Manajemen | Fakultas Ekonomi Universitas Maritim Raja Ali Haji 0007491042000231502
Bulletin of Indonesian Economic Studies
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
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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Carfax Publishing
Bulletin of Indonesian Economic Studies, Vol. 40, No. 3, 2004: 307–27
Taylor & Francis Group
WHAT SORT OF FINANCIAL SECTOR
SHOULD INDONESIA HAVE?
Stephen Grenville
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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: massive 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 understandable. But now, nearly seven years after the crisis began, it is time to move forward, 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
ISSN 0007-4918 print/ISSN 1472-7234 online/04/030307-21
DOI: 10.1080/0007491042000231502
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the integration of financial markets brought huge capital inflows into the minuscule 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 operational 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 passing of ownership: it changed the way the banking system worked. In the old
world, the state banks were seen principally as ‘agents of development’, channelling 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 enterprises 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 intermediation, 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 expanding private banking 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 undesirable 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 Indo-
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nesia, there was even ambiguity about just who had responsibility for the prudential 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 government 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 governance 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 limited (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 private 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 prudential 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 supervision 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 insolvent, 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 understanding 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 (MacIntyre 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 principle, 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 supervisor; 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
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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 deregulation. 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 proponents 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 volumes 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 equilibrium 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 financial 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
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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 dramatically, 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 indirect credit 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 Indonesian 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 appreciation.
The Crisis
The long and short of this is that Indonesia experienced the not unusual combination of ‘Good-bye financial repression, hello financial crash’ (Diaz-Alejandro
1985). The two critical vulnerabilities coming out of the history of financial deregulation 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 historical precedents for such action: so-called ‘Sumarlin shocks’ (episodes of sudden and severe monetary contraction implemented by former finance minister
Sumarlin) had been used twice before, in July 1987 and February 1991. Unfortunately, this left the banking system without enough funds to fulfil its reserve
requirements and its need for clearing balances to meet cheque-payment settlement (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 liquidity. Knowing the president’s strong view that banks should be kept open, BI provided 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 created 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
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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 financial 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 Widjojo 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 little has 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 sector taken over, to a large degree, by foreigners. In contrast, the Indonesian banking 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, however, 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 system 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
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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 nonperforming 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 strengthened (especially with better information technology systems and better liquidity
control), enforcement and compliance are probably little improved since the crisis. The current intention is to address the problem of lack of prudential effectiveness 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 represents a continuing and serious moral hazard, and will be difficult to remove without 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 difficult enough, but divesting the core SOBs will be much more difficult.2
The central bank’s position is still tarnished by the legacy of the BLBI controversy (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 reputation makes it difficult for it to assert its authority or take an active part in economic policy making. It still carries out prudential supervision, despite the
in-principle decision eventually to shift this function elsewhere. While implementation 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 banking 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
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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 crisis would be an opportunity for reform proved wrong, and why the crisis 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 element 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 levels of crisis, whereas an economy-wide crisis clears away both bad and good interest 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 situation 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 weakest 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 incentive structure 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 provided 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: international 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 maintain 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
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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 recognised 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 created enough dust to obscure the weak position of foreign creditors. The Indonesian 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 circumstances 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 resolutions. There should be a clear understanding between the parties that if a government 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 rupiahdenominated 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 overcome, calling for widespread hedging is irrelevant to the problem at hand.
Two additional elements would reduce the ‘collateral damage’ from the reversal 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 policies (watching for the asset price bubbles that accompany excessive inflows).
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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 provided 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 authorities 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.3 In reality it is probably impossible to draw this distinction in the heat
of an economy-wide crisis. Others might draw the line between systemically
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important banks and others. If this line is drawn before the crisis, there is substantial moral hazard for the banks designated ‘systemic’. If it is drawn during a crisis, 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 circles 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,4 and 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 government, they need to have absolutely safe assets, so they should hold predominantly 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.6 The 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 commercial banks would operate alongside them. Indeed, over time the savings
banks would probably shrink in importance as the financial sector gained in reputation, 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 borrow 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.7 There 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
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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 culture, 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 arrangements 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 culture, they will once again find ways to lend to the only people they trust—themselves. 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 corporate loans, and they took deposits from parties who, by and large, were ‘consenting 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 sector 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 improving discipline for equity markets and the issuing of company debt. They have,
potentially, the incentive and capacity to obtain, and act on, commercial information, 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
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that, it is promised, will create a transparent world where good investment decisions 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 individuals, 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 having different characteristics and being 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 specific, it may produce full-service financial institutions that provide a wide range
of financial services, creating a twofold problem: first, that the institution is taking 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 balance 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 desirable 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 zookeeping, 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.
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Once the differences between the types of institutions are recognised, the desirability 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 government-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 depositors who 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.8 Commercial (i.e. non-governmental) deposit insurance could
develop, and because this would be sponsored privately rather than by a govern
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
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
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Bulletin of Indonesian Economic Studies, Vol. 40, No. 3, 2004: 307–27
Taylor & Francis Group
WHAT SORT OF FINANCIAL SECTOR
SHOULD INDONESIA HAVE?
Stephen Grenville
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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: massive 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 understandable. But now, nearly seven years after the crisis began, it is time to move forward, 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
ISSN 0007-4918 print/ISSN 1472-7234 online/04/030307-21
DOI: 10.1080/0007491042000231502
© 2004 Indonesia Project ANU
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the integration of financial markets brought huge capital inflows into the minuscule 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 operational 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 passing of ownership: it changed the way the banking system worked. In the old
world, the state banks were seen principally as ‘agents of development’, channelling 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 enterprises 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 intermediation, 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 expanding private banking 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 undesirable 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 Indo-
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nesia, there was even ambiguity about just who had responsibility for the prudential 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 government 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 governance 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 limited (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 private 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 prudential 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 supervision 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 insolvent, 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 understanding 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 (MacIntyre 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 principle, 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 supervisor; 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
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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 deregulation. 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 proponents 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 volumes 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 equilibrium 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 financial 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
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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 dramatically, 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 indirect credit 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 Indonesian 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 appreciation.
The Crisis
The long and short of this is that Indonesia experienced the not unusual combination of ‘Good-bye financial repression, hello financial crash’ (Diaz-Alejandro
1985). The two critical vulnerabilities coming out of the history of financial deregulation 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 historical precedents for such action: so-called ‘Sumarlin shocks’ (episodes of sudden and severe monetary contraction implemented by former finance minister
Sumarlin) had been used twice before, in July 1987 and February 1991. Unfortunately, this left the banking system without enough funds to fulfil its reserve
requirements and its need for clearing balances to meet cheque-payment settlement (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 liquidity. Knowing the president’s strong view that banks should be kept open, BI provided 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 created 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
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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 financial 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 Widjojo 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 little has 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 sector taken over, to a large degree, by foreigners. In contrast, the Indonesian banking 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, however, 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 system 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
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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 nonperforming 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 strengthened (especially with better information technology systems and better liquidity
control), enforcement and compliance are probably little improved since the crisis. The current intention is to address the problem of lack of prudential effectiveness 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 represents a continuing and serious moral hazard, and will be difficult to remove without 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 difficult enough, but divesting the core SOBs will be much more difficult.2
The central bank’s position is still tarnished by the legacy of the BLBI controversy (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 reputation makes it difficult for it to assert its authority or take an active part in economic policy making. It still carries out prudential supervision, despite the
in-principle decision eventually to shift this function elsewhere. While implementation 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 banking 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
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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 crisis would be an opportunity for reform proved wrong, and why the crisis 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 element 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 levels of crisis, whereas an economy-wide crisis clears away both bad and good interest 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 situation 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 weakest 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 incentive structure 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 provided 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: international 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 maintain 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
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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 recognised 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 created enough dust to obscure the weak position of foreign creditors. The Indonesian 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 circumstances 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 resolutions. There should be a clear understanding between the parties that if a government 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 rupiahdenominated 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 overcome, calling for widespread hedging is irrelevant to the problem at hand.
Two additional elements would reduce the ‘collateral damage’ from the reversal 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 policies (watching for the asset price bubbles that accompany excessive inflows).
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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 provided 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 authorities 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.3 In reality it is probably impossible to draw this distinction in the heat
of an economy-wide crisis. Others might draw the line between systemically
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important banks and others. If this line is drawn before the crisis, there is substantial moral hazard for the banks designated ‘systemic’. If it is drawn during a crisis, 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 circles 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,4 and 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 government, they need to have absolutely safe assets, so they should hold predominantly 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.6 The 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 commercial banks would operate alongside them. Indeed, over time the savings
banks would probably shrink in importance as the financial sector gained in reputation, 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 borrow 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.7 There 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
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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 culture, 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 arrangements 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 culture, they will once again find ways to lend to the only people they trust—themselves. 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 corporate loans, and they took deposits from parties who, by and large, were ‘consenting 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 sector 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 improving discipline for equity markets and the issuing of company debt. They have,
potentially, the incentive and capacity to obtain, and act on, commercial information, 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
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that, it is promised, will create a transparent world where good investment decisions 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 individuals, 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 having different characteristics and being 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 specific, it may produce full-service financial institutions that provide a wide range
of financial services, creating a twofold problem: first, that the institution is taking 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 balance 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 desirable 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 zookeeping, 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.
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Once the differences between the types of institutions are recognised, the desirability 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 government-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 depositors who 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.8 Commercial (i.e. non-governmental) deposit insurance could
develop, and because this would be sponsored privately rather than by a govern