Resolution and Mitigation of Bad Debt Risk

HERYUNANTO

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Just recently, we were shocked by reports of defaults on several private corporate bonds, two of which were issued by textile/garment companies and two others by property companies.

The growth of the textile and garment industry is actually high enough. During the second quarter of this year, the textile and garment industry grew 20.7 percent year-on-year (yoy), above the growth of the overall manufacturing industry, which grew only 3.54 yoy in the same period.

The growth of the textile and garment industry fell to its lowest point in 2015 but it gradually recovered thereafter. In fact, the textile and garment industry is one of the four priority sectors in the Industry 4.0 roadmap launched by the Industry Ministry.

On the contrary, the property sector continued to show a downward trend after reaching its peak in 2012. This downward trend coincided with the fall in commodity prices in 2011. A number of policies have been issued such as Bank Indonesia’s (BI) macroprudential regulation -- on the easing of loan to value ratio (LTV), which allows banks to offer mortgage loans without down payment -- and the government\'s fiscal program policies related to the 1 million housing program and tax easing, but these have not been enough to revive the performance of the property sector. In fact, the property sector is known as one of main economic indicators.

Potential defaults due to the increase in corporate debts especially those related to the construction sector were previously unveiled by the World Bank.

Recently, McKinsey in its report “Asian Bond Stress Signal” published in July 2019 also gave the same warning. McKinsey said there was increasing pressure on the financial sector due to high corporate debt. McKinsey\'s research shows that the share of the long-term debts of Indonesian companies with Interest Coverage Ratio (ICR) of below 1.5 times reached 32 percent.

It is the third highest after India (43 percent) and China (37 percent). An ICR of below 1.5 times indicates that the ability of companies to pay interest is low. The ICR is calculated as the ratio of operating income before paying interest, taxes, depreciation and amortization (EBITDA) to the payment of long-term debt interest.

The concept of bank resolution

Of course we don\'t want bankruptcy in the banking sector to occur again, such as the closure of 16 banks in 1997, which led to the bank recapitulation program in 1998, and the closure of Bank Century in 2008 due to defaults of its corporate borrowers. Banks should have realized that there is the Financial Crisis Prevention and Mitigation (PPKSK) mechanism.

If banks suffer financial difficulties, they will no longer receive bailout funds from the government. It is now the task of the Deposit Insurance Corporation (LPS) to handle problematic banks. The LPS distinguishes the handling of failed banks into two categories, namely failure of systemic banks and failure of non-systemic banks.

Banks that fall under the category of systemic banks or non-systemic banks are determined by the Financial Services Authority (OJK) every quarter. Since the PPKSK Law was issued, the number of banks that fell into the systematic category reached 15 banks. Of the total, 12 banks received systematic status in 2016, and the other three in 2018.

The increase in the number of systemic banks was partly due to the increase in bank assets and the complexity of the bank\'s business.

Handling failures in systemic banks can be done in two ways. First, shareholders inject fresh capital of at least 20 percent of the required fund, and the LPS provides temporary capital participation (PMS) of a maximum of 80 percent. Or through the second way in which the LPS provides PMS funds amounting to 100 percent of the required funds. By using the two approaches, banks should follow the rescue program set by the LPS, which should be decided through a general shareholders meeting.

Furthermore, the LPS can divest assets within a maximum of five years, which is three years plus an extension of one year and one more year if necessary. While for failures in non-systemic banks, the LPS can propose a revocation of bank licenses even though there is still an option for the banks to receive a rescue program from the LPS, if approved by shareholders.

The Century Bank case in 2008 was the first case of a systemic bank failure being handled by the LPS. The experience of Century Bank, which later changed its name to Bank Mutiara, provided a good lesson on potential hazard learning because the bailout funds could rise beyond initial calculations.

With such a potential moral hazard, LPS assets, which totaled Rp 110.37 trillion in April 2019, will not be enough if it has to provide PMS to systemic banks.

Not to mention that the LPS must also provide guarantees for customer funds worth up to Rp 2 billion per account. The concentration of national bank deposits and credit in systemic banks make the task of the LPS even harder. There is no choice as any failure of systemic banks should be resolved through a rescue program.

Restructuring premiums

The cost of restructuring a bankrupt bank is not cheap and has political risks. With the PPKSK scheme, the bailout funds no longer come from state revenue, but from the LPS. The LPS funds come from regular premium payments of 0.2 percent deposits or third-party funds (DPK), which are charged every half, and most recently from the premium of the Banking Restructuring Program (PRP) of 0-0.007 percent of the affected assets a year.

However, this premium is unlikely to be sufficient given the large amount of assets of a systemic bank, which requires a strict prevention and supervision system.

Banks are known to have a very prudential analysis process. The obligation to know your customers (KYC) is part of the standard operating procedures (SOP) of bank decisions in providing credit. However, in the case of default on some of the customers above, the debtors are all old customers (senior debtors) so that credit analysis can be less stringent than beginner debtors.

The senior debtor usually has a good credit rating that is trusted by banks. Nevertheless, "the world is changing", both in terms of sectoral and corporate capabilities. The big names of the debtors should not make banks ignore the prudential analysis and the KYC principle.

Affiliated transactions should be watched because they can be part of fictitious transactions or transfer pricing to avoid taxes. Of course, banks are also required to pay attention to sectoral, domestic and global macroeconomic conditions that can have an impact on (micro) corporations.

Strict discipline in the process of giving large loans to all debtors, including senior debtors, is the first step to prevention, which should be followed by a monitoring process through alarm indicators that are commonly known as alarm dashboards.

On the other hand, the debtor\'s obligation to hedge their debts should be a condition for obtaining credit. The hedging facility not only protects customers from potential exchange rate losses, but also protects the economy from potential bankruptcies.

Although the Financial System Stability Committee\'s press release for the second quarter of 2019 assessed the situation of the domestic financial market to be more conducive, some potential defaults on corporate credit accompanied by warnings from the World Bank or McKinsey needed serious attention.

Another indicator related to high corporate debt is the credit to GDP gap indicator, for which the Bank for International Settlements announced a score of 6.4 at the end of 2018.

Positive values indicate that Indonesian corporations have very high debt compared to the ability of the economy to bear the debt (excessive leverage). A value below zero (negative) is a safe leverage. Learning from the source of the crisis that has occurred so far, usually the financial crisis begins with high debt, exchange rate losses and defaults that lead to the bankruptcy of banks.

Hopefully, the recent failure of several corporations to repay debts will not become a source of "fire" of a crisis that could burn the Indonesian economy.

Lana Soelistianingsih, Lecturer in the school of economics and business, University of Indonesia