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Bulletin of Indonesian Economic Studies
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
INDONESIA'S BANKING CRISIS: WHAT HAPPENED
AND WHAT DID WE LEARN?
Charles Enoch , Olivier Fre´caut & Arto Kovanen
To cite this article: Charles Enoch , Olivier Fre´caut & Arto Kovanen (2003) INDONESIA'S BANKING CRISIS: WHAT HAPPENED AND WHAT DID WE LEARN?, Bulletin of Indonesian Economic Studies, 39:1, 75-92, DOI: 10.1080/00074910302010
To link to this article: http://dx.doi.org/10.1080/00074910302010
Published online: 17 Jun 2010.
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ISSN 0007-4918 print/ISSN 1472-7234 online/03/010075-18 © 2003 Indonesia Project ANU
INTRODUCTION
The economic crisis that engulfed Indo-nesia in late 1997 brought to an end 30 years of uninterrupted economic growth.1 The banking crisis that ensued
proved to be one of the most serious in any country in the world in the 20th cen-tury in terms of its immediate impact on GDP and its ultimate impact in adding to the country’s stock of debt. In part the severity of the crisis derived from the economic problems that hit all the coun-tries in the region—from Japan to Korea and Thailand—provoking a withdrawal of foreign capital and removing possible locomotives that could have supported an economic recovery.2 Perhaps as
im-portantly, however, the crisis in Indone-sia was exacerbated by the political transition that occurred during this pe-riod, which had a major impact on the way the crisis was handled and on
ex-ternal reactions to it as it unfolded. The political transition was played out both in parliament and in the streets. With President Soeharto’s period in power coming to an end, memories were fresh of the bloody consequences of the pre-vious change of government 32 years earlier.
This paper focuses specifically on the banking crisis, which in part was driven by—and in part drove—broader eco-nomic and political developments. It covers the period from late 1997 until the end of 1999 (see also Cole and Slade 1998; Nasution 2000). By this latter date, the stabilisation phase of the overall re-structuring program was largely com-plete. The situation was still extremely fragile, and significant reversals were very possible; many important tasks re-mained to be carried out, but the basics
INDONESIA’S BANKING CRISIS:
WHAT HAPPENED AND WHAT DID WE LEARN?
Charles Enoch, Olivier Frécaut and Arto Kovanen*
International Monetary Fund, Washington DC
This article traces the stages of the Indonesian banking crisis of the late 1990s. Al-most every stage of the handling of the crisis was complicated by governance issues. Beyond these, among the lessons identified are how quickly things can get out of hand in an apparently strongly performing economy; that at the outset of a crisis information will be very limited; and that management of a crisis will be an evolving process. A blanket guarantee covering all bank liabilities may be indispensable; how-ever, the authorities are ‘buying time’, and the more time that has to be bought the more expensive the process will be. Transparency too is indispensable, to generate public trust and support, and to ensure that actions taken by the authorities are irre-versible. Overall, while not everything was done right, the strategy put in place had positive elements that have served to protect a core banking system and establish conditions for recovery.
were largely in place. At the same time, a key element of the political transition seemed to have been completed with the inauguration of the new government under President Abdurrahman Wahid. The political situation, especially in Jakarta, had been tense throughout the previous two years, as evidenced, for instance, by the permanent presence of large numbers of troops throughout cen-tral Jakarta; with the election of the new president, and Megawati Sukarnoputri as vice president, in September 1999, the troops disappeared from the centre of Jakarta almost overnight.
The next section summarises the main developments in the banking sector un-til end 1999. We then offer views on a selection of salient issues related to the banking crisis, and conclude with an assessment of the system at end 1999 and a statement of core lessons.
THE BANKING SECTOR: 1988–99
Seven phases can be identified to eluci-date developments in the Indonesian banking system, from the bold but un-balanced financial sector liberalisation initiated in the late 1980s to the crisis of 1997—which was initially limited but then spun out of control—and the two attempts that proved necessary to bring stability back to the banking sector.
Phase I, 1988 to August 1997
Unbalanced Liberalisation
In October 1988 a comprehensive pack-age of deregulation measures was intro-duced for the Indonesian banking system, including liberalising the re-quirements for the establishment of new private domestic banks and joint ven-ture banks. The number of banks in-creased substantially, from 111 in 1988 to a peak of 240 in 1994–96, with a large number of local conglomerates estab-lishing their own banks.3
The regulatory and supervisory framework was improved substantially, but enforcement, particularly of the le-gal lending limit, remained a constant problem. Moreover, while the doors were wide open for new banks to enter the market, no proper exit mechanism was set up for failing banks. This was well illustrated by the Bank Summa in-cident (MacIntyre and Sjahrir 1993: 12–16). Among the larger banks, with li-abilities of $750 million, Bank Summa began to face serious financial problems as a result of the deteriorating quality of its loans; most of them were in the real estate sector and to related parties, and far exceeded the legal limit for such lending. For two years, Bank Indonesia (BI) relied on its traditional approach of holding talks with the shareholders and trying to persuade them to solve the bank’s problems, while continuing to provide substantial liquidity support. Eventually BI withdrew its support, and Bank Summa’s licence was revoked in December 1992. But, in line with the law, the management of Bank Summa itself was given the responsibility of liquidat-ing the bank. The process was long and difficult, and included public protests and street demonstrations directed against BI. This strenuous experience, and the inadequacies it revealed in the legal framework for resolving problem banks, reinforced BI’s bias against bank closures.
Serious problems also remained un-addressed in the state-owned banks, which traditionally held a dominant market position in Indonesia, with some 70% of market share in the late 1980s. The track record of repayment of their loans, especially those extended to the largest and most influential Indonesian conglomerates, was poor. Extensive and repeated financial support became nec-essary, and was provided on several
occasions with World Bank financial participation.
Phase II, October–November 1997
Contained Banking Difficulties
After the unpegging of the Thai baht on 2 July 1997, the rupiah came under se-vere downward pressure. The authori-ties had to widen, and then to abandon, the fluctuation band for the rupiah. By October 1997, when Indonesia requested the IMF’s assistance, the currency had depreciated by close to 40%—at that stage the largest depreciation among the Asian crisis countries.
To assess the impact of the macro-economic disturbances on the banking sector, a large scale review of individual banks was undertaken. It concluded that 34 banks were insolvent: two state-owned banks, six regional development banks and 26 private banks. For 16 of the insolvent private banks (with a com-bined market share of 2.5%), the finan-cial situation was particularly dire, and the prospects for recovery non-exis-tent. All these banks were slated for liquidation, including three that had direct links with President Soeharto’s family: Bank Andromeda, owned by one of the president’s sons; Bank Industri, whose main shareholders in-cluded one of the president’s daughters; and Bank Jakarta, controlled by the president’s half brother. The 10 other insolvent private banks (market share 3.0%) were not closed, because they were already engaged in a legally bind-ing process of resolution under BI’s monitoring.
In addition to the 34 insolvent banks, the review identified a number of weak banks, with problems of varying de-grees of seriousness. These included several of the largest banks in the coun-try. The weak banks were placed under conservatorship, subjected to
re-habilitation plans or placed under in-tensive supervision.
At that stage, there was a consensus view among the authorities and the IMF that the problems in the banking sector were not of a systemic nature: the state-owned banks’ weaknesses appeared manageable; the major private banks— some, like Bank Central Asia, highly re-garded by the international banking community—still reported comfortable cushions of positive equity; and deposi-tors’ runs had essentially been limited and reflected flight to quality.
The 16 insolvent banks were closed on 1 November 1997. The authorities decided to protect depositors up to Rp 20 million (around $6,000 at the pre-vailing exchange rate), which covered some 90% of the depositors, but a far smaller share—less than 25%—of the de-posits. A full guarantee of the deposit was not thought appropriate by the au-thorities at that stage, because of the moral hazard issue: most of the banks that were closed had been offering de-posit rates far above market rates, often to connected parties, while it was widely known to the public that they were in dire financial condition.
The actual process of closure was carried out smoothly, with eligible de-posits being transferred promptly to designated recipient banks. The imme-diate response to the announcement of the program was positive, and the ex-change rate rebounded from its earlier steep falls. The fact that several well con-nected banks had actually been closed was perceived as a major turning point for the country. In the following days, the public observed with astonishment the son of President Soeharto, who owned Bank Andromeda, protest loudly but to no avail against the closure of his bank. Similarly, the president’s half brother initially rejected BI’s decision to
liquidate his Bank Jakarta. He kept it open, but had to give up after a few days and see it closed.
Phase III, December 1997
Losing Control
Within a few weeks, however, the posi-tive sentiment had entirely reversed. A number of developments contributed to the turnaround, including a further rapid deterioration of the financial mar-ket situation in Korea, an equally rapid deterioration in the domestic economic environment, and rumours about Presi-dent Soeharto’s health.
Then there was the Bank Alfa inci-dent. The credibility of the bank resolu-tion program was shattered when the president’s son, whose Bank Androm-eda had been closed on 1 November, was allowed to take over the tiny Bank Alfa. He then transferred into it most of his former activities, customers and staff, effectively reopening his former bank under a new name. Domestic and international observers concluded that no real change had actually taken place. Combined with several other signs that the authorities were not genuinely de-termined to implement the program agreed with the IMF, this fostered a per-ception that the root causes of the crisis were not being tackled.
Trust in the banking sector dissipated. In the fast-deteriorating international and domestic environment of that pe-riod, even the best banks in the country began to lose the public’s confidence. By early December 1997, bank runs had become pervasive across the system, along with rumours that a new wave of bank closures was under preparation. By mid December, 154 banks, represent-ing half of the total assets of the system, had to varying degrees faced erosion of their deposit base.
BI was reluctant to consider any ad-ditional bank closures at that stage, and
thus had no other option but to provide liquidity to banks unable to borrow di-rectly from the interbank market, reflect-ing growreflect-ing segmentation of the market (see also Djiwandono 2000). Indeed, BI liquidity support increased from about Rp 24 trillion at end October 1997 (equivalent to 3.5% of GDP) to Rp 34 tril-lion (5% of GDP) in mid December. Li-quidity support, paid in rupiah, was used by banks in part to meet withdraw-als of their dollar deposits; as a result, it served in effect to fuel the continuing de-preciation of the exchange rate. Concern over the safety of banks had merged into broader disquiet over the currency, and indeed the stance of economic policy overall. Dollar withdrawals from the banks led to uncertainty about banks’ ability to continue to meet the demand for liquidity, prompting further with-drawals. At this point the crisis had be-come fully systemic.
Phase IV, January–February 1998
Laying the Ground for Stabilisation
In January 1998, the rupiah went through an episode of disastrous depreciation: during that month, the rate fell from Rp 4,600 to Rp 14,000/$, with some trades even at Rp 17,000/$. At the same time, BI continued to provide massive emer-gency liquidity support to the banking system, with the total outstanding amount reaching Rp 60 trillion (7% of 1997 GDP) by late January 1998. The pros-pect of hyperinflation and complete financial sector meltdown became in-creasingly real.
On 27 January 1998 the government introduced a new financial sector strat-egy. First, all depositors and creditors were to be fully protected under gov-ernment guarantee, with both rupiah and foreign currency claims payable in rupiah (at the exchange rate in effect on the day of the claim).4 Second, a new
institution, the Indonesian Bank
structuring Agency (IBRA), was estab-lished for a period of five years to take over and rehabilitate ailing banks, and manage their non-performing assets. Third, a framework for handling cor-porate restructuring was proposed. The impact of the announcement was im-mediate, with the exchange rate recov-ering to Rp 10,000/$ and appreciating further in subsequent days, while ru-piah deposits flowed back into the banking system.
In the following two months, efforts were made to re-establish monetary con-trol by restructuring BI liquidity facilities and developing effective penalties to de-ter banks from seeking access to these facilities. At the same time, the authori-ties moved quickly to make IBRA opera-tional. By mid February 1998 IBRA was ready to take action. It proposed that all banks that had borrowed at least twice their capital from BI should be brought under its auspices. On Saturday, 14 Feb-ruary, the owners of 54 banks (compris-ing 36.7% of the bank(compris-ing sector), of which 50 had borrowed heavily from BI and four were state banks under restructur-ing programs, were summoned to BI, warned about their perilous financial condition, and invited to apply to come under the auspices of IBRA. All the bank-ers agreed. IBRA officials entered their banks before business began on the fol-lowing Monday.
While the interventions were deter-mined on a transparent and uniform basis and were carried out smoothly, the government introduced a last-minute change that severely undermined the operation: President Soeharto decided that there should be no publicity. Thus, instead of being able to demonstrate that they had started to take hold of the situ-ation, IBRA officials had to work over the following weeks against a public perception that the agency was still non-operational.
Also, IBRA officials in the banks ap-pear to have carried little credibility or authority. They were not able to assert full control over the staff of the institu-tions. IBRA was weakened further when its first head was dismissed in late Feb-ruary.
Phase V, March–May 1998
First Initiatives and New Shock
The ensuing three months saw the au-thorities take a series of initiatives to re-solve the problem of ailing banks, only to face a major new shock. The main focus turned to establishing the neces-sary infrastructure for handling the banking crisis: making IBRA opera-tional, preparing the legal framework, obtaining better information on the fi-nancial condition of the banks, and be-ginning to take action.
In March 1998, BI announced the re-design of its liquidity support facilities, with focus on non-market sanctions for heavy users, that is, the transfer to IBRA of banks that had borrowed heavily. In early April, in its first major public ac-tion, IBRA took over seven large systemi-cally important banks. At the same time, seven small banks were closed and their deposits transferred to a state bank. These banks had all borrowed heavily from BI. The focus at that stage was on liquid-ity, rather than solvency, in identifying the banks for which intervention would be appropriate, partly because reliable data on the solvency condition of the banks were not available, and partly because of the urgent need to tackle the provision of BI liquidity support in or-der to stabilise monetary conditions. The criteria for takeover and closure were simple and transparent, and the moves were received favourably in the markets. These actions were a major step to dem-onstrate the authorities’ commitment to bank resolution and finalisation of a re-vised IMF program in late April 1998.
Within two weeks, the bank runs had ceased and deposits began to flow back into the system.
In May 1998, however, widespread ethnic riots, directed at Indonesians of Chinese descent who were blamed by some elements of the public for the eco-nomic collapse, led to a reversal of the recent stabilisation of the rupiah and a further loss of confidence by both do-mestic and foreign investors. In the after-math of the riots there were massive and prolonged runs on Bank Central Asia (BCA), the largest private bank (with a market share of 12%). BI supplied over Rp 30 trillion in liquidity support. On 29 May 1998, BCA was brought under the auspices of IBRA.
The specific nature of the attacks against BCA was especially devastating to confidence in the banking sector, with many viewing the run on the bank as politically inspired. In this environment, other bankers sought to maximise their immediate liquidity in order to protect themselves in the event of runs. The stock of vault cash increased, interme-diation declined even further, and inter-bank markets became more segmented. With interest rates rising in the face of the uncertainty, banks bid up deposit rates to levels substantially above those that they were able to charge their bor-rowers. The sizeable negative interest spreads across much of the banking sec-tor caused a continuing erosion of the capital base of the affected banks. Never-theless, liquidity support from BI—ex-cept to BCA—was limited.
Meanwhile, the bank restructuring process was given a fresh impetus. In-ternational auditors were contracted— financed by the World Bank and by the Asian Development Bank—to conduct portfolio reviews on the basis of inter-national accounting standards and the recently introduced new classification and provisioning rules.
Phase VI, June–September 1998
Design of a Comprehensive Strategy
In June, the first results of the reviews, for six large private IBRA-controlled banks, concluded that they had cata-strophic losses hidden in their loan port-folios: 75% of the total assets on average were to be declared in the ‘loss’ category. There were some serious questions as to whether the accountants had been ex-cessively diligent in applying the pru-dence principle in marking down the portfolios, but there was no dispute about their finding that the examined banks were deeply insolvent. The results of the audits were immediately leaked to the press. Beyond the shock at the con-dition of the banks, the leaks prevented any further denial of the seriousness of the crisis, and forced the authorities to recognise that drastic action was ur-gently needed. In August, IBRA closed three of the banks. As in the case of the previous closures, their deposits were transferred to a state bank.
Meanwhile, also in August, the re-sults of the reviews for a second group of 16 large private banks, all of them non-IBRA except for BCA, became avail-able. These banks were clearly different from the first group, with, overall, a far higher quality of assets, even if many of them were also insolvent. Given that these banks were the strongest in the country, this confirmed the deep insol-vency of the banking system as a whole, at that time estimated at Rp 300 trillion (about 30% of 1998 GDP). While the in-solvency of the entire banking system was not surprising to many outside ana-lysts, it was deeply shocking to policy makers.
The recognition of the pervasive in-solvency of the banking system led to the idea that a joint recapitalisation pro-gram, through which the government and the owners of selected banks would jointly provide the resources needed to
absorb the losses, was in the country’s best interest. This would restore a core group of banks to financial health, and preserve the financial expertise needed to support the economic recovery. A fea-sibility review concluded that the gov-ernment should provide 80% of the recapitalisation needed, while the own-ers would provide the remaining 20%.
During the same period, the authori-ties pressed ahead with a comprehen-sive program of measures to address the pervasive problems of the corporate sec-tor, and sought passage of a bill provid-ing IBRA with appropriate powers. BI also conducted a thorough overhaul of its prudential regulations. By September 1998, with the legal and regulatory re-quirements largely in place, the macro-economic situation more stable, and better information available on the con-dition of the banks, the authorities had devised a comprehensive strategy to re-store the banking system to health. There were three central elements in this strategy: first, resolving the banks un-der IBRA; second, restructuring the state banks; and third, offering joint recapitalisation under stringent condi-tions for private banks meeting speci-fied conditions.
Phase VII, October 1998 – December 1999
Indecisiveness Increases Costs
If, by the last quarter of 1998, the reso-lution strategy was largely in place, its slow and uneven implementation over the following year—to the end 1999 cut-off date for this study—led to sharp in-creases in the total costs of the bank resolution program.
Private Banks. By March 1999, after a number of reversals of policy and other delays, all private banks were eventu-ally categorised into three groups. In the first category were 73 banks (with 5% of banking sector assets) classified as ‘A’ banks, i.e. considered strong enough to
carry on their activities on their own. Sixteen banks were classified as ‘B’ banks, meaning that they were insolvent but deemed salvageable. Among them nine (accounting for 10% of banking sec-tor assets) were eligible for joint recapi-talisation with government financial assistance (labelled as ‘B pass’ banks), while the seven others failed the criteria for joint recapitalisation and were taken over by IBRA. Finally, 38 private banks (5% of the banking sector) were classi-fied as ‘C’ banks—meaning they were non-salvageable—and hence were closed.5
Subsequent work included drawing up investment and performance con-tracts for the banks eligible for joint recapitalisation, and monitoring imple-mentation of all the conditions, which were eventually met by seven of the nine eligible banks.
IBRA and the IBRA Banks. IBRA was slow in obtaining proper legal powers: the relevant legal amendments were passed in October 1998, but the neces-sary implementing regulations became effective only in February 1999. Mean-while, IBRA had been unable properly to secure the assets of the banks that it had taken over, or to transfer them fully to its ownership.
By late 1999, IBRA had control of 13 banks, accounting for one-quarter of the total banking market. Disappointingly, very little progress was made during 1999 in enhancing the loan recoveries of any of these banks, or in preparing them for privatisation, and the costs increased considerably. Concern also persisted about the roles of, and coordination be-tween, IBRA and the Jakarta Initiative Task Force (JITF), the body responsible for facilitating corporate restructuring, as few of IBRA’s largest borrowers had elected to participate in the JITF. IBRA’s work program for 2000 was seen as ambitious. It was expected to include
cash collection targets of around Rp 26 trillion, a modest fraction of the total as-sets—with a face value of Rp 441 tril-lion (36% of GDP)—that had been placed under IBRA’s control.
State Banks. As of mid 1998 there were seven state banks, accounting for 50% of total banking sector assets and for a significantly larger share of the losses. All were deeply insolvent and would have been categorised as ‘C’ on the ba-sis of the analyba-sis employed for the pri-vate banks. However, the government committed itself to recapitalising all the state banks, with recapitalisation to fol-low operational restructuring.
By mid 1998 it had been decided to merge the four weakest of these banks into a single newly established bank, to be called Bank Mandiri. The merger was designed as a vehicle to downsize the banks and make best use of scarce mana-gerial and advisory resources. Bank Mandiri was established as a corporate entity during September 1998, and be-gan as a holding company owning the shares of the four banks. Its legal merger with the four component banks took place in late July 1999. Progress on the three other state banks was slower. Sev-eral blueprints were considered for their restructuring, but at end 1999 decisions were still to be reached on the future focus of these institutions.
SELECTED VIEWS
ON THE BANKING CRISIS Challenges of
Large-Scale Intervention
The program the Indonesian authorities put in place in the months following the onset of the crisis in late 1997 was aimed at restoring the viability of the financial sector. This already formidable chal-lenge was further complicated by the fact that the banking crisis was coupled with a general economic crisis that brought about a severe depreciation of
the exchange rate and rapidly rising in-flation. Even worse, the program was undertaken in a period of political tran-sition during which governance issues were never far below the surface. Progress in addressing banking prob-lems was repeatedly set back, causing the recovery process to be much more protracted than it might otherwise have been.
General reluctance to commit to the future in Indonesia was heightened by the political uncertainty resulting from the twilight of the Soeharto regime and the memories of the chaos that had ac-companied the previous regime change three decades earlier. An alternative bank resolution strategy that relied more on market mechanisms might have proved successful, but would have been substantially riskier, with a significant possibility of total meltdown of the en-tire banking sector and the elimination of payment services in the country.
Addressing a banking crisis is very likely to involve interventions in particu-lar banks—that is, closures or takeovers by the authorities. If these occur at the outset of a crisis, the authorities are likely to have to rely on liquidity crite-ria, such as the amount a bank has bor-rowed from a central bank, in order to determine in which banks to intervene. Over time, as more information becomes available, interventions can be deter-mined on solvency grounds—the extent to which a bank has negative equity. In any case, it is important that the criteria for interventions are credible and trans-parent, are applied uniformly, and are explained well to the public.
The immediate costs of such interven-tions are likely to depend on the skill with which the interventions are carried out, to ensure that owners and managers are not given a chance to strip the banks, that the authorities get full access to the pre-mises, and that depositors and other
liability holders can be reassured that they are being fully protected. Success-ful intervention will require substantial staff resources—several hundred took part in the interventions in Indonesia— and good coordination among the vari-ous official bodies.
Ultimate costs depend very largely on how the authorities handle the banks after intervention. In the case of banks that are closed, the authorities need to secure and manage the assets until sold. With an approach where banks are kept open the situation could be even more difficult: a new management team needs to be brought in to run the bank; former owners and managers need to be kept away; and the bank needs to be made ready for sale. Where the crisis is deep, and where there have been interventions in a significant share of the banking sec-tor, such rehabilitation may take years. The ultimate costs will be very much greater in Indonesia than they might have been. Although the interventions in April 1998 were carried out effectively, the in-ordinate delays in passing and making effective the necessary amendments to the law meant that IBRA was unable fully to take possession of the assets of the closed banks until February 1999. Banks taken over were initially managed under twinning arrangements with managers from state banks, but with limited suc-cess. Seeking to restore their deposit base, these banks offered depositors among the highest interest rates of any bank in the country—far higher than the returns they could make from using the funds. Ultimately, these negative spreads led to greater costs to the government, ei-ther in payments to meet the guarantee obligations to depositors if the bank was closed, or in recapitalising the bank if it was kept open.
In Indonesia, where the banking sys-tem was complex and there were inter-ventions in many banks, a wide variety
of techniques was relied upon to match the specific condition of each bank or group of banks with the most appropri-ate resolution approach. Among those used were closure, merger, recapitalisa-tion on the basis of operarecapitalisa-tional restruc-turing, and creation of a platform bank able to absorb efficiently a number of other banks in which the authorities have intervened. The new banking sec-tor that is emerging reflects this variety.6
Moral Hazard
Moral hazard can arise in a number of forms when a blanket guarantee is put in place. Conventionally, a major risk is thought to be that banks’ owners and managers, when facing insolvency, gamble on recovery and undertake es-pecially risky business. In this case, how-ever, the moral hazard seems also to have extended to the depositors, as weak banks sought to recover lost de-posits by offering uneconomically high interest rates. To limit this type of moral hazard, the authorities introduced an interest rate ceiling together with the guarantee. However, the ceiling still of-fered sufficient room to generate inter-est rate differentials and redistribution of deposits toward weaker banks, as well as an overall level of deposit inter-est rates that led to negative interinter-est spreads for much of the crisis period.
The government commitment to recapitalise all the state banks regard-less of their condition also proved costly. With this commitment, state banks’ managements lost much incen-tive to pursue bad borrowers aggres-sively; recognising this, borrowers had less incentive to continue to service their debts. Loan performance fell dra-matically from mid 1998, reportedly even among those with the ability to pay. The prospect of ‘haircuts’ (oppor-tunities to renegotiate loan obligations) for borrowers in difficulty added to this
trend, with the presumption that it would be hard for the banks to distin-guish those unable to pay from those merely unwilling to do so, and that therefore it was unlikely to be benefi-cial for borrowers to continue to service their debts fully.7
Costs and Government Responsibility
The government recognised that bank restructuring, particularly when a blan-ket guarantee is in place, is a govern-ment responsibility. Costs have three main elements: compensation to BI for the liquidity support extended to the banks; compensation to those banks tak-ing over the liabilities of the banks that have been closed; and recapitalisation of those banks that are undercapitalised and stay open. In all cases finance is pro-vided by bonds, the interest cost of which appears as a budget item. There is no alternative source of funding of such expenditure in the economy. If the burden were laid on BI, this would prob-ably undermine BI’s ability to pursue its monetary policy objectives, and would ultimately lead to equivalent fiscal costs through the need for the government to recapitalise BI. With the cost assumed on the budget, it is set out transparently with other elements of public expenditure, providing appropriate incentives to re-solve the banking crisis expeditiously and effectively. Recoveries, through IBRA or other agencies, provide a direct offset to these costs on the budget.
One depressing factor in this regard was the persistent rise in estimates of the cost of restructuring. This lasted until the end of 1999, when estimates of the total need for bonds passed the Rp 600 trillion ($80 billion) mark. In part, these higher estimates derived from better recognition of the depth of the problems in the banking sector. In part, however, they were due to the protracted nature
of the implementation process, which greatly extended the period during which the banking sector continued to accumulate additional losses.
Assessment of the condition of a bank depends primarily on an evaluation of the worth of its loan portfolio. This in turn requires assessment of the likelihood that loans will be serviced properly, as well as valuation of collateral—and calcula-tion of the probability of securing it—if the loans are not serviced. All these ele-ments proved difficult during the Indo-nesian banking crisis, delaying full recognition of its depth, and increasing the cost of addressing it. Valuation of col-lateral may be difficult at any time. In times when the market—for instance in real estate—has become paralysed, as is bound to be the case during a banking crisis, it may be almost impossible. In the case of the Indonesian crisis, these valu-ation difficulties were compounded in at least two ways. First, as non-performing loans were restructured, there were no clear standards as to what would be the minimum revised payments profile that would allow the bank to declare a loan to be once again performing. Second, le-gal uncertainties over banks’ ability to seize collateral made it unclear to what extent collateral should be recognised in assessments of banks’ financial condition. Together these issues had a substantial impact, complicating the triage of the banks by the authorities.
Blanket Guarantee
The issue of whether the blanket guar-antee should have been introduced ear-lier—such as at the time of the October 1997 bank closures—is one of the most contentious regarding the handling of the banking crisis. With the benefit of hindsight, there clearly would have been a case for such a move. But the extent of the banking sector’s difficulties was not apparent at the time, nor was the
harto government’s lack of commitment to carrying out many of the supporting measures included in the agreement signed with the IMF. Had the commit-ments to the IMF been implemented in full, the original bank strategy might have had a fair chance of success. Con-versely, given the revelation over the following months of the government’s unwillingness to implement many of the agreed measures, it is quite likely that any bank strategy—including one with a blanket guarantee—would have failed. A blanket guarantee without the robust implementation of supporting measures would not have been sufficient to stop the crisis.
The blanket guarantee announced on 27 January 1998 followed closely the provisions of that promulgated in Thai-land. All depositors and creditors were to be covered (except the holders of sub-ordinated debt) for both domestic and foreign currency claims, although the latter too would be paid in domestic currency, at the rate of exchange on the day the claim was made. The guarantee was given to domestic banks whose owners were willing to sign a contract with BI and the government agreeing to a number of prudential restrictions. A small premium—0.5% of the value of the deposits—was levied for the guarantee.8
A number of measures were intro-duced in order to mitigate the moral hazard resulting from the guarantee. These included limits on interbank ac-tivity and, most importantly, caps on de-posit rates to prevent weak banks from trying to attract deposits by offering in-terest rates that they knew they could not afford. Banks were allowed to offer deposit rates up to 500 basis points above the rates set by the JIBOR banks.9
While such a premium may have been appropriate in the beginning in view of the lack of confidence in many of the banks, it eventually gave scope to banks
to maximise deposit shares by exploit-ing the guarantee. Chief among these were some of the so-called BTO banks,10
which achieved a remarkable rebuilding of deposits over the period. This may have helped to stabilise the banking sys-tem to begin with, but since the depos-its were attracted at rates above those the banks could earn from them, pur-suit of this strategy substantially in-creased the losses of these banks, and thus raised the ultimate cost of recapi-talisation.11
By early 1999, with the banking sys-tem largely stabilised, such a large pre-mium was clearly no longer necessary. In March 1999, BI announced an initial reduction of 50 basis points. On 19 April, it announced a further 100 basis point reduction to a 350 basis point maximum, and after May 1999 it reduced the maxi-mum spread in stages to 100 basis points. The announcement of the guar-antee did not of itself generate confi-dence that the government would indeed stand behind all depositors and creditors. Depositors initially continued to withdraw their funds, leading to a continuing need for BI liquidity support. Only after the bank closures of April 1998 had been succeeded by the prompt transfer of deposits from the closed banks to designated state banks was credibility of the guarantee achieved in the eyes of the public.
Although the authorities made imme-diate transfers of non-bank deposits from closed banks, there were substan-tial delays in the payment of interbank claims. Responsibility for the adminis-tration of the guarantee was passed from BI to IBRA and back again; the continu-ing non-serviccontinu-ing of the guarantee, which may have been a result of the bu-reaucratic passing of responsibilities, but may also have reflected concern at the insider nature of some of the claims, un-dermined the credibility of the
tee in the international community, and provided a serious irritant in its attitude to Indonesia. In March 1999 the govern-ment committed itself to prompt pay-ment of such claims for the banks that were eligible for the joint recapitalisa-tion scheme. However, these payments were in some cases not subsequently made, thus generating opportunities for intermediaries to offer to facilitate them. The use of government-connected facili-tators by the owner of Bank Bali, a large private bank seeking to meet the quali-fication requirements for the joint recapi-talisation scheme, led to a major scandal in August 1999, and possibly influenced the result of the presidential election under way at that time. Subsequently, international accountants were brought in to verify the eligibility of all remain-ing claims, and procedures were estab-lished to make the remaining payments in the early part of 2000.
Initially the blanket guarantee was to be maintained for a minimum of two years, with the government indicating that it would give at least six months notice of its termination. By the middle of 1998, there was a movement to termi-nate the guarantee on the earliest pos-sible date, out of a feeling that it had proved very expensive and had opened the door to abuses, and that expenditure could be saved by eliminating it at that point. In the middle of 1999, when the announcement would have to be made if the guarantee was to be eliminated at the earliest possible date, there was in-deed momentum to make such an an-nouncement. After some discussion, however, it was realised that the costs of the guarantee were essentially already sunk, that the banking system was still not sufficiently robust to withstand a serious shock to confidence, and that the announcement of the end of the guar-antee might itself provide such a shock. The authorities therefore announced
that the guarantee would be extended; no termination date was given, but the six-month minimum notice was reaf-firmed.
There has been some domestic criti-cism of the guarantee, blaming it for the high fiscal cost of the restructuring. This criticism is misplaced. To have tried to force depositors to bear the costs of the banking failures could have led rapidly to the collapse of most, or all, banks in the country, turning Indonesia into a wasteland of financial intermediation and returning it to a cash or barter economy, from which it would have taken many years to recover. In the end, the guarantee was fundamentally effec-tive. It is likely to have been a major fac-tor in the absence of significant runs on the banks during the difficult political transition of 1999 and the policy rever-sals before and since.
Lender of Last Resort Facility
In the period after the November 1997 closings of 16 small banks, the authori-ties had a clear preference not to close any more banks, given evidence of the increasing fragility of confidence in the banking system. With closures ruled out, and continuing depositor with-drawals, there was little alternative in the short run but to supply central bank liquidity. By end December 1997, over Rp 25 trillion of liquidity support had been supplied to banks. With the au-thorities unable to sterilise the impact on overall liquidity conditions, reflecting both the lack of effective instruments of monetary control at the time and the au-thorities’ concern about the impact of high interest rates on the banks, much of this finance was converted into dol-lars.12 For the early part of the period
there may have been opportunities for ‘round tripping’ by banks, as the rates for the lender of last resort (LOLR) fa-cilities remained sticky and below the
rates that banks might be able to earn from investing the funds. Later, LOLR interest rates were made punitive, up to double the JIBOR rate; however, it seems that most banks simply capitalised the interest payments, so the notionally high rate may not have served as much of a deterrent.
By June 1998, total support outstand-ing reached Rp 140 trillion—over 15% of pre-crisis deposits. Interestingly, the support was still heavily concentrated in a small number of banks, with around 80% of the total accounted for by just five banks: BCA, Bank Dagang Nasional In-donesia (BDNI), the state-owned Bank Ekspor–Impor Indonesia, Bank Dana-mon, and Bank Umum Nasional (BUN). Moreover, the granting of liquidity sup-port was not constant over the period. Times of intense liquidity support were interspersed with periods when there was no new support, or even small re-payments.
The operation of an LOLR facility to address banks’ short-term liquidity dif-ficulties is one of the classic functions of a central bank. Conventionally such lending should be only to banks that are solvent, and the banks should provide collateral. There should be restrictions against protracted use of such lending, since this is likely to be an indicator of solvency difficulties. However, after the bank closures of November 1997, while liquidity support escalated rapidly, no attempt was made to distinguish be-tween liquidity support and solvency support, and collateral was no longer taken. A criticism of BI’s LOLR practices relates to the lack of control over such lending—in particular over whether the lending matched a commensurate loss of deposits. While BI did undertake such matching in the latter part of the crisis—specifically in May 1998 when BCA was subject to protracted with-drawals—there seems to have been less
control during some of the earlier peri-ods.
When it became clear that the liquid-ity support was really solvency sup-port, the government’s obligation to meet the costs of bank restructuring was recognised as including payment for this support. The authorities agreed to pay BI for liquidity support in the form of bonds with the principal in-dexed to the rate of inflation, and to pay interest at 3% of the index-linked prin-cipal. In exchange for this payment, IBRA, as agent for the government, would take an equivalent claim on the banks.
In order to address the issue of lack of collateral from borrowing banks, BI required personal guarantees from bank owners that their borrowings were be-ing used to meet liquidity needs, and that their banks were in compliance with all prudential regulations. Those banks that subsequently failed, or were taken over by IBRA, were investigated by IBRA to see if they had indeed been fully compliant. For 10 of the 14 banks taken over or closed in 1998, IBRA found that there had been prudential violations— generally breaches of the legal lending limit. In all such cases, IBRA sought to negotiate a pledging of the owners’ as-sets that should be sold so that the gov-ernment could recover its outlays.
In September 1998 a ‘shareholders settlement’ was agreed between the gov-ernment and the owner of BCA that was meant to serve as a model for settle-ments with the other owners, and was to achieve repayment of the bulk of the liquidity support extended to the banks. However, there were protracted delays in reaching these other agreements, and their structure was such that the own-ers retained control over the assets being pledged until the assets were ac-tually to be transferred. Overall, receipts to the government turned out to be
much lower than earlier estimated, and in 2001 the government decided that the settlement agreements should be re-opened and additional assets commit-ted by the owners.
Governance Issues
Governance issues have been at the heart of the banking crisis in Indonesia. At the onset of the crisis, the banking sector was weak because of directed lending, breaches of legal lending lim-its, and inadequate capitalisation. The fact that several well connected banks were closed in November 1997 was per-ceived as a major turning point, but sub-sequent reversals of these closures by the authorities rapidly led to a reversal of the initial positive reaction. Thereafter, governance problems included serious ongoing issues with regard to each of the principal institutions involved (BI, IBRA and the state banks), and these were re-flected in a series of well publicised events that served to weaken the momen-tum for restructuring. These issues go well beyond the scope of this study and reflect the pre-existing structure, where there was no autonomy for individual public sector agencies, and limited adher-ence to the rule of law.
While governance issues are rather diverse, nearly all had a key element in common: they indicated to the public that the government was not sufficiently committed to thorough reform. The re-sult was a loss of confidence in the do-mestic currency, reflected in repeated depreciations that tended to wipe out the gains painfully achieved over pre-vious weeks or months. This weak ex-change rate performance not only undermined the credibility of the efforts themselves, but also had a marked ef-fect on the economy, prolonging the cri-sis far beyond what otherwise would have been the case.
CONCLUDING REMARKS General Assessment as of End 1999
By the end of 1999, most of the critical elements that could protect the core banking system and facilitate the revival of intermediation were in place. Also, the political transition to a newly elected president seemed to have been accom-plished with inauguration of the new government in December 1999. How-ever, substantial work to complete the restructuring of the banking system was required, and many opportunities for slippage or reversal remained.
The new government faced a daunt-ing agenda. On BI’s side, a comprehen-sive program aimed at strengthening the capacity to supervise banks had been drawn up and was set for implementa-tion. The key remaining objectives in bank restructuring included the achieve-ment of an 8% capital adequacy ratio and sustainable profitability for all banks by end 2001; the eventual replacement of the comprehensive deposit guaran-tee scheme with self-financed deposit insurance; completion of the restructur-ing and subsequent privatisation of the state banks, and of the banks taken over by IBRA; the raising of governance and supervision of banks to world stan-dards; the deepening of bond and equity markets; and the acceleration of corporate restructuring through imple-mentation of a functional corporate re-structuring framework.
Some Core Lessons
The first lesson from the crisis is how quickly matters can get out of hand, and an apparently well managed and strongly performing economy be plunged into deep crisis, when there is little reliable information on economic and financial trends, when analysts are not watching developments closely, and when the authorities demonstrate
a clear lack of commitment to come to grips with the crisis.
In Indonesia, clearly not everything was done well in handling the banking crisis. However, overall, a comprehen-sive and—as long as governance issues did not get in the way—transparent strategy was put in place that served to protect a core banking system and es-tablish conditions for the revival of inter-mediation, the development of financial markets, and the recovery of some of the outlays of the public sector. The very depth of the crisis, and the myriad of measures that had to be taken to address it, provide the opportunity to draw a wide set of important lessons.
A banking crisis is bound to be diffi-cult to handle. At the outset there will be limited information and heavy pres-sures on policy makers for quick deci-sions and actions. By its very nature, a crisis is a sudden major change in con-ditions, and there may be reluctance to accept the extent to which conditions have in fact changed. Thus, there is likely to be a tendency to denial and thus to doing less than has to be done. In any case, management of a banking crisis will be an evolving process, with addi-tional techniques being brought into play as more information becomes avail-able, as denial becomes less possible, and as consensus is achieved that robust action is necessary. While policy mak-ers should always be seeking to devise a strategy for handling a crisis, and to establish credibility from the outset by adopting a comprehensive and trans-parent approach, it will be hard—and indeed probably premature and danger-ous—to enunciate it fully early on.
Following from this, it may be dan-gerous to seek to predetermine the ulti-mate outcome at the beginning. For instance, there was talk during the early part of the crisis of the optimal number
of banks in Indonesia, and what mea-sures could be taken to reduce the size of the system to that number. Indeed, the restructuring strategy proposed by some of the government’s advisers was based on such an objective.
At the outset, few observers could see the extent of the crisis in Indonesia. While some banks were known to be in difficulty, it was held that virtually all the major banks were sound. Similarly, economic management was held to be good, in large part because of the long history of uninterrupted growth, the sound fiscal position, the general open-ness of the economy, and the credibility inherent in the continuity of the eco-nomic policy team. There was little in-dication of the depth of the economic problems.
To some extent this was due to a pau-city of reliable information. The qual-ity of banks’ reporting was lamentable, depressed both by inadequate report-ing requirements and by lack of moni-toring or enforcement by BI. Hence high standards of financial disclosure, full adherence to international account-ing standards and regular professional independent audits would serve to pro-vide public information that could gen-erate prompt responses capable of averting a crisis. And if a crisis did emerge, they would greatly facilitate the authorities’ handling of it, and sig-nificantly reduce its length and sever-ity and the costs that resulted from it.
Handling a banking crisis is made much more difficult if the public does not have full confidence in what the au-thorities are doing. If there is a lack of confidence in the banking system, and in how the authorities will handle the crisis or whether they will protect de-positors, a natural reaction will be flight from the banking system and, perhaps, the currency. Particularly in this
tion, full transparency becomes critical. The authorities need to explain clearly to the public what they are doing and why. Decisions must be on the basis of simple, uniform, credible and defensible criteria.
Action needs to be taken across a broad front. Ad hoc measures by their nature are not capable of dealing with problems in the sector as a whole. More-over, the authorities’ credibility can be much enhanced by adherence to a com-prehensive macroeconomic and struc-tural program. Resolving a banking crisis will be particularly difficult when macroeconomic conditions are not sound, and when the authorities do not demonstrate an ability to organise them-selves coherently and to take difficult decisions on a timely and consistent ba-sis. This was a serious impediment dur-ing the first months of the crisis.
It is too early to come to definitive operational conclusions about some as-pects of the handling of the Indonesian banking crisis. Because one can never know the counterfactual—what would have happened had alternative policies been adopted—some issues can never be fully resolved. However, some gen-eral conclusions have already emerged. First, there is always substantial un-certainty as to the true condition of the banking sector in the early stages of a crisis. Reducing the uncertainty should be given a high priority, and close at-tention paid to public relations issues as the true situation is revealed. The strat-egy for handling the banking crisis in-evitably will evolve over time from initial efforts made on the basis of lim-ited information.
Second, a blanket guarantee is an in-dispensable instrument while a systemic banking crisis is being resolved. How-ever, the authorities are literally ‘buy-ing time’, and the more time that has to
be bought, the more expensive the over-all process will be.
Third, a centralised approach to bank restructuring, establishing a single agency responsible for holding banks taken over, and managing the assets ac-quired during restructuring, may well be the least problematic route when issues of governance and shortage of skills are involved. However, the success of such an agency can be separated to only a limited extent from the overall en-vironment within which it will operate. High levels of transparency and gover-nance are therefore indispensable, and concomitant early action, including the requisite legal reforms, will be integral to ensuring that the agency operates ef-fectively.
Fourth, the role of state banks in a banking crisis needs careful watching, as such banks may appear stronger than they really are; their precarious solvency may be disguised by an ab-sence of liquidity problems if they con-tinue to attract funds as depositors seek a flight to safety. A ‘too big to fail’ policy with regard to the state banks has major moral hazard effects. It needs to be complemented by very close monitoring of—and, if necessary, inter-ventions in—the operations of these banks, if it is not to prove extremely expensive.
Fifth, the structure of interest rates— both in the interbank markets and be-tween banks’ deposit and lending rates—provides critical information throughout a banking crisis on the mar-kets’ perceptions of the relative strength of the banks, of bank managements’ re-sponses to the crisis, and of the prospec-tive costs of resolving the crisis.
Finally, transparency is indispens-able throughout the handling of a bank-ing crisis, first, to generate public trust in what the authorities are seeking to
achieve; second, to generate public support for the resolution strategy and to gain public assistance in implement-ing it (for instance, as regards
non-prices due to excessive lending from un-regulated banks—as a major factor in causing the overall financial crisis. 8 This ‘insurance premium’ was in line
with practice in other countries. Refus-als by joint ventures to pay the premium led to the authorities agreeing to exempt such banks as long as they produced ‘comfort’ letters from their foreign part-ners. In the event this meant that the clo-sure costs of two joint venture banks in 1999 were borne entirely by the banks’ Japanese shareholders.
9 At the onset of the crisis, the Jakarta In-terbank Offer Rate (JIBOR) was the rate applicable among the 16 principal banks in the country, including the state banks and some foreign banks. As some of these banks faced financial problems during 1998 the number of banks in the group was reduced.
10 BTO stands for ‘banks taken over’ by IBRA, equivalent to a nationalisation. 11 A significant problem in this regard
de-rived from the government’s public commitment to recapitalising all state banks. With the blanket guarantee in place, and the prospect of unlimited re-capitalisation, some of the state banks sought to increase their share of depos-its by maintaining interest rates close to the permitted maximum. Moral hazard was mitigated only to a limited extent by the authorities undertaking to change these banks’ managements before re-capitalisation.
12 See Enoch, Baldwin et al. (2001) for fur-ther details about the development of BI’s monetary instruments.
cooperating debtors and non-cooperat-ing owners of failed banks); and third, to ensure that actions taken by the au-thorities are irreversible.
NOTES
* The authors would like to thank Michael Andrews, Luis Cortavarria, Peter Dattels, Stanley Fischer, Mathew Fisher, Lorenzo Giorgianni, Mark Griffiths, David Hoelscher, R. Barry Johnston, Mats Josefsson, Hassanali Mehran, Reza Moghadam, V. Sundararajan, Andrew Tweedie and Peter Wickham for com-ments on earlier versions of this paper. They also thank two anonymous refer-ees for their suggestions. The views ex-pressed in this study are those of the authors and not necessarily those of the International Monetary Fund. The au-thors remain responsible for any errors. 1 As noted in Kenward (1999), per capita income in Indonesia in 1967 was less than one-half that in India, Nigeria, or Bangla-desh. By mid 1997 it was five times that of Bangladesh, four times that of Nige-ria, and three-and-a-half times that of India.
2 A number of studies have dealt with the financial crisis of the late 1990s in Asia; see, for example, Baig and Goldfajn (1998); Boorman, Lane et al. (2000); Lindgren, Baliño et al. (1999); and Mishkin (1999).
3 Further analysis related to the develop-ments in the banking sector can be found in Nasution (1994, 1998).
4 This is discussed in more detail below. 5 Criteria for this category included
nega-tive net worth being not more than 25% of total assets.
6 A specific focus on the varieties of inter-vention in Indonesia is contained in Enoch (2000).
7 Krugman (1998) attributes a broader con-cept of moral hazard—inflation of asset
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