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What sort of financial sector should Indonesia
have?
Stephen Grenville
To cite this article: Stephen Grenville (2004) What sort of financial sector should Indonesia have?, Bulletin of Indonesian Economic Studies, 40:3, 307-327, DOI: 10.1080/0007491042000231502
To link to this article: http://dx.doi.org/10.1080/0007491042000231502
Published online: 19 Oct 2010.
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WHAT SORT OF FINANCIAL SECTOR
SHOULD INDONESIA HAVE?
Stephen Grenville
Sydney and Australian National University
At the time of the 1997 Asian crisis, Indonesia’s financial sector had serious weaknesses. This made it vulnerable to the key element of the crisis: mas-sive reversal of foreign capital flows. Despite huge expenditures on restructuring, many of these weaknesses remain and the current strategy does not seem likely to overcome them. The alternative strategy explored here advocates the creation of ‘savings banks’, holding government bonds as their principal asset. With these safe assets, deposits in such institutions would be secure, even in the event of a major economic crisis. With this safe ‘core’, the rest of the financial system could develop on conventional lines (allowing removal of the current blanket guarantee, and making it more feasible to close banks without this causing a run on the system as a whole). The inherent risk to the taxpayer of another expensive bail-out would be greatly diminished.
THE HISTORICAL LEGACY
Indonesia’s financial sector reflects the outcome of two forces. First, there were the long-standing, slow-moving tectonic pressures, whose origins can be found in the analysis of McKinnon (1973) and Shaw (1973), for removal or reduction of the ‘financial repression’ imposed by controls and regulations. The second was more sudden and violent: the Asian crisis of 1997–98. The result today is, to say the least, unsatisfactory. There are no clear, strong forces pushing the system in any particular direction, and there seems to be a gradual drift back towards the problems of the past. Given the stunning nature of the shock, this is understand-able. But now, nearly seven years after the crisis began, it is time to move for-ward, and to plot a path for the Indonesian financial sector that recognises the legacy of this experience but breaks away from its deficiencies.
Ending Financial Repression in Banking, 1988–96: Deregulation and Globalisation
Moves to deregulate Indonesia’s financial sector began in 1988. While the starting point was the McKinnon–Shaw idea of ending financial repression, this notion was greatly reinforced by the growing dominance in Indonesian policy thinking of the ‘Washington consensus’ (free market/efficient markets) paradigm, which was boosted by the collapse of the USSR, Japan’s poor performance in the 1990s, and the apparent success of the US ‘shareholder value’ model. Globalisation and
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the integration of financial markets brought huge capital inflows into the minus-cule financial markets of Asian countries (Volcker 1999).
The initial watershed was the 1988 package of bank reforms known as Paket 27 Oktober (‘Pakto’) (Binhadi 1995; Cole and Slade 1996), which put strong oper-ational content into the idea of deregulation. The clearest manifestation was the shift in ownership of bank sector assets. In 1988, 70% of the banks’ combined assets were in state-owned banks (SOBs), with domestic private banks making up somewhat more than 20%. By mid 1997, the state bank share had fallen by half, with most of the loss of share taken up by private domestic banks. Not only did their share increase, but so did their numbers—dramatically. Immediately before the crisis there were 203 private banks, of which only a dozen or so were of any size. The remainder were small affairs often run as part of a commercial business.
The change in the share of private banks was much more than simply the pass-ing of ownership: it changed the way the bankpass-ing system worked. In the old world, the state banks were seen principally as ‘agents of development’, chan-nelling funds (with greater or less efficiency) into areas considered high priority by the authorities. Before deregulation, liquidity credits (i.e. funds earmarked for specific areas, created by the expansion of the central bank’s balance sheet) had been the means by which the authorities directed funds into priority uses. After deregulation, these liquidity credits became less important, and the main source of funds became the household deposits that the banks (both state and private) attracted. The private domestic banks channelled these funds mainly to enter-prises within their own conglomerates, while the state banks lent them to favoured customers with good political connections.
While these were radical deregulatory changes, the institutional environment changed much less. For an effective and efficient process of financial intermedia-tion, two institutional requirements are paramount. First, there must be a credit culture and a legal system to back it up: borrowers accept that they will repay their loans on time and, in the rare cases where this does not occur, there should be a clear, speedy and equitable legal process that sorts out what should happen, in a way that does not damage the general process of financial intermediation. Secondly, there must be a reasonable volume of reliable commercial information available to depositors and, especially, to intermediaries. In Indonesia’s expand-ing private bankexpand-ing sector neither of these characteristics was present. A bank therefore had incentives not to intermediate between borrowers and lenders at arm’s length from itself, but rather to gather funds from the general public and channel them to companies with which it was associated. The bulk of lending would be so-called connected lending: in the absence of institutions to provide information and legal certainty, domestic banks lent to the only people they could trust—themselves. So Indonesia’s banking sector exchanged one set of undesir-able qualities (those associated with government allocation of credit) for another (those associated with insider relationships). This outcome would be familiar to followers of the work of Douglass North (1990), where outcomes follow the incentive structure, which in turn depends on the institutions (in the sense of the overall set of rules and constraints that govern cooperative endeavour).
Meanwhile the system of prudential supervision did little to adapt to the new world. Wherever there are state-owned banks, their relationship with the regulator is ambiguous and troublesome (some would say impossible). In the case of
nesia, there was even ambiguity about just who had responsibility for the pru-dential management of the SOBs—Bank Indonesia (BI) as the supervisor, or the Ministry of Finance as the shareholder. Whatever the operational ambiguity, there was, at least, no doubt that depositors were fully protected by an implicit govern-ment guarantee, so the discipline of the market was clearly not present for the SOBs. Active governance by the state—the shareholder—was therefore vital for a satisfactory outcome. This was not achieved in practice; examples include the Bapindo scandal (Fane 1994: 31) and the failed attempts to recapitalise the state banks in the early 1990s (Cole and Slade 1996: chapter 5). There was a clear gov-ernance case for actively shrinking the SOBs (which had continued to grow, notwithstanding their loss of market share). A modest step was taken in this direction with the partial privatisation of Bank BNI in 1996, but this was so lim-ited (and the shares so widely distributed) that it had no impact on governance.
While there was no improvement in the prudential supervision and governance of the state banks, it might have been hoped that, as these became less important, the problem would become smaller. What about prudential supervision of the pri-vate banks? The process of developing effective prudential supervision is long, and it may even take a crisis (preferably a small one) to put in place the experience and authority that are needed. While some institutional development of the pru-dential framework occurred in the years after Pakto, it was not enough. Perhaps the decisive moment came in 1993, with the sacking of the head of BI’s supervi-sion when he tried to enforce related lending limits on a well-connected private bank (Cole and Slade 1998: 65). Supervision relies for its effectiveness on the unquestioned authority of the supervisor. After this sacking, it was difficult to see how effective supervision could be developed.
The growth of the private domestic banks lent greater importance to the issue of depositor protection. There was no explicit deposit guarantee (and no deposit insurance) but, as is more or less universally the case in such circumstances, there was some sort of implicit government guarantee. Households could not be left without access to their deposits in the event of a bank becoming illiquid or insol-vent, and if households could withdraw, then it was difficult to draw a line between them and other depositors. The outcome was that, although entry of new banks was easy and encouraged by the system, there was no explicit under-standing of what should be done if they became insolvent. The failures of Bank Duta in 1990 (Soesastro and Drysdale 1990: 21–2) and Bank Summa in 1992 (Mac-Intyre and Sjahrir 1993: 12–16) established a strong presumption, understood very clearly by BI, that bank closure was traumatic and should be avoided—more or less at any cost. While it is true that President Soeharto had agreed in princi-ple, in early 1997, to the closure of several small banks, this was to be delayed until a propitious moment—after the elections the following year (Djiwandono 2004: 62). Closure as a crisis measure was clearly still off the agenda.
The foreign-owned banks presented no real problems for the prudential super-visor; they were branches of big banks that would exercise close control over their good management. To the extent that policy specifically took the foreign banks into account, the objective was to ensure that they did not compete too vigorously with the domestic banks.
With the discontinuance of financial repression, it seemed normal, indeed inevitable, that the financial sector would grow much more quickly than nominal
GDP. This has been a characteristic of financial deregulation everywhere, and leaves the authorities in a quandary—they observe the fast growth of bank credit, but are reluctant to do anything about it because it is the direct result of lifting financial repression. Indeed, to do anything about it would be to undo the dereg-ulation. There is usually some ambiguity here; there is, of course, a good case for the development of strong prudential supervision, but at the same time the spirit of the times is to leave it all to the market. It is not a coincidence that the propo-nents of financial deregulation hold strongly to this view, and usually argue it more simplistically than they should, in the interests of pushing a process that they believe is, in principle, desirable.
Capital Flows
The process of financial deregulation has many interconnected facets. In addition to the expansion of the banking system, capital account integration strengthened greatly in the 1990s. Indonesia had freed its capital account in the early 1970s, and there had been significant foreign direct investment (FDI) inflows. But it was not until the 1990s that there were large short-term and portfolio capital inflows, including large-scale overseas borrowing by the Indonesian corporate sector.
There were a number of different forces driving these flows. Many of them were on the supply side: foreign portfolio managers, with greatly expanded vol-umes of funds to invest, increasingly recognised the arguments for portfolio diversification; at the same time, East Asia had become the popular destination for funds, with mass conversion to the ‘Asian miracle’ story. Regional offices of the major banks were set up to facilitate these flows and, once set up, they had to justify their existence by promoting capital flows.1 Meanwhile, on the demand side, there had always been a big disparity between domestic and international interest rates, but few Indonesian borrowers were sufficiently well known to be able to tap international flows. Globalisation changed this, with firms such as the Hong Kong investment bank, Peregrine, serving as the institutional link between these small, unknown borrowers and the source of funds.
In this more integrated world, some kind of (admittedly tenuous) macro equi-librium might have been established if the exchange rate had been allowed to appreciate enough to create an expectation of a subsequent depreciation. (With such an ‘over-shooting’ of the exchange rate, Indonesians borrowing overseas would need to weigh the advantages of cheaper foreign interest rates against the possibility of depreciation.) But the authorities were not keen to allow this sort of appreciation, and in any case this would have been a very delicate balancing act. In the event, the stability of the exchange rate in the first half of the 1990s made the interest rate differential an attractive play for borrowers. All this conspired to encourage huge capital inflows in the first half of the 1990s.
The result of this constellation of forces was serious vulnerability of the finan-cial sector. Prudential regulation required banks to keep their net foreign exchange exposure within very tight limits. But there was insufficient attention given to the credit risk banks faced, both directly and indirectly. The direct risk was that the dollar-denominated loans that they had made might go into default in the face of a large change in the exchange rate. The banks’ foreign exchange position was balanced in the sense that this foreign exchange asset offset the bank’s own foreign exchange-denominated borrowing (which might be in the
form of a foreign exchange deposit by a resident or direct borrowing by the bank from a foreign source). The problem was that if the value of the currency fell dra-matically, borrowers would be unable to repay, and the bank would be left with its foreign exchange liability. In short, the Net Open Position (foreign exchange risk) limits protected banks from direct foreign exchange risk, but not from credit risk. They also faced a similar indirectcredit risk. Many of their borrowers had also borrowed directly from overseas sources. If the rupiah fell, these companies would become insolvent and unable to repay not just their foreign borrowings, but also the rupiah loans made to them by domestic banks. With these sorts of exposures, even a well-managed bank would be in trouble—and few of the Indo-nesian banks were well managed. The $80 billion of foreign borrowing and the $40 billion of dollar-denominated domestic borrowing were a hostage to sharp movements in the exchange rate. With a decade of relative stability, this risk was discounted, particularly as the pressure on the rupiah was consistently for appre-ciation.
The Crisis
The long and short of this is that Indonesia experienced the not unusual combi-nation of ‘Good-bye financial repression, hello financial crash’ (Diaz-Alejandro 1985). The two critical vulnerabilities coming out of the history of financial dereg-ulation were, first, very large and potentially volatile foreign capital inflows and, second, a fragile domestic financial system.
The unfolding of events is a complex story, already told, in its generality, in a number of places (e.g. Kenward 2002); for the story of the financial sector, see Enoch et al.(2003). Here we shall confine our attention to the events that triggered the banking collapse.
In August 1997, following the floating of the rupiah, base money was abruptly reduced by around 20%, through a requirement that state enterprises withdraw their bank deposits and buy Bank Indonesia Certificates (SBIs). There were his-torical precedents for such action: so-called ‘Sumarlin shocks’ (episodes of sud-den and severe monetary contraction implemented by former finance minister Sumarlin) had been used twice before, in July 1987 and February 1991. Unfortu-nately, this left the banking system without enough funds to fulfil its reserve requirements and its need for clearing balances to meet cheque-payment settle-ment (Grenville 2000a and 2000b). Two things inevitably followed from this. First, some banks would fail at clearance (breaching their reserve requirement, at best, or their requirement to have a positive clearing balance, at worst). Secondly, with these failures, BI would be faced with the immediate need either to close the banks that were not meeting their requirements, or to provide them with liquid-ity. Knowing the president’s strong view that banks should be kept open, BI pro-vided them with liquidity (later given the generic title of BLBI—Bank Indonesia liquidity support).
Were these banks illiquid, or insolvent? With the benefit of hindsight, as the enormity of the crisis unfolded it was very likely that all (or almost all) banks were, or soon would be, insolvent. But as the initial liquidity crisis had been cre-ated by the decision drastically to reduce base money, it was hard, at least at this early stage, to blame the banks. Was this the single critical decision that opened the flood-gates of BLBI, which in turn provided the liquidity to fund the huge
capital outflows that pushed the rupiah down to 20% of its starting value, in the process bankrupting most of the corporate sector? In a proximate sense, the answer is probably ‘yes’, although of course the intrinsic weakness in the finan-cial sector should take most of the blame. And other things were going wrong as well, such as the closure of 16 banks at the beginning of November 1997, which signalled to the public that their deposits were not safe. The point to be made here is that, in the heat of a crisis, mistakes will be made that may turn vulnerabilities into disasters.
THE IMPACT OF THE CRISIS ON THE FINANCIAL SECTOR
It has been a characteristic of Indonesian economic policy making that crises have been an opportunity for reform. The Pertamina crisis of 1975 (Anon 1975), for example, shifted the rules of the game somewhat in the right direction (although not far enough). So it is not surprising that some observers initially saw the unfolding crisis in 1997 as an opportunity for reform, and a chance to restore the position of the ‘technocrats’ (the team of economic experts led by Professor Wid-jojo Nitisastro; Thee 2003: 21–5) who had guided the economy so successfully for three decades.
Seven years later, it is hard to see much reform. Perhaps more surprising, given the size of the disruption, is how littlehas changed in the financial sector. The banking crisis in Argentina in 2001–02 saw deposits fall from the equivalent of $85 billion to $15 billion (Blejer 2003), and earlier crises had seen the banking sec-tor taken over, to a large degree, by foreigners. In contrast, the Indonesian bank-ing system did not shrink. The number of banks fell dramatically, from more than 237 to 136 by June 2003; this reduction reflected mergers as well as closures, how-ever, and in any case deposits of closed banks were shifted to surviving ones. No depositors lost their money. Foreign ownership is higher than before, but not by much. Before the crisis, the share of the state banks had fallen to 35% of banks’ combined balance sheet assets (half the pre-Pakto share), and there were prospects of selling off some of the SOBs to reduce this further. Now, even with most of the banks that were taken over during the crisis already back in the hands of the private sector, the state bank sector remains large, and the two largest state banks are so unattractive that there is little prospect that they can be sold to a majority shareholder.
One element was dramatically changed by the crisis—the asset side of the banks’ balance sheets, where loans to defaulting corporations were replaced by bonds issued by the government to recapitalise the banks. For the banking sys-tem as a whole, these bonds and SBIs now make up well over half of total assets. The banks’ main and most reliable source of income is now from the payment of interest on these government securities. The counterpart change was that the banks’ main customers, by and large, are now broke—or, more likely, their assets are so well hidden that they are not available as collateral. With almost all of the corporate sector unbankable (in the sense that no prudent bank would lend to them), the banks are seeking to enlarge their balance sheets by lending to the small and medium enterprise sector (which had not previously received much attention from them, because the information required to make sound lending
decisions was lacking), and to the retail sector, to finance the purchase of more motorcycles, cars and housing.
Despite the massive injection of funds—equal to more than half of GDP and around half of the total balance sheets of the banks—there are still large non-performing loans (NPLs) in the banks’ balance sheets. The degree of structural reform has been quite modest: the standard of governance is still generally poor, particularly in the SOBs. Instances of directed lending by state banks continue. While the formal measures of prudential supervision may have been strength-ened (especially with better information technology systems and better liquidity control), enforcement and compliance are probably little improved since the cri-sis. The current intention is to address the problem of lack of prudential effective-ness by creating a separate stand-alone agency. However, it is not at all clear that such an agency can achieve greater independence than the central bank achieved in the past (and the experience with a major institution created to help deal with the crisis—the Indonesian Bank Restructuring Agency (IBRA)—would suggest that this is a formidable challenge). The blanket guarantee for depositors repre-sents a continuing and serious moral hazard, and will be difficult to remove with-out the threat of major disruption.
For the SOBs, the general policy strategy was to fix governance problems through privatisation: the hope was (and is) that active shareholders would keep bank management in line and bring about efficiency improvements. This sounds sensible in theory, but would require a controlling shareholder with substantial banking experience, and there is little interest. Most foreign banks interested in Indonesia already have a network there, which they will prefer to expand rather than buy existing banks, especially those with heavily entrenched operational rigidities and serious legacy problems (inherited from the long history of state bank mismanagement). There will also be complaints about selling long-standing state assets. The sale of private banks taken over during the crisis has proven dif-ficult enough, but divesting the core SOBs will be much more difdif-ficult.2
The central bank’s position is still tarnished by the legacy of the BLBI contro-versy (Djiwandono 2004), the Bank Bali scandal (Booth 1999: 5–6) and attempts to sack the former central bank governor (McLeod 2000: 8). Deep fissures exist between the central bank and the rest of the administration. BI’s damaged repu-tation makes it difficult for it to assert its authority or take an active part in eco-nomic policy making. It still carries out prudential supervision, despite the in-principle decision eventually to shift this function elsewhere. While imple-mentation may be technically improved, BI lacks the authority to discipline banks. Parliament has an unfortunately high degree of involvement in many decisions that would be better left to the administration. Moving outside the financial sector, we find the budget hamstrung by the interest burden of the huge volume of domestic government debt resulting from recapitalisation of the bank-ing system. The balanced budget principle that served for three decades as the keystone of fiscal discipline and prudence is now gone. Potentially more serious still, there has been a devolution of power to the regions: this will increase the likelihood of debt on a large scale at local government level, a problem that has proved fatal to fiscal discipline in a number of Latin American countries. The common assessment is that corruption in Indonesia is larger in scale and more
widespread than before. The legal system, which proved totally inadequate in sorting out the bankruptcies, remains largely unreformed.
In the face of this sad litany, it might be asked why the initial belief that the cri-sis would be an opportunity for reform proved wrong, and why the cricri-sis did not act as a way of breaking up vested interests and shifting institutional roadblocks to reform, as suggested by Mancur Olson (1965). How did almost the whole of the banking sector become insolvent, without large-scale foreign ownership resulting (as occurred in response to crises during the 1990s in Mexico and Argentina)? Why has so little progress been made in setting up the legal and institutional infrastructure that would be the basis for developing a credit culture? One ele-ment of the answer is that vested interests were successful in shifting much of the cost of the crisis back onto taxpayers (Frécaut 2004; McLeod 2004)—as reflected in the rise in domestic debt from zero to 60% of GDP. Another part of the answer may be that the Olson process produces beneficial change in response to low lev-els of crisis, whereas an economy-widecrisis clears away both bad and good inter-est groups and entities, leaving no nucleus around which the reform can grow.
Whatever the answer, few would dispute that the barriers to reform remain largely unchanged by the crisis. It might even be argued that the pre-1997 situa-tion had in it the capacity for gradual improvement, with a dynamic economy making it more possible to privatise the SOBs and gradually weed out the weak-est elements among the private banks. With the deregulation ethos providing some momentum (the process of deregulation has its own internal dynamic), there was at least some hope for beneficial adaptation. To use Douglass North’s terminology (North 1990), the institutional structure has not changed much, so the incentivestructure remains much the same. Moreover, as a further constraint on reform, the crisis has produced a search for scapegoats that seems so random in its outcome that this must seriously inhibit bureaucratic decision making in the future.
THE TASK AHEAD
These are wide-ranging issues. Our attention here will re-focus more narrowly on the prospects for the financial sector, which—to summarise—we now know was too fragile before the crisis, and is quite possibly little improved since. How will it fare next time? We can divide this examination into the two elements that pro-vided the vulnerabilities in 1997: the volatility of capital flows, and the structure of the financial sector.
Capital Flows
There is no immediate danger from volatility of international capital flows: inter-national capital has left and seems unlikely to be excessive in the foreseeable future. But if the countries of Southeast Asia are successful in regaining the rapid pace of growth that they need to meet their pressing requirements, then this type of capital will return. The intrinsic disequilibrium is that these economies are in the process of closing the technological gap. This phase is characterised by high growth, high profits and high investment; high interest rates are needed to main-tain domestic macro-balance. High interest rates attract large capital flows, thus helping to fund the high investment, but these flows will be volatile because of
the shortage of information (hence risk assessments can change dramatically) and because the exchange rate is not well anchored in the fundamentals. Expectations are volatile, and shifts in market opinion tend to be characterised by ‘herding’.
The 1997–98 crisis provides some helpful lessons relating to foreign borrowing by Indonesian non-bank corporates. In concept, these flows were always on the basis that such debt would be a matter for the parties directly involved. Default by the Indonesian party would lead the foreign party to attempt restitution through whatever legal means were available. If this had been more clearly recog-nised during the crisis, then there might have been less concern in the markets about the weight of this debt on the exchange rate, as much of it simply went into default: the Indonesian party would have trouble repaying the debt (hugely increased in rupiah terms), and the foreign lender had little recourse, given the well-known inadequacies of the Indonesian judicial system.
One thing that went wrong during the crisis was that foreign lenders brought pressure to bear on the government to help in securing repayment, and this attempt received more support than it should have from both the government and international financial institutions (IFIs) such as the IMF. This support cre-ated enough dust to obscure the weak position of foreign creditors. The Indo-nesian authorities should have provided the foreign borrowers with a room for negotiation with the debtors and a copy of the relevant Indonesian laws, and left it at that. For their part, the IFIs should have kept quiet, without raising the false hope of some special exchange-rate arrangement (Grenville 2004). If these cir-cumstances recur, foreign creditors should be reminded that they had added high-risk premiums to their contracts, and that sometimes risks go bad. There is also a need to limit the involvement of governments via their export promotion arrangements, which brought government-to-government matters (including linkages with aid programs) into what should have been private-sector resolu-tions. There should be a clear understanding between the parties that if a govern-ment provides some form of insurance as part of an export-promotion or investment-promotion scheme, the scheme should simply pay out the creditor in the event of definitive default—not take the debt over and pursue its repayment at a government-to-government level.
A confusing (or confused) strand of argument was often heard as the crisis unfolded: that Indonesian borrowers should have hedged their foreign-exchange exposure. The implication is that next time hedging should be compulsory or de rigueur, and that this will solve the problem. Unfortunately, this misunderstands the macroeconomics of hedging: while individual risk can be shifted to another party (another Indonesian can take the risk), it would only be if foreigners were prepared to take on rupiah risk that Indonesia as a whole could eliminate the exchange-rate exposure. There is a limited appetite among foreigners for rupiah-denominated risk, so it is hard to see how such a hedging requirement could be implemented. Unless this problem of ‘original sin’ (Hausmann 1999) can be over-come, calling for widespread hedging is irrelevant to the problem at hand.
Two additional elements would reduce the ‘collateral damage’ from the rever-sal of these international capital flows. Both depend on the authorities having a good register of the flows and outstanding balances of these debts. This would allow the authorities to take these flows into account in setting their macro poli-cies (watching for the asset price bubbles that accompany excessive inflows).
Moreover, such a public enumeration would allow Indonesian banks to know which of their customers was running an exchange-rate risk, and trim their own lending accordingly. This would also be a proper focus of the prudential regulator.
There would be one more safeguard in the system suggested here. During the 1997 crisis, corporates that were in trouble because of their overseas borrowing were able to negotiate loans from domestic banks, mainly the SOBs, to help them stave off insolvency and perhaps make some repayments of their foreign loans. This raised the cost of the subsequent bank bail-outs, borne by the Indonesian taxpayer. A well-functioning banking system, without the lax access to credit pro-vided by the implicitly guaranteed state- and conglomerate-owned banks, would have reduced the downward pressure on the exchange rate and left a smaller debt legacy.
With the benefit of hindsight, it has become widely assumed in policy circles that capital flow reversals have such damaging and intractable results that policy should aim at preventing them—without this analysis offering much advice on how to handle them if they occur. ‘Increasingly, it has been realised that there is no good way to deal with the consequences of a capital account crisis—only more or less bad ways’ (Boorman et al.2000: 60). This may be a realistic assessment, but it leaves a big gap in the range of operational advice. The reality is that emerging countries will have significant capital flows and, even with best endeavours to improve the institutional infrastructure, crises will occur. To suggest otherwise is a reminder of the old Irish joke about asking the way to Dublin: ‘Oh, I wouldn’t go there from here’. The reality is that countries will go there—either voluntarily or in response to the pressures of globalisation (see, for example, Friedman 1999)—and will get into trouble. While preventive measures are obviously the first priority, measures to make the financial sector more resilient should also be a high priority. This will be our central focus in the remainder of this paper.
STRENGTHENING THE FINANCIAL SECTOR
The question addressed here is: what does the financial sector have to look like if it is to be an efficient intermediary and provider of financial services, and at the same time robust in the face of the vulnerabilities that Indonesia will inevitably face, both from inadequate institutional infrastructure and from its vulnerability to capital flow shocks?
Our starting point is the recognition that there will be another crisis, and that the central bank inevitably will be forced to support the banking system. This does not mean that every individual bank has to be supported, but the authori-ties must be able both to stop the contagion of bank runs and to ensure the smooth running of the payments system.
If the central bank is not going to support all banks (as it did in the 1997 crisis), it must be able to draw quick and clear distinctions among financial institutions (which will be helped, and which will not) that are widely understood and accepted. The ability to draw such distinctions is at the heart of the proposals made below. In the textbook world, a distinction can be made between banks that are illiquid and those that are insolvent, with a view to helping the former but not the latter.3In reality it is probably impossible to draw this distinction in the heat of an economy-wide crisis. Others might draw the line between systemically
important banks and others. If this line is drawn before the crisis, there is substan-tial moral hazard for the banks designated ‘systemic’. If it is drawn during a cri-sis, it is inevitably drawn too widely, because even a small bank can set off a bank run and thus be seen as ‘systemic’.
The Institutional Make-up: Different Institutions with Different Risks
The proposal made here envisages the financial sector as a series of concentric cir-cles embracing institutions of varying importance and vulnerability, in order to create, as far as possible, a strong negative correlation between importance and vulnerability. The core element at the centre of the concentric circles is a new type of bank (at least in the Indonesian context) that is very safe, and that offers a core level of payments services, provides international trade finance,4and acts as the repository of household savings. Because of their vital payments system function and their role as holders of household savings, these banks should be absolutely secure, and only a government guarantee can provide this security. In order to make them safe without posing a potential open-ended liability for the govern-ment, they need to have absolutely safe assets, so they should hold predomi-nantly government securities on the asset side of their balance sheets.5
These core institutions might be thought of as savings banks. They are, of course, ‘narrow banks’ in the tradition of Friedman (1959), Tobin (1985, 1987) and Litan (1987), but the term ‘savings banks’ is used here in the hope that they will be judged by their fitness for the current circumstances of Indonesia, rather than through the preconceptions of the earlier debate on narrow banks.6The standard argument against narrow banks is based on the entire banking system being made up of them, in which case there are legitimate concerns about the adequacy of financial intermediation to meet the needs of private sector borrowers, and about whether normal financial sector development will be stunted by the requirement that banks be narrow. The proposal made here does not envisage that savings banks would be the only type of bank, but rather that normal com-mercial banks would operate alongside them. Indeed, over time the savings banks would probably shrink in importance as the financial sector gained in rep-utation, as they did in other countries such as Australia.
Perhaps the one argument that carries over from the earlier debate on narrow banks is the possible bias these institutions might create for governments to bor-row too much, using the savings banks as a cheap and ready form of finance. This issue might be best addressed at source—by limiting the capacity of governments at all levels to tap the domestic financial market, through a return to the balanced budget policy that served Indonesia so well for three decades.
With the asset side of the savings banks’ balance sheets comprised almost entirely of government bonds, the deposits are safe.7There is no extra liability for the government, over and above the liability it already has for these bonds. The balance sheets would be very simple, and easily understood and monitored by the prudential authorities. The critical issues would be twofold: first, to make sure there was good separation of the balance sheets of the savings banks from those of any other financial institution that might be part of the same ownership structure; and second, to make sure that the depositors had a well-informed and transparent choice about where to put their money. It would be relatively simple to move from the present system to the one suggested here. Most of the major
banks failed during the crisis and were recapitalised by the government, with the bad loans on their balance sheets replaced by government bonds; they still have very large holdings of these bonds on their balance sheets. Once depositors make their choice between guaranteed deposits at the savings bank entity and non-guaranteed deposits at the commercial entity, banks could rearrange their assets to form the two separate balance sheets, without the need for any major restructuring beyond clear legal separation of the savings bank balance sheet from that of the rest of the entity. Where banks had insufficient bonds to match their deposits, they would purchase their additional requirement in the bond market.
The second concentric ring serves the intermediation function for corporates and other low-risk customers who want to borrow from banks: what might loosely be termed commercial banking. This is important, too, as it provides the credit that is the life-blood of commerce. But it must have a set of clear-cut rules (Douglass North’s ‘institutions’) that will foster the development of a credit cul-ture, including mechanisms for quick and clear resolution when a loan goes bad. When it is clear to all parties that these institutions will not be bailed out by the government, they are more likely to develop the collateral and legal arrange-ments they need, because it will be in their own vital interest to do so. If they are not supported by the government in creating such an economy-wide credit cul-ture, they will once again find ways to lend to the only people they trust—them-selves. So the issue of connected lending is not principally one of prudential rules, but of overall credit culture.
The third concentric ring is made up of the non-bank financial intermediaries (NBFIs). These have not played any important part in Indonesia so far, but they are of interest because of the Thai experience in 1997. In the pre-crisis boom times, Thai finance companies were the institutions that had made the most risky cor-porate loans, and they took deposits from parties who, by and large, were ‘con-senting adults’ in the degree of risk they were taking. These institutions were all liquidated in the early days of the crisis, without this causing a run on banks proper. Of course, part of the reason was that depositors at these institutions did not lose their money: their deposits were transferred to state-owned banks. But it is also true that, in one surgical stroke, the most fragile part of the financial sec-tor could be quickly and cleanly closed down, with little contagion effect on the core banking system. No such opportunity existed in Indonesia, because there was not a set of clearly distinguishable institutions that could be closed down quickly.
Insurance companies and funds managers occupy the fourth concentric ring. Their early development in Indonesia seems greatly constrained by their recent history, as yet unresolved. The case for having such institutions is clear, but the preconditions for safe and efficient insurance seem to be some distance away. As the wider financial sector develops, such institutions have a vital role in improv-ing discipline for equity markets and the issuimprov-ing of company debt. They have, potentially, the incentive and capacity to obtain, and act on, commercial informa-tion, and to carry out the analysis that distinguishes good investments from bad. But Indonesia does not yet have the level of transparency that makes this possible. Further out still is the equity market and the market for corporate paper. There is a vogue at present for setting down long lists of corporate governance rules
that, it is promised, will create a transparent world where good investment deci-sions can be made with confidence. These may help, over time. But it might be observed that, in the US experience, companies such as the failed Enron had most of the formal elements of good governance (including boards that, judged by their credentials, were sound), while companies such as Warren Buffett’s hugely successful investment company Berkshire Hathaway have broken many of these rules, but have returned more than twice the market rate of profit and created a level of trust between management and shareholders that goes beyond written rules. As long as Indonesian equity investors are being asked to place their money in family-dominated companies, they are putting their trust in individu-als, and they should know the risk of doing this. A lone director representing minor shareholders will not make much difference.
The Financial Zoo
The proposal here depends crucially for its effectiveness on an ability to separate various types of financial institutions from others. In the analogy put forward by Wojnilower (1991), the financial sector can be likened to a zoo, with animals hav-ing different characteristics and behav-ing separated from each other by appropriate divisions or cages. The fashion—current over the past decade or so—is to let the animals out of their cages and allow them to sort out their competitive positions in an open world. The presumption is that this process is to some extent inevitable and, for most of its proponents, desirable, as it will distinguish the most efficient intermediaries and providers of financial services from the rest. The problem, of course, is that the law of the jungle may not produce the best outcome; it may produce a zoo of fat lions and not much else. To be more spe-cific, it may produce full-service financial institutions that provide a wide range of financial services, creating a twofold problem: first, that the institution is tak-ing a wide variety of risks, which are hard for the prudential supervisor to assess; and second, that any support the authorities might give to keep such an institution operating through critical times has to be provided to the whole bal-ance sheet of the institution, and not just to the elements that the government regards as critical to systemic stability.
This multi-function model became common in countries with mature financial markets for a number of different reasons. Partly, it was inevitable: the animals were already out of their cages and could not be put back. Others saw it as desir-able on two grounds—both very much based on the ‘efficient markets’ view of the world. The first was that competition would produce the optimal outcome; the second was that any differences in prudential or regulatory framework for different types of institutions would provide an unacceptable absence of the much-vaunted level playing field.
These latter arguments are much less persuasive now, with the experience of a variety of financial crises. The operational question is: ‘is it too late to keep the animals in their cages?’ For Indonesia, the answer, at least for the moment, is ‘no’, as banking has not melded irretrievably with embryonic insurance and pension/fund-management services. Whatever the long-term trends in zoo-keeping, Indonesia has the opportunity to keep the animals separated during the critical period in which a deeper legal and prudential framework is built up and a stronger credit culture established.
Once the differences between the types of institutions are recognised, the desir-ability of keeping the animals in their cages is clear. Just because they have been let out in mature markets is no reason for demolishing the cages and fences that still exist—and can be strengthened—in emerging markets.
Other consequences (mostly positive) follow from this strategy. The difficult task of replacing the current blanket guarantee for depositors with a govern-ment-run deposit insurance scheme would no longer be needed. The key idea here is that depositor protection is provided to the institution, rather than to a subset of depositorswho are defined by some characteristic (e.g. size of deposit) that will become contentious in times of crisis. Thus those who are protected are self-selected, and the unprotected cannot complain: it was their choice not to bank elsewhere.8Commercial (i.e. non-governmental) deposit insurance could develop, and because this would be sponsored privately rather than by a gov-ernment body, it would stand a better chance of being able to set appropriately risk-differentiated premiums. The strength or weakness of this guaranteeing institution would be clear, as it would have nothing more than the accumulated premiums to use in the case of a crisis. Nor would there be any constraint on an individual bank obtaining guarantees for its deposits from a stronger institu-tion—say, a large foreign bank.
The other important institutional change needed would be in the Financial Ser-vices Authority (OJK, Otoritas Jasa Keuangan), intended to be a universal super-visor overseeing all financial institutions, including insurance companies and pension and mutual funds. A universal supervisor has an interest in treating all financial institutions in a uniform way, which encourages the idea that they are all equally well protected by implicit government guarantees. This is diametri-cally opposed to the proposal being made here, which depends fundamentally on establishing clear and prominently transparent distinctions between the various institutions in terms of their degree of risk or safety.
In this proposal, savings banks and commercial banks would be tightly regu-lated and actively monitored by the prudential supervisor. For the savings banks, just about all that would be required would be to ensure that they actu-ally held government bonds equal to their deposits. For commercial banks, the task would be much as it is at present, with the addition of clear prompt-action/early-intervention requirements. This should be easier to implement than it is now, because there will be no difficult decisions to be made on whether depositors will be protected: they will not.
Insurance and pension funds should be separately regulated and separately supervised. It is a modern myth that their balance sheets and management are much the same as those of banks. The characteristic of bank assets is that they are idiosyncratic, and their value cannot easily be judged by the market: banks’ spe-cial expertise (and the source of their value added) is in judging credit risk. Insur-ance and pension funds mainly hold market-traded assets, and their principal task is matching the market-determined, changing value of their asset portfolio against their actuarially determined liabilities, many of which have long and uncertain maturity. Their time horizons and need for liquidity are quite different from those of banks. Their vulnerability in the face of a macroeconomic crisis is also quite different from that of banks, as they are not subject to runs (although the value of their assets would be greatly affected by a crisis).
Other positive effects would result from implementation of the proposal made here. With the savings banks having a compelling reason to hold government bonds, there would, for the first time, be a substantial demand for such long-dated paper. An active market in these bonds would develop, as the banks man-aged their balance sheets. This, in turn, would give the opportunity for the government to bed down its huge debt obligations at a rate of interest that reflects the greater demand for these instruments and the value of a government guaran-tee. The present path—of trying to create a significant demand among the non-bank public for the huge volume of recap bonds (bonds issued to recapitalise the banks)—seems destined for failure, and if the authorities persist in allowing these bonds to pass out of the balance sheets of the banks it will create a body of volatile debt that constantly threatens the government with roll-over problems, whose dangers have been illustrated so clearly in Latin America.
Foreign versus Domestic
Foreign ownership has traditionally played a minor role in Indonesia’s financial sector. Even this modest share may exaggerate the importance of the foreign influence: it seems that foreign banks mainly served companies from their own home markets. In this, a great opportunity was lost to spread the beneficial influ-ence of the foreign banks’ practices more widely. It is true that many of the top bankers in Indonesia’s domestic banks have worked at some stage in foreign banks, but the influence of the foreigners on the domestic industry is far smaller in banking than, say, in the hotel business, where the arrival of foreign manage-ment in the 1960s and 1970s quickly transformed standards over the entire sector. It is worth contemplating how the degree of technological transfer can be increased. The lifting of restrictions on the number and location of foreign bank branches may help. More helpful still would be a greater effort to facilitate the sale of the recap banks (the private banks taken over and recapitalised in the aftermath of the crisis) to foreigners.9While these should be open to purchase by domestic parties, realistically the capital and knowledge requirements point to the desirability of foreign owners, perhaps with Indonesian partners.
There is another powerful argument in favour of a significant degree of foreign ownership. The financial sector is probably the most risk-prone element in the economy, and when this is combined with the implicit guarantee for depositors— so that the government bears much of the risk—the case for passing this off onto foreign owners and foreign governments is strong (Fane 1998). It greatly relieves the burden of prudential supervision by passing it to the supervisor of the home country, usually a strong agency. The strategy of devolving banks to foreigners is quite common: New Zealand pioneered this (as it pioneered many aspects of financial deregulation), but we see it also in Mexico following the crisis of 1994–95, and in Argentina. The case of Argentina is particularly interesting, as the foreign-ers held a dominant position before the most recent crisis: this did not prevent the crisis, but it did spread the burden to foreign (particularly Spanish) banks.
State versus Private
As noted above, Indonesia finds itself with more of the banking sector in the hands of the government than was intended—or than, for most observers, seems desirable. What is the case against state-owned banks? Forty per cent of the
world’s population lives in countries where state-owned banks make up more than half of the financial system; there must be powerful reasons for this.
Banks are widely seen as the means of directing resources into favoured areas of the economy, so governments want to do this directly, perhaps in the belief that their economy-wide view would allow them to do a better job than the private sector, or perhaps because politicians and bureaucrats want to use banks for their own purposes. There is, too, an underlying suspicion of the power of banks, and so a desire to keep political control over them. Perhaps the fact that banks are fragile and the implications of their failure serious for the whole economy may be a motivation.
On the other side of the ledger, the incentive effects of state ownership are all in the wrong direction. Borrowers may feel that, because it is state money, no one loses in the event of default. Depositors (or, more realistically, the large profes-sional lenders to state banks) legitimately feel they have the guarantee of the state backing their funding, so do not feel the need to exercise commercial discipline on such banks. Perhaps the point most relevant to Indonesia is that state banks, with considerable political support, are seen as ‘agents of development’. There is nothing wrong with that idea as such, but the bitter experience is that this role is easily subverted, so that the state bank becomes agent for whatever is the favourite ‘prestige project’ or provides the greatest under-the-counter incentives. No matter how attractive the idea of banks as ‘agents of development’ is in the-ory, the practice is almost always an unhappy one. One place where transparency has a clear and overwhelming rationale is in the provision of subsidies, and if a project is deemed by the political process to have social merit, good governance requires that the incentive be provided transparently, probably through the budget process.
The governance implications of state ownership of banks are nearly all adverse. In short, the view that privatisation is an important step towards good governance in the financial sector, as incorporated into the letters of intent from the Indonesian government to the IMF, has strong logic as a generalisation. How-ever, its feasibility needs to be re-assessed in the specific political context of Indo-nesia.
While the governance case for full privatisation is strong, political support for it is weak. It might therefore be more effective to concentrate on advocating the advantages of privatising the recapitalised banks (whose sale has met with some political opposition, even though they had no tradition of state ownership), and to accept that gaining political support for full privatisation of the core SOBs will be so difficult as not to be worth the effort and cost in terms of political capital. This also acknowledges the reality that there is limited demand from suitable buyers (preferably foreign) for Indonesian banks, particularly ones with the asset mix of the SOBs.
How, then, to address the very real governance problems of the SOBs? There are several core areas of governance that can be improved, ranging from the staffing of boards to the role of the Ministry of State-Owned Enterprises. But there seems to be little that can be done to protect these banks against their greatest weakness—that they will be used, again, for directed lending to ‘priority’ proj-ects, justified on some ‘agent of development’ ground. Partial privatisation (which is under way in the case of Bank Mandiri and Bank Rakyat Indonesia) will
not be enough to ensure tight governance, as the main shareholder (with manage-ment dominance) will still be the governmanage-ment (as was the case with Bank BNI, which was partially privatised in 1996).
There is no neat, watertight way of overcoming this problem (unless of course the SOBs can be fully divested to new owners with the skills to run them effi-ciently and safely), but a change in the organisational structure of the state banks might go a long way to addressing it. The change would be to split the SOBs into two units (in the same way that Bank Mandiri recently created its syariahunit), one part being a normal commercial bank and the other a savings bank of the type suggested above. It might be hoped that the intrinsic governance problems of state-owned commercial entities would encourage the shareholder—the state—to keep a very tight rein on their lending and, over time, divest these com-mercial loans to the private comcom-mercial banks. It is only if this is done that there is a solution to the inherently irreconcilable governance problems of the SOBs, which stem from the government’s inability to remove the implicit guarantee on their deposits, combined with their susceptibility to outside influence. Until the state gets out of the business of commercial banking it will not be possible to cre-ate a clear, risk-based distinction between savings banks and commercial banks as proposed here. No matter what undertakings are made beforehand, and no matter how small the government’s shareholding may be, an implicit guarantee for depositors will always be associated with government ownership.
How the Sector Would Look
To return to the concentric circles notion, in the centre would be the savings banks. These would be largely the core SOBs, with their very large holdings of recap bonds, but there would be no reason to prohibit private banks from having savings bank subsidiaries. There are plenty of government bonds on issue (some Rp 400 trillion) to provide the necessary assets for the savings bank balance sheets; if needed, the bonds BI currently holds could also be restructured to become ordinary bonds available for this purpose.
With this financial structure there would still be ample finance for corporate and household borrowers—at least for the moment. Most corporates currently are not sufficiently creditworthy to attract loans from a prudent bank, and it will take some years for a core of new bankable businesses to develop and for the legal system to provide the infrastructure for a credit culture. Most growth in the banking sector would be here, in this private commercial bank sector and, being constrained by commercial criteria, it would develop at the pace dictated by improvement in the availability of reliable commercial information, in the credit culture, and in the legal system. Sophisticated (i.e. risky) banking with complex instruments would develop in banks that have the capacity to manage this (or in offshore banks, where foreigners would take the risk). If connected lending is seen as a danger, the prudential regulator will have to implement firm control. As long as conglomerates are allowed to own banks, connected lending will be dif-ficult to prevent, and prohibiting banks from being part of industrial conglomer-ates—as is done in many countries—ought to be an issue for policy consideration. While the traditional SOBs will want to retain commercial bank business, they might be strongly encouraged over time to move out of commercial banking, swapping this business with private banks and taking the recap bonds that are
currently held by private banks to enlarge their savings bank business. In this proposal, legitimate political demands are met, in the sense that Indonesia retains a core of government-owned banks; illegitimate ones (directed lending and so on) would be discouraged; and bank management would lose the ability to misuse the government guarantee to fund careless or improper loans.
Of course this will not make the Indonesian financial sector immune to shocks. In fact, if there is not significant demand on the part of the public for deposits with the proposed savings banks, then the safe core of the banking system (as represented by these savings banks) will not be large enough to perform its sta-bilising role in the event of a crisis. This is, in large part, a matter of proper imple-mentation. If the authorities succeed in establishing that there are both safe and less safe banks (i.e. in convincing the public that the authorities will not bail out the commercial banks in the event of a crisis), then, provided that there is proper pricing of these different deposit risks, much of the existing stock of government bonds will tend to gravitate to the savings banks, which would make them large enough to perform their stabilising role.
A banking crisis would still be very painful and politically disruptive, because financial institutions would fail. But the central point of the proposed system is that financial institutions would differ in their risk susceptibility (the animals in the financial zoo would have transparently different characteristics), and that these differences would be known beforehand. The most vulnerable people in the community (‘widows and orphans’) would be encouraged to put their savings with the risk-free savings banks, while more adventurous depositors could seek the higher returns (and bear the higher risks) of the commercial banks and NBFIs, with the clear understanding that in the event of a crisis the authorities would allow insolvent commercial banks and NBFIs to fail. Because the possibility of failure is foreseen by all parties, it should be easier (although still not easy) to allow some individual institutions to fail speedily and definitively, without this threatening the whole financial system.
CONCLUSION
The proposal made in the second half of this paper springs directly from the legacy problems identified in the first half of the paper. Indonesia’s financial sec-tor was not robust enough to withstand the 1997 crisis, and on balance seems no stronger now. Such crises will recur, so something different and more robust is needed. Present strategy has not been able to achieve this. It needs a re-think. The proposal made here has pluses and minuses, but at least deserves serious consid-eration.10
NOTES
1 The most extreme version of this occurred in Thailand, with the Bangkok International Banking Facility (see, for example, International Monetary Fund 1998: 35).
2 In its January 2004 ‘Review under the Extended Arrangements’, the IMF described the situation in this way: ‘The mission expressed concerns … with the continued fragility in the state banks. In addition to general concerns about the condition of the state banks, serious questions have been raised about Bank BNI … The mission urged the authorities to maintain close oversight over the other state banks … Concerns about state banks’ performance remain, particularly with regard to the pace of corporate lending. In this regard, the authorities agree with the need to monitor closely Bank Mandiri’s compliance with its action plan … [The mission] encouraged the authorities to expedite work on the development of a strategic plan for the future of Mandiri (and the other state banks) that would provide a framework for increasing private sector participation.’ [Bank Mandiri is Indonesia’s largest state bank, formed through the merger in 1999 of four state banks, Bank Dagang Negara, Bank Bumi Daya, Bank Exim and Bank Pembangunan Indonesia.]
3 It may be true that, with the 20/20 vision of hindsight, it would have been better to allow some of the private banks to close immediately, even if their depositors had to be paid out in full. At least this would have stopped the banks from continuing to fund capital outflow and further loans to bankrupt companies, which had the effect of shift-ing more of the losses from the private sector to the public.
4 If the commercial banking system were to collapse again it would be desirable to have some banks that can keep export finance going. This kind of lending is relatively safe and simple to operate.
5 In order to carry out their payments functions and to provide trade finance, they would need a small amount of other assets.
6 For a recent discussion of the case for narrow banks, see Bossone (2001).
7 They are even safe against interest-rate risk, provided the bonds have a floating inter-est rate; given that the government is the main determinant of the rate of inflation, this is a proper way of ensuring that the risk lies with the entity capable of controlling it. 8 Of course they may still complain, but it should be easier for the government to resist
these complaints if it has ensured that there is an alternative safe repository, and that the risks were transparent.
9 This is legally possible (and indeed foreigners have participated in some of the sales). But there is strong resistance from both the parliament and the public (mainly the staff and management of the banks being sold), which slows the process and discourages foreigners from bidding.
10 Alternative suggestions are provided by McLeod (2004) and Frécaut (2004).
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