Challenges of the Asian Economy and Financial Markets (2)

2. Each Country's Measures Aimed at Revitalizing the BankingSector

(1) Measures Taken after the Currency and Financial Crises

After the 1980s, Asian finance was liberalized without preparing adequate systems and regulations.Therefore the banking sector, which serves as the core of the financial system, engaged in imprudentactivities such as excessive lending, and borrowing excessively from overseas. This resulted insevere damage to the banking sector during the currency and financial crises. After the crises,Asian countries took drastic steps aimed at revitalizing their banking sectors, such as disposal ofnon-performing loans, increase of equity capital, downsizing and other forms of restructuring, andstrengthening supervisory and regulatory frameworks. The operating environment for Asian banks hasthus been undergoing major changes both internally and externally.

(Disposal of non-performing loans)

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In addition to disposal of non-performing loans through write-offs or sale to third parties, other methods include transfer to government agencies or asset management companies (AMCs), transfer to AMCs that are subsidiaries of banks, and the reclassification as normal loans along with agreements for corporate debt restructuring. After the crises, each nation's efforts at disposing of non-performing loans have led to major reductions in the proportion of non-performing loans held by Asian banks. (In Malaysia and South Korea, the proportion is under 10%, and in Thailand and Indonesia it is under 20%. Although this is only superficial disposal, the biggest reason for the reductions in the proportion of non-performing loans has been transfers to public and private AMCs.)

Table: Proportion of Non-performing Loans inAsian Countries
(Non-performing loans/All loans)

	Thailand	Indonesia	Malaysia	South Korea
A Finance Sector (at peak)	47.7% (May 1999)	49.2% (Dec. 1998)	14.3% (Feb. 1999)	11.3% (June 1999)
B Finance Sector (at the end of 2000)	17.9%	18.8%	9.6%	8.1%
B + amount transferred to AMC (at the end of 2000)	26.8%	57.1%	14.4%	19.5% (Sep. 2000)

Sources: ADB "Asian Recovery Report", ARIC Indicators.

* Non-performing loans - In

Thailand and Korea: held by all financial institutions;
In Indonesia and Malaysia: held by all banks

(Capital Increase)

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Banks' capital ratios have been increased through government injections of public funds and through voluntary fund-procurement, so that they are almost achieved at the minimum capital adequacy ratio demanded by each country's central bank.

Table: Capital Ratios of Local Commercial Banksin Asia

	Thailand	Indonesia	Malaysia	South Korea
Minimum capital adequacy ratio	8.5%	4% (8% by Dec. 31, 2001)	10%	10% (8% from March to Dec. 2001)
Average capital ratio	12.0% (Dec. 2000)	6.3% (Mar. 2001)	11.8% (Apr. 2001)	10.4% (Mar. 2001)

Sources: Documents provided by each country's central bank, etc.

(Restructuring [Consolidation])

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Asia's banking system was described as "over-banking" before the crises, but now the number of commercial banks has declined considerably. Restructuring methods include the closure or nationalization of banks and non-bank financial institutions that cannot continue to operate (disposal/collection of assets taken over; privatization of nationalized banks), sale to foreign banks or foreign capital, and consolidation of local banks through a holding-company system (creation of core banks) or other means. During this process, it might be advisable to pay attention to the necessity of indicating prospects not only for disposing of non-performing loans, but also for privatizing nationalized banks.

Table: Changes in Composition of Banking Sectorin Asian Countries
(Before Crises to current situation)

Thailand (June 2001)	Indonesia (Dec. 2000)	Malaysia (March 2001)	South Korea (Dec. 2000)
Local commercial banks: 15-->13 (4 of 9 private banks foreign-affiliated; 4 state-run or nationalized) Foreign banks: 21 Finance companies: 91-->22	Private commercial banks: 160-->81 Nationalized commercial banks: 7-->5 Regional development banks: 27-->26 Foreign banks/ joint ventures: 44-->39	Regional commercial banks: 21-->11 Foreign banks: 14 Islamic banks: 2 Finance companies: 38-->11 Merchant banks: 12-->9	Banks: 26-->17 (city banks: 16-->11 (foreign-affiliated 6); Regional banks: 10-->6. Six of these banks have been nationalized) Foreign banks: 44 General finance companies: 30-->6

Source: Documents provided by each country's central bank, etc.

(Strengthening of regulatory and supervisory frameworks)

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After the crises, prudential rules have been strengthened. These include such measures as restrictions on large-scale financing and real estate financing, stricter definition of classifications for non-performing loans, increased ratios of reserves for doubtful debts, regulation of capital ratios, management of exchange rate risk, establishment of risk management system within banks and promotion of disclosure. Strengthening of bank supervising authorities has also been attempted in line with the Basel Core Principles.

1)		In Asian countries, amid the low interest rates prevailing after the currency and financial crises, banks and corporations have refinanced themselves by paying off their short-term borrowings from foreign banks and issuing long-term bonds in their own country's currency, thereby reducing their external short-term liabilities. At the same time, they have been taking steps to encourage direct foreign investment and foreign portfolio investment.
2)		Along with weakness in the banking sector, the capital flows have also been cited as a cause of the previous currency and financial crises. In the past, there have been discussions about the capital control versus the complete liberalization of capital. Because there are practical difficulties with directly controlling capital flows in a globalized economy, some people thought that along with managing external debt at the macroeconomic level, dependence on foreign capital could be managed to some extent through such mechanisms as prudential regulations for banks (for example by including a company's debt equity ratio among listing standards).

Table: Statistics Related to External Debt

	Thailand		Indonesia		Malaysia		South Korea		The Philippines
	June '97	Dec. '00	June '97	Dec. '00	June '97	Dec. '00	June '97	Dec. '00	June '97	Dec. '00
External short-term debt/ foreign currency reserves (%)	163.1	41.3	198.5	100.2	67.8	29.4	234.9	44.1	106.6	66.1
Balance of external short-term debt (US$ billions)	51.1	13.2	40.4	22.6	18.0	8.6	80.0	42.4	10.4	8.6
Balance of foreign currency reserves (US billions$)	31.4	32.0	20.3	22.5	26.6	29.5	34.1	96.1	9.8	13.1

Source: Joint BIS-IMF-OECD-World Bank Statistics on External Debt.

(Participation of Foreign Banks)

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So far, liberalizing foreign banks' participation and activities has not been part of the financial liberalization efforts of Asian countries, and banks have been restricted in areas such as foreign capitalization and licenses for branch. After the currency crisis, however, all Asian countries substantially loosened restrictions on participation and activities by foreign banks, and foreign banks, especially Europeans and U.S.-affiliated ones, have made progress in establishing themselves in Asia.

By loosening restrictions on foreign capital, Asian countries (other than Malaysia) affected by the crises have promoted privatization of nationalized banks by using foreign capital in the settlement of failed banks. Furthermore, by buying local banks after the crises, foreign banks have established branch networks and entered the retail market and are competing with local banks for customers. (Before the crises, the number of branches of foreign banks was limited very strictly, so they focused on corporate financing.)

Table: The Banking Sector in Emerging Markets
(Ratio of Foreign Capital to Total Assets)

	Thailand	Malaysia	South Korea
End of 1994	0.5	6.8	0.8
End of 1999	5.6	11.5	4.3

Note: Covers banks with more than 50% foreign capital.
Source:	IMF "The Role of Foreign Banks in Emerging Markets" in "International Capital Markets"(2000).

(Control and Limitation of Short-term Capital Flows)

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Several Asian countries have strengthened restrictions on transactions involving their own currency which are not based on actual demand in off-shore markets, in order to restrain currency speculation.

Some people thought that this trend toward restricting currency transactions would force a review of the strategies of major banks whose financial transactions in Asia had been concentrated in such financial centers as Singapore, Hong Kong, and Tokyo.

Table: Recent Trends Related to ASEAN CurrencyTrading Regulations

Main Points of Regulation

Date of Implementation

Thailand

Limits on bhat-denominated credit that resident can grant to non-resident (unless backed by actual demand, each trading partner can be granted up to 50 million bhat in credit)

January 1998

Official notice advising that non-residents not be allowed to have a negative balance in bhat-denominated accounts (borrowing of bhat by non-residents)

October 2000

Stronger requirements for reporting currency transactions conducted with off-shore banks

March 2001

Indonesia

Residents prohibited from making loans to non-residents - Non-residents prohibited from transferring rupiah-denominated funds - Amount of foreign currency that residents are allowed to sell forward to non-residents reduced to US$3 million, from 5 million

January 2001

Malaysia

-		Fixed foreign exchange rate(US$1 = 3.8 ringgits)
-		Prohibition (in principle) against fund transfers between non-residents' savings accounts
-		Limits on amounts that non-residents can deposit or withdraw from savings accounts
-		Restrictions on currency used for trading (trades cannot be settled in ringgit terms)

September 1998

Tax on remittances of capital gains on stocks

Phased out by May 2001

Expansion of ringgit-denominated credit granted in connection with non-residents acquiring real estate in Malaysia (effective retroactively until April 25, 2001)

July 2001
(Government announcement in May)

Source:

Based on materials provided by each country's central bank, etc. (documents submitted by Mr. Yamagami at the 8th meeting of the Expert Group)

(Massive Issuance of Government Bonds)

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To rehabilitate their banking sectors, Asian governments have issued bonds in massive amounts, to support liquidity, protect the full amount of deposits, buy non-performing loans, and inject capital. In addition, Asian countries affected by the crises have expanded fiscal outlays in order to provide support for their economies while the economic growth was negative, so their fiscal deficits have expanded. In the future, there is a danger that the governments will be saddled with additional fiscal burdens when their losses are defined as they try to collect on the non-performing assets they have purchased and when they procure funds to redeem the bonds they have issued.

Table: Trends in Fiscal Balance (relative toGDP) (%)

	1995	1996	1997	1998	1999	2000
Thailand	3.0	2.4	-0.9	-2.4	-2.8	-2.2
Indonesia	0.6	0.2	0.0	-3.7	-2.3	-4.8
Malaysia	0.8	0.7	2.4	-1.8	-3.2	-5.5
South Korea	0.5	0.0	-1.5	-4.2	-2.7	1.1

Source:

IMF "International Financial Statistics", ADB "Asian Development Outlook 2000".

(2) Current Status of Banks' Financial Intermediation Function

As stated above, each country has taken steps since the crises torevitalize its banking sector, and some progress has been made in each area. However, as thingsstand, it seems difficult to say that banks have sufficiently recovered their financialintermediation function.

(Lending Slump and Restructuring of Corporate Debt)

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Despite the central bank's low-interest policies and heightened liquidity due to increased deposits, banks' loan balances have not yet recovered to pre-crisis levels in most countries. Even if non-performing loans have been decreasing on bank balance sheets, corporate borrowers are still saddled with excessive debt, so banks cannot help being cautious about new lending as they work to dispose of non-performing loans while striving to increase their capital. Also, some companies are issuing bonds to repay loans from local and foreign banks while some banks are increasing their investment in stocks without increasing lending.

1)		For the final disposition of non-performing loans, including improvement in businesses' profitability, it is essential to solve the fundamental problem of corporate debt. However, in many cases negotiations for the restructuring of corporate debt ends with rescheduling of debt, abandonment of credits, or securitization of debt without touching on the restructuring of corporate management. Although some bankruptcy laws have been revised, there remains more work to be done. The progress of court cases has been slow due to such factors as debtors being in a stronger position than creditors and the number of cases exceeding the capacity of the courts.
2)		Businesses saddled with massive debt are having a hard time even making enough profit to provide funds for repaying the money they borrowed before the crises, and it is very difficult for them to secure operating funds. In addition, corporate performance has deteriorated with the economic slowdown that began in the second half of last year, and there is a danger that new non-performing loans will be generated. It has been pointed out that a vicious cycle has arisen whereby bank lending will be less and less likely to increase.
3)		In the case of Southeast Asia, where foreign capital controls key export industries, some people believe that even if the financial intermediation function of domestic banks sinks quite low, export industries will not be strapped for funds and the non-performing loan problem will not obstruct economic recovery. But others fear that if banks' disposition of non-performing loans drags on for too long, local banks will (a) not be able to compete adequately with newly participating foreign banks and will lose their markets, (b) not be able to provide credit for local industries or small and medium-sized businesses, causing a slackening of internal demand, (c) be forced to specialize in financing small and medium-sized businesses, or (d) end up having their non-performing loans to be bailed out by national governments, causing fiscal deficits that result in long-term economic stagnation.

Table: Bank Lending Indices (Bank LendingBalance/GDP)

	June '97	Dec. '97	June '98	Dec. '98	June '99	Dec. '99	June '00	Dec. '00
Thailand	100	118	115	110	108	103	95	84
Indonesia	100	116	132	102	44	39	36	40
Malaysia	100	109	109	111	105	109	99	102
South Korea	100	111	116	123	125	136	140	152
The Philippines	100	115	101	97	84	85	77	81

Note: Bank lending balance/GDP as of June 30, 1997 = 100.
Loans that have been transferred to AMCs are not included in bank lending balances.
Source: IMF "International Financial Statistics".

(Decline in Financing of Small and Medium-sized Businesses)

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Furthermore, Western-affiliated foreign banks have expanded their participation. In addition to the area of corporate finance, they have made full-fledged entries into retail markets by buying local banks, and a substantial proportion of domestic deposits has been absorbed. Meanwhile, local banks have been forced into a defensive position, partly because the areas in which it is possible for them to operate have been limited. It is indicated that new imbalances are being created. Such as local banks have reduced financing of small and medium-sized businesses and have instead been focusing more on small-lot and consumer loans.

(Little Progress in Improving Profitability)

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Since the crises, local banks have been consolidated through mergers and buyouts, etc. This trend has led to expectations that banks will become more competitive due to more efficient management and greater profitability, but so far there has been no conspicuous success in this area. The reasons for this situation include the banks' inability to operate independently and efficiently because, for example, they are sometimes forced to merge with small and inefficient banks through consolidation; or they may still have high levels of non-performing loans and be unable to invest adequately; in some countries there is government intervention in bank management, or they may be expected to fulfill a social service role rather than operate purely as businesses, etc.

For example, even in South Korea, which is praised for having made progress with structural reform, "financial restructuring" has been limited to a superficial improvement in fiscal health by cleaning up bank balance sheets, without necessarily leading to "operational restructuring" involving profits.

Table: Profitability of Banking Sectors (AverageROEs of Commercial Banks)

(%)

	1995	1996	1997	1998	1999	2000
Thailand	20.7	18.5	2.3	-83.4	-102.1	3.7
Malaysia	15.3	15.2	17.3	-3.0	3.2	9.2
South Korea	4.2	3.8	-14.2	-52.5	-23.1	-11.9

Source: ARIC Indicators.

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