The Asian experience with bank restructuring has already produced valuable lessons, many of which will evolve as the process continues. In particular, many “conclusions” at this time are actually interim assessments, as it will take several years before the restructuring of the financial and corporate sectors will be completed and the full economic implications of different measures become apparent.

The Asian experience with bank restructuring has already produced valuable lessons, many of which will evolve as the process continues. In particular, many “conclusions” at this time are actually interim assessments, as it will take several years before the restructuring of the financial and corporate sectors will be completed and the full economic implications of different measures become apparent.

More than any other recent financial crisis, the one in Asia has highlighted the linkages between financial sector soundness and macroeconomic stability. Highly leveraged corporate sectors with large amounts of unhedged foreign currency debt, much of which is short-term, and domestic bank borrowing, fed by large capital inflows during years of exceptional economic growth and exchange rate stability, created major vulnerabilities. The crisis highlights the danger that formally or informally pegged exchange rates may lull investors into ignoring currency risks (see Figure 8). Following the shocks to market expectations caused by exchange rate devaluations and widespread doubts about private sector solvency, the size and speed of the impact on the financial systems was unprecedented. Foreign banks cut their credit, asset prices collapsed, leading to major wealth losses, and real demand contracted sharply. The close integration of the Asian economies in world financial markets helped to spread the crisis to other countries in the region and to the rest of the world. Close attention should be paid to prudential supervision of foreign currency exposures and risks, especially when exchange rate regimes are inflexible.

Figure 8.
Figure 8.

Nominal Exchange Rate

(National currency per U.S. dollar, end of period)

Source: IMF, International Financial Statistics.

Why did the financial sector crises take everyone by surprise? There were clear signals of overheating, such as prolonged rapid credit expansions, asset price inflation, and overcapacity in key sectors, although the underlying deterioration in banks’ loan values and capital adequacy ratios were not yet reflected in their balance sheets. Meanwhile, the buildup of corporate indebtedness, unsustainable banking practices (such as directed, connected, and insider lending) and weaknesses in prudential regulation and supervision were known to policymakers and market participants. The fact that all these factors were largely overlooked by most private sector and published official analyses—both at home and abroad—was probably related to the long-running success of those economies. In any event, greater disclosure of macroprudential and microinstitutional indicators and greater transparency of monetary and financial policies could have strengthened market discipline and policy effectiveness and could have helped to expose some vulnerabilities much earlier.

Compared with the three crisis countries, Malaysia and the Philippines had been pursuing policies before the crisis that clearly lessened the damage. Both countries, which had undertaken bank restructuring and structural reforms in the 1980s, avoided a full-blown crisis. Malaysia’s traditional policies of limiting short-term foreign borrowing, encouraging foreign direct investment inflows, and relying on equity capital prevented the corporate sector from building up the large unhedged foreign exchange exposures and very high debt equity ratios that were so damaging in the crisis countries. These policies notwithstanding, Malaysia also faced substantial financial sector distress. In general, the crisis highlights the benefits of having developed money, bond, and equity markets. Developed capital markets would reduce corporate leverage and improve corporate governance; the reduced reliance on bank financing would make the system more resilient to shocks. The development of bond markets—especially for government bonds—would also facilitate financial sector restructuring.

The first priorities in the crisis countries were to stop excessive central bank credit expansion to insolvent institutions, stabilize the financial system, and prevent capital flight. To achieve this and to prevent bank runs, the governments needed to offer blanket guarantees for depositors and most creditors, close the worst institutions, and introduce credible macroeconomic stabilization and bank restructuring plans. These measures were successful in stopping the domestic deposit withdrawals, particularly after the credibility of the guarantees had been tested, but were less effective in securing rollover of foreign liabilities. To achieve the rollover, other measures, such as the debt renegotiation in Korea, were needed. The experience of the crisis countries suggests that in a systemic crisis, a blanket guarantee, rather than a limited deposit guarantee, is needed to restore confidence in the financial system.

While closing the most insolvent institutions was considered necessary, it also became clear that any closing of financial institutions and sharing of losses with private sector creditors is an extremely difficult task to manage. Closing deeply insolvent institutions provides a way to cease central bank support, allows loss sharing with creditors, removes excess intermediation capacity, and frees resources to deal with remaining institutions. Decisions to close may have to rely on liquidity “triggers” until banks’ loan-losses are recognized in their accounts. Any closing of financial institutions must be accompanied by a well-managed information campaign to support the policy, explain the reasons for bank closings, and reassure the public.

In all countries, except initially in Indonesia, the central banks were able to sterilize their liquidity support to individual banks, since deposits withdrawn from weak banks were largely deposited in other domestic banks perceived as being safer. To absorb excess liquidity of the latter and stem capital outflows, interest rate increases for short-term central bank instruments were necessary. This recycling was successful in all countries, except in Indonesia, where economic and political turmoil made the situation unmanageable during the first six months. Nonetheless, in all countries, exchange rates initially depreciated sharply due to concerns about creditworthiness and solvency of domestic counterparties and to uncertainties about policy implementation.

A slowdown in real credit growth to the private sector should not have come as a surprise. In addition to a sharp fall in credit demand, owing to overcapacity in the real sector and bleak short-term economic prospects, bankers became more cautious, as borrowers’ creditworthiness deteriorated, reflecting in particular the large foreign exchange component of their debt. This slowdown seems to be more explained by structural factors than by an excessively tight monetary policy. Any policies to stimulate bank lending should be used cautiously so as not to worsen banks’ conditions; for example, excessively low interest rate margins will be deterrents to new lending and further undermine banks’ solvency and recapitalization. Lending cannot be expected to normalize until the corporate sector has regained its profitability and repayment capacity and banks’ capital bases have been restored.

In broad terms, the strategies for systemic restructuring have sought to restore the financial systems to soundness as soon as possible. The process involves the introduction of the necessary legal, institutional and policy frameworks for dealing with nonviable financial institutions, strengthening viable ones, and resolving value impaired assets in the system. Systemic bank restructuring is a complex multiyear microeconomic process, which in the aggregate has major macroeconomic effects. No two situations are the same, and specific measures, pace, and effectiveness of implementation have varied between the different countries depending on the specifics of the problem, laws and institutions in place at the outset, and the sometimes strong preferences of the authorities for certain solutions. For example, there have been major differences in the ability of each government to endow official agencies involved in the restructuring with sufficient operational authority, financial independence, protection from lawsuits, and means to attract necessary expertise.

Key principles for the restructuring process in the three crisis countries have included strict criteria to identify viable and nonviable institutions and to remove existing owners from insolvent institutions. Private capital injections have been encouraged or required under binding memoranda of understanding schemes that also foster operational restructuring. To complement domestic equity investment in banks and to bring in international expertise, the three crisis countries liberalized their foreign ownership rules for the financial sector. To encourage new private equity investment, public solvency support also has been offered under strict conditions.

Successful implementation of systemic bank restructuring demands that national authorities take full responsibility of all the aspects of the program. Given the microeconomic nature of financial restructuring and the need for well-coordinated interplay between so many different government institutions, the process can be successful only if the authorities themselves take full control of the implementation process. However, because systemic banking crises occur very infrequently and require skills not readily available in most countries, access to international expertise can be particularly helpful. Thus, the IMF, the World Bank, and other international and bilateral agencies have provided advice and shared experiences from other countries that have dealt with similar problems. The institutions have also helped countries obtain the necessary expertise from the public and private sectors to assist in the restructuring.

A realistic valuation of financial institutions’ assets is essential to measure net worth, yet extremely difficult in cases of severe corporate and financial distress. The valuation of nonperforming loans is particularly hampered by the lack of clear market values and continuously changing economic conditions. To better support the valuation process, all countries tightened their rules for loan classification, loss provisioning, income recognition, and collateral valuation, and have substantially strengthened their supervisory scrutiny of compliance with such rules by bankers and auditors. Asset valuation is a key element in computing banks’capital adequacy requirements, which have been the basis for their recapitalization plans. In this connection, all the countries seek to bring their capital adequacy requirements into full compliance with international standards by the end of the restructuring process. In doing so, banks have been given time, according to transparent rules, to gradually restore their severely eroded capital bases. Recent developments suggest that transparency in loss recognition practices has helped in the issuance of new private bank equity.

Management of nonperforming loans and other value-impaired bank assets is one of the most critical and complex aspects of bank restructuring. There is no single optimal strategy for all circumstances but rather a combination of options that may vary over time and for each bank, depending on factors such as the nature of the problem assets, their overall size and distribution, and legal and governance constraints. The strategy will need to consider the speed of disposition of the assets, whether or not to use a centralized process, which also involves ownership choices.

Countries have taken different views on the role of asset management companies. Indonesia, Korea, and Malaysia have opted for centralized public asset management companies that buy assets from private banks to help banks clear their balance sheets. Thailand has aggressively liquidated the impaired assets of closed institutions through a central agency but does not permit public sector purchases of impaired assets from private banks; the Thai authorities are instead encouraging each bank to establish its own asset management company. The key issue in asset purchases by an asset management company is realistic valuation, so as to ensure that it does not become a tool for the indirect bailout of existing shareholders, thus undermining the incentives for private sector recapitalization and proper governance of asset management companies and banks. The sale of banks’ assets to an asset management company forces immediate recognition of the value of the loan. This may deter such sales in cases where banks have been carrying these loans at inflated values.

The use of vast amounts of public resources has been necessary to help restructure the financial system. This affects medium-term fiscal sustainability in the three crisis countries. An estimate of the exact cost of the crisis is not possible, as the costs are still emerging and the corporate debt restructuring process is far from completed. The outlays initially took the form of central bank liquidity support, but have been gradually identified as solvency support and been refinanced by public or publicly guaranteed debt. Only the carrying costs of the latter have been brought into the government budgets so far. The ultimate public sector costs will be reduced by proceeds from asset sales and bank privatizations. Moreover, more rapid and sustained economic growth as a result of a restructured, more efficient, and profitable financial system will yield additional tax revenue.

The problems in the financial sector also reflected profound problems in the corporate sectors. Solving the banking and the corporate sector crises therefore must go hand in hand. Resolving banking problems requires not only bank recapitalization, but also broad-based corporate debt restructuring. At the same time, resolving corporate sector turmoil, in turn requires properly functioning banks as a counterpart. Widespread corporate weaknesses and insolvencies are much more difficult and time-consuming to deal with than bank restructuring. Bankruptcy and other laws, which were either not in place at the onset of the crisis or inadequate, as well as judicial systems, are now being reformed to speed up corporate debt restructuring. Nevertheless, lags in corporate reform are slowing progress in bank restructuring.

Bank restructuring provides a key lever for corporate restructuring. Tighter and better enforced prudential regulations can induce the financial restructuring of corporations, especially those that are highly leveraged. Moreover, banks can play a lead role in inducing corporate restructuring, particularly if they have strong government support to do so, as is the case in Korea.

The IMF programs designed to deal with the problems of crisis countries in Asia have centered on structural reforms of the financial sectors since it was clear that macroeconomic measures alone would be insufficient. This represented a major departure from a traditional IMF-supported adjustment program. Program design and implementation allowed IMF staff to share with the authorities broad experiences from systemic crisis management in other countries. At the same time, the magnitude, depth, and local circumstances of each country required quick and innovative responses and a major deployment of IMF staff and experts in close cooperation with the World Bank. The structural components and conditionality of IMF- and World Bank-supported programs were clearly instrumental in implementing the authorities’ restructuring programs.

The different country experiences have provided IMF staff with important lessons in actual crisis management. The crisis experiences have confirmed that all major elements of the IMF’s Toward a Framework for Financial Stability, prepared in 1997 and published in 1998, remain valid (see Folkerts-Landau and Lindgren, 1998). The crisis has again highlighted the main vulnerabilities identified in that paper: problems of valuing bank loans (identified as “the Achilles’ heel” of effective corporate governance, market discipline, and official oversight) and therefore banks’ net worth; design of lender-of-last-resort facilities; deposit guarantee schemes and exit procedures; and importance of supervisory authority and capacity. Areas in which that paper could be expanded would be more in-depth analysis of the macroeconomic environment as a source of financial sector vulnerability and the relationship between the financial and real sectors.

Could the crisis have been prevented? In each country, alternative courses of policy that would have been preferable can be identified—but this is to give hindsight too much of a role. In the financial sector itself, more transparency of macro- and microeconomic data and policies clearly would have helped in bringing matters to a head earlier, which could have lessened the depth of the crisis. Policies to foster corporate governance and lower corporate leverage would also have helped. Better regulatory and supervisory frameworks would have helped, for example, in detecting and correcting problems such as excessive real estate lending and the proliferation of financial institutions. However, even if the Basel Core Principles (of April 1998) had been in place, bank supervisors probably would have been unable to take restrictive action, since the underlying problems were masked by the economic boom. For similar reasons, there was no way for fiscal policies to anticipate the size of the fiscal contingent liabilities building up in the financial systems. In particular, foreseeing the sudden and massive erosion of loan and asset values that took place once market sentiment changed and the exchange rates collapsed would have been very difficult.

Comprehensive reforms of legal, institutional, and administrative frameworks have been initiated with the aim of introducing international standards and best practices. Such reforms encompass modernization of financial sector laws and prudential regulations, including operational procedures for exit of problem banks. Reforms also include a strengthening of supervisory powers, procedures, and capabilities with the aim of bringing about better risk management in banks. Another key area of reform is new laws and procedures for corporate bankruptcy and governance.

The above reforms are facilitated by the broad-based international efforts under way to implement new standards, codes, core principles, and best practices. International initiatives have been undertaken to improve financial sector architecture, surveillance over national and international financial markets, dissemination of data, macroeconomic vulnerability indicators, and prudential regulations and supervision of international lenders. This last initiative, led by the Basel Committee on Banking Supervision, aims at revising, among others, solvency requirements and country risks.

National authorities may also draw other lessons from the crisis in terms of countercyclical prudential policies and more supportive macroeconomic policies. Banks’ net worth, including capital and reserves, should be built up in times of economic booms so that a cushion is available to deal with inevitable downturns. Such prudential policies are often referred to as countercyclical, and could include a strengthening of requirements regarding liquid assets, collateral margins, capital adequacy ratios, and general loan-loss provisioning in good times— when the future bad loans are extended. It should also be stressed that prudential policies are not substitutes for a proper mix of macroeconomic policies.

The experience of the crisis countries illustrates once more the importance of prompt and decisive action to deal with banking problems, including preemptive bank restructuring actions, and the dangers of waiting for the situation to reverse itself. Preventive action, notably in prudential regulation and supervision and in the form of more transparency, would have improved bank governance and market discipline and helped prevent weaknesses from building up. Early action also could have reduced the magnitude of the portfolio losses and the need for liquidity and solvency support. Conversely, once credible programs were put in place with broad domestic and international support, the crisis became manageable and provided a foundation for economic recovery: the scale and complexity of the problems would have made it difficult to address them without such support. This also suggests the importance of countries obtaining international assistance early in the process, in which the IMF and the World Bank play key roles.

Appendix I Indonesia

In the decade prior to the emergence of the Asian crisis, Indonesia had undergone rapid development, with per capita income doubling from 1990 to 1997.63 This resulted from a significant diversification of the economy away from a dependence on oil and gas to a wider export basket consisting of primary products, textiles, and light manufactures. Economic growth was supported by a stable macroeconomic environment, characterized by balanced budgets and low inflation policies geared to maintaining a stable real exchange rate.

Indonesia has a tradition of a liberal capital regime. Restrictions on both inflows and outflows were largely relaxed in the mid-1970s. Nevertheless, until the early 1990s capital inflows played only a minor role, given a relatively undeveloped financial system, while the stable macroeconomic environment avoided any large capital outflows.


In the 1990s, Indonesia significantly liberalized its domestic economy but direct and indirect state influence still remained very important. In the financial area, less government control led to a significant increase in the number of banks, often associated with specific industrial groups. A stock exchange and other financial institutions complemented the system. These developments notwithstanding, state banks continued to play a major role in the system.

Macroeconomic Setting

Prior to the crisis, Indonesia had been struggling with significant capital inflows. Bank Indonesia had, on several occasions, widened the exchange rate band, each time leading to a maximum appreciation of the rupiah within the band. In response to the real appreciation of the currency, exports in late 1996 and early 1997 showed rapid signs of decline.

The crisis in Indonesia was essentially triggered by contagion from Thailand, especially after Thailand floated its currency, the baht, in July 1997. Contagion occurred despite the fact that Indonesia had stronger macroeconomic fundamentals than Thailand, particularly as they pertained to exports and the fiscal balance. Following a widening of the rupiah’s band in July, the currency was floated in August 1997. After a temporary reprieve, exchange market pressures heightened in September and October, by which time the rupiah had fallen by more than 30 percent since July, the fastest depreciation among the crisis countries. On November 5, 1997, the IMF approved a three-year Stand-By Arrangement with Indonesia, equivalent to $10 billion; additional financing was committed by other international financial institutions and contingent credit lines from other countries. The initial response to the program was positive, but it proved short-lived, and the exchange rate fell again precipitously in December 1997. A strengthened program was announced in January 1998 but political difficulties in the run-up to, and after, the presidential election led to severe economic disruption in the economy. In June, the rupiah hit an end-of-the-day low of 16,650 rupiah against the U.S. dollar.

In the aftermath of the May 1998 riots and the replacement of the President, the macroeconomic program was modified and a limited degree of macro-economic stability was restored. The exchange rate recovered to 11,075 rupiah against the U.S. dollar by the end of August 1998, and has stabilized at about 8,000 rupiah per U.S. dollar since late 1998.

Characteristics of the Financial Sector

Rapid economic growth, a liberal capital account regime, and regulatory changes have all contributed to substantial development in Indonesia’s banking sector. The main characteristics of the system at the outset of the crisis can be summarized as follows:

  • Size and concentration. After relaxing bank entry, the number of banks increased from 111 in 1988 to 240 in 1994. (The financial system in Indonesia remains dominated by commercial banks; see Box 14.)64 A 1994 increase of minimum capital requirements from 10 billion rupiah to 50 billion rupiah reduced the number of potential entrants, leaving the number of institutions almost constant until the crisis broke. The seven state banks had combined assets accounting for about 40 percent of the entire system, although their share of total bank lending declined markedly after liberalization.65

  • Ownership and entry. Liberalization increased the attraction of the financial sector to commercial and industrial concerns, and many of Indonesia’s large business conglomerates founded one or more banks. The 10 foreign banks that operated in Indonesia obtained licenses in the late 1960s. Since then and until 1999, the entry of foreign banks was limited through the requirement to form either joint ventures (with a maximum of 85 percent foreign ownership) or buy shares of domestic banks on the Stock Exchange where the maximum foreign holding was set at 49 percent.

  • Areas of business activities. Domestic banks were required to direct 20 percent of credit to small-scale business projects, and foreign banks were required to lend 50 percent to export-oriented businesses, although these requirements were often not met.

Indonesia: Outline of Steps Toward Bank Resolution

The process of resolving the banking crisis can be broken into nine steps.

Step 1. As of the end of June 1997, before the crisis, the Indonesian banking system consisted of the following categories:

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Step 2. As part of the commitments included in the October 31, 1997, letter of intent, 50 banks identified as weak were subjected by Bank Indonesia to specific resolution measures, which included the closure of 16 private domestic banks:

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Step 3. On February 14, 1998, the Indonesian Bank Restructuring Agency (IBRA) took over the surveillance of 54 banks, including 4 state banks subject to a restructuring plan under World Bank auspices, and 50 private and regional development banks that had borrowed from Bank Indonesia more than 200 percent of their capital, and had a capital adequacy ratio below 5 percent on adjusted end of December 1997 figures:

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Steps 4-A and 4-B. On April 4, 1998, IBRA took action against the 14 worst banks placed under its surveillance since February.

The seven largest borrowers from Bank Indonesia had borrowed more than 2 trillion rupiah each and accounted together for over 75 percent of the total Bank Indonesia liquidity support to the banking system. IBRA took control through suspending shareholders’ rights and (apart from in the state bank) changing the management of the following banks. These were known as banks-taken-over (BTO).

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Seven small banks in a particularly critical condition had borrowed from Bank Indonesia more than 500 percent of their equity and 75 percent of their assets. These banks were frozen, equivalent to a closure, and their deposits transferred to designated state banks (BBO banks, or Bank Reku Operati, i.e., banks whose operations are frozen):

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As a result, the total number of active banks in Indonesia was reduced from 222 to 215, of which 47 were under IBRA’s, and 168 under Bank Indonesia’s surveillance.

Step 5. On May 29, 1998, following relentless runs that led Bank Indonesia to provide it with 32 trillion rupiah of liquidity support, Bank Central Asia, the largest domestic private bank (12.0 percent of the liabilities of the banking sector) was taken over by IBRA, the owners’ rights were suspended, and the management replaced, and Bank Central Asia became the eighth BTO bank.

The number of IBRA banks went from 54 to 55 (40 active, 8 BTO, and 7 frozen), but was shortly thereafter reduced to 53 when 2 nonforex IBRA banks were merged with another IBRA bank.

During the same period, two non-IBRA private domestic banks (one forex and one nonforex) were merged with other non-IBRA banks. At that stage, the distribution of banks was therefore as follows:

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Step 6. On August 21, 1998, based on the results of portfolio reviews, the authorities announced that three of the banks taken over by IBRA on April 4 (Step 4-A), namely Bank Umum Nasional, Bank Dagang Nasional Indonesia, and Bank Modern would be frozen, and their deposits transferred to designated state banks. The number of active banks was to be reduced to 208. Danamon was to be recapitalized by the government to serve as a bridge bank, PDFCI and Bank Tiara Asia were to be given a final opportunity for recapitalization by their owners, and negotiations began with the owners of Bank Central Asia to reacquire their bank.

Step 7. On September 30, the authorities announced the intent to merge four banks (Bumi Daya, Bank Pembangunan Indonesia, or BAPINDO, BRI, and EXIM) into the newly formed Bank Mandiri. They also announced a plan for the recapitalization of the state banks.

Step 8. In the October 19, 1998 Supplementary Memorandum of Economic and Financial Policy, the authorities announced their intention to commence the liquidation of the 10 IBRA frozen banks (Steps 4-B and 6). The distribution of surveillance responsibilities for the 208 active banks changed again, as only the BTO and frozen banks remained under IBRA’s responsibility, while 11 other banks were returned to Bank Indonesia for supervisory purposes (in advance of the prospective restructuring of the state banks).

Step 9. On March 13, 1999, the government announced the results of the private recapitalization program; 74 banks, comprising 6 percent of total banking sector assets, had over 4 percent capital adequacy requirement and were categorized as “A” banks. Nine banks, comprising 12 percent of liabilities, had capital adequacy requirements between 4 percent and -25 percent, and were deemed eligible for recapitalization; seven banks, comprising 4 percent of liabilities, were taken over by IBRA; and 38 banks, comprising 5 percent of liabilities, were closed, including 17 banks with capital adequacy requirements worse than -25 percent (the “C” category banks). After these measures, the breakdown of the banking sector was as follows:

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Weaknesses in the Financial Sector

Several issues related to ownership and business practice made the Indonesian financial sector vulnerable to the shocks that were experienced in 1997.

Structural Vulnerabilities

  • Nontransparent ownership and portfolio problems. Quantification of the extent of problem loans in Indonesia was difficult, given the large number of banks and the complex pattern of cross holdings of equity and loans, which impaired the transparency of reports.

  • Loan concentration in the real estate sector. While difficult to detect in the data collected by Bank Indonesia before the crisis, there had been a sharp increase in real estate and property-related lending, which increased to about 20 percent of total outstanding loans in early 1997. In Indonesia, the dangers of loan concentration were heightened by difficulties in seizing and realizing collateral.

  • Exposure of banks to market risks. From 1988, Bank Indonesia regulated banks’ activities in other financial areas and limited banks’ direct involvement in leasing, venture capital, securities trading, and investment management. Banks were, however, permitted to pursue such activities through the formation of subsidiaries operating as nonbank financial institutions, and they made frequent use of this option.

Prudential Regulation and Supervision

In the late 1980s and the first half of the 1990s, Indonesia improved banking regulation and supervision. A comprehensive set of well-drafted and up-to-date prudential regulations was prepared and issued. An advanced version of the U.S.-inspired capital, asset, management, equity, and liquidity (CAMEL) rating system was put in place. All these regulations were frequently updated and improved. Yet shortcomings in the legal and regulatory framework remained, particularly in the areas of loan classification and establishment of an effective exit mechanism for failed banks. Even more important, enforcement of the regulations was a major problem, often owing to political interference.

Prudential regulation
  • Loan classification and provisioning. Even when problem loans were identified, loan classification standards in Indonesia remained inadequate because it was easy to restructure loans to reduce the size of reported portfolio problems. Moreover, Indonesian standards allowed a bank to reclassify loans back to performing status as soon as one payment was made, irrespective of the anticipated future payment stream on the loan. Banking supervisors, while recognizing the drawbacks of these practices, had not focused thoroughly on the extent of loan restructuring as an additional indicator of banking sector soundness.

  • Bank exit. No effective bank closure and exit regulation was in place. Instead, failed private banks were generally absorbed by Bank Indonesia. In late 1996, a bankruptcy law for banks was passed, but it was deficient because it granted important rights to shareholders in the liquidation process and foresaw a liquidation process lasting several years.

Prudential supervision

Despite the improvements in the supervisory framework, serious implementation shortcomings remained. These included:

  • Substantial forbearance. Violations of prudential rules were not appropriately sanctioned and noncompliance was widespread.

  • Ineffective on-site supervision. Onsite inspections in Indonesia yielded limited additional insight into the actual number of problem loans, in contrast with the experience in other countries, where these inspections usually found a much higher number of nonperforming loans than reported by banks.

  • Insolvent banks remained in the system. Given the problems with bank closure, several known insolvent banks remained open. While the combined overall negative net worth of insolvent banks remained relatively small (about 0.5 percent of GDP in 1996), the situation created moral hazard problems.

Impact of the Crisis on Bank Performance and Initial Resolution Measures

The following provides a chronology of the developments in the Indonesian banking crisis and summarizes the initial reactions.

From a Limited to a Systemic Banking Crisis: October-December 1997

When Indonesia requested IMF assistance in early October 1997, teams from the IMF, the World Bank, and the Asian Development Bank worked jointly to review the condition of the banking sector to provide support on financial sector issues. Based on data made available by Bank Indonesia, the financial condition of 92 of the 238 banks, representing 85 percent of the assets of the banking system, was evaluated. The depreciation of the rupiah, combined with a sharp shift in market sentiment, had already made a serious impact on the banking sector. At that stage, however, the banking sector did not show the characteristics of a systemic banking crisis despite deposit withdrawals from some small banks. State-owned banks’ weaknesses appeared manageable as part of the fiscal adjustment, and most major private banks still posted comfortable cushions of positive equity.

In the framework of the overall program, aiming at a swift macroeconomic recovery, the IMF and the Indonesian authorities agreed on a comprehensive bank resolution package consisting of:

  • intensified supervision, including frequent and detailed reviews, in addition to daily monitoring of key elements like liquidity and foreign exchange exposure for six of the country’s largest private banks (market share: 18.0 percent) in which some critical weaknesses had been identified;

  • rehabilitation plans, based on memoranda of understanding or cease-and-desist orders for seven small private banks (market share: 0,7 percent) in which serious weaknesses, including undercapitalization, had also been identified;

  • conservatorship for three small, severely undercapitalized private banks (market share: 0.1 percent), and for six insolvent regional development banks (market share: 0.4 percent), pending the results of discussions with the regional government owners;

  • transfer of the performing assets for two insolvent state-owned banks (market share: 9.6 percent) to a third state-owned bank; merger of the two insolvent banks, and transformation of the resulting entity into an asset recovery agency;

  • definition and implementation of rehabilitation plans for 10 insolvent private banks (market share: 3.0 percent) that had benefited from a Bank Indonesia-sponsored and legally binding rescue package prior to the crisis, accelerating their return to solvency; and

  • immediate closure of 16 small and deeply insolvent private banks (market share: 2.5 percent), with protection limited to small depositors.

In total, the resolution package announced to the public included 50 banks, representing 34.3 percent of the banking system. This package included the closure of the 16 small private banks. Since the remaining 34 banks were not identified, however, this created uncertainty among the public regarding the fate of all other banks. In the announcement, Bank Indonesia indicated its readiness to provide protection against runs through liquidity support for all banks that remained open, while a comprehensive action plan to improve the institutional, legal, and regulatory framework was set in motion.

After a short-lived positive reaction to the recovery program, and an appreciation of the rupiah, the environment rapidly began to deteriorate again. By early December, a number of elements had combined to reduce public confidence in the banking sector:

  • the depreciation of the rupiah, high interest rates, and a slowdown in the economy took an increasing toll on bank profitability and soundness;

  • rumors about the President’s health and his last minute cancellation of a high-profile trip abroad created an atmosphere of political instability;

  • the fast deterioration of the macroeconomic situation in Korea added to the uncertainty; and

  • the developments regarding Alfa Bank were viewed as a sign that the authorities were not genuinely determined to implement the program as agreed with the IMF.66

The deposit runs multiplied amid rumors that a new wave of bank closures was under preparation, and the segmentation of the interbank market intensified. By mid-December 1997, 154 banks representing half of the total assets of the system had faced, to varying degrees, some erosion of their deposit base. During December 1997, Bank Indonesia’s liquidity support increased from 13 trillion rupiah to 31 trillion rupiah, equivalent to 5 percent of GDP. Insofar as the liquidity support, paid in rupiah, was needed by banks to meet reductions in dollar deposits, in effect it served to fuel capital flight and, thus, the continuing depreciation of the exchange rate. In contrast to other crisis countries, efforts at sterilization were not successful, reflecting a loss of monetary control by Bank Indonesia.

Stabilizing the Banking Sector: January-February 1998

During January 1998, a sudden and deep deterioration in the economic environment took place, with the rupiah heading into a free fall. The rate fell from 4,600 rupiah per U.S. dollar at the end of December 1997 to 15,000 rupiah per U.S. dollar in late January 1998, with some trades even at 17,000 rupiah. The Indonesian authorities signed a letter of intent with the IMF on January 15, 1998, but continued evident failure to live up to commitments by the Indonesian authorities led to further exchange rate depreciation, notwithstanding renewed discussions to bolster the commitments made in the January 1998 letter of intent. When it became impossible for Indonesia to present a credible recovery program to the IMF, the banking sector problems turned into a full-fledged systemic crisis, with liquidity support from Bank Indonesia exceeding over 60 trillion rupiah (about 6 percent of 1998 GDP), risk of hyperinflation, and complete financial sector “meltdown.”

On January 27, 1998, a new financial sector strategy was introduced, with the authorities’ immediate priority being to avoid a financial collapse and to stabilize the banking sector. The government announced a three-point emergency plan. First, all depositors and creditors of all domestic banks were, henceforth, to be completely protected.67 Second, IBRA was established for a period of five years, under the auspices of the ministry of finance, to take over and rehabilitate weak banks and manage the nonperforming assets of intervened banks. Third, a framework for handling corporate restructuring was proposed. The impact of the announcement was immediate, with the exchange rate recovering to 12,000 rupiah per U.S. dollar and appreciating further in subsequent days. Attempts were made to place restrictions on banks’ activities to mitigate the moral hazard effects of the blanket guarantee; for instance, deposit rates were capped at a specific premium above the levels being offered by the best-run banks.

In the following two months, efforts were made to reestablish monetary control by rationalizing Bank Indonesia liquidity facilities and by developing effective penalties to deter banks from seeking access to these facilities. To better assert the authorities’ control, surveillance over 54 banks (comprising 36.7 percent of the banking sector; see Box 14, Step 3) that had borrowed heavily from Bank Indonesia was transferred to IBRA on February 14. This included four state-owned banks (BAPINDO, Bank Bumi Daya, BDNI, and Bank Exim), accounting for 24.7 percent of the liabilities of the banking sector. IBRA examiners were placed in those banks, and the banks were required to sign memoranda of understanding setting out the strengthened supervision under which they would operate.

While this initial operation was carried out relatively smoothly, its impact was much reduced by the refusal of the President to publicize it lest it trigger a renewal of runs. As a result, the initial workings of IBRA were not apparent to the public, there was confusion as to the authorities’ intentions, and the momentum generated by the January 27 announcements was largely lost. Even worse followed when, in late February, the President dismissed the head of IBRA, at that time a highly respected finance ministry official, and some of the staff seconded into IBRA were returned to Bank Indonesia. The government itself drifted through the period up to the presidential election of 1998 and a prolonged debate ensued over the possible introduction of a currency board arrangement. Liquidity support to the banking system continued to increase, largely to meet continuing deposit withdrawals but also in the face of withdrawals of credit lines to domestic banks, as well as emerging losses in derivatives businesses in a few banks, including one state bank with more than 20 trillion rupiah (2 percent of GDP) of such losses. Altogether, by that time, liquidity support to banks stood at more than 60 trillion rupiah (6 percent of GDP).

First Resolution Initiatives and New Shock: March-May 1998

The ensuing three months saw the authorities taking their first initiatives to resolve ailing banks and then facing a major new shock. With monetary conditions progressively being brought under control, the main focus turned to establishing the necessary infrastructure for handling the banking crisis: making IBRA operational, preparing the legal framework, obtaining better information on the financial condition of the banks, and beginning to take action.

In early March 1998, Bank Indonesia announced the redesign of its liquidity support facilities. Until then, support had been provided through several windows—with the deterrent to usage, in theory, being highly punitive interest rates. Virtually no banks, however, were actually paying interest, which was therefore routinely capitalized, causing a rapid further expansion in outstanding liquidity support. The new system involved a single liquidity facility with interest rates, generally only a small margin above market rates. The new focus was on nonmarket sanctions; any bank with borrowings outstanding for more than a week would have a special Bank Indonesia inspection, which would produce a report within a further week, increase restrictions on the bank’s activities, and culminate in possible transfer to IBRA.

By late March 1998, the new IBRA management team was ready for more substantive intervention into the most critical of IBRA banks. On April 4, in its first major public action, IBRA took over the seven banks (Box 14, Step 4, part A) that had each borrowed more than 2 trillion rupiah (all but two of these had borrowed more than 5 trillion rupiah each, and two of them over 20 trillion rupiah); together they accounted for about 72 percent of total Bank Indonesia liquidity support to the banking system. The focus at this stage was on liquidity, rather than solvency, to determine which banks should be intervened. This was partly because, in the absence of reliable data on the solvency condition of the banks, liquidity criteria could serve as a proxy, and partly because of the urgent need to tackle the provision of Bank Indonesia liquidity support itself in order to stabilize monetary conditions.

For the six private banks among them, owners were suspended and managements removed; new management was put in place through “twinning” arrangements with designated state banks.68 At the same time, seven smaller banks (Box 14, Step 4, part B), comprising 0.4 percent of the banking system, which had each borrowed more than 500 percent of their capital, were closed; all deposits were transferred over that weekend into a designated state bank, Bank Negara Indonesia. Great efforts were made to ensure uniform application of objective criteria in the choice of both sets of banks, and there was an intensive and professional public relations campaign over the weekend to explain the moves to the public. As a result, the moves were received favorably in the markets; there were sporadic runs on a few of the acquired banks, but these diminished. These actions were a major step to demonstrate the authorities’ commitment toward bank resolution and to bring a revised IMF-supported program to the IMF’s Executive Board for consideration in late April.

The riots in mid-May of 1998 led to a depreciation of the recently stabilized rupiah and a further loss of confidence by both domestic and foreign investors. In the aftermath of the riots, there were massive runs on Bank Central Asia, the largest private bank, which accounted for 12 percent of total banking sector liabilities. Given the circumstances, support was effected relatively smoothly. Bank Indonesia, in conjunction with two of the state banks, supplied over 30 trillion rupiah in cash to Bank Central Asia over the week following May 16 as deposits were withdrawn. On May 29, Bank Central Asia was brought under the auspices of IBRA, the owners’ rights were suspended, and an outside management team introduced. By the end of the month, runs on Bank Central Asia had decreased.

The specific nature of the attacks against Bank Central Asia was especially devastating to confidence in the banking sector, with many viewing the run on the bank as politically inspired.69 In this environment, other bankers sought to maximize their immediate liquidity to protect themselves in the event of runs. The stock of vault cash increased, intermediation declined even further, and interbank markets became more segmented. With interest rates rising in the face of uncertainty, banks bid up deposit rates to levels substantially above those that they were able to charge their borrowers. The sizable negative interest spread across much of the banking sector caused a continuing erosion of the capital base of the affected banks. Nevertheless, liquidity support from Bank Indonesia—apart from that to Bank Central Asia—remained limited, and Bank Indonesia was increasingly successful in stabilizing monetary conditions in line with commitments under the IMF-supported program. By mid-July 1998, Bank Indonesia also reintroduced market-based monetary management—with the start of auctions of one-month central bank bills—to enhance monetary control, and thus helping to redistribute liquidity in the segmented interbank market (three-month auctions of central bank bills were started in October 1998).

Meanwhile, the bank restructuring process was given a fresh impetus. A third head of IBRA had been appointed, a finance ministry official with previous experience in the banking sector. Continuity in the restructuring process was assured with the appointment of the first head of IBRA as finance minister in the new government. The new team needed to ascertain the true condition of the banks in order to undertake appropriate remedial action. The banks’ own reported figures were deeply unreliable, with many banks still posting profits in early 1998 on the basis of unrealized foreign exchange valuation gains and lack of recognition of deterioration in their loan portfolios. In March 1998, Bank Indonesia had announced new provisioning and classification guidelines, broadly in line with international standards, but application was very patchy, in part because of lack of expertise both at Bank Indonesia and in the banks.

International auditors were contracted—financed by the World Bank in the case of the 55 IBRA banks, and by the Asian Development Bank in the case of the major non-IBRA banks—to conduct portfolio reviews on international accounting standards by using the new classification and provisioning rules.70 As these were completed, they confirmed the picture of deep and pervasive problems.

Toward a Comprehensive Resolution Strategy

Portfolio Review

Action toward the resolution of ailing banks resumed when audit results became available. In June 1998, the results of the portfolio reviews of the condition of the six private banks included in the seven largest borrowers of Bank Indonesia resources (Box 14, Step 4, part A) showed that they had non-performing loans equivalent to at least 55 percent of total loans (over 90 percent in one large bank), and all the banks were proven to be deeply insolvent.71 For most of these banks the loan portfolios were dominated by connected lending. In July 1998, four of the six banks were formally declared insolvent. On August 21, a resolution strategy was announced for these six banks. Three were “frozen” (Box 14, Step 6), while a rehabilitation program was defined for the other three. One bank, Danamon, the second largest private bank in terms of number of depositors before the crisis, was to be recapitalized and used as a “bridge” bank to receive deposits and assets from some of the closed banks. For the two remaining banks, the former owners would be given a last opportunity to clear their insolvencies; otherwise they would be merged into Danamon or closed. The process served also to highlight deficiencies in the legal framework under which IBRA had been operating, with recalcitrant shareholders in the remaining two banks able to hold up the insolvency declarations in those banks. Ensuring proper powers for IBRA to assume control of insolvent banks was one of the most important objectives of the amendments to the banking law prepared at the time.

By early August 1998, the results of the portfolio reviews for a group of 16 large banks, all of them non-IBRA except for Bank Central Asia, were becoming available. These showed that the banks were, in general, clearly different from IBRA banks, in terms of quality of risk controls, compliance with prudential norms, and overall quality of management. Nevertheless, the financial condition of these banks, too, was shown to be very weak, with many of the banks insolvent. Given that many of these banks would have been expected to be among the strongest in the country, these reviews confirmed the deep insolvency of the banking system as a whole.

Legal and Supervisory Preparations

In October 1998, the parliament passed amendments to the banking law that modified previous requirements regarding bank secrecy and ended restrictions on foreign ownership of banks. These amendments also enabled IBRA to operate effectively—for instance to be able to transfer assets and to foreclose against a nonperforming debtor.

Consistent with program commitments, substantial progress has also been achieved in reviewing and strengthening the prudential and regulatory framework on a number of critically important issues, as follows:

  • Loan classification, loan provisioning, and the treatment of debt restructuring operations. These three new regulations became effective as of the end of December 1998. Five loan categories are defined, namely, pass, special mention, substandard, doubtful, and loss, with respective provisioning of 1 percent, 5 percent, 15 percent, 50 percent, and 100 percent.

  • Liquidity management. Banks are now required to submit a liquidity report twice monthly for their global consolidated operations. The report comprises a foreign currency liquidity profile, and a combined rupiah and foreign currency profile. The liquidity report collects data in weekly maturity bands for four weeks and for the next two-month period. The report includes a section outlining the efforts the bank intends to take to cover any liquidity shortfall or absorb any liquidity surplus.

  • Foreign exchange exposure. The regulation has been broadly satisfactory but there are certain shortcomings regarding implementation of the regulation. For example, Bank Indonesia may (rather than must) impose administrative sanctions on banks that do not comply with the limits for foreign exchange exposure.

  • Connected lending. The newly published regulations tighten the rules in this field where the most widespread and damaging abuses took place in the period leading to the crisis, by and large in line with international best practices.

  • Capital adequacy. The required capital adequacy level has been temporarily lowered to 4 percent. The new regulation also ensures that banks can compute as supplementary capital (Tier 2) only general reserves for possible earning asset losses up to a maximum of 1.25 percent of total risk-weighted assets, whereas the previous regulation allowed banks to count as Tier 2 both general and specific loan-loss provision. The regulation will be reviewed by the end of 1999 to evaluate setting the date for banks to comply again with a minimum capital adequacy requirement of 8 percent.

  • Disclosure of financial statements. Banks are now required to publish their financial statements quarterly, beginning April 1999.

IBRA conducted forensic type audits to identify possible irregularities and to examine the compliance with legal requirements of the 14 banks then under its control. On August 21, 1998, the government announced that former owners of 10 of the banks that had been out of compliance with legal requirements had one month to pay back the liquidity support Bank Indonesia had provided, or be subject to further penalties. By late September, about 200 trillion rupiah of assets, at the owners’ valuation, had been pledged from several of these owners as well as about 1 trillion rupiah in cash. IBRA’s advisors valued the assets at 92.8 trillion rupiah, and IBRA tentatively announced full settlement with owners of three of the banks, including Bank Central Asia. These agreements, however, were not accepted by the government, which sought a greater up front contribution of cash. After protracted negotiations, the owners agreed to settle their obligations within four years, but that assets representing these obligations would be transferred to IBRA to be placed into a holding company; it was intended that 27 percent of the obligations would be realized in the first year. With Bank Central Asia arriving at the first such agreement, other former owners reached similar agreements quickly. In mid-1999, however, owners of three banks were deemed not to be negotiating seriously, and in fact, IBRA was preparing to take legal action against them.

Strategy for State Banks

In late August 1998 the authorities announced that the four state banks (including Bank Exim) under IBRA’s auspices would be merged into a single new bank, Bank Mandiri, under a management and operational restructuring contract with a major international bank. The corporate business of a fifth, non-IBRA state bank, Bank Rakyat Indonesia (BRI), was also considered to be merged into this bank. Bank Mandiri would start with 30 percent of the assets of the banking sector. Although this share might decline as part of the restructuring, Mandiri would still be, by some margin, the largest bank in the country.

On September 30, 1998, Mandiri was established as holder of 100 percent of the shares of the four component banks. On February 12, 1999, a voluntary severance scheme was offered to the headquarters staff of the four component banks as a prelude to integrating their functions, and plans were finalized for centralizing two critical functions—treasury and credit assessment. The bad loans from the component banks were transferred to the asset management unit at the end of March 1999, and performing loans were progressively transferred from the component banks into Bank Mandiri.

Meanwhile, the portfolio reviews confirmed that the three remaining state banks—Bank Negara Indonesia, BRI. and BTN—were also deeply insolvent. The government announced plans to recapitalize them, and in April 1999 presented a blueprint for the restructurings. Bank Negara Indonesia is likely to be the second largest bank in the country, with about 15 percent of the sector. Meanwhile, the government had also announced plans to recapitalize the 27 regional development banks, which together made up 2 percent of the banking sector.

Bank Mandiri has made solid progress in implementing its restructuring plan, and is preparing to almost halve its staff and close branches. Plans to enhance loan recoveries have been prepared. A merger of its four component banks is scheduled; capitalization of the bank is envisaged to be completed by the end of the year. Privatization is scheduled to begin within two years.

Meanwhile, the other state banks are in the process of finalizing blueprints for their restructuring. Recapitalization is envisaged to take place between September 1999 and March 2000. Privatization of the largest of these banks, Bank Negara Indonesia, is expected in 2002. IBRA announced the resolution strategy for the banks it has taken over. One small bank will be merged into Bank Central Asia, and eight banks into Danamon. Bank Central Asia and the “B” bank whose owners were unable to provide their share of the recapitalization needs are expected to be sold by the end of 1999. At that stage, therefore, there will be only one IBRA bank (Danamon), which will serve as a “bridge bank” to wind down the activities of the banks brought under its control.

Strategy for Private Banks

On September 30, 1998, on behalf of the government. Bank Indonesia announced a plan for the joint recapitalization of those remaining private banks that met certain specified conditions. The objective of this plan was to retain a residual private banking sector from among the “best” private banks, recognizing that given the economic turmoil that has affected Indonesia, even well-run banks would likely have run into serious difficulties. Moreover, the plan was designed to foster burden sharing between the private sector and the government regarding the cost of resolving these banks. The details are as follows:

  • For those banks that had capital adequacy ratios between negative 25 percent and 4 percent, business plans that demonstrated medium-term viability, and owners deemed to be “fit and proper,” the government indicated its willingness to contribute up to four rupiah for every rupiah contributed by those owners to restore a bank to having a capital adequacy ratio of 4 percent—the minimum capital adequacy requirement for the end of December 1998. Owners’ contributions would generally be in cash, while those of the government would be in bonds.

  • The government announced that it would obtain its equity stake through preference shares that would be convertible into ordinary shares in either of two situations—if the bank failed to comply with the targets of its own business plan, or after a period of three years. During the three-year period, the owners would be able to reacquire their shares in the bank by repaying the government’s contribution (in effect, the contribution would have been a loan), either for their own account or for an outside investor. At the end of the three years, the government would seek an independent valuation of the bank, and the owners would have the first option to buy back the government’s shares. Otherwise, the government would sell its shares within a specified period. To encourage owners to put in new capital, the government pledged to allow owners to retain day-to-day control of banks.

  • In addition, once the joint recapitalization was agreed upon, all category 5 loans (i.e., those loans classified as “loss”) were to be transferred at a zero price to the asset management unit, which would enter into a contract for the recovery of the loans with the originating bank. At their discretion, the banks could also transfer category 4 loans (those classified as “doubtful”) at zero price to the asset management unit, for handling on the same basis as the category 5 loans. Any recoveries from such loans would be used immediately to buy back the government’s preference shares, thus giving the government the prospect of an early return of its financial infusion, and reducing the amount to be paid by the owners to reacquire full control of their bank.

In December 1998, the plan was threatened to be reversed when the President announced instead a strategy of forced mergers. With the uncertainty in the markets, as well as the worst rioting since May 1998, leading to renewed depreciation of the rupiah (from about 7,500 rupiah to the U.S. dollar to 9,000 rupiah per U.S. dollar), the private bank recapitalization plan was finally reaffirmed. In February 1999, Parliament passed a budget that included 34 trillion rupiah for bank restructuring (17 trillion rupiah net of expected recoveries).

By that time, work on assessing business plans— the fitness and propriety of owners and managers and availability of capital infusions—had been completed, and bank closures were widely regarded as imminent. Indeed, ministers had made it clear that banks that failed the tests for the recapitalization plan would be closed on February 26, 1999, However, intense lobbying from owners of banks that realized that they were in danger of being closed succeeded in postponing the government-scheduled interventions at the last minute. The public recognized the cause of the postponement, and amid clear indications of government disarray the rupiah fell another 10 percent, to almost 10,000 per the U.S. dollar.

On March 13, 1999, the government announced the closure of 38 banks (comprising 5 percent of the banking sector) and the takeover by IBRA of seven others (comprising 2 percent of the sector). Nine banks (or 10 percent of the banking sector) were deemed eligible for recapitalization under approved business contracts. The banks subsequently provided their share of capital by April 21. At the time, 73 banks (5 percent of the banking sector) had capital adequacy ratios of at least 4 percent and, hence, did not need government support. Although the terms of the original recapitalization plan were thus broadly reaffirmed, the government did not explicitly restate its earlier commitment to leave the day-to-day running of the banks in the hands of the owners.

The closures and takeovers were handled efficiently by Bank Indonesia and IBRA, although the agencies had difficulty transferring the deposits to designated recipient banks over the weekend of March 13, since staff in a number of banks denied them access in order to increase their bargaining power for higher severance payments. IBRA undertook to pay twice the legal minimum, and indicated that severed staff should negotiate with the former owners for anything more. Although over the following weeks there were public disturbances by employees of the closed banks. Bank Indonesia/IBRA gradually achieved access to the remaining branches of the banks.

The March 13, 1999 announcements indicated also that the “A” category banks would be subject to review regarding the fitness and propriety of their owners and managers and, for some of them, the sources of their capital infusions. The sources of capital were verified by April 21. However, one-third of the owners, managers, and commissioners failed the “fit and proper” test. These commissioners and managers were required to be replaced immediately and failed owners themselves were given up to 90 days to divest their holdings.

Of the nine banks eligible for recapitalization under the government’s plan, owners of seven banks supplied their share of the necessary additional capital in advance of the April 20 deadline. IBRA became involved in intense discussions as the deadline approached to resolve the situation of the remaining two banks. Ultimately, one of these banks (holding about 1 percent of total bank assets) was acquired by a major foreign bank, the largest such acquisition since the banking crisis began; for the other—discussions on which were hampered by the absence of a controlling shareholder—no sources of capital could be found in time, and the bank was taken over by IBRA.

Over the following month, IBRA negotiated performance contracts and memoranda of understanding with the managements of the eight remaining banks. The government had decided that it wished to hold its shares in these banks as ordinary stock, rather than convertible preference shares, but these memoranda of understanding provided essentially the same protection to the owners of the banks—that is, the owners retained the day-to-day control of the banks, and various areas of the government retained the right to become involved if necessary. Meanwhile, updated audits provided revised figures for the banks’ insolvency, indicating capital needs almost double the amount earlier estimated.

At the end of May 1999, the owners of the banks provided their share of the extra capital requirement, and the government issued bonds to provide its share of the necessary recapitalization.72 In the case of the listed banks, a rights issue underwritten of up to 80 percent by the government served to reduce need for public funds; for the largest recapitalized bank, this issue was particularly successful in attracting new private investment. The government now owns between 60 and 80 percent of the stock of these banks; at the end of three years independent valuations of these banks will be conducted, and the owners will be given the right of first refusal to buy back the government’s shares. If the owners decide not to purchase the shares, the government will sell its shares over the following year. In the meantime, the government can only dilute its shareholding with the concurrence of the owners. The government’s share will also decline during the three years, representing the loan losses realized that will be subsequently transferred to IBRA. During this period, the owners may themselves buy back the government’s shares, at the price the government paid plus interest. With the prices of these banks shares now rising strongly, it appears that the owners of at least one of the banks are already seeking to buy back the government’s shares. Thus, the recapitalization program has saved these banks, and the government seems likely to get back at least a share of its investment sooner than originally envisaged.

State of Restructuring Efforts

The Indonesian banking sector has been consolidated significantly in the last two years (Figure 9). Since mid-1997, the number of private domestic banks has been nearly halved through closures or state takeovers. Reflecting this consolidation, banks under state control now hold about 70 percent of liabilities, compared to 40 percent before the crisis.

Figure 9.
Figure 9.

Indonesia: Progress in Financial Sector Restructuring

Source: National authorities; and IMF staff estimates.Note: As of the end of July, 60 private and three public domestic banks and three joint venture and foreign banks had been closed. The state had intervened in 14 private and 15 public domestic banks and in one joint venture/foreign bank. Four private domestic banks had exited through merger. Categories are not mutually exclusive.

Public Cost of Financial Sector Restructuring

As of mid-1999, the public contribution to financial sector restructuring has been equal to 51 percent of GDP (Table 15). The largest share of this has been used to recapitalize banks and provide liquidity support. The expected budgetary cost of bank restructuring (i.e., the interest cost on the government bonds) in the 1999/2000 fiscal year is 34 trillion rupiah or 3 percent of GDP; half of this is to come from recoveries, mainly from shareholder settlements. IBRA has been investigating all failed banks (those closed and those taken over) to see if there were violations of insider lending limits, and, if so, will pursue the former owners of these banks to provide assets as compensation for these violations. Agreements have already been reached with the former shareholders of eight such banks, and negotiations with several more are in progress. Two of these agreements have so far resulted in assets being transferred from two of these banks to holding companies under the joint control of IBRA and the former owners. Sales from these assets are likely to begin in the coming months, with over 12 trillion rupiah expected by March 2000.

Table 15.

Indonesia: Public Cost for Financial Sector Restructuring

(as of mid-1999)

article image
Source: National authorities; and IMF staff estimates.

Converted at 7,500 rupiah per U.S. dollar.

Meanwhile the state and IBRA have intensified their loan recovery efforts. Each institution has published the names of their largest debtors and invited them to begin negotiations. IBRA aimed at classifying all debtors into four categories by the end of August 1999, depending on their degree of cooperation and business viability. IBRA hoped to adopt a strategy for each debtor based upon its classification. Noncooperating debtors will be widely publicized. An interdepartmental committee has been established to coordinate the preparation of a database on the debtors, and to facilitate the establishment of a joint-creditor negotiating position, with the debtors under a lead creditor institution.

Appendix II Korea

Korea, a largely industrialized country and member of the Organization for Economic Cooperation and Development (OECD), was initially thought immune from the financial sector problems in its less developed neighboring countries.73 Nevertheless, by late 1997, structural similarities and the forces of contagion contributed to the extension of the crisis to the Korean economy.


Korea’s exchange rate remained broadly stable through October 1997. However, the high level of short-term debt and the low level of usable international reserves made the economy increasingly vulnerable to shifts in market sentiment. While macroeconomic fundamentals continued to be favorable, the growing awareness of problems in the financial sector and in industrial groups (chaebols) increasingly led to the difficulties for the banks in rolling over their short-term borrowing. Declining rollover rates brought this ratio down to less than half at the end of 1997. International reserves decreased from the equivalent of 2.6 months of imports in 1993 to two months in 1996, and—with the onset of the crisis—dropped to 0.6 months in 1997. Korea widened the exchange rate band on November 17, 1997; the won fell sharply, and the Bank of Korea had to provide large amounts of foreign exchange for Korean banks to honor their overseas commitments.

On December 4, 1997, Korea entered into a three-year Stand-By Arrangement with the IMF, amounting to $21 billion, augmented by arrangements with the World Bank and the Asian Development Bank. Several countries pledged additional $22 billion as a second line of defense. Agreement on the program— which also included far-reaching steps toward financial sector rehabilitation—initially failed to increase rollover rates of short-term foreign debt, and the won fell further. However, the combination of an agreement with private foreign bank creditors on a voluntary rescheduling of short-term debt (concluded by the end of January 1998) and a rephasing of the IMF arrangement to allow an advancement of drawings succeeded in alleviating short-term foreign exchange pressures and permitted stabilization to begin. Progress in stabilization allowed a gradual reduction in interest rates, now standing at below pre-crisis levels. The won, which had depreciated close to 2,000 won per U.S. dollar, has stabilized in the range of 1,200 won per U.S. dollar. Useable reserves have increased to $52 billion as of mid-1999. Growth is now expected to be about 9 percent in 1999.

Macroeconomic Setting

Prior to the crisis, Korea’s macroeconomic performance was generally praised, with GDP growing at an average rate of 8 percent in 1994–97. An increase in investment and exports fueled the growth. Unemployment remained low, averaging slightly above 2 percent during the period, and inflation was stable at about 5 percent. The fiscal position appeared to be strong, and public debt was below 11 percent of GDP, of which only about one-fifth was foreign debt. Developments in the external sector followed closely the evolution of the yen, which in 1995–96 led to a widening of the current account deficit to the equivalent of almost 5 percent of GDP in 1996 and which declined the next year to 2 percent. This external deficit was financed by private capital inflows. The ratio of total external debt to GDP increased significantly from 20 percent of GDP in 1993 to 33 percent in 1996 and to 35 percent in 1997. At the same time, the proportion of short-term debt to total debt increased, amounting to about two-thirds of total debt in 1996.

Characteristics of the Financial Sector

The Korean financial system was unusual among emerging markets for its diversity. It comprised private commercial banks, a number of government-owned specialized and development banks, and a wide variety of very sizable nonbank financial institutions. These institutions were closely interlinked. In particular, commercial banks had significant off-balance sheet exposures to nonbank financial institutions through their holdings or guarantees of commercial paper and corporate bonds underwritten by merchant banks.

Commercial banks accounted for just over half the assets of the financial system. As of September 1997, the sector comprised 16 nationwide banks, 10 regional banks, and 52 foreign banks. The top eight banks accounted for about two-thirds of commercial bank assets (excluding trust accounts). Regional banks were established to develop specific regions, particularly to foster the growth of small- and medium-sized enterprises. Foreign banks have been allowed to open branches since 1967, although their market share remained very small. Commercial banks were supervised by the Office of Banking Supervision at the Bank of Korea.74 Commercial banks also operated trust accounts that were separately accounted for but were managed like the rest of their banking business.75 Trust accounts had grown rapidly in recent years (they accounted for close to 40 percent of total commercial bank assets as of the end of 1997), largely because they had been less regulated and had been able to offer higher interest rates than regular commercial bank business.

Specialized and development banks were established in the 1950s and 1960s to provide funds to specific strategic sectors.76 They accounted for about 17 percent of financial system assets. Although specialized banks could borrow from the government, deposits constituted their main source of funding. Funding for development banks, which are wholly government-owned, came mainly from bonds issued domestically and abroad.77 The Korean Development Bank, the largest development bank, was established in 1954 to supply long-term credit to major industries. Its assets were heavily concentrated in lending to large corporations, mainly financing fixed investment (including infrastructure projects). These banks were traditionally not subject to the same prudential standards and supervision as commercial banks, and were overseen by the ministry of finance and economy.

Meanwhile, nonbank financial institutions comprised 30 percent of financial system assets at the end of 1997 and consisted of three types of institutions: investment companies, savings institutions, and insurance companies. Of these, investment institutions, which consisted of merchant banks, investment trust companies, and securities companies, were the largest in terms of assets, followed closely by savings institutions. Many nonbank financial institutions were predominantly owned, directly or indirectly, by chaebols and other large shareholders. They were used to finance activities within the chaebol group, and became an increasingly important source for intermediating chaebol notes and other paper. Nonbank financial institutions and trust accounts at commercial banks provided a means to circumvent restrictions on commercial bank intermediation.

Precrisis Weaknesses in the Financial System

Structural Vulnerabilities

During the 1960s and 1970s, Korea embarked on an outward-oriented industrialization strategy spear-headed by the chaebols, which were supported by preferential access to subsidized credit (so-called policy loans).78 Interest rates were administered, financial innovation was restricted, and competition in the banking system was limited. These government policies resulted in a tightly controlled, government administered financial system characterized by chronic excess demand for credit.

Since the mid-1970s the government took steps-including the granting of tax preferences—to develop capital markets and thus to reduce corporate reliance on bank borrowing. A program of gradual domestic financial sector reform was introduced in the early 1980s, including bank privatization and deregulation of banks’ activities, abolition of credit controls, introduction of new financial instruments, granting of greater business opportunities to the non-bank financial institutions, and partial interest rate deregulation. At the same time, many controls remained, particularly on commercial bank lending and interest rates. In an effort to reduce the reliance of the chaebols on bank borrowing, the government tightened the credit control system by setting a ceiling on the share of bank credit to chaebols. In addition, banks were required to meet minimum credit targets (initially set at one-third of new lending) for small- and medium-sized enterprises.

Beginning in the early 1980s, government involvement in bank lending decisions was gradually reduced, but banks developed few skills in credit analysis or risk management. Lending decisions were still largely based on the availability of collateral rather than on an assessment of risk and future repayment capacity. Because of their large exposures and inadequate capitalization, banks were generally in a weak position relative to their chaebol clients. Reflecting the history of directed lending, banks did not insist on, or receive, full financial information from chaebols. In addition, basic accounting, auditing, and disclosure practices were significantly below international best practice (for example, consolidated accounting or marking to market were mostly absent in Korea). Furthermore, the strong role of banks in the bond market, along with the bonds’ relative illiquidity and the lack of transparency in the equity market (due to lax disclosure standards), impeded the capital markets’ role in ensuring sound corporate governance. Meanwhile, the banks were rapidly expanding their foreign operations and becoming subject to significant liquidity risk; failure to manage this risk was a probable cause of the crisis.

The high leverage ratios of the chaebols and their low profitability made them very vulnerable to any shock to their cash flow.79 The health of the banking system, in turn, was extremely dependent on the viability of the chaebols. Banks were highly exposed to them, both directly through loans and discounts, and indirectly through the guarantee of corporate bonds and commercial paper.80

A large portion of the foreign borrowing by banks, particularly by merchant banks, was undertaken through overseas subsidiaries and foreign branches.81 Several factors explain the reliance on short-term capital inflows:

  • The capital account had been only partially liberalized, with intermediation through domestic banks favored over foreign direct investment and direct corporate borrowing.82 Restrictions against short-term foreign borrowing by financial institutions were relaxed, while limits on long-term borrowing and foreign participation in domestic equity and bond markets were retained, encouraging the development of large maturity mismatches in banks’ balance sheets. At the end of December 1997 short-term assets covered only about half of short-term liabilities in commercial banks, and 25 percent in merchant banks, despite the introduction of a required minimum ratio of 70 percent.

  • Increased access to trade credits and deregulation permitted the use of trade credits for working capital. There was a seven-fold increase in trade credits during 1994–96, only partly accounted for by the rapid growth in trade volume.

  • The substantial nominal interest differential in favor of dollar and yen borrowing was reinforced by the expectation of a stable exchange rate resulting from the won’s managed peg to the dollar. In addition, the short-term risk premium was lower than for longer maturities, and short-term funds could be raised relatively easily in international money markets.83 Thus, domestic banks relied on external short-term funds to finance long-term domestic investments.

Weaknesses in Prudential Regulation and Supervision

Prudential regulations and, especially, supervision were not strengthened when the banks were granted greater independence in lending decisions and when domestic financial markets and the capital account were liberalized. A reform plan included several proposals to bring prudential regulations closer to international standards. Commercial banks were required to reach a minimum of 8 percent capital adequacy ratio by the end of 1995. In 1995, the Office of Banking Supervision introduced a reporting system based on the CAMEL framework, designed to give early warning of problems. In addition, the government introduced, effective January 1997, a deposit insurance scheme funded by the financial institutions. The scheme provided full coverage for all insured deposits, up to 20 million won per individual depositor. Despite these reforms, several aspects of the Korean supervisory and regulatory framework diminished the effect of these improvements.

Supervision was fragmented. Commercial banks were under the direct authority of the monetary board (the governing body of the Bank of Korea) and the Office of Banking Supervision. However, specialized banks and nonbank financial institutions were under the authority of the ministry of finance and economy, although the ministry delegated on-site examination of some nonbank financial institutions to the Office of Banking Supervision. This lack of a unified system of supervision and regulation, together with the weak supervision performed by the ministry on non-bank financial institutions, created conditions favorable to regulatory arbitrage and high-risk practices, especially among commercial banks’ trust business and merchant banks. In addition, the supervisory authority had the power to waive requirements, which not only facilitated forbearance but also made enforcement non transparent.84

Standards for loan classification and loan-loss provisioning were rather lax. Nonperforming loans were defined as loans that had been in arrears for six months or more. Published data on bad loans only included those nonperforming loans not covered by collateral.85 The classification system was based on the loan’s servicing record and the availability of collateral without regard to the borrower’s future capacity to repay. Provisions were based on credit classification and consisted of 0.5 percent of “normal” credits, 1 percent of “precautionary” credits, 20 percent of “substandard” credits, and 100 percent of “doubtful” and estimated “loss” credits. However, the minimum provisioning requirements were to be phased in over a number of years ending at the end of 1998. Losses were not expected to exceed 2 percent of total loans, and any excess provisioning over 2 percent was not tax deductible. As a result of these regulations, aggregate provisions were still under 2 percent at the end of 1997.

Provisioning rules and accounting standards for securities holdings also fell short of international best practice. Banks’ books recorded securities at cost: mark-to-market accounting was not fully applied. Meanwhile, the banks had large unrecorded losses arising from their equity holdings during a period of declining market prices. Furthermore, there was no consolidation of statements encompassing a parent bank and its subsidiaries.

The lax limitations on risk concentration facilitated the highly leveraged corporate finance structure of Korean conglomerates. A 1991 revision of the General Banking Act set the limit for single borrowers at 20 percent of a bank’s capital for loans and 40 percent for guarantees, with a very generous grandfathering clause and a phase-in period of three years. The grandfathering arrangements were extended in 1994 and 1997. Limits on lending to big conglomerates were set bank-by-bank under the “basket control system,” under which the shares of loans to the top 5 and 30 business groups relative to total loans of the bank should not exceed the ratios set by the Office of Banking Supervision. These limits were tightened in August 1997; they limited lending to a single chaebol (including guarantees) to 45 percent of banks’ capital for commercial banks and 150 percent for merchant banks. Not only were these tighter regulations still lax in comparison to those in other OECD countries but many banks continued to breach them.

Restoring the Soundness of the Financial Sector

Emergency Measures

From the late summer of 1997, international creditors began to reduce their exposure to Korean financial institutions and to withdraw their short-term credit lines. The devaluation of the Thai baht in July 1997, the subsequent contagion to other regional currencies, and the crash of the Hong Kong stock market in late October 1997 sent shock waves to the Korean financial system. Market confidence dropped sharply and rating agencies downgraded Korea’s sovereign status.

In August 1997, the Korean authorities announced that they would ensure that Korean financial institutions would meet their foreign liabilities. Nonetheless, the withdrawal of foreign credit lines intensified in the ensuing weeks. Faced with increasing difficulties in meeting their short-term foreign obligations, banks turned to the Bank of Korea for foreign exchange liquidity support.

Meanwhile, the government had deliberately stepped back from direct intervention and did not bail out failing chaebols. From the beginning of 1997, an unprecedented number of the highly leveraged chaebols went into bankruptcy, dragged down by excessive investment, declining profits, and a substantial debt burden. By the end of November, six of the top 30 chaebols had filed for court protection; a seventh went into bankruptcy in December. These large bankruptcies, together with rising bankruptcies among small- and medium-sized enterprises, further damaged the asset quality of financial institutions.

By the fall of 1997, the balance sheets of Korean financial institutions had deteriorated severely. The share of nonperforming loans in total assets of commercial banks had increased by about 70 percent between December 1996 and September 1997 and amounted to about 80 percent of banks’ capital.86 As a result, the net worth of many financial institutions fell perilously low, and a significant shortfall in capital adequacy emerged.87 Of the 26 commercial banks, 14 had capital adequacy requirements below 8 percent, of which two were deemed to be technically insolvent (with zero or negative capital). In addition, 28 of the 30 merchant banks had capital adequacy requirements below 8 percent and 12 were deemed technically insolvent.

During November and December 1997, the Bank of Korea placed some $23 billion of official reserves in deposit at foreign branches and subsidiaries of domestic financial institutions, which the banks used to repay their short-term debt that they could not rollover. The Bank of Korea’s usable official reserves were thus quickly depleted. On November 19, the government attempted to calm markets by announcing a reform package that included a widening of the daily exchange rate band to +/- 10 percent (from +/- 2¼ percent) and measures to purchase nonperforming loans. Market concerns remained, however, and during the last week of November the depletion of international reserves intensified to some $1 billion to $2 billion a day, driving usable reserves to only $5 billion by the end of the month.

To maintain public confidence in the banking system, in mid-November 1997, the government guaranteed all deposits of financial institutions until the end of 2000. and announced that it would provide temporary liquidity support to banks when needed. Strengthening the financial sector was a key component of the IMF-supported program adopted in December 1997.

Institutional Changes

The government also completed important reforms of the institutional arrangements, which had been recommended by the Presidential Commission on Financial Reform earlier in 1997. Many of these reforms became part of the IMF-supported program. These reforms included:

  • Laws passed in December 1997 significantly strengthened the independence of the Bank of Korea; consolidated all financial sector supervision (for commercial banks, merchant banks, insurance companies, securities firms, and other nonbank financial institutions) in a single Financial Supervisory Commission separate from the government; and merged all deposit insurance protection agencies into the Korea Deposit Insurance Corporation (KDIC), a new agency. The new supervisory agency was established in two stages to give time for the necessary preparation and not to detract unnecessarily from the management of the crisis. The Commission itself was established in April 1998, and the various supervisory bodies fell under its control as of that date. However, the full unification of supervisors, as the Financial Supervisory Service (FSS), with concomitant and extensive management and structural changes, took place only as of January 1, 1999. In April 1999, the operational autonomy of the Financial Supervisory Commission was strengthened with the passage of legislation to grant it the power to license and de-license financial institutions, as well as to supervise specialized and development banks.

  • In early 1998, the government established a Financial Restructuring Unit within the Financial Supervisory Commission to oversee and coordinate the restructuring of the financial sector. A similar unit was also set up to spearhead the government’s efforts to restructure the financial position of the weaker chaebols. The KDIC was provided with powers and funds to pay back deposits in failed institutions and, if necessary, to also provide recapitalization funds to banks.

  • A bridge bank (Hanaerum Merchant Bank) was created at the end of December 1997 to take over the assets and liabilities of closed merchant banks. The role of the Korean Asset Management Corporation (KAMCO) was expanded to enable it to purchase impaired assets from all financial institutions (Box 15),

Korea: KAMCO Operations

The Korean Asset Management Corporation (KAMCO) was established in 1962 to collect nonperforming loans for banks. In November 1997, legislation was passed to create a new fund under KAMCO, supported by contributions from financial institutions and government guaranteed bond issues. This KAMCO-administered fund was given the mandate to purchase impaired loans from all financial institutions covered by a deposit guarantee.

On August 10, 1998, a major reorganization of KAMCO as a “bad bank” was completed with a view to strengthening its asset management and disposition capabilities. KAMCO adopted a structure similar to the U.S. Resolution Trust Company, providing additional business functions such as workout programs for non-performing loans and more efficient asset disposal. To enhance the transparency and the efficiency of its operations, KAMCO has its accounts audited semiannually and publishes the results.

As of mid-June 1999, KAMCO has purchased assets with a face value of 46 trillion won (11 percent of GDP). Its purchases comprise two categories of assets: (1) “general” assets of companies currently operating and (2) “special” assets, which correspond to cases that are currently in court receivership and account for 70 percent of the total portfolio. Only 20 percent of these special assets have been finally resolved by the courts. Until recently, KAMCO only purchased won-denominated assets, owing to lack of funding capacity in foreign exchange. To overcome this deficiency, KAMCO for the first time issued U.S. dollar denominated bonds in late December 1998 for $513 million to purchase foreign currency denominated assets from commercial banks.

For the purchase of nonperforming loans, KAMCO pays 45 percent of the book value of the underlying collateral, which is the average price obtained in auctions of similar collateral in the market. For unsecured loans, the price is set at 3 percent. The prices for the ordinary nonperforming loans are final. However, most of the loans purchased so far have been special loans and for these types of loans, KAMCO pays 45 percent of the face value of the loans; but once a court ordered repayment schedule is implemented, the price of the purchase is readjusted to reflect the present value of the settlement.

KAMCO’s sale strategy is to dispose of nonperforming loans in the fastest way possible, but in a manner that maximizes recovery value. KAMCO has used four methods to collect on its assets: it has sold nonperforming loans to international investors, foreclosed and sold underlying collateral; sold nonperforming loans in a public auction; and collected on loans. As of June 1999, KAMCO had recovered—through sales and collections—about 9 trillion won from loans with a face value of 17 trillion won. Details on these operations are provided in the table below.

Disposition and Sale of KAMCO’s Assets

(In trillions of won, as of June 1999)

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Source: KAMCO

A Bank Restructuring Plan

As part of the financial sector restructuring program, the authorities examined financial institutions to determine their solvency; several groups of institutions were also subject to external diagnostic reviews. Based on these examinations, the Financial Supervisory Commission required weak institutions to submit rehabilitation plans that had to be approved by evaluation committees set up by the Financial Supervisory Commission. These plans specified how the affected institutions would raise capital and operationally restructure to improve profitability. Institutions whose plans were approved signed memoranda of understanding with the Financial Supervisory Commission promising to meet targets set forth in their rehabilitation plans. For institutions whose plans were not approved, the Financial Supervisory Commission developed and implemented several exit strategies.

The government undertook to commit public resources for bank recapitalization only under limited circumstances. After June 30, 1998, public resources—through subscription of capital instruments and nonperforming loan purchases—could only be committed in the context of approved recapitalization plans, and on the condition that adequate contributions be made by shareholders and other stakeholders (exceptions would be made only under well-specified conditions).

The program was implemented in stages, starting with the most serious problems—the clearly insolvent merchant banks. Simultaneously, the government announced a timetable for merchant banks and commercial banks to be evaluated, and to attain minimum capital adequacy requirements. From mid-1998, steps were taken to restructure the remaining non-bank financial institutions, in particular, investment trust companies and life insurance companies. Measures were adopted to strengthen prudential regulations and supervision, particularly in the areas of loan classification and provisioning, foreign exchange liquidity, large exposures, and connected lending.

Merchant banks

In mid-December 1997, at the height of the crisis, the government announced the suspension of 14 merchant banks, of which 10 were closed the following January. The bridge bank, Hanaerum Merchant Bank, took over and liquidated their assets.88 The remaining 20 merchant banks were required to submit rehabilitation plans that demonstrated the ability to gradually strengthen their capital adequacy requirements. On the basis of these plans, four merchant banks were closed by the end of April, 1998. The remaining 16 merchant banks were required to meet capital adequacy requirements of 6 percent by the end of June 1998 and 8 percent by the end of June 1999. In July and August 1998, the Financial Supervisory Commission conducted examinations to ensure that merchant banks were complying with their plans. As a result of these examinations, two more banks were closed. Subsequently, two merchant banks announced mergers with commercial banks and one more was closed in June 1999, leaving a total of 11 merchant banks.

The government has not directly committed resources to recapitalize merchant banks in view of their small size and the fact that many are owned by chaebols. Rather, these remaining merchant banks have raised significant amounts of capital from current owners between the end of December 1997 and the end of June 1999, with capital increasing from 0.4 trillion won to 2.5 trillion won.

Commercial banks

In December 1997, the government took over two large commercial banks, Korea First Bank and Seoul Bank, which were technically insolvent. Given their systemic importance, the government recapitalized them, and following the approval of requisite legislation, wrote down the equity of existing shareholders by a factor of about 8:1 and removed managers responsible for the losses. The government and the KDIC injected capital, acquiring a stake of about 94 percent in each bank. Since March 1998 the banks have been prepared for privatization with the help of foreign advisors; memoranda of understanding to sell them have been signed with Newbridge Capital and HSBC (in late 1998 and early 1999), but the deals have yet to be finalized (Box 16.).

Korea: Mergers and Foreign Investment in the Financial Sector

Mergers of financial institutions and foreign investment have been important elements in the changing financial structure in Korea. A number of mergers among the stronger banks have taken place, supported by purchases of impaired assets by KAMCO. These include the merger between Kookmin Bank and Long-Term Credit Bank, and between Hana Bank and Boram Bank, both announced in September 1998. Each merger was supported by about 300 billion won in nonperforming loan sales to KAMCO.

Weaker banks were also encouraged to merge with government support in the form of nonperforming loan purchases and capital injection. These include the Commercial Bank of Korea and Hanil Bank, which merged in September 1998 to form Hanvit Bank; Cho Hung Bank, Kangwon Bank, Hyundai Merchant Bank, and Chungbuk Bank, which announced their plans to merge into one bank in early 1999. The government has become the largest shareholder in both banks, although it intends to reduce its shareholdings by 2002, possibly by selling stakes to strategic foreign investors. In both mergers, memoranda of understanding were signed by management, specifying targets on profitability, management, and operational restructuring.

Foreign investment is also an important element in the recapitalization of the Korean banking sector. In June 1998, the International Finance Corporation invested $152 million in Hana Bank and $25 million in KLTCB. Germany’s Commerzbank invested $249 million in Korea Exchange Bank, acquiring a stake of 30 percent, mainly by converting existing credits to this bank into equity. In December 1998 a U.S. consortium agreed, subject to due diligence, to purchase a 51 percent stake in Korea First Bank. In February 1999, HSBC Holdings similarly agreed to purchase a 70 percent stake in Seoul Bank. Conclusion of the deals is pending, with ongoing negotiations focusing on the evaluation and treatment of the nonperforming loans. In April 1999, Goldman Sachs announced that it would invest $500 million to acquire a 17 percent stake in Kookmin Bank. In the same month, Shinhan raised $400 million through global depository receipts. Most recently, ING Group acquired a 10 percent stake in Housing and Commercial Bank for about $280 million, while New York Life and the International Finance Corporation signed memoranda of understanding to purchase a two-thirds stake in Kookmin Life Insurance for $105 million.

In early 1998, 12 commercial banks that did not meet the minimum capital adequacy requirement of 8 percent at the end of 1997 were required to submit recapitalization plans, which the Financial Supervisory Commission evaluated with the help of internationally recognized accounting firms. On June 29, 1998 the Financial Supervisory Commission announced the decisions on the recapitalization plans. Five small- to medium-sized banks were closed, with their assets and liabilities transferred to five stronger banks in purchase and assumption operations.89 Four large banks and three small banks received conditional approval for their rehabilitation plans and were requested to submit revised plans by the end of July 1998.90 The three small banks will not be allowed to engage in foreign exchange business. In any event, the resubmitted plans were approved at the end of 1998: five of these banks have merged (with public financial support) to create two new banks, one has been recapitalized with funds from the Bank of Korea and a foreign bank, and the remaining small bank has raised capital from current owners (this capital was matched with public funds).

All of these banks have signed memoranda of understanding with the Financial Supervisory Commission undertaking to meet recapitalization and restructuring targets, such as branch closures.

The government has provided about 30 trillion won (7 percent of GDP) to support commercial banks. About 50 percent of this amount has been used by KAMCO to purchase nonperforming loans, while the other half has facilitated mergers and the purchase and assumption operations. Government recapitalization of banks has been conditional on a write down of current owners and management changes. As a result of the restructuring, the government now owns shares in 11 out of the 17 remaining banks; its ownership exceeds 90 percent in 4 large banks (Table 16).

Table 16.

Korea: Government Ownership of Commercial Banks

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Source: Financial Supervisory Commission (FSC).

Preferred shares.

Financial consolidation was helped by mergers and foreign investment. In September 1998 four relatively strong banks merged into two new entities, each undertaking facilitated by some KAMCO purchases of nonperforming loans. In the case of two rounds of mergers among much weaker partners, announced in September 1998 and early 1999, government involvement in loan purchases and capital injection amounted to a total of more than 8 trillion won and led to the effective nationalization of the two new banks. Foreign investment of about $1 billion has been announced, and several other significant undertakings are in advanced stages of preparation.

In the summer of 1998, banks not undercapitalized at the end of 1997 were also subject to diagnostic reviews. As a result of these reviews and the Financial Supervisory Commission’s own appraisals, three small banks were subject to prompt corrective action procedures and were required to raise additional capital.

Other financial institutions

The government has also recapitalized the specialized and development banks, whose portfolios had deteriorated significantly, and made them subject to regulations in line with those applied to commercial banks. In the case of the Industrial Bank of Korea, these moves effectively reversed the process of privatization that had begun before the crisis. Recapitalization was done by buying equity in the banks and paying for it with government shares in public enterprises. A total of more than 9 trillion won has been injected into these banks.

Once the strategy for commercial and merchant bank restructuring was in place, the authorities targeted the restructuring of other financial institutions whose soundness had deteriorated significantly because of the severity of the crisis and inadequate supervision. At the end of March 1998, the Financial Supervisory Commission estimated that this sector had about 30 trillion won in nonperforming loans, about 7 percent of those institutions’ total assets (and almost equal to nonperforming loans in commercial banks). In June 1998 the Financial Supervisory Commission announced a restructuring plan for life insurance companies, investment trust companies, leasing companies, and securities companies.

The restructuring program for life insurance companies began with diagnostic reviews of 18 “weak” life insurance companies by the Financial Supervisory Commission. As a result, four companies were closed through purchase and assumption-type operations, seven were required to submit rehabilitation plans, while the remaining seven were required to sign memoranda of understanding with the Financial Supervisory Commission undertaking to meet explicit restructuring objectives. In 1999, six of these companies (having failed to implement their plans) were put up for sale by the Financial Supervisory Commission. To strengthen the supervision and regulation of life insurance companies, the Financial Supervisory Commission revised the solvency margin regulation in April 1999, making it consistent with the European Union standard. Accounting rules and loan classification standards were also brought in line with those applying to commercial banks.

In mid-1998, the Financial Supervisory Commission revoked the licenses of two investment trust companies, and the six remaining were placed under management improvement orders and required to submit rehabilitation plans and raise new capital from owners and reduce their indirect borrowings from trust assets.91 Measures to reform the sector include the requirement that all funds established after mid-November 1998 be marked-to-market; further, all funds have to be marked-to-market by mid-2000. Ten out of 25 leasing companies were closed and their businesses transferred to a bridge leasing company. Several securities companies were also closed, and regulations were issued to assure full segregation of proprietary and customer accounts, which had been a problem.

The Financial Supervisory Commission also took steps to bring the regulation of mutual savings companies and credit unions into line with that of the commercial banks. These companies were required in January 1999 to meet capital adequacy requirements calculated on the same basis as commercial banks. Companies that failed to meet minimum thresholds have been subject to prompt corrective action rules—resulting in the closure of 19 mutual savings and 40 credit unions.

The Korean financial sector has thus been significantly consolidated (Figure 10). Since December 1997, 9 out of 26 commercial banks and 19 out of 30 merchant banks have been either closed or merged. Moreover, a substantial recapitalization effort has taken place, including through foreign capital.

Figure 10.
Figure 10.

Korea: Progress in Financial Sector Restructuring

Source: National authorities; and IMF staff estimates.1 Does not include trust accounts.2 Banks with majority government ownership (Hanvit, Cho Hung, Korea First, and Seoul). Also includes the Bank of Korea-owned Korea Exchange Bank.Note: As of the end of July 1999, five commercial banks, 17 merchant banks, four life insurance companies, three investment trust companies, and more than 50 mutual savings and credit unions had been closed. The state had intervened in 11 commercial banks. Four commercial banks and two merchant banks had exited through merger. Categories are not mutually exclusive.

As of mid-1999, the government has spent close to 47 trillion won (11 percent of GDP) to recapitalize financial institutions and purchase nonperforming loans (Table 17). The budgetary cost, that is, interest on bonds issued to financed restructuring, is close to 2 percent of GDP. An additional amount of 16 trillion won (4 percent of GDP) in asset swaps has also been spent to recapitalize government-owned, specialized, and development banks.

Table 17.

Korea: Public Cost for Financial Sector Restructuring

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Source: National authorities; and IMF staff estimates.

Corporate restructuring

The process of reconstructing the financial sector was accompanied by measures to rehabilitate the finances of many of the chaebols. A number of the larger firms were dealt with by a modified version of the “London Approach.”92 This has involved setting up debt workout units within banks and voluntary creditor committees (including banks and other creditors). These arrangements are expected to contribute to strengthening credit analysis and risk management capacity within domestic banks. Debt workouts often involved rescheduling, interest rate reduction, and debt forgiveness, as well as swaps of bank debt for equity or convertible bonds. In the case of small- and medium-sized enterprises, banks were encouraged to roll over debt until the viability of such firms could be better assessed in the light of the performance of the economy. The largest five chaebols are proving a less tractable problem, and it may not be clear for some time to what extent further value adjustments to bank claims are necessary in these cases. The entire process will not be concluded for some time and, in the meantime, the need for further restructuring in the financial sector, including the provision of more government funds, may be needed.

Banks have provided some of the impetus for corporations to restructure. One reason for this is because measures to strengthen prudential regulations and supervision, including limits on large exposures and connected lending, require banks to reduce their exposures to corporations. Another reason is the role of government-owned banks (commercial or development), which are better able to pressure large chaebols into restructuring.

Strengthening the Banking Environment

To prevent the recurrence of banking system problems, the financial reform strategy calls for improving the supervision and management of banks. The main elements comprise a shift to consolidated bank supervision and a strengthening of prudential regulations and supervision; the liberalizing of restrictions on foreign ownership and management of banks; and a strengthening of the banks’ credit evaluation and risk management capabilities.

As noted earlier, the Financial Supervisory Commission is responsible for the supervision and prudential regulation of all financial institutions. Regulations are being phased in to bring merchant banks and other financial institutions under the supervisory umbrella and to subject these institutions to prudential standards in line with those applied to commercial banks. Supervision is also being enhanced to cover the full range of banking risks of financial institutions on a consolidated basis.93

The authorities strengthened prudential standards and supervision procedures—with special emphasis on the regulations of foreign exchange activities—to bring them in line with best practice as set out in the “Core Principles for Effective Banking Supervision” recommended by the Basel Committee. On June 30, 1998, the authorities introduced new loan classification standards and provisioning rules under which loans more than three months overdue will be classified as substandard, and the general provisioning requirement was increased from 1 percent to 2 percent. The Financial Supervisory Commission also introduced regulations to require the provisioning for securities losses and to cease the inclusion in Tier 2 capital of all provisions for nonperforming loans (as of January 1999). The Financial Supervisory Commission is now preparing to issue guidelines for loan classification and provisioning that would apply to banks’ end of 1999 accounts. The new guidelines are designed to take into account a borrower’s future capacity to repay in classifying and provisioning loans. This prospective reform is likely to lead to a need for increased provisions.

The Financial Supervisory Commission has announced the strengthening of prudential supervision and regulation of foreign exchange operations by commercial and merchant banks.94 Regarding foreign exchange liquidity management, compliance with the guidelines that require short-term assets (less than three months) to cover at least 70 percent of short-term liabilities, and long-term borrowing (more than three years) to cover more than 50 percent of long-term assets, has been enforced for commercial banks as of January 1999 and will be enforced for merchant banks as of December 1999. A maturity ladder approach, monitored by the Financial Supervisory Commission on a monthly basis, has been implemented for commercial banks since January 1, 1999 and since July 1, 1999 for merchant banks.95 Overseas branches and subsidiaries are included in the calculations. In addition, banks have to maintain overall foreign currency exposure limits per counterparty, including foreign currency loans, guarantees, security investments, and offshore finance. In line with international best practice, the limit on spot foreign exchange transactions of banks has been removed, leaving a global limit on spot and forward positions.96

The large exposure of banks to the big conglomerates has been a major source of difficulty. Exposure limits to single borrowers and groups were too generous, and the authorities passed legislation in January 1999 to tighten them. These limits have been redefined to include all off-balance sheet exposures. Both single borrower and group limits for commercial and merchant banks will be progressively reduced to 25 percent of total capital by 2004, and aggregate exposures in excess of 10 percent of total capital will be gradually reduced to 500 percent of total capital. Connected lending by merchant banks will be limited to 25 percent of equity capital by January 2001. Excesses in aggregate exposures and connected lending will be published regularly.

Increasing foreign ownership and management of banks is recognized as a means to help recapitalize banks, increase competition, and improve the management of banks. Since December 1997, full foreign ownership of merchant banks has been allowed. Nonresident purchases of equity in banks and other financial institutions (excluding merchant banks) are subject to the laws governing equity ownership of Korean companies by foreigners. Currently, the individual foreign ownership limit is set at 50 percent, although the Financial Supervisory Commission may grant exemptions. (These limits are more generous than those for residents, which are 4 percent for nationwide banks and 15 percent for regional banks.) In addition, the government has submitted legislation to abolish regulations prohibiting foreigners from becoming bank managers.

Banks have also been encouraged to adopt operational improvements. Banks’ rehabilitation plans have included specific benchmarks to improve their profitability and the quality of their portfolios. Banks have lowered labor costs and reduced their staffing, and have closed down uneconomical branches domestically and overseas.97

Appendix III Malaysia

Despite Malaysia’s long history of outward-oriented macroeconomic and financial policies, the country did not escape contagion from the Thai crisis.98 In addressing the situation, Malaysia has adopted some measures significantly different from those in the other countries, most notably the reintroduction of capital controls in September 1998. While Malaysia has not adopted an IMF-supported program, it has nevertheless received technical assistance from bilateral and multilateral sources, including the IMF.


Macroeconomic Setting

At the outset of the crisis, Malaysia’s macroeconomic performance was good. Growth was about 8 percent a year, driven in part by very high savings rates. Prudent financial policies had kept inflation low at about 3 percent, and there was a history of fiscal surpluses. The current account deficit had peaked in 1995 at about 8 ½ percent of GDP, but had fallen to slightly above 5 percent in 1996. External debt appeared manageable. The debt to export ratio was about 38 percent (roughly one-third of the Thai ratio). Short-term debt comprised about 60 percent of international reserves, again lower than in the other crisis countries.

Beginning with the emergence of the financial crisis in Thailand in mid-1997, Malaysia experienced increasing turbulence in financial markets (including a sharp increase in offshore ringgit interest rates). Market concerns about the economic vulnerabilities in Malaysia were reflected in a sharp fall of the ringgit and the stock market in the order of 40 percent to 50 percent by the end of 1997. Concerns included the current account deficit, rapid growth in domestic demanded led mainly by large infrastructure projects, strong credit growth, and the future course of asset prices and their potential impact on the banking system.

The authorities responded to market pressures initially through foreign exchange market intervention accompanied by an increase in interest rates, and by subsequently allowing the ringgit to depreciate. There were substantial outflows of capital, through commercial banks and sales of stocks by foreigners. By the first half of 1998, real output (year by year) had declined by 5 percent, led by sharp declines in manufacturing and construction output. Sharp decreases in imports (by more than 25 percent) exceeded the slowdown in exports (by about 10 percent), leading to current account surpluses. Gross international reserves fell to 3.5 months of imports at the end of 1997 from 4.6 months in 1996. Severe corporate and financial sector distress also led to a surge in the number of listed companies seeking court protection from creditors. Nonperforming loans soared to more than 25 percent by late 1998.

Characteristics of the Financial Sector

At the beginning of 1998, the Malaysian financial system, which is dominated by the banking system, comprised 22 domestic and 13 foreign-owned commercial banks (with about 69 percent of the system’s assets), 39 finance companies (about 22 percent), 12 merchant banks (6 percent), seven discount houses (3 percent), and money and exchange brokers. Nonbank financial institutions included the National Savings Bank, pension and provident funds, insurance companies, and specialized credit agencies (Table 18). The range of activities that finance companies and merchant banks could undertake had been gradually extended with similar, but not identical, regulatory requirements—though there remains a sharp demarcation in the roles and activities of these institutions vis-à-vis commercial banks. A two-tier structure, predicated on market share and condition, was introduced at the end of 1994 for commercial banks and extended in 1996 to merchant banks and finance companies.99 There were restrictions on foreign ownership (30 percent) and on the activities of foreign banks. In addition to the domestic financial system, there was an offshore market in Labuan, governed under its own separate legal framework by the Labuan Offshore Financial Services Authority.

Table 18.

Malaysia: The Structure of the Malaysian Financial System

(December 31, 1997)

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Source: Bank Negara Malaysia.

Under the classification system in place during 1997.

Precrisis Weaknesses in the Financial Sector

In the wake of market turbulence and contagion effects in the second half of 1997, concerns among market participants about the true condition and resilience of the financial system increasingly became a central issue, highlighted by the known frailties among finance companies.

Structural Vulnerabilities

Standard official indicators of the Malaysian financial system soundness improved significantly in the 1990s. The ratio of nonperforming loans to total loans in banks and finance companies fell from 20 percent in 1990 to about 3.8 percent for banks, and 4.7 percent for finance companies in 1996; risk-weighted capital adequacy requirements rose to levels in excess of minimum Basel standards; and general provisions of commercial banks increased from 0.75 percent in 1990 to 2 percent of outstanding loans in 1996.100 However, the persistent pace of credit expansion at an annual rate of nearly 30 percent (particularly by smaller Tier 2 financial institutions) to the private sector,101 in particular to the property sector and for the purchase of stocks and shares, exposed the financial system to potential risks from price declines in property and other assets that occurred in 1997. As a result, nonperforming loans rose in 1997, and official estimates showed further deterioration in the months leading up to the announcement of the reform program. In response to these concerns, Bank Negara Malaysia had earlier imposed limits on property lending (20 percent of total loans) and securities lending for the purchase of shares, effective from April 1, 1997. In October 1997, the authorities issued a directive that no new loans should be approved for the property sector, except for low income housing. The authorities also asked banks to submit credit plans for 1998 to moderate loan growth of the banking system to 20 percent by March 1998 and to 15 percent by the end of 1998. Nevertheless, overall credit growth remained strong, falling only slightly, to 26.5 percent by the end of 1997.

In addition to the exceptionally high level of indebtedness, the combination of the economic slowdown, decline in asset values (particularly property and stock market securities), rising interest rates, and the depreciation in the ringgit severely affected credit performance and bank profitability. Tight liquidity conditions and segmentation of the interbank money market also contributed to narrowing interest spreads, especially for finance companies, and a growing level of nonperforming loans in many financial institutions.

Weaknesses in Prudential Regulation and Supervision

After the banking problems of 1985–87, the authorities took actions to improve the legal and regulatory framework for banking supervision.102 In 1989, a new banking law was adopted. In 1994, a new law on the Bank Negara Malaysia was enacted, and a large number of prudential regulations and circulars were issued covering enhanced prudential supervision, regulation standards, and the provision of regular statistical reports and inspections.103 The new banking law and the Banking and Financial Institutions Act (BAFIA) provided broad regulatory enforcement and intervention powers to the supervisory authorities. Bank Negara Malaysia updated regulations, and overall a flexible framework was developed that permitted the authorities, by and large, to address prudential concerns.

One area of uncertainty in the implementation of the prudential framework related to the fact that the BAFIA provided broad exemption powers to the ministry of finance—albeit formally at the recommendation of Bank Negara Malaysia—with regard to individual prudential regulations, such as lending to connected parties,104 ownership of shareholdings in banks, and large exposure limits.105 There are, however, no reports of systematic or widespread use of this power.

Impact of the Regional Crisis and Initial Responses

As regional uncertainties unfolded, concerns about the true condition of the financial system increased. These concerns stemmed from the exceptionally fast rate of growth of credit in the banking system, the private sector’s high leverage (163 percent), the concentration of bank loans in real estate development and in financing share purchases, and the decline in asset qualities given the slowdown in economic activity. These worries were manifested in deposit flights to quality assets and institutions. Already vulnerable to liquidity shocks, given low excess reserves and high loan/deposit ratios, conditions in the money market were aggravated by changed perceptions of counterparty credit risks that resulted in severe money market segmentation and pressure on the payment system. Bank Negara Malaysia responded initially by acting to recycle liquidity through Bank Negara Malaysia deposit placements, supported by the announcement on January 20, 1998 of a general guarantee of deposits. There was no formal deposit insurance scheme in Malaysia.106

The authorities, with a view to strengthening the financial sector, announced several prudential measures, effective January 1, 1998, including a requirement for banks to classify loans as nonperforming when they were three months overdue; an acceleration of the classification of “doubtful loans” from 12 months overdue to six months, and “bad loans” from 24 months to 12 months; and a rise in the required general loan-loss reserves from 1 percent to at least 1½ percent. The requirements for booking interest-in-suspense were also tightened, so that banks were now required to reverse unpaid interest out of income and record it in the interest-in-suspense account. Banks were also required to report on a quarterly basis the ratio of nonperforming loans broken down into substandard, doubtful, and loss; loans by sectors; general and specific provisions for bad and doubtful loans; as well as their risk-weighted capital ratios.107

As of February 1998, only 10 commercial banks and four finance companies had Tier 1 status. Profits of the system varied greatly; four banks and eight finance companies made losses or zero profits while eight banks and 23 finance companies had rates of return on assets below 1 percent. In part, due to the monetary management instrument framework used by Bank Negara Malaysia (differential reserve requirements across institutions, limited reserve averaging, and differential liquid asset requirement with no averaging) but more so related to the fact that since 1994, private sector loan/deposit ratios had exceeded 90 percent, the banking system operated with very low excess reserves, suggesting very limited ability to react to adverse liquidity shocks. (Loan/deposit ratios were 96 percent for banks and 101 percent for finance companies.)

On March 25, 1998, the authorities announced a package of measures aimed at strengthening the financial sector. The measures focused on a broad-based strengthening of the regulatory and supervisory framework requirements for increased disclosure; strengthening the finance company sector through consolidation into a smaller number of core companies; and preemptive recapitalization of banks. The measures also included initiatives to improve the framework for bank liquidity management and monetary operations, and are detailed in Box 17..

Malaysia: Measures Announced on March 25, 1998

Loan classification and provisioning standards. Classification standards (including three months for nonperforming loans) to be brought to best practice; 20 percent provisioning requirement against uncollateralized portions of substandard loans; off-balance sheet items incorporated in the loan classification and provisioning system.

Capital adequacy framework. Increase risk-weighted capital adequacy requirements of finance companies from 8 percent to 10 percent, with interim requirement of 9 percent; minimum capital for finance companies increased from 5 million ringgit to 300 million ringgit: compliance with capital adequacy requirement required every financial quarter.

Other prudential guidelines. Single borrower limit reduced from 30 percent to 25 percent of capital funds; prudentially based liquidity framework introduced; technical study on international practices regarding depositor protection schemes to be undertaken.

Disclosure. Aggregate statistics on nonperforming loans, provisions, and capital positions for all financial institutions to be published monthly by the Bank Negara Malaysia; all institutions to report and publish key indicators of financial soundness on a quarterly basis.

Intensified monitoring. More intensive and rigorous supervision of banks through monthly stress tests by Bank Negara Malaysia and a requirement for similar exercises by individual institutions on the basis of parameters set by Bank Negara Malaysia,

Merger program. Bank Negara Malaysia-facilitated merger program of finance companies on market-based criteria. Mergers allowed only if merged entity would be fully capitalized. Approval contingent on up-front due diligence. Government to extend a one-year guarantee on net asset value determined from due diligence, and to share in upside gains as well as downside risks. Any institution electing to stay out of the merger process was required to demonstrate its ability to comply with new capital requirements, failing which, appropriate action as provided by BAFIA would apply.

Monetary measures. Commercial bank liquidity management to be improved through widening the band for reserve averaging and providing market participants with daily information on Bank Negara Malaysia operations and liquidity forecasts; normal liquidity support operations to be separated from emergency liquidity support, and lending operations collateralized; the role of base lending rate and maximum interest spread restrictions, and liquid asset ratio, to be reviewed.

Design of the Restructuring Program

Strengthening the Prudential Framework

The authorities vigorously implemented the announced program. By April 1998 targeted improvements to the loan classification and provisioning standards and the reduction in single borrower limits from 30 to 25 percent of capital had been completed and incorporated in the ongoing supervisory and regulatory framework. Moreover, in addition to its initial broad diagnostic review of the banking system in March 1998 that used stress tests (projections of capital adequacy adjusted for varying scenarios of nonperforming loans, specific provisions, collateral values, and other measures of other balance sheet risks), Bank Negara Malaysia grouped the banks into three categories; sound banks, those on a secondary watch list, and those on a primary watch list. A program of intensified surveillance was instituted that involved reaching understandings with each vulnerable bank on a rehabilitation program. To augment its surveillance system, Bank Negara Malaysia initiated a program to develop an early warning system with the assistance of the World Bank. It also took the initiative to provide daily information to the market on its assessment of liquidity based on a daily forecast of factors affecting reserve money.108 All disclosure requirements were observed by the end of May 1998, and a prudentially based framework for assessing bank liquidity risks was introduced effective August 2, 1998.109

Finance Company Merger Program

In addition to the announcement that finance companies would be subject to higher risk-weighted capital adequacy requirements, the Malaysian authorities announced a program of consolidation of the industry. The program envisaged the consolidation of 39 companies into eight, to be achieved through three modules. The first, covering 14 institutions, would involve the consolidation of finance companies into their parent banks; the second, relating to three firms, would involve consolidation through a swap of shares; and the third was a straight merger of 15 companies into six anchor institutions. Companies consolidated in this last module would carry a one-year government guarantee on the net asset value arrived at during the due diligence process. During 1998, however, as the economy and loan quality deteriorated sharply, and amid concerns about the possible open-ended nature of the government guarantee, the finance company merger program was drastically scaled back. The sole remaining requirement was that finance companies affiliated with banks be merged. Moreover, the initial schedule for compliance with the requirement for increased capital for the merged entities was postponed, and the government guarantee of net asset values, aimed at facilitating purchase, was withdrawn. Smaller finance companies not eligible for support through Danamodal Nasional Berhad (the restructuring agency) would not receive government support for recapitalization. Notwithstanding the slower than anticipated progress in consolidating this industry segment, Malaysia reports that the number of finance companies declined by eight in 1998 and is expected to decline by another 14 in 1999.

Commercial Banks: Asset Management and Recapitalization

Complementing earlier initiatives to restore sound intermediation, Malaysia established in August 1998 an institutional framework to strengthen efforts to rehabilitate the commercial banking system by using public funds to acquire nonperforming loans and recapitalizing commercial banks. It also instituted measures that were focused on facilitating the restructuring of corporate debt.

Institutional Framework

Danaharta Nasional Berhadm, the public asset management company, was established in June 1998 as a public company under the Companies Act. The Danaharta Act of 1998 gave Danaharta the ability to acquire nonperforming loans through statutory vesting and to appoint special administrators who can take control and manage the assets of a borrower unable to pay its debts. Danamodal was established in August 1998 as a limited liability company wholly owned by Bank Negara Malaysia, with objectives to inject new capital in undercapitalized banks and facilitate rationalization of the system. The general policy positions of both Danamodal and Danaharta incorporate principles of economizing the use of public funds and finding least-cost solutions to government. Although Danamodal issues progress reports on its operations, it has not released a public statement as to its operational principles, criteria for selecting operations, formulae for burden sharing, or exit strategy. Danaharta’s principles of operation, including valuation methodology, asset acquisition guidelines, and expected nonperforming loan sales strategy are already public knowledge. The Corporate Debt Restructuring Committee has also been established to act as an informal debtor/creditor broker to achieve debt restructuring as an alternative to companies filing for bank bankruptcy under the Companies Act. To facilitate coordination at both the policy and operational levels, an overarching Steering Committee on Restructuring is chaired by the Governor of Bank Negara Malaysia and composed of the managers of Danaharta, Danamodal, and the Corporate Debt Restructuring Committee.

Operational Process

In practice, the operations of Danaharta and Danamodal are guided by Bank Negara Malaysia’s classification of banks. Bank Negara Malaysia initially classifies institutions into a primary and secondary watch list. The process is fine-tuned by Danamodal with the assistance of two investment banks acting as its advisors.110 Danamodal has identified 14 institutions that are either currently undercapitalized or likely to be so in the future.111 Danaharta used the same database to identify 18 institutions (including the Danamodal 14) that are most likely to sell nonperforming loans. Danamodal’s intentions are carefully coordinated with nonperforming loan sales to Danaharta through ensuring that Danamodal’s due diligence, and Danaharta’s nonperforming loan acquisition and write-downs of capital of affected institutions occur concurrently.

Danaharta has divided its nonperforming loan acquisition process into three stages, starting with secured loans, properties, and quoted shares. A second stage will cover unsecured loans, to be followed by acquisitions of foreign currency loans. Through March 1999, Danaharta had acquired 23 billion ringgit in nonperforming loans from 37 financial institutions. The average discount at which Danaharta has purchased nonperforming loans has been about 60 percent of the principal value. As of the end of June 1999, none of the acquired assets has been sold. On July 1, Danaharta began the process of auctioning $143 million (face value) of foreign loan assets.

Danamodal has injected 6.2 billion ringgit as fresh capital into 11 financial institutions that represent approximately one-fifth of the financial system’s needs. The Danamodal investment initially was as Tier 2 subordinated debt that will be converted into equity, debt, or a hybrid capital instrument.

The Corporate Debt Restructuring Committee had been set up to prevent companies from abusing the protection against creditors afforded by Section 176 of the Companies Act. The process of resolution can be initiated by either party, but once an appeal has been filed, there is a six-month moratorium on action during which credit committees will work with the affected parties to achieve a workout strategy. As of the end of June 1999, 52 applications, representing about 22 billion ringgit in affected debt, have been received by the Corporate Debt Restructuring Committee. Creditor committees had been formed to conduct due diligence studies and to formulate restructuring proposals, and these are in various stages of completion. Four cases have been rejected and turned over to Danaharta for resolution.

Public Cost of Financial Sector Restructuring

As of the end of March 1999. Danaharta and Danamodal have spent about 15 billion ringgit (5 percent of GDP) to purchase nonperforming loans and recapitalize banks (Table 19).

Table 19.

Malaysia: Public Cost for Financial Sector Restructuring

(As of the end of March 1999)

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Source: National authorities; and IMF staff estimates.

Managing Credit Recovery and Rehabilitation

The reforms described above were complicated by concurrent attempts by the authorities to stimulate credit growth in the face of the economic downturn. By mid-1998, the authorities were faced with a sharp decline in credit. Credit flows were negative to the extent of 1.5 billion ringgit, and undrawn commitments declined from 144 billion ringgit to 125 billion ringgit between December 1997 and July 1998. While the Malaysian authorities wished to use interest rates to stimulate credits, they were constrained by onshore/offshore interest rate differentials. While relatively stable—and in fact declining in mid-1998—these differentials limited the scope for reducing onshore interest rates without possibly triggering ringgit flight offshore. The authorities, therefore, introduced additional measures in September 1998 aimed at eliminating the offshore ringgit market, fixing the exchange rate, and improving the conditions for increased bank lending. These measures included:

  • Exchange control measures. A broad range of measures to restrict international capital flows, which effectively eliminated the offshore ringgit market and prohibited nonresidents from repatriating portfolio capital held in Malaysia for a period of 12 months, were adopted.112

  • Exchange rate policy. Subsequent to the introduction of capital controls, the authorities fixed the exchange rate of the ringgit at 3.8 ringgit to the U.S. dollar.

  • Reserve requirements. Statutory reserve requirements were reduced to 4 percent of eligible liabilities—from 10 percent in February 1998 to 8 percent in August—applied to the maintenance period beginning September 15, 1998. The allowed averaging of 20 percent was kept unchanged.

  • Loan limits. Existing limits on lending to the property sector, and for the purchase of shares, were relaxed. Loans for residential mortgages up to a value of 250,000 ringgit were made exempt from the 20 percent ceiling on loans to the property sector—the previous exemption was 150,000 ringgit. The ceiling on loans for share purchase was increased for commercial banks from 15 percent of portfolio to 20 percent. Also, financing margins for the purchase of motor vehicles were increased from 70 percent to 85 percent.

  • Credit floor target. A floor target for credit growth during 1998 was established at 8 percent. However, the authorities indicated that weak banks on the Bank Negara Malaysia watch list would not be expected to comply, and banks that could indicate prudential constraints—for example, rising nonperforming loans or the prospect of violating prudential standards—would be exempted from the target.

  • Base lending rate. The formula for computing the base lending rate was modified to reflect greater sensitivity to Bank Negara Malaysia policy rates, and to lower the premium that banks charge.

  • Loan classification. Bank Negara Malaysia announced changes in the classification system so that the default period for classifying loans as nonperforming was increased from three to six months, and 20 percent specific provisions on substandard loans were no longer required.113

Effective March 24, 1999, Bank Negara Malaysia amended its loan classification and provisioning guidelines again so that substandard loans—those overdue between three and six months—would require provisioning of 20 percent. Doubtful loans— overdue between six and nine months—would require provisioning of 50 percent; and loss loans —those overdue for more than nine months—would require provisioning of 100 percent.114 Provisions must cover losses in the value of securities. Nonperforming loans can be reclassified as performing when repayments are made continuously for six months, rather than 12 months as required before.

Appendix IV The Philippines

The Philippines has been less affected than neighboring countries by the Asian crisis and did not undergo a similar degree of capital outflows, banking sector distress, and other forms of financial upheaval.115 Nevertheless, the combination of initial weaknesses in the banking sector, the fallout from the crisis in neighboring countries, and the possibility of more intensive contagion led the Philippines to undertake preemptive measures to address potential financial sector weaknesses. The program, developed with the support of the IMF and the World Bank, complements and deepens the efforts to improve the efficiency of financial intermediation deployed during the previous years.116


Macroeconomic Setting

The performance of the Philippine economy prior to the current crisis had been improving. After several years of accelerating growth rates, the expansion of real GNP reached 6.8 percent in 1996. Inflation remained well below 10 percent a year. The balance of payments remained strong, and foreign reserves of the Philippines’ central bank, the Bangko Sentral ng Pilipinas increased from less than $5 billion at the end of 1993 to about $8 billion (1.7 months of imports) at the end of 1997; strong capital inflows—which reached $8 billion in 1996—offset the rapid widening of the current account deficit to almost 5 percent of GDP in 1996.

In early 1997, the Philippines were faced with a large decline in the stock market and pressure on the exchange rate. From mid-1997, although to a lesser degree than in other Asian countries, the regional crisis led to a further substantial disruption in economic activity. Following the devaluation of the Thai baht in early July, the Philippines experienced a large decline in capital inflows, a further fall in the stock market, and pressures on the peso. The Bangko Sentral ng Pilipinas initially intervened in support of the peso; these efforts, however, proved unsustainable when about $2 billion in Bangko Sentral ng Pilipinas reserves were lost in a few days. The peso was allowed to float and fell from about 26 pesos per U.S. dollar at the end of June 1997 to a low of about 44 pesos in September 1998, before stabilizing at about 36 pesos per U.S. dollar. Interest rates—measured by the return on the 91-day treasury bill—increased gradually from 10.5 percent in June 1997 to about 19 percent by January 1998 as the authorities attempted to keep the depreciation of the peso under control; they subsequently fell back to about 13.5 percent by early 1999. The authorities’ strategy thus initially focused on tight monetary and fiscal policies. But, as stabilization took hold, the stance shifted gradually toward supporting recovery.

Real GNP growth reached 5.8 percent in 1997— reflecting very strong growth in the first part of the year—but fell to only 0.1 percent in 1998, while at the same time inflation increased to over 10 percent, and accelerated further in early 1999.117 Despite the significant contraction in capital inflows—the capital account surplus fell to $900 million in 1997 and $400 million in 1998—foreign reserves recovered during 1998 owing to the rapid adjustment of the current account of the balance of payments, which recorded a surplus of over 1 percent of GDP in 1998.

Characteristics of the Financial Sector

Private banks in the Philippines comprise universal or “expanded” banks (by far the largest component of the banking system), nonexpanded commercial banks, thrift banks, and rural banks (Table 20).118 Only one universal bank, the Philippine National Bank, is partly owned by the government.119 Thrift banks cater mainly to the consumer retail market and small- and medium-sized enterprises. There are two fully government-owned specialized banks, the Land Bank of the Philippines and the Development Bank of the Philippines, which also undertakes some commercial banking functions. The small government-owned Islamic bank is currently under a rehabilitation plan. Total assets of the banking system amounted to over 2.8 trillion pesos in 1998, roughly equivalent to annual GNP; banks represented 90 percent of the banking system, up from 85 percent in 1991.

Table 20.

Philippines: Selected Banking Sector Indicators as of December 31, 1998

(In billions of pesos, unless otherwise indicated)

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Source: Bangko Sentral ng Pilipinas.

Data for rural banks in the Balance Sheet and Annual Income and Expenses entries are for June 30, 1998.

There are significant restrictions on the size and operation of foreign banks.120 The number of foreign banks that operate wholly owned branches in the Philippines is currently capped at 14. Other foreign banks may apply for a universal or a nonexpanded bank license and can operate by acquiring up to 60 percent of the voting stock of an existing domestic bank or of a new institution incorporated locally. On average, foreign equity is about one-fifth of total equity for universal banks, 13 percent for nonexpanded commercial banks, and negligible in the case of thrift and rural banks.121

Precrisis Weaknesses in the Financial Sector

Prior to the Asian crisis, the Philippines had undergone a period of financial liberalization, coupled with rapid financial deepening.122 The changes appear to have come too fast for supervision to remain fully effective. Hence, although the financial condition of the Philippine banking system in terms of capital adequacy was better than several of the neighboring countries, the corporate sector was more resilient, and the real estate boom less pronounced, there were notable weaknesses in the financial sector around the time of the crisis.123 The principal weaknesses and supervisory challenges are discussed next.

Structural Vulnerabilities

Several characteristics of the Philippine banking sector that existed before the crisis appear to have made it vulnerable to shocks. They include:

  • A very rapid growth in banks’ lending following gradual liberalization of banking and substantial financial deepening.124 The speed of this growth in lending brought about significant problems, including a decline in the average loan quality, an increase in unhedged foreign exchange operations, and for some banks, growing involvement in real estate lending. These problems have been particularly acute for smaller commercial banks, thrift banks, and rural banks.

  • A significant growth in financial intermediation in foreign currency. Mirroring overall trends in banking sector activity, financial intermediation in foreign currency also grew significantly until mid-1997, owing in part to the prevailing significant institutional advantages for bank operations conducted in foreign currency.125 Total foreign currency deposits in the banking system expanded at an annual rate of 38 percent from 1994 to 1996, and reached a maximum of $16.3 billion in June 1997; as a result, foreign currency deposits increased to more than half of total bank liabilities, up from only 3 percent in 1990.

  • A weakening in capital levels. The deterioration in banks’ portfolios led to a significant weakening in capital levels. Average capital levels remained still comfortable at the onset of the crisis, but capital adequacy ratios had been on a downward trend since 1993. Capital adequacy declined from 19.2 percent in 1993 to 16 percent in 1997. Moreover, average capital levels disguised problems of individual institutions— one large and several among the smaller ones— that suffered from low capital levels relative to the risk implied by their asset portfolios. Finally, a special regime granted to a few universal banks allowed them to operate with a minimum capital adequacy requirement of 8 percent instead of the 10 percent generally required.

Weaknesses in Prudential Regulation and Supervision

Despite significant progress since the early 1990s, at the onset of the crisis the banking sector still suffered from problems both in the supervisory framework and the implementation of supervision. The main areas of concern were shortcomings relative to international norms of prudential standards, the effectiveness of bank supervision, and the enforcement of the bank regulatory and supervisory framework. Finally, mechanisms for bank exit were inadequate.

Prudential standards

Problems in bank supervision included the following:

  • Loan classification and provisioning. Until mid-1997, loan-loss provisions were not required for bank assets backed by collateral, even if such assets were classified as substandard, or for any bank assets classified as “especially mentioned.”126 There was also limited capacity of the Bangko Sentral ng Pilipinas to assess bank risks.

  • Marking to market. Philippine accounting conventions regarding banks’ portfolio investments follow closely the U.S. pattern. Banks were not required to mark to market their equity portfolios, but in contrast to U.S. norms, this included their trading accounts—thus they could defer recognition of losses. The large changes in the value of banks’ securities portfolios following the onset of the crisis resulted in significant changes in their market value, but the adjustment to book values arising from marking to market was not properly accounted for. The true soundness of certain banks was thus not readily apparent.

  • Transparency. Although banks listed in the stock exchange were required to disclose their balance sheets publicly on a quarterly basis, no information was provided on the level of non-performing loans, classified assets, and loan-loss provisions, for instance. Unlisted banks were under no obligation to disclose their financial accounts to the public. External audits of banks were not integrated into the supervisory process, as external auditors were not under an obligation to report materially adverse factors and events to banking supervisors.

  • Consolidated supervision. The Bangko Sentral ng Pilipinas did not address bank solvency on a consolidated basis, nor did it consolidate the banks’ trust activities with on-balance sheet activities to determine capital adequacy. It also did not attempt to consolidate foreign currency exposures between banks and their affiliated foreign currency deposit units in determining compliance with prevailing regulatory limits.

Effectiveness of supervision

Although some improvements took place during the years prior to the beginning of the Asian crisis, supervisory practices in general remained weak.

  • On-site examinations. The on-site examination process was not oriented toward an analytic approach that would allow an assessment of risk at the bank level and of the systems used by banks to manage risk.127 Rather, it was heavily weighted toward the examination of asset quality and compliance with laws, rules, and regulations. Moreover, bank solvency was assessed on an unconsolidated basis. Finally, the scheduling of on-site bank examinations was too constrained. On-site examinations were undertaken on an annual basis, and additional examinations required Monetary Board approval. Bank secrecy legislation prevented supervisors from accessing disaggregated loan information, preventing assessments of risk concentration.

  • Off-site monitoring. The approaches used for offsite monitoring were not well-suited to evaluate the financial condition of the institutions. The CAMEL system excluded sensitivity analysis for market risk. The individual component ratings were applied mechanistically with no role for the supervisor’s judgment; in addition, to determining the overall CAMEL rating of a bank, the supervisors normally averaged the individual component ratings; as a result, it was possible for an insolvent bank to be evaluated as “good.”

Enforcement capacity

Even though the supervisory authorities generally received good compliance from banks on routine requests, their ability to require banks to adopt actions to correct problems was limited. Furthermore, penalties for noncompliance with norms and regulations were low, and there was inadequate protection for supervisors against lawsuits related to actions taken in the course of their official duties. There were also no mandatory administrative actions to be triggered when a bank’s financial condition deteriorated beyond certain preestablished limits.

Framework for bank exit

The framework for bank closures was time-consuming. If the Monetary Board deemed that a troubled bank could not be rehabilitated, it would be closed and placed under Philippine Deposit Insurance Corporation (PDIC) receivership. However, there were no specific time limits for the Monetary Board to take such a decision. The PDIC had to determine within a maximum of 90 days whether to rehabilitate or close the bank; it was limited in its role as a receiver since it could not dispose of assets of a bank in receivership until the bank was closed. Even worse, the Secrecy of Bank Deposits law prevented the PDIC from gaining access to information regarding the liabilities covered by deposit insurance before it was named as receiver of the bank. All local currency bank deposits are insured up to 100,000 pesos. The actual liquidation of a bank may take several years to complete under the current system, reflecting inadequacies in the judicial system. Moreover, even when fully under way, in some cases the courts have ordered the authorities to reverse their decision and reopen a bank. Since supervisors, as well as the management and board of the Bangko Sentral ng Pilipinas, do not have explicit immunity from prosecution (although such immunity has been proposed in legislation pending before Congress), an overruling by the judiciary has had a chilling effect on the Bangko Sentral ng Pilipinas’s willingness to act.

The process of closing down a bank has been complicated further by the fact that the Bangko Sentral ng Pilipinas may incur financial losses. Such losses may arise from uncollateralized overdraft lending to a troubled bank; the inability by the Bangko Sentral ng Pilipinas to realize the collateral backing emergency loans to banks (in part owing to valuation problems); and the fact that, in the event it runs out of resources, the PDIC can borrow from the Bangko Sentral ng Pilipinas.

Avoiding a Crisis and Bolstering the Financial Sector

The Philippine authorities adopted a financial sector reform program in early 1998 aimed at strengthening the banks’ capacity to withstand shocks, enhancing the prudential and supervisory framework, and encouraging market-based consolidation in the banking sector. Minimum capital and loan-loss provisioning requirements were tightened, regulatory standards in a number of areas were brought closer in line with international best practice standards, the focus of bank supervision was reoriented toward the analysis of risk, and bank exit policies were strengthened. The main provisions of the financial sector reform program include the following.128

Bank Capital Requirements

Minimum capital requirements for banks would be raised through the end of 2000, with intermediate minimum levels for the end of 1998 and the end of 1999.129 At the same time, the lower capital adequacy requirement of 8 percent (instead of the usual 10 percent) that was allowed for certain universal banks was phased out in January 1999. The larger banks have not encountered problems in meeting the new minimum capital requirements. Several entities among the other groups of financial institutions have encountered more problems meeting the new requirements. The authorities have addressed the more severe cases by stimulating mergers, signing memoranda of understanding with the Bangko Sentral ng Pilipinas, and setting a clear timetable for compliance or applying the policies contained in the matrices of sanctions and prompt corrective action approved recently by the Monetary Board.

Loan-Loss Provisions

Banks are now required to make a general loan-loss provision of 2 percent and specific loan-loss provisions of 5 percent for loans especially mentioned and 25 percent for secured substandard loans. The new specific provisions had to be met by April 1999 and the general provision by October 1999. To avoid an undue restriction of credit growth, the Bangko Sentral ng Pilipinas in early April 1999 temporarily freed any net increase of bank lending above the March 1999 level from the general provisioning requirement. Most institutions are complying with these new regulations. For those that are not, especially thrift and rural banks, the sanctions outlined in the newly instituted policy of prompt and graduated corrective actions, such as restrictions on branching and payment of dividends, are applied.

Marking to Market

The Bangko Sentral ng Pilipinas has required banks to start marking to market their trading securities portfolio. Accounting standards have been agreed upon with the Bankers Association of the Philippines, and the relevant price benchmarks have been discussed with market operators.

Transparency and Disclosure

To enhance transparency and market discipline, the Bangko Sentral ng Pilipinas instructed all banks listed in the Philippine Stock Exchange to disclose publicly, as of December 1998, detailed information on a quarterly basis, including the level of nonperforming loans and the ratio of nonperforming loans to the total loan portfolio, the amount of classified assets and other risk assets, and the extent of specific and general loan-loss reserves.

Consolidated Supervision

The authorities have started to supervise financial conglomerates in a consolidated fashion. Since legislative changes are needed to fully impose consolidated capital requirements and extend consolidated supervision of financial institutions to include their interests in nonfinancial ventures, the authorities have proposed an amendment of the General Banking Act in this regard. The amendment is currently under consideration by Congress. The Bangko Sentral ng Pilipinas has already begun to consolidate limits on foreign currency exposures between banks and their affiliated foreign currency deposit units.

Bank Licensing

Stricter licensing guidelines for establishing banks have been in place since July 1998, focusing on the three additional requirements: the submission of the statement of income and expenses for the last three years for each of the subscribers; evidence of asset ownership; and in the case of a foreign bank, certification by the home supervisory authority that it agrees with the proposed investment.

Supervisory Methods

The Bangko Sentral ng Pilipinas has changed the focus of its supervision activities from a purely compliance-based and checklist-driven assessment of banks’ condition to a forward-looking and risk-based framework. Together with the change in emphasis towards a risk-based approach, significant improvements have taken place in the area of rating methodologies. The CAMEL rating system has been revised to ensure that the composite rating will never be better than the bank’s individual factor rating for capital adequacy. As of July 1998, “sensitivity to market risk” (“S”) was added to arrive at a CAMELS rating system, and the composite rating system will be based on the weighted sum of the component ratings, with each component assigned a different weight depending on the size, complexity of activities, and risk profile of the institution being rated.

The Role of External Auditors

External auditors of banks have been required, since the end of September 1998, to report to the Bangko Sentral ng Pilipinas all matters that could adversely affect the financial condition of their clients, any serious irregularity that may jeopardize the interests of depositors and creditors, and any losses incurred that substantially reduce the bank’s capital. Noncompliance by auditors with this requirement will lead to loss of accreditation.

Bank Resolution

The authorities also addressed problems in the recognition and resolution of weak banks:

  • Intensified bank monitoring. The Bangko Sentral ng Pilipinas has adopted a program of intensified monitoring of selected banks and is conducting special examinations of banks without specific previous authorization on the basis of a regularly updated list of banks in potential distress, which it started to compile based on forward- and backward-looking indicators in early 1998.

  • Bank receivership. The authorities have agreed to adopt two measures to improve the ability of PDIC to act as the receiver of banks, including selling assets of distressed banks to pay for the administration costs related to receivership, and faster approval by the Monetary Board of a proposed liquidation.

  • Prompt corrective action for bank capital shortfalls. The Bangko Sentral ng Pilipinas has adopted explicit procedures to be used when banks fail to reach certain thresholds of capital adequacy. In particular, the authorities have issued a matrix of sanctions and of graduated corrective actions to be taken according to the degree of capital shortfall and noncompliance with other prudential norms.

  • Measures to reduce Bangko Sentral ng Pilipinas financial losses. The Philippine authorities have taken several steps to reduce the financial risk for the Bangko Sentral ng Pilipinas associated with assistance to banks in distress. A sampling includes stopping the distribution of dividends, imposing certain obligations on the banks’ owners and officers, and eliminating uncollateralized overdrafts.

Bank Restructuring

Measures in the area of bank restructuring are currently limited to the privatization of the remaining government stake in the Philippine National Bank and the announcement of merger incentives:

  • An important element of the authorities’ strategy to enhance the overall soundness of the banking system is to strengthen the financial performance of Philippine National Bank, the second largest bank in the country in terms of assets. Philippine National Bank’s financial performance has deteriorated significantly due to the effects of the current regional crisis. In early 1999, the bank retroactively recognized the impairment of its assets and wrote down its capital accordingly. Philippine National Bank’s risk-weighted capital fell below regulatory norms, although it continued to meet the minimum capital requirement. The authorities intend to privatize their remaining holdings of the bank stock by mid-2000.

  • The Monetary Board has granted additional incentives for banks considering the option of merging if otherwise unable to comply with the new minimum capital and provisioning requirements. The merged bank would in general be allowed time to comply with specific rules and regulations.

Linkages with Corporate Sector Reforms

Philippine companies have been affected by the regional crisis to a lesser degree than those in neighboring countries, in part because of their lower exposure to foreign debt and better corporate performance. However, there is a concentrated ownership structure in the corporate sector as well as the cross shareholdings between banks and corporations. The authorities’ structural reform agenda includes some measures to strengthen the corporate sector, including a strengthening of the institutional capacity of the Securities and Exchange Commission to deal with distressed corporations while protecting the contractual rights of creditors. The new emphasis on risk-based bank supervision methods as well as the more rigorous disclosure requirements for banks will also provide an early warning system of corporate distress.

Impact of the Regional Crisis on Bank Performance

In spite of early measures to avoid a wider banking crisis, the banking sector underwent a period of increased stress. The developments include the following:

  • Activity in the banking sector decelerated. In the first half of 1998, total deposits expanded merely by 5 percent, and the stock of outstanding loans contracted by over 2 percent. The financial crisis seemed to have prompted a more conservative attitude on the part of the banks while noticeably slowing the demand for credit. At the same time, banks started to scale down their expansion programs to ensure compliance with new minimum capital and loan-loss provisioning requirements that became effective in the fourth quarter of 1998.

  • Foreign currency deposits contracted, falling by 17 percent between June 1997 and June 1998. Most of the Philippine banking sector’s foreign currency liability exposure is to domestic residents, which may make it less vulnerable to capital flight than in other Asian countries. Nonresidents’ deposits grew by 70 percent a year during 1994–97 and continued growing in the first half of 1998, but still accounted for less than 25 percent of total foreign currency deposits by June 1998.

  • The decline in the banking sector’s capital adequacy requirements prior to the crisis has been reversed; it reached 17.6 percent at the end of 1998.130 On average, all classes of banks enjoyed healthy capital adequacy ratios; among large banks, all except one have a capital adequacy ratio well in excess of 10 percent. The improvement in the level of capital adequacy ratios reflected a slowdown in banks’ asset growth, a shift in asset composition from loans to investment in government paper, and other zero risk-weighted assets, as well as the new minimum capital requirements.

  • Nevertheless, asset quality deteriorated. The rapid increase in the ratio of nonperforming loans to total loans since mid-1997 is an important indicator of the growing problems in the banking sector. The officially reported overall nonperforming loan ratio reached 14 percent by mid-1999, compared to 4 percent in June 1997. The nonperforming loan ratio is much higher among thrift banks and rural banks than it is among commercial banks.

  • Bank earnings fell, reflecting a general slowdown in the business environment and the need to constitute the new loan-loss provisioning requirements. The envisaged tax deductibility of loan-loss provisions was not implemented as scheduled, hence the after-tax profit of banks was much weaker than expected, making it more difficult for some smaller banks to comply with minimum capital requirements. For the banking system as a whole, the average return on equity declined to 1 percent by the end of 1998, from 1.7 percent in 1997, and an average of over 2.3 percent from 1990 to 1996.

  • Bank failures. Since the start of the current difficulties, one small commercial bank, seven thrift banks, and 18 rural banks have failed. Their combined assets amounted to less than 1 percent of total assets.

Unlike the crisis countries, however, the structure of the financial system has seen little change: one small commercial bank was closed and several others are in talks to merge.l3l Reflecting the lesser problems in the financial system, no public funds have been needed for financial sector restructuring, except for liquidity support provided to the one small commercial bank that was subsequently closed.

Appendix V Thailand

The floating of the Thai baht on July 2, 1997 triggered a deep macroeconomic and financial sector crisis,132 Thailand was not only the first among the crisis countries, but the first to enter into a stabilization program supported by the IMF.


Macroeconomic Setting

Under the framework of a pegged exchange rate regime, Thailand had enjoyed a decade of robust growth performance, but by late 1996 pressures on the baht emerged. Pressure increased through the first half of 1997 amidst an unsustainable current account deficit, a significant appreciation of the real effective exchange rate, rising short-term foreign debt, a deteriorating fiscal balance, and increasingly visible financial sector weaknesses.

Following mounting exchange rate pressures and ineffective interventions to alleviate these pressures, the baht was floated on July 2, 1997.133 In light of weak supportive policies, the baht depreciated by 20 percent against the U.S. dollar in July. To arrest the pressure, Thailand, on August 20, 1997, entered into a three-year Stand-By Arrangement with the IMF, augmented with funds from the World Bank, the Asian Development Bank, Japan, and other countries. Key policy measures of the program included steps to restructure the financial sector, such as fiscal adjustment and the continuation of a floating exchange rate system.

As the crisis spread to other Asian countries and the sentiment of investors toward the region remained shaky, rollover ratios of short-term debt declined and the baht continued to depreciate. Economic activity also declined, as investment, consumption, and export demand fell sharply. The increasing lack of confidence in the government’s ability to manage the situation culminated in a change of government in November 1997. After a significant strengthening of the economic program there was, starting in early 1998, a gradual return of confidence, which was reflected in a firming exchange rate, although real output continued to decline.

To support the exchange rate, monetary policy was initially tight, resulting in relatively high money market rates. In March 1998, this was combined with a more accommodative fiscal stance to allow automatic stabilizers to work. By mid-1998, with a deeper recession than expected and a marked strengthening of the baht, monetary policy was eased and interest rates were gradually lowered. By early 1999, the exchange rate had stabilized and money market interest rates stood below precrisis levels. Growth for 1999 is now projected to be positive, albeit small. Notwithstanding considerable progress in financial sector restructuring, and an improved market sentiment, significant downside risks to economic recovery remain.

Characteristics of the Financial Sector

As of December 1996, the financial system in Thailand consisted of 15 domestic commercial banks, 14 branches of foreign banks, 19 foreign banks established under Bangkok International Banking Facilities, 91 finance and securities companies, 7 specialized state-owned banks, some 4,000 savings and agricultural cooperatives, 15 insurance companies, approximately 880 private provident funds, and 8 mutual fund management companies. Total assets of the system amounted to 8.9 trillion baht (190 percent of GDP), of which the commercial banks alone accounted for 64 percent (121 percent of GDP), finance companies for 20 percent (39 percent of GDP), and specialized state banks for 10 percent (8 percent of GDP). One large commercial bank and two finance companies were majority state-owned.

In an effort to make Bangkok an international finance center that could compete with Hong Kong and Singapore, the Bangkok International Banking Facilities was established in 1993 to formalize offshore banking business in Thailand. Bangkok International Banking Facilities’ operations mainly involved borrowing in foreign currencies from abroad and on-lending the funds locally and conducting international trade financing. As an incentive for development, the Bangkok International Banking Facilities benefited from a number of tax exemptions. As of December 1996, 45 financial institutions held licenses to operate offshore banking businesses, of which 15 were Thai commercial banks, 11 foreign bank branches already operating in Thailand, and 19 other foreign banks.

Precrisis Weaknesses in the Financial System

Structural Vulnerabilities

In response to banking sector weaknesses in the 1980s, the Thai authorities had initiated reform measures, including the creation of the Financial Institutions Development Fund, a separate legal entity within the Bank of Thailand with a mandate to restructure, develop, and provide financial support (liquidity and solvency) to financial institutions. Notwithstanding these and other reform efforts, the authorities failed to properly manage the risks in the rapidly growing banking system. Structural weaknesses that, in conjunction with the macroeconomic developments outlined above, led to the emergence of a full-blown banking crisis included:

  • The quality of loan portfolios in banks and finance companies was weak. In banks, nonperforming loans (more than six months’ overdue) were 7.2 percent of total loans at the end of 1995, and increased to 11.6 percent in May 1997. In finance companies, nonperforming loans also increased sharply over the first few months of 1997 (from 6 percent at the end of 1996 to 12 percent in May 1997). Given the weak accounting standards, market analysts believed the figures were too low, and estimated nonperforming loans to be at least 15 percent of total loans for banks, and at least twice as high in finance companies. Most finance companies’ assets were related to real estate.

  • Banks and finance companies had not put aside sufficient reserves for their rapidly deteriorating loan portfolios. There was, for example, no provisioning requirement for substandard loans: loan classification and loss provisioning was only tightened in March 1997.134

Weaknesses in Prudential Regulation and Supervision

The structural weaknesses resulted, in part, from weaknesses both in the content and the implementation of prudential regulations. The main weaknesses were:

  • The rules for loan classification, provisioning, and accounting were inadequate and were applied inconsistently. Thus, the reported capital adequacy ratios were grossly misleading since loans were not appropriately classified and provisioned for. For example, financial institutions had built up large loan portfolios of increasingly questionable quality, secured by generally overvalued asset collateral. These loans were often simply restructured (“evergreened”) when payment problems arose and not reclassified.

  • Interest on nonperforming loans continued to accrue and, hence, significantly overstated financial sector earnings. This had made it possible to pay dividends, bonuses, and taxes on nonexistent profits, effectively decapitalizing these institutions.

  • There were no prudential limits on loan concentration. In the absence of such restrictions, banks built up excessive exposure to particular sectors such as the property market. There was also excessive lending based on collateral rather than proper credit assessment; thus, when the asset price bubble burst, banks faced rapid declines in the value of their collateral.

  • The prudential framework was generally weak and fragmented. The ministry of finance was charged with the overall authority for supervision of banks and finance companies, but had delegated the day-to-day responsibility for supervision to the Bank of Thailand. The ministry of finance had authority to grant, suspend, and revoke banking licenses and to intervene in banks and finance companies through a control committee for each institution. Liquidation of financial institutions was under ministry of finance authority and was subject to the bankruptcy act for nonfinancial corporations.

Impact of the Crisis and Initial Resolution Measures

The Crisis in Finance Companies

Finance companies had disproportionately the largest exposure to the property sector and were the first institutions affected by the economic downturn. Much of the later spillover to other institutions, in particular to the banking sector, was triggered by the failure of the initial measures to stabilize this sector.

Financial sector restructuring was initiated on March 3, 1997, when the Bank of Thailand and the ministry of finance announced that 10 as yet unnamed finance companies had asset quality problems and insufficient liquidity, and would need to increase capital to cover weak real estate loans and finance growth. According to the announcement, there was to be a tight deadline for the increase in capital—the shortest period of time allowed in the law—and, if the finance companies were unable to raise capital, they would have to sell their shares to the Financial Institutions Development Fund. The Financial Institutions Development Fund would therefore effectively take over the finance company. The public was also assured that, apart from the 10 institutions mentioned, all other financial institutions could increase capital through their own efforts.

In the period from March to late June, the Bank of Thailand—in absolute secrecy—provided liquidity support at below market interest rates to 66 finance companies. There was also liquidity support to two banks.135 A small part of the liquidity was provided from the Financial Institutions Development Fund’s own accumulated reserves, some through Financial Institutions Development Fund borrowing in the overnight repo market, and the remainder was financed through Financial Institutions Development Fund bonds, which were purchased by the Bank of Thailand.

To stop the liquidity drain, on June 29, 1997, the Bank of Thailand suspended for 30 days the operations of 16 finance companies, including 7 of the 10 “initially targeted” institutions, based on their capital inadequacy and the need for liquidity. These 16 companies were required to submit rehabilitation plans to the Bank of Thailand by July 11. Companies that failed to submit plans, or whose plans were rejected by the Bank of Thailand/ministry of finance, would have their licenses revoked and be absorbed by Krung Thai Thanakit, a majority government-owned finance company. In addition, four other identified “core” finance companies were invited to play a role in absorbing some of the suspended companies. The government also announced that it:

  • would not suspend any more finance companies beyond the 16 already suspended; and

  • would guarantee all domestic and foreign depositors and creditors, of all finance companies other than those suspended.

However, these measures failed to calm the markets, mainly because there was increasing uncertainty over the exact extent of the guarantees due to inconsistencies in official statements. With inconsistencies among the different announcements unresolved, official assurances raised rather than reduced the market’s apprehension.

Design of Initial Resolution Efforts

After the peg of the baht was abandoned on July 2, 1997, the rapidly depreciating exchange rate and falling property values led to major deterioration of banks’ loan portfolios. This raised concerns about the solvency of the entire financial system. Estimates undertaken by an IMF advisory mission in mid-July 1997, based on rough assumptions of the level of problem loans and recovery rates, suggested that by mid-1997, some 500 billion baht ($17 billion or 9 percent of projected 1997 GDP) would be required to restore the legally required minimum capital adequacy of banks and finance companies. The “hole” was estimated to be about 270 billion baht ($9 billion) in banks and 230 billion baht ($8 billion) in finance companies. These aggregate figures indicated that many, if not most, of Thailand’s 91 finance companies were insolvent, while banks as a group were solvent, but undercapitalized. In the absence of detailed supervisory information on individual institutions, there was an expectation that the five largest banks (representing about two-thirds of the banking system) were among the strongest in the system, so that several of the small- and medium-seized banks most likely were insolvent.

At this stage, the authorities developed a strategy to restructure the financial system in cooperation with the IMF. The strategy was based on three steps:

  • exit of all nonviable financial institutions;

  • issuance of a temporary blanket guarantee protecting all depositors and creditors in the remaining financial institutions, so as to calm the market and give the authorities sufficient time for restructuring measures; and

  • restructuring and rehabilitating of the Thai financial system to raise to international standards.

  • The strategy depended on the implementation of a range of supporting measures, in particular:

  • macroeconomic policies that restored fiscal and monetary control;

  • establishment of the FRA to replace the Bank of Thailand and the ministry of finance temporarily as decisionmaker on all matters related to financial sector restructuring; and

  • announcement of a consistent and comprehensive medium-term restructuring strategy, to be explained to the public through a professionally managed information campaign.


On August 5, 1997, the ministry of finance and the Bank of Thailand issued a joint statement announcing measures to be taken to strengthen confidence in the financial system. The implementation of the program to a large extent followed the steps just outlined. The policy framework was built on the separation of finance companies facing actual or imminent insolvency from those that were judged to be viable, based on the following three criteria: (1) magnitude of liquidity support (borrowing from Financial Institutions Development Fund); (2) deterioration of capital; and (3) the size of nonperforming loans.

Finance companies deemed to be facing actual or imminent insolvency were suspended and given 60 days to complete due diligence and present a rehabilitation plan to the Committee on Supervision of Merger or Transfer.136 In all, 58 finance companies out of 91 had their operation suspended, including the 16 finance companies suspended earlier. At this stage, the authorities decided not to take any action against commercial banks, even though there were signs that at least two small banks faced serious weaknesses.

A government guarantee for depositors and creditors in all remaining finance companies and banks was announced, and the conditions were spelled out in a joint press release by the ministry of finance and the Bank of Thailand.137 However, there were major uncertainties surrounding the guarantee, including whether it would be legal for the Bank of Thailand to provide the liquidity to honor the guarantee. Shareholders and holders of subordinated debt were not covered by the guarantee.

There were delays in initiating some of the announced restructuring measures. The magnitude of the problems, along with interagency issues of coordination and political problems, all took time to resolve, delaying the implementation of necessary policies. The committee managing the process was reorganized, and only by late September were instructions issued to the suspended companies on what information they had to submit, and which criteria had to be met before they would be allowed to resume operations.

The government through its actions made clear that it stood fully behind the Bank of Thailand. To support the restructuring/rehabilitation process, emergency decrees were passed on October 24, 1997 to: (1) establish the FRA to deal with the suspended finance companies; (2) amend the Commercial Banking Act and the Finance Company Act so as to empower the Bank of Thailand to request capital reductions, capital increases, or changes in management in troubled commercial banks and finance companies; (3) establish an asset management company to deal with assets of the 58 finance companies that had their operations suspended, or impaired assets in any financial institution in which the Financial Institutions Development Fund had acquired shares (intervened) and assumed management control; and (4) amend the Bank of Thailand Act to empower the Financial Institutions Development Fund to lend to these institutions with or without collateral, raise the fee charged to financial institutions whose depositors and creditors were protected, and make explicit the government’s financial support of the Bank of Thailand (thus making the guarantee more credible).

The finance companies were given until the end of October 1997 to submit their rehabilitation plans to the FRA, which in turn had one month to assess the rehabilitation plans submitted and to make a recommendation to the ministry of finance on how many finance companies should be allowed to resume their operations. With the assistance of private consultants, the FRA refined its analysis to allow thorough technical consideration of the rehabilitation plans based on uniform criteria.

On December 8, 1997 the FRA and the ministry of finance announced the permanent closure of 56 finance companies. Only two companies were allowed to reopen, subject to the stipulated new capital being paid in. The fact that various politically attractive but financially dubious merger proposals had been rejected was a sign of the integrity of the analysis.138 Immediately after the decision to close the 56 companies, the focus of the FRA shifted to managing their assets, in order to prevent a further deterioration in asset quality prior to disposition.

Banking Sector Issues

Magnitude of the problem

Initial crisis resolution had focused solely on finance companies, but it soon became evident that banks also faced problems and that the public had started to lose confidence in the banks, Banks’ asset quality was deteriorating rapidly, and many banks experienced deposit withdrawals and reduced rollover rates for external credit lines; these were facilitated through liquidity support from the Financial Institutions Development Fund/Bank of Thailand. Seven out of the 15 commercial banks were facing such severe liquidity problems that they needed liquidity support from the Financial Institutions Development Fund more or less on a daily basis. The deposit withdrawals represented a flight from private banks perceived to be weak into larger stronger domestic banks, branches of foreign banks, and state-owned specialized banks.

Based on Bank of Thailand data as of the end of June 1997, assessments of the financial condition of Thai banks were made. These assessments indicated that all banks had a capital shortfall (that is, a capital adequacy ratio below 8.5 percent); the shortfall amounted to roughly 400 billion baht if international best practices were to be applied, and approximately 250 billion baht on the less stringent Bank of Thailand criteria.

Resolution principles

On October 14, the authorities announced their strategy for dealing with the banking sector, based on the following principles:

  • All banks were required to adjust (first write down and then increase) capital in order to absorb the losses that had already occurred. They had to meet the new and more stringent rules on loan classification and provisioning that would shortly be issued by the Bank of Thailand;

  • None of the banks was allowed to pay dividends for the remaining part of 1997 or during 1998;

  • The Bank of Thailand was to initiate discussions with each individual bank on how the bank would be recapitalized. Following such discussion, banks were required to present recapitalization plans to the Bank of Thailand;

  • The requested capital would have to be injected at the latest during the first quarter of 1998;

  • If a bank could not raise the capital requested within the time given, the Bank of Thailand would have the right to demand a memorandum of understanding with the bank that would give existing owners additional time to provide the capital, as long as they could furnish the Bank of Thailand with viable, legally binding, plans for recapitalization;

  • Banks were encouraged to try to find foreign partners since it was unlikely they could raise all the capital needed in Thailand;

  • For banks that could not raise the capital, losses would be written off against capital, ensuring that existing shareholders lose their stake, with the exception of a token position that had to be kept for legal reasons. The Financial Institutions Development Fund would then take control of the banks, recapitalize them and later privatize them (by selling them to domestic or foreign investors) or merge them with another bank; and

  • The strategy clearly stated that no bank would be closed and that depositors and creditors would be fully protected by the government guarantee.

Banking sector intervention

The Bank of Thailand was initially reluctant to intervene in banks since it feared that interventions could cause a run on the whole banking system and severely deepen the crisis. With the October 1997 amendments to the Commercial Banking Act, the Bank of Thailand was given specific powers to write down capital and change management in troubled commercial banks. Based on these new powers on December 31, 1997, the Bank of Thailand intervened in a medium-sized bank, Bangkok Metropolitan Bank: management was changed, and the Bangkok Metropolitan Bank was told that if capital had not been raised within roughly three weeks, the Bank of Thailand would order the bank to reduce its capital and have the Financial Institutions Development Fund recapitalize it. In the following month, the Bank of Thailand intervened in two more small-or medium-sized banks—First Bangkok City Bank and Siam City Bank. These three banks represented 10 percent of banking system deposits. In mid-May, the Bank of Thailand intervened in seven finance companies; the government thus had become the owner of six banks and nine finance companies, which accounted for roughly one-third of total deposits.139

The authorities hired a financial advisor to assist them with developing a strategy to deal with the three banks mentioned above and with Bangkok Bank of Commerce. This financial advisor worked out an initial proposal for the banks to be absorbed by either domestic or foreign banks. Meanwhile, in the course of 1998, these banks’ assets continuously deteriorated to the point where nonperforming loans were approaching 70–85 percent in each bank. Although clearly increasingly insolvent, no decision was made on how to proceed, since more problems were emerging and there was an urgent need for the authorities to work out a comprehensive plan on how to address other outstanding weaknesses in the financial sector.

Toward a Comprehensive and Viable Financial Sector

The above measures primarily addressed the immediate liquidity and solvency problems. There was also a need for a strategy to strengthen the remaining viable financial institutions. Consequently an effort was made to focus on the longer run and more strategic needs for supporting a sustainable financial sector. Measures included revamping the prudential framework, and taking steps to restructure the sector.

Improved Prudential Framework

Following failed attempts to tighten prudential rules in early 1997, the severity of the crisis helped focus attention on a fundamental revamping of the prudential framework. The strategy was to maintain the capital adequacy requirement of 8.5 percent for banks and 8.0 percent for finance companies, but allow gradualism in building up loan-loss provisions according to a fully transparent timetable. There was to be an immediate tightening of loan classification and interest suspension rules, while provisioning requirements were to be increased every six months to bring them fully into line with international best practices by the end of 2000. This phasing was thought necessary to give the banking industry the required time to adjust and raise the new capital.

New loan classification, loss provisioning, and interest suspension rules were issued on March 31, 1998. Loans had to be classified into five categories, and strict rules on interest accrual were established. The new loan-loss provisioning requirements were gradually tightened by 20 percent every six months starting July 1, 1998, thus making it possible for the requirements to be fully implemented by the end of 2000. A new regulation was also issued on the valuation of collateral for loans above a certain size; it must now be independently appraised. Finally, to set clear incentives for banks and finance companies to actively initiate restructuring of nonperforming loans, rules for how restructured loans should be classified and provisioned for were defined in regulations for debt restructuring.140

A Comprehensive Plan for Financial Sector Restructuring

By mid-1998, the depth of the economic and financial sector crises raised doubts whether the measures described above, combined with the strengthening of prudential rules, would be sufficient to create the necessary private sector recapitalization and efficient restructuring of the sector. In particular, the deteriorating domestic and regional economic environment, and the associated decline in asset quality, had introduced uncertainties about the effectiveness of the market-based and private-sector-led restructuring of Thailand’s financial system. While several private banks, including the two largest, had been able to secure injections of private capital in early 1998, and a controlling share in a small bank had been acquired by a foreign strategic investor, their success had not been widely shared, and it was doubtful whether the banking system would be in a condition to support the government’s efforts to secure economic recovery.141

Hence, on August 14, 1998 the government announced a comprehensive financial sector restructuring package to address the remaining weaknesses in the financial sector. The augmented restructuring strategy focused on the following elements:

  • creation of a high-level financial restructuring advisory committee (FRAC) to advise the minister of finance and the governor of the Bank of Thailand;

  • the commitment of public funds to assist in the recapitalization of viable banks and finance companies;

  • incentives for accelerating corporate debt restructuring at an equal rate with recapitalization;

  • the efficient management of nonperforming assets;

  • the exit, merger, or sale of nonviable commercial banks and finance companies;

  • equitable loss-sharing arrangements and containment of public sector costs;

  • the strengthening of prudential supervision and an accelerated adoption of international best practices;

  • operational restructuring of state banks and their preparation for eventual privatization; and

  • Bank of Thailand intervention in remaining nonviable institutions.

Commitment of Funds Through Capital Support Facilities

The objective of the package was to restore and maintain the solvency and credibility of the Thai financial system. The government recognized that the terms and conditions of any public support facility should be transparent and subject to the strongest possible safeguards, while facilitating the restructuring and consolidation of financial institutions and protecting the economy from further weakening. Two schemes were designed to assist with the recapitalization of the viable financial institutions. The first aimed at catalyzing new private Tier 1 capital. The second provided financial resources and incentives to accelerate corporate debt restructuring and encourage new lending through the provision of Tier 2 capital (Box 18).

Thailand: Capital Support Facilities

These capital support facilities apply to banks and finance companies incorporated in Thailand and deemed viable by the Bank of Thailand.

Tier 1 capital. Under this facility, the government matches capital injected by private investors (including existing shareholders). Any institution that enters the scheme is required to make full provisions upfront, in line with Bank of Thailand’s end-2000 loan classification and loan-loss provisioning (LCP) rules. Existing shareholders must thus bear all the up-front losses, and the government in making its contribution will rely on due diligence performed by private investors. The Financial Sector Advisory Committee (FRAC) arbitrates on any disputes regarding the magnitude of the write-down of losses. To qualify for support, the institution must present an operational restructuring plan including measures to strengthen internal control and risk management, increase revenues, cut costs, and strengthen internal procedures for dealing with non-performing loans. These plans must be acceptable to the FRAC and the Bank of Thailand. The government will provide the capital injection in the form of equity paid up with 10-year, tradable government bonds carrying a market-related interest rate. The new government/private capital injections would have preferred status over existing shareholders. The government and the new investors have the right to change the board of directors and management of the institution. The government also reserves the right to appoint board member (s) according to the size of its equity holding, and has the right of nominating at least one board member even if this is not warranted by the size of its equity share.

Tier 2 capital. This scheme is set up to encourage corporate restructuring. At the end of each quarter, the institutions can apply to the FRAC for government injection of Tier 2 capital by reporting any debt-restructuring agreement, the original loan contract, and evidence that the borrower had been able to service the loan. The amount of Tier 2 capital provided is set at a minimum equal to the total write-down exceeding previous provisioning or 20 percent of the net increase in lending to the private sector. Each institution is eligible to receive a maximum amount of Tier 2 capital injection equal to 2 percent of risk-weighted assets. Within this limit, the amount of Tier 2 capital injection for new lending to the private sector cannot exceed 1 percent of risk-weighted assets. Also, no single debt restructuring agreement is eligible for more than 10 percent of the amount available to the institution. Institutions that bring forward the end-2000 LCP rules will be allowed to defer the cost of debt restructuring over a period of five years (20 percent per year) while those which choose not to bring forward the end-2000 rules will have to take the costs according to the existing regulation (full loss taken by end-2000). The capital injection will be provided by the government buying debentures issued by the bank with a maturity of 10 years and paid for with nontradable government bonds with matching maturity and carrying market-related interest rates. The rate on debentures is expected to be 1 percentage point higher than that carried by the government bond in order to cover administrative costs for the government.

To facilitate and oversee banks’ efforts to raise capital, at the beginning of every six-month period, the Bank of Thailand makes an assessment of each bank’s provisioning needs, profitability, and growth in assets. It then calculates whether the bank has sufficient capital to meet the required capital adequacy requirement. If a bank falls short of capital, it would be required to present plans on how, what amount, and by when capital would be raised, and those commitments would be formally agreed upon in a memorandum of understanding. Banks that cannot raise capital through their own efforts would be recommended to apply for public support under the Tier 1 scheme. The Bank of Thailand has reserved the right to intervene in any financial institution that fails to meet commitments under their memoranda of understanding.

Facilitating the Establishment of Private Asset Management Companies

Additional arrangements were needed to provide maximum flexibility for financial institutions to deal with their bad assets, while allowing them to restructure their balance sheets. Thus the government devised a plan under which institutions were encouraged to set up, capitalize and fund private asset management companies. Such companies were defined as financial institutions, which allows them to borrow, relend funds to existing customers, and provide full flexibility in setting interest rates. However, asset management companies are not permitted to take deposits. The rules also provide for a transfer of assets from the founding institution to its asset management companies without legal impediments or taxes and fees. According to the rules, asset management companies must be fully consolidated into the founding institutions’ balance sheets, provided the institution owns more than 50 percent of the shares. Two large private banks have announced that they will set up their own private asset management companies, and others are considering doing so.

On August 14, 1998, the Bank of Thailand intervened in all remaining banks and finance companies considered nonviable. This included two more banks, one small- and one medium-sized, and five finance companies. Subsequently, the authorities decided to merge three of the intervened banks into the existing state-owned banks (Krung Thai Bank and Radanasin Banks), and create a new bank (Bank Thai), from the merger of Krung Thai Thanakit, one intervened bank, and the 12 intervened finance companies.

Five banks are now in the process of being privatized and are expected to be privatized by the end of 1999. In July 1999, one additional small bank was intervened. The government is supporting the privatization process through capital injections and by offering stop-loss guarantees and/or profit and loss sharing arrangements to potential new investors. Four of the intervened banks have been closed: one formally through liquidation, and the other three indirectly through mergers with state-owned banks.

Asset Disposal

The FRA has now almost completed the disposal of assets from the 56 closed finance companies. In its first auction, it managed to sell 36 billion baht of assets (hire purchase loans, mortgages, and commercial loans) and in a second auction it sold 28 billion baht of noncore assets (foreclosed assets, repossessed vehicles, equity, and debt instruments). The recovery rate in these two auctions was 47–48 percent. In a third auction in December 1998, FRA offered 370 billion baht ($10 billion) of lower quality business loans, mainly consisting of corporate loans with or without questionable collateral. This auction was less than fully subscribed and obtained far lower prices because of the low quality of the loans. In total, 32 billion baht of assets were sold, with a recovery rate of 37 percent, and an additional 110 billion baht of assets were later allocated to bidders after profit-sharing arrangements had been negotiated guaranteeing a minimum recovery rate of about 20 percent of book value. For the first time, the government asset management company established in late 1997 was allowed to participate in the auction as a bidder of last resort, and it ended up becoming the owner of assets with a book value of 185 billion baht for which it paid about 17 percent. In sum, out of the 860 billion baht in finance company assets managed by the FRA, 206 billion baht have been sold to the private sector and 185 billion baht to the asset management company. Total recovery to FRA is about 96 billion baht or 25 percent of face value; final recovery value will only be known after the outcome of profit sharing arrangements and asset management company liquidations are completed.

Bank Privatization and Resolution

The private sector-led recapitalization of Thai banks has worked well, and all seven of the remaining private banks, have raised sufficient capital for the next 12 months. However, all banks need to raise additional capital before they can have sufficient capital to meet the end-2000 loan classification and provisioning rules.

Of the six state-owned banks, four are in the process of being privatized with the assistance of foreign investment banks. It is expected that the privatization process will be completed this year. The government has made significant efforts to ensure that the process is transparent, and that there are proper profit/loss sharing arrangements in place to ensure a deal can be justified politically. The timetable and strategy for the privatization of the other two state-owned banks is being reconsidered to ensure that the eventual sale of shares in these banks can substantially contribute to reducing the government’s final restructuring costs.

The financial sector in Thailand has been consolidated although only one commercial bank has been closed (Figure 11). The number of domestic commercial banks has declined by two as a result of mergers. The most significant change is with the finance companies—56 were closed and a further 13 (together with five banks) were merged. Some foreign capital has been invested in commercial banks and finance companies, most notably two private domestic banks that now have foreign ownership greater than 50 percent.

Figure 11.
Figure 11.

Thailand: Progress in Financial Sector Restructuring

Source: National authorities; and IMF staff estimates.1 Two of these have greater than 50 percent foreign ownership.Note: As of end of July 1999, one commercial bank and 56 finance companies had been closed. The state had intervened in seven private, domestic commercial banks and in 12 finance companies. Three intervened commercial banks and 12 finance companies had exited through merger. Categories are not mutually exclusive.

Public Cost of Financial Sector Restructuring

As of the end of 1998, the public sector contribution for financial sector restructuring was close to 25 percent of GDP (Table 21). The largest portion of this, 20 percent of GDP, was used for liquidity support; another 8 percent was used for recapitalization.

Table 21.

Thailand: Public Cost for Financial Sector Restructuring

(As of the end of 1998)

article image
Source: National authorities; and IMF staff estimates.


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For simplicity, “bank” and “financial institution” are used interchangeably in this paper. When referring to a specific type of financial institution (e.g., commercial bank, merchant bank), that reference will be used in full.


Nonviable financial institutions are those judged unable to maintain minimum thresholds of liquidity, solvency, and profitability.


This paper does not address the causes of the crisis. Detailed expositions on this subject can be found in Lane and others (1999), International Monetary Fund (1997), and International Monetary Fund (1998). Other studies, such as Furman and Stiglitz (1998), Goldstein (1998), and Radelet and Sachs (1998), have also addressed the subject.


For example, in Thailand, bank lending and borrowing through Bangkok International Banking Facilities received favorable tax treatment, while in the Philippines, banks were subject to lower taxes on onshore income from foreign currency loans compared to that from domestic currency loans.


In Thailand other inflows were 8 percent of GDP in 1996 compared to 3 percent of GDP for direct investment and portfolio inflows; in Indonesia and Korea, other inflows were on average 1 percent of GDP, and direct and portfolio investment 4 percent.


In addition, domestic nominal interest rates were above foreign rates, especially with regard to yen rates.


By mid-1997, total outstanding claims held by foreign banks on domestic residents in the three crisis countries amounted to $232 billion, of which $151 billion was short term. Short-term debt amounted to 20 percent of total foreign debt in Indonesia, 44 percent in Korea, 50 percent in Malaysia, 60 percent in the Philippines, and 30 percent in Thailand. In Indonesia, Korea, and Thailand, the ratio of short-term liabilities to international reserves was above 1; in Malaysia it was 0.6, and in the Philippines it was 0.8 (see also Lane and others, 1999).


In some cases, such clauses would permit the lender to require immediate repayment if a country’s bond or sovereign rating were downgraded.


Data for the end of 1998 for the European Union and the end of 1996 for the other countries. Data for nonbank financial institutions in these countries are not readily available.


Banks had lent substantial amounts in foreign currency to borrowers without secure foreign exchange revenue streams. The corporate sector’s repayment capacity became severely impaired once the currencies started to depreciate, leading to corporate insolvencies and major problems for the banks.


Nonbank financial institutions had become increasingly important compared to commercial banks in Korea and Thailand. This trend has been particularly striking in Korea, where commercial banks’ share of total deposits has fallen from 71 percent in 1980 to 30 percent at the end of 1996 to the benefit of investment trust companies, insurance companies, and other nonbank financial institutions.


There is an argument for less stringent prudential requirements for nonbank financial institutions, insofar as they perform a narrower range of activities. However, these institutions in the Asian crisis countries operated broadly like commercial banks.


Finance companies in Malaysia also faced liquidity shortfalls. There, the government’s policy has been to strengthen the sector through mergers (see Section V).


In comparison, such ratios were about 110 in the United States, 140 in Germany, and 200 in Japan; see the World Bank (1998).


For example, between 1991 and 1996, leverage had doubled in Malaysia and Thailand; see the World Bank (1998).


In addition, in Korea, commercial, development, and merchant banks were regulated and supervised by different agencies, allowing for regulatory arbitrage and making consolidated supervision difficult.


In Korea, the government initially announced a guarantee on foreign debt, but this failed to stem capital outflows, probably because of uncertainty about the legal status of the measure and about the government’s ability to honor it. In Indonesia, the government initially announced a limited deposit guarantee that soon had to be replaced by a blanket guarantee.


See Lane and others (1999) for a more detailed discussion of macroeconomic policies in the crisis countries.


Low levels of public debt meant that there was a lack of government paper—usually a core element of well-developed money markets. In Indonesia, the development of a market for central bank bills had been stunted by the authorities’ failure to allow full market determination of interest rates.


The guarantees were, as a rule, not applied to shareholders and holders of subordinated debt. In Indonesia, insider deposits were not covered by the guarantee. In Thailand, directors’ and related persons’ deposits and/or claims were not covered by the guarantee unless they could prove that these transactions were at “arms length.”


A cabinet decision in July 1997 had already guaranteed the deposits in finance companies. There were two phases in the suspension of these companies. In the first phase, 16 companies were suspended and only depositors were covered by the guarantee. In the second phase, 42 companies were suspended, and both depositors and creditors were covered by the guarantee.


This partial scheme had been planned by the authorities for some time.


No explicit expiration date was announced in Thailand and Malaysia. The Indonesian government extended the guarantee for at least two years, with a six-month notification period before it would be lifted. In Korea, the guarantee would expire by the end of the year 2000.


Subsequently, the guarantee protected the banking system in the weeks following President Suharto’s resignation in May 1998 even though there were further runs on the largest private bank, the owners of which were closely associated with the President, and the rupiah depreciated to its lowest level ever.


Creditors of 16 finance companies suspended in June 1997 were treated more harshly than those of 42 companies suspended in August


In Korea, there is no special contribution to the blanket guarantee as such, but financial institutions must contribute to the insurance fund administered by the Korean Deposit Insurance Company.


For example, four times bank capital was used in Indonesia and three times in Thailand for the suspension of the 58 finance companies.


García-Herrero (1997) discusses the monetary impact of a banking crisis.


For example, in Korea, credit aggregates would have shown a decline in credit over 1998 unless adjustments were made to take into account the large amounts of nonperforming loans being sold to the public asset management company. Monetary aggregates should also be adjusted for the large exchange rate valuation changes.


For a discussion, see Lane and others (1999), in particular Box 6.5, which, based on several empirical studies, concludes that the findings are mixed. Empirical work is presented in Ghosh and Ghosh (1999), who found evidence for a credit crunch in Indonesia (in late 1997), and in Korea and Thailand (from late 1997 to early 1998), although in the latter two countries, credit demand fell so sharply that supply was not a binding constraint. Dollar and Hallward-Driemeier (1998) found that in Thailand, from late 1997 to early 1998, the lack of access to credit was regarded as the least important factor by manufacturing firms as reasons for slowing down output; Ding, Domaç, and Ferri (1998) found evidence for a widespread credit crunch in Thailand, particularly in the first few months of the crisis.


For a discussion of these and related issues, as well as enhancements to the monetary survey to address these weaknesses, see Frécaut and Sidgwick (1998).


Growth in security holdings other than those acquired as part of recapitalization exceeded the growth in loans for Korea, Malaysia, and Thailand during 1998


Some measures that existed before the crisis, such as credit or guarantee facilities for exporters, were augmented.


These policies were components of the Stand-By Arrangement with the IMF, approved in March 1998, and of the Banking Sector Reform Loan with the World Bank, approved in December 1998.


However, the perceived sound fiscal positions concealed the costs of directed credits, liquidity support to banks, and other rapidly increasing government contingency liabilities.


Nonperforming or value-impaired loans or assets are those whose estimated value is below their original book or contractual value.


Valuations should, of course, be based on consistent assumptions regarding key economic variables and on best practice accounting and valuation standards.


Such due diligence valuations typically take three to six months and are preconditions for investors to buy assets or take strategic ownership interests.


These new regulations are discussed in Section VI


Gradualism, as discussed here, differs from prudential forbearance in that the latter refers to the authorities’ providing adhoc exemptions and waivers from prudential norms for individual financial institutions in a nontransparent way.


In principle, showing the actual capital adequacy requirement is more transparent and is in line with international accounting standards.


However, full up-front application of final provisioning rules is required in cases where banks seek public funds to match new private equity contributions.


In Korea and Thailand, this was also done for institutions that had been suspended, to give them a last chance to prove their viability.


In these banks, owners will keep day-to-day control of their banks and have first right of refusal to buy back the government’s stake at the end of three years


The new investor has the option to buy back the government shares within three years at the government’s initial cost plus carrying costs. If after full provisioning, the Tier 1 capital adequacy requirement falls below 2.5 percent, the government will recapitalize the bank up to this level before matching private funds.


A legal restriction has prevented the writing down of subordinated debt except in cases of legal closure and liquidation.


The intervened institutions were insolvent and not in a position to raise capital. Financial Institutions Development Fund took control, recapitalized them, and is preparing them for reprivatization.


In Korea, the bridge bank, a subsidiary of the KDIC, was given a life span of three years and was used only for the good assets of closed merchant banks.


According to the most recently announced merger exercise (July 29, 1999), the domestic commercial banks, finance companies, and merchant banks will be consolidated into six large financial groups.


So far, more than half of the assets of the 56 finance companies have been sold to the private sector and most of the remainder will be sold to the public asset management company that was set up as the residual buyer of all FRA managed assets that could not be sold in the auctions.


This was done to prevent associates of some of the failed banks from setting up private asset management companies, which could have circumvented rules for pricing and prudent governance.


Consolidated accounting needs to ensure that transfers to private asset management companies are not used as an artificial way of cleaning up the banks.


In Korea, the asset management company had to change its criteria for determining the purchasing price, since the purchase prices determined initially appeared to be too high; even after the adjustment the asset management company had no difficulty in getting banks willing to sell assets.


In Indonesia, a significant offset to the cost of restructuring is also likely to come from the disposal of assets pledged by shareholders of failed banks in violation of legal lending limits. IBRA also hopes to secure significant recoveries based on forensic examinations of illegal transactions of some of the failed banks.


Banks’ accounts may continue to show additional losses for some time even if economic conditions improve because the positive effect of recovery on the loan portfolio may be offset by losses from existing loans.


For example, Merrill Lynch estimated recapitalization requirements for commercial banks—just one component of gross costs— at 42 percent for Indonesia, 10 percent for Korea, 11 percent for Malaysia, and 26 percent for Thailand (Merrill Lynch, 1999).


Under special circumstances, governments could decide to issue non-negotiable bonds, for instance to prevent insolvent banks from selling those bonds and investing the proceeds in risky assets (as in Indonesia).


For a discussion of the development of a microstructure for government securities, see Dattels (1997). The importance of smooth functioning money markets for the development of central bank open market operations is discussed in Quintyn (1997).


Public recognition of the size of the crisis was delayed because these economies had for long been viewed as highly successful, and therefore unlikely to face a major crisis.


Banking institutions were given an option of reporting nonperforming loans using either the standard of three months or six months past due. Of the 78 financial institutions, 21 (representing 46 percent of the system’s loans) have retained the three-month nonperforming loan classification criteria.


Korea’s limited deposit insurance scheme, which existed before the crisis, is scheduled to replace the current blanket guarantee as of the end of the year 2000. Thailand did not have a deposit insurance scheme and is now working on the design of such a scheme to be introduced by special legislation.


This appendix draws on a draft by Charles Enoch and Olivier Frécaut.


This discussion excludes 9,200 rural banks, which are limited in the geographical area of operations, may only accept time and saving deposits and extend loans, and hold 1–2 percent of total banking assets. Minimum capital for rural banks is 50 million rupiah.


Five state banks were included in a World Bank rehabilitation project, which at the time imposed limits on their asset growth.


The President’s son, whose Bank Andromeda had been closed on November 1, was allowed to take over the small Alfa Bank, which was immediately granted a foreign exchange license by Bank Indonesia, and to transfer into it most of his former activities, effectively reopening his former bank under a new name.


The blanket guarantee was to last a minimum of two years, and at least six months’ notice would be given before its termination. Subsequently, the guarantee was retroactively applied to the 16 closed banks and thereafter to the 9,200 rural banks.


In the seventh bank, the state-owned Bank Exim, part of the management team was replaced. The bank now has become part of the new Bank Mandiri.


Seventy percent of Bank Central Asia was owned by the Salim Group, the largest conglomerate in the country, and associated with the Suharto government. Thirty percent of the bank was owned by two children of the then President.


Portfolio reviews on a similar basis were conducted by Bank Indonesia supervisors themselves in the case of the smaller, nonforeign exchange banks.


Results of these initial reviews were quickly leaked to the press, causing consternation among the public. Security procedures, and other aspects of conducting the reviews, were tightened substantially in the light of experience with this first “wave.”


Except for the bank being taken over by the foreign bank, where the capital infusion will follow once the foreign bank has completed its due diligence.


This appendix draws on Baliño and Ubide (1999) and on contributions from Peter Hayward and Leslie Teo.


The banks’ trust account business and leasing affiliates were not under the supervision of the Office of Banking Supervision.


In 1970, the trust business was assigned exclusively to Korea Trust Bank, which merged with Seoul Bank in 1976. By the end of 1995, all deposit money banks and development institutions, with the exception of the Korea Export-Import Bank (KEXIM) and foreign banks, were allowed to engage in trust businesses.


There are four specialized banks—the Industrial Bank of Korea and three other banks centered on agricultural, fisheries, and livestock cooperatives. Development banks comprise the Korean Development Bank, KEXIM, and the Long-Term Credit Bank.


Although those bonds did not carry a formal government guarantee, the government was legally obliged to ensure that the banks were always in a position to meet their liabilities when they fell due.


The National Investment Fund was created in 1974 for this purpose, and was funded by the compulsory deposit of savings from pensions, savings and postal savings accounts, and by other purchasers of National Investment Fund bonds, such as life insurers.


The debt ratio of most chaebols exceeded 400 percent during the 1990s, compared with an average of 210 percent in Japan, 150 percent in the United States, and 90 percent in Taiwan, Province of China. Low profits decreased their ability to service this debt; operating cashflow as a percentage of interest payments was only 80 percent in 1996.


At the end of 1997, the 30 largest chaebols accounted for half, and the five largest chaebols for one-third, of the corporate debt outstanding. The top 30 chaebols were responsible for about 30 percent and the top five chaebols for about 18 percent of commercial bank loans at the end of 1997.


Foreign liabilities of domestic financial institutions, including those of overseas subsidiaries and foreign branches, increased from $40 billion at the end of 1993 to $160 billion by the end of September 1997.


There were restrictions on issuance of securities abroad—only corporations that had obtained an international credit rating of BBB and above could undertake such issuance—and on contracting loans at spreads higher than 100 basis points over LIBOR. These regulations strengthened the role of the major Korean banks (whose ratings benefited from implicit government support) as the conduits of external finance to domestic corporations.


International interbank lending to Korea of about $15 billion in 1994 and about $25 billion in 1995–96, to reach a total of $108.5 billion at the end of 1996. Of this amount, about 70 percent had a maturity of less than a year.


Supervisors sometimes allowed only partial application of regulations, such as provisioning requirements, to avoid weakening banks’ earning reports.


Nonperforming loans, as a percentage of total loans, were only 0.8 percent in 1996; however, if “substandard” loans were included, the figure, even using Korean definitions, would have been 4.1 percent


Nonperforming loans are a lagging indicator of the soundness of the banking sector, especially when loans are only classified as nonperforming after having been in arrears six months, rather than the usual three months. A more valid measure is the ratio of dishonored bills and checks, which more than doubled during the same period and increased fivefold in the last quarter of 1997.


One measure of balance sheet deterioration is the shortfall in capital adequacy represented by the amount of funding needed to bring a bank’s ratio of capital to risk-weighted assets to the minimum of 8 percent recommended by the Basel Committee for Banking Supervision. Estimates based on the end of September 1997 balance sheet data showed, under Korean provisioning and loan classification rules, a shortfall of some 11.3 trillion won (3.0 percent of 1997 GDP) for commercial banks, merchant banks, development, and specialized banks.


The bridge bank was financed by the KDIC. In January, it took over the deposits of the suspended merchant banks along with most of their performing assets. After a due diligence process, the value of assets and liabilities transferred was set at 8.7 trillion won and 12.1 trillion won, respectively. Shortly after intervention, depositors were offered cash reimbursement, with households being compensated first, followed by enterprises and financial institutions. As of the end of June 1999, 99 percent of private and institutional depositors had been repaid, as well as all financial institutions’ call money deposits, for a total amount of 9.7 trillion won. A further 4.4 trillion won remains to be repaid, mainly deposits of financial institutions.


The five closed banks had capital adequacy requirements between -4 percent and -11 percent at the end of March and a negative net worth totaling 920 billion won (representing 7 percent of total assets of the banking sector).


One small bank was given conditional approval despite receiving a negative evaluation from the Evaluation Committee because the Korean legislation did not allow for the closure of a bank with positive net worth. This legislation was amended in August 1998.


One ITC subsequently converted into an investment trust management company.


The “London Approach” is a framework for voluntary workouts between creditors (banks) and borrowers (corporations). The approach involved establishing a corporate restructuring agreement, signed by financial institutions, under which they agreed to follow specific procedures for debt workouts and to subject themselves to binding arbitration by a private agency, especially set up for the purpose, called the Corporate Restructuring Coordinate Committee (CRCC). These procedures included the creation of creditor committees to deal with the restructuring of individual corporations or conglomerates. Lead banks or groups of institutions holding more than 25 percent of a corporation’s debt were able to call a creditors’ committee meeting. An automatic standstill on debt payments applied while the committee negotiated. Upon agreement among banks, the lead bank negotiated with the debtor corporation. In all cases, arbitration by the CRCC has been available to seek to resolve bottlenecks in the negotiations.


In particular, all trust accounts with guarantees are being regarded as on-balance sheet items for supervisory and accounting purposes. For capital adequacy ratio calculations, assets in such accounts are weighted at 50 percent as of January 1999 and will be weighted at 100 percent as of January 2000. The operations of foreign affiliates are also now fully consolidated.


The government has amended the Foreign Exchange Act to move responsibility for the setting of foreign exchange open position limits and the supervision of foreign exchange risk to the Financial Supervisory Commission from the Bank of Korea, with information provided regularly through the Bank of Korea.


This will require banks to report maturity mismatches for different time brackets (sight to seven days, seven-day to one month, one to three months, three to six months, six months to one year, and over one year), and to maintain positive mismatches for the first period. From sight to one month, any negative mismatch should not exceed 10 percent of total foreign currency assets, and from sight to three months, it should not exceed 20 percent of such assets.


This measure was designed to induce an increase in turnover in the foreign exchange market, and enhance the pricing of the forward market so as to reflect interest rate differential. It has already encouraged greater swap market activity, leading to a closer link between won and dollar money markets.


The number of bank employees decreased by 34 percent and the number of branches decreased by 17 percent as of the end of 1998, compared to the end of 1997.


This chapter draws on an initial draft by David Marston and contributions from Patrick Downes, Michael Moore, and Inci Ötker-Robe.


The two-tier regulatory system was perceived to have failed to achieve the desired strengthening of the capital base of domestic banks and was abolished in April 1999. Until then, banks with at least 1 billion ringgit in equity, and which complied with Bank Negara Malaysia’s CAMEL requirements, were eligible to be Tier 1 banks. These banks were given certain privileges (e.g., allowed to operate foreign currency accounts on behalf of exporters, participate in equity derivatives, undertake securities borrowing or lending, and enjoy less stringent restrictions on branch expansion).


Interpretation of the indicators of improved soundness should be treated with caution because, in an overheated economy with an asset price bubble and very rapid credit growth and extensive collateralization of lending, the nonperforming loan ratio may decline even though underlying asset quality deteriorates. The deterioration only becomes obvious after the asset bubble has burst. Moreover, capital adequacy requirements are not adjusted for provisioning deficiencies.


Rapid credit growth among smaller institutions in part reflected their efforts to build their asset basis to achieve Tier 1 status.


During this episode, nonperforming loans grew to 30 percent, and institutions were restructured with government and central bank support.


Prior to 1998, banks in Malaysia did not routinely report data on a consolidated basis. When activities of subsidiaries were taken into account, a number of banks announced a sharp deterioration in profitability and solvency.


Lending to directors, officers, and employees was prohibited, as well as to firms in which these persons have an interest greater than 5 percent—as a partner, manager, agent, or guarantor. Also, firms in which managers, directors, or employees held shares were excluded from receiving credit from the institution.


BAFIA prohibited institutions from holding shares in any corporation. Exceptions were made for shares held as security or as a result of foreclosure or as repayment or credit.


At its peak in January 1998, Bank Negara Malaysia placements amounted to 34.7 billion ringgit or 13 percent of GDP. This figure declined by 15.8 billion ringgit in mid-February/March concurrent with a reduction of reserve requirements from 13.5 percent to 10 percent.


Through March 1998, no provisioning was required for substandard loans, 50 percent for doubtful, and 100 percent for bad/loss. The amount on which provisions were to be made was not based on collateral; by regulation, real estate collateral must be marked-to-market semiannually while security collateral is revalued daily.


Based on this estimate, Bank Negara Malaysia also indicated its intention to either supply or withdraw liquidity and invited price or volume bids depending on the intended signal.


It was envisaged that the framework would run parallel to the existing liquid asset requirement for a period of six months during which banks would be required to comply with the existing 17 percent ratio. Officials indicated that this would be applied flexibly, as there might be cases where banks—which were assessed to have adequately adapted to the new framework—internal information systems, recomposition of liquid holdings according to types of asset holdings, and forecasting capabilities—would be allowed to operate on the new system alone. Bank Negara Malaysia reserved the right to extend compliance with the liquid asset requirement beyond the six-month parallel run in those cases where it was assessed that a bank was not adequately prepared for the new framework. In early May 1999, 17 institutions migrated to the new framework.


Danaharta employs the services of Arthur Andersen, while the financial advisors to Danamodal are Solomon Smith Barney and Goldman Sachs.


Two institutions have since been taken out of the Danamodal process.


In view of continued weakness of investor confidence and concerns about the possibility of a massive capital outflow upon the expiration of the 12-month period in September 1999, the authorities in February 1999 replaced the 12-month rule with a declining scale of exit levies. Under this arrangement, for funds that entered Malaysia before February 15, 1999, repatriation of the principal of portfolio investments is subjected to a levy, with the levy decreasing with the duration of investment in Malaysia (starting from 30 percent, reduced in steps to 0 percent if repatriated after 12 months from the date of entry or September 1, 1998, whichever is later).


The modifications introduced in September 1998 should be seen against the more stringent loan classification system instituted in December 1997. This system had introduced an automatic 20 percent provisioning against substandard loans defined as nonperforming for a period of three months. On the basis of that scheme, Bank Negara Malaysia classified institutions, and Danamodal and Danaharta determined estimates of recapitalization needs, and likely nonperforming loan sales. On that basis, nonperforming loans in July had increased to 14.2 percent. Banks, if they wish, can retain the more conservative three months’ nonperforming loan classification. Of Malaysia’s 78 financial institutions, 21 (accounting for 46 percent of total loans in the system) have retained this tight classification rule.


For trade finance loans, the default periods for the classifications are shortened as follows; substandard—default between one and two months; doubtful—default between two and three months; and bad—default greater than three months.


This appendix draws on an initial draft by Enrique de la Piedra and contributions from Elizabeth Milne and Greta Mitchell-Casselle.


Banking sector reform is a major component of the IMF’s Stand-By Arrangement approved in March 1998, and the World Bank’s Banking Sector Reform Loan, approved in November 1998.


In addition to contagion from the other Asian countries, the Philippines was also adversely affected by the weather pattern associated with El Niño.


Universal and nonexpanded commercial banks are jointly referred to as the commercial banks.


In June 1996, the government had reduced its ownership in Philippine National Bank from 100 percent to 45.6 percent. The stock in private hands is widely dispersed.


Foreign banks are not authorized to open more than six branches or to borrow from head offices more than $4 for every $1 of domestically held capital.


Legislation pe