Thursday, February 05, 2009

One bad bank model 

One of the places I worked as an adviser was in Indonesia in 2000. My function there was to evaluate the solvency of the government. What called it into question was the issuance of a huge amount of debt to bail out the banking system there following the collapse of the rupiah in 1998. As we hear more discussion of the Obama administration creating a 'bad bank' for holding "troubled assets", I'd like to give a couple of thoughts about the Indonesian experience.

The plan adopted in March 1999 came after a review of all banks. About half were found to be sound. For the remainder, 38 (a quarter of all banks, but not nearly so much in deposits) were closed and deposits were transferred to other banks. The last batch were taken over and operated by IBRA, which eventually issued 650 trillion rupiah in bonds to swap for banks' bad assets. IBRA bonds were obligations of the government. The question was whether or not they would be paid off by the government. Answering that question meant I had to do two things -- assess how much of the bond issue would be covered by sales of the assets IBRA had received in return for the bonds. (The project was fun because we had to assess the present value of the stream of royalties Indonesia received from the oil fields.)

IBRA eventually got between 20 and 25 cents on the dollar. Five years after its creation, the assessment of IBRA was not very positive:

Political meddling, periodic inertia and the sheer scale of its task have kept IBRA in business long after other nations affected by the Asian crisis declared victory over their own banking debacles. The prolonged process stunted Indonesia's economic recovery and alienated investors.

In retrospect, many critics say, the agency was, in part, hamstrung by its mandate to dismantle the empires of the friends and family of former President Suharto who are blamed by many for the banking debacle.Once a band of idealistic financial reformers, the agency's staff slowly surrendered its battle of attrition with the country's richest, most powerful people, they say.

''They've reached a modus vivendi with the ruling class,'' said James Redway, a lawyer in the Singapore office of Latham & Watkins who has represented both borrowers and creditors in Indonesia.

The problem was that the political solution imposed by reformers was to punish Suharto's cronies which, while certainly understandable given his unfortunate and corrupt reign, hamstrung the efforts to resell the assets.
IBRA was saddled with two strictures that many bankers now say crippled it: first, assets could not be sold back to their former owners, and, second, all but the tiniest borrowers were required to pay back 100 percent of the principal on their debts. To help IBRA squeeze Suharto's cronies, the agency was given authority to seize assets, by force if necessary, without having to go through Indonesia's corrupt courts.
Poor infrastructure really harmed the process, something less likely to happen here. Collateral laws were not very strong, and debtors could simply wait out IBRA's collection efforts until the latter tired and moved on to something else. Unable to deal with the people most knowledgeable about the loans, IBRA found itself with a very broad variety of assets and ill-informed investors who were wary of paying more than a few cents on the dollar. Bank deposits at these banks were guaranteed for six and a half years.

In the end, Indonesia paid over half of a year's GDP for its bank rescue, according to this IMF database. A full third of banks were closed. Much of the money spent went to recapitalization of the banks that were not closed; those owners were able to stay in business. And while the economy was moving better in 2003 than in 1998, much of that was tied to the reviving fortunes of its oil fields. And the Indonesian system is still plagued by corruption even after the attempt to remove Suharto's influence.

What does this say about the current Obama plans for a bad bank? Yves Smith has been very critical, and I'd say rightly so. Indonesia in fact did apply triage (grading banks A, B, and C, and then allowing all the C's and the worst of the B's to cease to exist), and it killed off the majority of the banks that got lumped into IBRA. And even then it had trouble because its political solution meant limiting the number of potential buyers and its legal structure inhibited bankruptcies. A clean slate, with the dud banks out of the picture, seems vital to make the bad bank model work.

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