Working Paper Series: 05-02

Governance Reforms in the Banking Sector in Southeast Asia:

Economic and Institutional Imperatives

Dipinder S Randhawa* * Saw Centre for Financial Studies NUS Business School National University of Singapore 1 Business Link Singapore 117592 bizdsr@nus.edu.sg (65) 6873-1160

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Governance Reforms in the Banking Sector in SE Asia: Economic and Institutional Imperatives

Dipinder S Randhawa* * Saw Centre for Financial Studies NUS Business School National University of Singapore 1 Business Link Singapore 117592 bizdsr@nus.edu.sg (65) 6873-1160

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Introduction

For institutions that account for an overwhelming proportion of funds mobilized by the corporate sector and that have been at the epicenter of repeated instances of financial crisis since the early eighties, governance of banks has received surprisingly little attention. While corporate governance of firms has assumed centre stage in the debate on governance reforms, banks and related institutions have been relatively neglected. On the face of it, this neglect of the role of financial institutions is puzzling. However, as this paper shows, reasons can be offered for this oversight.

In the aftermath of the Asian Financial Crisis of 1997 a substantial volume of

research has investigated the causes and manifestations of the crisis, as well as the efficacy of initiatives taken to deal with its aftermath. Macroeconomic instability, failures in co-ordination, contagion effects, problems latent in the financial sector, widespread lapses in governance, moral hazard problems in the domestic banking sector and among multinational banks lending to Southeast Asian entities, are considered the main explanations for the crisis. The literature provide an informative analysis and useful insights into what went wrong, and the initiatives that have been undertaken since to enhance the resilience of the financial sector, and, thus of the economy. Lapses in governance assume a central position in the debate.

Failures in governance in both the private and public sectors are widely acknowledged as one of the major causes of the Asian financial crisis. The breakdown is by no means confined to the corporate sector. The banking system, capital markets, and indeed the regulatory authorities entrusted with the task of supervising financial markets and institutions, and surveillance of the financial system, were themselves remiss in their delegated tasks and responsibilities.

Resource allocation by the invisible hand of free markets can be efficient only when the governance of institutions is sound. Good corporate governance seeks to ensure that individuals who run companies serve the interests of those who own the companies. An analysis of governance should encompass the institutions, structures, and channels through which objectives are set and implemented and provide the means for attaining those objectives and monitoring performance (OECD, 2003).

This paper examines the problems latent in the banking sector that led to the financial crisis in 1997, the reforms that have been carried out since, and the effectiveness of these reforms. It focuses on two issues. We make the case that corporate governance of the banking sector is intrinsically different from governance of nonfinancial firms, and delineate the characteristics distinctive of the economies of SE Asia that compounded the effects of the financial crisis. We suggest reasons why governance of the banking sector has been neglected in the literature. This is followed by a preliminary assessment of the reforms that have been carried out over the past seven years. Many of these reforms are ongoing. In order to lend a sharper focus to the analysis, we concentrate on channels of governance external to banks, e.g. the role of competition, regulation, efforts at reducing information asymmetries and improving governance. We do not consider the role of

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internal agents, such as the board of directors and the audit committee. These issues have been dealt with in detail in the country studies and overview papers in this volume. The experience of Malaysia, Thailand and Indonesia, the economies that were the most affected by the crisis, are examined in detail. Where possible we present evidence for other Southeast and East Asian economies.

At the outset we explain the neglect of financial institutions in the debate on

corporate governance. This is followed by a discussion on the obstacles in the way of effective governance of financial institutions. Section three summarizes the impact of the Asian financial crisis on financial institutions in the region. This is followed by a review of the response of policymakers to the crisis. Section 5 surveys the reforms in governance of financial institutions that have been carried out over the past five years. Section 6 briefly discusses some policy issues that arise from the ongoing reforms. The paper concludes with some observations on outstanding issues and the challenges that lie ahead. 2 Governance of Financial Institutions 2.1 Why has the banking sector been neglected in the debate

Studies on governance have concentrated on the corporate sector. This orientation draws upon the Anglo-American model with capital markets predominant in the financial sector. In Asian economies, and indeed in nearly all economies other than the US and the UK, banks rather than capital markets account for a majority of funds lent to the corporate sector (See Table 1). Thus governance of banks and other financial institutions is vital.

Several reasons can be proffered for the neglect of banks in the debate on

corporate governance. Much of the academic and policy debate is grounded in market dominated economies where the focus is on corporate governance. Governance of the banking sector has often been deemed synonymous with risk management in the banking sector. Over the past decade the focus has been on efforts to stem potential contagion effects– this is reflected in the Basel Accord on capital adequacy. Issues of governance in the banking sector, for reasons that we shall spell out, are more nuanced and complicated and are predicated on broader reforms in the financial system and the economy. 2.2 The Case for Governance of Financial Intermediaries

Governance of the financial system and the firms to which it dispenses resources is important. The market places a premium on firms that demonstrate sound corporate governance. Similarly banks that are deemed to be well-governed and meet global standards of disclosure and risk management find it easier to attract funds and clients and to raise funds at a lower cost. Effective governance nurtures efficient banks and capital markets. Domestic and foreign capital is drawn by confidence in the system. This can lead to a broadening of the shareholder base as a premium is placed on well-managed companies and banks. Monitoring of financial institutions and the corporate sector’s operations ensures efficient utilization of resources, minimizes the chances of misuse of resources, and eventually paves the way for sustained growth in the economy.

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There has been extensive research on corporate governance and reform in the

financial sector following the Asian crisis (Mitton, 2002, Johnson, et al. 2000). The focus has been on issues pertaining to monitoring of firm’s activities, board composition, disclosure norms and regulations and rights of minority shareholders. Curiously corporate governance in the banking sector has received little attention in this context. Curious because capital markets in SE Asia, where considerable attention has been directed, continue to be in the formative stages of development, albeit with considerable heterogeneity across the regional economies. Banks on the other hand account for a majority of funds mobilized by the corporate sector (Table 1). The damage inflicted on the economy by a banking crisis is severe, thus the banking system bears considerable responsibility for efficiently allocating and monitoring the use of funds.

Table 1: Composition of External Finance Domestic credit provided by

banking sector Stock market capitalization

Outstanding Debt Issues

China 62.89 25.49 11.63 Hong Kong 26.29 71.25 2.46 Malaysia 41.81 36.58 21.61 Singapore 31.22 57.72 11.07 South Korea 57.52 20.76 21.72 Thailand 71.15 14.11 14.74 Sources: World Bank and BIS (From Barry Eichengreen, Financial Development in Asia: The Way Forward, 2004)

There are stronger reasons for ensuring banks fulfill their mandate of efficient allocation of resources. Aside from occupying a unique and distinctive space in the economy, banks account for an overwhelming proportion of funds transferred to the corporate sector. Unlike the corporate sector, where the costs of default are borne by shareholders, bondholders, and banks, the burden imposed by a bank failure is transmitted throughout the economy, e.g. liquidity problems encountered by banks can readily metamorphose into solvency problems, leading to bank failure and possible contagion effects. Instances of systemic failure in the banking system are well documented through history.

A bank failure can cause severe disruption to the payments system, wreak havoc

with liquidity creation in the economy, and lead to widespread loss of confidence and resultant flight of capital from the banking system. Firms that are functioning normally may find that access to liquidity has dried up abruptly. A sudden rush on deposits can lead to systemic problems in the banking sector. High leverage ratios increase banks’ vulnerability to liquidity constraints. The burden imposed by bank failures is borne not only by the exchequer but the entire population as the payments system is disrupted, liquidity dries up and firm’s access to funds is disrupted. The costs of a crisis, reflected in nonperforming loans, the cost of bank bailouts and capital injections soars (Table 2). Costs resulting from rehabilitation of the banking system require governments to make across the board cuts in spending programs. This may reduce growth potential in the economy for years to come.

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The costs of the banking crisis in Thailand add up to nearly a quarter of its GDP, in Indonesia it exceeds 50% of GDP. According to some estimates (Litan, et al. 2002) the costs of assuming the obligations of private sector banks exceeds 100% of GDP in Indonesia. The costs rise as bank management and the monetary authorities deal with the mounting legacy of nonperforming loans and fiscal costs arising from government bailouts. Table 3 provides estimates of the magnitude of nonperforming loans (NPLs)

Table 2: The Costs of Banking Crises

Peak Nonperforming Loans as % of Total Loans

Cost of restructuring: as % of GDP

Chile 1978-83 19 41 United States 1984-91 4 5-7 Norway 1988-92 9 4 Finland 1991-93 9 8-10 Sweden 1991-93 11 4-5 Mexico 1995-97 13 14 Argentina 1995 -- 2 Brazil 1995- 15 5-10 Thailand 1997- 47 24 South Korea 1997- 25 17 Indonesia 1997- 55 58 Malaysia 1997- 25 10 Philippines 1998- 12 7 Sources: IMF, World Economic Outlook, May 1998; JP Morgan, Asian Financial Markets, 28 April 2000; World Bank, Global Economic Prospect and Developing Countries, Table 3.6; Barth, Caprio and Levine (2000), Table 2; Central Banks, extracted from BIS ‘The Banking Industry in Emerging Market Economies: Competition, Consolidation and Systemic Stability” 2001

Table 3 Overview of the banking system and NPLs

End-2002 (in percentages) Indonesia S Korea Malaysia Philippines Thailand Banking system assets as % of GDP

74 154 158 84 136

Assets of state-owned banks as % of total assets

49 NA NA 11.5 27.71

NPLS / GDP Peak 26.8 8.4 25.5 7.9 54.1 End-2002 2.12 8.4 18.5 6.23 8.4 NPLs / Total loans

Peak 48.6 9.7 30.1 18.1 51.6 End-2002 8.12 9.7 8 153 10.11 Source: BIS FSI Occasional paper No 3

Developments in the domestic and international financial systems over the past two decades have further underscored the importance of governance of financial institutions. Aside from the substantial costs and negative externalities resulting from a banking crisis, which have soared with increasing financial globalization and cross-

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border financial flows, the frequency of banking crises has also risen dramatically over the past two decades. Looking ahead, as economies open up to external investment and competition, and foreign investment into the financial sector accelerates (BIS, 2004), the banking system has to adapt on multiple fronts. Domestic consolidation and the entry of foreign banks and narrowing margins from funds mobilization from capital markets have all added to competitive pressures on banks. The immediate impact may be felt via narrower margins. Well managed and effectively monitored banks alone would be in a position to grow in such an environment. 2.3 How Governance of Financial Institutions is different

The dominance of banks in the financial system coupled with the underdeveloped state of financial markets creates a strong case for paying special attention to banks in developing economies, including SE Asia. Governance of banks raises a unique set of challenges on account of the distinctive characteristics of banks (Levine, 2004). Table 4 provides a synopsis of these challenges.

Table 4: Challenges of Governance of Financial Institutions Assumptions underlying

traditional model Banks

Market structure Competitive Banking structures tend towards monopolistic competition

Information asymmetry Forms crux of agency problem Agency problem far more complex, Banks are opaque

Capital structure Low leverage ratios Highly leveraged Regulation Common for all sectors Intensive and extensive

regulation in the financial sector, with intervention of 3rd party regulatory agency

Ownership Dispersed, or a few controlling owners

Family ownership and government ownership / control common in SE Asia

Three characteristics define how governance of banks is different from

governance of nonfinancial firms. Firstly banks are opaque. In economies where accounting systems and practices are not well-developed and estimation of borrower’s creditworthiness is difficult to assess, it is extremely difficult to estimate the value of bank portfolios. This allows managers to exploit the information gap to their advantage. Loans to favored clients, risky investment decisions, rolling over of nonperforming loans are some of the common excesses uncovered during enquiries into bank behavior as having occurred in the years before a crisis. The information gap between bank management and outside stakeholders also precludes outside agents from marshalling enough information to execute a takeover.

The difficulties inherent in assessing the value of a bank’s loan portfolios is

reflected in empirical studies documenting how bond analysts have greater disagreement on value of bank portfolios than other corporate entities (Morgan, 1999). Furthermore, as is evident from the Barings Banks and Allied Irish Bank cases, it takes a single rogue

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trader to bring down or severely impair an entire business. Enron was brought down by its financial intermediation business, not the energy trading division (Sale, 2005).

The opacity in information availability makes it easier for bank managers to

exploit the institution for personal gain. Some of the most egregious yet unheralded financial crimes take place in the banking sector. “Banks have proved themselves to be the most hazardous economic institutions known to man. Breakdowns in banking lie at the centre of most financial crises. And banks are unusually effective at spreading financial distress, once it starts, from one place to another” (Economist, Survey on Banking, Mar 1, 2003). For external agents, it is extremely difficult to make informed and accurate assessments of the value of banks’ portfolios and, thus, a priori, to assess the merits of banks’ decision-making.

The problem is serious in developing economies with inadequate and poor disclosure regulations that impair the ability of outside stakeholders and regulatory and supervisory authorities to monitor banks. In economies where family ownership plays an important role, the problem is compounded by the presence of cross-ownership and the ‘evergreening’ of loans. This was true of banks in East and Southeast Asia in the years leading up to the financial crisis.

Secondly, the financial sector is and in the foreseeable future will continue to be,

the most extensively regulated sector in the economy. The rationale for regulation is to ensure fair and efficient functioning of the financial system and create conditions for financial stability. Within the financial sector banks are the most heavily regulated entities.

Source: BIS, ‘The Banking Industry in Emerging Market Economies: Competition, Consolidation and Systemic Stability” 2001

In developing economies the regulatory agenda often goes beyond the objectives of safety and stability to meet strategic national goals via directed lending, portfolio controls, or outright control of lending decisions. This is especially true if there is pressure on banks to meet financing needs of state owned enterprises. These policies may be inimical to the interests of shareholders. The manifestations of regulation are manifold. The presence of deposit insurance reduces incentives for depositors to monitor banks, and makes banks less dependent on uninsured depositors for funds. This induces

Table 5: State-Owned Banks Assets held by State Owned Banks as

a Percentage of Total Bank Assets Return on Assets

Capital Ratio: Risk-weighted

1980 1990 2000 1998 1998 Hong Kong 0 0 0 - - Indonesia … 55 57 -19.9 -21.4 Korea 25 21 30 -5.2 6.9 Malaysia … … 0 … … Philippines 37 7 12 0.5 13.3 Singapore 0 0 0 - - Thailand Na 13 31 -12.1 8.7

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bank managers to reduce the bank’s capital base and frequently seek low cost loans from the central bank. Government ownership of banks, restrictions on ownership, regulatory restrictions on credit allocation, are aspects of regulation that tend to restrict competition and may result in different and possibly conflicting objectives for regulators and bank managers. As Table 5 shows, a number of banks were nationalized during the crisis. Policymakers are now confronted with the challenge of re-privatizing these banks and putting them back on the path to growth.

The challenge of corporate governance in banking is further complicated as banks

are highly leveraged and operate in industries characterized by highly concentrated, if not monopolistic, market structures. High leverage ratios increase the vulnerability of financial institutions and firms to a downturn in the economy. It is also indicative of a small shareholder base. This eliminates an important channel for governance – competition. Coupled with this, in most Asian economies the concentrated ownership structure of banks, often under family ownership or association with industrial groups, etc. makes banks particularly vulnerable to exploitation. In Indonesia in 1997, an economy with few macroeconomic problems, it is difficult to explain the massive collapse in the banking system and the sharp downturn in the entire economy. However, a closer examination by Tabalujan (2001) documents some banks in which insiders’ borrowings accounted for 85% - 345% of bank capital. These loans were often extended on terms much more favorable than those available to outsiders. Exposure at such levels often financed through funds mobilized in international markets made banks vulnerable to any downward trend in the economy, especially where external borrowing was mediated by the domestic banking system.

The shallow base of the financial system in developing economies compounds

governance problems in the banking sector (Barth, Caprio and Levine, 2001). The absence of deep capital markets precludes some obvious takeover mechanisms, furthermore securities that can be deployed to effect greater monitoring may not be available (e.g. subordinated bonds, etc.). Low liquidity levels in capital markets make it difficult for a potential takeover agent to mobilize adequate resources for takeovers. The dependence on banks for funds and the resultant high leverage ratios in the corporate sector increases the vulnerability of the entire economy to an economic downturn.

Banks draw heavily upon borrowed funds. Other than the ones with large

capitalization, most banks, especially those in developing economies tend to have thinly traded issues. Furthermore a substantial maturity mismatch in bank balance sheets accentuates vulnerability of the bank to a change in the economic environment. Problems at a single bank can easily be transmitted to other banks and result in a systemic crisis. Notwithstanding these challenges, banks in developing economies banks are uniquely placed to enhance the general level of corporate governance.

Given the unique role banks play in the economy and the distinctive problems

they face, risk management and corporate governance are inextricably intertwined. This is manifest in the dual nature of governance challenges faced by policymakers, regulators and bank managers. As stated earlier, efficient financial intermediation requires effective

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governance of banks and by banks. Risk management calls for timely disclosure and accurate and timely valuation of bank’s risk exposure, sound governance requires bank managers to work in the best interests of the shareholders by extending loans to creditworthy clients. In practice the two notions are flip sides of the same coin, efficient screening and monitoring of borrowers, would facilitate selection of borrowers with the highest probability of repayment. This is in the interests of bank shareholders, regulators and the bank management itself. However in the presence of information asymmetries and a safety net provided by deposit insurance, bank management has incentives to lend to high risk borrowers and maximize short term profits, at the expense of both shareholders and bond holders. This distinctive characteristic of banks makes their governance a challenging and complicated task relative to governance of nonfinancial corporations.

3 The Impact of the Asian Financial Crisis on Banks

SE Asia achieved impressive growth rates in the two decades leading up to the 1997 crisis. The 1997 crisis notwithstanding, outward economic orientation, coupled with commensurate financial sector policies constitutes an important explanation for the widely divergent performance between Latin America and East and Southeast Asia since the seventies. This macroeconomic framework in tandem with policies conducive to domestic and foreign investment laid the foundations for rising volumes of investment in SE Asia. Generally prudent fiscal and monetary policies paved the way for sustained capital inflows, rapid high levels of investment and growth.

At the end of June 1997, the classic symptoms of impending crisis – an unsustainable fiscal deficit and rising inflation rates - were not present. The only indication of macroeconomic disequilibria was a rising current account deficit, but at levels it was believed that could be financed with sustained capital inflows. The only warning signs were pressures on exchange rates and some incipient problems in the banking sector, notably in Thailand, with the Farmer’s Bank receiving considerable attention in the press. A World Bank report the same year located this problem in a more systematic context (Claessens and Glaessner, 1997). A speculative attack on the Thai Baht in the summer of 1997 eventually forced the Bank of Thailand to initially defend and then as speculative pressures mounted, take the Baht off the peg. A sharp and abrupt devaluation and a flight of capital followed. Overnight, a large number of banks found themselves facing serious liquidity and, shortly thereafter, solvency problems. Tables 6 and 7 document the impact of the crisis on the capital positions of banks across Asia. The massive losses in the banking system in Indonesia resulted in significantly negative bank positions. Elsewhere, aside from the Philippines and Malaysia, capital levels in the banking system fell below the 8% level prescribed by the Basel accord.

With hindsight a number of weaknesses were latent in the financial sector.

Clearly high levels of exposure to the property sector, the shortening of the maturity structure of external borrowings by the banks, and the increasing level of dependence on borrowed funds rendered banks increasingly fragile. As is almost inevitable with periods of rapid growth, leverage ratios of nonfinancial firms grew and the brisk growth of credit resulted in bank portfolio leverage increasing to levels that threatened stability. .

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Table 6: Percentage of Bank Capital to Assets (in percentage)

1998 1999 2000 2001 2002 2003 Bank Regulatory Capital to Risk-Weighted Assets

Hong Kong 18.5 18.7 17.8 16.5 15.7 15.6 Indonesia -13.0 -2.4 -18.2 19.2 19.7 21.4 Korea 8.2 10.8 10.5 10.8 10.5 10.4 Malaysia 11.8 12.5 12.5 13.0 13.2 13.4 Philippines 17.7 17.5 16.2 15.8 16.7 16.1 Singapore 18.1 20.6 8.3 7.8 8.1 7.6 Thailand 10.9 12.4 12.0 13.9 13.7 13.6 Bank Capital to Assets

Hong Kong 7.7 8.1 9.0 9.8 10.7 11.5 Indonesia -12.9 -4.1 5.2 5.4 7.3 8.3 Korea 2.8 3.9 3.8 4.1 4.0 4.0 Malaysia 8.9 8.9 8.5 8.5 8.7 … Philippines 14.8 16.0 15.3 15.4 15.5 15.9 Singapore 7.5 7.8 7.1 9.6 8.3 8.5 Thailand 4.8 5.5 4.5 5.5 5.8 6.2 Source: National authorities; EDSS; OECD; IMF staff estimates

Table 7: Bank Provisions to Non-Performing Loans (in percentage)

1998 1999 2000 2001 2002 2003 Hong Kong … … … … … … Indonesia 28.6 77.7 59.4 97.7 125.7 152.5

Korea 46.2 66.6 81.8 85.2 109.4 … Malaysia … 39.0 41.0 37.7 38.1 38.5

Philippines 36.4 45.2 43.7 45.3 53.2 52.2 Singapore … 86.2 87.2 90.1 96.7 96.6 Thailand 29.2 37.9 47.2 54.9 61.8 60.8

Source: National authorities and IMF staff estimates 4 Response of policymakers to the crisis

Timing is of the essence when dealing with banking crisis. A delayed response by bank management and monetary authorities to the onset of a crisis results in rising NPLs, panic withdrawals by depositors, an exodus of foreign deposits, and increased panicked borrowing to cover positions. In this scenario, liquidity problems can easily turn into solvency problems. A multitude of approaches were followed countries confronted with the crisis. Thailand, Indonesia and South Korea turned to the IMF for loans, Malaysia responded by imposing capital controls which were controversial in the initial stages but subsequently acknowledged to have largely achieved their original intent. Singapore and Hong Kong with the most effectively regulated and managed banking systems were able to withstand the crises through internal policy initiatives.

The initial efforts of policymakers sought to contain panic within the banking system. This was done through explicit guarantees to depositors and provision of liquidity to banks. Once a modicum of stability was restored, efforts turned towards

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medium and longer term issues of dealing with nonperforming loans and recapitalization of banks.

Recapitalization was carried out through injection of funds from the IMF, via issuance of bonds by the fiscal or the monetary authorities, and where possible, through bonds issued by the banks themselves. Bank restructuring assumed several forms. In Indonesia a large number of private banks were closed down. In Thailand a number of finance companies, a class of intermediaries that experienced large losses, were closed. Malaysia put into operation a comprehensive consolidation program via mergers and acquisitions in the banking system. The consolidation program was centered around a core of ten anchor banks. In Indonesia bank consolidation is nearing completion, though as Table 11 shows, problems with nonperforming loans persist. Thailand opened its banking sector to foreign acquisitions. Earlier this year the authorities announced a strategy for consolidation within the banking sector. The huge volume of outstanding nonperforming loans, especially in Indonesia, Thailand and Malaysia, point towards the unfinished task ahead for policymakers. The objective was to deal with the losses from the crisis and also to strengthen the banking system to face increasing competition from multinational banks once the WTO accord on financial services was implemented.

Regulatory and legal reforms have been initiated at different speeds across the region. Singapore has been the most proactive. A substantially improved disclosure regime and adoption of Basel II standards allowed for a paradigm change from close and intrusive regulation to a risk-based supervisory regime. Local banks faced with serious competition on their home turf from foreign banks had to adapt quickly to new entrants. In Malaysia disclosure and regulatory reform is widely acknowledged to have been effective. The authorities in Thailand have pursued a gradualist approach to reforms, but the move towards consolidation is expected to gather pace soon. Indonesian banks saddled with some of the most serious problems in the region, seem to be turning the corner. Increasing competitive pressures via entry of foreign banks and further deregulation of the domestic banking sector has provided an impetus to regulatory authorities and bank management to accelerate the pace of change.

Incorporated as independent entities, AMCs take over nonperforming loans and are delegated with the vital task of recovering these bank loans. AMCs were established in Malaysia, Indonesia and Thailand, the three economies most seriously affected by the financial crisis. To fulfill their mandate AMCs would be required to confront the powerful and vested interests in the economy, the ‘crony capitalists’, large and influential industrial houses and groups that may have had access to easy credit. These entities are generally well connected and influential, often with direct links to the ruling establishment. Thus the independence and efficacy of AMCs is a strong indicator of the seriousness of authorities to address the root causes of the crisis and confront powerful business interests. Table 8 offers a detailed insight into the operational autonomy granted to AMC managers entrusted with the task of recovering NPLs. Korea has made concerted efforts to deal with NPLs, especially those held by chaebols. In Indonesia on the other hand, although IBRA, the national asset management and bank restructuring has

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completed its mandate a large volume of NPLs remain outstanding. Reported data suggests that the problem is more serious in Thailand (Table 11).

Table 8: Legal Environment for AMCs in Asset Resolution

Business Laws (corporate, Bankruptcy, Foreclosure, etc)

Special Legal Powers1

Legal Protection for AMC Staff

Independence

Indonesia Revised and updated in 1998

Yes No No

Japan Ongoing revisions No No Limited Korea Strengthened in 1998 Yes No Yes Malaysia Ongoing revisions Yes No Limited Thailand Revised in 1998 Yes No Limited 1. For example, power to seize assets or foreclose on loans without going through the courts, to buy or sell loans without debtor approval, or exemptions from taxes. Source: National authorities; BIS, Financial stability Institute, Working Paper 4, 2004. 5 Reform of Corporate Governance of Financial Institutions

It is difficult to construct quantitative measures that offer direct insights into the impact of governance and broader financial reforms on the performance of banks and the broader economy. In the absence of direct data, proxies indicating effectiveness of reforms offer useful insights. For banks that have issued equity and public debt, mandated disclosure requirements partially help bridge the information gap. Ratings agencies conduct a detailed analysis of banks that issue public debt. Following sharp criticism of their inability to detect problems in the financial sector, rating agencies specializing in evaluating banks, such as Moody’s and Fitch’s have undertaken to expend more resources and energy on their business in the financial sector.

Market discipline is one of the three pillars of the Basel II accord on capital

adequacy. Central banks have been proactive in persuading banks to mobilize funds from the public. Aside from vanilla securities, the issuance of hybrid instruments is also encouraged. As an illustration, issuance of subordinated debt is seen as an instrument for enhancing monitoring effort by a class of stakeholders exposed to greater risk than plain bond holders. In the absence of deep capital markets, prospects for use of these instruments as monitoring devices are limited. However with a broader spectrum of banks going public, this trend is laying the foundations for issuance of an expanded array of market instruments that could be used for monitoring financial institutions.

Disclosure norms and requirements and their effectiveness differ significantly

across countries, and across banks within a country. Following the financial crisis the multilateral agencies took a number of initiatives to improve disclosure within financial institutions and enhance the stability of the financial system. Foremost among these are the Financial Sector Assessment Program (FSAPs) conducted by the International Monetary Fund, and the move by the Bank for International Settlements to improve the timing and quality of disclosure. Many of these norms are prescribed in the disclosure requirements encapsulated in the Basel II accord on capital adequacy. FSAPs conduct country level surveys of the structure, stability, regulatory imperatives, and vulnerability to instability of the financial sector. Periodic neutral appraisals of this sort facilitate

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identification of systemic weaknesses and sources of instability, and serves as a guidepost for market players and policymakers alike.

At the bank level, measures indicating changes in the financial strength of banks and in the volume of NPLs over time offer insights into the stability, solvency and profitability of the banking system. At the macroeconomic level, broader indices measuring effectiveness of public institutions are important proxy measures of reforms in governance. Moody’s ‘Weighted Average Bank Financial Strength Index’ is a useful metric for evaluating a bank’s financial strength and over time, progress with respect to banking reform. For changes in the macroeconomic environment, the Economist Intelligence Unit’s Transparency and Fairness of Legal System Rating Score provides measures indicating the effectiveness of the broader reform agenda. Research shows a high correlation between indices of transparency in public life and stability and resilience of the financial sector. Market movements or changing macroeconomic circumstances aside, losses in the banking system are in large measure due to malfeasance in extending loans. ‘Crony capitalism’, connected lending, loans within industrial groups, overexposure to single sectors or borrowers etc, fall in this category. Economies with sound disclosure levels in the banking system, which in turn is related to transparency in public decision making, suffer lower levels of corruption. Data since 1998 (Table 9 and 10) shows little improvement in the scores for countries most seriously affected by the crisis, viz. Indonesia and Thailand. Malaysia’s scores demonstrate a marginal improvement. The EIU’s Transparency and Fairness of Legal System Rating Score mirrors similar trends. The EIU scores also provide indicators of the likely effectiveness of AMCs, as they often have to work through the legal system to recover assets. Again, timeliness, consistency and transparency in decision making here is crucial.

On the role of institutions and public governance

Corporate governance cannot be meaningfully analysed in isolation. The effectiveness or otherwise of corporate governance hinges crucially on the wider institutional context in which firms operate (Williamson, 1985, 1996, 1998, 2000). Probity and efficiency of governance in the public domain has powerful implications for the effectiveness of corporate governance. One is hard pressed to think of an instance in which a country with poor public governance scores high on corporate governance. Tables 9 and 10 highlight Transparency International and EIU Intelligence Unit findings on ‘Corruption Perception’ and ‘Transparency and Fairness of Legal System’. The close links between scores on transparency and legal reform and the performance of the banking sector are self-evident. The low scores for Indonesia and Thailand correspond to the weak performance of the banking sector.

The opacity of bank portfolios makes the challenge of reform in bank governance

daunting. Large borrowers have close and often intricate and concealed relationships with banks. Lack of transparency in decision making regarding loans, and an inadequate infrastructure for assessing creditworthiness of borrowers enables powerful and connected borrowers to corner loans. Outside stakeholders lack the wherewithal to accurately assess the value of banks. In the absence of reliable and timely disclosure – a requirement not fulfilled in most emerging market economies - even the central bank

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itself may find it challenging to make an informed assessment. In the case of NPLs, even the benefit of hindsight makes it a challenging task to differentiate loans made with poor judgment from those where mal-intent may have been at work.

Table 9. Corruption Perception Index 1998-2003 1998 1999 2000 2001 2002 2003

Country CPI Score CPI Score CPI Score CPI Score CPI Score CPI ScoreHong Kong 7.8 7.7 … 7.9 8.2 8.0 Indonesia 2.0 1.7 … 1.9 1.9 1.9 Japan 5.8 6.0 … 7.1 7.1 7.0 Malaysia 5.3 5.1 … 5.0 4.9 5.2 Philippines 3.3 3.6 … 2.9 2.6 2.5 Singapore 9.1 9.1 … 9.2 9.3 9.4 South Korea 4.2 3.8 … 4.2 4.5 4.3 Thailand 3.0 3.2 … 3.2 3.2 3.3 United States 7.5 7.5 … 7.6 7.7 7.5 Vietnam 2.5 2.6 … 2.6 2.4 2.4 Source: Transparency International Annual Report

Transparency International's Corruption Perception Index (CPI) is a composite index drawing on different polls and surveys from independent institutions carried out among business people and country analysts. The CPI focuses on corruption in the public sector and defines corruption as the abuse of public office for private gain. The country with the lowest score is the one perceived to be the most corrupt of those included in the index.

Table 10. The EIU's Transparency and Fairness of Legal System Rating Score

Country 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 China 1 1 1 1 1 1 1 1 1 1 1 Hong Kong 4 4 4 4 3 3 3 3 3 3 3 India 3 3 3 3 3 3 3 3 3 3 3 Indonesia 2 2 2 2 2 2 2 2 2 2 2 Japan 4 4 4 4 4 4 4 4 4 4 4 Korea 3 3 3 3 3 3 3 3 3 3 3 Malaysia 2 2 2 2 3 3 3 3 3 3 3 Philippines 2 2 2 2 2 2 2 2 2 2 2 Singapore 3 3 3 3 4 4 4 4 4 4 4 Thailand 2 2 2 2 2 2 2 2 2 2 2 Vietnam 2 1 1 1 1 1 1 1 1 1 1 Source: EIU Market Indicator & Forecasts. EIU's Transparency & Fairness of Legal System Rating scores countries between 1 and 5 on the transparency and fairness of legal system, with 1 being very low/unfair and 5 being very high/fair . Legend: 2002, 2003 = Estimated Score; 2004 = Forecasted Score

These ratings are particularly meaningful for the operation of asset management

companies. A related yardstick is the performance of asset management companies. AMCs are entrusted with the important mandate of recovering nonperforming loans from defaulters. There is a direct correlation between transparency and corruption levels and bank’s financial strength. Transparency facilitates meaningful monitoring of banks. Greater transparency in investment and lending decisions also helps eliminate incentives and avenues for corruption resulting in reduction of connected lending.

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Rapid economic recovery after the crisis, fuelled by devaluation of the regional

currencies, continued growth in the US economy and sustained export performance has masked many of the underlying structural faults in regional economies. Family and state ownership of banks in SE Asia is widely prevalent. Though the region has made impressive strides in reducing the volume of NPLs, there is still a large overhang of bad loans. Table 12 traces the evolution of NPL ratios in the crisis affected countries. By factoring in the role of Asset Management Companies, we can obtain a nuanced insight into the management of the NPL problem by banks and monetary authorities. It is evident from the data that a large overhang of NPLs persists (Table 11). Government ownership of banks, in part brought on by the need to nationalize failing banks during the crisis, continues. While this need not necessarily translate into inefficiency, it may conceal the true health of the banking system.

Table 11: NPLs in the Commercial Banking System of The Crisis-Affected Countries (in Percentage of Total Loans)

1997 Dec

1998 Dec

1999 Dec

2000 Dec

2001 Dec

2002 Dec

2003 Dec

2004 Jun

Indonesia a

Excl. IBRA - 7.2

- 48.6

64.0 32.9

57.1 18.8

48.8 12.1

31.1 7.5

18.1 6.8

17.9 6.2

Korea b

Excl. KAMCO & KDIC 8.0 6.0

17.2 7.3

23.2 13.6

14.0 8.8

7.4 3.3

4.1 2.4

4.4 2.7

2.6

Malaysia Excl. Danaharta

- -

21.1 16.7

23.4 16.7

22.5 13.4

24.4 16.3

22.4 14.7

21.2 13.1

20.1 12.3

Philippines c 4.7 10.4 12.3 15.1 17.3 15.0 14.1 13.8 Thailand d

Excl. AMCs - -

45.0 45.0

41.5 39.9

29.7 19.5

29.6 11.5

34.2 18.1

30.6 13.9

29.6 13.0

Memo: Malaysia e Excl. Danaharta

- -

10.6

10.6

8.3

10.5

9.3

8.3

7.7

a. Only includes IBRA’s AMC b. The NPL ratio increased in 1999 due to the introduction of stricter asset classification criteria

(forward looking criteria) c. From September 2002 onwards the NPLs ratios are based on the new definition of NPLs (BSP

Circular 351) which allows banks to deduct bad loans with 100% provisioning from the NPL computations

d. Includes transfers to AMCs but excludes write-offs. (Note that the jump in the headline NPLs in December 2002 was a one-off increase, reflecting a change in definition and did not affect the provisioning requirements). The June 2003 figure is preliminary and was estimated using transfers to AMCs and lending to AMCs as of March 2003

e. NPL series used by Bank Negara Malaysia, net of provisions and excludes interest in suspense. Source: BIS, FSI Occasional paper No 3, 2004 As discussed earlier, AMCs play a vital role in resolving the huge overhang on NPLs. Aside from the profound implications for the fiscal deficit, the effectiveness of AMCs determines how equitably and fairly the burden resulting from the crisis is distributed. To function effectively, AMCs need the power and authority to seize assets of defaulters, and where necessary carry out restructuring or liquidation of defaulting firms. The institutional requirements for AMCs to fulfill their mandate are demanding. At the very least they need to be autonomous of bureaucrats and politicians. An

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autonomous, fair, transparent judicial system which dispenses justice expeditiously, a clearly defined exit policy for firms, well defined property rights, an efficient bureaucracy, liquid capital markets and a stable macroeconomic climate, and at a broader level, efficiently functioning institutions - are all a sine qua non for successful AMCs.

It warrants repetition that information is central to the functioning of banks. One needs to bear in mind that if information were freely available, banks would lose their raison d’etre, and, of course agency problems would cease to manifest themselves. Meaningful reforms in corporate governance and risk management are predicated on enhanced, timely and accurate disclosure. Thus, increased disclosure and transparency are crucial for effective risk management and corporate governance. In developing economies, poor enforcement of disclosure laws, and accounting standards render regulatory authorities unable to monitor banks. The challenge for bond and equity holders is more daunting.

In situations where outside stakeholders lack the wherewithal to produce information to monitor banks, rating agencies can play an important role. However, if data sources are weak, rating agencies have to make their own inferences also depend on qualitative information to make assessments. In the period leading up to the crisis of 1997 the performance of rating agencies came under severe criticism. A number of reasons have been put forth to explain their performance. These range from outright incompetence to being misled by questionable information provided by financial institutions. Reforms since the crisis have focused on the mandate before these agencies, and on measures that would enhance their effectiveness.

Table 12: Moody’s Weighted Average Bank financial Strength Index1

(in percentage) Financial Strength Index Percentage Change Dec. 2001 Dec. 2002 Dec. 2003 from Dec. 2002 Hong Kong 66.6 62.3 62.3 0.0 Indonesia 1.7 3.0 3.0 0.0 Korea 14.2 16.7 18.3 10.0 Malaysia 30.4 31.7 33.3 5.3 Philippines 17.5 20.4 20.4 0.0 Singapore 75.0 74.7 74.7 0.0 Thailand 15.8 15.8 15.8 0.0 1. Constructed according to a numerical scale assigned to Moody's weighted average bank ratings by country. 0 indicates the lowest possible average rating and 100 indicates the highest possible average rating. Source: Moody’s

Moody’s Bank Financial Strength Ratings (Table 12) provide investors with a

metric measuring bank’s resilience in the face of financial stress. BFSRs thus supplement ratings awarded to banks with public debt issues. BFSRs are bank specific ratings, nevertheless, averaging them across a country offers insights into the strength of a banking system over time. Mirroring the trends or lack thereof in the EIU scores, BFSRs show evidence of marginal improvement over the past three years.

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An improvement in disclosure and prudential risk management helps lower the

cost of capital for financial intermediaries and for nonfinancial corporations. Investors gain confidence and are willing to pay a premium for firms with higher disclosure and better governance. This enables corporate entities to draw funds from international markets, attract overseas investors, especially mutual funds which may be restricted by home country regulation to firms that meet global transparency norms. In response to increasing competition from capital markets, banks are increasingly issuing market based-instruments and syndicated loans. Interest margins are narrowing, thus the main source of income in traditional banking is relationship banking. For money–centered banks, improved transparency and governance is crucial for banks to obtain funds at competitive rates. Conversely the lack of transparency may well place a premium on the cost of funds. To outside investors, poor disclosure suggests the possibility of corrupt practices, connected lending, and the ability to conceal weaknesses in the balance sheet.

Timely detection of problems in the banking sector is crucial for monetary authorities. Costs associated with problems in the banking sector increase exponentially over time. Delays in responses by policy makers in countries ranging from Japan to Indonesia led to a massive increase in the damage stemming from problems in the banking sector. ‘Evergreening’ of loans leads to a rapid escalation in the volume of NPLs. The deeper an individual bank gets into trouble, the stronger are the incentives for witholding information from regulators. The risk of contagion effects, as weak banks start pulling down other banks in the economy or beyond, grows rapidly. The Basel Capital adequacy accords are in response to concerns regarding systemic crises as financial systems and institutions become more integrated.

Table 13: Indicators of Institutional Framework

(mid-1997, unless otherwise indicated) Country Bank regulatory

framework Bank supervision quality

Transparency GS Frailty Score (0=best, 24=worst)

GS Camelot Score (1=best, 10=worst)

Hong Kong, Very good, improving

Good, improving Very good 8 3.5

Indonesia Satisfactory, improving

Weak, improving Satisfactory 15 4.6

Korea Weak, improving Fair Fair, improving 18 Na Malaysia Satisfactory,

improving Weak, improving Satisfactory 15 4.5

Philippines Good Fair Satisfactory 13 3.7 Singapore Very Good Very Good Poor 7 4.0 Thailand Weak, improving Weak Poor, improving 22 5.2 Source: Gochoco-Bautista, Ma. Socorro, Soo-Nam Oh, and S. Ghon Rhee, 2000“In the Eye of the Asian Financial Maelstrom: Banking Sector Reforms in the Asia-Pacific Region” Asian Development Bank

Table 13 offers a snapshot of the institutional framework that prevailed just prior to the onset of the crisis. The overall picture conforms closely to the scenario that emerges for 2003.

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The importance of transparency followed by clearly enunciated policy measures to stem the outflow of funds and loss of confidence cannot be overemphasized. In this context the range of experiences across the ASEAN states is instructive. The handling of SARS in 2003 in the region offers an interesting parallel. Countries that came out in the open with the incidence of the disease and its transmission were able to deal with the medical emergency much more effectively than nations that were hesitant to acknowledge the problem and then divulge the rates of infection and transmission. After the initial pain, with timely disclosure and transparency in decision-making, damage control and regaining confidence of international markets (community, in the case of SARS) is much easier. 6 Concluding Observations

Economic recovery in the region since the 1997 crisis has been impressive. The macroeconomic indicators of growth, foreign exchange reserves, export performance, the fiscal situation and inflation management all point towards promising medium term prospects. The growing volume of foreign exchange reserves has raised a number of policy issues, including a debate on how they could be deployed more profitably with reduced reliance on an uncertain US dollar.

In the near future external developments and structural change in the economy are likely to provide impetus from within the banking system to improve governance. With further liberalization under the WTO agreement on financial services, banks will be facing increasing competition both internally as well as from overseas entrants. In the domestic arena as consolidation gains pace and capital markets develop, savers and borrowers will have an expanded menu of choices necessitating increasing efforts on the part of banks to attract business. Foreign direct investment in the financial sector has grown at a rapid pace over the past fifteen years. A substantial volume of this is in overseas expansion and acquisitions by multinational banks. Deregulation in the US, and the global trend towards universal banking has opened up new opportunities and imposed competitive pressures on the banking system. As banks move into fee based services and increase linkages with financial markets, activities where increasing returns are often obtained, consolidation is a natural corollary. For Asian economies, development of capital markets and contractual savings institutions is an overriding priority. This would also help to absorb a larger proportion of foreign exchange reserves and lend resilience to the financial sector. Underdeveloped financial markets, inadequate financial regulation and lack of policy coordination are hurdles facing many Asian economies when it comes to building a sound financial sector.

Aside from national efforts, ratings agencies and multilateral institutions have also been proactive in designing policies and recommending reforms to enhance the resilience and efficiency of financial institutions. Moody’s, S&P and Fitch have expanded the number of banks rated. Bank Strength Financial Ratings compiled by Moody’s offer useful insights into individual banks financial health (Table 12). The financial sector adjustment program (FSAP) initiated by the IMF offers detailed insights into factors impacting the stability and resilience of the financial system. Since the Asian Financial Crisis the BIS has taken a number of initiatives oriented towards increasing

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stability and early identification of problems in the banking sector. These range from more timely and detailed information on bank portfolios, to detailed guidelines for computing risk-adjusted capital. ‘Connected lending’, ‘crony capitalism’, ‘evergreening of loans’, etc. are thinly veiled euphemisms for what are essentially corrupt practices. Our earlier discussion pointed towards the importance of efficiently functioning institutions and a transparent and fair judicial system as prerequisites for resolution of problems stemming from accumulated NPLs. Without efforts at getting to the roots of corruption and enhancing transparency and fairness in the legal systems, problems in the banking sector cannot be resolved. The data on this is disquieting. As Tables 6 and 7 show, despite the wide range of reforms undertaken since 1997, most regional economies have made only marginal progress towards tackling the most important, albeit and challenging problems, namely corruption, the lack transparency and the large volume of outstanding NPLs.

A detailed micro level analysis and scrutiny is required to obtain a nuanced picture of the state of reforms of governance of the financial sector. This would encompass the effectiveness of the disclosure regime, and in what could be construed as a sign of confidence in the banking system - the prospects for an eventual shift from a regulatory governance regime to a risk based supervisory regime.

A brief report card on reforms in the banking sector shows impressive gains in recapitalization of banks and in consolidation within the banking sector. There remains considerable work to be done in establishing the institutional infrastructure for enabling the third leg of the Basel II Accord, market discipline, to be effective. With the advent of foreign banks, consolidation in the domestic banking sector and the impending opening of the financial sector in accordance with the WTO accord, competitive pressures have increased. This should benefit governance. Bond and equity markets have been growing, albeit slowly, liquidity remains a concern. Sustained growth in the region would be depend on raising standards of governance, strengthening the legal and regulatory environment, and exploiting long term sources of funding through the development of capital markets and contractual savings institutions.

Promising medium term growth prospects and the buildup of foreign exchange reserves provides the economies with an opportunity to address the underlying weaknesses and further consolidate the gains made over the past six years. Growth by itself should partially help address the most serious weakness in the banking sector, nonperforming loans. As liberalization proceeds domestic banks will face more stringent competition on their home turf. This is already the case in Singapore and Hong Kong. Unless, transparency and corporate governance are improved and the infrastructure to effect a shift to risk-based supervision put into place, the likelihood of a recurrence of the problems of the summer of 1997, especially in the event of an economic downturn, will remain.

Experience over the past decades does not offer insights into fundamental questions such as: Are market dominated systems or bank dominated systems better?

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Why are there such differences in performance between banking system in Japan and Germany – both bank dominated economies? What mix of policies facilitates effective public governance and private governance? The data shows there is a close relationship between corporate governance and public governance. Understanding the precise nature of the links requires further research.

There is no blueprint policymakers can follow to design efficient financial systems. However, we do know that efficient and transparent public governance does lay the foundations for efficient corporate governance. Transparency in rules and regulations and in the actions of public decision makers is clearly conducive to governance.

The gist of this brief overview is that SE Asian economies have made impressive gains in dealing with the legacy of the financial crisis of 1997. However, there are wide differences in the extent to which the necessary reforms have been carried out. The agenda on reforms in public governance that have a direct bearing on corporate governance reforms, though well under way, remains incomplete. There is some concern that, with satisfactory macroeconomic performance in recent years, policymakers run the risk of becoming sanguine about the remaining underlying weaknesses in the financial sector.

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