EXPERTS APPLAUD BANKING REFORMS BUT WARN OF LONGER TERM

UNCLAS SECTION 01 OF 03 JAKARTA 002690 SIPDIS SIPDIS DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-ABAUKOL SINGAPORE FOR SBAKER TOKYO FOR MGREWE COMMERCE FOR 4430/BERLINGUETTE DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR TCURRAN DEPARTMENT PASS EXIM BANK E.O. 12598: N/A TAGS: EFIN EINV ECON PGOV ID SUBJECT: EXPERTS APPLAUD BANKING REFORMS BUT WARN OF LONGER TERM CHALLENGES FOR ASIAN BANKS JAKARTA 00002690 001.2 OF 003 ¶1. Summary. Financial sector experts working in Asia gathered at the Federal Reserve Bank of San Francisco on September 6-7 to discuss the opportunities and challenges facing Asian banks over the next decade. They lauded Asian policymakers for largely correcting the excesses that led to the 1997-98 Asian financial crisis and downplayed the likelihood of large-scale banking sector instability in Asia in the near term. Experts expressed concern that the massive growth predicted for Asia over the next decade, along with financial sector innovation, will strain the ability of banks and regulators to manage risk. While Indonesia's progress in implementing banking sector reforms has lagged some of its neighbors, experts consider the Indonesian banking sector to be generally sound. End Summary. Regional Macro Reform Substantial -------------- ¶2. Regional experts at the Federal Reserve Bank of San Francisco conference on "Asian Banking: Challenges and Opportunities" lauded Asian policymakers for largely correcting the excesses that led to the 1997-98 Asian financial crisis. They universally agreed that macroeconomic policymakers across Asia are now generally getting it right. Asian countries have moved away from pegged exchange rate regimes; effectively discouraged short-term foreign currency borrowing in the public and private sector; and reined in fiscal deficits. ¶3. Experts also highlighted the importance of strong political and regulatory leadership in the aftermath of the 1997-98 crisis. Korea recovered relatively quickly due to the leadership of then-President D.J. Kim and his government's emphasis on improving financial sector regulation. In contrast, Japan and Indonesia took longer to recover from their banking sector woes. In Japan, the regulators consistently downplayed the level of problems faced by the large banks. In Indonesia, the political transition and lack of interagency coordination slowed much needed reforms. Once strong political and regulatory leadership emerged in Japan and Indonesia, the pace of banking sector reforms accelerated. Asian Banking Reforms Largely Successful, Indonesia Less So -------------- ¶4. Experts also discussed the success of Asian banking sector reforms, although progress on micro-level reforms was less even across the region, with a number of weaknesses concentrated in Indonesia. The ten banking sector reform categories discussed at the conference were: -- Profitability: The vast majority of banks across the region, including those in Indonesia, are now profitable. -- Consolidation: Consolidation efforts in Asia aimed at strengthening banks and easing pressure on supervisory resources have been successful. One unwanted side effect is that governments now have a vested interest in keeping their "creations" alive. The Indonesian banking sector remains one of the most fragmented sectors in Asia with a large number of questionably viable, small institutions still in operation. -- State-ownership: Most Asian governments are no longer in the banking business. Indonesia and China are two very important exceptions to this trend. -- Foreign Bank Presence: Foreign bank participation in Asian markets, particularly in Indonesia, has increased, bringing in more competition, fresh capital and international best practices. -- Credit Bureaus and Credit Rating Agencies: A number of countries, including Korea and Malaysia, have established credit bureaus and domestic credit rating agencies in an effort to build a stronger credit culture. These institutions have contributed to more robust bank balance sheets, particularly in the consumer loan portfolio. International credit rating agencies are on the ground in Indonesia, but the domestic credit rating industry, which experts believe is integral to expanding rating capacity beyond the largest JAKARTA 00002690 002.2 OF 003 Indonesian firms, remains underdeveloped. -- Supervision and Regulation: Asian regulatory authorities have systematically overhauled their supervisory regimes in the last 5-10 years. While the rules are largely in line with international best practices, the supervisory skills of Asian banking regulators, including Indonesian regulators, still lag their European and US counterparts. -- Corporate Governance: Building a strong corporate governance and risk management culture requires a significant shift in mind-set at all organizational levels, which can take as long as a generation. Asian banks have made progress in adopting sound corporate governance rules and stronger risk management practices, but bank managers, particularly state-owned bank managers, have not yet successfully imbedded these cultural changes throughout their organizations. -- Financial Market Depth: Both equity and debt markets in Asia have grown significantly in the past 5-10 years, diversifying risk in the financial sector, but banks continue to be the primary source of external finance in Asia. Analysts predict that bank dominance will wane over the next decade as capital markets develop further. -- Financial Infrastructure: All of the countries impacted by the 1997-98 financial crisis have made significant progress in improving the capacity of payments systems and crisis management over the past decade. However, interagency coordination remains a problem in a number of Asian countries, including Indonesia. -- Vitality of Corporate Sector: In contrast to the pre-crisis years, the majority of Asian corporations now generate income at levels that exceed their cost of capital. Moreover, the Asian corporations that survived the crisis have largely de-leveraged, generating much healthier balance sheets. The Indonesian private sector has mirrored these trends, but the true condition of state-owned enterprises is largely unknown. -- Asset Bubbles: While Asian growth rates have recovered from the crisis period, asset price growth in many Asian countries has been somewhat subdued. Nevertheless, experts expressed concern about real estate price bubbles in Jakarta and Singapore and an equity price bubble in Indonesia. -- Transparency: Lack of transparency remains a problem across Asia, inhibiting Asian regulators and investors from forming a clear picture of risk in the region. Likelihood of Major Near-Term Financial Instability: Very Low -------------- ¶5. The general view among conference participants was that the likelihood of major financial sector instability anywhere in the region in the near term is very low. The region's macro- and micro-level reforms have significantly lowered the probability of large-scale capital flight from Asia or banking problems in the near term. The relative lack of complexity of financial instruments in the region has also shielded the regions' banks from recent US-led volatility. Nevertheless, most speakers at the conference reject the notion that Asia has "de-coupled" from the U.S.: U.S. recession would have a significant impact on Asian financial and real sectors. Experts consider the Indonesian banking sector generally sound, though inconsistencies in bank regulation may open the door for future vulnerabilities. Other potential sources of vulnerability in Indonesian banks include rapid growth in the banks' consumer portfolio in the absence of a strong risk management culture and the potential overheating of property markets. Massive Future Growth to Stress Risk Management -------------- -- ¶6. Asia is poised to experience massive growth in the next ten years, stressing Asian banks' capacity to manage risk. Fueled by rapid growth and a growing pool of foreign currency reserves, Asia JAKARTA 00002690 003.2 OF 003 is set to become a dominant source of financial power in the world. Four of the top ten financial centers in the world are already in Asia. Yet banking analysts at the conference asserted that Asian risk management systems are currently too weak to cope with rapid growth and financial innovation. Competition from foreign banks with the ability to attract the best talent will put additional pressure on Asian bank profitability and soundness. If Asian bankers do not match rapid growth rates and the ensuing war for talent with significant new investment in risk management and information technology systems, Asian banks are likely to have weaker balance sheets and experience more volatility in the next decade. In the face of Asia's newfound global power, experts also cautioned Asia bankers to avoid becoming arrogant, and thereby blind to potential vulnerabilities. Challenges for Regulators -------------- ¶7. Rapid growth, financial innovation and globalization in the region pose parallel challenges for Asia's banking sector regulators. Asian banking supervisors will need significant additional training and improved information flows to stay ahead of these issues. At the same time, the demand for private sector talent is likely to pose staffing challenges for supervisory authorities as the private sector lures away seasoned supervisory staff. Asian regulators also need to improve information sharing and regulatory coordination at the national and international levels in order to keep problems in one institution from spilling over into other sectors or markets. Finally, conference participants warned Asian regulators not to rush to adopt the Basel II capital accord. In their view, premature adoption of some advanced capital models under the new accord will strain supervisory capacity and further cloud their understanding of risks in the banking sector. HUME