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Indonesian experience: In some crises, bank closures may be more effective than resolution efforts

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2000
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Intervention in banks by the public authorities is often an integral element of a government’s program for resolving a systemic banking crisis. Banks may be closed outright (“closure”) or permitted to remain open, but under new rules for conducting business (“open bank resolution”). In some circumstances, closures may be more effective than open bank resolution. In a recent study, Interventions in Banks During Banking Crises: The Experience of Indonesia, Charles Enoch, Senior Advisor in the IMF’s Statistics Department, examines a number of interventions in Indonesia, most of which included bank closures.

Closures and their aftermath

Between November 1997 and March 1999, there were four major bank closures in Indonesia. This process, Enoch notes, has been controversial, particularly in its early stages, although the more recent closures have been viewed more positively.

November 1997%. Indonesia began negotiations with the IMF on a comprehensive adjustment program, as the effects of the currency crisis in Thailand, which began in July 1997, spread to Indonesia. By October 1997, the rupiah had depreciated by almost 40 percent. At the same time, runs had been building up on some private banks, as depositors sought to move their funds out of banks believed to be in trouble into banks that were thought to be more secure. As part of the comprehensive program, the government adopted a bank resolution package. On November 1, it was announced that 16 banks, comprising about 2.5 percent of the assets of the banking sector, would be closed immediately.

The immediate response to the program, Enoch observes, was positive. The exchange rate rebounded slightly, and the runs on the banks declined after a few days. However, within a few weeks, sentiment turned negative. Runs became pervasive across the system as concerns over banks’ safety merged into broader concerns about the currency and the stance of economic policy overall. Liquidity support provided by Bank Indonesia, the central bank, and currency depreciation intensified, approaching 60 trillion rupiah at the end of January 1998 and threatening imminent financial meltdown.

Although some commentators have blamed the economic problems that occurred after November 1997 on the closure of the 16 banks, Enoch points out that this closure was only one element of an overall bank resolution and macroeconomic program; it was the failure of the government to implement the program that probably undermined confidence in the banks and in the economic management of the country more generally.

Establishment of restructuring agency%. To stop the bank runs, restore monetary control, and address the banking sector’s problems, the government announced in late January 1998 a blanket guarantee for all depositors and creditors of domestic banks, as well as the establishment of the Indonesian Bank Restructuring Agency (IBRA). In mid-February, 54 banks were brought under the auspices of the IBRA. However, although the interventions were determined on a transparent and uniform basis and were carried out smoothly, the government, prompted by a concern that the interventions could spark renewed runs, determined that no publicity should accompany the action. This last-minute change severely undermined the operation, Enoch notes.

The establishment of the new restructuring agency was an important step forward, Enoch notes, but because it was established as an agency of the Ministry of Finance, rather than as an autonomous institution, its effectiveness was compromised by the need to obtain political authority, even for its technical operations.

April 1998%. The February interventions appeared to have little effect on the behavior of many banks, and liquidity support from Bank Indonesia continued at its earlier levels for several more weeks, Enoch says. By April 1998, it was apparent that forceful intervention was necessary to establish the credibility of the IBRA and the restructuring strategy and to halt the continuing liquidity emissions from Bank Indonesia. At this point, 75 percent of total liquidity support to the banking system (comprising 222 banks) was accounted for by only seven banks, representing 16 percent of the liabilities of the banking system. A newly constituted IBRA team earmarked these banks for “hard” open bank intervention—that is, the suspension of shareholders’ rights and the assumption of ownership control by the IBRA—and the replacement of the managers by management teams from designated state banks. In addition, seven small banks were closed.

The operation was carried out smoothly, starting on the weekend of Friday, April 3—this time with ample publicity, and with frequent press briefings by the Finance Minister and the Head and Deputy Head of the IBRA, who explained what was happening and assured all depositors that they were totally protected. All deposits from the closed banks were transferred to the state-owned Bank Negara Indonesia—widely regarded as the strongest bank in the country—and all depositors were able to have immediate access to the deposits by Monday morning.

Like the November 1997 experience, the announcement of bank closures was followed rapidly by the announcement of agreement on an IMF-supported program. This time, however, the authorities demonstrated their commitment in the following weeks to carrying out the other elements of the program.

August 1998%. During the spring and summer of 1998, international accounting firms conducted portfolio reviews of the banks taken over by the IBRA in April 1998. The first results, Enoch notes, were devastating, showing levels of nonperforming loans ranging from 55 percent to more than 90 percent of the banks’ portfolios. In June 1998, the audit results were leaked to the press. The immediate consequence was shock that the state of the banks was so bad; but beyond that, the leak prevented any further denial of the seriousness of the crisis and forced the authorities to recognize that further drastic action was urgently needed. In addition to developing an overall plan for the banks it had already taken over but not closed in April and May 1998, the IBRA closed three more banks, representing 5 percent of the liabilities of the banking sector, on August 20, 1998.

March 1999%. With the share of the state sector in the banking system increasing substantially and evidence mounting that most of the remaining significant private banks were insolvent, the government announced a plan for restructuring the private banks, in order to retain a residual private banking sector. The plan involved a triage of the banks, primarily according to their capital asset ratios. On March 13, it was announced that 73 banks (representing 5.7 percent of the assets of the banking sector) could continue to function without government support, 38 (5 percent) were to be closed; 7 (2.5 percent) were to be taken over by the IBRA, and 9 (10 percent) were deemed eligible for joint recapitalization. The March 13 interventions, and the subsequent implementation of the measures announced at the same time, were well received by the markets, according to Enoch. The comprehensive nature of the action, involving a resolution decision based on uniform and transparent criteria, added to the credibility of the action and to its favorable reception. The general feeling was that the authorities had finally gotten a full grip on the banking situation. At least partly as a result, Enoch observes, market interest rates began falling rapidly from their crisis levels. With the fall in interest rates, prospects for the economy and for the banking system in particular improved dramatically.

Lessons from the closure process

The massive insolvency of the Indonesian banking system called for a major restructuring of the entire sector, Enoch observes. No single closure strategy could have worked successfully throughout the entire crisis and restructuring period, because the true magnitude of the problem became apparent only over time, calling for a phased implementation of more forceful and more comprehensive measures.

The initial stages of a bank restructuring program are bound to be particularly difficult and messy, Enoch notes. The authorities will always be acting on limited information and are likely to have to operate with an inadequate institutional infrastructure and legal framework. They may also be working in a difficult political environment in which there are strong forces resisting change.

Although every banking crisis will be different, there is a strong case for closing some banks at the outset, especially those that are clearly insolvent and riddled with fraud, according to Enoch. An open bank solution, which may limit the capacity to control further losses and where the bank itself has lost credibility, may not be cost-effective. In bank closures, gross costs are realized up front and are easily identifiable, while in open bank resolutions, the costs are realized over time and increase dramatically if the bank is not properly managed.

In Enoch’s view, the experience from November 1997 proved that bank closures must be based on transparent, uniform, simple, and defensible criteria. There should be no exceptions to the specified rule, he states, since the credibility of the entire operation will only be as strong as its weakest link.

In most cases, the authorities will have to identify one or more banks that will be in a position to immediately receive the deposits of the banks being closed. In the absence of a clear alternative, they are likely to select a state bank, as the Indonesian authorities did with Bank Negara Indonesia in April 1998. Although this may be appropriate in some cases (and in Indonesia, there was probably little alternative, Enoch notes), state banks may themselves also suffer from serious weaknesses, and there could be advantages to using a private, or possibly even a foreign, bank for this purpose.

The closure process will reduce the number of banks, boosting the potential for profitability among those remaining. Given that most, or all, of the bank closures will occur in the private sector—and that open bank resolution will likely involve a takeover of private banks by the government—the share of state-owned institutions will rise during a bank restructuring. An important corollary of the restructuring strategy—to which the Indonesian government has committed itself—is a program for the privatization of a large part of the private banking sector.

Bank closures and other forms of bank intervention, Enoch stresses, are not the only element in a bank restructuring process. Governments need to introduce a comprehensive program, of which closures may be a part.

Copies of IMF Policy Discussion Paper No. 00/2, Interventions in Banks During Banking Crises: The Experience of Indonesia, by Charles Enoch, are available for $7.00 each from IMF Publication Services. See page 162 for ordering information.

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