This Selected Issues paper takes stock of the progress made in meeting the objectives under Indonesia’s Extended Arrangements (1998–2003) program. The paper addresses progress in achieving the programs’ core macroeconomic objectives, with an emphasis on how Indonesia’s economic recovery compares with those of the other major Asian “crisis” countries. A major conclusion of the paper is that, while significant progress has been made against many of the key objectives of the arrangements, Indonesia’s overall economic performance has lagged behind others in the region.


This Selected Issues paper takes stock of the progress made in meeting the objectives under Indonesia’s Extended Arrangements (1998–2003) program. The paper addresses progress in achieving the programs’ core macroeconomic objectives, with an emphasis on how Indonesia’s economic recovery compares with those of the other major Asian “crisis” countries. A major conclusion of the paper is that, while significant progress has been made against many of the key objectives of the arrangements, Indonesia’s overall economic performance has lagged behind others in the region.

II. Assessing Indonesia’s Banking Sector Reforms1

A. Introduction

1. This paper examines the measures taken to deal with the banking crisis and assesses their success in stabilizing and restructuring the banking sector. 2 It also examines the steps taken to develop an effective bank supervision regime and progress made to date in replacing the blanket guarantee with a financial sector safety net. The paper concludes by identifying the remaining challenges to further strengthen the banking sector.

2. Prior to the 1997–98 financial crisis, Indonesia’s financial sector was characterized by poor governance and widespread directed and related-party lending. State banks accounted for 40 percent of banking assets in 1997 and carried high levels of problem loans stemming from directed lending operations. A small number of family-owned conglomerates were the dominant owners of private banks, which were used as vehicles to finance nonfinancial companies owned by the same controlling shareholders. Private banks expanded rapidly in the 1990s, lending heavily to related parties beyond prudentially prescribed lending limits, in foreign currencies, and to the real estate sector. 3 Foreign bank penetration remained low, with only 8 percent of banking assets under foreign control.

3. Prudential regulation and supervision were also extremely weak. Rules on loan classification and provisioning allowed for easy restructuring and evergreening of loans, while enforcement actions were not taken against widespread violations of legal lending limits. Also absent was an exit mechanism for failing banks and a deposit insurance system for small-scale depositors. Close ties between bank owners and the political elite deterred supervisory authorities from taking corrective actions against weak and noncompliant banks.

4. The lack of political commitment and transparency both contributed to the crisis and undermined initial steps to stabilize the financial sector in late 1997. At the outset of the crisis some initial steps were taken to address the weaknesses in the banking sector. Sixteen banks (representing 2½ percent of system assets) were identified for closure and liquidation, with another 34 (representing 22 percent of system assets) placed under Bank Indonesia (BI) supervised rehabilitation programs. The government also announced a guarantee on deposits of up to Rp 10 million, accounting for 90 percent of depositors, but only 25 percent of deposits. The credibility of the authorities’ program to stabilize the banking sector was shattered when one of the closed banks reopened under a new name, and the fate of the 34 banks under rehabilitation programs was not clearly articulated to the public. Contagion from other crisis countries, the rapid deterioration of the corporate sector, and rumors about the President’s health deepened the crisis of confidence, triggering widespread bank runs and prompting BI to extend massive amounts of emergency liquidity loans equivalent to 15 percent of GDP in 1998.

Crisis Strategy

5. In early 1998, the government adopted a new bank restructuring strategy founded on four main pillars. These included: a blanket guarantee for all depositors and creditors of banks; the creation of the Indonesian Bank Restructuring Agency (IBRA); a recapitalization program for private and state-owned banks; and an out-of-court debt restructuring mechanism. These four elements were designed to stop the runs on banks, close and restructure insolvent banks and dispose of the assets from the failed banks, restore the state bank sector to health, and facilitate financial restructuring in the corporate sector.

6. Once the credibility of the blanket guarantee had been established it was successful in ending bank runs and in stabilizing the system. The guarantee fully protected all depositors and creditors, but not shareholders, in both rupiah and foreign currency. Although the guarantee was announced in January 1998, runs continued until the authorities took action in April of that year and closed 14 banks and promptly transferred protected deposits to other institutions or suspended shareholder rights and replaced management (the latter were referred to as “banks taken over” or BTO banks). Subsequently, bank runs became rare and were primarily a response to idiosyncratic events affecting specific banks. Measures were adopted to limit the moral hazard of the guarantee, including additional prudential restrictions on and enhanced surveillance of banks with guaranteed deposits. Banks were required to pay a premium of 0.5 percent of total deposits to partially defray the future costs of the guarantee. A cap was also placed on the interest rate that could be paid on deposits covered by the guarantee.

7. IBRA was given particularly broad powers and responsibilities. (An assessment of IBRA’s success is provided in the next chapter.) IBRA’s responsibilities included the rehabilitation and liquidation of failed private banks, the management and sale of nonperforming loans, the recapitalization and divestment of the BTO banks, and the negotiation of settlements with shareholders. IBRA appointed new management for BTO banks, in line with the goal of returning ownership and management control to the private sector. The government also implemented a recapitalization program for private banks not taken over by IBRA. Seven banks were jointly recapitalized by their owners and the government. The private owners of jointly recapitalized banks were allowed to retain management control to avoid a complete nationalization of the system and to give owners an incentive to inject new equity into the banks. IBRA had the responsibility for administering the government’s majority shares in these banks.

8. The strategy for rehabilitating state banks revolved around a single merger and massive recapitalization. Four insolvent state banks were merged to create Bank Mandiri, which was subsequently recapitalized with Rp 175 trillion in recapitalization bonds during 1999–2000. Since its creation, Bank Mandiri has remained Indonesia’s largest bank, with a 23 percent market share in 2003, more than double its nearest competitor, state-owned BNI.

Post-Crisis Stabilization Strategy

9. In the period following the crisis, financial sector reforms focused on fostering structural changes that would lay the groundwork for the recovery of the banking system and prevent a recurrence of a banking crisis. In recent years the emphasis has been on addressing weaknesses in governance and balance sheet vulnerabilities by improving bank supervision and prudential regulation, and providing a framework for dealing with bank failures that enables banks to exit from the system smoothly. The strategy was directed toward achieving longer term reforms that would result in a sound and well-capitalized banking system that would be led by the private sector, and developing a financial safety net to replace the blanket guarantee. While significant progress has been made by the authorities in each of these areas, the process remains incomplete.

B. Progress in Rehabilitating the Banking System

10. Banking sector reforms were implemented against the background of a difficult political transition, weak institutional capacity, and an unreliable legal framework. The reform strategies introduced during the crisis were based on well-tested principles. However, reform suffered from a lack of consistent implementation. The condition of the banking sector has nonetheless shown significant improvement, although vulnerabilities remain.

11. The measures taken to stabilize and recapitalize the banking sector achieved their goal, and overall financial indicators have shown a marked improvement. Asset quality, however remains a concern and, as described below, there remains a significant dichotomy between private and state banks. In part, the asset quality deficiencies at some of the state banks stems from loans purchased from IBRA. Efforts to privatize the state banks have succeeded in raising revenue for the government, but the process has been partial, with the government retaining sole voting control of these banks.

Ownership structure

12. Systemic restructuring efforts have led to a dramatic change in the ownership structure of the banking sector. The number of banks has been reduced from 238 in 1997 to 138 at end–2003. IBRA’s privatization of banks has returned over 20 percent of banking assets to the private sector, primarily to owners that were not affiliated with the mismanagement of the banks in the run-up to the crisis (Figure II.1). The sale of banks BCA, Danamon, Niaga, and BII to strategic investors represented particularly important milestones in increasing the private sector orientation of the financial sector. Privatization also raised the share of banking assets under foreign management which has brought much needed know how and competition to the financial services industry.

Figure II.1.
Figure II.1.

Banking System Ownership Structure 1/

Citation: IMF Staff Country Reports 2004, 189; 10.5089/9781451818314.002.A002

Source: Bank Indonesia.1/ Foreign banks include branches of foreign banks, joint venture banks (those with very minor domestic participation) and domestic private banks with majority ownership by foreign investors.2/ Data for 1996 are based on shares in credit rather than total assets.

13. Nevertheless, the banking system is highly concentrated and state banks maintain a dominant presence. The 10 largest banks account for 70 percent of banking assets and future mergers and acquisitions could raise concentration even further. Moreover, state banks retain a high share of banking assets, which, at 44 percent of the total, is above its pre-crisis level. The fast-growing regional development banks account for another 6 percent of banking assets. Hence, one-half banking assets are under state control.

Financial condition

14. The financial condition of the banking system has improved sharply since the crisis. This has been due primarily to a massive recapitalization by the government and the transfer of NPLs to IBRA. The government injected Rp 425 trillion in bonds into the banks (and another Rp 230 trillion into BI) as the counterpart of around Rp 400 trillion in loss loans transferred to IBRA, in one of the world’s costliest banks recapitalization operations, at 50 percent of GDP. The replacement of nonearning assets with high-yielding government bonds and the gradual resumption of lending, particularly to the high-margin consumer sector, has underpinned a steady improvement in financial soundness indicators. The improved macroeconomic environment has also supported bank financial performance by facilitating reductions in provisioning and increases in operating margins. From 1999 to September 2003, nonperforming loans declined from 20 to 6 percent of total loans, after-tax profits rose to 2 percent of assets from a loss of 9 percent, and liquidity has remained high.4 Over the same period, the capital adequacy ratio (CAR) increased to 23 percent (from a negative value), owing largely to the low share (40 percent) of risk-weighted assets in total assets.5 Equity as a percent of total assets, while less robust at 9 percent, has risen from a negative of 5 percent in 1999.

15. Private banks have shown the greatest improvement in financial conditions. Measures of asset quality, earnings, liquidity and capital are all relatively better for the private banks (Table II.1). These banks have been more aggressive in cleaning-up their loan books and positioning themselves to expand in various niche markets. Many of the purchasers of IBRA banks have replaced management with bankers who have had international experience.

Table II.1.

Indicators of Banking Soundness

article image
Source: Bank Indonesia.

End-September data.

Compromised assets include reported NPLs, restructured loans classified as pass or special mention, and foreclosed real estate and equities. The denominator “loans” includes foreclosed real estate and surrendered equities.

16. Nevertheless, important fragilities remain in the banking system as the state banks remain in a weak financial condition. State banks face weaker liquidity and capital positions than the private banks. A particular concern is that, while reported NPLs have fallen, they understate the level of problematic assets, reflecting high levels of restructured loans, some of which were purchased from IBRA. 6 The bulk of restructured loans are categorized as pass or special mention, despite indications that they may still be impaired. Some loans have been kept “current” by rolling over maturing repayments or through “cosmetic” restructurings, involving changes in repayment terms without corresponding payments to the banks. In addition, some banks carry large amounts of real estate assets or equities in troubled companies, acquired as collateral or in debt-for-equity swaps, at values on their balance sheets that do not reflect current market values. Overall, the ratio of “compromised assets” to loans stood at 24 percent in September 2003 at the state banks, almost four times the reported NPL ratio and over double the figure for private banks. Although this ratio has declined from 33 percent in 2001, this is attributable mainly to charge-offs and the expansion in total loans, rather than recoveries. While state banks are well-provisioned with respect to reported NPLs, provisions are sufficient to cover less than half of their broader compromised assets.

State bank restructuring

17. Following the merger and recapitalization of the state banks, efforts have focused on improving their governance structures. One of the main weaknesses has been that state banks are under the joint oversight of the Ministry of State Owned Enterprises and Ministry of Finance. The authorities have taken some steps to improve oversight of the state banks through the appointment of commissioners and the preparation of annual business plans. However, these steps have been only partially effective and governance and accountability remain weak, with insufficient procedures in place to ensure that lending policies are fully consistent with sound banking practice.

18. The next step in the process of state bank restructuring is to increase private sector management. To date, this has taken the form of the divestment of 30 percent stakes in Mandiri and BRI. While these moves may have led to increased transparency and market scrutiny of the banks’ operations, they have not significantly affected the banks’ operations, as the divested shares are nonvoting. To further strengthen the state banks, more fundamental moves towards private-sector management are needed, through the divestment of majority voting stakes or private management contracts. This will be particularly important as the large state banks compete directly with the private banks. 8

Credit developments

19. During the past two years credit growth has been strong, especially in the SME and consumer loan sectors. Annual credit growth exceeded 20 percent in both 2002 and 2003, with the rate of expansion in consumer loans even faster. In the latter loan category, credit practices have been strengthened, and given the spreads on these loans, banks have shown great interest in expanding into this market. 9 At the same time, however, the strong interest shown in the retail and consumer market reflects the high risks of lending to larger borrowers. Heightened risk aversion has prompted many private banks to shift lending away from large-scale manufacturing companies toward smaller scale firms in trade and services and towards consumers.

20. Credit risks in the economy are still high, exacerbated by a weak legal system with poor enforcement of creditor rights, especially against large corporate borrowers. At the same time the capacity to price risk is limited. Margins on lending to the comparatively few good corporate borrowers are very thin, and may be below risk-adjusted rates. In addition, loan concentration may be very high at some banks. Available data for selected banks suggest that some are exposed to a relatively small number of borrowers, with the top 20–25 borrowers accounting for 30 percent or more of total loans.

21. Enhancements to the financial infrastructure would facilitate financial intermediation and encourage prudent loan growth. The lack of systematic credit information makes it difficult for banks to properly assess prospective borrowers and manage and price credit risk. This, in turn, leads to higher interest costs for creditworthy borrowers and weakens the prudential basis for lending decisions. Specifically, the absence of a credit bureau deprives banks of sufficient information on prospective borrowers and this in turn is reflected in the pricing and availability of credit.

C. Prudential Regulation and Supervision

22. Prudential regulations have generally been brought in line with the Basel Core Principles. In 1998–99, BI issued new regulations on loan classification and provisioning, related-party lending, capital adequacy, and foreign exchange rate risk, among others.10 Subsequently, BI developed a master plan to address the deficiencies identified in a Basel Core Principles for Bank Supervision (BCP) assessment. New regulations have been issued and the supervisory skill set has shown marked improvement over the past two years (Box II.1). A recently completed BCP self-assessment showed compliance with 16 of the core principles. This assessment outlined the remaining steps needed to reach full compliance. The number of full-scope bank examinations has increased five–fold since 1999, and BI has placed on-site examiners at the larger banks to improve the quality of supervision at these banks.

Enhancements to Bank Regulations and Bank Supervision

A. Enhancements to Bank Regulations (1998–1999)

  • Loan classification rules were tightened by shortening the time period for nonrepayment in determining the various levels of classification of NPLs. In addition, borrower repayment capacity and cashflow analysis were made part of the classification process.

  • Provisioning requirements were adjusted to conform to new classification rules, and collateral valuation procedures were refined to reflect difficulties in foreclosure.

  • Rules on debt restructuring were tightened by establishing formal procedures for restructuring, reporting, and monitoring, applying clear accounting rules, and placing special restrictions on the restructuring of connected loans.

  • Banks were required to report cashflow projections and a maturity-gap analysis, including off-balance sheet items.

  • Quarterly publication of financial statements was required.

  • Net open position limits on foreign exchange risk were reduced.

  • The concept of “related party” was better defined and expanded.

  • Limits on foreign ownership and control of banks were removed.

B. Enhancements to Bank Supervision (2000–2003)

  • Completion of a risk-based supervision manual.

  • Development of risk management and internal control guidelines.

  • Availability of banking data on the BI web site.

  • Issuance of a “Know Your Customer” regulation.

  • Issuance of regulation to limit risks associated with the purchase of loans form IBRA.

  • Regulation on equity investments by banks to give BI greater control over expansion into nonbanking activities.

  • An expanded bank licensing regulation.

  • Increasing the minimum capital adequacy ratio to 8 percent.

  • The issuance of a market-risk capital charge that will be fully implemented in 2004.

23. Risk-based banking supervision is gradually taking hold. BI’s implementation of its “Master Plan to Enhance Banking Supervision” has resulted in a much improved supervisory process. Bank examiners are now better trained and effective in identifying major weaknesses in banks. Classifications are no longer solely based on applying past-due criteria but also reflect the examiner’s evaluation of the likelihood of repayment. As a result, examiners frequently diverge from bank management on loan classification and provisioning, though there is no mechanism or timeframe for resolving outstanding differences. Formal supervisory actions, such as memoranda of understanding and cease and desist orders, are in the early stages of development, and supervisors still rely on more informal communications, where sanctions against noncompliance are sometimes unclear or enforced inconsistently. Going forward, enforcement and implementation need to be strengthened. Also, while the regulatory framework provides the foundation for excellent supervision, regulations for consolidated supervision should be adopted and the regulations governing legal lending limits need to be tightened.

D. Financial Safety Net

24. The blanket guarantee was successful in stabilizing the banking system, but was intended as a short-term crisis management measure. After the system had stabilized there was a need to replace the guarantee with a financial safety net that could provide a flexible structure to respond to emerging instability while limiting moral hazard. Prior to the crisis, Indonesia lacked such a structure, as BI’s lender of last resort function (LOLR) was ill-defined and there was no explicit deposit insurance. The proposal recently developed jointly by BI and the Ministry of Finance provides the needed framework. The safety net will have three elements: the creation of a deposit insurance agency and the implementation of a deposit insurance scheme; an explicit granting of LOLR powers to BI, subject to certain restrictions; and the creation of a Joint Committee to coordinate the government’s actions with regard to systemically important institutions experiencing difficulty.

25. Progress has been made in obtaining legislative approval for the financial safety net. The necessary amendments to the BI Law giving LOLR powers to BI have been passed by Parliament and an enabling Memorandum of Understanding between BI and the Ministry of Finance has been signed. The memorandum will govern procedures until the end of 2004, by which time a Financial Safety Net law is to be passed that both formalizes these procedures in law and clears up any inconsistencies between statutes. In addition, the draft deposit insurance law was recently submitted to Parliament and, once it is passed, the authorities envision a calendar driven phase out of the blanket guarantee over a two year period. In the interim, with IBRA having ceased operations, the responsibility for the blanket guarantee has passed to a new unit in the Ministry of Finance.

E. Conclusions and Remaining Reforms

26. The measures undertaken at the height of the banking crisis have by and large been successful. Public confidence was restored with the blanket guarantee and banks have been recapitalized. The return of banks to the private sector and the infusion of professional management with foreign bank experience bode well for financial intermediation and the effective operation of private banks.

27. However, as the system remains dominated by the state banks, the strategy has not fully succeeded in fostering a market oriented commercial banking system. Only one state bank, BRI, serves a public policy goal (microfinance and SME lending in rural areas) and undertakes it profitably. The other state banks compete head-to-head with private banks both for funding and loans, and their dominance has distorted competition in these markets. Consequently, the bank restructuring process is incomplete. Moreover, the most significant fragilities that remain in the banking sector are primarily found in the state banks. Addressing these will require significant improvements in governance at these banks.

28. All banks face a legal system that is not favorable to creditors. Weaknesses in the legal structure and corruption in the courts have tilted the system in favor of borrowers who have the resources to fight creditors through the legal system. The response of many of the private banks has been to focus their lending on consumers and SMEs, and to lend only to corporate borrowers who were able and willing to service debts incurred during the crisis. Reform of the legal system, therefore, is a critical element of banking sector reform that remains unfulfilled.

29. Bank Indonesia has achieved a marked improvement in its bank supervision capabilities and regulatory regime, but there is scope for further improvement. In particular, additional regulations are needed, particularly with respect to consolidated supervision, and to enforce the regulations that are in place, in order to bring BI into full compliance with best international practice as embodied in the Basel Core Principles.


  • Cole, David and Betty F. Slade, 1998, “Why Has Indonesia’s Financial Crisis Been So Bad?,Bulletin of Indonesian Economic Studies, vol. 34, August, pp. 6166.

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  • Enoch, Charles, Barbara Baldwin, Olivier Frecaut, and Arto Kovanen, 2001, “Indonesia: Anatomy of a Banking Crisis—Two Years of Living Dangerously—1997–99,IMF Working Paper 01/52 (Washington: International Monetary Fund).

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  • Pangestu, Mari and Manggi Habir, 2002, “The Boom, Bust, and Restructuring of Indonesian Banks,” IMF Working Paper 02/66 (Washington: International Monetary Fund).

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Prepared by Steven Seelig, Michael Taylor, and Cem Karacadag.


See Cole and Slade (1998), Enoch et al. (2001), and Pangestu and Habir (2002) for comprehensive overviews of Indonesia’s banking crisis and initial stabilization and reform efforts.


The number of private banks number grew from 101 to 182 between 1988 and 1991 (Pangestu and Habir, 2002), and peaked at 240 in 1994 (Enoch et al., 2001). The share of foreign currency and real estate loans more than doubled to 20 percent and 21 percent, respectively, by mid–1997.


Indicators of financial soundness are based on the top 16 banks, accounting for 75 percent of banking assets.


It should be noted that CARs are overstated due to the assignment of a 50 percent risk weight to loans extended to state-owned enterprises (international standards call for a 100 percent weighting).


As of September 2003, restructured loans accounted for 20 percent of total loans in state banks, compared with 3 percent at private banks. While some restructured loans were purchased from IBRA at steep discounts, often at 20 percent of face value, many have not been returned to paying status. Some banks are writing down the purchase value to reflect the lack of recoveries on these loans.


Compromised assets include reported NPLs, restructured loans currently categorized as pass or special mention, foreclosed real estate, and equities obtained under debt-equity swaps.


State bank BRI is the dominant micro-finance lender and does not compete with private banks for this business.


Bank Danamon, for example, has recently acquired a large finance company to gain a greater foothold in consumer lending for the purchase of automobiles and motorbikes.


For a full discussion of the changes to the regulatory framework that began during the crisis see Enoch et al. (2001).