, after some process of policy responses by the government and reactions from the market players, the problems rapidly spread and deepened to effect all sectors of the national economy, before finally impacting on politics.

Thus, it started with the market pressure on the rupiah as part of the contagion effects from the currency market imbalance in the region. Faced with such a currency market pressure, on July 11, 1997, the government - based on the current exchange rate management of managed floating with creeping depreciation and intervention bands adjusted continuously - made the decision to further widen the bands, from 8% to 12%; the same day the Philippines' peso was floated. The market reaction to Bank Indonesia's move was contrary to past patterns The rupiah was further under pressure, and intervention in the currency market was exercised. However, the market pressure was not abating, and Bank Indonesia floated the rupiah on August 14, 1997. After Bank Indonesia's intervention and monetary tightening, the problems spread to the banking sector. The banking industry started to experience distress. The problems persisted, and because of lack of confidence, the banking sector experienced the familiar process of flight to quality and flight to safety. The crisis of confidence was also contagious, from the weakening rupiah, to interbank money market, bank depositors and creditors. The last case is exemplified by the refusal of foreign banks to accept letters of credit (L/Cs) of Indonesian banks in January 1998. After some time, the real sector began to feel the impact of the crisis, the development of which is self-explanatory..

Some of the salient developments in the Indonesian crisis, can chronologically be presented as follows:

  1. The rupiah was under heavy pressure, following the floating of the baht (July 2), and the peso (July 11).
  2. Bank Indonesia's (BI) intervention bands was widened, from 8% to 12%, following similar steps taken in previous years (five times since 1994).
  3. The rupiah was freely floated, thus abolishing BI intervention bands on August 14.
  4. BI interventions in the currency market, started with forward sales of US dollars to sales at the spot markets. This move was complemented with steps to tighten the monetary stance: by stopping sales of money market bank certificates, raising BI certificates' rates (SBI rates of interest); requesting state enterprises to move their bank deposits to be placed in SBI, and temporary stopping government expenditures.
  5. The government took some macro-economic management steps, a precursor of the IMF supported program, on September 3, 1997.
  6. The government made the decision to request for IMF assistance on October 8, 1997.
  7. The process of negotiations began for an IMF supported program, from precautionary to stand by arrangements. The first letter of intent to the IMF, encompassing programs for economic and financial restructuring, complemented with prudent monetary and fiscal programs, was signed on October 31, 1997, with $23 (or 18) billion front line plus $23 billion of second line facility.
  8. The liquidation of 16 banks and the first drawing of the IMF loan of $3 billion on November 1, 1997, was followed by political repercussions over the next two months.
  9. The new state budget was announced on January 6, 1998, immediately followed by negative market reactions.
  10. The government's second letter of intent to the IMF was signed on January 15, 1998, followed by negative market reactions to the nomination of Dr. Habibie for the vice presidency.
  11. By the end of January, 1998, further steps on bank restructuring with full guarantee for depositors and creditors were taken, followed by the introduction the Indonesian Bank Restructuring Agency (IBRA)
  12. The monetary crisis was further compounded by the distraction of the Currency Board System (CBS) proposal, followed by negative public reactions during the month of February, 1998.
  13. On March 23, 1998, the government took steps to raise SBI rates from 22% to 45% for the one-month rate.
  14. On April 4, 1998, the government announced the decision to freeze seven banks and to place an additional seven banks under intensive watch by IBRA.
  15. The third letter of intent to the IMF, signed on April 8, 1998, included additional features on social safety nets and corporate debts.
  16. On May 21, 1998, under intensive political pressure following the May13-14 riots in Jakarta, President Suharto resigned and was replaced by Vice President Habibie.
  17. On May 23, President Habibie announced his Reformation Cabinet and the decision to give BI an independent status.
  18. An agreement on private sector debts was reached in Frankfurt on June 4, 1998, after two previous meetings in Tokyo and New York
  19. The fourth letter of intent to the IMF was signed on June 24, 1998.
BANKING RESTRUCTURING IN INDONESIA

It has been conjectured that banking soundness is vital for a sustainable macro-economic management of a national economy. Despite the continuous competition from other financial intermediaries due to the globalisation process, the banking sector in a national economy still plays a dominant role, particularly in developing countries. The condition of the banking sector generally reflects the status of the financial sector as a whole. Thus there is the over-arching concern over bank soundness.

According to the IMF Executive Board, efforts to strengthen the banking system should be guided by the following principles:

  • the soundness of a bank is first and foremost the responsibility of its owners and managers; yet the soundness of a banking system is a public policy concern;
  • bank soundness is crucially linked to sound macroeconomic policies;
  • a framework for sound banking must include structures to support internal governance and market discipline, as well as official regulation and supervision; and
  • international cooperation and coordination can play an important role, not only in strengthening the global financial system, but also in improving the soundness of the national banking system.

Let me summarize how banking restructuring was conducted in Indonesia with a view to the principles mentioned before. Before the current banking crisis, the most recent experience with dealing with problematic banks was the closure of Bank Summa, a sizable bank, at the end of 1992. A significant number of banks, including most state banks, were faced with serious non-performing loans, partly due to the drastic monetary policy implemented during 1991-1992 to halt the overheating of the economy. The IMF classified the condition of Indonesian banks then as experiencing significant problems. The closure of Bank Summa was a distressing experience since it took a long time to be resolved. However, in the course of time, conditions improved as shown in the national average of the non-performing loans, which declined from 25% of total lending in 1993 to 12% in 1995.

The banking crisis was preceded by a short period of distress when, due to a process of erosion of confidence, banks lost their deposit bases. In addition, the inter-bank money market functioned poorly, in that it suffered from compartmentalization. Weak banks had to rely on Bank Indonesia to keep afloat. The confidence was completely lost when the process of "flight to quality" was rampant and bank-runs confronted a substantial number of banks in a short period. Strangely, in the recent Indonesian experience, these phenomena happened following the closure of the 16 banks in early November 1997, which was originally designed to boost confidence in the banking system. Individually, a bank confronted with a problem of mismatch in liquidity could easily change into becoming insolvent. For the banking sector, the problem changed from distress to crisis.
When the currency crisis spread to inflicting the national economy, the government's efforts to address the banking problems were put together with other policies and treated as part and partial of the adjustment policies for stability and sustaining growth. But, this treatment was more explicit in the IMF supported programs, from the first letter of intent in November 1997 to the most recent (the fourth) in June 1998.

The Indonesian government asked for a three-year stand-by loan from the IMF, which was processed through an emergency procedure. The amount of the stand-by loan is SDR 7,3 billion, and together with those provided by the World Bank and the Asian Development Bank, the total loans amounted to US$18 billion. This amount, plus US$5 billion of Indonesia's own reserves set aside for the balance of payments support, makes the total amount available to be drawn is US$23 billion. Together with bilateral facilities as second line, the total amount of the rescue package amounts to US$43 billion.

Basically, the IMF supported program comprised of a comprehensive policy package to deal with insolvent and weak banks, and to overcome structural rigidities in the economy, supported by prudent fiscal and monetary policy. The financial restructuring program which had been put together with technical assistance from the IMF, the World Bank, and the ADB to restore public confidence in the financial system comprised of five parts, namely:

  • the closure of 16 insolvent banks, which was executed on November 1, 1998.
  • the establishment of proper procedures and policies to deal promptly with weak but viable financial institutions, so that they can be placed quickly on the road to recovery; some banks were to be put in conservatorship or intensified supervision of BI.
  • the resolve of specific problems of state and regional development banks.
  • the strengthening of institutional, legal and regulatory frameworks for banking operations to ensure the emergence of sound and efficient financial system; this program includes the modification of such laws as the central bank law, the law on bank liquidation, and the bankruptcy law.
  • the establishment of Indonesia Bank Restructuring Agency (IBRA), after the second letter of intent.

The program for banking restructuring was part and partial of a comprehensive program that comprises both the real and financial sectors, supported by prudent fiscal and monetary policy.
If we look at what was put into the program, one could argue that the right steps were taken to address the Indonesian crisis. But, why is Indonesia's IMF supported program showing negative results thus far? In comparison with the implementation of other IMF supported programs, the Indonesian case is definitely the worst, particularly when one compares the rate of currency depreciation, the growth prospect, the inflation rate, and the development of other variables in the respective countries.

The process continues until now, so any analysis will not give conclusive explanations. However, some observation can be presented here, in anticipation of further detailed studies. Without making detailed assessments on the implementation of the programs, several points could be raised here:

  1. On banking soundness as a requisite for sustainable monetary policy, I would argue that the Indonesian experience supports it. We may even suggest that the linchpin of the crisis is the weak banking system, which has been constrained the monetary authority in conducting monetary policy and banking supervision as well as facilitating payments system. I would support the inclusion of banking soundness as an objective to be achieved monetary policy. However, in an effort to create a sound banking system by implementing a program that combines banking restructuring for sound banking system and monetary management, one has to be very cautious of the fact that we are working with variables which are different in terms of their time frame. In monetary policy, one is basically dealing with short run problems, while banking restructuring is a long-term problem. In addition, as Manuel Guitian argues, there are interaction and feedback effects between bank soundness and macroeconomic policy choices. Conflicts between the aims of price stability and bank soundness entail an intertemporal trade-off.
  2. The Indonesian experience also teaches us that when public expectation (in this case the domestic market) is fragile, the closure of banks could produce an adverse result. It may not be realistic, but the liquidation of banks should be done when the economy is not fragile. But, in general, the sooner the better. The sooner the authority identifies the problems, the sooner the authority accepts the reality about the problems, and the sooner a well prepared restructuring steps are implemented, the better. Why? Because it will be less costly, and the chance for success is better.
  3. I cannot help but observe that, even though there is increasing awareness of the close link between banking soundness and macroeconomic policy, due to the socialization campaign by the IMF and others, it has not prepared monetary authorities and market players in developing countries to cope with the crisis. This lack of preparation has created devastating impacts, especially in Thailand, Korea and Indonesia. In Indonesia's case, we had been working so hard in coping with the problem, including taking steps to strengthen in coping with external shocks. But, the crisis was so devastating that what we did, even if it was right, was just too little and too late.
TOWARDS A SOUND BANKING SYSTEM

As I mentioned above, the IMF supported program that Indonesia is implementing includes a comprehensive restructuring of the banking system. With the help of the ADB, the World Bank and the IMF, IBRA is working to address the problems of the weak banks' through a combination of mergers, recapitalization and freezing of insolvent banks. The bad loans of the banks are to be transferred to an Asset Management Unit (AMU) to be established within IBRA.
To strengthen relatively sound banks, schemes will be announced soon so that banks that achieve a special increase in capital can sell their bad loans to the AMU so that they can improve their CAR, and a provision will be made for the creation of tier two capital in the form of subordinated loans to banks whose capital has been increased by their owners.

Discussions are under way with foreign banks regarding investment in the banking sector. To facilitate the process all restrictions on foreign ownership of banks will be lifted as part of the prospective amendments to the banking law. As an interim measure, teams of foreign banks will be used to strengthen the management of banks under IBRA's control.

All banks are to achieve minimum capital adequacy ratios of 4 percent of risk-weighted assets by the end of 1998, rising to 8 percent by the end of 1999 and 10 percent by the end of 2000.

These are, of course, steps needed to get the banking sector back to a normal footing, i.e. being solvent. However, for the banking system to be sound most banks should be solvent and are likely to remain so. And the IMF stipulates that the likelihood of remaining solvent will depend, inter alia, on banks' being profitable, well managed, and sufficiently well capitalized to withstand adverse events. But, aside from the fact that the banking sector has to be sound, all infrastructures - namely regulations, prudential measures, disclosures, accounting practices and the legal base - to support the industry have to be working well. Manuel Guitian, mentions the three-pillar paradigm for banking soundness, namely official oversight (prudential standard), internal governance (risk management in each individual bank), and market discipline (sound banking practices). But, this paradigm still has to be complemented with adherence to several principles for strengthening the banking system: responsible owners and managers of banks and professional authorities, prudent macro management and, in a globalized financial system, good international cooperation.

The problems that the Indonesian banking system are presently facing seem to be so complicated. The steps which need to be taken are often problematic. In a way, measures which had been taken all these years to put the prudential regulations in place were wiped out by the crisis. At the same time, an opportunity arises to put all the necessary pillars for sound banking system in place. A comprehensive program towards that seems to be in place. What has to follow is a the discipline to implement the program.

SOME LESSONS TO BE LEARNED

The Asian crisis which has been lingering for a year now shows that globalisation has brought both ample opportunities and risks. Indonesia, together with Thailand and Korea in particular, and other countries have benefited substantially from the openness of the respective economies as well as the huge inflows of capital since the beginning of the nineties. However, weak financial systems and changes in market sentiments seem to enable an external shock to create banking crisis in a short time. I have showed you how the crisis unfolded in Indonesia. From both the process of how the problems arise and the policies that the authorities is implementing, the following lessons can be learned:

  • Lessons from crisis in the eighties are still valid here, namely that the sooner the better and the problems are always worse than expected. A study on Indonesia related to the banking problems and steps taken to resolve them, undertaken by the Monetary and Exchange Affairs Department of the IMF in 1996, indicates that in terms of the number of problem banks and the cost for restructuring was definitely much smaller than the present figures. The sooner the problems are identified, recognized and being treated properly, the better the chances for being successful, and the smaller the cost involved. Bank Indonesia's efforts to consolidate and strengthen the banking system before the crisis and the awareness of combining micro-macro policies in monetary policy did not help in facing the contagious shock that Asia was experiencing. In a way, the world's awareness of the issues and the concern that went with it should have come sooner to give positive impact on national policies.
  • The timing for executing the closure of insolvent banks, definitely a requirement for solving bank problems, must be taken into account and considered carefully. Ideally, closing banks should be done when public expectation is not fragile. But, this is very difficult to operate. When the economy is rapidly growing, it is difficult to caution people to be prudent.
CONCLUDING REMARKS

It is my assessment that the Indonesian crisis originated from an external shock in the currency market, due to changes in market sentiment in the region which incited contagious effects. Confronted with the contagion effects, the national economy which had been suffering from inefficiencies in the real sector ( the high cost, high ICOR economy) and a weak financial and banking system, could not cope with the shock. The weakening of the rupiah adversely affected both the financial and the real sectors. A monetary shock turned into an economic crisis through distress, which in turn affected the banking and financial systems. Similarly, the change from economic crisis in to a socio-political crisis was facilitated by weaknesses in our social and political systems.

As in facing other contagious problems, it is valid to state that, in efforts to restructure the banking system, the quicker we identify the problems and address them with good programs and discipline in implementing the programs - with a touch of good luck - the better the chance to succeed.

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