INDONESIAN FINANCIAL CRISIS AND BANKING REFORM

Jerry Ng

Former Deputy Chairman of IBRA

Senior Advisor to CEO Bank Danamon

Jakarta
 BANKING CRISIS IN ASIA STARTED IN 1998

Indonesian financial crisis and Asian financial crisis can be attributed to external and
internal factors

The crisis was triggered by external systemic events

1. Overheated economies that created confidence crisis in the tiger economies
2. Political instability
3. Massive currency devaluation

1. ... Within the banking system, currency devaluation led to

4. Interest surge and mounting NPL
5. ... Negative margin ...
6. ... the financial system that is already comprised of small and undercapitalised
banks is further weakened

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 1 Over heated
Economy

OVERHEATED ECONOMY LED TO CONFIDENCE CRISIS ...

High current account deficit . . . . . . Higher debt burden . . . . . . triggered crisis confidence.

Current Account Deficit Debt Service & Short term Debt Local Currency 1997
(% GDP) (% Foreign Reserved) (Indexed to April’97 vs USD)
Philip
Indonesia Korea
pines Thailand Malaysia MayJuneJuly Aug Sep Oct Nov Dev Jan
294 0.9

1.1 Korean
243
Won
1.3
Thailand
1.5 Baht
-3.3
-3.7 1.7
-4.8 -4.7 137
122 1.9

2.1
69
2.3
Indonesian
-8.5 2.5 Rupiah

Philip
Indonesia Korea
pines Thailand Malaysia

Source: NYU Stern, International Financial Statistics, OANDA

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 2 Political
Instability

... EXACERBATED BY POLITICAL CRISIS ...

Indonesian Rupiah vs USD

Jun 97 Jul 97 Aug 97 Sep 97 Oct 97 Nov 97 Dec 97 Jan 98 Feb 97 Mar 98 Apr 98 May 98 Jun 98
0
Indonesia seeks IMF
2,000 help

4,000

6,000
New cabinet was
8,000 Thai Baht sharply fell announced
after crisis in
confidence
10,000

12,000 Soeharto announced his

budget – Rp plunged to
11,000
14,000 Govenment announced
deposit guarantee

Government announced
price hike, riots ensued

Soeharto announced his

resignation
Habibie announced
as VP candidate

Source: Worldbank, OANDA

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 3 Massive
Devaluation

... MASSIVE LOCAL CURRENCY DEVALUATION THAT LED TO CRISIS

Rp i
Crisis of Banking
Confidence 1 2 3 4 Crisis
Rising
Rupiah Surge in
Capital Flight Borrower
Devaluation Interest Rates
Defaults

Rupiah lost >75% of Multiple sources of Interest rates Average level of Foreign exchange
its value since 8/97 investor concern peaked at over NPLs estimated to losses due to open
• Unclear political 70% p.a, the be >50% of total US$ net positions
Unexpected removal transition highest rate loans outstanding
of the currency • Bank closures since 1966 Level of NPLs grew
intervention band • Widespread riots Some banks have dramatically
left many companies • Droughts, forest close to 100%
and banks with fires NPLs Interest spreads
mismatched and
became negative
unhedged ($/Rp) Led to estimated
assets and liabilities US$18 Bn of capital
flight, mainly to Customers rushed
Singapore to take deposits
out of the
Source: Analyst reports, literature, BCG analysis
system/country - 4 -
 4 Large
NPL

DEVALUATION AND UNHEDGED DEBT POSITIONS LED TO A HIGH

LEVEL OF NON PERFORMING LOANS

Estimated Non Performing Loans (%) in the

NPLs by Types of Banks in Indonesia
Banking System in Indonesia

% 60 57
80
1997
72
1998
50 70

1998E (NPL)
60 57
Korea 21%
40 52
Thailand 44%
50
45
Malaysia 17%
30
Philippines 28% 40 36

20 30

10 9 20
15
10 8
11 11
10 6 5
3 3
0
0
1995 1996 1997 1998
State Forex Non-Forex Regional Joint Foreign
Total Loans Banks Private National Develop- Venture Banks
235 293 445 545 National Banks ment Banks
(Rp. Tr.)
Banks Bank

Source: Bank Indonesia, BCG analysis

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 5 Negative
Spread

A MASSIVE RECAP PROGRAM OF RP 420 TN

Almost 2/3 of all banking assets were lost as a result of the crisis
• A majority of the banking sector was technically bankrupt
• Banks’ role as a financial intermediary was seriously eroded

The government could not afford the banking sector to collapse

• Indonesia’s economic foundation would be destroyed – perhaps
permanently
• Political considerations and the welfare of people who would lose their
savings(1)

... Therefore, a large amount of recapitalisation bonds were issued to save the
banks
• Kind of “promissory notes” due for redemption within 2009 – initially ...
• Coupon at fixed and variable rates
(1) A deposit guarantee scheme was introduced

-6-
 5 Negative
Spread

NPLS COUPLED WITH EXPENSIVE COST OF FUNDS CAUSED

NEGATIVE SPREADS IN MOST BANKS ...
Weighted Average Interest Rate
% 70

60

Weighted Average
Deposit Rate
50

40
Negative spread

30

Weighted Average
20 Lending Rate

10

0
Jan Feb Mar Apr May Jun Jul Agt Sept Oct Nov Dec Jan Feb Mar Apr May Jun Jul Agt Sep Oct
1997 1998

Source: Economic Outlook 1999, BCG analysis

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 6 Small &
Weak Banks

... WHICH WEAKENED THE BANKING SYSTEM EVEN FURTHER

Indonesia banking system was mostly made of

. . . that is further weakened by the crisis
small banks . . .

Number of Banks Pre-crisis Equity/ Assets of Banks

(%)
208

8.8 10.3
8.1
6.8

144

-1.6

54
-8.3
46
34
-12.9 -13.6
27 26
Overall State Private Foreign & JV
Indonesia Japan India Taiwan Malaysia Philip Hong
pines Kong

1997 1998

(1) In Asiaweek Financial 500

(2) Based on assets
Source: Asiaweek, BCG analysis
-8-
CRISIS CREATED IMPETUS FOR EXTERNAL AND INTERNAL REFORM

External Internal

Large NPL ...

Over-heated economy
... Negative margin ...
Crisis Cause Political instability
... Weakened the small and
Massive depreciation
weak banking system

1. Asset management 4. Starts lending again

Action 2. Bank recapitalisation 5. Risk management &

Post-Crisis corporate governance
3. Banking sector
consolidation 6. Improving capabilities

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 INDONESIA LEAST SUCCESSFUL IN GOVERNMENT-LED REFORM
Korea
Established Kamco as
AMC
Asset
So far, disposed ~50% of
Management & loans purchased by
Loan Kamco
Restructuring
Government recapitalized
feasible banks in return for
purchased NPL made by
Recapitalization & Kamco
Balance Sheet
Restructuring Average banks’ capital has
exceeded the minimum
defined by BIS
Government plays an
active role in banks M&A
Banking Sector So far has closed 5 banks
and 23 merchant bank
Consolidation
6 banks and 3 merchant
banks has successfully
merged
Thailand Malaysia Indonesia
No centralized asset Established Danaharta as Established an AMC
management companies AMC underneath IBRA
were established
• AMCs were Established Corporate Has managed to dispose
established by the debt restructuring comm. xx % of loans transferred
banks - Most of loans disposed
• Framework for AMC Danaharta has Disposed were unrestructured
creation was ~80% of loans purchased
established
Recapitalization was Established Danamodal to 11 private and 4 state
private sector led recapitalize, revitalize and banks were recapitalized
restructure banking sector by the government using
However, the government • A comprehensive bonds not cash
provided capital support framework of banking
scheme sector improvement is Many banks are still
in place undercapitalized, exposed
to interest rate risk and
liquidity risk
3 local banks were Government is Banks declined from ~225
acquired by foreign banks authoritative in pursuing to 162 some closed and
consolidation liquidated
56 finance companies were
closed Government mandated Limited M&A activity, 7
merger of banks to 10 banks merged into
However, limited anchor banks possibly to 6 Danamon while 4 state
consolidation amongst in the future banks merged into Mandiri
local banks
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STRONG LEGAL FRAMEWORK
PRE-REQUISITE TO ACCELERATE LOAN RESTRUCTURING
Korea
Established Korea Asset
Management Corporation
which purchases NPL from
banks
Financial Supervisory
Commission (FSC) and
Financial Supervisory
Service(FSS) leads,
formulate the policy and
enforce the banking reform
• FSC & FSS in
cooperation with other
institution leads reforms
in real sector (corporate
sector)
Government takes an active
role to reform the judicial
system, including replacing
commercial judges
Improvement in
legal infrastructure
1 Asset
Management
Thailand Malaysia Indonesia
Government plays Established Danaharta to Established AMC under
supporting role rather than purchase loans from banks IBRA which purchases
leading role in asset as part of the recap loans from banks and
management program conducted restructuring
• Maintain low interest
rate level as well as Created a comprehensive Financial Sector Policy
provide tax incentives to framework to acquire loans, Committee is established to
facilitate loan manage assets and defined play an active role in
restructuring clear exit/ disposal strategy establishing policies for
financial sector
• Developed a framework
• Involved in making
for creating a private
decisions for large loans
AMC rather than
restructuring
creating a centralized
AMC that would
However, lack of reforms in
purchase loans from
legal framework and
banks
infrastructure has so far
impeded progress in asset/
loans restructuring
Create clear Lack of clarity of
Private led asset
framework and decision makers of
management
targets asset management
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 1 Asset
Management

SEPARATING BAD ASSETS REDUCED THE NEED

FOR BANKS TO FOCUS ON LOAN RESTRUCTURING

NPL increased significantly after the crisis ... ... reduced significantly after transfer to AMC

NPL End of 1998 (%) NPL 2001(1) (%)

48
42

19
13 13
10 10
4

Indonesia Thailand Korea Malaysia Indonesia Thailand Malaysia Korea

(1) Indonesia as of April 2001, Korea June 2001, Malaysia & Thailand July 2001
Source: ADB Asia Recovery Report Sep 2001
- 12 -
 2 Recap &
B/S Repair

ALL GOVERNMENT UNDERTAKE MASSIVE

RECAP PROGRAM TO RESCUE BANKS

Massive Cost of Recapitalization At the cost of Large Government Deficits

Expected recapitalisation need (US$ ‘b) Government Deficit in 1998 (% GDP)

70
Korea Thailand Malaysia Indonesia

31 30
-3.9%

-5.0%
9
-6.0%

Indonesia Korea Thailand Malaysia

-9.0%

Source: JP Morgan, MSDW 1998, IBRA

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 2 Recap &
B/S Repair

IN INDONESIA, MORE THAN RECAPITALIZATION IS

REQUIRED TO REPAIR BANKS’ BALANCE SHEET

High
Healthy bank
Panin Danamon

Mandiri
BCA
3 Market Risk:
Lippo
Bukopin Low
1 Capital Solidity: BNI
Medium
CAR(1) (%) Niaga Buana High
SCB
HSBC

Bali Citibank
Universal 4 Asset Size:
0
BII
Rp. 100 Tn
Low

High 2 Credit Risk: Low

NPL as % of Loans (%)

Source: Financial Statements June 2001, BCG analysis

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 3 Consolidation

WHY CONSOLIDATION AND/ OR SALE IS IMPORTANT?

1 Allow relatively strong banks to use their balance sheet to address

problems of weaker banks around work outs of bad loans and
recaptalising

2 Contain possibility of loss of confidence which could result in bank runs

and breakdown of banking system; capital flight e.g. in Indonesia real
Rupiah deposits have fallen by 30% between 1997 and 3Q 1998; foreign
currency deposits have fallen 50% in the same period

3 Restore confidence of depositors and investors in the banking system,

this will be key for the banks to begin value creation

4 Complements banks’ capabilities especially in the area of risk

management, scale in operations and application of technology

5 Bring in new capital from foreign strategic investors and expertise in risk,
new product development, management, global network through sales to
foreign investors

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 3 Consolidation

SALE AND CONSOLIDATION PLANS

Pre-crisis had 78 banks (local and foreign)
• 5 commercial banks and 23 merchant banks already shut down
• Govt has ordered healthy banks to take over weaker banks in 1998 for
restructuring and recapitalisation; Merger of 6 banks and 3 merchant banks
has taken place so far

Pre-crisis had 33 banks (local and foreign)

• 3 local banks were acquired by foreign banks (DBS, Stan Chart & ABN Amro)
• so far, only 1 merger took place between local banks

Govt has encouraged consolidation from original number of 34 (local and foreign);
banks to 10 anchor banks
• Recently completed the stage 1 (10 banks) and moving to stage 2 (six banks)

Pre-crisis had 225 banks (local and foreign); 16 have been liquidated and 54 banks put
under supervision. Govt aiming for 4 “mother banks”
• So far, only BCA and Niaga is successfully divested ...
• ... Stakeholders management makes it difficult to divest the banks
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 3 Consolidation

GOVERNMENT INITIATIVE IS KEY FOR CONSOLIDATION

Example of Banks M&A in Korea
Merger of banks (in1998)
Gov’t decision-making tree
1 Kookmin + Daedong
• W 57 trillion(1) • W 8.6 trillion
Due diligence on banks,
• 9.78%(2) • 2.98%
identify banks with • 12,000(3) • 1,700
BIS ratio <8%
Evaluation on bank
2 Hao Sing + Dongnam
• W 38 trillion • W 7.5 trillion
management
• 10.29% • 4.54%
performance • 11,000 • 1,700
FSB ‘verdict’ on 3 +
Shinhan Dongwha
bankruptcy • W 42 trillion • W 12 trillion
• 10.29% • 5.34%
• 4,700 • 1,800
Survival on
Survived Bankrupt 4 +
condition Koram Kyonggi
• W 15 trillion • W 7.6 trillion
Restructuring Transfer of • 8.57% • 6.69%
Normal
plan within asset & • 2,100 • 2,200
operation
one month liability 5
Hana
+ Chungchung
• W 15 trillion • W 6.1 trillion
• 9.29% • 7.05%
‘Voluntary’ M&A
• 1,700 • 1,400
Merger of equals
6 Commercial Bank + Hanil
Reach BIS ratio of >8% of Korea • W 55 trillion
• W 50 trillion • 4.53%
• 3.28% • 7,488
Note: (1) Total asset (2) BIS ratio (3) No. of employees
• 7,806
Source: FSB, Korea Daily Economic
- 17 -
 4 Start
Lending

INDONESIAN BANKS NEED TO START LENDING AGAIN

Indonesia has a smaller proportion of loans

... when compared to other Asian countries
particularly in consumers ...

Total Bank Assets & Liabilities(1)

Deposits are significantly larger than
Retail Funds(1) 2% corresponding wholesale and retail assets
6% 4% 1%
Consumer Loans 7% • Loans write-off, corporate de-leveraging and
Mortgage 7% 21% a high interest rate environment are the main
drivers
Wholesale Loans 28%

Retail lending still small compared to deposits

• Customer sophistication and income levels
72%
are the main drivers for future growth
Deposits 52%

Total Other Indonesia

Asian Countries

(1) Other Asian countries 1999, Indonesia 2000

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 5 Risk Mgt &
Governance

IMPROVING RISK MANAGEMENT AND GOVERNANCE IS A PRE-

REQUISITE
Areas of Focus Improvement Opportunities

Many banks are still lagging the 4 core principles of good

corporate governance
• Ineffective board partly due to banks ownership structure
• Lack of transparency
Corporate • Weak internal controls and audit performance
Governance • Unreliable reporting

Many banks lack robust integrated risk management systems

that can be considered compliant to Basel II requirement
• Building banks with a strong credit risk management will
continue to be the key challenge
Risk Management • Only one bank is expected to be FIRB(1) compliant by 2002

(1) Fundamental Internal Rating Based Approach according to Basel II requirements

Source: Basel II Capital Accord
- 19 -
 6 Improving
Capabilities

DOMESTIC BANKS ARE TRYING TO IMPROVE THEIR CAPABILITIES

Implementation by
Improvement Areas Improvement Initiatives
Domestic Banks

• Headcount reduction
Human
1 • Training
Resources
• Performance incentives

• Network rationalisation (e.g., branches)

2 Network • Network optimisation (e.g., ATMs)
• Network sharing (e.g., ATMs, card businesses)

• Outsourcing of processes
3 Process • Back office centralisation (within a bank)
• Back office sharing (among banks)

= all or almost all banks = many banks = few banks = very few banks = none

- 20 -
 WHAT’s NEXT FOR THE INDONESIAN BANKING SECTOR?

Banks are expected to play a key role in financial intermediation over the next 5-10
years, with the typical pattern of
• People placing money with the banks (small savings) instead of pursuing
capital market products (affordability)
• Banks channeling the funds to companies, which have limited sources of
finance given a stagnant domestic capital market (low demand)

Competition expected to increase - domestically

• A wave of consolidation may follow a tighter regulatory environment
• Foreign banks hesitate to enter – albeit BCA and Niaga divestments – and
Danamon in the pipeline

An after-thought: Have the Indonesian banking sector learnt its lesson (corporate
governance and risk management) to avoid a “second crisis”?

- 21 -