INDONESIA'S FINANCIAL SECTOR POLICY PACKAGE

UNCLAS SECTION 01 OF 06 JAKARTA 010361

SIPDIS

SENSITIVE
SIPDIS

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-SEARLS
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO

E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV PREL ID
SUBJECT: INDONESIA'S FINANCIAL SECTOR POLICY PACKAGE

REF: JAKARTA 1833


1. (SBU) Summary. The Government of Indonesia issued its
Financial Sector Policy Package on July 5, tackling two
important issues of non-performing loans at state-owned
banks, and insolvent insurance firms. Success in these
areas will represent one of the most significant changes in
the financial sector since the post-crisis restructuring.
This is the third of three economic policy packages that
included Infrastructure (issued in February) and the
Investment Climate (issued in March). The Financial Sector
Package was issued jointly by the Coordinating Minister for
the Economy, the Minister of Finance, the State Minister of
SOEs and the Governor of Bank Indonesia (BI). It is
designed to showcase achievements and bolster the GOI's
credibility on financial reforms. Like the other packages,
the Financial Sector Policy Package is presented in matrix
format: it has over 50 action items, each with a specified
output, targeted timeframe, and responsible agency to
address financial system stability; banking institutions;
non-bank financial institutions; and capital markets. The
matrix can be downloaded at from the Coordinating Ministry's
website at
http://www.ekon.go.id/v3/images/stories/versi inggris1.pdf.
End Summary.

New Financial Sector Policy Package
--------------


2. (U) The Government of Indonesia issued its Financial
Sector Policy Package on July 5, mainly tackling two
important issues: non-performing loans at state-owned banks,
and insolvent insurance firms. Success in these areas will
represent one of the most significant changes in the
financial sector since the post-crisis restructuring.
President Yudhoyono noted in his August 16 annual policy
speech that, "The Government and Bank Indonesia will
continue to endeavor to perfect the policies, mechanisms,
regulations, instruments and the quality of the economic
institutions and the financial industry, such as, among
others, stipulated in the package of policy reform in the
financial sector. This measure is necessary so that our
economy has a growing elasticity and resistance to
fluctuations and uncertainties."


3. (U) This is the third of three economic policy packages
that included Infrastructure (issued in February) and the
Investment Climate (issued in March). The package is
divided into four principal chapters:

A) Financial system stability;
B) Banking institutions;
C) Non-bank financial institutions;
D) Capital markets.

A short, fifth section for "miscellaneous issues" addresses
the privatization of state-owned enterprises and
establishment of a National Export Financing Agency. The
time horizon of the package runs through December 2007, but
most measures are slated for action in 2006. Several
tougher issues such as a tax policy for the financial
sector, infrastructure financing, and improving SME
financing were deleted but may reappear in a follow-on
package next year. The Coordinating Minister plans to issue
in 2007 a medium-term package mapping out financial sector
reforms through the end of President Yudhoyono's term in

2009. A decree is in the works to establish an oversight
committee to monitor Package implementation.


4. (SBU) Minister Boediono, as Finance Minister under then-
President Megawati, issued transparent policy matrices like
these to show Indonesia's commitment to reform after
completion of its IMF program in December 2003. This
package has been carefully designed to include achievable
action items, many of which were already in train. Many
items simply call for the MOF to "improve" a regulation or
issue a decree, or for Bank Indonesia to issue a circular on
a certain subject. In this respect, the package at least
partly succumbs to the tendency of the bureaucracy to

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measure implementation in terms of issuing official decrees,
although we do not doubt the commitment of Coordinating
Minister Boediono and in particular of Finance Minister Sri
Mulyani to effecting tangible change.

Improving Financial System Stability and Oversight
-------------- --------------


5. (SBU) The first section of the package deals with
financial system stability, a goal reinforced by the
currency mini-crisis of August 2005, which was exacerbated
by a lack of coordination between the fiscal and monetary
authorities. Our contacts at the International Monetary
Fund (IMF) say it is unclear whether the package will
actually improve policy coordination, noting Indonesia's
tendency to "create domestic problems out of international
shocks through a slow policy response." The package calls
for the drafting of a Financial Sector Safety Net Law and
its submission to Parliament by December 2006. In addition,
the matrix echoes goals laid out in the State Ministry for
National Development and Planning (BAPPENAS) National Medium
Term Development Plan for 2004-2009 (issued as a
Presidential Regulation in January 2005).


6. (SBU) The new package calls for the establishment of a
long-discussed Financial System Stability Forum (FSSF),
whose members will include the financial supervisory and
regulatory agencies including BI, the MOF's Capital Markets
and Financial Institutions Supervisory Agency (BAPEPAM-LK),
and the Indonesian Deposit Insurance Agency (LPS). The FSSF
will be charged with conceptualizing an Indonesian Financial
System Architecture and establishing a Macro Early Warning
System for disturbances in the financial sector. A senior
international advisor in the Finance Ministry told us that
the FSSF would normally sit within the Central Bank, but
because Sri Mulyani does not trust BI, the forum is a hybrid
and took two years of negotiations to finalize. Bank
Indonesia and LPS signed an MOU to develop the FSSF on
December 30, 2005 (reftel). On the same date, the Minister
of Finance also issued a Decree on the Financial Safety Net
(No 135/PMK 05/2005),in force until the new law is in
place.


7. (U) The proposed Financial Sector Safety Net Law would
enhance the existing LPS law to help protect depositors from
bank failures as well as protect the government from the
risk of future bailouts. It also creates a formal mechanism
between BI, the MOF, and the deposit insurance agency (LPS)
for dealing with troubled banks. The GOI has been working
on a financial sector safety net, consisting of a lender of
last resort, deposit insurance agency, and institutional
mechanism for dealing with distressed banks, since the
financial crisis of 1997-98. Building blocks of the safety
net have been covered by other laws, such as the phrase-out
of blanket deposit insurance (completed) and creation of a
consolidated regulatory and supervisory agency for the
financial sector (not yet completed). (Note: The Financial
Services Authority, or OJK, is mandated by Law 23/1999. End
Note.)

Strengthening State-Owned Banks
--------------


8. (SBU) The main policy goal of this part of the package is
to improve the performance of state-owned banks by resolving
their NPLs. Bank Mandiri and Bank Negara Indonesia (BNI)
are the principal targets of the measures elaborated in the
package, having accrued large amounts of NPLs through years
of lax governance, related lending, and poor risk
management. The package includes smaller policy programs to
professionalize the banking sector, such as expanding
certification testing for basic banking operations,
including risk management; improving methodologies for risk-
based banking supervision; implementing formal Good
Corporate Governance standards for commercial banks; and
bringing Indonesia's new credit bureau, inaugurated in June,
into line with international standards and expanding its
access to information. BI Deputy Governor Maman Somantri
told us he expects the credit bureau will be privatized in

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two years. After the nascent mutual fund industry suffered
losses of 70 percent last year over non-transparent pricing
and risk, the package also calls for information
transparency for banking products and other consumer
protection measures. These include a standardized system
for consumers to file complaints and the establishment of an
independent dispute mediation body.


9. (SBU) Although Bank Mandiri and BNI lobbied BI to be
allowed to establish special purpose vehicles that would
take NPLs off their books, the policy actions will instead
amend the rules governing NPLs. They will allow state-owned
banks to work around state laws that have thus far prevented
them from resolving bad loans using techniques commonly
employed by commercial banks. Existing laws, such as the
2003 State Finance Law, treat state-owned banks assets as
"state" assets. As a result, state-owned banks taking a
haircut (loss) on non-performing debt or reselling it at a
discount could be accused of causing a financial loss to the
state, currently considered a criminal corruption offense.
An international advisor at the Finance Ministry tells us
that Bank Mandiri has been waiting for President Yudhoyono
to sign the government regulation allowing state-owned banks
to take haircuts on debt, which has been on his desk since
the end of July.


10. (SBU) Getting rid of the NPLs is only half the battle,
however. Resident expatriate economists note that because
an excess of NPLs reflects a bank governance problem, bank
management must be improved to prevent them from
accumulating anew. Besides allowing the state-owned banks
to resolve NPLs using techniques employed by commercial
banks, the Package also urges they emulate the more
professional management practices of their private sector
counterparts. The package calls for the State Ministry of
SOEs to "ensure the commitment of state-owned banks'
management to corrective measures in governance and risk
management and to efforts for resolving problem loans." The
medium specified for achieving this is the signing of
management contracts on these subjects with the boards of
directors of state-owned banks, a pretty weak mechanism for
producing results.


11. (SBU) The Finance Ministry advisor characterized Bank
Mandiri as "very cooperative" in reform efforts. A senior
contact at Mandiri also pointed out that the bank's new
president, Agus Martowardoyo, had replaced all the group
heads at the bank, which took months. In contrast, BNI is
not replacing key staff, suspended an audit that was
undertaken 18 months ago, and has a disengaged board of
commissioners. The IMF notes that BNI is bloated in terms
of personnel, at two-thirds the size of Mandiri, and unlike
the latter is still non-transparent about its NPLs.


12. (SBU) An international banking consultant told us that
it is not only the old legacy loans that are problematic,
such as the Mandiri loans that have been the subject of
headlines in the past year. New loans are going bad at a
worrisome tempo because banks do not have proper risk
assessment procedures. The consultant lamented that at
least a third of Mandiri's employees are corrupt,
incompetent, or both, and estimated that some 40-50 percent
of new SME loans are going bad because Mandiri still does
not have good risk managers or account officers.


13. (SBU) Though the Financial Sector Package aims to
improve the banks, some debtors still have an attitude
inherited from the New Order, when one of the perks of crony
capitalism was that it was understood that state-owned bank
loans did not always need to be repaid. Our senior contact
at Bank Mandiri told us in confidence that after Bank
Mandiri tried a "name and shame" strategy earlier this year,
publishing the names of problem-loan holders, some debtors
had started to pay, some were paying only interest, and some
who could pay have a bad attitude and are refusing to.
Mandiri's actions provoked a backlash from some companies
that reached out to Palace contacts in an attempt to get the
President to intercede, which he declined to do on advice of
Finance Minister Mulyani. We heard a similar story about

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debtors with bad attitudes from the Finance Ministry
advisor, who told us that Mandiri had "quite legally" seized
a few cash deposits that were used as collateral on
nonperforming loans. In one instance, the customer
complained to the police, who hauled in several dozen
Mandiri staff members including a director for questioning
until 4 a.m. The advisor noted that in the past, Mandiri
would have just made the problem go away by paying the
police more than the client had, but now Mandiri's approach
is to work things out through proper channels.

Bank Consolidation
--------------


14. (SBU) The Financial Sector package includes an item
designed to encourage the consolidation of Indonesia's 131
banks required under BI's Indonesian Banking Architecture
vision. The matrix calls for Bank Indonesia to provide
"incentive" for banks to merge over the next two years, but
does not explain what the incentive will be. BI has had
trouble energizing its bank consolidation program, since the
owners of small private banks like being bank proprietors,
do not want to sell or close their banks, and are unlikely
to respond to rational incentives. The large state-owned
banks, however, have shown sustained interest over the past
year or so in merging with each other, raising the
undesirable prospect of too much banking sector
concentration in precisely the segment that is most poorly
managed. BI has rebuffed these proposals. However, BI's
recently announced "single presence" policy, if it goes
ahead, would bar investors from holding a majority ownership
stake in more than one bank. Designed to encourage
consolidation (and possibly to mollify nationalists piqued
at foreign investment in Indonesian banking),it is unclear
whether the policy would apply to the government, which
holds controlling stakes in the country's three largest
lenders measured by assets-Mandiri, BNI, and Bank Rakyat
Indonesia (BRI).

Next Up, Insurance Sector
--------------


15. (U) The third section of the package deals with non-bank
financial institutions, with a marked focus on the insurance
industry. (Note: Indonesia's insurance sector is in bad
health and poorly regulated. Some domestic insurance
companies were merely appendages of conglomerates. End
Note.) The matrix calls for improved implementation of
"Know-Your-Customer" principles across the non-bank sector;
general moves to strengthen the pension fund sector,
including drafting a development road map for the industry
and good governance guidelines; and MOF decrees on
strengthening the capital structure, regulation and
supervision of finance companies and venture capital firms.
Both insurance pension industries are underdeveloped in
Indonesia, depriving the nation of good sources of long-term
capital that could be invested in infrastructure. The
insurance industry is small, according to the World Bank in
January 2005, with assets equal to just 5 percent of GDP and
6 percent of total financial sector assets. The industry is
also highly concentrated, with the ten largest insurance
firms dominating three-quarters of the sector. The pension
sector is similarly small, commanding only about 3 percent
of financial system assets.


16. (SBU) Indonesia's insurance industry has made progress
since international insurers Manulife (in 2002) and
Prudential (in 2004),were declared "bankrupt" by the
Indonesian court system on spurious grounds. Now the GOI is
wrestling with genuinely bankrupt insurance firms, in
particular, Bumiputra 1912, Indonesia's preeminent domestic
insurance company. Bumiputra 1912 is "totally bankrupt,"
according to our insurance industry contacts, with premiums
collected today being paid out tomorrow in claims. It
should theoretically be shut down, but since it insures
teachers and similar professions in the lower-to-middle
class, the GOI is concerned about disruptive social
consequences if the firm were allowed to fail. Upon
discovering that Bumiputra 1912 is incorporated as

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Indonesia's only mutual life insurance company, the GOI made
an exception for mutual life insurance firms in the solvency
law to avoid having to close Bumiputra down.


17. (SBU) Our insurance industry contacts note some concern
among foreign insurance firms that GOI will ask them to
rescue bad firms. The Minister of Finance apparently only
learned recently that Bumiputra 1912 was insolvent, and that
she and Isa Rachmatarwata, Director for Insurance at Bapepam-
LK, are still trying to devise a strategy. The
international advisor in the Finance Ministry commented that
Director Isa "has inherited a real rat's nest" in the
insurance sector, referring to the Bumiputra problem. The
advisor told us that Isa has conferred with a World Bank
actuary on the Bumiputra problem and believes the firm's
deficit to be at least $500 million, but that international
interest in buying into the firm should help resolve the
situation. (Note: As part of the MOF's reorganization, the
Capital Market Supervisory Agency, BAPEPAM, merged last year
with the MOF's Directorate General of Financial
Institutions, which supervised insurance, pensions, and
other non-bank financial institutions, to form a
consolidated regulator for all these institutions, now
called BAPEPAM-LK, under the MOF. This merger is a
transitional step toward the formation of the fully
consolidated and independent regulatory body for financial
services or OJK, mandated under Law 23/1999. End Note.)

Capital Markets
--------------


18. (U) The section on capital markets includes a slew of
measures to "develop," "improve," and "refine" supervision,
infrastructure, systems and procedures. One noteworthy
program aims to develop the secondary market for bonds,
including better price discovery mechanisms, starting up a
bond repo market, and establishing a primary dealer system
for government bonds. All these measures would further GOI
efforts to broaden and deepen the domestic capital market
for better GOI debt management and deficit financing options
in future. The MOF has already completed one action item on
the matrix, the issuance of Indonesia's first-ever
government retail bond (ORI). Most Indonesian citizens put
their money into very short-term time deposits of 30 days.
The government is promoting the three-year retail bonds to
encourage the development of an "investment society" that
will help finance national development through the capital
markets. The small retail bond issue, originally targeted
to raise only about $230,000, attracted strong interest.
The GOI accepted all bids for a final issue of over $360,000
at the August 9 auction.

Privatization of SOEs
--------------


19. (SBU) The last section includes a couple of measures to
further the politically sensitive, stalled policy of
privatizing State-Owned Enterprises (SOE). According to the
matrix, a Privatization Committee should be established by
Presidential Decree this month, and a blueprint for SOE
privatization should be drafted by November. Our foreign
advisor contact in the Finance Ministry described Minister
of State Owned Enterprises Sugiharto as a stumbling block to
privatization efforts, saying that Sugiharto would like to
create a Temasek-style holding company and will not sell any
SOE if he can help it. The advisor said that Sugiharto has
had to cede some power, however, and that the divestment
committee will no longer be chaired by Sugiharto but by
Boediono.

Comment: Less and More
--------------


20. (SBU) The matrix contains less than earlier drafts the
Embassy had seen. This may not be a bad thing, however, as
the GOI was criticized for slow implementation of earlier
measures which were announced with great fanfare. It would
be better for the GOI to take small steps which build
credibility in its ability to deliver, rather than broad

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strokes which are ultimately realistic. We believe many
elements of this new package are feasible, though missing
specific benchmarks and targets to measure results.


21. (U) This cable was researched and drafted by TDY
Economic Officer Juliet Berger.

PASCOE