Jerry Ng

Former Deputy Chairman of IBRASenior Advisor to CEO Bank Danamon

Jakarta

INDONESIAN FINANCIAL CRISIS AND BANKING REFORM

- 2 -

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

- 3 -

OVERHEATED ECONOMY LED TO CONFIDENCE CRISIS ...

Over heatedEconomy

Over heatedEconomy

1

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

294

243

137122

69

-3.3

-4.8 -4.7

-8.5

-3.7

Indonesia Korea Philippines Thailand Malaysia

Indonesia Korea Philippines Thailand Malaysia

Current Account Deficit (% GDP)

Debt Service & Short term Debt (% Foreign Reserved)

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

MayJuneJuly Aug Sep Oct Nov Dev Jan

Local Currency 1997 (Indexed to April’97 vs USD)

IndonesianRupiah

KoreanWon

ThailandBaht

Source: NYU Stern, International Financial Statistics, OANDA

- 4 -

... EXACERBATED BY POLITICAL CRISIS ...

Political InstabilityPolitical Instability

2

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

Jun 97 Jun 98Jul 97 Aug 97 Sep 97 Oct 97 Nov 97 Dec 97 Jan 98 Feb 97 Mar 98 Apr 98 May 98

Habibie announced as VP candidate

Soeharto announced his budget – Rp plunged to

11,000Govenment announced

deposit guarantee

Government announced price hike, riots ensued

Soeharto announced his resignation

New cabinet was announcedThai Baht sharply fell

after crisis in confidence

Indonesia seeks IMF help

Indonesian Rupiah vs USD

Source: Worldbank, OANDA

- 5 -

... MASSIVE LOCAL CURRENCY DEVALUATION THAT LED TO CRISIS

Surge in Interest Rates

Rising Borrower Defaults

Crisis of Confidence

Banking Crisis3 4

Multiple sources of investor concern

• Unclear political transition

• Bank closures• Widespread riots• Droughts, forest

fires

Led to estimated US$18 Bn of capital flight, mainly to Singapore

Interest rates peaked at over 70% p.a, the highest rate since 1966

Average level of NPLs estimated to be >50% of total loans outstanding

Some banks have close to 100% NPLs

Foreign exchange losses due to open US$ net positions

Level of NPLs grew dramatically

Interest spreads became negative

Customers rushed to take deposits out of the system/country

Source: Analyst reports, literature, BCG analysis

i

Capital Flight

2

Massive Devaluation

Massive Devaluation

3

Rupiah Devaluation

1

Rupiah lost >75% of its value since 8/97

Unexpected removal of the currency intervention band left many companies and banks with mismatched and unhedged ($/Rp) assets and liabilities

Rp

- 6 -

DEVALUATION AND UNHEDGED DEBT POSITIONS LED TO A HIGH LEVEL OF NON PERFORMING LOANS

NPLs by Types of Banks in IndonesiaEstimated Non Performing Loans (%) in the Banking System in Indonesia

10 9 8

57

0

10

20

30

40

50

60

1995 1996 1997 1998

%

Total Loans (Rp. Tr.)

235 293 445 545

1998E (NPL) Korea

Thailand

Malaysia

Philippines

21%

44%

17%

28%

11

36

11

53

52

72

36

15

57

45

0

10

20

30

40

50

60

70

80

State Banks

Forex Private

National Banks

Non-Forex National Banks

Joint Venture Banks

Foreign Banks

Regional Develop-

ment Bank

1997

1998

Source: Bank Indonesia, BCG analysis

LargeNPL

LargeNPL

4

- 7 -

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

Negative Spread

Negative Spread

5

(1) A deposit guarantee scheme was introduced

- 8 -

NPLS COUPLED WITH EXPENSIVE COST OF FUNDS CAUSED NEGATIVE SPREADS IN MOST BANKS ...

0

10

20

30

40

50

60

70

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

Weighted Average Deposit Rate

Negative spread

Weighted Average Interest Rate%

Source: Economic Outlook 1999, BCG analysis

1997 1998

Weighted Average Lending Rate

Negative Spread

Negative Spread

5

- 9 -

... WHICH WEAKENED THE BANKING SYSTEM EVEN FURTHER

Small & Weak Banks

Small & Weak Banks

6

(1) In Asiaweek Financial 500(2) Based on assetsSource: Asiaweek, BCG analysis

Indonesia banking system was mostly made of small banks . . .

27 26

208

144

54

4634

Indonesia Japan India Taiwan Malaysia HongKong

. . . that is further weakened by the crisis

Philippines

Number of Banks Pre-crisis Equity/ Assets of Banks(%)

-13.6

-1.6

8.8

6.8

10.38.1

-12.9

-8.3

Overall State Private Foreign & JV

1997 1998

- 10 -

CRISIS CREATED IMPETUS FOR EXTERNAL AND INTERNAL REFORM

Over-heated economy

Political instability

Massive depreciation

Over-heated economy

Political instability

Massive depreciation

ExternalExternal InternalInternal

Crisis CauseCrisis Cause

ActionPost-Crisis

ActionPost-Crisis

Large NPL ...

... Negative margin ...

... Weakened the small and weak banking system

Large NPL ...

... Negative margin ...

... Weakened the small and weak banking system

1. Asset management

2. Bank recapitalisation

3. Banking sector consolidation

1. Asset management

2. Bank recapitalisation

3. Banking sector consolidation

4. Starts lending again

5. Risk management & corporate governance

6. Improving capabilities

4. Starts lending again

5. Risk management & corporate governance

6. Improving capabilities

- 11 -

INDONESIA LEAST SUCCESSFUL IN GOVERNMENT-LED REFORM

Asset Management &

Loan Restructuring

Asset Management &

Loan Restructuring

Recapitalization & Balance Sheet Restructuring

Recapitalization & Balance Sheet Restructuring

Banking Sector Consolidation

Banking Sector Consolidation

Korea Thailand Malaysia Indonesia

Established Kamco as AMC

So far, disposed ~50% of loans purchased by Kamco

Established Kamco as AMC

So far, disposed ~50% of loans purchased by Kamco

No centralized asset management companies were established

• AMCs were established by the banks

• Framework for AMC creation was established

No centralized asset management companies were established

• AMCs were established by the banks

• Framework for AMC creation was established

Established Danaharta as AMC

Established Corporate debt restructuring comm.

Danaharta has Disposed ~80% of loans purchased

Established Danaharta as AMC

Established Corporate debt restructuring comm.

Danaharta has Disposed ~80% of loans purchased

Established an AMC underneath IBRA

Has managed to dispose xx % of loans transferred

- Most of loans disposed were unrestructured

Established an AMC underneath IBRA

Has managed to dispose xx % of loans transferred

- Most of loans disposed were unrestructured

Government recapitalized feasible banks in return for purchased NPL made by Kamco

Average banks’ capital has exceeded the minimum defined by BIS

Government recapitalized feasible banks in return for purchased NPL made by Kamco

Average banks’ capital has exceeded the minimum defined by BIS

Government plays an active role in banks M&A

So far has closed 5 banks and 23 merchant bank

6 banks and 3 merchant banks has successfully merged

Government plays an active role in banks M&A

So far has closed 5 banks and 23 merchant bank

6 banks and 3 merchant banks has successfully merged

Recapitalization was private sector led

However, the government provided capital support scheme

Recapitalization was private sector led

However, the government provided capital support scheme

3 local banks were acquired by foreign banks

56 finance companies were closed

However, limited consolidation amongst local banks

3 local banks were acquired by foreign banks

56 finance companies were closed

However, limited consolidation amongst local banks

Established Danamodal to recapitalize, revitalize and restructure banking sector

• A comprehensive framework of banking sector improvement is in place

Established Danamodal to recapitalize, revitalize and restructure banking sector

• A comprehensive framework of banking sector improvement is in place

Government is authoritative in pursuing consolidation

Government mandated merger of banks to 10 anchor banks possibly to 6 in the future

Government is authoritative in pursuing consolidation

Government mandated merger of banks to 10 anchor banks possibly to 6 in the future

11 private and 4 state banks were recapitalized by the government using bonds not cash

Many banks are still undercapitalized, exposed to interest rate risk and liquidity risk

11 private and 4 state banks were recapitalized by the government using bonds not cash

Many banks are still undercapitalized, exposed to interest rate risk and liquidity risk

Banks declined from ~225 to 162 some closed and liquidated

Limited M&A activity, 7 banks merged into Danamon while 4 state banks merged into Mandiri

Banks declined from ~225 to 162 some closed and liquidated

Limited M&A activity, 7 banks merged into Danamon while 4 state banks merged into Mandiri

- 12 -

STRONG LEGAL FRAMEWORK PRE-REQUISITE TO ACCELERATE LOAN RESTRUCTURING

Korea Thailand Malaysia Indonesia

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

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

Government plays supporting role rather than leading role in asset management

• Maintain low interest rate level as well as provide tax incentives to facilitate loan restructuring

• Developed a framework for creating a private AMC rather than creating a centralized AMC that would purchase loans from banks

Government plays supporting role rather than leading role in asset management

• Maintain low interest rate level as well as provide tax incentives to facilitate loan restructuring

• Developed a framework for creating a private AMC rather than creating a centralized AMC that would purchase loans from banks

Established Danaharta to purchase loans from banks as part of the recap program

Created a comprehensive framework to acquire loans, manage assets and defined clear exit/ disposal strategy

Established Danaharta to purchase loans from banks as part of the recap program

Created a comprehensive framework to acquire loans, manage assets and defined clear exit/ disposal strategy

Established AMC under IBRA which purchases loans from banks and conducted restructuring

Financial Sector Policy Committee is established to play an active role in establishing policies for financial sector

• Involved in making decisions for large loans restructuring

However, lack of reforms in legal framework and infrastructure has so far impeded progress in asset/ loans restructuring

Established AMC under IBRA which purchases loans from banks and conducted restructuring

Financial Sector Policy Committee is established to play an active role in establishing policies for financial sector

• Involved in making decisions for large loans restructuring

However, lack of reforms in legal framework and infrastructure has so far impeded progress in asset/ loans restructuring

Improvement in legal infrastructure

Improvement in legal infrastructure

Private led asset management

Private led asset management

Create clear framework and

targets

Create clear framework and

targets

Lack of clarity of decision makers of asset management

Lack of clarity of decision makers of asset management

Asset Management

Asset Management

1

- 13 -

SEPARATING BAD ASSETS REDUCED THE NEED FOR BANKS TO FOCUS ON LOAN RESTRUCTURING

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

(1) Indonesia as of April 2001, Korea June 2001, Malaysia & Thailand July 2001Source: ADB Asia Recovery Report Sep 2001

19

1310

4

Indonesia KoreaMalaysiaThailand

NPL 2001(1) (%)

48

42

1310

Indonesia Korea MalaysiaThailand

NPL End of 1998 (%)

Asset Management

Asset Management

1

- 14 -

ALL GOVERNMENT UNDERTAKE MASSIVE RECAP PROGRAM TO RESCUE BANKS

Massive Cost of RecapitalizationMassive Cost of Recapitalization At the cost of Large Government DeficitsAt the cost of Large Government Deficits

9

3031

70

Indonesia Korea Thailand Malaysia

Expected recapitalisation need (US$ ‘b)

-5.0%

-3.9%

-6.0%

-9.0%

Korea Thailand Malaysia Indonesia

Source: JP Morgan, MSDW 1998, IBRA

Government Deficit in 1998 (% GDP)

Recap & B/S RepairRecap &

B/S Repair2

- 15 -

IN INDONESIA, MORE THAN RECAPITALIZATION IS REQUIRED TO REPAIR BANKS’ BALANCE SHEET

Source: Financial Statements June 2001, BCG analysis

Low

Medium

High

Market Risk:

Asset Size:

3

4

LowHigh

Low

High

NPL as % of Loans (%)

CAR(1) (%)

Credit Risk:

Capital Solidity:1

2

Panin

Mandiri

BNI

Citibank

Lippo

Danamon

Bukopin

Buana

BII

SCBNiaga

BaliUniversal

0

HSBC

Healthy bank

Rp. 100 Tn

Recap & B/S RepairRecap &

B/S Repair2

BCA

- 16 -

WHY CONSOLIDATION AND/ OR SALE IS IMPORTANT?

Allow relatively strong banks to use their balance sheet to address problems of weaker banks around work outs of bad loans and recaptalising

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

Restore confidence of depositors and investors in the banking system, this will be key for the banks to begin value creation

Complements banks’ capabilities especially in the area of risk management, scale in operations and application of technology

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

1

2

3

4

5

Consolidation Consolidation3

- 17 -

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

Consolidation Consolidation3

- 18 -

GOVERNMENT INITIATIVE IS KEY FOR CONSOLIDATIONExample of Banks M&A in Korea

Gov’t decision-making treeMerger of banks (in1998)

Due diligence on banks, identify banks with

BIS ratio <8%

Evaluation on bank management performance

FSB ‘verdict’ on bankruptcy

SurvivedSurvival on condition

Bankrupt

Normal operation

Restructuring plan within one month

Transfer of asset & liability

‘Voluntary’ M&A

Reach BIS ratio of >8%

Kookmin• W 57 trillion(1)

• 9.78%(2)

• 12,000(3)

Hao Sing • W 38 trillion• 10.29%• 11,000

Shinhan• W 42 trillion• 10.29%• 4,700

Koram• W 15 trillion• 8.57%• 2,100

Hana• W 15 trillion• 9.29%• 1,700

Commercial Bank of Korea

• W 50 trillion• 3.28%• 7,806

Daedong• W 8.6 trillion• 2.98%• 1,700

Dongnam • W 7.5 trillion• 4.54%• 1,700

Dongwha• W 12 trillion• 5.34%• 1,800

Kyonggi• W 7.6 trillion• 6.69%• 2,200

Chungchung• W 6.1 trillion• 7.05%• 1,400

Hanil• W 55 trillion• 4.53%• 7,488

+

+

+

+

+

+

1

2

3

4

5

6

Note: (1) Total asset (2) BIS ratio (3) No. of employeesSource: FSB, Korea Daily Economic

Merger of equals

Consolidation Consolidation3

- 19 -

INDONESIAN BANKS NEED TO START LENDING AGAIN

Start LendingStart

Lending4

Indonesia has a smaller proportion of loans particularly in consumers ...

... when compared to other Asian countries

Deposits are significantly larger than corresponding wholesale and retail assets

• Loans write-off, corporate de-leveraging and a high interest rate environment are the main drivers

Retail lending still small compared to deposits

• Customer sophistication and income levels are the main drivers for future growth

Deposits are significantly larger than corresponding wholesale and retail assets

• Loans write-off, corporate de-leveraging and a high interest rate environment are the main drivers

Retail lending still small compared to deposits

• Customer sophistication and income levels are the main drivers for future growth

52%

72%

7%4%6%

21%

28%

7%

1%2%

Total Other Asian Countries

Indonesia

Deposits

Wholesale Loans

MortgageConsumer LoansRetail Funds(1)

Total Bank Assets & Liabilities(1)

(1) Other Asian countries 1999, Indonesia 2000

- 20 -

IMPROVING RISK MANAGEMENT AND GOVERNANCE IS A PRE-REQUISITE

Corporate Governance

Risk Management

Many banks are still lagging the 4 core principles of good corporate governance

• Ineffective board partly due to banks ownership structure

• Lack of transparency

• Weak internal controls and audit performance

• Unreliable reporting

Many banks are still lagging the 4 core principles of good corporate governance

• Ineffective board partly due to banks ownership structure

• Lack of transparency

• Weak internal controls and audit performance

• 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

• Only one bank is expected to be FIRB(1) compliant by 2002

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

• Only one bank is expected to be FIRB(1) compliant by 2002

Areas of Focus Improvement Opportunities

(1) Fundamental Internal Rating Based Approach according to Basel II requirementsSource: Basel II Capital Accord

Risk Mgt & Governance Risk Mgt &

Governance5

- 21 -

DOMESTIC BANKS ARE TRYING TO IMPROVE THEIR CAPABILITIES

Improvement Areas Improvement InitiativesImplementation by Domestic Banks

• Headcount reduction• Training• Performance incentives

• Network rationalisation (e.g., branches)• Network optimisation (e.g., ATMs)• Network sharing (e.g., ATMs, card

businesses)

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

Human

Resources

Human

Resources

NetworkNetwork

ProcessProcess

1

2

3

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

ImprovingCapabilities ImprovingCapabilities

6

- 22 -

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”?