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Cablegate: Experts Applaud Banking Reforms but Warn of Longer Term

VZCZCXRO2317
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #2690/01 2670602
ZNR UUUUU ZZH
R 240602Z SEP 07
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 6407
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHKO/AMEMBASSY TOKYO 0842
RUEHBJ/AMEMBASSY BEIJING 4331
RUEHBY/AMEMBASSY CANBERRA 1234
RUEHUL/AMEMBASSY SEOUL 4208
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 03 JAKARTA 002690

SIPDIS

SIPDIS

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-ABAUKOL
SINGAPORE FOR SBAKER
TOKYO FOR MGREWE
COMMERCE FOR 4430/BERLINGUETTE
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR TCURRAN
DEPARTMENT PASS EXIM BANK

E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: EXPERTS APPLAUD BANKING REFORMS BUT WARN OF LONGER TERM
CHALLENGES FOR ASIAN BANKS


JAKARTA 00002690 001.2 OF 003


1. Summary. Financial sector experts working in Asia gathered at
the Federal Reserve Bank of San Francisco on September 6-7 to
discuss the opportunities and challenges facing Asian banks over the
next decade. They lauded Asian policymakers for largely correcting
the excesses that led to the 1997-98 Asian financial crisis and
downplayed the likelihood of large-scale banking sector instability
in Asia in the near term. Experts expressed concern that the
massive growth predicted for Asia over the next decade, along with
financial sector innovation, will strain the ability of banks and
regulators to manage risk. While Indonesia's progress in
implementing banking sector reforms has lagged some of its
neighbors, experts consider the Indonesian banking sector to be
generally sound. End Summary.

Regional Macro Reform Substantial
---------------------------------

2. Regional experts at the Federal Reserve Bank of San Francisco
conference on "Asian Banking: Challenges and Opportunities" lauded
Asian policymakers for largely correcting the excesses that led to
the 1997-98 Asian financial crisis. They universally agreed that
macroeconomic policymakers across Asia are now generally getting it
right. Asian countries have moved away from pegged exchange rate
regimes; effectively discouraged short-term foreign currency
borrowing in the public and private sector; and reined in fiscal
deficits.

3. Experts also highlighted the importance of strong political and
regulatory leadership in the aftermath of the 1997-98 crisis. Korea
recovered relatively quickly due to the leadership of then-President
D.J. Kim and his government's emphasis on improving financial sector
regulation. In contrast, Japan and Indonesia took longer to recover
from their banking sector woes. In Japan, the regulators
consistently downplayed the level of problems faced by the large
banks. In Indonesia, the political transition and lack of
interagency coordination slowed much needed reforms. Once strong
political and regulatory leadership emerged in Japan and Indonesia,
the pace of banking sector reforms accelerated.

Asian Banking Reforms Largely Successful,
Indonesia Less So
-----------------------------------------

4. Experts also discussed the success of Asian banking sector
reforms, although progress on micro-level reforms was less even
across the region, with a number of weaknesses concentrated in
Indonesia. The ten banking sector reform categories discussed at
the conference were:

-- Profitability: The vast majority of banks across the region,
including those in Indonesia, are now profitable.

-- Consolidation: Consolidation efforts in Asia aimed at
strengthening banks and easing pressure on supervisory resources
have been successful. One unwanted side effect is that governments
now have a vested interest in keeping their "creations" alive. The
Indonesian banking sector remains one of the most fragmented sectors
in Asia with a large number of questionably viable, small
institutions still in operation.

-- State-ownership: Most Asian governments are no longer in the
banking business. Indonesia and China are two very important
exceptions to this trend.

-- Foreign Bank Presence: Foreign bank participation in Asian
markets, particularly in Indonesia, has increased, bringing in more
competition, fresh capital and international best practices.

-- Credit Bureaus and Credit Rating Agencies: A number of
countries, including Korea and Malaysia, have established credit
bureaus and domestic credit rating agencies in an effort to build a
stronger credit culture. These institutions have contributed to
more robust bank balance sheets, particularly in the consumer loan
portfolio. International credit rating agencies are on the ground
in Indonesia, but the domestic credit rating industry, which experts
believe is integral to expanding rating capacity beyond the largest

JAKARTA 00002690 002.2 OF 003


Indonesian firms, remains underdeveloped.

-- Supervision and Regulation: Asian regulatory authorities have
systematically overhauled their supervisory regimes in the last 5-10
years. While the rules are largely in line with international best
practices, the supervisory skills of Asian banking regulators,
including Indonesian regulators, still lag their European and US
counterparts.

-- Corporate Governance: Building a strong corporate governance and
risk management culture requires a significant shift in mind-set at
all organizational levels, which can take as long as a generation.
Asian banks have made progress in adopting sound corporate
governance rules and stronger risk management practices, but bank
managers, particularly state-owned bank managers, have not yet
successfully imbedded these cultural changes throughout their
organizations.

-- Financial Market Depth: Both equity and debt markets in Asia
have grown significantly in the past 5-10 years, diversifying risk
in the financial sector, but banks continue to be the primary source
of external finance in Asia. Analysts predict that bank dominance
will wane over the next decade as capital markets develop further.

-- Financial Infrastructure: All of the countries impacted by the
1997-98 financial crisis have made significant progress in improving
the capacity of payments systems and crisis management over the past
decade. However, interagency coordination remains a problem in a
number of Asian countries, including Indonesia.

-- Vitality of Corporate Sector: In contrast to the pre-crisis
years, the majority of Asian corporations now generate income at
levels that exceed their cost of capital. Moreover, the Asian
corporations that survived the crisis have largely de-leveraged,
generating much healthier balance sheets. The Indonesian private
sector has mirrored these trends, but the true condition of
state-owned enterprises is largely unknown.

-- Asset Bubbles: While Asian growth rates have recovered from the
crisis period, asset price growth in many Asian countries has been
somewhat subdued. Nevertheless, experts expressed concern about
real estate price bubbles in Jakarta and Singapore and an equity
price bubble in Indonesia.

-- Transparency: Lack of transparency remains a problem across
Asia, inhibiting Asian regulators and investors from forming a clear
picture of risk in the region.

Likelihood of Major Near-Term
Financial Instability: Very Low
-------------------------------

5. The general view among conference participants was that the
likelihood of major financial sector instability anywhere in the
region in the near term is very low.
The region's macro- and micro-level reforms have significantly
lowered the probability of large-scale capital flight from Asia or
banking problems in the near term. The relative lack of complexity
of financial instruments in the region has also shielded the
regions' banks from recent US-led volatility. Nevertheless, most
speakers at the conference reject the notion that Asia has
"de-coupled" from the U.S.: U.S. recession would have a significant
impact on Asian financial and real sectors. Experts consider the
Indonesian banking sector generally sound, though inconsistencies in
bank regulation may open the door for future vulnerabilities. Other
potential sources of vulnerability in Indonesian banks include rapid
growth in the banks' consumer portfolio in the absence of a strong
risk management culture and the potential overheating of property
markets.

Massive Future Growth to Stress Risk Management
--------------------------------------------- --

6. Asia is poised to experience massive growth in the next ten
years, stressing Asian banks' capacity to manage risk. Fueled by
rapid growth and a growing pool of foreign currency reserves, Asia

JAKARTA 00002690 003.2 OF 003


is set to become a dominant source of financial power in the world.
Four of the top ten financial centers in the world are already in
Asia. Yet banking analysts at the conference asserted that Asian
risk management systems are currently too weak to cope with rapid
growth and financial innovation. Competition from foreign banks
with the ability to attract the best talent will put additional
pressure on Asian bank profitability and soundness. If Asian
bankers do not match rapid growth rates and the ensuing war for
talent with significant new investment in risk management and
information technology systems, Asian banks are likely to have
weaker balance sheets and experience more volatility in the next
decade. In the face of Asia's newfound global power, experts also
cautioned Asia bankers to avoid becoming arrogant, and thereby blind
to potential vulnerabilities.

Challenges for Regulators
-------------------------

7. Rapid growth, financial innovation and globalization in the
region pose parallel challenges for Asia's banking sector
regulators. Asian banking supervisors will need significant
additional training and improved information flows to stay ahead of
these issues. At the same time, the demand for private sector
talent is likely to pose staffing challenges for supervisory
authorities as the private sector lures away seasoned supervisory
staff. Asian regulators also need to improve information sharing
and regulatory coordination at the national and international levels
in order to keep problems in one institution from spilling over into
other sectors or markets. Finally, conference participants warned
Asian regulators not to rush to adopt the Basel II capital accord.
In their view, premature adoption of some advanced capital models
under the new accord will strain supervisory capacity and further
cloud their understanding of risks in the banking sector.

HUME

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