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Indonesia: Selected Issues

Author(s):
International Monetary Fund
Published Date:
September 2010
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III. Enhancing Financial Stability1

1. Indonesia has made great strides since the Asian crisis in improving macroeconomic and financial stability. As a result, the financial system has withstood the contagion from the global financial crisis and Indonesia was one of the best performing economies in 2009. Nevertheless, the FSAP team identified a number of vulnerabilities and recommended key measures to boost financial stability in the following three areas: bank regulation and supervision, crisis prevention and resolution, and BI’s financial autonomy (Appendix III.1). Above and beyond specific financial sector issues, progress in enforcing the rule of law, especially creditors’ rights, is an overarching consideration to improve the performance of the Indonesian economy with critical implications for the ability of the financial system to function efficiently. This paper summarizes the main recommendations and conclusions of the recently completed review of the financial sector under the Financial Sector Assessment Program (FSAP). These conclusions are placed in a broader context by describing the substantial improvements in financial stability achieved over the last ten years and drawing on cross-country experience in key areas.

A. Major Achievements Since the Late 1990s

2. Since the late 1990s, bank regulation and supervision have been strengthened substantially in Indonesia. Improvements include stricter loan classification and provisioning, tightened related-party lending limits, a higher capital adequacy requirement, and a tightened foreign exchange open position limit. In particular, the capital requirement was raised from 4 percent to 8 percent of risk-weighted assets by 2001. Empowered by the 1999 BI Act, BI has taken measures to improve banks’ transparency and corporate governance; enhance on-site and off-site supervision; and institute fit-and-proper tests for controlling shareholders and bank management (Morales, 2007). More recently, BI launched a “second generation” of reforms. These initiatives include the development of a new rating system architecture and methodology to support individual bank risk assessments; the implementation of consolidated supervision; and a progressive move toward Basel II.

3. The improvements in banking regulations and supervision are also reflected in banks’ financial position. Despite a mild slowdown in economic activities in 2009, preliminary data show that banks reported a robust 1.8 percent return on assets after tax. The capital adequacy ratio stood at 17.5 percent, well above the regulatory minimum of 8 percent and BI’s informal target of 12 percent. The NPL ratio stood at 3.3 percent with reserve coverage of 62 percent.

4. The authorities have also introduced the main components of a comprehensive financial safety net (FSN). These include: (i) a deposit insurance scheme, a deposit guarantee agency (LPS), and a bank resolution framework; and (ii) a Financial Stability Forum (FSF), with participation of BI, the Ministry of Finance (MOF) and the LPS to coordinate the government’s actions regarding systemically important institutions. Nevertheless, it is important to further strengthen the FSN by passing the FSN law as noted in Section C.

B. Strengthening Banking Regulations and Supervision

5. The recently completed FSAP recommended strengthening the definition and calculation of regulatory capital and regulating interest rate risks. The FSAP’s recommendations are informed and supported by the stress test results.

Stress Test Results

6. In the stress test exercises, the banking system was put under a set of extreme shocks, representing tail risks, and proved to be resilient to all but the most extreme shocks owing to the existence of significant capital and liquidity buffers. The stress tests included a scenario of a severe economic downturn and a number of shocks to market risk factors. The results show that the banking system is generally robust with banks most vulnerable to credit risk, followed by interest risk. While some banks are vulnerable to liquidity shocks, a few large banks are susceptible to concentration risk. However, exchange rate and contagion risks are not major concerns.2

Prudent Banking Regulations and Supervision

7. The stress test underlines the importance of prudent banking regulations and supervision. Given that credit risk remains the most potent, it is crucial to follow international best practices in asset classification and provisioning, and to ensure the quality of banks’ capital. Banks’ vulnerability to interest rate risk highlights the importance of issuing a regulation on interest rates to limit the sensitivity of banks’ portfolios to this risk.

8. While the quality of banking supervision has increased significantly in recent years, the assessment of compliance with the Basel Core Principles for Effective Banking Supervision (BCP) has identified a number of areas for improvement (Appendix III.2):

  • Progress should be made by ensuring that all items included in capital meet the required permanence and availability to cover losses and that risk weights properly reflect the quality of banks exposures.

  • Strengthen the regulatory definition of exposure and eliminate exemptions from prudential limits, including related party exposure.

  • Upgrade asset classification and provisioning norms, including the treatment of restructured loans.

9. In addition, the authorities need to address deficiencies arising from application of nonstandard risk weights to ensure that there are no capital shortfalls on this account during the transition to Basel II. BI plans to implement Basel II in the next five years, deploying Pillar 1 in 2011, Pillar 2 in 2012–2014, and Pillar 3 in 2011–2014. Initially a simplified approach will be adopted. Basel II is a complex framework with three mutually reinforcing Pillars. Pillar 1 minimum capital requirements need to be complemented by Pillars 2 and 3. Any revisions to the Basel II framework by the Basel Committee on Banking Supervision (BCBS) would also need to be properly reflected. Consistent with the BCP assessment findings, BI also needs to improve its supervisory capacity with regard to the oversight of banks’ risk management systems. In addition, Indonesia’s adoption of new accounting standards based on IAS 32 and IAS 39 should be managed and implemented carefully as they potentially affect banks’ capital.

C. Crisis Prevention and Resolution

10. The FSAP recommends that Indonesia adopt a prompt corrective action regime to reduce undue delays in resolving problem banks, strengthen the financial safety net law, and ensure coordination of macro-micro supervision.

Prompt Corrective Actions

11. Through the establishment of a prompt corrective action (PCA) regime, emerging problems can be quickly contained. However, such a regime must be grounded in law to give it legal power. Currently, there is no time limit for a problem bank to remain under intensive supervision before being transferred to special surveillance, under which it must be rehabilitated or have its license withdrawn within nine months. With protracted action plans and weak legal protection for supervisors, a bank tends to remain troubled for an extended period and is rarely placed under special surveillance. This process raises the expected cost when the bank finally fails. PCA, which mandates corrective actions when a problem emerges, has the added benefit of giving supervisors additional protection by making explicit the required actions when certain trigger points are breached.

12. Besides curtailing supervisors’ discretion and reducing political interference, the PCA provides banks with incentives to maintain high capital and reduce risk exposures. Because measures for capital restoration and resolving failing banks are mandated, PCA limits the scope for forbearance and provides some insulation from political pressure against taking tough measures. In terms of incentives to banks, moderately well capitalized banks have the incentive to strive for a higher capital level so as to reduce the intensity of supervision; struggling banks are encouraged to improve their capital level to avoid being placed, at least temporarily, under the control of regulators, or, worse, being closed or merged with other institutions.

13. The U.S. experience with PCA implementation has been viewed as effective in promoting financial stability. Benston and Kaufman (1997) noted that regulators acted in a more timely manner to impose corrective action against poorly performing institutions and to resolve failing institutions in the 1990s following the enactment of the FDICIA. As a result, the level of NPLs and the number of troubled banks declined significantly. The ratio of book value capital to assets for the banking sector climbed above 8 percent at the end of 1993 for the first time since 1963.3Aggarwal and Jacques (2001) show that PCA standards, along with restrictions on the activities of undercapitalized banks, have reduced the risk level in both the adequately capitalized and undercapitalized banks. Both groups have increased their capital ratios, and accelerated their adjustment to the desired leverage ratio.

14. PCA has been adopted by many countries, including some Asian countries (Appendix III.3). Evidence from the experience of the United States in the 1980s and early 1990s suggests that PCA was effective in promoting financial stability. In addition, although not politically popular, quicker sales and resolutions, on average, achieve higher present values than delayed sales and resolutions. Therefore, following its banking crisis, Japan enacted PCA in 1998, as did Korea. Most recently, Thailand implemented PCA when the Financial Institution Business Act was adopted in 2008. PCA has been implemented in many Latin American countries such as Brazil, Mexico, and Peru, and its adoption is also being considered by many European countries (Eisenbeis and Kaufman, 2007, and Mayes, 2009).

Strengthen the Financial Safety Net

15. Many elements of a financial safety net (FSN) have been put in place. These include a lender-of-last-resort (LOLR) facility, an explicitly limited deposit insurance scheme, and a Financial Stability Forum (FSF) with the participation of BI, the Ministry of Finance (MOF), and the deposit guarantee agency (LSP). However, in light of the potential establishment of an integrated supervisory authority (OJK), it is urgent to pass a new FSN law that clearly defines a framework for dealing with banking and broader financial sector problems and the role of each authority. This law should be introduced together with any law establishing the OJK to ensure that a proper legal framework is in place for financial crisis prevention and resolution. In addition, the deposit insurance fund needs to be increased in proportion to its recently increased deposit coverage.

16. An FSN law needs to address the following issues:

  • Roles of BI and MOF as lenders of last resort and the access criteria to LOLR facilities.

  • Crisis management framework. The decision-making framework and procedures were introduced during the global financial crisis by a Presidential decree, which has since lapsed. Therefore, it is important to explicitly establish triggers for different types of enforcement and crisis prevention actions, including rules and procedures for dealing with both systemic and nonsystemic banks to increase transparency and promote timely decision-making.4 In addition, with the possible establishment of OJK, the roles of the different authorities also need to be redelineated.

  • Legal protection for staff dealing with the resolution of problem banks. Staff needs better legal protection against “second guessing” of their decisions as managing a failing bank is inherently risky. Concerns regarding the strength of the legal protection may inhibit the full use of the resolution powers contained in the LPS Act.

17. The LPS fund needs to be increased in proportion to its increased coverage. During the global financial crisis in late 2008, coverage of deposits was increased twenty fold to provide depositors with the appropriate assurance regarding the safety of their deposits. Similar measures were implemented by many countries across the world. As a result of this expanded coverage, the ratio of the LPS fund to insured deposits has declined substantially. Even though LPS can seek a loan from the government when facing liquidity difficulties and an allocation of funds if capital falls below the original capital level, international experience shows that in countries where a deposit insurance fund is undercapitalized, problem banks tend to be bailed out or kept open.

Ensure Coordination of Macro and Micro Supervision

18. The recent global financial turmoil highlights the importance of complementing micro-prudential supervision with macro-prudential supervision. The common exposure of financial institutions to risks and hence the covariance of such macroeconomic risks can create systemic events, as occurred in some countries in response to a run-up in real estate prices. The objective of micro-prudential supervision is to limit the likelihood of the failure of individual institutions, or to reduce “idiosyncratic risk.” It cannot capture the common exposure of the system. In contrast, macro-prudential supervision aims to limit the costs to the economy resulting from financial distress, and to lessen the likelihood of the failure, and corresponding costs, of significant portions of the financial system. This is often loosely referred to as limiting “systemic risk.” Monitoring the potential impact of individual institutions’ behavior on financial system stability and financial infrastructure, as well as the linkage between financial institutions and financial markets, is an integral part of macroprudential supervision.

19. Macro and micro supervisions share common aspects, but also can have conflicts. For example, by insuring that individual institutions are “safe and sound,” micro supervision should reduce the system-wide risks or the risk of failure of a financial institution that has systemic implications. In addition, the two approaches share some common tools such as liquidity requirements, minimum capital standards, and loan provisioning requirements. However, micro-supervision, which is intended to reduce an individual institution’s risk, could amplify institutions’ tendency to over-expose themselves during financial booms and become overly risk-averse during financial downturns, with a resultant drop in lending and herding into assets deemed safe, leading to overvaluation of such assets.

20. Central banks are well suited for assuming responsibility for macro-prudential supervision. This is because of their expertise and analytical capabilities in monetary and financial stability analysis, as well as their closeness to the money and financial markets. The linkages between monetary policy and prudential policy, as well as the interactions between the financial system and the real sector further strengthen this rationale.

21. Ensuring macro and micro coordination will be essential for financial stability before and after the establishment of the OJK. A permanent coordination mechanisms would cover the following aspects:

  • Clear legal mandate: To the extent possible, the responsibilities of BI in macro prudential supervision and OJK in micro supervision should be delineated in their respective laws. To monitor macro financial stability, BI must be able to continuously monitor large banks and financial conglomerates that are systemically important. Therefore, there would need to be some overlap in BI’s and OJK’s responsibilities.

  • Coordinated regulatory policies: As noted above, the macro and micro regulations share some policy instruments, and their objectives might be in conflict at times. Therefore, it is important that macro and micro policy be coordinated and any differences be settled in the Financial Sector Coordinating Committee (KSSK) chaired by the Minister of Finance, as envisaged under the FSN Law.

  • Fluid information flows: Safeguarding financial stability will require fluid two-way communication and coordination between OJK and BI. BI needs to continuously monitor individual banks’ liquidity, including their balance sheets and their participation in the payments system and the interbank and foreign exchange markets. BI will need access to this data on a continuous real-time basis; OJK will need data with regularity but typically with less frequency. BI also needs to continue monitoring individual large banks and financial conglomerates that are systemically important; this need is recognized in the draft OJK Law. The protocols to facilitate the coordination should be established by law.

  • Coordinated crisis management: BI can use monetary and prudential policies to deal with emerging systemic problems. It needs to be able to spot weaknesses in bank liquidity and solvency, and prepare to take action that is both bank-specific and systemic in its LOLR capacity. OJK and BI need to cooperate closely to prevent a banking crisis from occurring and to deal effectively with any crisis if it were to happen. This will require a new legal framework for an FSN, as discussed in the previous section.

D. Promoting Bank Indonesia’s Financial Autonomy

22. The IMF/World Bank technical assistance on assets and liabilities management and FSAP team recommends that the nontradable government bonds held by BI be restructured into tradable bonds at market terms to enhance BI’s financial independence. Supported by prudent fiscal policy, BI has been successful in improving macro stability. However, the large stock of noninterest bearing government bonds on BI’s balance sheet and the need to undertake extensive liquidity absorption could, in the extreme, potentially create a conflict of interest in BI’s monetary policy implementation, and should be rectified. Setting BI on a sound financial footing will promote continued improvement in macro stability, which is essential for a healthy financial system.

The Impact of Nonmarketable Government Debt on BI’s Operations

23. Corresponding to the large excess liquidity in the banking system, BI’s balance sheet holds a large amount of nonmarketable government debt (Table III.1). On the asset side, BI holds Rp 254 trillion nonmarketable government bonds (SUPs) that pay close to zero interest rate. These are bonds that BI received in exchange for the liquidity provisions to banks during the crisis in the 1990s, and they account for more than one quarter of its assets. On the liability side, the stock of SBIs is Rp. 259 trillion, roughly matching the stock of SUPs. The interest cost of SBIs forms the lion’s share of BI’s expenses, leading to a deficit in some years (Tables III.2 and III.3).

Table III.1.Simplified Balance Sheet of Bank Indonesia, End-2009(In trillions of rupiah)
AssetsLiabilities
International reserves620Currency in circulation279
Government bonds, marketable25Bank deposits157
Other claims on government254SBI259
(Nonmarketable bonds)FASBI86
Other assets (net)16Other liabilities42
Unrealized valuation gains/losses9
Capital and reserves84
Total assets916Total Liabilities916
Source: Bank Indonesia, Annual Financial Statements, 2009.
Source: Bank Indonesia, Annual Financial Statements, 2009.
Table III.2.Simplified Income Statement of Bank Indonesia, 2009(In trillions of rupiah)
Amount
Revenue29.7
Foreign reserves25.6
Money market and credit and financing2.6
Payment system0.2
Banking supervisions0.2
Others1.1
Expenditure30.8
Monetary operations22.5
Payment system operations4.0
Banking regulation and supervision0.1
General and others4.2
Source: Bank Indonesia, Annual Financial Statements, 2009.
Source: Bank Indonesia, Annual Financial Statements, 2009.
Table III.3.Bank Indonesia Profit and Loss Outcome, 2005–08(In trillions of rupiah)
2000200120022003200420052006200720082009
Total profit/loss2.617.62.91.50.716.231-1.417.3-1.0
Without extraordinary income/expenditure27.17.62.9-7.20.716.2-6.9-1.417.3-1.0
In percent of GDP1.91.10.2-0.40.00.6-0.20.00.30.0
Source: Bank Indonesia, Annual Financial Statements, 2003–2009.
Source: Bank Indonesia, Annual Financial Statements, 2003–2009.

24. This large volume of nonincome bearing assets and stocks of SBIs can potentially compromise the effectiveness of BI’s monetary operations. The large stock of SBIs makes BI a net borrower from the domestic financial system, which may create a conflict of interest in BI’s conduct of monetary policy. When a central bank is a net debtor with a weak balance sheet, financial considerations create a disincentive to raise interest rates when warranted by macroeconomic developments, especially when the central bank is subject to reputational risk if its operational balance were to deteriorate further. In extreme cases, the central bank could be tempted to subordinate its policy target to debt servicing considerations.

25. Strengthening BI’s balance sheet by a swap of SUPs with tradable bonds bearing a market interest rate not only enhances BI’s operational independence, but also promotes capital market development. Such an exchange requires no legislative changes and will have no impact on the consolidated sovereign balance sheet of the government and BI, holding maturity structure constant. The central bank’s domestic debt is part of public domestic debt. From this vantage point, accumulated losses on the central bank balance sheet represent interest free credit to the government. Eliminating this financing source sets the correct policy incentive and, hence, touches on the core of central bank operational independence. In addition, with more tradable government securities on its balance sheet, BI would be able to use repos for liquidity absorption and, therefore, have greater flexibility in implementing monetary policy. Such a swap also provides an opportunity to develop an integrated strategy for managing public debt and, hence, promote market development, as it is beneficial to have only one issuer of bills and bonds.

Appendix III.1: FSAP Recommendations

1. The FSAP made a series of recommendations designed to address the vulnerabilities that were identified during the assessment:

  • Improve micro-macro prudential coordination while reforming the financial supervisory framework. An integrated financial stability board is under consideration. While its form, along with the assignment of macro and micro prudential responsibilities, is still being debated in Indonesia, the recent financial crisis underscores the importance of close coordination among regulators.

  • Amend the BI Act and the Capital Markets Law to strengthen and enhance the scope of legal protection for bank supervisors and securities regulators. The current law protects supervisory staff from any decisions taken in good faith. However, the onerous proof of “good faith” can nullify the protection in practice. Consequently, the threat of legal prosecution inhibits supervisors from taking timely corrective actions.

  • Enact crisis management legislation including protection for officials involved. The Crisis Management Protocol, which was established by a presidential decree, functioned well during the crisis, but it has lapsed. Therefore, it is crucial to adopt a law ensuring prompt responses in times of crisis. The continued political wrangling over the decision to rescue a medium-sized bank at the height of the financial crisis underscores the importance of legally protecting decision makers and supervisors in discharging their duties.

  • Increase the deposit insurance fund to adequately handle the failure of at least two mid-sized banks through higher premiums or capital injection. The deposit coverage was increased twenty-fold in 2008 to counter the contagion from the global financial crisis. As a result, the ratio of the fund’s resources to insured deposits has declined substantially.

  • Submit to the House of Representatives (DPR) draft prompt corrective action (PCA) legislation to promote timely corrective measures. PCA legislation has been enacted in a number of countries, including the United States and several Latin American countries, as a way for parliaments to limit supervisory discretion and restore confidence. Such rules have the added benefit of giving supervisors additional protection by making explicit that certain actions must be taken when specified trigger points are breached.

  • Issue and enforce regulations on interest rate risk in the banking book. Stress testing shows that besides credit risk, banks are most vulnerable to interest rate risk.

  • Deal with insolvent insurance companies to avoid a systemic failure. At least five insurance companies are insolvent. While the insurance industry is small, immediate and prudent corrective action against the insolvent companies is needed to forestall a systemic failure in the insurance sector, which could potentially spill over to the broader financial sector.

  • Strengthen the payments system legal framework. The current framework poses a systemic risk in the event of a bank’s bankruptcy. The law ought to clarify, among other things, who has access to the payments system. In addition, the concepts of netting, finality, and delivery-versus-payment (DVP) should be included for all types of transactions in the law rather than in regulations.

  • Strengthen BI’s balance sheet by restructuring zero interest government debt into interest bearing debt. This would set BI on a sound financial footing.

2. Some gaps and weaknesses are not an immediate threat to financial stability, but could pose a risk in a sharp economic downturn. Accordingly, the team recommends the following measures:

  • Ensure adequate capital and provisions by (a) addressing deficiencies arising from application of nonstandard risk weights and tightening accounting definitions of Tier 1 capital; (b) strengthening the regulatory definition of exposure and eliminate exemptions from prudential limits, including related party exposure; and (c) improving asset classification and provisioning norms, including the treatment of restructured loans.

  • Establish regular contact with domestic and foreign supervisors to strengthen consolidated supervision.

  • Maintain capital adequacy requirements in line with the Basel I norms until Pillar 2 and Pillar 3 of the Basel II framework are operational; more generally, handle carefully the transition to Basel II and new accounting standards to ensure the right balance between various interactive elements.

3. To promote financial development and provide adequate financing to the real economy, the FSAP also made a number of recommendations on improving governance, promoting capital markets, and developing market infrastructure.

  • Improve the selection process of BI’s Board members. The current practice of drawing up a list of multiple candidates amongst whom the parliament designates the winner opens up competition on undisclosed criteria, frequently perceived as only partly related to the professional competency of the candidates.

  • Amend the capital market law to augment regulators’ independence and enforcement powers, including authority to assist foreign regulators, and to give them more expeditious access to bank accounts.

  • Improve the price discovery mechanism of government bond trading. This will help develop bond markets, and provide a source of long-term financing to meet investment needs.

  • Pass an insurance law to provide the insurance regulator with the power to seize control of insolvent companies’ assets to protect policyholders.

  • Improve the data quality and coverage of the national credit bureau; consider private credit bureaus.

  • Ensure banks’ compliance with PSAK 55 (IAS 39).

  • Improve the certainty and speed of execution of collateral and of bankruptcy proceedings.

  • Enact new financial reporting and accounting laws to regulate the accountancy profession, including qualifications for licensing and compliance with an internationally accepted code of ethics for accountants and auditors.

  • Enforce the law requiring audited consolidated accounts for major corporations.

Appendix III.2: Strengthening Capital, Asset Classification, and Exposure Regulation

1. The FSAP notes that the risk weights and the accounting definition of Tier 1 capital are not in line with Basel I levels. Since March 31, 2006, BI has lowered the applicable risk weights for certain categories of assets below those prescribed under the Basel I rules. Applying risk weights consistent with Basel I would lower the CAR for the banking system by about 150 basis points to 16 percent from the current average level of 17.5 percent. In addition, the BI Tier 1 capital regulation allows for unrealized foreign currency transaction gains. No deduction is required for cross holding of equity and the equity holding of subsidiaries as part of credit restructuring.

2. While there is no internationally agreed norm, it is advisable to exclude the following from Tier 1 capital to improve its quality and certainty: (i) specific (designated for certain liabilities) reserves that neither the bank management nor BI had the authority to appropriate for meeting losses on an ongoing basis, and (ii) unaudited profit for the current year. Since net head-office and net inter-office funds of foreign banks can be fairly volatile and change from day-to-day, it would be useful to report system CAR excluding foreign branches. It is also prudent to require the Tier 1 innovative capital and Tier 3 bonds to meet certain standards, for example requiring the bonds to meet at least a certain maturity.

3. The assets classification regime can be improved in the following ways:

  • Abolish the exemption limit (currently about US$1 million) for application of the uniform asset classification norm;

  • Reduce considerably the exemption limit (currently about US$2 million) for asset classification determined by the three Pillar approach;

  • Disallow the immediate upgrading of restructured doubtful or loss loans. Although the level of required provisions may be unaffected by the upgrade, it would still understate the severity of the reported loan classification within the NPL category;

  • Provide disincentives for repeatedly restructured accounts in terms of asset classification, provisioning, and risk weights. Current regulations and implementation of provision requirements may produce a bias toward restructuring rather than a critical assessment of repayment likelihood, which could lead to serial restructuring. Some jurisdictions limit restructurings to two over a five-year period. BI may wish to review its policies to ensure conservative application of restructuring standards;

  • Regulations may need to be enhanced to ensure the Board of Commission is actively managing troubled assets; and

  • Consider requiring provisions for the secured exposure in light of the low loan and collateral recovery rate.

  • BI may also consider whether additional criteria, such as a longer timeframe (rather than the current requirement of three payments) should be considered in judging whether banks are permitted to upgrade the asset classification status of restructured accounts to ‘current’ category.

4. Definition of exposures can be strengthened in the following areas:

  • Undrawn balances on sanctioned loans;

  • Interbank placements within Indonesia up to 14 days;

  • Export bills of exchange under a issuance letter of credit accepted by a prime bank;

  • Exposures covered by a prime bank guarantee that meets the specified norms;

  • Placements at prime banks;

  • Exposures guaranteed by the Multilateral Development Agency; and

  • Temporary equity participation as a part of the restructuring package. For related parties, the definition of ‘exposure’ should be aligned with the above and any exemptions should be eliminated.

Appendix III.3: Prompt Corrective Actions in the United States, Japan, Korea, and Thailand

1. PCAs were first enacted in the United States in response to the savings and loans crisis in the late 1980s and early 1990s. Between 1980 and 1994, 2,912 banks and thrifts failed, costing the taxpayer $150 billion or 2.1 percent of 1994 GDP (Garcia, 2008). After Congress and the public had lost confidence in the supervisors, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991, instructing supervisors to take PCA and requiring FDIC to take the least cost method to resolve failed banks and to adopt a risk-based deposit insurance scheme, which imposes higher premiums on riskier banks. Mandatory PCA and least cost resolution are intended to minimize forbearance and political interference

2. Like the United States, Japan uses capital adequacy as the sole criterion for PCA (Tables III.3.1III.3.3). However, the Japanese PCA is less stringent as no actions are mandated until a bank’s capital falls below the mandatory minimum. In addition, no closure is required before capital reaches zero.

Appendix Table III.3.1.United States: PCA Triggers 1/
Total Risk-Based

Capital 2/
Tier 1 Risk-Based

Ratio 3/
Tier 1 Leverage

Ratio 4/
Well capitalized. 10. 6. 5
Adequately capitalized. 8. 4. 4
Undercapitalized< 8< 4< 4
Significantly undercapitalized< 6< 3< 3
Critically undercapitalizedTangible equity 5/. 2

See Table 1 in Aggarwal and Jacques (2001).

Total capital is the sum of Tier 1 and Tier 2 capital. Tier 1 mainly comprises permanent shareholders’ equity, i.e., common stock and disclosed reserves or retained earnings. Tier 2 comprises loan loss reserves, subordinated debts, asset revaluation reserves, hybrid capital instruments, etc. Total risk-based capital ratio is the ratio of total capital to risk-weighted assets.

Tier 1 risk-based ratio is the ratio of Tier 1 capital to risk-weighted assets.

Tier 1 leverage ratio is the ratio of Tier 1 capital to total assets.

See Table 1 in Aggarwal and Jacques (2001).

Total capital is the sum of Tier 1 and Tier 2 capital. Tier 1 mainly comprises permanent shareholders’ equity, i.e., common stock and disclosed reserves or retained earnings. Tier 2 comprises loan loss reserves, subordinated debts, asset revaluation reserves, hybrid capital instruments, etc. Total risk-based capital ratio is the ratio of total capital to risk-weighted assets.

Tier 1 risk-based ratio is the ratio of Tier 1 capital to risk-weighted assets.

Tier 1 leverage ratio is the ratio of Tier 1 capital to total assets.

Appendix Table III.3.2.United States: Measures Required Under Prompt Corrective Measures
Mandatory ProvisionsDiscretionary
Well capitalized (Zone 1)
Adequately capitalized (Zone 2)
1. No brokered deposits, except with FDIC approval.
2. Risk-based deposit premiums increase.
Undercapitalized (Zone 3)1. Order recapitalization
1. No brokered deposits2. Restrict inter-affiliate transactions
2. Suspend dividends and management fees3. Restrict deposit interest rates
3. Require capital restoration plan4. Restrict certain other activities
4. Restrict asset growth5. Any other action that would better carry out prompt corrective action
5. Approval required for acquisitions, branching and new activities
6. Limit access to the Federal Reserve’s discount window
Significantly undercapitalized (Zone 4)
1. Same as for Zone 31. Any Zone 3 discretionary actions
2. Order recapitalization 1/2. Conservatorship or receivership if fails to submit or implement plan or recapitalize.
3. Restrict inter-affiliate transactions
4. Restrict deposit interest rates 1/3. Any other Zone 5 provision, if such action is necessary to carry out prompt corrective
5. Pay of officers restricted 1/
6. Prohibit the payment of subordinated debt.7. Improve management.
8. Require divestitures.
Critically undercapitalized (Zone 5)
1. Same as for Zone 4
2. Receiver/conservator within 90 days 1/
3. Receiver if still in Zone 5 four quarters
4. Suspend payments on subordinated debt 1/
5. Restrict certain other activities
6. If a bank is, on average, critically undercapitalized for 270 days, then a receiver must be appointed unless it (i) has positive net worth, (ii) in substantial compliance with an approved capital restoration plan, (iii) is profitable, (iv) is reducing its ratio of nonperforming loans to total loans, and (v) the FDIC chairperson and the regulators certify that the bank is both viable and not expected to fail.
Source: Benston and Kaufman, 1997; Weinstock, 2009.

Not required if primary supervisor determines action would not serve purpose of prompt corrective “action” or if certain other conditions are met.

Source: Benston and Kaufman, 1997; Weinstock, 2009.

Not required if primary supervisor determines action would not serve purpose of prompt corrective “action” or if certain other conditions are met.

Appendix Table III.3.3.Japan: Outline of the Prompt Corrective Action (PCA) 1/
ClassCapital Adequacy RatioActions
With

International

Operations
Pure Domestic

Operations
1Less than 8 percentLess than 4 percentTo order the formulation of a management improvement plan (in principle includes measures to increase capital) and its implementation
2Less than 4 percentLess than 2 percentTo order such measures as below:
  • Formulation of a capital increase plan

  • Restraint or prohibition on paying dividends, or on paying bonuses to directors and senior overseers

  • Restraint on the increase of total assets, and reduction of total assets

  • Restraint or prohibition on receiving deposits at a high interest rate

  • Prohibition on entering new business fields

  • Curtailment of currently performing businesses

  • Prohibition on opening new offices and curtailment of existing offices

  • Curtailment of business activities of subsidiaries and overseas affiliate companies, and prohibition on establishing or holding such entities

2-2Less than 2 percentLess than 1 percentTo order to implement measures selected from the following:
  • Significant increase in capital

  • Drastic curtailment of business

  • Merger or closure

3Less than 0 percentLess than 0 percentTo order to suspend the whole or a part of a banking business.

However, the 2-2 class of actions can be taken in the following cases.

(1) If the net value of assets, as with unrealized gains of financial institutions, is

positive.

(2) Even when the net value as with unrealized gains is negative, if the net value

becomes clearly expected to be positive.

Furthermore, even if a financial institution does not belong to this class, a business suspension order can be issued when the net value of assets, including unrealized losses, is negative or when it is clearly expected to become negative.
Sources: Paragraph 2, Article 26, Japan Banking Act; and Order on Providing Classification of FSA; and Ministry of Finance.

Actions for higher categories can be applied to financial institutions in category 2, 2-2 or 3 if they have already formulated management improvement plans that are deemed rational and also expected to achieve their goals in a relatively short time.

Sources: Paragraph 2, Article 26, Japan Banking Act; and Order on Providing Classification of FSA; and Ministry of Finance.

Actions for higher categories can be applied to financial institutions in category 2, 2-2 or 3 if they have already formulated management improvement plans that are deemed rational and also expected to achieve their goals in a relatively short time.

3. PCA in Korea and Thailand has two types of triggers: quantitative triggers tied to capital and qualitative triggers (Tables III.3.4 and III.3.5). The capital triggers in Korea share similar characteristics with Japan, but they also classify banks into categories based on qualitative assessment. The capital triggers in Thailand start at the minimum capital requirement, but closure is required before capital is exhausted. In addition, corrective measures are required in Thailand when banks violate other regulations.

Appendix Table III.3.4.Korea: Prompt Corrective Framework
TriggersCategory 1Category 2Category 3
Quantitative Trigger
Banks (CAR)



Mutual savings (CAR)

Insurance companies (solvency margin ratio)

Securities companies (equity capital ratio)
Below BIS level (8 percent)



Below BIS level (5 percent)



100 percent







150 percent
Below 6 percent



Below 3 percent



Below 50 percent







Below 120 percent
Below 2 percent



Below 1 percent



Below 0 percent







Below 100 percent
Qualitative Triggers
Management evaluation













Others
  • Overall rating: 3rd grade or above and

  • Rating for asset quality or capital adequacy is 4th or 5th grade as a result of the management status evaluation.

  • If obviously adjudged to meet the above-mentioned requirements due to serious financial incidents or bad loans.

  • Overall rating: below 4th

  • (Same as left-hand column).









  • If it fails to faithfully implement its management improvement plan.

  • Failing financial institutions provided by Article 2, Item 3 of the Act on Structural Improvement of Financial Industry

  • If judged as a distressed financial institution.

  • If deemed either to be unable to or not to be implementing its management improvement plan

Corrective measures 1/
  • Improvement in manpower and management.

  • Cost reduction

  • Restrictions on investments in fixed assets, entries into new business areas, and new capital investments;

  • Dispose of nonperforming assets

  • Increases in, or reductions of paid-in capital

  • Restriction on dividends

  • Allocation special allowance for credit loss

  • Closure, consolidation, or restriction on the establishment of new business office

  • Downsizing

  • Restrictions on holding risk assets and disposals of assets

  • Divesture of subsidiaries

  • Demand replacement of officers

  • Partial suspension of business

  • Setting up plans on mergers, entries as a subsidiary under a financial holding company under the Financial Holding Companies Act, acquisitions by third parties, or transfers of all or parts of businesses;

  • Measures applicable to category three institutions

  • Retirements of all or parts of the issued stocks;

  • Suspension of duties against officers and new appointments of administrators;

  • Mergers or entries into as a subsidiary under a financial holding company (including cases of being subsidiaries after establishing the FHC independently or jointly with other financial institutions);

  • Transfers of all or parts of businesses;

  • Acquisition of financial institutions by a third party;

  • Suspension of business within six (6) months;

  • Transfers of all or parts of contracts; and

  • Measures applicable to category two institutions.

Time line for measures
  • Submit improvement plan in 60 days

  • Implement the plan within a year

  • Submit the quarterly implementation result of its plan

  • Submit improvement plan in 60 days

  • Implement the plan within 1.5 year

  • Submit the quarterly implementation result of its plan

  • Submit improvement plan in 60 days

  • Implementation period prescribed by FSC.

  • Implementation checked within 2 month

Source: Korea Banking Act Article 45-(4), Regulation on Supervision of Banking Business.

Measures, such as suspension of all businesses, the assignment of all businesses, the transfer of all contracts and the retirement of all stocks, for Category 3 shall be limited to the case where the financial institution is a failing financial institution. A failing institution meets one of the following criteria: a) financial institutions whose liabilities exceed their assets; Financial Services Commission (FSC) or the Deposit Insurance Committee may determine that because of a massive financial scandal or nonperforming claims, the institutions’ liabilities exceed their assets. In this case, the liabilities and assets are valued according to the standards set by the FSC in advance; (b) financial institutions which are under suspension of payment of claims such as deposits or redemption of money borrowed from other financial institutions; and (c) financial institutions which are deemed unable to pay claims such as deposits or redeem borrowed money without support from outside, including the Financial Services Commission or the Deposit Insurance Committee referred.

Source: Korea Banking Act Article 45-(4), Regulation on Supervision of Banking Business.

Measures, such as suspension of all businesses, the assignment of all businesses, the transfer of all contracts and the retirement of all stocks, for Category 3 shall be limited to the case where the financial institution is a failing financial institution. A failing institution meets one of the following criteria: a) financial institutions whose liabilities exceed their assets; Financial Services Commission (FSC) or the Deposit Insurance Committee may determine that because of a massive financial scandal or nonperforming claims, the institutions’ liabilities exceed their assets. In this case, the liabilities and assets are valued according to the standards set by the FSC in advance; (b) financial institutions which are under suspension of payment of claims such as deposits or redemption of money borrowed from other financial institutions; and (c) financial institutions which are deemed unable to pay claims such as deposits or redeem borrowed money without support from outside, including the Financial Services Commission or the Deposit Insurance Committee referred.

Appendix Table III.3.5.Thailand: Prompt Corrective Actions
Categories and ActionsArticle of FIA
When banks violate the FIA or regulations, Band of Thailand (BOT) could order banks to stop the violation and dismiss management89
When a financial institution’s actions or positions may cause damage to the public, BOT has the power to order corrective actions, order to increase or reduce capital within 90 days of receiving the notice, order to stop doing any or all activities temporarily within a given deadline, order to dismiss management, take control of the institution or close the institution90
When a financial institution causes damage to the public, that is: (i) refuses to take corrective actions to comply with the FIA and regulations, (iii) in violation of prudential regulations such as capital requirement, securities holding, related party transactions, large exposure, assets classification, and provisioning (ii) falsifies financial reports, (iii) makes a loss, or (iv) BOT has reason to believe that the bank cannot maintain its capital level92
BOT has the power to close banks that default on their payments93
A financial institution should not pay a dividend and bonus when its capital level could fall below the minimum94
When capital falls below the minimum requirement, the institution needs to submit a plan to BOT within 60 days. The plan needs to outline quarterly target that will increase the capital level to the minimum level within a year. The plan needs to be approved by BOT95
When capital is lower than 60 percent of the minimum, BOT issues an order to control the financial institution. If such order causes a negative impact on the economy or the financial institution takes prompt actions to increase the capital to the minimum level, BOT may not have to issue a control order. If a subsidiary of the institution is insolvent or misses three regular payments in three consecutive months, BOT can order the institution to liquidate the subsidiary96
When capital is lower than 35 percent of minimum capital, BOT should issue an order to close the business, unless such order causes a negative impact on the economy97
Source: Thailand Financial Institution Business Act B.E. 2551 (A.D. 2008).
Source: Thailand Financial Institution Business Act B.E. 2551 (A.D. 2008).

A. United States

4. The PCA in the United States has eight attributes.

  • Required measures become increasingly stringent as a bank’s capital declines.

  • Corrective measures are mandated by law.

  • Banks are classified into 5 categories (Table III.3.2).

  • Three capital measures are used: leverage ratio, Tier 1 capital, and risk-based capital, with the first two specified in the law and the third one added by regulation.

  • Banks in the bottom three categories are required to take increasingly stringent measures.

  • Closure within 90 days (can be extended twice) is mandated when the leverage ratio falls below 2 percent.

  • Supervisors are held accountable by the inspector general, Congress, and the Government Accountability Office (GAO). Supervisors appear before Congress periodically and are audited by GAO. The Congress also investigates deficiencies in supervision.

  • There is a systemic risk exception that would allow the FDIC to protect uninsured creditors. However, invoking this exception requires a two-thirds majority in the boards of both the FDIC and the Federal Reserve and the approval of the Secretary of the Treasury after he has consulted with the President. In addition, banks are required to pay a special assessment proportional to their total liabilities to recoup the additional costs incurred by this exception (Garcia, 2008).

B. Japan

5. Following the bursting of the real estate and equity bubbles in the early 1990s, banks in Japan suffered from a rapid rise in nonperforming assets, leading to the failure of three major banks in 1997–98. All the other major banks also suffered severe losses. The banking crisis exposed hidden losses that were disguised previously. The authorities had to issue an explicit guarantee covering all bank liabilities and intervened in the three large banks and a number of smaller banks. In response to this crisis, Japan adopted the PCA as outlined in the amendment to the Banking Act and detailed in a regulation.

C. Korea

D. Thailand

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Prepared by Xiangming Li.

A full discussion of the stress test scenarios is contained in the staff report for the 2010 Article IV Consultation.

Measured by market value, the capital to asset ratio increased even more as stocks were traded at about 80 percent of book value in 1990, and at close tol50 percent of book value in 1996.

It is important to note that whether a bank is systemic or nonsystemic may depends on the environment. For instance, at a time of high financial uncertainty, some normally nonsystemic banks could become systemic.

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