Banking collapse and restructuring in Indonesia, 1997-2001.

• Jurisdiction: United States
• Date: 22 September 2002
• Author: Fane, George

Indonesia's banking sector was devastated by the crisis that began in October 1997. Of the largest banks--the seven original state banks and the ten largest formerly private banks--none managed to remain solvent, and those that still operate under their original names do so only because they were bailed out by the government. (1) The number of private banks was halved from 157 to 79:65 were closed, 9 merged, and 4 nationalized (Table 1). Most of the assets of the banking sector are now controlled by the Indonesian Bank Restructuring Agency (IBRA), which was set up to manage nationalized banks as well as the assets that the government acquired when it took over the liabilities of insolvent banks as a result of a blanket guarantee to bank creditors issued in early 1998.

The net cost to the government of bailing out depositors will probably be at least 40 percent of annual GDP. The exact amount will depend on IBRA's ability to collect doubtful debts and sell off its huge share portfolio. In order to amortize this cost over several years the government has issued a large volume of bonds, the value of which exceeds the total liabilities of the whole banking system at the time the guarantee was issued. Despite the resources that have been poured into the banking sector, however, its weakness continued to impede economic recovery as of mid-2001.

The 1997-98 Banking Crisis

The massive real depreciation of the rupiah in 1997-98, combined with the sharp rise in interest rates and the refusal of creditors to roll-over loans, led to the insolvency of many Indonesian businesses and banks. (2) At the beginning of November 1997, the Indonesian government entered into its first crisis support agreement with the IMF and simultaneously closed 16 small private banks that were experiencing liquidity problems and were seriously in breach of various prudential regulations. This exacerbated the public's loss of confidence in the banking system because, in the absence of clearly stated criteria for closures and of information on the soundness of the remaining banks, there was great uncertainty about which banks might be closed next. At the time, the government guaranteed deposits in the closed banks only up to an amount of Rp20 million--then equivalent to about $6,000.

Several of the remaining private banks continued to experience liquidity problems in the last quarter of 1997, and Bank Indonesia (BI, the central bank) supplied them with large amounts of last resort loans. Late in January 1998 the government tried to restore confidence by issuing a blanket guarantee of all deposits and other liabilities (except equity and subordinated debt) at domestically incorporated banks. Although the government initially intended to terminate this guarantee at the end of January 2000, it now seems unlikely to do so before setting up a self-funded compulsory deposit insurance scheme, which is not expected to be introduced until 2004.

In January 1998, IBRA was set up to perform three main roles. One is to oversee the restructuring or liquidation of weak banks so as to limit the fiscal costs of the government's blanket guarantee. Its second role is that of a large state-owned banking conglomerate. It acquired this role because it had to take responsibility for the troubled private banks that the authorities took over but did not close down. IBRA's third role is that of an asset management company. It was given the task of managing the very low quality (category 5) loans that, as described later, the government stripped from all banks that were recapitalized. It also acquired the assets of the banks that were closed down, many of which were low-quality loans. Lastly, it has acquired large, and often controlling, parcels of shares in some of Indonesia's best known companies. This happened in two ways. First, in the banking panics of 1997-98 BI refused to provide emergency liquidity support unless bank owners deposited shares as collateral, or issued personal or corporate guarantees that their banks would repay. In the case of banks that failed, IBRA took over their liabilities to BI, along with the collateral and the guarantees that had secured them. Second, controlling shareholders in banks that had violated prudential regulations faced strong pressure to surrender shares to IBRA to avoid prosecution under the banking law of 1992, which contained very severe penalties in the form of lengthy terms of imprisonment and heavy fines for violations of the prudential regulations (McLeod 1992).

Despite the blanket guarantee, several private banks continued to experience liquidity problems throughout the first half of 1998, in response to which BI provided large amounts of last resort loans. It became clear subsequently that some banks continued to make large loans to affiliated companies, which used them to repay foreign borrowings or to speculate against the rupiah. In April 1998 IBRA took over management control of six private banks and one state bank, and a further seven small private banks were closed. In May 1998 it had to take control of Bank Central Asia (BCA), then the largest of all the banks, in response to a severe run on its deposits. In August 1998, three of the private banks under IBRA's control were closed, and the remaining four were effectively nationalized pending further action.

The Government's Bank Restructuring Strategy

As the crisis deepened in mid-1998, it became apparent that a policy of closing down all insolvent banks would wipe out a large proportion of the entire banking sector. The government and the IMF therefore drew up plans for recapitalizing some of the insolvent banks and merging or closing down the rest. These plans appear to have been strongly influenced by those adopted by Sweden to resolve its 1991-94 banking crisis (Ingves and Lind 1997).

All seven state banks had to be recapitalized. Four of them were merged to form Bank Mandiri, which became Indonesia's largest bank, with 30 percent of all bank deposits. The three remaining state banks were recapitalized separately. (3)

In the case of insolvent, or undercapitalized, private and joint venture banks, the government had to choose between immediate sale to a strategic investor, liquidation, and partial or full nationalization. (4) Its first step was to arrange for all the surviving nonstate-owned banks to be audited by a group of internationally reputed accounting firms, which estimated the amount of capital needed to recapitalize each bank and sorted them into three categories:

* Category A: those that did not need to be recapitalized;

* Category B: those deemed to be potentially worth saving, but in need of recapitalization;

* Category C: those that were to be liquidated.

At the onset of the crisis, the government was in the process of raising the minimum CAR from 8 percent, which is the norm for industrialized countries under the Basle Capital Accord (www.bis.org/ publ/bcbsc002.htm). By September 1997, the specified minimum was already 9 percent, and this was scheduled to increase to 10 percent by September 1999 and to 12 percent by September 2001. In the event, in order to reduce the amount of new equity needed to recapitalize the banks, the CAR was instead reduced to only 4 percent in February 1999. Although the government announced that the former 8 percent minimum would again apply with effect from the end of 2001, it has not proposed the reinstatement of the more ambitious 12 percent target. The cutoff points between the categories were then set in terms of the CAR estimated by the auditors. Category A banks were defined to be those with a CAR above the new minimum of 4 percent, and the category C banks were those with a CAR of less than minus 25 percent. Those potentially eligible to participate with the government in recapitalization (the category B banks) were those with a CAR of less than 4 percent but more than minus 25 percent. In the remainder of this section we deal only with these category B banks. In the event, none of them had a positive estimated CAR. Subordinated debt in these banks was therefore written off.

Provided that their managers and principal shareholders passed the central bank's "fit and proper test," and that they were able to propose an acceptable business plan, the private shareholders of category B banks could choose whether or not to participate in recapitalization. If they chose not to participate, their banks were nationalized and they received nothing in return. If instead they wished to preserve an interest in their banks, they had to supply cash equal to at least 20 percent of the capital needed to raise the CAR to 4 percent. The remaining amount was to be supplied by the government in the form of newly issued bonds.

By way of illustration, consider a bank with deposits of Rp340 billion, and total assets (loans, cash, and other securities) valued by the auditors at Rp250 billion, implying negative equity of Rp90 billion. On the assumption that cash and government securities, which have a zero risk weight, (5) were a negligible part of total assets, a capital injection of Rp100 billion would have been needed to raise the CAR to 4 percent. Under the government's bank recapitalization plan, the private shareholders would have had to contribute at least Rp20 billion in cash if they wished to participate, while the government would have contributed up to Rp80 billion in bonds. Following recapitalization, and assuming that the private shareholders had not contributed more than the minimum necessary, the bank's balance sheet would have been as shown in Table 2.

Of the Rp10 billion of equity (at book value), Rp8 billion would have been held by the government and Rp2 billion by the private...