Indonesia Joint Recapitalization of 1999

The government pursued a three-pronged strategy: resolving the banks already under IBRA; restructuring state-owned banks; and finally providing joint recapitalization under strict conditions for private and regional development banks (Enoch et al. 2001). The purposes of the plan were to preserve only the best private banks in the banking sector and build burden sharing of the costs of bank resolution between the private sector and the government (Lindgren et al. 1999).

This intervention was accompanied by monetary policy tightening by BI. The increased interest rates were meant to reduce excess liquidity in the system (BI 1999).

Additionally, the capital injections were complemented by a simultaneous debt restructuring plan to deal with the banks’ nonperforming loans, the details of which can be seen in another YPFS case (Smith and Nunn 2021).

In May 1999, the government moved to improve supervision and regulation with an amendment to the 1968 Central Bank Act. Under this new act, Bank Indonesia was guaranteed full independence to conduct monetary policy and given priority in supervision and regulation over any other government entity (Sato 2005). With assistance from the World Bank, Bank Indonesia began to formulate “a master strategy for strengthening Bank Indonesia’s regulatory, supervisory, and examination activities” (Sato 2005).

In May 1999, a new Central Bank Act (Act No. 23 of 1999) was enacted, replacing the Central Bank Act of 1968. This act provided the bank the ability to issue and revoke bank licenses, as well as supervise banks. It also reinforced the independence of BI, which at the time was being questioned under the regime of President Soeharto. Finally, the act gave BI complete monopoly on bank control and supervision, prohibiting intervention by any other organization in these matters (Sato 2005).

Under the new act, BI had purview to make temporary capital investment in banks (Sato 2005). With this legal backing, the Ministry of Finance and Bank Indonesia issued a joint decree on December 31, 1998, outlining the structure of the recapitalization program (Indonesian Government 1998b).

While the structure of the legal regulations and limitations on the BI changed in response to the financial crisis, this structure did not specifically change in support of the joint recapitalization project.

The announcement of the various bank closures and restructurings on March 13, 1999, received a positive reaction. It had been formulated in conjunction with public relations efforts including specialist consultants, and the markets reacted positively. However, public confidence in the banks eligible for joint recapitalization faltered due to some confusion and negative public comments, leading to runs and a dearth of liquidity (Enoch 2000).

This confusion may have been due to President Habibie’s announcement in December 1998 that, rather than the recapitalization plan, there would instead be a strategy of forced mergers. After a brief period of rioting, market uncertainty, and further depreciation of the rupiah, the government reaffirmed the private bank recapitalizations, and the parliament passed a budget for it in February 1999 (Lindgren et al. 1999).

As such, the public expected that bank closures and restructurings would take place before the end of February; however, two days before the expected implementation of the plan (the weekend of February 26, 1999), the government postponed it yet again on the grounds that there was a lack of political consensus surrounding the plan for several of the banks. The public reacted negatively, with some belief that decisions were influenced by outside factors. Over the next two weeks, political consensus was achieved, and “B” banks lacking acceptable business plans were permitted to resubmit their plans (Enoch 2000).

A further interesting aspect to the communication of the joint recapitalization plan was that upon its implementation, on March 13, 1999, the government generally reaffirmed the terms of its original commitment but neglected to “explicitly restate its earlier commitment to leave the day-to-day running of the banks in the hands of the owners” (Lindgren et al. 1999).

During May 1999, when further audits revealed that banks needed more capital than had initially been estimated, the government communicated to the public that it would continue to provide 80% of the necessary capital for joint recapitalization. For the largest private recapitalized bank, this strategy was especially successful in attracting private investment (Lindgren et al. 1999).

Sato (2005) writes that “Bank Indonesia, which was formerly placed under the executive branch of government and given only limited authority, was legally guaranteed independence from the government and obtained broad authority over the banks.”

The MOF oversaw IBRA (Indonesian Government 1998a). It is unclear how much IBRA handled specifically, but Sharma (2001) mentions that IBRA deposited the 80% of government funds for joint recapitalization, which implies that the organization had oversight over the day-to-day activities.

The original budget for the joint restructuring allowed for about Rp 300 trillion of bonds to finance the recapitalizations. Of the Rp 300 trillion of bonds, the recapitalizations required an additional Rp 34 trillion due to the interest rate paid on the capital injected paid for in both bonds and through the liquidation of assets from closed banks ( Jakarta Post 1999b). However, upon beginning capital injections, the costs expanded. By the end of the capitalizations, the government had spent slightly above Rp 500 trillion, with state banks accounting for Rp 303.4 trillion of the allocations and private banks accounting for Rp 199.2 trillion (Suta, Musa, and Slangor 2004). The capital injections were funded by newly issued government bonds (Fane and McLeod 2002).

Banks had to fall into one of three categories (the “B” category) to be eligible for joint recapitalization:

1. “A” group—banks with CARs estimated to be more than 4% that did not require government support,

2. “B” group—banks with CARs between –25% and 4%—at the time, no “B” bank had a positive CAR (Fane and McLeod 2002),^FOnce a recapitalization was agreed upon, the bank’s most severely impaired (Category 5) loans were transferred at no price to IBRA’s Asset Management Unit (AMU/AMC), which then entered into a contract with the originating bank for the recovery of the loans. Banks could, at their discretion, also transfer loans classified as doubtful to the AMU/AMC for the same treatment. “Any recoveries from such loans would be used immediately to buy back the government’s preference shares, thus giving the government the prospect of an early return of its financial infusion, and reducing the amount to be paid by the owners to reacquire full control of their bank” (Fane and McLeod 2002; Lindgren et al. 1999). or

3. “C” group—banks with CARs below –25%, which were not eligible to receive government support and were to be liquidated (Fane and McLeod 2002).

Nine of the banks classified as category “B” (with capital ratios of between –25% and 4%) were eventually eligible for recapitalization (Sharma 2001).

First, banks seeking recapitalization were required to submit business plans spanning three years (Indonesian Government 1998b). The work plan for commercial banks eligible for recapitalization under the scheme required that a series of points be addressed:

1.  The current condition of the bank and weaknesses needing attention;
2. Any assumptions made in creating the plan;
3. Steps and a schedule for resolution of problem loans and nonperforming property loans;
4. The bank’s strategy to improve performance and health, both short and long term;
5. Financial projections to achieve a capital adequacy ratio of 8% by 2001;
6. Plans to settle with BI within three years of injection, with repayment of 20% the first year, 30% in the second and third years, and 50% of the remaining balance per year ongoing;
7.  plan to meet capital shortages;
8. Plans to resolve violations of legal lending limits no later than a year after signing the recapitalization agreement with BI;
9.  A plan to resolve net open position violations; and
10.  Any planned mergers with other commercial banks (Indonesian Government 1998b).^FTranslation based on Google Translate.

Banks were encouraged to include mergers in their business plans with two or more banks, with projections based on such a merger (Enoch et al. 2001). Banks placed in category “A”—having a capital ratio above 4%—were also required to submit business plans, though only a subset of the list above (points 1–7) were required (Indonesian Government 1998b).

The recapitalizations required four committees to consider banks’ submissions of business plans. The Steering Committee’s members consisted of the minister of finance and BI’s governor. The Policy Committee, consisting of BI’s regulation and development directors, BI’s supervision directors, IBRA’s chairman, and the directorate general of the Ministry of Finance, examined the validity of the business plan, administered a fit-and-proper test to shareholders, and provided a recommendation on a commercial bank’s participation in the recapitalization to the Steering Committee. The Evaluation Committee had representatives from BI, the Ministry of Finance, and IBRA, and existed to assess submitted business plans and provide a recommendation to the Policy Committee on the eligibility of the business plans as well as the results of the fit-and-proper test. This committee also supervised the implementation of business plans and reported to the Policy Committee.

Finally, the Technical Committee, also with representations from BI, IBRA, and the MOF, evaluated business plans as well as assessed the results of the fit-and-proper test. The Technical Committee could employ outside consultants to assess business plans. Additionally, representatives from the World Bank, Asian Development Bank, and IMF attended committee meetings to monitor the decision-making process as nonvoting members in each committee (Suta, Musa, and Slangor 2004).

However, the international consultants hired tended toward a more negative view of banks than the BI did due to low confidence externally in the possibility of loan recovery. To address the mismatch, the above four-stage committee process was created whereby BI, the Ministry of Finance, and IBRA assessed valuations and recommendations by the external consultants and determined a policy decision in tandem. In the event of irreconcilable differences between the external consultants and the bank evaluation committees, the BI evaluation took precedence because the central bank was primarily responsible for the capital injections (Enoch et al. 2001).

Due to bank management being perceived as unprofessional in allowing outside interference and as lacking in competency and integrity, after proposing a business plan, bank managers had to pass a test ensuring that they were technically competent enough to run their bank (BI 1999; Fane and McLeod 2002). This technical test was based off of a review of a portfolio, as well as the experience and knowledge of BI officials. Banks were also required to provide a share of the capital to be injected in the recapitalization (Enoch et al. 2001). The fit-and-proper test consisted of several items, including:

1. A written commitment to Bank Indonesia,
2. Engagement of delinquent individuals in the banking sector,
3. Engagement of bad debts in the banking sector,
4. Integrity,
5. Any interventions in bank operations,
6. Any violations of prudential principles by directors or commissioners, and
7. Competence and independence (BI 1999).

Once bank owners agreed to joint recapitalization, the bank was required to provide 20% of the capital required to reach a 4% CAR requirement in cash, and the government provided the remaining 80%. The government became a large shareholder of the bank, with owners in daily control. The owners received prioritized call options to buy back their shareholdings at the end of three years (Enoch 2000).^FAs Fane and McLeod (2002) state: For each bank, the number of options issued was equal to the number of shares acquired by the government. Their exercise date was set three years after recapitalization and their exercise price was set equal to the issue price of the new shares, plus an allowance for accumulated interest during these three years. The total number of new shares was set at 100 times the number of shares already in existence prior to recapitalization, and the issue price of the new shares was calculated to ensure that the value of new equity injected into each bank was enough to raise its CAR to 4 percent, given the auditors’ estimate of the value and average risk-weight of its existing assets. The government saw leaving owners in day-to-day control of the bank as a way to encourage them to contribute new capital (Lindgren et al. 1999).

However, state banks were not subject to the same requirements for capital injection. Due to ongoing restructuring of the state banks because of repeated failures of previous recapitalizations, these banks were not required to submit business plans. Additionally, recapitalization funds were tranched to maintain the momentum of operational restructuring (Enoch et al. 2001).

Foreign and joint venture banks were excluded from the recapitalization program (Nasution 2000).

Rather than ask each bank to apply for specific capital injection amounts, BI allocated enough capital for each participating bank to reach a 4% capital adequacy ratio (Indonesian Government 1998b).

The capital injections were funded by newly issued government bonds. Originally, the government planned to utilize variable-interest-rate bonds to raise capital adequacy ratios to 0% and fixed-interest-rate bonds to cover the additional 4% to reach a 4% capital adequacy ratio. However, in practice, some of the fixed-rate bonds were used to bring banks’ capital to 0% (Fane and McLeod 2002).

The variable-rate bonds paid interest between 13% and 15% per year, paid every three months, with a three- to 15-year maturity period, whereas fixed-rate bonds paid interest between 12% and 14% per year with interest paid every sixth months. When the Indonesian government increased interest rates in 2000 to more than 17%, the government offered a bond exchange to increase the rates of the fixed-rate bonds to be more attractive, with new bonds carrying coupon rates of 10%–15% with five- to 10-year maturity periods. In addition, to hedge for exchange rate risk, the government issued hedge bonds linked to the Rp/USD exchange rate. Every three months, the interest rate and nominal value of the hedge bond was reevaluated based on the exchange rate—so the depreciation of the rupiah increased the nominal value of the hedge bond. The interest rate was based on the Singapore Interbank Borrowing Rate (Feridhanusetyawan and Pangestu 2003).

Additionally, while bonds were intended to bring capital adequacy ratio upwards, the banks were injected with cash from a yearly interest payment on bonds (Jakarta Post 1999a). Interest payments alone were estimated to amount to Rp 34 trillion (Jakarta Post 1999a). The bonds were tradable (Lindgren et al. 1999).

Private shareholders of banks participating in the capitalization scheme also received call options over the government shares purchased. The government made these call options available to private shareholders who provided the 20% of the capital for injection. The price of these options was the share issuance price, plus accumulated interest; the total number of new shares was 100 times the number of shares existing before recapitalization. Issue price was determined such that the value of new equity met the 4% threshold given auditors’ estimates of the value of the bank’s assets. The call options provided an opportunity for shareholders weary of participating in the scheme to profit from the recovery of the bank that had been recapitalized, as share prices for the options were set equal to the issue price of the bank’s shares, plus any accumulated interest (Fane and McLeod 2002).

Shareholders were also provided certificates of entitlement, an instrument tradable on the capital market. These COEs entitled the asset holder to proceeds of collections and sales of assets transferred to IBRA over a specified period, with the idea of increasing the incentive to participate in the recapitalization process. The COEs had no underlying commitment from the government to pay the holder (Suta, Musa, and Slangor 2004).

These agreements with shareholders were met with public controversy as they were perceived as disadvantageous to the government while advantageous to the shareholder. However, the government used the recapitalization terms as an opportunity to encourage controlling shareholders to incur the costs of the recapitalization, as well as provide itself an exit strategy in divestment through the call options on government-owned shares (Suta, Musa, and Slangor 2004).

Due to Indonesian capital markets regulation, the process for raising capital was slightly hindered for banks. The government required private banks to issue new shares to increase liquidity available in the recapitalization scheme, but Indonesian regulation required a preemptive rights issue as shareholder protection. The process for rights issues was lengthy, causing delays in the recapitalization process. While the Financial Services Authority of Indonesia issued a regulation allowing direct public offerings, there were protests within the agency over this method as it lacked protection of minority shareholders. To combat this, the Financial Services Authority required all banks undergoing recapitalization to undertake a rights issue, preventing banks from raising capital through direct public offerings and creating delays in the process (Enoch et al. 2001).

These governance issues applied to all of the Indonesian government’s efforts to salvage its banking system, not just the joint recapitalization program. The issues were “diverse,” and included problems with “each of the principal institutions involved,” such as BI and IBRA, leading to public perception of a lack of commitment to reform of the banking sector (Enoch et al. 2001).

Though able to coerce debtors into promises in reworking loans, IBRA struggled to enforce such promises. Not allowed to use existing powers to legally seize court assets, the agency was forced to take debtors to court. There, it lost four of every five cases. Under pressure to sell assets so that revenues could contribute to the budgetary deficit under IMF provisioning, IBRA often sold assets cheaply to foreign buyers ready with cash (Arnold 2003).

IBRA replaced the management of the banks; almost all of the banks eligible for joint recapitalization had provided their share of the capital; and the markets reacted well to the news (Enoch 2000).

The owners of the banks that chose to participate in recapitalization were banned from managing other banks in the future (Sharma 2001). While state and regional banks did not face changes in ownership, of the 42 business-group-affiliated private banks involved in recapitalization or restructuring, only seven kept their doors open without ownership changes; of those, only one major bank—Bank Panin, not a participant in the recapitalization scheme—was left untouched (Sato 2005).

The government often sold shares of banks not affiliated with groups; rather than sole acquisitions, groups of investors purchased shares of banks. Of the recapitalized banks, Bank Internasional Indonesia was sold to Temasek Group of Singapore and Kookmin Bank of Korea (Sato 2005).

The joint decree establishing the parameters for recapitalization also placed requirements on boards. Shareholders of each commercial bank participating in the recapitalization program were required to elect a member to each bank’s board to serve as a compliance director. The board member’s appointment also required Bank Indonesia’s approval. Compliance directors were required to submit the ongoing results of the recapitalization to Bank Indonesia quarterly (Indonesian Government 1998b).

The banks remained able to reacquire their shares during the three-year period by paying the government back either for their account or an outside investor. At the end of the three-year period, the bank’s value was independently assessed and the owners had the first option to buy back their shareholdings. If the owners did not buy back their shares, the government sold them over the course of the next year (Lindgren et al. 1999).

According to an IMF report from 2000, even if banks reached the 4% CAR requirement, BI and IBRA continued to monitor the banks, as the CAR requirement increased to 8% for end-2001 (Giorgianni et al. 2000). The status of the various banks’ CARs can be seen in Figure 5.

Figure 5: Banks’ Performance as of March 2000

Source: Giorgianni et al. 2000.