Indonesia

1. Indonesia Financial Sector reform Challenges April2003 William Haworth

2. Overview of Financial Sector Reform in Indonesia

3. Indonesia’s underlying financial weakness was revealed by the ’97 crisis • Economic performanceappeared strong until ‘97 • Strong GNP growth – inflated by a massive bad debt bubble • Apparently improved GDP per person and household • 50% of the financial sector privatized • The Asia Crisis and ensuing political turmoil reversed economic progress • GNP shrunk, high inflation • Vast hardship on many people with high levels of unemployment • Financial sector collapsed and was “nationalized” • Foreign Direct Investment turned negative • Recovery has been slower than hoped, but Indonesia has proven to be both tough and resilient

4. The Indonesian Financial Crisis Was, First and Foremost, a Debt Crisis Caused by Underlying Structural Problems • The Indonesian banks were riddled with bad debts that had been mounting for many years • In addition, irresponsible international lending, much of it based in US $’s, exacerbated and deepened the crisis • Political problems were both the cause and the effect of this financial crisis • Ongoing political problems, caused in part by the economic crisis, discouraged foreign investment, deepening and prolonging the crisis • Ultimately, our failed efforts at financial sector reform underlay a large part of the depth, breath and length of this crisis • Leading us to ask: what should we have done differently? What could we have done differently?

5. The Starting Point: The Indonesian Banking Sector Under Suharto (Personal Observations) • The managing boards (president directors and directors) of the Indonesian state banks were direct presidential appointments • There were often back-room deals that surrounded these appointments • Political favours to the military, Suharto cronies, etc • Positions were granted for contributions to “charitable foundations”, etc • It was very common practice to supplement low compensation with “Upati” from customers, suppliers, and so forth, throughout the banks • To a very large extent, there was no “commercial” credit process within the state banks • Many loans were directed from the top down – often Suharto would call and instruct a president director how much to lend to whom • Many loans were granted for kick-backs with little real analysis or attempt to develop meaningful cash flow or security analysis • Additional lines of credit were often extended to cover interest payments – capitalization of interest was extremely common • These abuses were most common on the largest loans and were less common on the smaller loans

6. Indonesian Banking Sector Under Suharto….(Personal Observations)… • Asset values were grossly distorted due to capitalization of interest and other poor accounting and reporting practices • Many of the largest companies in Indonesia, both state and private, were in very poor financial condition – sometimes from mismanagement, sometimes from abuses • The state banks had very weak internal controls, usually focused on tellers • State auditors applied lax standards in their reviews, often encouraged, where necessary, by supplemental donations to their favourite charities • Banking supervision was ineffective and often corrupted • Based on information that I was able to glean by 1989, I concluded that all of the Indonesia state banks had massive bad debt problems and huge capital shortfalls • I believe that these problems were widely recognized and were behind the drive to improve the performance, and to deregulate and privatise the financial sector

7. Indonesian Banking Sector Under Suharto…(personal Observations)… • Offshore branches, bank pensions funds, and bank subsidiaries were also used to manage certain transactions, park funds, mask ownership, etc • These problems were allowed to fester – in fact the Suharto government encouraged these problems with specific policies issued by the MOF, BI and state audit agency • While the world bank was aware of these problems and insisted on revised business plans to address these issues, the banks and the government actively enabled the problem to continue to build • Financial collapse was only a matter of time

8. How Do We Deal With the Real Issues? • The core issues in effective financial sector reform in most developing economies revolve around power and money controlled by an elite group • The question is: how do we alter this power structure and create a balanced set of incentives to encourage the development of a stable and productive financial sector? • Not surprisingly, most failures occur around our ability to change the power allocation from the elites to an institutional structure that can be controlled through a workable political process (not just creating new elites) • This was the main problem in Indonesia under Suharto and it remains a part of the problem today • However, the collapse of the Suharto regime, the shift to democracy, and ongoing improvements in the regulatory and governing structures create opportunities that were not present before

9. Lessons Learned…. • Deregulation by itself does not enable “market forces” to create efficient economies – Indonesia was the most deregulated market on earth for some time • Privatization, in and of itself, does not correct the incentive problems in banking: • Mexico • Venezuela • Indonesia • In fact, privatization and deregulation can cause even more destructive private sector behaviors than are possible in a state-owned, regulated economy • Introducing private sector competition into a state controlled system can have very perverse effects • Deregulation and Privatisation each require vastly stronger regulators and enforcement. We have consistently underestimated this challenge

10. Lessons Learned….. • New laws and regulations, by themselves, do little to change behavior in settings where there is a history of endemic corruption and weak enforcement – you can still buy the judges • Building skills, without changing the institutional context and “culture”, will have little impact on behaviors • The better we understand the way a system really works, the better our chances are to change it • Real, effective change, requires addressing the entire matrix of issues that impact the structure of a financial system – legal, regulatory, political, skills, and incentives • Failing to make significant progress on all fronts simultaneously – so they reinforce each other – usually results in a slow catastrophe

11. Trying to create a stable and productive financial sector is difficult and important……….Why is it so difficult? • Every banking system is complex, interactive, opaque and filled with incentive problems and competing interests . . . DepositorsOwnersRegulators Competitors Borrowers ManagersTax authoritiesSubstitutes Financial EmployeesAuditors AcquirersInstitutions • . . . With major legacy issues . . .Political Economic Structure CulturalalLegal Organizational/Operational Personal relationship • Why is it so important? Cost to GDP of crisis:USA:  5% Japan: 15%? Venezuela: 35%?Mexico: 20%? Korea: 20%? Indonesia: 50% ?

12. Do We Agree on the Ultimate Objectives ? • First, a largely privatised financial sector, broadly held, profitable and well managed • Able to gather deposits and employ these productively in building strong companies and create employment • Able to facilitate trade and investment flows • Able to manage risks through a variety of tools such as insurance, etc • Able to operate transparent capital markets and provide underpinnings for economic growth based on equity • Second, a strong supervisory structure and organization that effectively oversees the financial sector and maintains its strength and prevents abuses • Thirdly, assurance and reporting organizations that provide transparent, complete and comparative views on the health and returns in the financial sector leading to sound investment decisions and capital allocation • Fourthly, the legal infrastructure that underpins this financial sector, with laws and courts that support both the civil and criminal processes that facilitate business

13. A Possible Approach -- Creating a Change Master Plan…. • Study the People and the culture, not just the institutions-- • Leadership matters - look at Singapore • Understand the underlying relationships • Understand the incentives • Be objective • Be opportunistic • Seek out strong champions, nurture them, protect them • Focus on changing the way the underlying relationships operate • Study the incentives and disincentives to behavior change • Recognize that we need to change systems, behaviors and incentives together • Understand that we do not have enough power or influence to change things quickly – we must be relentless and strategic -- using influence to shift behaviours, incentives, and institutions over time • Understand that while the components of success are the same, the way that they can evolve and develop will be very different in different countries at different times

14. A Possible Approach… • Understand the real compensation levels and systems in the Central Bank, the commercial banks, the auditors and rating agencies and the government • Look at the lifestyle indicators - cars, houses, trips, etc • Make a judgment, is this a corrupt system • If it is corrupt, we need to focus on programs that bring “sunshine” to the system, as well as programs that change the compensation and incentive structures, as well as building skills • Start where we can – elites won’t give-up power willingly – work where we can succeed, look for explicit trades that can be offered • If we are working in a newly “deregulated” environment, watch-out for the poor risk management and destructive systemic competition that leads to asset bubbles • requires a system-wide analysis of both borrowers and lenders • involving both local and international players • Usually new and demanding roles for regulators and government

15. Elites, Culture Change, Political Change – Can Privatisation Provide a Bridge? • What is the alternative?

16. Privatisation Presents Two Broad Sets of Challenges … Sectoral and Institutional Sectoral challenges affect the entire economy and privatization process Institutional challenges affect all companies improving from state to share market ownership • Sequencing • Legal system • Regulations • Supervision and oversight • Preparing industry segments for privatization/ sale • Sequencing the sale of individual firms within industry segments • Balancing conflicting political agendas • Balancing conflicting financial pressures • Ensuring appropriate levels of competition • Balancing price, percentage sold and timing • Ensuring overall economic growth • Ensuring “reasonable” price • Ensuring responsible ownership • Ensuring strong management • Ensuring continuing capital investment • Ensuring profitable growth and job creation

17. Review of the BNI Privatization Experience

18. The Market and Foreign Investors Remain Guarded About Investing in Indonesian Banks – in Part Because of the BNI Experience BNI financial performance has deteriorated significantly after financial crisis BNI stock performance has under performed the market Cost/Income ratio BNI stock price JSX index Interest income/ total income Net Interest Margin ROA Time of IPO: Nov 1996 Stock price is closely linked to company’s key financial metrics Source: Bloomberg, A T Kearney analysis

19. BRI Could Be Easier to Privatize Than BNI Cost/Income ratio(1) ROA Gov. Bond To Total Assets Net Interest Margin Note: Figures as year 2000; (1) Operational expenses/ (net interest income + non-interest income)

20. Privatization Experiences: • Mexico • Commonwealth Bank Of Australia

21. The Recent Privatization Experience in Mexico Illustrates the Possibility to Successfully Privatize the Whole Banking Sector Situation of Mexican Banking Industry after 1994 Peso Crisis Re-privatization of Banking Sector Implications • Nationalization of Banks, 1982 • Rapid privatization 1991-92 • All 18 banks sold in 14 months • Weakness in Industry • Inexperienced and inappropriate management • Insufficient regulation • Mexican Peso crisis, Dec 1994 • Government intervention 1995 • Government took over 12 banks • Lack domestic resources to re-capitalize banking industry • Changed law to allow foreign purchase of all but three largest institutions • 1995 response to Mexico banking crisis • Government removed restrictions on foreign ownership • By 1998 Mexican banking industry successfully undergone rapid privatization • Bank of Montreal acquired 16% of Bancouver • HSBC acquired 20% Serfin • Central Hispario acquired 20% of Bital • BBV acquired 70% Probursa • Scotiabank acquired 55% Inverlat • Santander acquired 75% Mexicano • Citibank acquired 100% Confia • Privatization offers opportunity for massive government debt reduction • Privatization requires strong initial government regulation • Experienced and appropriate management is vital for privatization success

22. Privatization Experiences: • Mexico • Commonwealth Bank Of Australia

23. The Commonwealth Bank of Australia (CBA) Performed at About Market Average Prior to Privatisation Pre-Privatization Cost-Income Ratios Pre-Privatization ROE Source: Department of Finance, University of Melbourne

24. The CBA Privatisation Was a Five Year Process, With Benefits Only Being Realised After Full Privatisation Cost-Income Ratio, Partial and Complete Privatization ROE, Partial and Complete Privatization Source: Department of Finance, University of Melbourne

25. The CBA Privatisation Was a Clear Success, Which Can Be Translated Across to BRI BRI Is In A Similar Position To CBA Prior To Privatization ROE, Partial and Complete Privatization Source: CBA Annual Reports, ASX

26. Challenges of Moving from Managing a State-Owned Bank to a Private Bank

27. Privatisation Requires a Transition in Management Focus … State Owned Bank Privatized Bank • Manage politically directed credit • Sect oral • Provincial • Developmental • Provide comprehensive service provision • Widespread branch network • Deposits • Credit availability • Maintain high levels of employment • Balance political and commercial agendas • Maintain depositor confidence • Meet shareholder return requirements • Ensure profitable growth • Reporting detailed LOB results and discussing action plans • Manage analysts and shareholder expectations • Key Metrics: • Liquidity • Employment • Credit growth • Key Metrics: • Return on equity • Cost to income ratio • Growth rate • Branches maintained • Rural lending extended • LOB performance • Acquisition targets • New products/ services

28. Boards and CEOs in privatized banks are primarily focused on two basic metrics that largely determine share price Share Price Cost to Income Ratio Versus Competitors Growth Rate

29. Privatization Is Critical to Meeting Government Budget Targets and Is Currently Behind Schedule Announced/Planned Completed Indonesia Privatization Timetable Excluding IBRA Sales  SOE’S NAME Proceeds (Rp Billion) 2001 2002 2003 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 125 125 3,000 967 PT Indo Farma PT Kimia Farma PT Pupuk Kaltim PT Wisma Nusantara PT Sucofindo PTPN III PT Sarinah PT Socfindo PT Tambang Batu Bara Bukit Asam PT Krakatau Steel PT Bank Mandiri PT Angkasa Pura II PT Indocement PT Semen Gresik PT Telkom PT Indosat PT Bank Rakyat Indonesia PT Bank Negara Indonesia  IPO  Further Divestment Delay? Delay?   Source: BUMN Review, Kompas

30. IBRA’s Plan to Divest recapitalised Banks Is Also Moving Slower Than Hoped IBRA Bank Restructuring and Divestment Bank Plan & Progress BCA Niaga Danamon Bukopin BII Lippo Patriot, Artamedia, Bali, Prima Express, Universal • Recently completed the divestment process of 51% of BCA’s shares • Generated receipts of US$ 567 million • Currently in bidding stage, but postponed due to lower-than-expected initial bids • Plan to increase share divestment to 71% (20% of which offered to public) • Completed recapitalisation program and merger process • Divestment is still in planning stage • Completed recapitalisation program • Now considered to be healthy and has been repatriated to Bank Indonesia • Recapitalisation program in progress • In the process of rights issue • Will be divested in near future, but discussion has not been initiated • In a merger process

31. In the Banking Sector, There Is Likely to Be a Strong Competition for Potential Investors’ Funds Funds To Be Raised By Privatizing Indonesian State-owned Banking Sector (2002-2003) Privatizing Bank Gov’t Ownership (%) To Be Sold( (%) Market Value of Equity(2) (Rp Trillion) Value To Be Privatized/Raised (Rp Trillion) Mandiri BNI BRI Danamon Niaga BII 100 99.12 100 99.35 97.15 56.78 30 30-60 ~ 51 51 Rights Issue 16 10 7 6 2 N/A 5 3-6 2 3 1 3 25 20 17 8 Amount To Be Raised Total FDI 2001 Value of Non-Govt Bank Ownership 30/5/02 Amount To Be Raised Rp 17 - 20 Trillion BRI needs to stand out among the privatized banks (In Rp Trillion)

32. Privatized banks also have a significantly more demanding financial reporting process – Adding “sunshine” to the system • Forward budget and earnings projections by quarter are released to stock market analysts, shareholders and public • These projections are evaluated and the share price is affected based on projected earnings, growth, risks, etc., And credibility of management estimates • Results are tracked quarterly – any divergence from budget is reflected in immediate changes in share price • In general, a privatized bank is “punished” for missing targets for volatility in earnings • As a result, privatized banks expend a great deal of energy managing the budgeting and reporting processes

33. Experience to Date Shows That It Is Difficult to Attract Qualified Investors Even at an Attractive Price Latest Banking Privatization/ Divestment Efforts

34. Building Privatized Bank Management and Reporting Infrastructure Takes Time, and the Process Begins Years Before the Offering Date Share Issue Date Corporatisation Phase Privatization Phase Business Strategy Development Portfolio Alignment Privatization IPO Business Restructuring 2-3 months 3-12 months 6 months Timing Key Activities • Conduct organization-wide diagnostic • Assess competitive environment • Generate and evaluate strategic options • Develop new strategic direction • Develop flight plan • Identify core and non-core businesses • Spin-off non-core actions • Consider to strengthen portfolio • Develop new organization and governance • Implement improvement initiatives • Process quality and efficiency • Performance measurement systems • staff skills and capabilities • Structure share offering transaction • Financial restructuring • Due diligence and prospectus preparation • Road show and investor communications • Issue shares A.T. Kearney Investment Bank

35. Business Strategy Development Involves Envisioning the Future Direction of the SOE in a Competitive Environment Corporatisation Phase — Step 1 (Business Strategy Development) Conduct Organization-Wide Diagnostic Develop New Strategic Direction Develop and Prioritize Improvement Initiatives Timing 3-6 weeks 2-3 weeks 2-3 weeks Key Activities • Conduct internal and external stakeholders’ interviews • Identify distinctive capabilities and existing performance gaps • Conduct staff surveys on overall readiness for change and on detailed values and behaviours • Conduct interviews and surveys with operators and customers • Survey other best practise organisations • Conduct gap analysis • Generate and evaluate strategic options • Assess competitive environment • Conduct strategic direction workshop to develop new core purpose, vision, strategic objectives, strategies and values • Obtain hi-level stakeholders inputs on new strategic direction • Finalise and communicate strategic direction • Develop hi-level process maps of key business processes • Develop detailed improvement initiative project plans, including objectives, scope, timing and resource requirements • Develop prioritisation criteria and flight plan Competitive Positioning Assessment Project Flight plan Strategic Direction > Industry > Industry Q3 Q3 Q1 Q1 Average Average 2002 2003 2004 Competitor A Competitor A Competitor C Competitor C Improve revenue growth Expand operation to EU Revenue Growth Revenue Growth Industry Industry Average Average Maximise shared services Competitor B Competitor B Core Vision Enhance portfolio value Purpose Realign investment portfolio Company X Company X < Industry < Industry Q2 Q2 Q4 Q4 Average Average Reengineer core business processes Improve management and < < Industry Average Industry Average > Industry > Industry operation efficiency Average Average Industry Industry Profit Growth Profit Growth 1) 1) Average Average Bubble size indicates relative revenue Bubble size indicates relative revenue

36. Non-core or Non-performing Assets Should Be Divested While New Businesses With Strong Potential Should Be Added to Strengthen the Portfolio Corporatisation Phase — Step 2 (Portfolio Alignment) Identify Core and Non-Core Businesses Spin-off Non-Core or Loss Ridden Assets Consider Acquisitions Or Build New Business Units To Strengthen Portfolio Timing 1 month 2-11 months Ongoing Key Activities • Review business units’ objectives and performance against business strategy • Identify non-core or non-performing business units • Identify gap between current assets and strategies to determine potential for new line of businesses • Prepare non-core assets for divestiture • Conduct valuation of non-core assets • Identify prospective buyers • Conduct negotiations and conclude deal • Identify options for new business lines (acquisition vs. build) • In case of acquisition • Identify potential targets and conduct preliminary assessment • Select target and conduct negotiation • Conclude deal and perform post merger integration Portfolio Alignment Strategic Option Matrix Independent Board New Business BU “A” High CEO “Defend” “M&A / Build” Non - Core BU “B” Business Business Business Business Business Market Attractiveness Unit A Unit B Unit C Unit D Unit E BU “E” Low Consider divestiture or other options • “Diversify” “Harvest ” New Business BU “C” BU “D” Low High Core Competencies

37. Business Restructuring Needs to Be Centrally Managed for Optimal Results Corporatisation Phase — Step 3 (Business Restructuring) Develop new organization structure Implement improvement initiative flight plan Timing 1-2 months 4 -10 months Key Activities • Conduct functional analysis • Assess gaps to identify missing functions • Develop organization guiding principles • Design and finalize new organization structure • Design required changes in organizational governance • Implement new organization structure • Establish program office • Staff project teams • Establish unit goals, plans, metrics, etc. • Implement initiatives • Monitor implementation progress and take corrective action as necessary Audit Audit Audit Audit Court of Directors Committee Committee Committee Committee Wave N* Public Relations Group Governor Internal Audit Group Top Management Top Management Wave 3 Committee Committee Wave 2 FI Development FI Development MP Steering MP Steering Monetary Policy Monetary Policy HR Committee HR Committee Board Board Committee Committee Board Board Wave 1 : Organisational and Process Strategic Capabilities Corporate Support Services Monetary Stability Financial Sector Stability Money Market Money Market Improvement Roll - Out Committee Committee Validation of Strategic Organi - Note Printing Monetary Strategic Human Financial Financial Supervision Board Policy Services Resources Market Sector Direction/Roles and sadditional Group Group Group Group Operations Policy Group Group Responsibilities Redesign Note Prepare Prepare Implement Implement Printing Works FIDF FIDF CDRAC CDRAC Finance IT Security Board Board Committee Committee Data General Operations Group Group Group Financial Sector Mgmt Admin Group Group Rehabilitation IT/User Committee IT/User Committee Change Management FIDF CDRAC Group Group Northern Region • Cheque HVP& Note Northeast Region • Clearing Settlement Issuance Southern Region • =Transferred to other =Transferred to other System Group Group Legal Litigation Central Region • Program Management departments or out of BOT departments or out of BOT Group Group in due course in due course Note: Detailed list of functions performed by each department at Note: Detailed list of functions performed by each department at tached in appendix tached in appendix

38. Maximizing Company Performance and Potential of SOEs Often Requires Organizational Transformation Potential Transformation Value Drivers 1. Develop Clear Business Strategy and Growth Plans for New Environment 4. Improve Operating Efficiency and Cost Position 2. Align Business Portfolio 5. Improve Management / Employee Capabilities and Prepare for Change 3. Reorganize Enterprise to Improve Efficiency and Market-Orientation 6. Improve Reporting and Risk Management Disciplines While many SOEs go through the motions of “transformation” prior to privatization, outside perspectives and support are often needed to drive real and significant change Source: A.T. Kearney analysis and experience

39. The value of a privatized Bank will be strongly influenced by management actions taken over the next two years Key Determinants Of Privatization Value Deal Structure and Sales Process 3 Company Performance and Potential 5 Key Areas of Management Focus Financial Market Conditions 2 Industry Attractiveness 3 Areas of Govt. Policy Influence Ability of Privatizing Government to Influence Factors Within the Privatization Timeframe 1 3 5 Low/None High Moderate

40. Privatized Bank Management Focuses on Income and Income and Growth Guiding Rules Goal • Fundamental change … not incremental change • Sustainable platform for world class performance … not short term, slash and burn • Well targeted on key revenue and cost levers … not uniform across the board • Protecting long term strategic goals … while recognizing links and interdependencies to current initiatives Sustainable improvement in cost / income plusgrowth

41. Basle II presentssome interesting challenges for Indonesian Banks Simple Intermediate Increasing Sophistication Decreasing Capital Advanced General intuition suggests that the advanced approach will provide the most capital relief

42. Several Factors Will Influence the Strategic and Financial Attractiveness of the Advanced Measurement Decision Cost/Benefit?

43. As Measurements Become More Granular, Capital and External Ratings Become More Directly Linked

44. Variations in Return Under Basle II May Drive Foreign Banks Away From Indonesian Risk • Capital can be improved – but only for higher quality portfolios • Preferences for retail portfolios over corporate portfolios will be driven by mix and market