Indonesia
Selected Issues

The paper reviews the progress being made toward Indonesia's full emergence from the crisis. Banking sector restructuring has been at the heart of the reform program. Corporate debt restructuring is critical for resumption of normal credit flows and Indonesia's full and sustainable economic recovery. Finally, successive reform programs have aimed at alleviating the impact of the crisis on the poorest households and creating conditions for reversing the rise in poverty. Resuming Indonesia's long-term record of poverty reduction depends on effective social spending schemes and sustainable recovery.

Abstract

The paper reviews the progress being made toward Indonesia's full emergence from the crisis. Banking sector restructuring has been at the heart of the reform program. Corporate debt restructuring is critical for resumption of normal credit flows and Indonesia's full and sustainable economic recovery. Finally, successive reform programs have aimed at alleviating the impact of the crisis on the poorest households and creating conditions for reversing the rise in poverty. Resuming Indonesia's long-term record of poverty reduction depends on effective social spending schemes and sustainable recovery.

I. Status of Banking System Reform1

1. This paper briefly overviews the strategy and stages of the bank restructuring program, assesses the current financial status of the banking system, and discusses key areas of reform that remain. In response to the banking crisis in late 1997, the Indonesian authorities have put in place a comprehensive program aimed at restoring the viability of the financial sector. Two and a half years later, many of the critical elements needed to protect the core banking system and facilitate the revival of intermediation are taking root. Nevertheless, significant tasks remain to restore full functionality of the banking system and enable it to contribute to Indonesia’s economic recovery.

A. Background and Strategy

2. The comprehensive banking system reform has had three overlapping phases—stabilization; restructuring and recapitalization; and revitalization and soundness.

Stabilization

3. At the height of the banking crisis (late 1997 and early 1998), stabilization of the monetary and banking system was the immediate priority. At that time, confidence had collapsed—capital was in flight, the currency was in free fall, and depositors and creditors to Indonesian banks were in full retreat (Figure 1). Bank Indonesia had extended large amounts of liquidity support (almost 20 percent of GDP) to keep banks from default and the payments system functioning. While bank restructuring would take time to implement, depositor and creditor confidence had to be secured immediately; therefore, the blanket guarantee of third party depositors and creditors was introduced in January 1998. Even then, liquidity support was further extended during periods leading into successive bank closures and at times of bank-specific instability, as well as for the payment of external arrears. By mid-1998, international creditor banks were provided with an offer to extend the term of interbank liabilities with a guarantee from Bank Indonesia. The blanket guarantee remains in place.2

Figure 1:
Figure 1:

Liquidity Support and Exchange Rate

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

4. Removing deeply insolvent private banks from the system, while keeping a core of private bank ownership was the next plank of the program. A formal triage was used using bank audits and Bank Indonesia inspections, and private banks were grouped according to solvency.3 In total, 48 banks were closed and liabilities transferred to designated receiver banks, seven private banks were jointly recapitalized, and a total of 12 systemic banks were taken over.4 State banks, numbering seven before the crisis, were consolidated into four majors by merging four banks into a new state bank—Bank Mandiri—which now represents the single largest bank in the system with about 30 percent of deposits.5 Later, IBRA (Indonesian Bank Restructuring Agency) reduced to five the number of banks under its management, having completed a recent merger of eight taken over banks into Bank Danamon.

5. The end result was a dramatic change in the structure of the banking system—the public owned share of liabilities in the banking system rose from 40 percent precrisis to 70 percent post-crisis. The total number of banks has been reduced from 238 to 157, with the number of private banks falling by one half (Text Table 1).

Table 1.

Indonesia: Restructuring of the Banking System

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Sources: Bank Indonesia; and Fund staff estimates.

Includes 27 regional rural development banks.

6. Credible actions to resolve banks and to stabilize monetary conditions are helping rebuild confidence in Indonesian banks, but depositors remain wary. Inflation which peaked at over 100 percent (monthly at annual rates) in early 1998, has been subdued, allowing interest rates to ease from their peak in August 1998 of over 70 percent (SBI rates) to almost single digit, before the recent episode of currency instability. Regarding the banking system, rupiah deposits in real terms have stabilized, even as real interest rates have declined to precrisis levels (Figure 2). However, deposits continue to be held in very liquid form—the average deposit term is less than one month, compared with over six months before the crisis.

Figure 2:
Figure 2:

Real Deposits and Interest Rates

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

Restructuring and recapitalization

7. Deep restructuring was required for state banks and banks taken over. The broad approach to restructuring, which has applied both to state and taken-over banks, has been to: (i) refocus business strategies on core areas of competence and market niche, including significant operational restructuring and branch consolidation in addition to mergers; (ii) imbue professional management by placing qualified and key management personnel into banks, and contracting with management for the achievement of specific performance related goals, while supporting management’s efforts with international advisors across core bank activities; (iii) strengthen credit policies and procedures, focussing first on loan workouts and recoveries; and (iv) clean up balance sheets through the transfer of nonperforming loans to IBRA, including loans connected with former shareholders, and recapitalize the bank. Progress has been uneven and slower than anticipated, but some recent results are encouraging:

  • State banks. Bank Mandiri, owing to its complex merger, has faced the most difficult tasks, but has made significant progress. Early on, a professional management team was put in place and key steps taken. Through a voluntary separation scheme, the bank has shed one third (9,000) of its staff, while reducing the number of its branches by 20 percent (149). Credit work-outs are proceeding and about one-half of the value of the remaining nonperforming loans (following the transfer of loss loans to IBRA) have been restructured. Nonetheless, considerable work lies ahead in accounting and information systems, and further operational downsizing. Further, structural liquidity difficulties need to be addressed (see below). Progress has been slower in other state banks but recent strides have been made. Management of BNI was changed in February 2000 and the business plan for restructuring of operations has been approved. BRI was less affected by the crisis owing to its more specialized focus on microcredits and small and medium scale enterprises; it is to shed much of its corporate business that had attracted losses. BTN is to refocus its activities narrowly on mortgage lending, and to do so it must shed its other activities.

  • Taken-over banks. Despite delays, the legal merger of eight taken-over banks into Danamon went ahead on June 2000. As part of the mergers, 90 percent of the staff will be retrenched, and 80 percent of the branches will be closed.6 The eight banks collectively had been losing Rp 360 billion per month. Bank Niaga has been recapitalized and it is being prepared for privatization. Following a clean up of its balance sheet, and with new management installed, an initial public offering of BCA was made in May 2000; plans are being finalized for its early majority privatization.

8. Recapitalization of banks has been linked to progress on restructuring—improved management, approved business plans, and operational restructuring—so as to protect against moral hazard and future bail outs. Accordingly, state and taken-over banks were to be recapitalized in stages with acceptance of viable business plans and execution of those plans after passing of specific hurdles. However, the slow pace of restructuring of state banks and taken-over banks has resulted in a number of delays in recapitalization.

9. The recapitalization program gives recognition to the (gross) costs of stabilizing the banking system (Text Table 2). Liquidity support extended by Bank Indonesia during the crisis that could not be repaid by banks, owing to their insolvency and closure, was replaced with indexed bonds issued by the government amounting to Rp 218 trillion.7,8 Residual insolvency, as well as a cleaning of the balance sheet and recapitalization of open banks, was financed by bonds purchased by banks in exchange for government equity stakes amounting to a projected Rp 453 trillion. The bulk of bonds goes to cover nonperforming loans (either transferred to IBRA or provisioned for loans remaining on the balance sheet). Loans were also removed from the balance sheet of banks and replaced by bonds in connection with the settlement of connected loans with former bank shareholders of taken-over banks.9 Off balance sheet exposures and net open positions added to losses—foreign exchange losses by Bank Exim were particularly noteworthy, mounting to some $2 billion. Costs were also associated with monetary stabilization as interest rates on deposits were driven up well in excess of what banks were able to earn on performing loans (the so called “negative spread”), and these were absorbed in commercial bank balance sheets. Finally, delays in recapitalizing banks increased the amount of the bonds that were eventually needed to cover continuing and accumulated losses. Recovery of some of these gross costs will depend on progress toward revitalization of banks and recovery of loans and assets by banks and IBRA. Such recoveries are estimated at about 8 percent of GDP, implying that net costs would be in the order of 47 percent of GDP.10

Table 2.

Recapitalization of the Banking System

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Sources: Bank Indonesia; and Fund staff estimates.

Includes a Rp 21 trillion contingency, partly to cover the cost of raising state banks’ capital from 4 to 8 percent CAR by end-2001.

Revitalization and soundness

10. The objective of the third phase of the banking program is to strengthen governance and safeguard soundness while, at the same time, revitalizing credit activities and improving the performance of the banking system.

11. To revitalize the banking system, a key policy is the injection of private capital and management into banks (with adequate safeguards). While stabilization has involved a major shift in ownership in the banking system—from private to public—revitalization calls for the opposite—a return of banks to private ownership. Accordingly, the government’s strategy for restoring vitality and soundness is to privatize taken-over banks, jointly-recapped private banks, and Bank Mandiri. For a number of these sales, capital is expected to come from foreign strategic and financial investors. After taking over Bank BCA, the largest private (and nonpublic) bank in June 1998, the bank restructuring agency has sold 22½ percent of its share in an initial offering to the general public in May 2000.

12. To achieve targets for profitability and capital adequacy, the resumption of lending activities is vital. Broadly, business plans of recapitalized banks rely partly on the widening of income margins, as well as on the healthy growth of credits and deposits, to generate sufficient retained earnings to build capital. Faster progress in corporate restructuring is, therefore, needed to both speed economic recovery and to put corporations on a credit-worthy footing. In this connection, IBRA plays a key role in the restructuring of the corporate sector and resolving nonperforming credits. Finally, restoration of confidence in the economy and an upswing in domestic and foreign investment would greatly ease the transition to soundness and profitability.

13. To help safeguard the performance of the banking system, oversight and governance are to be further strengthened. Strenuous efforts are being undertaken to bolster governance and oversight across several fronts: (i) from the outset, efforts have been made to bring regulations of commercial banks up to international standards—in particular, classification and provisioning rules and those regarding risk exposures to connected lending have been tightened, even if banks were not yet able to meet all standards; (ii) to build supervisory capacity—extensive technical assistance is being extended to Bank Indonesia to strengthen on site inspections and off site analysis of banks; and (iii) to restore bank soundness the benchmark for this being the attainment of capital adequacy standards of 8 percent by the end of 2001.

B. Present Financial Position of the Banking System

14. Substantial progress has been made in restoring the financial position of the banking system, but strains remain that need to be addressed.

Capitalization and solvency

15. As the recapitalization program nears completion, overall solvency of the banking system has been restored (Text Table 3). Remaining bonds are to be delivered in tranches to two state banks over the next two quarters, in line with implementation of their business plans. Following the recent legal resolution of Bank Bali and Parliamentary approval, the bank is also to be recapitalized, and the government would be the standby buyer of a rights issue, as was done for the other private recapitalized banks.

Table 3.

Market Share and Solvency Position of Operating Banks, June 2000

(In trillions of Rupiah)

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As of March 2000.

Bond issuance through July.

For additional recap needed for Bank International Indonesia.

Measures of profitability

16. For the first time since the crisis, net earnings (before provisions) of the banking system are positive (Text Table 4). Declines in deposit rates have restored intermediation margins (Figure 3), while the recapitalization of banks has increased income from noncredit earning assets. Indeed, net income from securities has replaced loans as the single most important source of earnings (Figure 4).

Table 4.

Indonesia: Quarterly Summary Income Statement - All banks

(In billions of rupiah)

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Sources: Bank Indonesia, Bank Mandiri published financial statements for September 1999, and Fund staff estimates.
Figure 3:
Figure 3:

Bank Intermediation Margin

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

Figure 4:
Figure 4:

Income From Loans and Securities

(In billions of punjab)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

17. Provisioning against losses has declined sharply as the peak of the crisis has passed and loans undergo restructuring. Loan provisions peaked in the fourth quarter of 1998, reflecting delays by banks in recognizing and reporting the gravity of the situation. Furthermore, loans classified as loss were removed from the balance sheets of banks undergoing restructuring and transferred to IBRA in the first half of 1999. Nevertheless, provisions made in the first quarter of 2000 absorbed almost 45 percent of net earnings.

18. Consequently the net operating result in the first quarter of 2000 is about flat, compared to enormous losses recorded at the end of 1998 and throughout 1999. Net earnings after provisions are positive, but this is slightly surpassed by (noninterest) costs of bank operations (overhead and salaries).

19. Pockets of negative earnings remain in the banking system. Banks that had yet to be recapitalized exhibited negative earnings in the first quarter of 2000, including two state banks (BNI and BRI) and a number of taken-over banks.

Asset quality

20. Provided that the nascent economic recovery continues and corporate restructuring advances, loans would appear to be adequately provisioned. Net of provisions, nonperforming loans as a percentage of gross loans is about 7 percent (Text Table 5). In relation to total assets, Indonesia compares favorably to other regional countries, reflecting the greater extent to which nonperforming loans were removed from balance sheets (and replaced by bonds).

Table 5.

Loan Performance and Provisions, March 2000

(In billions of Rupiah)

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Source: Bank Indonesia.

21. However, loan performance overall continues to be very poor with nonperforming loans amounting to over 30 percent of gross loans (after transfer to IBRA of loss loans). The situation reflects slow progress in key areas of reform—including credit practices of banks and corporate restructuring—as well as the early stage of economic recovery. Continued poor loan performance raises concerns about the prospects for restoration of bank intermediation, and underscores the need for greater progress on critical areas of loan recovery and corporate restructuring.

22. Furthermore, the composition of bank assets reconstituted in the aftermath of restructuring and recapitalization tends to limit profitability. The yield from recapitalization bonds offsets satisfactorily the costs of servicing interest sensitive liabilities, but it does not provide a substantial margin to income. Meanwhile, following restructuring, loans amount to only one-third of earning assets, with recapitalization bonds almost two times as much. In other words, the coverage by profit generating loans of deposit liabilities is poor—the loan to deposit ratio is less than one-half. As a result, the return on assets is biased lower and prospects for profitability more limited (Figure 5).

Figure 5:
Figure 5:

Back Earning Assets

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

Liquidity and net open position

23. Liquidity in the banking system is not well distributed. Private and foreign banks hold ample liquidity (Text Table 6). However, accumulating losses and insolvency in major state banks, as well as bank specific factors, have led to a drain on their liquidity. As a result, state banks offer higher deposit rates than many private Indonesian banks, which is keeping pressure on income margins of state banks. Also, deposit rates have become somewhat sticky downwards as state banks—which are price leaders in setting deposit rates—are less responsive to an easing in the monetary stance. Recapitalization bonds could be sold to raise liquidity.11 However, in current poor market conditions, their long maturities, as well as pricing, makes them less attractive to other buyers in the absence of a discount, while, state banks either need to seek approval to sell bonds or are reluctant to do so.

Table 6.

Average Deposit Rates by Group of Bank; SBI Holdings and Rates, June 15, 2000 1/

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Source: Bank Indonesia (PIPU system).

Based on an average of rates posted by each bank; retail amounts (less than Rp 1 billion).

SBI holdings divided by deposits.

24. The liquidity position of state banks is being addressed. State banks have recently been recapitalized, and in time the earnings on bonds will help restore liquidity. However, additional measures are needed to address the structural component of liquidity deficits so as not to erode the financial position of state banks and disturb the overall functioning of the banking system. Under consideration are measures that include: permitting state banks to sell some of their bonds; a phasing in of some of MoF regulations governing investments of insurance and pension funds, allowing them to maintain large deposits with state banks; and the downsizing of state bank balance sheets. As well, the government plans to commence issuing to the general public shorter term government securities, while using the proceeds to purchase (and retire) from the secondary market bonds held by banks to assist in liquidity adjustment.

25. Over time, state banks also need to unwind large open positions in foreign currency. As many foreign currency loans stopped performing during the crisis and were subsequently transferred to IBRA, a large (short) foreign currency position opened in state and taken-over banks. Hedged bonds were issued as part of recapitalization to cover exposure in rupiah terms, while giving time to unwind positions smoothly (Text Table 7). The bonds mature at regular intervals (each quarter) and convert into regular fixed-rate rupiah bonds (over three years). Banks must, therefore, close their positions by buying dollars and draw down their rupiah liquidity—which can add stress to money and currency markets in a weak market environment.

Table 7.

Net Open Position of State and Taken-Over Banks, June 2000

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Sources: Bank Indonesia; and Fund staff estimates.

“+” equals short dollar position.

Overall assessment

26. In sum, the overall financial position of the banking system is solvent and income margins are positive—a major milestone in the banking program (Figure 6). However, strains remain and the system is vulnerable. Although solvent, the banking system is nevertheless undercapitalized—prudential regulation requires banks to build capital adequacy to 8 percent by end 2001. The thin capital base gives little cushion to shocks—increases in interest rates or pressure on the exchange rate. While intermediation margins are now positive, overall profitability and efficiency is low. Poor loan performance and the slow pace of restructuring means that credit intermediation would continue to be weak, hampering internal generation of earnings needed to rebuild capital positions, as anticipated for in bank business plans. Strains in the banking system—liquidity deficits of state banks and foreign currency exposures—need to be addressed and monitored closely to protect the financial position of the system. Achieving a viable and sound banking system will require additional efforts to address remaining strains in the banking system, complete financial and operational restructuring, and meet challenges of the next phase of the bank program.

Figure 6:
Figure 6:

Bankings System-Financial Position

(In billions of rupiah)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

C. Restructuring Agenda Ahead

27. Significant work lies ahead to complete banks restructuring with the focus shifting from financial to operational restructuring, restoring soundness, and restarting credit intermediation in the third phase of the banking program.

State banks

28. The state banks face significant challenges—high operating costs and low earnings potential. The state banks represent half the deposit liabilities in the banking system but less than one third of the loans. Postcrisis, costs of large branch networks and staff are out of line with earning assets. Accordingly, while state banks need to restructure further their balance sheets, their business plans place great emphasis in the period ahead on strengthening management and operational restructuring to improve viability (Box A):

  • Balance sheets of state-controlled banks need to be further restructured and downsized to make them viable. Accordingly, the bank program calls for inter alia: (i) faster progress by IBRA to restructure and make loans performing that can be exchanged with banks (boosting bank profitability) for bonds (lowering government debt stocks); and (ii) sales of bonds by banks to help downsize their balance sheets. Such adjustment is to be facilitated by actions to develop secondary and primary markets for government securities.

  • Cutting operating costs is an important part of an overall strategy to restore profitability. Business plans lay out considerable work in areas involving operational restructuring; in particular, reducing and rationalizing branch and staff operations. This is especially important as credit is unlikely to grow at the pace earlier expected.

  • Business strategies need to be rationalized and professional management fully installed. A priority area is to clarify the business strategies of the state banks and to build professional management to carry them out, coupled with adequate oversight. In this connection, some old tendencies had reemerged, such as political appointments to management of state banks. As well, in some cases, existing management of state banks have resisted efforts to refocus operations on core competencies. Stronger political commitment to the commercial orientation of state banks is essential for restructuring to be successful.

  • State banks need to be prepared for divestment. Privatization would help state-owned banks prepare for the pressures of globalization and better capitalized domestic banks, while also reducing the fiscal burden of the bank recap program. Work needs to move ahead for the development of a formal divestiture plan.

Joint recap banks

29. The performance of private recap banks appears satisfactory. Bank Indonesia continues to monitor closely the performance of the seven private banks which were jointly recapitalized (Text Table 8).12 Through March 2000, each bank is reporting progress toward meeting business plans and earning positive incomes. Capital adequacy is generally above the 4 percent required, and in several cases above the future standard of 8 percent. However, return on equity has fallen short of business plans in several banks. While progress thus far has been satisfactory, IBRA and Bank Indonesia will need to jointly monitor developments to ensure banks remain on track, especially to meet the increased required capital by end-2001.

Table 8.

Performance of Private Recap Banks, March 2000

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Source: Bank Indonesia.

30. There are some prospects for the sale of government ownership in private recap banks before the end of the term fixed in the recap agreement. While it is unlikely that the majority holders would exercise their right to buy the state’s shareholding,13 possible new financial and strategic investors could be brought into these banks with the sale of government shares in agreement made among the government and majority shareholders and new investors.14

State-Owned Banks1/

Financial highlights: (at June 30, 2000; in trillions of rupiah)

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As of July 25, 2000-remaining 30 percent expected end-October.

General issues

  • Farther loan loss provisioning may be needed and would be revealed by year 2000 audits.

  • Credit risk management: While progress has been made in the area of establishing manuals and procedures, a new credit culture with strong checks and balances needs to be implemented and systems made fully operational.

  • Corporate Governance: Board of Commissioners is now slated to become active but membership needs to be expanded and clear responsibilities defined (audit, HR, compensation, etc).

  • Interim performance contracts (valid till October 2000) have been signed between MoF and the management of banks BNI, BRI and BTN. Final performance contracts to be signed upon completion of mid-year 2000 assessments.

  • Divestiture: The government has yet to develop a full fledged plan to divest banks.

Specific issues

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1/

Prepared by World Bank (Jakarta Office).

Taken-over banks

31. Taken-over banks have now been mostly recapitalized, while restructuring is proceeding (Box B). With the exception of Bank Bali, all taken-over banks have been recapitalized. Following the legal merger at end-June, Danamon’s management plans an aggressive program to complete the required branch closures and integrate the small number of performing assets, branches, and staff to be retained from the eight banks. Danamon has achieved modest profitability so far in 2000, and its baseline forecast is for a near break-even performance after the merger. The achievement of significant profitability in the business plan is predicated on the purchase of performing loans from IBRA with recap bonds.

32. Government divestiture would need to gain momentum and help reposition banks in the private sector. Although by far the largest portion of the divestiture lies ahead, the initial public offering and sale of 22V2 percent of BCA is an important milestone towards returning what was the largest private sector bank to the private sector. Furthermore, the government has renewed its commitment to the privatization of taken over banks and has recently announced that it will sell its entire holdings of BCA and Bank Niaga by the end of the year.15

Private banks

33. Further consolidation of private banks is likely. As the time to achieve the required 8 percent CAR by end-2001 approaches, pressures for further consolidation of the number of private banks—73 private banks, which account for some 5 percent of the system—are likely to mount. In advance of this, Bank Indonesia has been taking a proactive stance, and encouraging banks with signs of weakness to seek equity injections or merger partners. Meanwhile, foreign controlled banks continue to report a generally satisfactory financial condition, By virtue of their generally liquid positions and access to capital from their foreign parents, foreign banks are well positioned to expand their lending activity, but are unlikely to lead other banks owing to their conservative stance.

Taken-Over Banks1/

Financial highlights (as at 30 June 30, 2000; in trillions of rupiah)

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A total of Rp 4.8 trillion bonds expected to be issued to Bank Bali in October 2000.

Bank BCA’s BTO status was reverted when it was formally returned to BI on April 27, 2000.

Includes 8 smaller BTO banks legally merged into Bank Danamon in June, 2000.

General issues remaining:

1) Risk Management: An improved credit culture with strong checks and balances has been introduced at each bank. New lending has resumed as well. Moreover, both banks need to significantly improve their balance sheet structure by growing the loan portfolio, while keeping with prudent banking practices. It is also note worthy that considerable amount of loans under IBRA had gone into BTO banks for either outsourcing or sale.

2) Interim Management and Performance Agreements; IMPA have been signed between IBRA and the management, with the exception of Bank Bali. Compliance is monitored by a department within IBRA’s Bank Restructuring Unit (BRU). Key performance indicators for the BTO banks’ are published monthly by IBRA.

3) Divestiture; The government has agreed to dispose banks BCA and Niaga by end-2000; Bank Danamon is to be offered for sale in 2001. Bank Bali’s original shareholders have dropped their past legal claims; divestment is expected in 2001.

Specific issues remaining:

BCA

  • An IPO was held in May 2000, disposing 22.5 percent of government holding with proceeds of approximately Rp 927 billion. Government ownership currently account for 70 percent, which will be divested by end-2000.

  • Asset portfolio dominated by low yielding government recap bonds. The bank needs to generate higher interest income by converting bonds into loans.

  • Strong franchise value with 772 nationwide branches and 1,858 ATM network supported by sophisticated technology.

Danamon

  • Operational mergers to be completed in October 2000.

  • The bank received its second recap tranche in June 2000.

  • Asset portfolio concentrated in government recap bonds, which need to be converted into loans.

  • Management team led by expatriate banker.

Niaga

  • Loan quality needs to be significantly improved as the NPL rate reached a high 73 percent of total loan portfolio.

  • Exposure in foreign currency loans need to be decreased, as foreign exchange loans currently account for 60 percent of total outstanding loans.

Bali

  • Government reached legal settlement agreement with previous owner, removing the main obstacle to recapitalization.

  • While the recapitalization is now scheduled for October 2000, the bank is experiencing an average monthly loss of Rp 44 billion.

  • High NPLs of 75 percent, with provisions covering 73 percent of NPL amount. Most NPLs to be transferred to IBRA prior to recapitalization.

1/

Box contributed by the World Bank (Jakarta).

D. Regulatory Framework and Governance Issues

34. To safeguard the soundness and performance of the banking system, key areas of regulatory and governance need to be strengthened.

Regulatory compliance

35. The ultimate goal is to have all banks in compliance with all regulatory norms. However, in the current economic situation, Bank Indonesia has permitted a phase-in period for banks to achieve compliance with a number of key prudential regulations, including capital adequacy requirements, legal lending limits, and foreign exchange net open position limits (Box C).16 To reinforce the ultimate goal of compliance, banks must submit plans demonstrating that they can reach the targets within the required time frame. Some forbearance has also been characteristic of other Asian economies undergoing restructuring.

Building BI’s supervisory capacity

36. Bank Indonesia has established a master plan to upgrade supervisory capacity. Progress has been made in important areas—comprehensive fit and proper tests of owners and managers, establishing an effective special investigations unit, and promoting transparency in the banking sector through publicly listed financial statements. However, significant work lies ahead. Even without forbearance, Indonesia would be materially noncompliant with many of the Basle Core Principles for effective banking supervision due to the current absence of regular and effective verification of banks’ compliance with prudential standards. Also, the ability of Bank Indonesia to undertake a forward looking assessment of banks and the system as a whole needs to be strengthened—this calls for the adoption of a forward-looking risk-based approach compared to the more historical compliance orientation. Banks need to be given requirements that incorporate this risk-focused approach, and Bank Indonesia needs to incorporate such an approach into in its supervision and examination processes. The above weaknesses have already been identified by Bank Indonesia, and successful implementation of the supervision master plan should address these deficiencies. The authorities’ efforts are being supported by technical assistance provided by IMF/MAE.

Strengthening governance

37. Strengthening overall governance of the banking system is a key area of reform. Commercial banks as well as Bank Indonesia have been subject to audit by external accountants. Bank Indonesia is committed to monitoring and enforcing compliance with the new prudential regulations. Parliamentary committees give approval for recapitalization, after receiving briefings by government on progress on banking system restructuring. A governing Board has recently been established in IBRA. However, additional measures are needed to buttress governance, especially through the critical period ahead. These include:

  • Governance and Oversight Unit (MOF). As stakeholder, the government needs to assume greater responsibility for the performance of state banks, their overall business strategy and for their divestment. Specific issues that need to be addressed include: (i) compliance with the banks’ performance contracts (including financial and operational restructuring targets) and recommend actions or adjustments when targets are not met; (ii) the accuracy of the banks’ financial reporting to MoF; (iii) make recommendations to enhance governance and shareholders’ interests; and (iv) divestment. While the unit has been formed, the full mandate outlined above has yet to be delegated.

  • Onsite presence of Bank Indonesia supervisors in state banks. Bank Indonesia has recently announced its intention to soon establish such a presence in states banks to facilitate the monitoring and improvement of (i) risk management systems; (ii) progress in achieving goals outlined in the business plan; and (iii) the flow of information between the state-owned banks and Bank Indonesia.

  • Data reporting systems. Bank Indonesia is working to strengthen its reporting of financial data on banks. This is a critical area. Without timely and accurate information on the state of each bank, effective supervision and monitoring of the banking system would be difficult.

Regulatory Forbearance

  • Minimum total risk-weighted capital ratio of 8 percent is not required until end-2001: The current capital adequacy ratio is 4 percent, and banks have until end-2001 to achieve an 8 percent risk-weighted total capital ratio.

  • Extension of the time period by which banks must comply with the legal lending limit if the violation is deemed unintentional: Banks whose violation of the legal lending limit arose from the increase in value of foreign currency denominated assets relative to the value of their rupiah denominated capital have been given until May 2001 to come back into compliance. In the case of loans restructured under the JITF, a longer extension to December 2002 was granted. The legal lending limit for individual debtors or group of debtors (1) is 30 percent of capital until year-end 2001, 25 percent of capital during year 2002, and 20 percent commencing January 1, 2003 for non-connected parties; and (2) 10 percent of capital for connected parties. “Intentional violations” of the legal lending limit must be corrected within one month from the date of the violation.

  • Relaxation of the prudential rule that prohibits banks from directly owning shares in nonflnancial institutions: Originally, if a bank acquired an equity position in a company resulting from debt restructuring, it was required to divest the equity position as soon as the company achieved profitability for two consecutive years, even though retained earnings were still negative. Equity holding arising from restructurings can now be held until the earlier of five years or the point in time when retained earnings become positive.

  • Phase in of net open position limits: Banks were required to gradually come into compliance with the requirement that their net open foreign exchange position not exceed 20 percent of capital. While all banks are required by regulation to meet the 20 percent requirement by end-June, many banks are still reporting significant excesses.

    • From June 30, 1999, NOP is not more than 70 percent of the excess NOP reported at December 31, 1998;

    • From December 31, 1999, NOP is not more than 40 percent of the excess NOP at December 31, 1998; and

    • By June 2000, NOP is not more than 20 percent of capital.

II. Bank Restructuring in Indonesia: Fiscal Costs and Debt Dynamics1

A. Introduction

1. The banking crisis that hit Indonesia toward the end of 1997 is one of the most severe ever faced by any country.2 The steep depreciation of the rupiah triggered a loss of confidence in the banking system, which by January 1998 reached systemic proportions. Massive deposit withdrawals and capital flight by panicked investors in the face of a currency in free fall had a devastating effect on bank liquidity and, eventually, solvency. Banks and corporations alike were caught largely unprepared to deal with the dramatic depreciation of the currency. This resulted in corporations being unable to service their loans causing, eventually, very large losses to banks. Over time, these losses were compounded by banks’ inability to pass on to borrowers the higher costs of funds, resulting from the steep (but delayed) interest rate tightening by the central bank.

2. The resolution of the banking crisis has involved (temporary) nationalization of bank assets, and has resulted in very large costs for the state. These costs mainly reflect (i) the provision of liquidity support by the central bank, which was largely not repaid by recipient banks; (ii) the honoring of the guarantee on bank deposits and other liabilities, especially for those banks that were closed or merged; (iii) the need to recapitalize a deeply insolvent banking system.

3. However, a portion of these costs is expected to be recovered from the resolution of the distressed assets acquired by the government through IBRA (the Indonesian Bank Restructuring Agency). These assets principally consist of bank nonperforming loans; industrial assets pledged by former owners of closed banks (who were found in violation of prudential norms); and equity stakes in banks. Recovering value from these assets is paramount to reducing the ultimate costs of the banking crisis.

4. The large stock of financial liabilities contracted by the government to fund the costs of bank restructuring has led to a steep increase in government debt, thereby exacerbating the vulnerability of the medium-term macroeconomic framework to shocks. Despite the fact that the government debt stock has risen by more than four times compared to the pre-crisis period, fiscal sustainability can still be assured through prudent macroeconomic and restructuring policies.

5. This paper will discuss in detail the origins of bank restructuring costs, their implications for the medium term fiscal position, and the conditions for fiscal sustainability. Section B will present the latest estimates of bank restructuring costs. The final magnitude of these costs will depend on IBRA’s ability to recover value from the assets transferred to it. Therefore, Section C will focus on IBRA’s asset recovery prospects. The implication of bank restructuring costs for the medium-term dynamics of government debt will be discussed in Section D. In this section, an alternative medium-term scenario for the debt profile is presented and the risks to sustainability illustrated.

B. Magnitude and Origins of Bank Restructuring Costs

6. Latest estimates place gross costs of bank restructuring at about Rp 670 trillion, or 55 percent of 2000 GDP.3 Over ⅔ of total gross costs are connected with the recapitalization of operating banks, while the rest is principally linked to the cost of bank closures and losses from the extension of liquidity support by Bank Indonesia.4

Table. Indonesia: Gross Costs of Bank Restructuring

(Indicative Estimates)

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Assumes an accounting exchange rate of Rp 8,000 to the dollar.

7. More than half of total gross costs are due to bank losses. The insolvency, or “hole”, in banks’ balance sheets originated mainly from three sources:

  • The need for setting aside provisions against large loan losses (including for the loans transferred to IBRA);

  • The cost of writing-off loans extended to related parties in violation of banking regulations; and

  • The accumulated effect of negative interest margins on bank profits.

By contrast, the cost of bringing bank equity from 0 to 4 percent CAR (currently the regulatory minimum) is only a tiny fraction of total recapitalization costs.

Table. Indonesia: Estimated Recapitalization Costs by Group of Banks

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Assumes an accounting exchange rate of Rp 8,000 to the dollar.

8. By and large, recapitalization costs were highest among the four state banks, with Bank Mandiri capitalization accounting for a share of over 40 percent of state bank costs.5 It is estimated that restructuring these banks (including the small regional development banks) will eventually cost the government about % of 2000 GDP, or more than 40 percent of total gross costs of bank restructuring. The main reason for these large cost estimates is to be found in the extremely poor quality of state banks’ loan portfolios, especially among the four legacy banks merged into Bank Mandiri. Additional losses were also caused by state banks’ deliberate policy of maintaining lower lending rates—relative to other banks—despite facing increasing cost of funds.

9. However, grass costs represent an upper bound of the ultimate cost to the government, as they do not take into account future recoveries from the resolution of the assets acquired by the government (IBRA) in the process of restructuring the banking system. Asset recoveries are expected to come from (i) the sale of companies pledged to IBRA by former bank owners of closed banks; (ii) the resolution of nonperforming loans transferred to IBRA; and (iii) the privatization of banks taken over by IBRA.

10. Nevertheless, even after taking into account asset recoveries, Indonesia’s bank restructuring costs are significantly higher than those experienced by other countries. Using the concept of net costs, which equals gross costs (amounting to about 55 percent of GDP) minus (the present value of) cumulative future asset recoveries (amounting to about 8 percent of GDP), the resolution of Indonesia’s banking crisis is expected to cost to the state about 47 percent Of GDP. This Corresponds to close to 2½ times the cost Of resolving the banking system in Mexico during 1994–99, and to more than 1½ time the cstimated cost of Thailand’s recent banking crisis.

Table. Restucturing Costs of Selected Banking Crises 1/

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Sources: staff estimates (Asian countries); and Lincgren, C. et al. (1996) Bank Soundness and Macroeconomic Policy, Washington, DC IMF.

Net costs deiined as stock of liabilities contracted by the state (directly or indirectly) minus (the present value of) actual and projected asset.

Refers to actual gross costs minus actual asset recoveries.

Includes toll road support programs.

Excludes assel recoveroes.

Financing of bank restructuring costs

11. Gross costs of bank restructuring are being financed by the government through the issuance of bonds, which so far amount to about Rp 630 trillion, or 95 percent of the estimated total need (Table II.1).6 About ⅓ of the issued amount has been placed with Bank Indonesia to cover its losses from past liquidity support, and to finance payments of claims under the guarantee on the liabilities of closed banks. The balance of bonds (over Rp 410 trillion) has been issued to operating banks as the government contribution towards their recapitalization. The characteristics of the government bonds are discussed in detail in Box A.

Table. Indonesia: Actual Government Bond Issues

(as of end July 2000)

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Assumes an accounting exchange rate of Rp 8,000 to the dollar.

Table II.1.

Indonesia: Timing of Bond Issuance for Bank Restructuring

(In trillions of rupiah, unless otherwise indicated)

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Does not include bond issues needed to bring state banks’ CAR from 4 to 8 percent

Includes boads for raising state banks’ capital adequacy from 4 to 8 percent (expected by end 2001).

12. Interest payments on government bonds are estimated at 4 percent of GDP in FY2000. Interest payments are estimated to increase to 4½ percent of GDP in 2001, and to decline gradually thereafter, reaching 3 percent of GDP by 2004, as the economy recovers and real interest rates ease.

Characteristics of Bank Restructuring Bonds

Government bonds issued to finance bank restructuring operations are of four types:

  • 20-year indexed bonds issued to Bank Indonesia; these bonds carry a 3 percent coupon rate and their principal is revalued every year in line with actual inflation. Amortization of these bonds is gradual, starting 5 years after issuance.

  • 3 to 10 year variable rate bonds issued to banks; these bonds carry an interest rate linked to the three-month SBI rate and have been issued mainly to cover bank’s negative net worth. This is because the variable rate feature of these bonds allows banks to match the return on assets with the cost of deposits, thereby preventing recurrence of equity shortfalls due to increases in interest rates.

  • 5 to 10 year fixed rate bonds issued to banks; these bonds carry coupon rates between 12 and 14 percent. Although initially they were issued in amounts equivalent to the positive capital shortfall (i.e., for the purpose of bringing the capital adequacy ratio from 0 to 4 percent), more recently fixed rate bonds have been issued in larger amounts, and have been preferred to variable rate bonds for the purpose of closing the negative equity gap. One attractive feature of fixed rate bonds is that they make government debt servicing costs more predictable.

  • Hedge bonds (i.e., dollar-linked rupiah-denominated bonds), issued to banks carrying large foreign exchange net open positions. These bonds, which pay a premium of 2 percent over the SIBOR, will be converted into rupiah bonds over a period of 2-3 years, as banks gradually achieve foreign exchange cover. One attractive feature of these bonds is that they prevent the emergence of bank equity shortfalls as a result of exchange rate fluctuations. However, the cost of this hedge is carried entirely by the government. So far, two state banks (Bank Mandiri and BNI) have received hedge bonds (Rp 35 trillion).

The maturity structure of the bonds issued is back loaded, with a bunching of maturing bonds expected between year 2005 and 2010. The first significant tranche of bonds will mature in 2003 (about Rp 40 trillion). Starting in that fiscal year, and for the following 6 years, the annual bond rescheduling need ranges about Rp 60-100 trillion.

C. Asset Recovery

13. As part of the bank restructuring program, the government has acquired through IBRA a large amount of assets, including nonperforming loans and industrial assets pledged by former bank owners. Recovering value from these assets is paramount to reducing the ultimate costs of the banking crisis, and containing the medium term government debt dynamics. This section discusses the medium term asset recovery strategy by IBRA, and the progress made so far.

IBRA asset portfolio and medium-term recovery prospects

14. IBRA’s asset portfolio originates from four sources:

  • “Core assets” comprising nonperforming loans transferred from closed, taken over, and state banks, and managed by the Asset Management Credits (AMC).

  • “Non-core assets,” including buildings and other properties, cars, office equipment, artwork, etc., acquired in the process of liquidating closed banks. These assets are also managed by the AMC.

  • “Shareholder assets” comprising the assets (mainly industrial) pledged by former bank shareholders in settlement of claims related to their violation of prudential norms, and managed by the Assets Management Investments (AMI). These assets are placed in holding companies and their disposal is the responsibility of a specialized Asset Disposal Unit (ADU) within AMI.

  • “Equity holdings” in banks recapitalized by IBRA (including taken over, and recapitalized private banks), and managed by the Bank Restructuring Unit (BRU).

15. Although the book (nominal) value of IBRA’s assets is very large (at over Rp 515 trillion, or 46 percent of GDP), their current market value is only a fraction of that. Updated conservative estimates by IBRA place the market value of IBRA’s asset portfolio (a crude measure of the potential recovery rate) at only about Rp 110 trillion, or just over 20 percent of the transfer value. This is much less than previous estimates.7

  • The bank loans representing IBRA’s core assets correspond to over % of total commercial bank credit outstanding, but they are largely nonperforming, and their recoverable value is estimated by IBRA at about 20 percent of their book value (Rp 256 trillion). This estimate is compatible with the recovery rates experienced by other countries—for example, loan sales by Thailand’s Financial Restructuring Agency during 1998-99 fetched, on average, about 25 percent of book value.

  • Transfers of the shareholder assets into holding companies have yet to be completed. However, the market value of the assets already transferred amounts to about one-third of their transfer value (or Rp 104 trillion). IBRA’s ability to exercise stewardship over the pledged assets and to implement the shareholder settlements has been slowed by a complex management structure for the holding companies that left the former shareholders in effective control of their assets.

  • The current book value of IBRA’s equity holdings in banks taken over and in the seven private recapitalized banks is only a small fraction of the almost Rp 150 trillion (about 12 percent of GDP) recapitalization bond issuance, reflecting the large negative net worth of these banks prior to their recapitalization.

A01ufig01

IBRA Asset Portfolio

(Transfer value: Rp 5 16 trillion, or $74 billion)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

Table. IBRA Asset Holdings

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Includes expected settlements of 1999 closed/BTO banks (Rp 10.5 trillion).

Includes projected equity injections. Market value is equal to banks’ net book value as of end-May 2000, plus actual recoveries to date.

16. Over the medium term, about half of IBRA’s total recoveries is expected to come from the restructuring and sales of the AMC’s core assets (Rp 53 trillion). The disposition of the shareholder assets is projected to contribute Rp 35 trillion (or ⅓; of total recoveries). As for the bank equity holdings, assuming that IBRA’s residual equity stakes in banks are sold at current book value (i.e., below Bank Central Asia’s IPO completed in March 2000, which was priced at 1.2 times book), IBRA should be able to recover about 11 percent of the issued recapitalization bonds (equivalent to about Rp 16 trillion, or 15 percent of total recoveries).

17. After peaking in 2001, recoveries (in cash and in form of bond retirements) are assumed to decrease gradually through 2004. This timeframe is in line with IBRA’s mandate to terminate its operations by 2004. Bank equity sales by the BRU are expected to be concluded by 2002, the deadline by which the owners of the seven recapitalized banks would be able to exercise their option of buying back the government’s equity investment. Recoveries from the disposition of industrial assets by the ADU and from the resolution of the loan portfolio by the AMC are expected to continue, albeit at a decreasing pace, through 2004.

A01ufig02

Medium Term IBRA Asset Recoveries

(In trillions of rupiab)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

AMC loan recovery strategy

18. IBRA’s AMC has been charged with restructuring and disposal of impaired loans transferred to it by closed and recapitalized banks. Since these loans were effectively acquired at hook value, AMC’s recovery efforts are particularly important to minimize final losses to the state.8 The AMC is also charged with the sale by auction of noncore assets transferred from closed banks. After illustrating the composition of AMC’s loan portfolio, this section will discuss the restructuring strategy and progress to date in loan recoveries.

Loan portfolio

19. The book value of the loan portfolio held by the AMC is large, representing over 30 percent of total private enterprise debt, and 20 percent of GDP. Loans in foreign currency amount to over $16 billion, and account for just less than half of the total loan portfolio (using an accounting exchange rate of Rp 7,000 to the dollar), or about 20 percent of private debt denominated in foreign currency.

20. The overall quality of the loan portfolio is very poor, and exposure is mostly confined to the primary industry and the property sectors. The AMC’s portfolio includes the most impaired loans (category 4 and 5 loans) of recapitalized banks (state, taken over, and private recapitalized banks), and all the loans of the closed banks, which by and large were deeply impaired. More than half of total loan transfers originated from the state banks, and about % from the closed banks. Loan transfers have taken place in batches, with the last one completed in March 2000.

21. Corporate loans account for the largest share of debt held by the AMC, but they represent only a tiny fraction of debtors. AMC has grouped its loans by size, into retail loans (with face value of less than Rp 1 trillion), SME loans (Rp 1 to 5 trillion in face value), commercial loans (Rp 5 to 50 trillion in face value), and corporate loans (with face value larger than Rp 50 trillion). It is the last category that accounts for almost 85 percent of AMC loans, although it represents only 1½ percent of IBRA’s 130,000 debtors.

22. For the purpose of monitoring progress in debt restructuring, IBRA has adopted the concept of obligor, which identifies a group of debtor companies belonging to the same conglomerate. Since many of IBRA’s corporate debtors belong to large conglomerates, the obligor concept identifies more easily the ultimate holders of IBRA’s exposure. Thus, the AMC has devoted particular attention to the restructuring efforts of the largest 21 obligors. The combined debt of these 21 obligors represents about ⅓ of the AMC’s loan portfolio (or Rp 88 trillion in debt); however, with just over 340 debtors, the 21 largest obligors account for less than 0.3 percent of all AMC debtors.

Debt restructuring strategy and progress

23. AMC’s strategy toward debt restructuring is to focus on the largest debtors, while outsourcing or selling small and medium-sized loans. In particular, the smaller retail and SME loans (up to Rp 5 billion in value) are being sold through open auctions, while the medium-sized commercial loans (i.e., those of value between Rp 5 and 50 billion) are being outsourced in batches to servicing agents through a competitive bidding process. Servicing agents are expected to manage and resolve these loans within two years from the acquisition date. The fee structure under the servicing contracts provides for financial incentives for early recoveries. As for the largest corporate debtors (with principal value higher than Rp 50 billion), the approach focuses on restructuring the loans of the cooperative debtors, taking legal action against noncooperative debtors, and selling restructured loans through a competitive bidding system. More recently, following the approval of IBRA’s “haircuts” policy, there has been a greater shift towards direct loan sales.

24. IBRA’s approach to debt restructuring depends on debtor cooperation and their business prospects. Cooperative debtors with good business prospects (category A debtors), as well as those with uncertain business prospects (category B debtors) are required to enter a sequential restructuring framework which begins with a standstill agreement and ends with the implementation of an agreed restructuring plan. A critical step of the sequential approach is step 6, corresponding to the signing of term sheets (MOUs), which defines the main components of a restructuring plan. Non-cooperative debtors (category C if with good business prospects, and D if with poor prospects) are dealt with by legal means (mostly bankruptcy and foreclosure, including using IBRA’s special powers to seize assets).

Table. The 8 Stages of IBRA’s Sequential Restructuring Process

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Table. IBRA’s Classification of Debtors into Ratings A, B, C, D

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Includes debtors for which a rating has not yet been assigned.

25. Encouraging progress has been made so far in the resolution of the loans held by the AMC.

  • As of end June 2000, IBRA had met its target of drawing up restructuring term sheets or filing legal actions for about 35 percent of the 21 largest obligors’ debt value (term sheets were signed for an equivalent of about Rp 25 trillion in loan value, or over 28 percent of the debt outstanding of the 21 largest obligors).

  • Another important step forward was the completion of IBRA’s first auction of corporate loans. These loans (amounting to about Rp 1 trillion in book value) were sold to three domestic and foreign investors, with an average recovery rate of over 70 percent of book value.9

  • Progress is also being made in the resolution of the smaller loans. The AMC has completed the process of outsourcing its holdings of over Rp 20 trillion of commercial loans, which were awarded to four different consortia of domestic and foreign investors.

  • The auction of a small tranche of retail and SME loans (consisting of over Rp 300 billion in mortgage loans) was completed in early July. The whole tranche was sold to Bank Danamon, which paid an average of 41 percent of original book value. IBRA expects to complete the sale of its smallest loans (accounting for a cumulative amount of Rp 11.5 trillion in book value) in three additional auctions to take place by mid-October.

26. However, progress in dealing with noncooperative debtors by IBRA has not been satisfactory. Thus far, IBRA has filed 11 bankruptcy petitions (for claims amounting to more than Rp 1½ trillion) and has initiated numerous foreclosure proceedings, including through the use of its special powers (PP17).10 However, in only two bankruptcy petitions has IBRA obtained favorable rulings by the Commercial Court (one of which, was heard by a panel of judges including an ad hoc judge). In one instance, IBRA withdrew its bankruptcy filing because the debtor eventually agreed to settle its obligations in full; and in the remaining 7 cases initiated by IBRA, the ruling was in favor of the debtor. Nevertheless, with the intensified legal reforms in the program, IBRA expects to achieve cash collections from legal actions ranging between Rp 0.4 and 0.6 trillion for 2000. As for the 21 largest obligors, legal actions have been taken for about 6 percent of these obligors’ total debt value. For this group of obligors, IBRA expects to initiate legal actions for an additional 8 to 10 percent in debt value by end 2000.

AMI asset recovery strategy

27. The AMI controls, through a complex holding company structure, a large number of assets, pledged by former bank owners in the settlement of their liabilities to IBRA. Ultimately, the AMI’s ability to recover value from these shareholder assets depends on a number of factors, including bank shareholders’ cooperation; the legal basis of the agreement entered into by IBRA and the shareholders; the valuation of pledged assets; and, importantly, IBRA’s ability to exercise stewardship over the pledged assets.

28. The obligations of bank shareholders to IBRA arise from losses suffered by banks, prior to being closed or taken over, as a result of legal lending limit violations. The legal basis for settling former bank owners’ obligations to IBRA is the so-called “shareholder settlement agreement.”11 Under these agreements, which are discussed in detail in Box B, former bank owners restructure their obligations to IBRA by issuing a promissory note backed with assets and companies grouped under specially created holding companies.

29. Shareholder cooperation is critical during the execution of the shareholder agreement, including by allowing IBRA to exercise its rights to sell pledged assets. Under the settlement agreements, the former bank shareholder continues to own and control the assets/companies under the holding company structure, although IBRA participates in the control of the holding company and its assets. More importantly, IBRA has the power, backed by the law, to sell the assets pledged under the holding companies.12 Even so, lack of cooperation by the owners, or the company management appointed by the owners could be a key impediment to the sale of the assets/companies.

IBRA’s Shareholder Settlement Agreements

Shareholder settlement agreements provide the legal basis according to which former owners of closed and taken over banks settle their obligations to IBRA.

  • Under these agreement, bank shareholders are required first to set up a holding company, and capitalize it by injecting a nominal amount of equity. Shareholders, subsequently, are required to place a number of (fully or partly owned) companies and assets under the holding company.

  • The holding company issues, in turn, a promissory note to IBRA, for an amount corresponding to the size of the former bank owners’ obligation. These promissory notes are backed, in the form of a pledge, by the companies (and assets) placed under the holding company.

  • The formula to determine the size of the promissory notes (i.e., the size of IBRA’s claim on former bank shareholders) depends on whether the bank in question was taken over or closed. In the first case, the size of the shareholder liability is equivalent to the gross book value of all loans and other credits extended by the bank to shareholders or related parties (including unpaid penalties and interest charges). In the case of closed banks, the size of the shareholder liability to IBRA is increased by the size of the negative equity.

There are two kinds of shareholder settlement agreements, depending on cooperation and ability to pledge assets: the so-called MSAA and MRA.

  • When the shareholder is cooperative and has adequate assets to pledge, IBRA and the shareholder enter into a Master Shareholder Acquisition Agreement (MSAA); in the MSAA case, no personal guarantee is involved, and the shareholder is released and discharged by any further obligations, even if the value of the companies pledged drops and IBRA bears losses. However, under the MSAA, the shareholder is required to surrender a small amount of additional assets (holdback assets), to cover (at least in part) against potential losses suffered by IBRA as a result of incorrect information provided by the shareholder in the settlement process.

  • When the value of the assets that could be pledged by the shareholder are insufficient to settle his liabilities to IBRA, a Master Refinancing Agreement (MRA) is sought. In the MRA, a personal guarantee is issued by the shareholder to IBRA for an amount equivalent to the shortfall in asset pledges. Holdback assets are not required under the MRA, as cover against losses by IBRA originates from the personal guarantee.

  • Under both structures, the former bank shareholder continues to own and control the assets/companies under the holding company structure; although IBRA participates in the control of the holding company and its assets, and (in the case of the MSAA) retains the right to appoint the management of the holding company.

A key factor in the closure of a settlement agreement is the valuation of the assets and companies that the shareholder intends to pledge. The broad principle adopted by IBRA is to ensure that valuation is based on the potential cash realization obtained from the asset. Of course, full disclosure of encumbrances on assets/companies is a key element of the valuation process.

Another crucial aspect of the shareholder agreements is that IBRA retains the power, backed by the law, to sell the assets pledged under the holding companies. Under Government Regulation No. 17/1999 on the Indonesian Bank Restructuring Agency, the agency is vested with the authority to “control and/or sell the goods or assets which have been transferred to obtain compensation in respect of the […] fault, negligence and/or improper transaction [on the part of bank shareholders, directors and commissioners]. Such persons [, are personally liable and] may be subject to criminal sanctions as stipulated in Article 50 of the Banking Law.

30. IBRA has signed a number of agreements with the shareholders of the fourteen banks closed or taken over in 1998; but, compliance with these agreements has been uneven.13 Thus far, only five holding companies have been formally set up, with only one being fully operative. In addition, not all the shareholders have complied with their contractual obligations of transferring assets under the holding companies. As a result, out of Rp 113 trillion of total obligations to be settled with the shareholders of the 1998 banks, the nominal value of the assets placed under the holding companies amounts to only around Rp 94 trillion. The largest (and fully operative) holding company is Holdiko Perkasa, accounting for about Rp 53 trillion of obligations from the Salim Group (formerly, the owner of Bank Central Asia). As for the banks that were closed in 1999, IBRA expects to conclude settlement agreements with 25 shareholders, owing about Rp 10 trillion to IBRA.14

31. Latest estimates of the market value of the companies pledged by the shareholders are substantially lower than the nominal value, as appraised at the time of the settlement. The estimated residual value of these assets is about 30 percent of the original nominal value. Various factors have contributed to this valuation change, including a likely initial overstatement of the true value of these companies, shareholder non-delivery and various encumbrances (such as, incomplete transfer of shares and land titles). Economic factors, such as fluctuations in the exchange rate and declining commodity prices (especially those of palm oil, coal and timber), have also affected company values. Nevertheless, some of the companies pledged by former bank owners are among the better managed in the country, and IBRA should still be able to recover value from their disposal. The span of sectors in which these companies operate is wide, ranging from chemical to financial services, from agribusiness to telecom, and automotive to real estate. Many of these companies are listed in the local stock market.

Actual asset recoveries and prospects for FY2000

32. In FY2000, IBRA aims to recover Rp 19 trillion in cash (after expenses) and an additional Rp 3.7 trillion in bonds. The ADU and the AMC—about equally—are expected to contribute about 80 percent of the total cash recovery target, with the remainder projected to come from the majority sale of banks BCA and Niaga. Other income should be sufficient to offset expenses. Including last year’s recoveries, by the end of 2000, IBRA will have recovered about 1/3 of total future expected recoveries.

Table. IBRA Asset Recoveries: 1999/00 - FY 2000

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Includes recoveries from outsourced commercial loans and from auctions of SME and retail loans.

Includes non-core asset recoveries, deposit guarantee fee, and other income (less IBRA expenses).

33. The recovery target for the ADU is ambitious, and its feasibility will depend not only on market conditions, but also on cooperation from owners and managers. There were no sales during the first quarter of FY2000. About 75 percent of total recoveries for the year are expected to derive from the sale of 5 companies out of 17 industrial, financial and real estate assets, in the last two quarters of the fiscal year. The authorities have sought to give credibility to the schedule by securing written commitments to sale from owners, and by engaging financial advisors. In all cases, full disposal of IBRA’s ownership in these companies is sought.

34. The AMC is, so far, on track toward meeting the recovery target for FY2000. By end June, loan recoveries had reached over Rp 3 trillion (slightly ahead of schedule), about half from the 21 largest corporate obligors. Prospective recoveries will mainly stem from:

  • Debt settlements (including refinancing agreements);

  • Auction sales of over Rp 11 trillion of retail/SME loans and of a small tranche (over Rp 2 trillion) of restructured corporate loans; and

  • Collections from the outsourcing agents charged with the restructuring of commercial loans.

More than half of the AMC’s loan recoveries is expected from corporate loan collections (Rp 6.5 trillion, of which about Rp 5 trillion is projected to be in cash). Therefore, much will depend on resolving the debt of the top 21 obligors, envisaged during 2000, as well as on IBRA’s ability to call on guarantees, and offset cash pledges made available by cooperating debtors in the process of restructuring negotiations.

35. The sale of IBRA’s stakes in banks BCA and Niaga are crucial to achieve IBRA’s cash recovery target for FY2000. Particularly important is the strategic sale of IBRA’s remaining 70 percent stake in BCA, following on the initial divestment achieved through an IPO earlier this year (which yielded just less than Rp 1 trillion). To this end, IBRA has developed and announced (for both banks) a detailed schedule of actions to be taken in the coming months, consistent with the completion of their sales by December 2000. These actions include Parliamentary approval, and appointment of financial advisors.

D. Fiscal Impact of Bank Restructuring Costs

36. Bank restructuring costs have an impact on the fiscal position mainly in two ways: (i) by increasing the stock of government debt, thus raising concerns over debt sustainability (a stock effect), and (ii) by increasing expenditures for debt service and, thereby, reducing the room for discretionary fiscal policy (a flow effect).

A01ufig05

Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

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Incidence of Interest Cost of Bank Restructuing on Budget Revenues and Expenditures

(in percent)

Citation: IMF Staff Country Reports 2000, 132; 10.5089/9781451818222.002.A001

Government debt dynamics

37. Driven by the large banking sector losses, government debt has risen sharply during the crisis, from under 25 percent of GDP to around 100 percent in 1998/99. By that year, more than half of total debt was attributable to bank restructuring costs. For a while, however, these costs were implicit government liabilities, as issued government bonds lagged behind the growing size of (quasi-fiscal) liabilities connected with bank restructuring. Therefore, the concept of government debt referred to here is that of “imputed” debt, which is defined to include the estimated negative net worth of the banking system. Staff estimates show that imputed liabilities were in the order of 40 percent of GDP at the end of 1998/99—almost three times larger than issued domestic debt. Over time, quasi-fiscal losses have been recognized as an explicit fiscal liability through the issuance of recapitalization bonds.

38. Bank restructuring costs, however, were only one factor, albeit an important one, contributing to the large increase in government debt. Another critical factor was the sharp depreciation of the rupiah, which amplified the domestic value of the existing stock of external government obligations. The depreciation and some increase in external budgetary financing caused the external debt to peak at 66 percent of GDP by end-1997/98, increasing by more than 2½ times from the previous year. However, this ratio is expected to come down to about 42 percent of GDP by the end of fiscal year 2000.

A01ufig07