INTERNATIONAL

FINANCE

Actions Taken to

Reform Financial

Sectors in Asian

Emerging Markets

United States General Accounting Office

GAO Report to Congressional Requesters

September 1999

GAO/GGD-99-157

United States

General Accounting Office

Washington, D.C. 20548

General Government Division

B-281526

Page 1 GAO/GGD-99-157 Asian Financial Sector Reforms

GAO

September 28, 1999

The Honorable Spencer Bachus

Chairman

Subcommittee on Domestic and International Monetary Policy

Committee on Banking and Financial Services

House of Representatives

The Honorable Michael N. Castle

Member

Subcommittee on Domestic and International Monetary Policy

Committee on Banking and Financial Services

House of Representatives

This report responds to your request that we analyze efforts to improve the

financial sectors1

 of emerging market countries, most of which

experienced crises since 1980.2

 Financial crises limit emerging countries’

economic growth3

 and foreign trade and strain their abilities to service and

repay international obligations. Developed countries, including the United

States, have felt the repercussions of these crises through losses on loans

to and investments in emerging markets and through diminished exports

to these countries.

To address your request, we focused on three countries—Indonesia, South

Korea, 4 and Thailand. We chose these countries, among other reasons,

because when we began our review, they had been receiving large capital

flows, were experiencing financial crises, and were making changes in

their financial systems. We focused on the banking sectors in these

countries because their economies, like most developing and transition

countries, relied more heavily on bank financing than on stock or bond

issuance or other types of market financing. Specifically, our objectives

were to determine (1) the nature of weaknesses in the countries’ financial

sectors, (2) the extent to which the countries have achieved reforms in

 1

The financial sector of a country’s economy is the complex of financial markets on which financial

instruments are traded and financial institutions that create and trade financial instruments.

2

We use the term “emerging markets” broadly to include countries that others classify as “developing

countries” or “countries in transition” as well as newly industrialized economies such as, for example,

Korea.

3

See Strengthening Financial Systems in Developing Countries: The Case for Incentives Based

Financial Sector Reforms, Biagio Bossone and Larry Promisel, World Bank, (Wash., D.C.: 1998).

4

We will refer to South Korea, officially named the Republic of Korea, as Korea throughout this report.
B-281526

Page 2 GAO/GGD-99-157 Asian Financial Sector Reforms

their financial systems, (3) the extent to which the countries have

implemented international principles for banking supervision, and (4) U.S.

government and multilateral institutions’ efforts to effect changes in the

financial sectors of these emerging markets.

We conducted our work in Washington, D.C.; New York City, New York;

Jakarta, Indonesia; Tokyo, Japan; Seoul, Korea; Basel, Switzerland; and

Bangkok, Thailand, between September 1998 and August 1999, in

accordance with generally accepted government auditing standards.

Appendix I describes our methodology.

The governments of Indonesia, Korea, and Thailand are implementing

multiple changes to reform their financial institutions and markets and

banking supervisory structures. Many of these changes are being

undertaken in response to a financial crisis. Some regulatory and legal

changes have been implemented in the short term, while other objectives

may take many years to accomplish due to the extent of the problems and

the enormity of the changes required. Currently, how robust the countries’

financial systems are to future disruptions is an open question, given the

risks to the financial systems posed by the continued weaknesses of the

corporate sectors of all three countries. 

Although the structure of the banking systems and related weaknesses in

the three countries differed prior to the crises, they had some fundamental

similarities. The economies of each country relied heavily on debt

financing and restricted the access of foreign financial institutions. At the

same time, the countries’ legal systems did not provide adequately for the

enforcement of contracts or provide mechanisms for resolving defaulted

corporate debt. Moreover, the financial data of many businesses were not

reliable for credit or investor analysis because accounting practices in

those countries were weak. The countries did not have adequate legal and

institutional frameworks ensuring their bank supervisors’ independence

and enforcement authority. The countries did not have deposit insurance

systems that forestalled runs on bank deposits.

Indonesia, Korea, and Thailand have made or are making changes to

address banking system and related weaknesses, with early priority given

to resolving nonviable banks and debtor companies. Some insolvent or

weak banks have been closed or merged. Ongoing efforts include the sale

of assets of failed banks and the recapitalization of banks, with the latter

partially dependent on the corporate debt workout process. All three

countries are changing laws to expedite resolution of loans in default.

Also, Korea and Thailand have changed or strengthened accounting

Results in Brief
B-281526

Page 3 GAO/GGD-99-157 Asian Financial Sector Reforms

practices by adopting internationally accepted accounting standards. Most

changes have been made only recently, allowing little time for assessment

of their effect on improving the transparency and independence of the

financial systems. The changes implemented or planned should, if applied

fully, serve to reduce the vulnerability of the financial systems of these

countries to currency depreciation and a reversal of credit and capital

flows.

Each of the three countries has partially implemented international

principles for effective bank supervision, but it is too early to determine

the effect of this on actual bank management or supervisory practices.

Implementation has involved, among other things, (1) increasing bank

supervisors’ independence and enforcement authority, (2) adopting more

stringent standards for capital adequacy of financial institutions, (3)

stricter rules for identifying loans at risk of default and determining loan

loss reserves for these loans, and (4) limits on foreign exchange exposure.

However, an examination staff that can fully implement revised

examination standards is widely expected to require years to develop. A

key indicator in determining the effectiveness of adopting these

supervisory principles is whether bank supervisors will take prompt

corrective actions concerning poorly performing or insolvent banks in the

future.

Efforts of the U.S. and multilateral institutions (the International Monetary

Fund (IMF), the World Bank, and the Asian Development Bank (ADB)) to

effect changes in emerging markets have focused on the countries’

immediate needs to resolve nonviable banks and debtor companies as well

as long-term goals to improve financial systems. In responding to the

countries’ immediate needs, IMF has made financial sector reform a key

condition for financial assistance. The World Bank has been providing

financial and technical assistance for implementing specific reforms in the

financial and corporate sectors, such as assistance in writing banking

regulations, in these three countries. ADB has provided loans in the three

countries to focus on banking sector reforms that included streamlining

their regulatory frameworks and improving transparency in the banks. The

U.S. Treasury Department is supporting financial sector reform by working

through the multilateral institutions. In addition, the Federal Reserve and

the U.S. Treasury, including the Office of the Comptroller of the Currency

(OCC), are providing bilateral assistance through financial system

technical advisors and bank supervisory training for all three countries.

With their central role in making payments and mobilizing and distributing Background savings, banks are a key part of a country’s economy and the international
B-281526

Page 4 GAO/GGD-99-157 Asian Financial Sector Reforms

financial system.5 Weaknesses in a country’s banking system can threaten

financial stability both within that country and internationally.6

 These

problems are not limited to emerging markets. Persistent problems in

Japan’s banking system, for instance, have limited that country’s economic

growth and prospects for growth elsewhere.

The financial crises in Indonesia, Korea, and Thailand began in the second

half of 1997. Banking systems in many Asian emerging markets were at the

core of the region’s financial crisis.7

 The crises resulted in sharp declines in

the currencies, stock markets, and other asset prices. By December 1997,

the Korean won (Korea’s currency) had depreciated by 55 percent in

relation to the U.S. dollar. By January 1998, the Indonesian rupiah

(Indonesia’s currency) had fallen by 81 percent and the Thai baht

(Thailand’s currency) by 56 percent. During the second half of 1997, dollar

returns on Asian equity markets yielded a loss of 56 percent. The crises

threatened the countries’ financial systems and disrupted their real

economies. Private capital flows via short-term international bank credit

and investment flows to Asia declined by about $100 billion during 1997

from 1996 levels. Most of the decline in capital flows to the Asian region

reflected declines in flows to the three study countries plus Malaysia and

the Philippines where net inflows of $73 billion in 1996 were replaced by

net outflows of $11 billion in 1997. Most of the turnaround in these

countries arose from a $73 billion turnaround in net bank lending flows—

with the largest share of outflows recorded from Thailand and Korea at

some $18 billion each.8

Financial crises in emerging markets have either been precipitated by or

exacerbated by problems in banking systems.9

 Countries with weak and

ineffectively regulated banking systems are less able to manage the

negative consequences of volatile capital flows and exchange-rate

pressures. Establishing a strong framework of regulatory policies and

institutions to underpin the financial sector is key to maintaining financial

 

5

See Bank Soundness and Macroeconomic Policy, Carl-Johan Lindgren, Gillian Garcia, and Matthew

Saal, International Monetary Fund, (Wash., D.C.: 1996).

6

See Preventing Bank Crises: Lessons From Recent Global Bank Failures, Gerard Caprio Jr., William

Hunter, George Kaufman, and Danny Leipziger, World Bank, (Wash., D.C.: 1998).

7

See The Asian Financial Crisis: Causes, Cures, and Systemic Implications, Morris Goldstein, Institute

for International Economics, (Wash., D.C.: 1998).

8

See International Capital Markets: Developments, Prospects, and Key Policy Issues, International

Monetary Fund, (Wash., D.C.: Sept. 1998).

9

See International Financial Crises: Efforts to Anticipate, Avoid, and Resolve Sovereign Crises

(GAO/GGD/NSIAD-97-168, July 7, 1997).
B-281526

Page 5 GAO/GGD-99-157 Asian Financial Sector Reforms

stability. The task of bank supervision is to ensure that banks operate in a

safe and sound manner and that they hold sufficient capital and reserves to

support the risks that arise in their business.

The costs associated with financial sector problems, particularly in

emerging markets, have been very large in terms of foregone growth,

inefficient financial intermediation, and impaired public confidence in

financial markets. The resolution costs have been largely borne by the

public sector. The United States had its own financial sector problems in

the 1980s and early 1990s with savings and loan institutions. We estimated

a direct cost to the economy for resolving these problems of about $153

billion or two to three percent of gross domestic product (GDP).10 The

estimated fiscal cost of systematic bank restructuring in Mexico since 1995

is on the order of 12 to 15 percent of GDP. 11 Resolving banking crises may

cost between 45 to 80 percent of GDP in Indonesia, 15 to 40 percent of

GDP in Korea, and 35 to 45 percent in Thailand, according to central bank

or market estimates.12 In early 1997, one financial expert suggested that

since 1980, the resolution costs of banking crises in all developing and

transition economies had approached $250 billion dollars.13 Most of the

resolution costs in Asian crisis countries have yet to be incurred, and

taxpayers in Indonesia, Korea, and Thailand will largely foot the bill.

Financial crises in emerging economies can be costly for developed

countries, particularly as the importance of emerging countries in the

world economy and in international financial markets has grown.

Developing countries now purchase one-fourth of developed countries’

exports. Thirteen percent of global stock market capitalization comes from

emerging market countries. The share of emerging market securities in

portfolios in developed countries is relatively small but has been

increasing. To the extent that financial crises depress developing

countries’ growth and foreign trade, strain their abilities to service and to

repay private capital inflows, and eventually add to the liabilities of

 

10See p. 13 of Financial Audit: Resolution Trust Corporation’s 1994 and 1995 Financial Statements

(GAO/AIMD-96-123, Jul. 2, 1996).

11See Banking Crises In Emerging Economies: Origins And Policy Options, Morris Goldstein and Philip

Turner, BIS Economic Paper No. 46, Bank for International Settlements, (Basel, Switzerland: Oct.

1996).

12The cost of restructuring will depend on factors such as domestic and external macroeconomic

conditions, the effectiveness of corporate restructuring, and the efficiency with which bank

restructuring is implemented, according to an IMF document. Private market estimates of resolution

costs exceed official government estimates.

13Banking System Failures In Developing Countries: Diagnosis and Prediction, Patrick Honohan,

Working Paper No. 39, Bank for International Settlements, (Basel, Switzerland: Jan. 1997).
B-281526

Page 6 GAO/GGD-99-157 Asian Financial Sector Reforms

developing countries’ governments, developed countries are likely to feel

repercussions.

The financial systems of Indonesia, Korea, and Thailand are different from

systems in many industrialized countries in several ways. Contrasting their

financial systems with the U.S. financial system is particularly illustrative.

The U.S. financial system emphasizes arms-length relationships between

businesses and institutions that provide financing, whether through debt

or equity markets, or other forms of financing. Indonesia, Korea, and

Thailand place greater emphasis on debt financing through bank loans

than on equity financing,14 have closer relationships between banks and the

companies that borrow from them, and have greater government direction

in credit allocation decisions.

While these nations experienced years of strong economic growth, their

financial systems have not been resilient when facing large capital

outflows and currency depreciations. Reasons for this lack of resilience

vary, but certain weaknesses in their financial systems appear as common

themes. These weaknesses included (1) weak credit analysis, problems

that banks faced in enforcing loan agreements in the case of defaults; (2)

weak accounting practices that precluded effective credit analysis by

banks or investors; (3) lack of hedging against foreign currency exposure

by corporate borrowers;15 and (4) weaknesses in bank supervision that

limited the governments’ ability to respond to financial problems.

While countries financial systems do not need to be mirror images of one

another, several characteristics are widely viewed as crucial to making a

financial system robust or able to weather shocks. These characteristics

were set forth in April 1997 by Deputy Finance Ministers of the Group of

Ten (G-10)16 in its strategy for fostering financial stability in countries

 

14Reliance on debt financing per se is not necessarily a weakness. As we noted in Competitive Issues:

The Business Environment in the United States, Japan, and Germany, (GAO/GGD-93-124, Aug. 9, 1993),

Japanese and German businesses have relied more heavily on debt financing than U.S. businesses. In

Indonesia, Korea, and Thailand, however, the inability or unwillingness of creditor banks to rollover

short-term loans during the East Asian financial crisis was a key to the severity of this crisis.

15World Bank officials told us that banks historically encouraged corporations to borrow without

hedging to achieve the illusion of lower interest costs.

16The G-10 is made up of 11 major industrialized countries that consult on general economic and

financial matters. The 11 countries are Belgium, Canada, France, Germany, Italy, Japan, the

Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.

Weaknesses in the

Countries’ Financial

Systems

Characteristics of Robust

Financial Systems
B-281526

Page 7 GAO/GGD-99-157 Asian Financial Sector Reforms

experiencing rapid economic growth and undergoing substantial changes

in their financial systems. 17 The G-10 calls for, among other things,

• a legal environment where the terms and conditions of contracts are

observed and where legal recourse, including taking possession of

collateral, is possible without undue delay;

• comprehensive and well-defined accounting principles that command

international acceptance and provide accurate and relevant information on

financial performance;

• standards for disclosure of key information needed for credit and

investment decisions that are high quality, timely, and relevant;

• effective systems of risk management and internal control with strict

accountability of owners, directors, and senior management;

• financial institutions that have capital that is commensurate with the risks

they bear;

• openness and competitiveness in banking and financial markets subject to

essential prudential safeguards;

• safety net arrangements—deposit insurance, remedial actions, and exit

policies—that provide incentives for depositors, investors, shareholders,

and managers to exercise oversight and to act prudently;

• supervisory and regulatory authorities that are independent from political

interference in their execution of supervisory tasks but are accountable in

the use of their powers and resources to pursue clearly defined objectives;

and

• authorities with the power to license institutions, to apply prudential

regulation, to conduct consolidated supervision, to obtain and

independently verify relevant information and to engage in remedial

action.

In June 1996, the G-7 heads of government18 called for the Basel Committee

on Banking Supervision—a committee of banking supervisory authorities,

which was established in 1974 by the central bank governors of the G-10

countries—to participate in efforts to improve supervisory standards in the

emerging markets. In response, the Basel Committee issued core

 

17See “Financial Stability in Emerging Market Economies: A Strategy For The Formulation, Adoption

and Implementation of Sound Principles And Practices To Strengthen Financial Systems,” by the

Working Party on Financial Stability In Emerging Market Countries, Deputies of the Group of Ten (G10), April 1997. Representatives of Argentina, France, Germany, Hong Kong, Indonesia, Japan, Korea,

Mexico, the Netherlands, Poland, Singapore, Sweden, Thailand, the United Kingdom, and the United

States participated in this work.

18The G-7 consists of seven major industrialized countries that consult on general economic and

financial matters. The seven countries are Canada, France, Germany, Italy, Japan, the United Kingdom,

and the United States.

Characteristics of Effective

Banking Supervision
B-281526

Page 8 GAO/GGD-99-157 Asian Financial Sector Reforms

principles for banking supervision in September 1997.19 The Core

Principles provide operational guidance for

• preconditions for banking supervision—bank supervisory agencies with

clear responsibilities, operational independence, and adequate resources;

legal protections for supervisors; legal powers to authorize banks and

address compliance and safety and soundness concerns;

• licensing and structure—clearly defined permissible activities; licensing

authority with the right to set criteria and reject applications;

• prudential regulations and requirements—minimum capital requirements

that reflect the risks undertaken by banks, independent evaluation of bank

practices relating to granting loans and making investments, adequate

practices for evaluating the quality of assets and the adequacy of loan loss

provisions and reserves; identification of loan concentrations to single

borrowers or groups of related borrowers, lending on arms-length basis;

procedures for controlling country risk, transfer risk, and market risk;

• methods of ongoing banking supervision—on-site and off-site supervision;

regular contact between bank supervisors and bank management;

independent evaluation of information supplied by banks; and ability to

supervise on a consolidated basis;

• information requirements—satisfaction that a bank has adequate records

and financial statements that fairly reflect a bank’s condition;

• formal powers of supervisors—adequate supervisory measures to bring

about corrective actions against a bank;

• cross-border banking—practicing global consolidated supervision,

adequately monitoring and applying prudential norms to the banking

organization’s foreign operations; establishing contact and information

exchange with other countries’ supervisors; requiring local operations of

foreign banks to operate at the same high standards as required of

domestic institutions and having powers to share information with homecountry supervisors to supervise on a consolidated basis.

These core principles are intended to serve as standards against which

countries may evaluate the adequacy of their supervisory systems as well

as guidance to countries that are changing their systems. Bank supervisors

from Indonesia, Korea, and Thailand participated in developing the Core

Principles. The G-10 central bank governors endorsed these principles.

 

19See “Core Principles for Effective Banking Supervision,” Basel Committee on Banking Supervision,

(Basel, Switzerland: Apr. 1997). The document was prepared by a group containing representatives

from the Basel Committee (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,

Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) and representatives

from Chile, the Czech Republic, Hong Kong, Mexico, Russia, and Thailand. Also associated with the

work were Brazil, Hungary, India, Indonesia, Korea, Malaysia, Poland, and Singapore.
B-281526

Page 9 GAO/GGD-99-157 Asian Financial Sector Reforms

Deficiencies in capital adequacy regulation are a problem area in the

financial sectors of emerging markets in which international standards for

prudential regulation have been particularly visible. In 1988, the member

countries of the Basel Committee on Banking Supervision agreed to a

method of ensuring capital adequacy, called the Basel Capital Accord,

which has since been expanded.20 The corresponding core principle states

that

“banking supervisors must set minimum capital requirements for banks that reflect the

risks that the banks undertake, and must define the components of capital, bearing in mind

its ability to absorb losses. For internationally active banks, these requirements must not be

less than those established by the Basel Capital Accord.”

Many countries adopted this standard for internationally active banks.

However, differences among the countries in accounting practices, such as

classifying and reserving for delinquent loans, can affect a bank’s level of

capital. Differences in accounting rules can make capital levels appear

higher than if the country followed stricter international rules. For

example, in Thailand, an unsecured loan had been considered substandard

after it was 6 months past due,21 while best practices in international

accounting classify a loan as substandard when it becomes 90 days past

due. Because reserves against specific substandard loans do not count as

part of a bank’s capital, banks would not have reserves for loans that are

overdue 90 days but less than 6 months, thus overstating their capital

reserves when compared to international best practices.

Prior to their financial crises, all three countries we studied fell short of

meeting several of the criteria for a robust financial system and the

principles for effective bank supervision. While these three countries’

economies relied heavily on debt financing, they had inadequate

procedures for the enforcement of loan contracts and workouts, according

to IMF and World Bank documentation. In Indonesia, for instance, legal

problems impeded banks’ abilities to enforce loan contracts and sell loans.

Banks did not have ready access to collateral on their loans and had

limited rights to liquidate the collateral. Korean bankruptcy laws and

procedures lacked clear economic criteria in judging a company’s viability

and did not allow for creditor participation in designing a company’s

restructuring plan. In Thailand, family groups generally controlled banks,

and the result was that these banks loaned to their owners’ business

 20For more information on capital adequacy and capital standards for banks see Risk-Based Capital:

Regulatory and Industry Approaches to Capital and Risk (GAO/GGD-98-153, July 20, 1998).

21A secured loan was considered past due at 12 months.

Weaknesses in the Financial

Systems of Indonesia,

Korea, and Thailand
B-281526

Page 10 GAO/GGD-99-157 Asian Financial Sector Reforms

interests. With the increasing defaults on bank loans, Thailand’s weak legal

frameworks for foreclosure and bankruptcy of the debtor often meant that

it could take up to 10 years to foreclose on an institution and collect

collateral.

Similarly, since accounting practices in these three countries were weak,

financial data on borrowers in these countries were not transparent or

reliable enough to support credit or investment analysis. Korea’s

corporations (called chaebols), for example, had a complex system of

cross-guarantees that made it difficult to identify the entity that would

ultimately be responsible for a loan.

Bank supervision in these three countries was hindered by aspects of the

countries’ legal system. In Indonesia, few banks were closed or merged

because of unclear legal authority to do so, according to IMF

documentation. In December 1996, a governmental directive was issued to

provide a firmer basis for Bank Indonesia (the central bank and

supervisory agency) to close insolvent banks, but political considerations

inhibited action. In Thailand, bank supervisors could be held personally

responsible for causing losses to the state. The fear of legal liability

limited their willingness to take corrective actions or, in certain

circumstances, to close failing institutions, according to a World Bank

official.

Although Korea had a deposit insurance system and Indonesia and

Thailand did not, existing arrangements were inadequate in the face of the

financial crises that began in 1997. Prior to the crisis, in Indonesia, Korea,

and Thailand, the perception was that a large part of the deposit base was

covered by implicit government guarantees. This perception changed when

the crises broke. For example, initial efforts during the financial crisis to

bolster confidence in banks through partial government guarantees of

deposits were not successful in Indonesia. Indonesia promised

compensation only to small depositors of the banks that were closed at the

beginning of the program. The guarantee was not widely publicized, and no

announcement was made regarding the treatment of depositors in other

institutions that remained open. After several waves of deposit runs, a

comprehensive scheme covering all bank depositors and creditors was

introduced.22

 

22According to IMF, although the deposit insurance system in Korea may have been inadequate at the

onset of the crisis in late 1997, a blanket guarantee on all deposits of financial institutions until the year

2000 was provided in November 1997. This was largely successful in preventing a run on deposits as

nonviable banks were closed. Later, in order to reduce moral hazard problems, the deposit insurance
B-281526

Page 11 GAO/GGD-99-157 Asian Financial Sector Reforms

Deficiencies in the corporate governance of individual financial

institutions were another weakness. Prior to the crisis, poor credit-risk

management led to the weak condition of financial systems in Indonesia,

Korea, and Thailand. Inadequately managed banks failed to undertake

adequate credit appraisals. Lax credit risk management led to

deterioration in the quality of loan portfolios. For example, excessive

lending to borrowers with limited ability to service foreign exchange

denominated loans in the event of a large depreciation or devaluation.

Appendix II provides a more detailed discussion of weaknesses in the

financial systems of each country.

The governments of Indonesia, Korea, and Thailand have taken or are

taking a variety of actions in response to their ongoing financial crises.

They have begun to close banks that are insolvent, merge weak banks with

stronger banks, sell bad assets, and assist the recapitalization of banks that

have not been targeted for closing or merger; many of these actions are

ongoing. They also have created frameworks involving various degrees of

government mediation to facilitate corporate debt workouts. Financial

sector restructuring23 in Indonesia, Korea, and Thailand has involved

efforts to restore confidence in the countries’ banking system by

guaranteeing deposits, strengthening regulatory structures, adopting

internationally accepted accounting standards, and creating legal

frameworks for bankruptcy and governance. Countries are also attempting

to ease barriers to competition from foreign banks. The challenges posed

by the financial sector and corporate debt restructuring in East Asia have

been considerable, however, and many of the problems that led to

financial crisis persist. The corporate and financial sectors in all three

countries are interwoven, so restructuring them is inherently a complex

and lengthy process.

 system was amended with the provision that only principal for accounts of 20 million won (about $16.7

thousand) or more would be protected for accounts opened after August 1, 1998. We used the

conversion rate of exchange of $1 to 1,200 won.

23We use the term “restructuring” broadly to capture the reform efforts that these countries were

making to their financial sectors and financial aspects of their corporate sectors.

Countries Are Taking

Steps to Improve

Operation of Their

Financial Sectors
B-281526

Page 12 GAO/GGD-99-157 Asian Financial Sector Reforms

As the crisis developed, the three countries had to take actions to limit the

damage to their banking systems. Similar approaches were taken in each

of these countries to bolster these systems. Each of the countries moved to

close and/or merge failing institutions. Each set up an institutional

arrangement to sell the loans of these banks as well as nonperforming

loans from banks that remained open. In general, the proceeds from the

sale of assets from distressed institutions are to go towards repaying the

cost to the governments of restructuring the financial systems. Finally,

each country moved to recapitalize those banks that remained open

through various financial arrangements. While the capital levels of these

banks generally were reported to be below the standards for

internationally active banks, the levels are now generally higher than

during the crisis.

According to the World Bank, the initial reform programs in these three

countries were (1) directed at reducing instability and uncertainty in the

domestic financial markets, and (2) assisting governments in developing

an institutional framework to restructure and resolve nonviable financial

institutions in a cost-effective manner. Because of the magnitude of the

immediate financial problems these three countries faced, the initial

reforms were carried out while considering the stress of the reforms on

the local economies. Indonesia, for instance, faced a situation where

almost all the banks were insolvent. Thailand faced several episodes of

bank runs during 1997. In December 1997, about half of Korea’s merchant

and commercial banks were insolvent or did not meet capital adequacy

standards. Over the longer-term, the goal is to build stronger and more

competitive financial systems and accompanying regulatory systems to

minimize the likelihood of future problems in the financial sector. Table 1

outlines several of the efforts these countries have undertaken so far to

improve their financial sectors.

Countries Have Begun To

Close and Merge Financial

Institutions; Sell Bad Assets;

and Recapitalize Remaining

Institutions
B-281526

Page 13 GAO/GGD-99-157 Asian Financial Sector Reforms

Action

taken

Closed and/or merged

financial institutions

Liquidity supporta and recapitalization of financial

institutions Selling bad assets

Indonesia As of July 1999, 66

banks have been closed,

the state has intervened

in 30 banks, and banks

have exited through

merger.

Bank runs in Indonesia led to stepped-up liquidity

support from Bank Indonesia.b In June 1998, Bank

Indonesia was providing $22.7 billionc or 17 percent of

GDP in liquidity support.

The government of Indonesia developed a

recapitalization scheme for private banks by

categorizing banks depending on capital levels.

Seventy-three banks with capital to asset ratios of 4

percent or better did not need to participate. Thirty-eight

banks had ratios below 4 percent but above negative

25 percent; 21 of these 38 banks were closed.

Seventeen banks with even lower capital did not qualify

for recapitalization and were closed. Bank

recapitalization was to be financed through (1) private

capital injected by bank owners and (2) the issuance of

government bonds.

The long-term cost of bank restructuring is estimated to

be $85 billion, or 51 percent of GDP, according to

national authorities and IMF staff estimates.

In January 1998, the Indonesian Bank

Restructuring Agency was established

to take over and rehabilitate ailing

banks and manage nonperforming

assets of intervened banks. The book

value of assets to be liquidated by the

Indonesian Bank Restructuring Agency

(IBRA) was $3 billion. Each state bank

has targeted its 20 largest delinquent

corporate borrowers for loan recovery,

restructuring, or bankruptcy filing.

Recoveries from sales of assets are to

be used to buy back government shares

in banks.

Korea As of January 20, 1999,

86 financial institutions

(including commercial

banks, merchant banks,

insurance firms, and

nonbank financial

institutions) had been

closed or suspended

operations.

According to Korean official sources, the government

has provided about $53.3 billiond or 15 percent of GDP,

to recapitalize intervened banks and purchase

nonperforming loans from distressed financial

institutions. The Bank of Korea (central bank) provided

foreign exchange support to commercial banks as

foreign creditors reduced their exposure on short-term

lines of credit. During November and December 1997,

the Bank of Korea placed about $23 billion of official

reserves in deposit at foreign branches and subsidiaries

of domestic foreign institutions to cover the banks’

short-term lines of credit, a portion of which has since

been repaid, according to IMF documents.

Established the Korea Deposit Insurance Corporation,

modeled after the U.S. Federal Deposit Insurance

Corporation. Korea Deposit Insurance Corporation, by

the end of 1998, issued about $17.5 billion of its

government-guaranteed bonds for recapitalizating the

banks and depositor protection.

Expanded the Korea Asset

Management Corporation’s charter to

be similar to the former U.S. Resolution

Trust Corporation. As of June 30, 1999,

the Korea Asset Management

Corporation had issued 20.3 trillion won

worth or about $16.9 billion of

government-guaranteed bonds to

purchase nonperforming loans acquired

from distressed banks. It announced

plans to sell over 50 percent of

nonperforming loans by end-2001. It

also plans to dispose of over 97 percent

of the total amount of acquired

nonperforming loans within the next 5

years; the sales price is to be

determined by market conditions.

According to OCC, asset disposition by

the Korea Asset Management

Corporation has been very slow to date.

Table 1: Countries Efforts to Improve Their Financial Systems
B-281526

Page 14 GAO/GGD-99-157 Asian Financial Sector Reforms

Action

taken

Closed and/or merged

financial institutions

Liquidity supporta and recapitalization of financial

institutions Selling bad assets

Thailand As of August 1999, the

Bank of Thailand closed

1 private bank and 57

finance companies. In

addition, 3 private banks

and 12 finance

companies were merged.

By early 1998, the Bank of Thailand’s Financial

Institutions Development Fund had committed

approximately about $20 billione of liquidity support to

private banks and finance companies to keep them

operational. The Bank of Thailand made allowance for

issuing about $7.5 billion of bonds with a 10-year

maturity to support the recapitalization effort. Private

banks and finance companies are to be recapitalized

through Bank of Thailand’s recapitalization program to

provide capital to banks based on banks meeting

certain requirements, including writing down bad loans.

State banks are to be recapitalized through the

Financial Institutions Development Fund. Through the

recapitalization program, two private banks have

received capital support. Five state banks were to be

recapitalized by the Financial Institutions Development

Fund. In addition, at least six private banks and several

finance companies have raised about $6 billion from

private instruments through market-led recapitalization.

In October 1997, the Financial

Restructuring Agency was established

to review suspended finance companies

and liquidate finance company assets

by auction. The Asset Management

Corporation was set up to act as bidder

of last resort for bad assets. Several

auctions took place between June 1998

and August 1999. The Financial

Restructuring Agency sold over 70

percent of closed finance companies’

assets, of which roughly 25 percent was

acquired by the Asset Management

Corporation.

a

Liquidity support is the amount of funds provided by a central bank to a country's banks.

b

Bank Indonesia is the central bank of the Republic of Indonesia. The Governor of Bank Indonesia

and its seven Managing Directors are normally appointed by the president for terms of five years.

c

We use an exchange rate of $1 for 7,500 rupiah.

d

We use an exchange rate of $1 for 1,200 won.

e

We use an exchange rate of $1 for 40 baht.

Source: GAO analysis of documents from the governments of Indonesia, Korea, Thailand and IMF

and the World Bank as well as interviews of officials.

The process for resolving troubled financial institutions has been difficult

and contentious in the three countries, and progress has varied. For

example, prior to the crisis, Indonesia did not have an agency with the

authority to resolve failing financial institutions. Therefore, it established

the Indonesian Bank Restructuring Agency (IBRA) in January 1998 to take

over and rehabilitate ailing banks, as well as manage the nonperforming

assets of banks requiring government assistance. As part of its efforts to

resolve failing banks, Korea had experienced delays in its plans to sell two

of the largest banks of which the government had taken control. While

Korea had committed to selling these banks as part of its agreement with

IMF for financial assistance, Korea requested a waiver to allow a delay in

accepting bids for these sales because the government had not reached

agreement with foreign bankers on the terms to purchase the banks.

Thailand officials reported that selling the assets of closed finance

companies has been a lengthy and political process. To deal with the

selling of assets, the Thailand government set up two agencies—the

Financial Sector Restructuring Authority and the Asset Management
B-281526

Page 15 GAO/GGD-99-157 Asian Financial Sector Reforms

Corporation. The asset sales have resulted in lower returns than originally

anticipated, though returns in the most recent auction have been

significantly higher, according to the IMF. According to Thailand officials,

debtors have been suspected of purchasing back their nonperforming

loans (at a discount) through intermediaries at the Financial Sector

Restructuring Agency auctions. World Bank officials told us that these

allegations have not been substantiated.

The governments of Indonesia, Korea, and Thailand are facilitating the

workout24 of loans that are not being repaid and are instituting frameworks

for voluntary debt restructuring.25 The approach, level of progress, and

degree of government involvement in corporate debt restructuring differ

between the three countries for a variety of reasons. Common goals,

however, include removing nonperforming corporate loans from bank

portfolios to allow new lending to corporations and sharing the cost

among lenders, borrowers, and the governments. In general, corporate

debt restructuring in all three countries has been hindered due to the lack

of tax, legal, and regulatory infrastructures needed for debt restructuring

and the limited institutional experience in the region with debt workouts,

according to IMF documentation. The restructuring process has also been

complicated by the complex nature of corporate and banking sector

relationships and the large number of participants (creditors and debtors)

involved in these efforts. The delay in corporate restructuring has affected

the economic recovery of the three countries because of the resulting high

debt servicing costs, higher interest rates, and the lack of available credit

to small and medium-sized companies. Continued weaknesses in the

corporate sector pose risks to these financial systems, according to a

Federal Reserve official and others that we spoke with.

The corporate sector in Indonesia was hard hit by the economic crisis and

a large part of it was insolvent. The government of Indonesia announced a

workout structure for creditors and debtors called the Jakarta Initiative in

September 1998. Under this initiative, the Indonesian government

envisages that workouts of debt to foreign commercial creditors will take

 

24A loan workout is an agreement between the lender and borrower to take remedial measures.

Remedial measures could be, for example, the rescheduling of principal and interest payments over a

longer period, forgiveness, or an equity for debt swap. A loan workout may temporarily take the place

of a foreclosure in which the lender attempts to sell at auction any collateral pledged by the borrower.

25The voluntary debt restructuring approach draws on the London Approach, which is an informal and

adaptable framework for private debt workouts that relies on voluntary agreement. The principles are

(1) if a corporation is in trouble, banks maintain credit facilities and do not press for bankruptcy; (2)

decisions about the firm’s future are made only on the basis of comprehensive information shared

among all parties; (3) banks work together; and (4) seniority of claim is recognized, but there is an

element of shared pain.

Governments Are

Facilitating Corporate Debt

Workouts, but Difficulties

Remain
B-281526

Page 16 GAO/GGD-99-157 Asian Financial Sector Reforms

place voluntarily on a case-by-case basis. The initiative provides general

principles for the out-of-court voluntary restructuring of domestic and

foreign debt with a view to accelerating debt restructuring, promoting

interim financing to borrowers, and providing company information so

that creditors can evaluate restructuring proposals. Indonesia established

the Indonesian Debt Restructuring Agency and the Jakarta Initiative Task

Force to implement this initiative. The Indonesian Debt Restructuring

Agency is designed to facilitate foreign exchange payments made by

Indonesian companies to their foreign creditors. The task force has a

mandate to facilitate negotiations between creditors and debtors and is to

provide a forum for one-stop approval of regulatory filings that are

required in the context of corporate restructuring. The task force may

recommend that the public prosecutor initiate bankruptcy proceedings in

the public interest. These measures were complemented by strengthened

bankruptcy law. The potential threat of foreclosure and initiation of

bankruptcy proceedings provides an important incentive for the successful

conclusion of restructuring agreements under the Jakarta Initiative. In May

1999, the Indonesian finance minister announced a more intensive

program for corporate restructuring that called for, among other things,

identification and publication of the names of noncooperating debtors,

starting with the largest debtors. As of July 1999, 22 of 234 insolvent

companies had reached agreements, and about 10 percent of foreign and

domestic debt of the Indonesian companies involved in the process had

been restructured. Creditors have generally not been willing to meet

debtors’ requests for partial forgiveness.

Korea’s corporate sector restructuring is being led by creditor banks under

principles agreed to by the government and business leaders in early 1998.

The government assisted the private sector initiative by strengthening

Korea’s legal and institutional framework for financial and corporate

restructuring. In addition, the government formed the Corporate

Restructuring Coordination Committee to act as an arbitrator. In

December 1998, Korea’s largest chaebols, or business groups, announced

their intent to undertake corporate restructuring and debt workouts. The

agenda for corporate reform includes

• adoption of combined financial statements from fiscal year 1999,

• compliance with international accounting standards,

• reinforcement of voting rights of minority shareholders,

• mandatory appointment of outside directors,

• establishment of external auditors committee,

• prohibition of cross-subsidiary debt guarantees from April 1998, and

• resolution of all existing cross-debt guarantees by the year 2000.
B-281526

Page 17 GAO/GGD-99-157 Asian Financial Sector Reforms

In May 1998, Korean creditor banks began to assess the viability of large

client firms showing signs of financial weakness. According to Korea’s

Ministry of Finance and Economy, creditor banks listed 55 firms as

nonviable, with outstanding loans of approximately 5 trillion won or about

$4.2 billion, and denied new credit to them, effectively putting them out of

business. Corporate workout programs also were extended to small- and

medium-sized Korean firms.

Although there are signs of more corporate workouts taking place, there

remain impediments in Korea to restructuring the large corporations

(chaebols). Large Korean chaebols are reported to still wield considerable

power and have cross-shareholdings that complicate liquidation. For

example, bank managers and financial analysts we met with in Korea said

that different companies within a chaebol or industrial group have

guaranteed each other’s loans, making it difficult to determine who

ultimately was responsible for repayment or to resolve any delinquent

loan. In addition, the chaebols have reported raising additional foreign

financing due to the economic recovery, and Korean banks have continued

to provide lending to the chaebols, according to the Korean Ministry of

Finance and Economy and the Financial Supervisory Commission.26

To encourage banks to restructure their holdings of corporate debt,

Thailand’s government relaxed classification rules for nonperforming

loans. Under the relaxed rules, nonperforming loans are classified as

performing immediately upon restructuring, subject to certain conditions,

instead of after what was previously a 3-month wait. In addition, it granted

more favorable tax treatment to both borrowers and creditors for

forgiveness of indebtedness and transfers of loan collateral, which is to be

in place until December 1999.

To mediate debt workouts, the government of Thailand established a

Corporate Debt Restructuring Advisory Committee with representatives

from the financial and corporate sectors and chaired by the Bank of

Thailand. Thailand’s voluntary approach, called the “Bangkok Approach,”

is a noncompulsory framework, that companies are encouraged to follow

in corporate workouts involving multiple creditors. Some financial market

 26Korea established the Financial Supervisory Commission to handle the majority of restructuring

related responsibilities during the crisis. Korea also established the Financial Supervisory Service in

January 1999 as a universal financial system supervisor that combines the former banking, nonbanking,

insurance and securities supervisors. The Financial Supervisory Commission governs the Financial

Supervisory Service. At the time of our visit to Korea, the reform activities were referred to broadly

under the auspices of the Financial Supervisory Commission. Throughout the report, we will refer to

their activities as the Financial Supervisory Commission, which includes the Financial Supervisory

Service. To date, distinctions between the two were becoming more apparent.
B-281526

Page 18 GAO/GGD-99-157 Asian Financial Sector Reforms

experts have viewed progress as being slow. As of May 1999, the

Committee’s efforts resulted in approximately 137 successfully

restructured cases out of the 680 companies focused on and had several

hundred more cases still pending. To expedite the process of restructuring,

a binding debtor-creditor plan and intercreditor agreement have emerged

from the private sector. The debtor-creditor plan is a binding agreement,

that commits signatories to follow a set framework for debt restructuring.

As of June 1999, 84 local and foreign financial institutions, including all

Thailand banks, finance companies, all foreign banks, and 300 debtor

firms, had signed the agreements and begun the process, according to IMF.

As part of the IMF and World Bank reform programs to strengthen the

financial sector, the three countries needed to make changes in their legal

and administrative systems. The nature of the changes differed among the

countries, however, reflecting each country’s legal, administrative, and

judicial systems that existed before the changes began. Because of their

importance in resolving loans to insolvent borrowers, changes to

bankruptcy laws have been among the most important changes in the legal

structure underlying the financial systems of these countries.

The World Bank has encouraged the three countries we reviewed to

provide the necessary legal framework for systemic restructuring.

Rebuilding the legal system at the same time that the banking system and

corporate sector are being restructured, according to the World Bank,27

means establishing

• transparent forms of ownership that clearly define liability of borrowers;

• judicial and alternative dispute resolution procedures to enforce contracts;

• a modern regime of secured lending, including the possibility of secured

interests in all forms of property as well as accurate, maintained, and

publicly available registries for all properties used as collateral; and

• procedures and institutions to permit foreclosure on collateral in a timely

and efficient manner.

Without such solid legal foundations, the World Bank warned that any

systemic bank restructuring, no matter how successful it appears, will

stand only until the next banking crisis.

Changes in foreclosure procedures and bankruptcy law were important for

all three countries. These laws are intended to provide a credible and

 

27“Systemic Bank and Corporate Restructuring: Experiences and Lessons for East Asia,” Stijn Claessens

and Margery Waxman, The World Bank Group, 1998.

Countries Have Initiated

Legal and Administrative

Changes
B-281526

Page 19 GAO/GGD-99-157 Asian Financial Sector Reforms

transparent way to resolve the debts, including bank loans, of insolvent

borrowers, according to IMF documentation. For example, in Thailand, the

law provided few options—a foreclosure could take up to 10 years in the

courts. In 1998 and 1999, Thailand changed its bankruptcy law, although

there was substantial political opposition because some of the legislators

feared that they would become liable for loans that they had personally

guaranteed, according to various officials. Indonesia also changed its

bankruptcy laws, which dated back to Dutch colonial rule, but problems

remain in the ability of the courts to enforce the newly established

commercial law. Whether or not the new commercial court can

expeditiously process bankruptcy applications is an open question,

according to a State Department official. Indications of success in

implementing changes in the laws of Indonesia and Thailand would

include faster resolution of bankruptcy cases in a more transparent

manner.

The countries also changed other laws affecting the structure and

operation of businesses. In Korea, a change in the law to eliminate crossguarantees within subindustry groups by the end of March 2000 could have

substantial effects on corporate governance. Indonesia also eliminated

some restrictive marketing arrangements.

Appendix III discusses these changes in greater detail.

To improve data disclosure and transparency, the countries we studied are

taking steps towards adoption of international accounting standards. It has

been broadly recognized that there is a need for international accounting

standards. Two broad overlapping approaches include standards

developed by (1) the Financial Accounting Standards Board, which are

followed in the United States, called the U.S. Generally Accepted

Accounting Principles (GAAP) and (2) the International Accounting

Standards Committee, which are followed by many other industrialized

countries, called the International Accounting Standards (IAS).

Accounting, which is the primary method of recording economic

transactions and provides the information required for businesses to

operate, is vital for a developed market economy. The lack of good

accounting data adds an element of risk (and cost) to all economic

transactions, especially for the banking system, which relies on financial

statements for credit decisions. A set of accounting standards provides a

first step to providing this information; further steps (not addressed in this

report) would include developing a strong, independent audit function to

verify that businesses’ financial data are prepared in accordance with

Indonesia, Korea, and

Thailand Are Taking Steps

Towards Adoption of

International Accounting

Standards
B-281526

Page 20 GAO/GGD-99-157 Asian Financial Sector Reforms

these standards. World Bank officials told us that there is a need not only

for international accounting standards but for use of truly independent

international auditors as opposed to state auditors or local franchisees of

international firms.

For example, the Business Advisory Council of the Asia-Pacific Economic

Cooperation (APEC) organization has reported that

“ [I]nformation is a crucial ingredient for investor confidence and participation. Building

long-term investor participation depends on transparent financial information based on

clear accounting rules and full disclosure of material information. Lax accounting and

disclosure standards impede capital formation by damaging the credibility of an economy’s

capital market and reducing participation in it . . . . Use of recognized accounting standards

attracts investors and enhances the ability to tap debt and equity markets for new capital.”

The World Bank requires the use of international accounting standards in

preparing financial statements to improve comparability between projects

and countries. If a country’s accounting practices do not meet

international accounting standards, it must disclose any material

departures from those standards and the impact of those departures on the

financial statements presented.

The recent economic crisis highlighted the need to adhere to international

accounting standards. For example, Korea had not adopted international

accounting standards prior to the 1997 crisis. A complicating factor in

Korea’s financial crisis was that the level of usable reserves at the central

bank, the amount of short-term debt of commercial banks, and the

magnitude of corporate cross-guarantees were not readily apparent from

publicly available data.28

As Korea began its financial sector reforms, it became necessary for Korea

to modify its accounting standards. Many officials we spoke with in Korea

said they considered the improvement of accounting standards in Korea to

be a major reform. In December 1998, as an effort to improve

transparency, credibility, and international comparability of financial

information, Korea’s Financial Supervisory Commission issued guidance to

upgrade accounting standards to the level of international standards.

Among others, the IMF and World Bank required the Korean government

 28According to Treasury officials and IMF documents, a leak of IMF documents to the press revealed

specific information on two Korean banks as well as the low levels of usable international reserves that

had not been readily available from public sources.

Koreans Adopting International

Accounting Standards
B-281526

Page 21 GAO/GGD-99-157 Asian Financial Sector Reforms

to upgrade accounting standards and disclosure rules to meet international

standards, including meeting IMF’s data dissemination standards.29

Korea’s accounting reform process has proceeded in several areas,

including (1) defining which financial accounting standards will be the

primary sources of Korean generally accepted accounting principles, (2)

establishing accounting standards for financial institutions, and (3)

establishing accounting standards for combined financial statements.

According to Korean government documents, Korea set international

accounting standards established by the International Accounting

Standards Committee as its benchmark. Where international accounting

standards do not exist or are not sufficient to address particular

accounting issues, Korea plans to adopt U.S. standards as an alternative

benchmark. For example, the Financial Supervisory Commission

established accounting standards for combined financial statements for

firms subject to external audit for fiscal years starting on or after January

1, 1999. Korea also revised its standards to eliminate the alternative

treatment for the foreign currency gains or losses. As a result, firms must

recognize any gains or losses arising from foreign currency translation in

the current income statement, regardless of its source. However,

according to OCC, improvement is still needed in many areas, including

financial statement disclosure and nonperforming loan classification.

The Korean government also announced in November 1998 that it had

implemented several improvements in its debt reporting system, based on

recommendations by the IMF and the World Bank. For example, the

Korean government adjusted its reporting of total external liabilities to

consider the results of a comprehensive loan-by-loan survey of outstanding

external liabilities and the introduction of several methodological

improvements to incorporate best international practices. Some of these

changes included improved sectional classification, exchange rate

valuation adjustments, consolidated reporting of preshipment export

financing liabilities, and comprehensive reporting on residents’ holding of

offshore foreign debt instruments.

Thailand and Indonesia also had to modify their accounting standards to

meet international standards. However, there was less emphasis on

improving accounting standards in Thailand because the quality of

financial information was better than in the other East Asian countries,

according to an IMF official. The Bank of Thailand has completed a review

of current accounting, auditing, and disclosure requirements for financial

 

29For more information on IMF’s data dissemination standards see GAO/GGD/NSIAD-97-168.

Thailand and Indonesia Have

Made Accounting Changes
B-281526

Page 22 GAO/GGD-99-157 Asian Financial Sector Reforms

institutions; and new specific rules on accounting, external auditing, and

financial disclosure are expected to be issued for banks and finance

companies and other financial institutions by the end of December 1999. In

Indonesia, the IMF conducted a review concerning Indonesia’s adopting

and implementing accounting and auditing rules that meet international

standards. As of July 1999, Indonesia had not made substantial changes to

its accounting practices, according to a World Bank official. However, in

recent months, as part of the IMF supported program, audits based on

international standards by international firms were initiated for key

financial institutions, including the central bank. Decisions on bank

closures and recapitalization have been made on the basis of these audits.

World Bank officials told us that, although work remains to be done on

accounting issues, Indonesia’s use of an international approach in

classifying loans and provisioning for losses has dramatically improved the

accuracy of bank financial statements.

As part of their commitment to overhaul the weak and noncompetitive

financial system, the study countries have eased some restrictions so that

foreign banks are more free to compete with domestic banks for the

provision of financial services.30 The over-reliance of debt financing from

domestic banks and restrictions on financing through foreign financial

institutions contributed to the weak financial systems in these countries.

Obstacles remain, hindering full participation by foreign financial services

firms.

Although foreign banks can offer a full range of banking services in

Indonesia, U.S. banks reported some restrictions relating to ownership,

computation of capital, personnel, and directed lending, according to U.S.

Treasury documentation. The government of Indonesia is easing

restrictions on foreign bank participation in the market for Indonesian

financial services. The Indonesian government promised, in its June 1998

letter of intent with IMF, to lift all restrictions on foreign ownership of

banks as it amended the banking law. Foreign ownership of publicly listed

banks was limited to 49 percent of outstanding shares. The government

promised to eliminate discriminatory capital requirements for joint venture

banks31 by the end of 1998. Under prior rules, these banks were required to

have twice the capital of domestic banks, and capital was computed using

 

30A U.S. Treasury official told us that although foreign banks are receiving some benefit from relaxed

restrictions, other financial services providers, such as securities and insurance firms, have not

benefited from the easing of restrictions.

31Joint venture banks have been permitted since 1988, provided that the local joint venture partner has

an equity interest of at least 15 percent.

Countries Have Eased Some

Restrictions on Competition

From Foreign Banks
B-281526

Page 23 GAO/GGD-99-157 Asian Financial Sector Reforms

only capital of the branch and not the capital of the parent bank. There are

restrictions on the number of work permits a foreign company could

obtain for foreign nationals. Also, foreign banks are limited to opening

branches in Jakarta and seven other cities in Indonesia. Finally, U.S. banks

reported difficulties complying with a government regulation requiring 20

percent of new lending to go to small- and medium-size enterprises,

according to the U.S. Treasury Department. On March 25, 1999, Indonesia

issued regulations for implementing the banking law amendments,

clarifying that all legal and administrative restrictions to the entry of

foreign investment into the banking system had been removed.

Korea has undertaken reforms that substantially liberalize its capital

markets, well beyond commitments undertaken when Korea joined the

Organization for Economic Cooperation and Development in 1996. In

addition, restrictions on foreign investment in Korea have been largely

dismantled. Korea, under its IMF program, allowed foreign banks to

purchase equity in domestic banks without restriction, provided that the

acquisitions contributed to the efficiency and soundness of the banking

sector. Korea also made changes to allow foreign financial institutions to

participate in mergers and acquisitions of domestic institutions. Despite

improvements, according to the U.S. Treasury’s National Treatment Study,

foreign banks operating in Korea continue to face competitive barriers.

The major problem continues to be the requirement to consider local

branch rather than parent company capital. This affects foreign banks’

funding and lending operations.

The presence of foreign banks in Thailand has increased in recent years

and now accounts for about 13 percent of commercial bank assets,

according to the Bank of Thailand. Until the 1997 financial crisis, there

were several restrictions on foreign banks operating in Thailand, according

to U.S. Treasury documentation. For example, foreign banks had a 25

percent ceiling on their ownership of domestic banks. After the crisis,

Thailand relaxed foreign bank ownership regulations to allow majority

foreign ownership for banks for a 10-year period to facilitate

recapitalization of the financial sector. However, after a 10-year period the

foreign banks cannot increase their existing holdings in Thailand banks,

according to IMF. Other restrictions also limit the expansion of foreign

banks in Thailand, including a limit on the number of branches, legal

lending limits based on locally held capital of the foreign branch, and limits

on the number of expatriate managers, according to U.S. Treasury

documentation.
B-281526

Page 24 GAO/GGD-99-157 Asian Financial Sector Reforms

All three of the countries we examined have begun changing their bank

supervisory and regulatory systems to meet international standards. In

particular, the countries have begun to change their supervisory systems to

align them with the Core Principles for effective supervision developed by

the Basel Committee on Bank Supervision, as discussed earlier. Similarly,

they have adopted or are currently implementing capital adequacy

regulations for banks that are based on the framework developed by the

Basel Committee, the Basel Capital Accord. Like most countries, however,

Indonesia, Korea, and Thailand do not adhere to all of the principles.

While these changes are being made, the impact that they will have on the

business of banking in the three countries is not yet clear. Changes in

supervision and regulation are only part of the necessary changes affecting

banking and financial services—legal and accounting changes, among

other “preconditions” for effective bank supervision, are also important.

Further, some of the changes in supervision and regulation are inherently

long term. For example, it will take time to develop a cadre of bank

examiners who have experience with the new standards.

A survey by the Basel Committee found that many nations have not fully

implemented the Core Principles. Relying on self-assessments by the 124

member countries, the Committee noted several common themes that we

also observed in the three study countries, including

• the difference between “having a regulation in place and having the

regulation effectively implemented,”

• the inability to attract and retain qualified staff to fully implement the Core

Principles, and

• not having a framework setting limits on concentration of lending and on

connected lending.32

Table 2 profiles the steps that Indonesia, Korea, and Thailand have made in

adopting selected international standards for bank supervision and

regulation.

 32Connected lending concerns loans extended to bank owners or managers and their related

businesses. The associated risks are the lack of objectivity in credit assessment and undue

concentration of credit risk.

International Bank

Supervisory Principles

Partially Implemented
B-281526

Page 25 GAO/GGD-99-157 Asian Financial Sector Reforms

International standard Indonesia Korea Thailand

Preconditions

Operational independence:

International standards call

for an effective bank

supervisory system with clear

responsibilities for each

agency involved and with

operational independence for

the supervisors to take

actions in good faith, free

from political pressure.

According to the Banking Act of

1992 and its amendments and the

Bank Indonesia Act of 1999, Bank

Indonesia has its independence as

the sole banking supervision

authority in Indonesia. Bank

Indonesia has the right to supervise

both commercial and rural banks.

The right to supervise banks

comprises the right to license, the

right to regulate, and the right to

impose sanctions.

Korea established the Financial

Supervisory Commission

effective April 1, 1998, and the

Financial Supervisory Service in

Jan. 1999, combining existing

banking, securities, and

insurance supervisory agencies

to provide (1) consistent

oversight to all financial

industries, and (2) operational

independence from the Ministry

of Finance and Economy.

Bank of Thailand’s operational

independence is to be

strengthened in a future Central

Bank Act.

Licensing and structure

Licensing: International

standards call for applicants

to be qualified as a way to

better ensure that a bank is

operated in a safe and sound

manner.

Bank licensing authority was moved

from the Ministry of Finance to Bank

Indonesia to lessen political

influence. Conditions for

establishing new banks have been

tightened: sources of capital are to

be scrutinized; bank owners and

managers must pass a fit and

proper test; organization, ownership

structure, and operating plans and

projected financial condition are

assessed. Foreigners may now own

up to 99 percent of Indonesian

banks.

Licensing authority was granted

to the Financial Supervisory

Commission in April 1999. Prior

to this, the authority for licensing

and revoking licenses had been

with the Ministry of Finance and

Economy.

Issued regulations regarding

finance company entitlement to

a banking license. The Ministry

of Finance is the licensing

authority.

Prudential regulation

Capital Adequacy:

International standards set

by the Basel Committee

provide for minimum capital

levels that reflect, in part, the

risks that a bank has in its

loan portfolio.

Bank Indonesia has a set of capital

requirements based on international

standards. Indonesian banks are to

hold capital equal to 4 percent of

risk-weighted assets by end-1999

and 8 percent at end-2001, which is

consistent with the Basel Capital

Accord.

The Financial Supervisory

Commission has adopted the

Basel Capital Accord for

internationally active banks,

phasing them in by Dec. 2000.

—by March 1999, banks were to

have at least a capital ratio of 6

percent (using international

accounting standards);

—by March 2000, banks’ capital

ratio is to be at least 8 percent;

—by Dec. 2000, banks’ capital

ratio is to be at least 10 percent.

The capital adequacy ratios

were changed in 1998 to comply

with Basel Capital Accord.

Capital adequacy standards in

Thailand are to be based on

classification and provisioning

standards that are to come into

full effect in 2001.

Table 2: Implementation of Selected International Supervisory Principles in Indonesia, Korea, and Thailand
B-281526

Page 26 GAO/GGD-99-157 Asian Financial Sector Reforms

International standard Indonesia Korea Thailand

Loan classification

Loan loss provisioning:

International standards call

for banks to establish and

adhere to policies for

evaluating the adequacy of

loan loss reserves.

The five loan classification

categories are pass, special

mention, substandard, doubtful, and

loss, with respective provisioning of

1 percent, 5 percent, 15 percent, 50

percent, and 100 percent. The

general loan loss reserve was

increased from 0.25 percent of the

loan portfolio to 1.0 percent.

Provisions for “precautionary

assets” were increased from 1

percent of assets to 2 percent.

For substandard loans, reserves

are to be 20 percent; for

doubtful loans, 75 percent; and

for loss, 100 percent.

Korea revised its criteria for the

calculation of capital ratios to

prevent counting reserves for

loans classified as substandard

or lower as part of a bank’s

capital by deducting the

provisions of those classified as

substandard or lower from a

particular class of capital.

Loan-loss provisions will also be

required for payment

guarantees of commercial

banks.

Regulations reflected an

increase in loan loss reserves

for 5 categories.

—Pass is 1 percent,

—Special mention is 2 percent,

—Substandard is 20 percent for

unsecured loans,

—Doubtful is 50 percent for

unsecured loans, and

—Loss is 100 percent for

unsecured loans.

The substandard classification

historically had no

provisioning—it was changed to

15 percent in 1997 and to 20

percent in 1998.

The provisioning for the doubtful

loans changed from 100 percent

to 50 percent for unsecured

loans.

Lending limits: International

standards call for lending to

related companies and

individuals on an arm’slength basis and limits

restricting bank exposures to

single borrowers or groups of

related borrowers.

Bank Indonesia’s rules on legal

lending limits are the same as

international rules. Bank Indonesia

has said that it will enforce a limit on

loans to one borrower or one group

of borrowers. For a single borrower

or group of borrowers related to a

bank there is a 10 percent rule—

lending can be no more than 10

percent of bank capital. For

borrowers not related to the bank

the rule is a maximum of 30 percent

from December 1998 to 2001, a

maximum of 25 percent by 2002,

and 20 percent by 2003.

To address Korea’s corporate

networks of cross-guarantees,

Korea set banks’ equity capital

limit to 25 percent for lending to

large shareholders and their

affiliates, and other restrictions

on connected lending. The

excess over the 25 percent limit

is to be progressively reduced

and eliminated by Jan. 1, 2001.

On directed lending, Korea

requires banks to provide 35

percent of new wondenominated lending to small

and medium-sized companies.

A new law on commercial

banking and financial institutions

that includes lending limits is

being drafted.

Foreign exchange exposure:

International standards call

for banks to have adequate

ways to manage international

risks and adequate reserves

against these risks.

Banks are to limit net open foreign

exchange positions (i.e., unhedged

exposures) to 20 percent of capital

by June 2000. Bank Indonesia also

increased reporting requirements on

foreign exchange transactions so

that exposure is to be reported daily

in a consolidated form.

Introduced control systems on

funding and maturity gaps of

banks’ foreign exchange

exposure and expanded its

monitoring of foreign exchange

exposures to include offshore

accounts.

As of October 1998, banks were

limited to net open foreign

exchange positions of 15

percent.
B-281526

Page 27 GAO/GGD-99-157 Asian Financial Sector Reforms

International standard Indonesia Korea Thailand

Methods of ongoing supervision

On-site supervision:

International standards call

for independent validation of

supervisory information

either through on-site

examinations or use of

external auditors.

Bank Indonesia has about 400 bank

examiners for regular examinations

and, when necessary, can employ

public accounting firms to examine

banks.

The Financial Supervisory

Commission was revising its

guidebooks on examination

regulations and providing

additional training for its

supervisors.

Examination guidebooks are

being revised and supervisors

are being provided with

additional training. A World

Bank official noted that

considerable technical

assistance is planned in this

area.

Off-site supervision:

International standards call

for supervisors being able to

do off-site monitoring to

identify potential problems,

thereby providing early

detection and prompt

corrective action before

problems become more

serious.

Bank compliance directors are to

analyze compliance with banking

regulation and report monthly.

Enforcement warnings can only be

issued twice prior to removal of

bank management.

The Financial Supervisory

Commission is expanding its offsite surveillance system to

capture more data in a more

timely manner.

The Bank of Thailand requires

banks to file reports on their

balance sheets, capital levels,

loan classification, changes in

lending or borrowing, and loans

over 5 million baht (about

$125,000). It plans to develop

an early warning system for

financial system risks.

Formal powers of supervisors

Supervisory authority:

International standards call

for bank supervisors to have

at their disposal adequate

supervisory measures to

bring about corrective action.

Indonesia will establish an

independent bank supervisory body

no later than 2002 to take over the

task of supervising banks in the

Indonesian banking system. Bank

Indonesia will retain its privileges to

examine banks if deemed

necessary.

Korea established the Financial

Supervisory Commission to

separate supervisory power

from the Ministry of Finance and

Economy and gave authority to

the Financial Supervisory

Commission to order prompt

corrective actions in cases of

unsound financial institutions.

Independence remains a

problem for bank supervisors.

Thailand law provides that a

bank supervisor can be held

personally liable for loss to the

state; supervisory staff has

expressed concerns that the law

could be broadly interpreted and

its enforcement could be subject

to political influence.

Information requirements

Financial statements:

International standards call

for banks and other financial

institutions to prepare reliable

financial statements.

Reliability of bank financial

statements is still questionable.

Bank Indonesia is making an effort

to improve the system of bank

reporting and check the accuracy of

reported data. Indonesia has made

some moves towards internationally

accepted accounting standards.

Korea is phasing in international

accounting standards and

requiring firms to report audited,

consolidated financial

statements.

The Bank of Thailand completed

a review of current accounting,

auditing, and disclosure

requirements for financial

institutions and finance

companies. New rules on

accounting, external audits, and

disclosures are to be issued by

Dec. 1999.

Cross-border banking

Global consolidated

supervision: International

standards call for adequately

monitoring and applying

appropriate prudential norms

to all aspects of the business

conducted by banking

organizations worldwide,

including their foreign

branches and subsidiaries.

Bank Indonesia follows the

international standard for crossborder banking.

The Financial Supervisory

Commission increased the

frequency of its monitoring from

quarterly to monthly and

enlarged the scope of

monitoring to include overseas

subsidiaries and off-shore

accounts.

While foreign bank branches are

supervised in the same way as

domestic banks, prior approval

from their home supervisors is

not required and Thailand

supervisors are not authorized

to share information with other

national supervisors. The

commercial banking law, in draft

form, would allow such

information sharing.
B-281526

Page 28 GAO/GGD-99-157 Asian Financial Sector Reforms

Source: GAO analysis.

In each country, progress in implementing international standards for bank

supervision and regulation has to be understood in the context of the

business practices impeding adoption of these measures. The practice of

directed and/or connected lending illustrates these barriers. In all three

countries, directed and or connected lending was a long-standing practice.

In Korea, for instance, connected lending occurred within the chaebol or

industry groups woven together by cross-ownership and loan guarantees

among the companies forming the group. A bank within a group was

expected to provide funding to other companies within the group that held

shares in the bank, in the same manner that the bank is expected to hold

shares in companies to which it made loans. The government would at

least tacitly approve such lending as a means of increasing the economy’s

growth rate. In Indonesia, directed and connected lending were problems,

with many state bank loans going to projects favored by the government

and many private bank loans going to large business conglomerates

associated with private banks.

Connected and directed lending also reflected the inability of banks in the

three countries to analyze the creditworthiness of many borrowers. In the

United States and other industrial countries, credit analysis is possible

because the borrowers’ financial statements are prepared and audited

according to defined and accepted accounting principles. In the United

States, “generally accepted accounting principles” for private companies

are defined by the Financial Accounting Standards Board. Using financial

data prepared under such consistent guidelines allows a bank to

understand the creditworthiness of borrowers. When there are no such

consistent guidelines, however, credit analysis is difficult. Financial

analysts in these countries noted that bank managers had not relied on

credit analysis to lend. Rather, lending decisions in these countries had

been made by the reputation of the borrowers—those who were “well

connected” would be considered better credit risks than other borrowers

because it was considered likely that the government would guarantee the

loan. Progress in implementing rules against connected and directed

lending, and in seeing bank loan decisions based on credit analysis, thus,

depends on progress in implementing accounting standards.

Another reform effort undertaken in these three countries included

strengthening the authority and operational independence of their

financial supervisors. The Basel Committee reported that the responses to

its survey on the protection of supervisors revealed that approximately
B-281526

Page 29 GAO/GGD-99-157 Asian Financial Sector Reforms

one-third of the respondents have yet to develop legal protection for their

supervisors, although some were drafting new regulations to do so.

Supervisors lacking operational independence from political pressure and

having inadequate supervisory powers to bring about corrective actions

were contributing factors to the recent financial crisis in the three

countries we studied.

The international standards require a clear, achievable, and consistent

framework of responsibilities and objectives be set by the government for

the supervisors. However, the standards also require that supervisors have

operational independence to pursue their objectives, free from political

pressure and with accountability for achieving them. Banking supervisors

also must have at their disposal adequate supervisory measures to bring

about corrective action when banks fail to meet prudential requirements,

such as minimum capital adequacy ratios, when there are regulatory

violations or where depositors are threatened in any other way.

Implementing these standards has posed challenges for the three countries

studied. For example, a major reform in Korea was its establishment of the

Financial Supervisory Commission in April 1998 and the Financial

Supervisory Service in January 1999 to provide consistent oversight to all

financial industries (banking, securities, insurance, and nonbank

institutions). Korea strengthened the formal powers of its financial

supervisors by granting them operational independence from the Ministry

of Finance and Economy and consolidating financial supervision into one

agency (formerly four). However, according to Korean officials, 10 to 12

positions at the newly established agency were filled with former Ministry

officials, who could rotate back to their Ministry positions after a few

years. In addition, the Financial Supervisory Service was staffed with the

same supervisors who had previously been at the Bank of Korea.

According to officials we spoke with in Korea, this raised questions about

the independence of the new Financial Supervisory Commission. They

asserted that it would take time for the new agency to operate

independently of the Bank of Korea and the Ministry of Finance and

Economy.

Korea also adopted prompt corrective action procedures to strengthen its

financial supervisory powers. For example, the Financial Supervisory

Commission established a three-step corrective measure to be imposed on

unsound financial institutions, according to the seriousness of problems.

For unsound financial institutions, the Financial Supervisory Commission

can now order a management improvement that includes the merger of

banks, the firing or suspension of senior managers, appointment of an
B-281526

Page 30 GAO/GGD-99-157 Asian Financial Sector Reforms

acting manager, transference of operations, and merger or purchase and

assumption, among other measures. Korean officials we met with said that

one sign of progress would be if the Financial Supervisory Commission

took corrective action against a Korean bank. There has been one such

action recently. According to a Ministry of Finance and Economy press

release in June 1999, the Financial Supervisory Commission designated a

bank as a nonviable financial institution under provisions of the new law.

The bank is to be subject to an order, whereby funds are to be sought

through the Korea Deposit Insurance Corporation and the Korea Asset

Management Corporation to purchase the bank’s nonperforming loans and

recapitalize the bank.33 According to Korean documents, additional funding

may be needed in the course of selling the bank to a foreign buyer or to

add more provisioning as the bank reclassifies its loans.

Bank supervisors in Thailand may be held personally liable for loss to the

state without immunity for their job performance under the Government

Enterprise Act. This act effectively states that if a supervisor causes loss to

a government entity through the course of his work, he/she can be

criminally prosecuted. Both the issues of losses and application of the law

are broadly defined and could potentially be subject to political influence.

While bank supervisors want to change this law, many of the legal staff at

the Bank of Thailand opposed the change, reasoning that a supervisor who

is properly performing his/her duties would not be subject to liability.

According to a World Bank official, this issue was still unresolved.

Progress in fully implementing some of the international standards will

take time. The ability to conduct effective onsite examinations is a key

component of adherence to the Basel Core Principles. The effectiveness of

the examination, in turn, depends on the qualifications of the examiner

staff and its experience. In the United States, for instance, while the bank

supervisory agencies have extensive formal training programs for

examiner staff, they rely heavily on on-the-job training for developing

qualified examiners. Officials at these agencies said that, as a rule of

thumb, it takes about 8 years for an examiner to become fully qualified.

While the United States and other governments have provided training and

technical assistance to the bank and financial supervisory agencies in

Indonesia, Korea, and Thailand, the supervisors in these three countries

have not had time to develop an examiner staff with experience operating

under the international standards that the countries have recently adopted.

 33The Korea Deposit Insurance Corporation provides capital to banks in return for an equity stake in

the bank. The Korea Asset Management Corporation purchases and sells nonperforming loans from

distressed banks.
B-281526

Page 31 GAO/GGD-99-157 Asian Financial Sector Reforms

While national authorities have the primary authority for addressing

banking problems, the United States and other industrial nations have

provided assistance to Indonesian, Korean, and Thailand efforts to

improve their financial supervisory systems. Much of this assistance has

been provided through international financial institutions, such as the

World Bank or IMF. The assistance has two related components:

• promoting financial stabilization and addressing the immediate causes of

the financial crises affecting these countries, and

• promoting reforms to build a stronger framework for financial supervision

and regulation to minimize the likelihood of a recurrence.

In promoting financial stabilization and addressing immediate causes and

consequences of the financial crises, the United States and the

international financial institutions have provided technical assistance and,

in the case of international financial institutions, funding to enable the

countries to close nonviable banks, to resolve nonperforming loans, and to

restructure and/or recapitalize open institutions. The United States and the

international financial institutions also support longer-term efforts to

increase the competency of the supervisory agencies in the three

countries. Finally, when possible, the United States and international

financial institutions have sought to promote the political independence of

the regulatory process.

While the Basel Committee does not provide direct assistance to countries

that are changing their systems, its standards for bank supervision and

regulation provide guidance both to the countries and to the international

organizations that provide assistance. It counts on countries to adopt and

implement its principles voluntarily. However, the Basel Committee does

not assess international compliance with these standards. Rather, it relies

on self-reporting by countries on how they have implemented the bank

supervisory standards. In 1994, we recommended that federal bank

regulators seek an expanded role for the Basel Committee in fostering

greater international implementation of the supervisory standards.34 We

suggested that Basel Committee could facilitate a peer review process for

bank supervisors that would provide independent, expert assessments of

implementation of the Core Principles and guidance on possible

improvements.

 

34See International Banking: Strengthening the Framework for Supervising International Banks

(GAO/GGD-94-68, Mar. 21, 1994).

Bilateral and

Multilateral

Approaches to the

Challenges of Financial

Sector Reform in

Emerging Markets
B-281526

Page 32 GAO/GGD-99-157 Asian Financial Sector Reforms

IMF, the World Bank, and other international financial institutions that

provide direct assistance use the Basel principles in assisting countries to

strengthen their supervisory arrangements in connection with their work

aimed at promoting financial stabilization and supporting improved

supervisory qualifications. To the extent that Basel principles for banking

supervision are conditions of funding, then these international financial

institutions judge compliance with these principles by countries receiving

financial assistance.

In each of the three countries we examined, the immediate objective of

international assistance to restructure the financial systems was to assist

the countries efforts to close nonviable banks, resolving nonperforming

loans, and restructuring and recapitalizing remaining institutions.

In the aftermath of the financial crises in Indonesia, Korea, and Thailand,

IMF has been providing financial assistance to these three countries. IMF

assistance, however, is conditioned on a country undertaking policy

reform intended to address the underlying cause of the crisis.35 In each of

the three countries, weaknesses in their financial systems were major

elements leading to the crises, according to the IMF, so each country’s

agreement with IMF stipulated actions that the country was to take to

address these weaknesses. These conditions covered

• closure of insolvent financial institutions, with their assets transferred to a

resolution or restructuring agency, merger of other institutions,

recapitalization of some institutions;

• announcement of limited use of public funds for bank restructuring, with

actual funds made explicit in country budgets;

• measures to significantly strengthen prudential regulations, including loan

classification and provisioning requirements, and capital adequacy

standards;

• measures to strengthen disclosure, accounting and auditing standards, and

the legal and supervisory frameworks;

• efforts to liberalize foreign investment in ownership/management of

banks;

• the introduction of more stringent conditions for official liquidity support;

• strengthening prudential regulation on loan exposure;

• the introduction of a funded deposit insurance scheme; and

• restructuring domestic and external corporate debt and closing nonviable

firms.

 

35See International Monetary Fund: Approach Used to Monitor Conditions for Financial Assistance

(GAO/GGD/NSIAD-99-168, June 22, 1999).

Promoting Financial

Stabilization
B-281526

Page 33 GAO/GGD-99-157 Asian Financial Sector Reforms

In Indonesia, for instance, conditions for financial assistance included

closing banks with capital ratios worse than negative 25 percent, and those

between negative 25 percent and positive 4 percent that did not submit

acceptable plans for their revitalization, merging four large banks and

transferring their problem loans to IBRA, and submitting a draft law to the

Parliament to institutionalize Bank Indonesia’s autonomy.

The IMF has also supported the process of coordinating workout efforts

between international creditors and debtors in resolving severe private

sector financing problems. Included in this process is IMF’s pursuit of

more effective bankruptcy laws at the national level. Bankruptcy reform

has been a particularly contentious issue in Thailand, for instance.

In addition to assisting the immediate need to foster financial stability,

international assistance sought to promote longer-term improvements in

bank and financial market supervision. The assistance sought to help the

countries strengthen supervisory institutions so that they would be

independent of political interference and would have adequate authority to

achieve their goals. International assistance also sought to increase the

technical qualifications of the supervisors through training programs.

IMF has also provided technical assistance on banking sector issues. In

Indonesia, for instance, IMF has provided a long-term advisor to Bank

Indonesia from the Bank of France as well as a payments system expert

from New Zealand. IMF has provided technical assistance in drafting the

new Bank Indonesia law. IMF has funded training of bank supervisors by

finance officials from Australia, Japan, and the United States. In Thailand,

IMF has taken the lead role in such areas as strategies for commercial

banks, legal frameworks for the central bank law, laws for supervisory

agencies and deposit insurance, and other banking laws.

The World Bank is also currently providing financial assistance for

Indonesia,36 Korea,37 and Thailand.38 Part of the overall assistance package

is directed at supporting financial sector reform and principles for a

framework for restructuring corporate debt. In the financial sector the

World Bank played an especially important role in

 36In Indonesia, the World Bank disbursed $899 million in 1997 and $1.2 billion in 1998.

37In Korea, the World Bank disbursed $3 billion in 1997 and $2 billion in 1998.

38In Thailand, the World Bank disbursed $365 million in 1997 and $700 million was approved for 1998.

Promoting Reforms to

Minimize the Likelihood of

Recurring Crises
B-281526

Page 34 GAO/GGD-99-157 Asian Financial Sector Reforms

• formulating and implementing the strategy for dealing with commercial

banks, finance companies, and for specialized institutions;

• assessing the solvency of the banking system and the standing of main

institutions, based on bank audits;

• developing plans for dealing with insolvent institutions, for disposing of

the assets of closed banks, and for handling the nonperforming assets of

banks that were to be publicly supported;

• improving the overall financial infrastructure including strengthening bank

supervision and redesign of prudential regulation according to the Basel

standards;

• providing expertise on instituting deposit insurance schemes;

• updating banking laws to include provisions that had been lacking,

including limitations on cross-ownership between banks and enterprises;

and

• stengthening the development of money markets and capital markets

through the encouragement of new institutional investors, asset

securitization, standardization of government bond issues, and

improvement of securities market prudential regulation and selfregulation.

The World Bank is seeking to promote more sound, more competitive, and

better supervised banking systems. The goal of one loan was to rebuild an

efficient financial sector, contain further bank losses, and protect

productive assets of corporations by

• completing portfolio reviews for banks,

• establishing an independent review committee to verify the sound and

transparent functioning of the Indonesia Bank Restructuring Agency, and

• establishing a framework that defines the government’s participation in

restructuring of private corporate debt.

The World Bank and IMF also mare seeking to effect change through a

joint effort with the government of Canada to create the Toronto

International Leadership Center for Financial Sector Supervision. The

objective of this center is to strengthen financial markets by enhancing the

leadership capabilities of public sector executives whose responsibilities

include banking supervision. The center uses a program of classroom

sessions where financial supervisors share their experiences about

financial institution and systemic failures and rescues with other financial

authorities. Program components include

• dealing with owners and managers of problem institutions,
B-281526

Page 35 GAO/GGD-99-157 Asian Financial Sector Reforms

• using the media and rating agencies to increase public understanding of

risks and issues,

• insulating the supervisor from personal legal risk,

• keeping politicians abreast of potential risks in the system,

• promoting change within the supervisor’s institution, and

• developing reporting procedures that keep information flowing up.

The World Bank is also providing technical assistance for financial sector

reform in Indonesia, Korea, and Thailand. In Indonesia, the World Bank

financed a firm of international consultants to advise the Indonesia Bank

Restructuring Agency. The World Bank financed the hiring of a number of

international accounting firms to perform portfolio reviews of IBRA banks

and state banks. It also financed the hiring of a legal team to assist in

drafting the regulation for establishing IBRA and for the guaranteeing

depositors and creditors. The World Bank also supported the Jakarta

Initiative framework for encouraging debtors to workout their debts with

creditors.

The World Bank has been assisting Korea’s corporate workout program.

The World Bank provided Korea with expertise and a technical assistance

loan of about $33 million to employ outside experts as advisors for the

design and implementation of corporate workout programs. In Thailand,

the World Bank has been involved jointly with the IMF in many of the

financial sector restructuring and supporting policy issues. The World

Bank has taken the lead in coordinating asset disposal, bank audits and

restructuring, and strategies for specialized institutions. In addition, the

World Bank is also developing and revising policies for bank supervision,

prudential regulations, and corporate debt restructuring.

ADB was active in the three-study countries. In Indonesia, the ADB

approved a $1.5 billion loan for Indonesia. Among other actions and in

coordination with the IMF and the World Bank, the loan was directed to

• assess the financial status and, where feasible, restructure existing banks;

• strengthen the supervisory capacity of Bank Indonesia;

• rationalize the supervision and regulation of nonbank financial institutions;

• rationalize the legal and regulatory environment to facilitate debt recovery

and structural adjustment; and

• improve accountability and transparency in both the public and private

sectors.

ADB has provided financing for the portfolio reviews of the banks not

under IBRA’s control and is to provide expert assistance to Bank Indonesia
B-281526

Page 36 GAO/GGD-99-157 Asian Financial Sector Reforms

to assess bank business plans prepared for the bank recapitalization

program.

In Korea, ADB approved a $4 billion financial sector program loan to

address

• restructuring financial institutions,

• recapitalizing financial institutions,

• strengthening prudential regulation and supervision, and

• capital market liberalization and development.

In Thailand, the ADB approved the Financial Markets Reform Program

Loan to address a variety of issues, including

• undertaking immediate resolution of finance company nonperforming

loans and rehabilitation of unliquidated finance companies;

• establishing institutional structure for resolution and/or rehabilitation;

• undertaking financial restructuring of finance companies;

• strengthening market regulation and supervision, particularly focused on

the Stock Exchange of Thailand (SET) and the Securities and Exchange

Commission (SEC);

• improving risk management;

• facilitating investor-issuer access to the domestic financial market; and

• developing long-term institutional sources of funds by promoting pension

systems.

U.S. agencies have provided bilateral and technical assistance to the

financial supervisory agencies in the three countries, as have other

national governments. Treasury and Federal Reserve officials told us that

they have bilateral meetings with their counterparts in these countries to

encourage changes in their financial systems. U.S. bank supervisors have

been providing technical assistance and training to banks and bank

regulators in these countries, covering such areas as corporate

governance, credit and market risk management, information technology,

and bank supervisory and examination techniques. The Department of the

Treasury, for example, has advisors working with IBRA. OCC and the

Federal Reserve System also provide training for bank supervisors in these

countries.
B-281526

Page 37 GAO/GGD-99-157 Asian Financial Sector Reforms

The Basel Committee does not independently assess the extent to which

countries have adopted international standards for bank supervision,

either in their laws or in practice. The committee’s information on

implementation is based on self-reporting by countries on their actions. In

1998, the committee surveyed countries on their implementation of the

Core Principles and published a report on the survey results.39

In 1994, we recommended that U.S. bank supervisors seek to increase the

Basel Committee’s role in encouraging and monitoring international

implementation of standards for bank supervision.40 One way we suggested

for increasing the committee’s role was to have it perform as a

clearinghouse for information on international supervisory practices. The

committee’s report on its survey of countries is an example of this

clearinghouse role.

We also suggested that the committee could facilitate peer reviews for

bank supervisory agencies desiring such reviews and that the committee’s

role could include providing guidance on the conduct of the reviews,

including safeguarding confidential supervisory information. A U.S.

Treasury official told us that peer review is unlikely to happen and that

monitoring the implementation of bank supervisory and other standards

will most likely be performed by IMF, the World Bank, or another new

entity. We continue to believe that peer reviews could provide a

mechanism for expert, independent assessments of the implementation of

the standards.

The IMF and the World Bank set up a Financial Sector Liaison Committee

to coordinate their efforts and minimize overlap. In general, IMF focuses

on macroeconomic and stabilization issues while the World Bank focuses

on long-term economic development, structural and sectoral economic

reforms. The Liaison Committee seeks to avoid inconsistent advice and

duplicative efforts as well as to help optimize resources and facilitate joint

work—including identification and dissemination of standards and good

practices. However, according to IMF and World Bank officials and

documents, the collaboration, particularly in the early stages of the crisis,

has not always worked. Initially, there were problems in operational

coordination between the World Bank and IMF staffs due to lack of

continuity and differences of opinion. For example, in the early stages of

 

39“Results of the Survey on the Core Principles for Effective Banking Supervision,” Basel Committee on

Banking Supervision, Basel, Switzerland, 1998 (BS/98/103).

40International Banking: Strengthening the Framework for Supervising International Banks (GAO/GGD94-68, Mar. 21, 1994).

Self-Reporting on Countries’

Implementation of

International Standards

Multilateral Institutions Are

Coordinating Assistance

Efforts
B-281526

Page 38 GAO/GGD-99-157 Asian Financial Sector Reforms

responding to the Asian crisis, the IMF undertook a lead role in bank

restructuring—an area of primary responsibility of the World Bank. Letters

of intent, covering financial sector policies that the World Bank was to

take the lead, were negotiated with country governments and IMF staff

without the full involvement of the World Bank staff. However, according

to IMF and World Bank documents, efforts undertaken to resolve these

problems through regular meetings have been generally successful.

Full implementation of the reform agenda will take many years to

accomplish due to the extent of the problems and the enormity of the

changes required. To date, the three countries were still finalizing bank

closings and bank recapitalizations and disposing of assets from distressed

institutions. Accurate accounting is vital for a developed market economy,

and changes in accounting systems are under way. Major challenges lie

ahead in completing the financial sector reforms. More needs to be done to

ensure that bank supervisors have the authority to take prompt corrective

action against failing or insolvent banks. Concerns have been expressed,

by officials in these countries and others, that once IMF and World Bank

money is disbursed, the countries will have less incentive to continue

politically unpopular financial reforms. If the lack of reform results in

diminished access to international capital markets there still may be

sufficient pressure for reform. However, if such access does not diminish,

these countries may continue to be destabilizing influences on the

international financial system.

We requested comments on a draft of this report from the Department of

the Treasury, the Department of State, the Board of Governors of the

Federal Reserve System, the Federal Reserve Bank of New York, OCC,

IMF, and the World Bank. In written comments, Treasury generally

concurred with our analysis of current reform and restructuring efforts in

the financial sectors of Indonesia, Korea, and Thailand (see app. IV). In

written comments, the World Bank found the draft informative and

balanced and described its ongoing initiatives to strengthen financial

sectors (see app. V).

We also received technical comments on a draft of this report from the

Treasury, the Federal Reserve Bank of New York, OCC, IMF, and the

World Bank. These comments were included in this report where

appropriate. The Board of Governors of the Federal Reserve System did

not comment on the draft report. State Department officials told us they

concurred with our report.

Conclusion

Agency Comments and

Our Evaluation
B-281526

Page 39 GAO/GGD-99-157 Asian Financial Sector Reforms

As we agreed with your offices, we plan no further distribution until 30

days from the date of this letter unless you publicly release its contents

sooner. We will then send copies of this report to Representative Jim

Leach, Chairman, and Representative John LaFalce, Ranking Minority

Member, House Committee on Banking and Financial Services;

Representative Benjamin Gilman, Chairman, and Representative Sam

Gejdenson, Ranking Minority Member, House Committee on International

Relations; Senator Phil Gramm, Chairman, and Senator Paul Sarbanes,

Ranking Minority Member, Senate Committee on Banking, Housing, and

Urban Affairs; and Senator Jesse Helms, Chairman, and Senator Joseph

Biden, Ranking Minority Member, Senate Committee on Foreign Relations.

We are sending copies of this report to: the Honorable Madeleine K.

Albright, Secretary of State; the Honorable Lawrence H. Summers,

Secretary of the Treasury; the Honorable John D. Hawke, Jr., Comptroller

of the Currency; the Honorable Alan Greenspan, Chairman of the Board of

Governors of the Federal Reserve System, and William J. McDonough,

President of the Federal Reserve Bank of New York. We are also sending

copies to IMF, the World Bank, the Asian Development Bank, and the

embassies of Indonesia, the Republic of Korea, and Thailand. Copies will

be made available to others upon request.

This report was prepared under the direction of Susan S. Westin, Associate

Director, International Relations and Trade. Major contributors to this

report are listed in appendix VI. If you have any questions please contact

me on (202) 512-8678 or Susan Westin on (202) 512-4128 if you or your

staff have any questions about this report.

Thomas J. McCool

Director

Financial Institutions and Markets Issues
Page 40 GAO/GGD-99-157 Asian Financial Sector Reforms

Contents

1 Letter

Appendix I 42

Objectives, Scope, and

Methodology

44

Indonesia 44

Korea 46

Thailand 48

Appendix II

Weaknesses in the

Financial Systems of

Indonesia, Korea, and

Thailand

51

Indonesia 51

Korea 51

Thailand 53

Appendix III

Legal, Administrative,

and Judicial Changes

in Indonesia, Korea,

and Thailand

Appendix IV 56

Comments from the

Department of the

Treasury

Appendix V 57

Comments from The

World Bank

Appendix VI 59

GAO Contacts and

Staff

Acknowledgments
Contents

Page 41 GAO/GGD-99-157 Asian Financial Sector Reforms

Table 1: Countries Efforts to Improve Their Financial

Systems

13

Table 2: Implementation of Selected International

Supervisory Principles in Indonesia, Korea, and

Thailand

25

Tables

Abbreviations

ADB Asian Development Bank

GDP gross domestic product

IBRA Indonesian Bank Restructuring Agency

IMF International Monetary Fund

OCC Office of the Comptroller of the Currency
Appendix I

Objectives, Scope, and Methodology

Page 42 GAO/GGD-99-157 Asian Financial Sector Reforms

Our objectives were to determine (1) the nature of weaknesses in the

financial sectors of the three countries, (2) the extent to which the

countries have reformed their financial systems, (3) the extent to which

international principles for banking supervision have been implemented by

the countries, and (4) U.S. government and multilateral efforts to effect

changes in the financial sectors of these emerging markets.

To select case study countries, we analyzed emerging market countries

based on several criteria, including U.S. bank exposure, private capital

flows, direct foreign investment, bank intermediation in the economy, and

the history of banking crises to determine how the countries differed. We

selected Indonesia, Korea, and Thailand because they (1) had received

larger capital flows compared with other emerging market countries, (2)

participated in developing the Basel Core Principles for effective

supervision, (3) were geographically proximate, and (4) were receiving

assistance from IMF and the World Bank.

To meet our objectives, we interviewed and obtained documents from U.S.

government officials from the Federal Reserve System and the Federal

Reserve Bank of New York; the Department of the Treasury, including the

Office of the Comptroller of the Currency; the Department of State in

Washington, D.C., and embassy officials in Indonesia, Japan, Korea, and

Thailand. In the United States, we interviewed officials of an association

representing international banks, four U.S.-based banks, and two

European-based banks. We also interviewed officials from international

organizations, including IMF; the World Bank, in Washington, D.C.,

Indonesia, and Thailand; the Asian Development Bank in Indonesia; and

U.S. representatives to the Basel Committee on Banking Supervision in

Basel, Switzerland.

In Indonesia, we interviewed and obtained documents from Indonesian

government officials from Bank Indonesia, the Ministry of Finance, the

Indonesian Bank Restructuring Agency, the Planning Agency, and the

Capital Markets Supervisory Agency. We also interviewed officials in

Inondesia from six U.S.-based commercial and investment banks, five

Indonesian Banks, one Canadian-based bank, one industrial group, and a

business school.

In Korea, we interviewed and obtained documents from U.S. Embassy

officials and Korean government officials from the Ministry of Finance and

Economy, the Bank of Korea, the Finance Supervisory Commission, and

the Bank Supervisory Authority. We also interviewed officials in Korea

from four U.S.-based commercial and investment banks, four Korean
Appendix I

Objectives, Scope, and Methodology

Page 43 GAO/GGD-99-157 Asian Financial Sector Reforms

banks, the Korean Institute of Finance, the Korea Development Institute,

and the Korea Securities Dealers Association.

In Thailand, we interviewed and obtained documents from government

officials from the Bank of Thailand, the Financial Institutions Development

Fund, the Financial Sectors Restructuring Authority, the Asset

Management Corporation, and the Ministry of Finance. We also

interviewed officials from five U.S.-based commercial and investment

banks, five banks and finance companies based in Thailand, and

representatives of the Thailand Bankers Association.

We also reviewed and analyzed documents collected from U.S.,

Indonesian, South Korean, and Thailand government organizations,

international organizations, and private firms. These documents included

books, official correspondence, legislation, memorandums, regulations,

reports, IMF and World Bank assessments of policies on financial sector

reforms, letters of intent (public and nonpublic), World Bank project

documents, Department of State cables, and testimony. Information,

observations, and conclusions regarding foreign laws mentioned in this

report do not reflect our independent legal analysis but are based on our

interviews and documentation provided by those that we met with.

We requested comments on a draft of this report from the Department of

the Treasury, the Department of State, the Board of Governors of the

Federal Reserve System, the Federal Reserve Bank of New York, OCC,

IMF and the World Bank. In written comments, Treasury generally

concurred with our analysis of current reform and restructuring efforts in

the financial sectors of Indonesia, Korea, and Thailand (see app. IV). In

written comments, the World Bank found the draft informative and

balanced and described its ongoing initiatives to strengthen financial

sectors (see app. V).

We also received technical comments on a draft of this report from the

Treasury, the Federal Reserve Bank of New York, OCC, IMF, and the

World Bank. These comments were included in this report where

appropriate. The Board of Governors of the Federal Reserve System did

not comment on the draft report. State Department officials told us they

concurred with our report.

We conducted our work in Washington, D.C.; New York City, New York;

Jakarta, Indonesia; Tokyo, Japan; Seoul, Korea; Basel, Switzerland; and

Bangkok, Thailand, between September 1998 and August 1999, in

accordance with generally accepted government auditing standards.
Appendix II

Weaknesses in the Financial Systems of

Indonesia, Korea, and Thailand

Page 44 GAO/GGD-99-157 Asian Financial Sector Reforms

Prior to Indonesia’s financial crisis, there were a variety of problems in

Indonesia’s banking system. Many of Indonesia’s large business

conglomerates owned at least one bank. State-owned enterprises and

pension funds also established banks and increased the potential for

connected lending. Since the late 1960s, entry of foreign banks into

Indonesia was limited in that they were required either to form joint

ventures with Indonesian banks, with a maximum of 85 percent foreign

ownership, or buy shares of domestic banks on the stock exchange where

the maximum foreign holding of stock in an Indonesian banks was set at

49 percent, according to IMF documentation.

Capital in Indonesian banks was typically overstated, because of

inadequacies in loan classification and loan loss provisioning. Banks’

assets were exposed to high risk because of, among other factors,

concentrated and directed lending, and unhedged foreign currency

borrowings by corporations. Between 1988 and 1994, the number of banks

more than doubled from 111 to 240. There was a lack of information about

the financial condition of most banks and corporations. Bank lending was

influenced by business connections and political pressures and was based

on collateral or “names” rather than cash flow analysis.

Banks had many overdue loan payments. In mid-1997, the Bank Indonesia

reported overall level of nonperforming loans—10 percent—was high and

approached levels witnessed in other countries before and during banking

crises. IMF officials told us that the reported nonperforming loans were

higher than 10 percent. Particularly problematic was the long-standing

high level of nonperforming loans for state-owned banks that was

attributed to politically directed lending. Rapid credit growth, foreign

exchange borrowing,1

 and related party2 lending had been inadequately

managed. In addition, there was a growing exposure to the real estate

market where prices tended to fluctuate and collateral was illiquid. For

example, real estate lending grew 40 percent from mid-1996 to mid-1997.

Banks’ lending to a small number of large borrowers was also very high.

Prior to the crisis, there was large-scale growth in connected and group.

Most major banks were associated with corporate borrowers through a

common majority owner.

 

1

 Foreign exchange borrowing is borrowing in a currency other than the currency of the country in

which the company or bank is located.

2

 Related party lending is lending to businesses that are associated with one another. We use the terms

related party lending, connected lending, and group lending interchangably.

Indonesia
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 45 GAO/GGD-99-157 Asian Financial Sector Reforms

Legal lending limits on loan to deposit ratios were violated by a number of

banks. Depositors and bank owners were convinced that the government

would never allow a bank to go bankrupt. Exit mechanisms for failed

banks were not established. Prior to the crisis there were a number of

insolvent banks whose resolution3

 was postponed. Some problem banks

had a negative net worth. State banks had a poor track record on loan

repayments, especially on loans extended to the largest and most

influential Indonesian conglomerates.

Indonesian bank supervision, conducted by Bank Indonesia, was

ineffective because of lack of independence and weak enforcement.4

 The

Bank of Indonesia’s Bank Supervision Department needed to be

strengthened to effectively implement risk-based oversight of the banking

system, according to government of Indonesia documents. Violations of

Bank Indonesia’s prudential principles were widespread. Compliance with

prudential regulations was low. Violations of prudential regulations were

sometimes met with regulatory forbearance. Prudential regulation needed

to be strengthened, with respect to patterns of related party lending and

the classification of nonperforming loans, according to IMF. For example,

classification guidelines understated the level of nonperforming loans

because of the liberal granting of options for restructuring and the ability

to reclassify a loan back to performing status as soon as one payment was

made and irrespective of anticipated future payments. Concentrated

ownership and connected lending made it difficult for bank supervisors to

evaluate the risk characteristics of a substantial part of the outstanding

credit portfolio of private banks. On-site inspections yielded limited

additional insight into the actual number of problem loans. Inadequate

bank management contributed to a more concentrated credit extension to

only a limited number of debtors, particularly to individuals or business

groups that had close ties with the banks, according to Bank Indonesia. In

some cases, bank supervisors allegedly abused their power for selfenrichment.

The absence of a deposit insurance scheme led to the provision of a

central bank implicit guarantee for the survival of commercial banks that

had systemic implications. Problem banks were more likely than healthy

banks to have a strong political lobby. State banks were more immune to

failure than private banks, while private banks with strong political

 3

 Resolution is the closing or merging of insolvent financial institutions.

4

 See Bank Indonesia. Report for the Financial Year 1997/1998. Jakarta: Indonesia, 1998.
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 46 GAO/GGD-99-157 Asian Financial Sector Reforms

connections were less vulnerable to closure than private banks without

strong political connections. No effective bank closure and exit regulation

was in place, and few banks were closed or merged. Failed banks were

generally absorbed into Bank Indonesia. In mid-1997, several banks with

negative capital continued to operate. The reluctance to allow failures and

enforce stringent disclosure5 rules had reduced the impact of market

forces and created opportunities for lending without due regard to risk

assessment, according to IMF. The unclear resolution mechanism for

problem banks led to a high-risk attitude among bankers.

Korea’s favorable economic performance for the past 30 years masked

weaknesses that contributed to the current crisis. Korea has a long

tradition of government control of the financial sector, directing credit and

preferential interest rates to promote key industries. The World Bank

reported that in 1990, 46.3 percent of Korea’s domestic credit was policy

loans, or directed loans, extended by banks. Commercial banks have

played a significant role in Korea’s banking system. Assets of Korea’s

nationwide commercial banks totaled approximately $318 billion, at the

end of 1997. Because of government-directed credit decisions, commercial

banks lacked a commercial orientation (i.e., they focused on increasing

market share over improving profitability) and did not have a welldeveloped system of credit-risk management.

The close links between business, the banking sector, and the government

encouraged the chaebols to expand boldly and to diversify and induced the

banks to ignore the risk associated with their highly leveraged clients.

Korean firms had made substantial investments, leaving Korea with excess

production capacity and large debt burdens for Korean firms. Most of

Korea’s corporate debt was comprised of either short-term borrowing or

from issuing promissory notes. At the end of 1997, it was not uncommon

for a Korean conglomerate to be leveraged about 400-600 percent. At the

end of December 1997, the 30 largest conglomerates owed about $58.6

billion, in loans and payments to Korean banks, according to Korea’s

Office of Bank Supervision. The conglomerates’ current liabilities (less

than 1 year) accounted for 60 percent of total liabilities and roughly half of

nominal gross domestic product (GDP) in 1996. Banks in Korea had also

focused on short-term lending, in part, due to more favorable costs for

short-term financing and limited access to the long-term capital markets.

 

5

 Disclosure is the release by banks and companies of all information, positive or negative, that might

bear on an investment decision.

Korea
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 47 GAO/GGD-99-157 Asian Financial Sector Reforms

The structure of the chaebols and the diversity of their holdings have been

a strength in Korea because it could overcome capital market

imperfections and benefit from managerial economies and vertical

integration in a semi-industrialized economy. However, according to the

Bank of Korea, the Korean economy has faced a “high-cost, low-efficiency”

industrial sector and could not operate properly in a socioeconomic

environment characterized by overregulation and “government meddling”

in the financial and corporate sectors. A complex web of shareholdings

and cross-guarantees between different firms (including the banks) within

a chaebol has not only retarded transparency regarding ownership and

financial health but also jeopardized the entire conglomerate as individual

companies began to fail, according to World Bank documents.

The heavy debt burden increased bankruptcies. According to the Bank of

Korea, the increase in bankruptcies contributed to the problems of an

already weak banking system. Large Korean companies had not had much

experience with bankruptcies prior to the crisis, and when Hanbo Steel

was allowed to fail in January 1997, it caused considerable speculation

about other corporations that may be allowed to fail. Prior to the crisis,

Korea had a system of bankruptcy law, but its procedures for handling

bankruptcies were weak. Korean laws permit both reorganization and

liquidation under two processes, court mediation and court receivership,

according to IMF documents. Korea’s court-supervised process for

mediation was originally designed to help small companies settle debts

without initiating the full bankruptcy process. The process allowed

nonviable companies to postpone debts, continue to operate with their

current management structure, and obtain new financing at lower interest

rates. Since the beginning of 1997, many large companies registered for

mediation under this process. Financial experts that we met with in Korea

told us the mediation process was very slow, and the court system was

unable to handle the additional workload. In addition, the IMF also noted

that Korea’s bankruptcy laws and proceedings lacked clear economic

criteria in judging a company’s viability and did not allow for creditor

participation in designing a company’s rehabilitation plan.

The health of the financial system was further affected by deregulation

that started in 1993, with World Bank assistance. Deregulation led to a

removal of restrictions on cross-border capital flows, allowing greater

financial innovation, increasing competition in financial services, and

blurring distinctions between the various financial intermediaries. These

changes were accompanied by a sharp increase in international borrowing

by the corporate sector. The easing of financial prohibitions on debt

financing encouraged borrowing that in many instances proved to be
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 48 GAO/GGD-99-157 Asian Financial Sector Reforms

unsustainable. The financial sector was further compromised by the

Korean system of promissory notes (cross-guarantees) that were

unsupported by sufficient credit analysis. In the absence of strengthened

prudential supervision, these developments led to the accumulation of

substantial loan losses. The Korean government estimated that

nonperforming loans at the end of 1997 were about $18.4 billion.

The weak state of the banking sector led to successive downgrades by

international credit rating agencies and a sharp tightening in the

availability of external financing. External creditors began to reduce their

debt exposure to Korean banks in the latter part of 1997, causing a sharp

decline in Korea’s usable reserves. A large amount of these reserves were

being used to finance the repayment of the short-term debt of Korean

commercial banks’ offshore branches. Historically, Korean authorities had

a policy of not letting private banks go into default. Consequently, the

Bank of Korea was providing foreign exchange support to commercial

banks as foreign creditors reduced their exposure on short-term lines of

credit. The total amount of foreign currency reserves that the Bank of

Korea held at the end of December 1997 was $20.4 billion, the usable

portion of which was $8.9 billion.6

 As of December 31, 1997, the total

amount of Korea’s private and governmental external liabilities was $154.4

billion, calculated under IMF standards. The Korean government estimated

that at the end of December 1997 external payments of about $27.3 billion

were due by the end of the first quarter in 1998. The ability of Korea to

repay its short-term debts was dependent on the willingness of foreign

lenders to extend the terms of existing loans and to offer new financing.

Korea continues to experience weaknesses in its financial and corporate

sectors. Recent noteworthy events in Korea have been particularly

illustrative of the difficulties Korea faces in addressing these weaknesses.

These events include the breakdown in negotiations to sell intervened

banks, the near bankruptcy of the Daewoo Group (a major Korean

conglomerate) in July 1999, and recent allegations of stock price

manipulation by Hundai Securities.

The onset of the financial crisis in Thailand highlighted and exacerbated

many of the weaknesses that existed in the banking system, such as weak

 

6

 Under the IMF program, Korea tightened its definition of usable reserves and has reported its reserves

under this stricter definition. Korea reported that its usable foreign exchange reserves as of end-June

1999 were $60.4 billion. Previously, Korea had included its deposits with overseas branches of Korean

financial institutions when reporting its foreign exchange reserves, thus overstating its usable reserves.

Usable foreign currency reserves equal the total foreign currency reserves less the amounts on deposit

with overseas branches of Korean financial institutions and swap positions between the Bank of Korea

and other central banks. For more information on Korea’s IMF program, see GAO/GGD/NSIAD-99-168.

Thailand
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 49 GAO/GGD-99-157 Asian Financial Sector Reforms

supervision and regulation, lending to related entities and weak

management. The Bank of Thailand’s supervision of Thailand banks and

finance companies was considered weak because supervisors lacked

adequate resources and training and had an unclear framework for

supervision. Generally, the process for supervision that existed did not

focus on risk-based approaches that analyzed the risks facing the bank but

focused on a compliance-based approach where satisfaction of certain

regulatory rules was determined by bank supervisors.

Weak credit analysis also existed in Thailand, and bankers tended to focus

on the available collateral, rather than the ability to repay. This absence of

credit analysis, combined with a generally low standard of transparency

and disclosure of financial information led to a fragile financial system in

Thailand. Weak legal frameworks pertaining to foreclosure and bankruptcy

often meant that it could take up to 10 years to foreclose on an institution

and/or collect collateral as court proceedings were lengthy and expensive.

According to local bank officials, before the crisis, Thailand tightly

regulated banks by making it difficult for banks to engage in higher risk

financing and leasing. Therefore, according to these officials, banks

created finance companies to engage in higher risk financing and leasing

through a loophole in the banking laws. According to an international

banker, over 100 finance companies were established before the Bank of

Thailand implemented a law to regulate finance companies. According to

another international banker, there was a finance company crisis in the

mid-80s that should have required the Thailand government to set stricter

regulatory requirements or “trip wires.” However, this was not done. In the

end, the Bank of Thailand facilitated the bailout of those finance

companies—91 remained—by allowing banks to inject capital and take

over finance company management. This set the stage for “moral hazard”

problems in the future, wherein financial market participants expected

that the government of Thailand would not allow failures of finance

companies.

According to Bank of Thailand documents, this expectation by financial

sector participants was an important weakness in the financial system. The

lack of a clearly stated policy on allowing financial institutions to fail gave

a misleading sense of security to market participants. Along with other

countries in the region, Thailand’s financial system was often

characterized as “no entry, no exit,” meaning that it was as difficult to get a

banking license as it was to let an institution fail.
Appendix II

Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Page 50 GAO/GGD-99-157 Asian Financial Sector Reforms

Loan classification and loan loss provisioning practices were not done

according to internationally accepted norms. For example, uncollected

interest income was allowed to accrue for 12 months, thereby overstating

banks’ income and capital. These factors, combined with weak accounting

standards, made transparency a problem that needed to be addressed.

Family groups generally control Thailand’s banks, resulting in family

lending, on a connected basis, to other family business interests. Since

these other nonbank commercial interests have also been affected by the

crisis, their financial problems have undermined confidence in the banking

system. In addition, Thailand’s system of interlinked family controlled

companies has created particular problems for corporate restructuring.

Creditors tend to associate restructuring of a parent company with

restructuring of either related companies or unrelated companies with

similar shareholders, despite the absence of cross-guarantees or other

formal links between corporations.

Weak middle management was evident in domestic banks, according to a

rating agency report. Bank management personnel at the very senior levels

were experienced and competent; however, the middle and lower levels

lacked quality staff. In addition, senior level staff recruits were often

discouraged because of the family controls over the business and the

consequent limits on promotions.

In addition, according to World Bank officials, although the Bank of

Thailand is technically independent, its officials had been subject to

political pressure. The pressure, combined with an unclear exit and entry

strategy, resulted in the unwillingness of senior officials at the central

bank to make “unfavorable” decisions, for example, to close insolvent

institutions. Other sources stated that Bank of Thailand also made

fundamental errors and at times, Bank of Thailand officials “turned a blind

eye” to ill advised, (at times criminal) lending. According to a Thailand

domestic bank official, in the precrisis days, supervision was soft and

banks could “negotiate” with supervisors—within reason—if there was a

problem. In addition to the supervisors’ lack of authority of to close banks,

they also did not (and currently do not) have any immunity for their job

performance. That is, if supervisors cause losses to a government

institution, by, for example, providing liquidity support that is not repaid,

they can be held personally liable.
Appendix III

Legal, Administrative, and Judicial Changes in

Indonesia, Korea, and Thailand

Page 51 GAO/GGD-99-157 Asian Financial Sector Reforms

Indonesia has proposed and made changes to a variety of laws, with the

intent of strengthening its financial system. A new bankruptcy law became

effective on August 20, 1998. The bankruptcy law was considered an

essential component of the framework for restructuring the enormous

debt burden of the private sector, according to IMF documentation.

Amendments to the banking law were passed by Parliament in October

1998. These amendments eliminated restrictions on foreign investment in

publicly held banks; amended bank secrecy law,with regard to

nonperforming loans, so that debtors could be publicly identified; and

enabled bank mergers and privatization. The Central Bank Law—designed

to increase the Bank of Indonesia’s autonomy—was submitted to

Parliament in March 1999 and became operational in May 1999.

To implement the bankruptcy law, a Special Commercial Court to process

bankruptcy applications was opened on August 20, 1998. The government

of Indonesia has (1) appointed experts as ad hoc judges to the Commercial

Court, (2) implemented an ongoing program of continuing education for

judges, (3) developed a transparent court fee to generate increased

resources for the court system that could be used for higher salaries for

judges, and (4) made decisions of the court publicly available. Officials of

the U.S. Department of State said that how well this court functions is

viewed as an indicator of whether or not financial sector reforms are

progressing and that initial decisions of the court lead to a mixed

assessment. The first final ruling was controversial because the court

dismissed the petition against the company because a related petition was

pending against its subsidiary. The second final ruling was the court’s first

order of bankruptcy against a debtor company. By mid-February 1999, the

Commercial Court had received 42 petitions. There have been concerns

that the amended bankruptcy law is not being implemented according to

either its letter or spirit and that the bankruptcy law is not working

effectively, according to IMF documentation.

Other legal and administrative reforms are to include

• lifting restrictions on debt for equity conversions,

• removing tax disincentives for restructuring,

• streamlining procedures and approval requirements applicable to the

admission of foreign direct investment,

• a new arbitration law, and

• measures to provide for the registration of collateral.

Korea has made several legislative changes to strengthen its financial

regulatory system and corporate governance, open its financial institutions

Indonesia

Korea
Appendix III

Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

Page 52 GAO/GGD-99-157 Asian Financial Sector Reforms

to foreign competition, and revise its labor laws. To strengthen its financial

regulatory system, Korea revised its Bank of Korea Act to provide central

bank independence, with price stability as its prime mandate. Korea also

passed legislation to consolidate supervision of commercial banks,

merchant banks, securities firms, and insurance companies into one

agency, the Financial Supervisory Commission. This agency was given

operational autonomy and has broad powers to deal with troubled

financial institutions. To deepen Korea’s capital markets, Korea also made

several revisions to liberalize capital in Korea’s bond and equity markets.

In an effort to improve corporate governance and the transparency of data,

Korea passed legislation requiring that corporate financial statements be

prepared on a consolidated basis and be certified by external auditors.

Related legislative changes included provisions in Korea’s Fair Trade Act

that eliminated cross-guarantees by April 2000. According to Korean

government documents, to reinforce management transparency and

accountability, the top thirty chaebols (industry conglomerates) and all

publicly held companies were required in February 1998 to organize an

“independent audit committee” to represent minority shareholders and

creditors. However, according to the World Bank, the independent audit

committees will have two-thirds of its members from outside the company

and one-third of its members from within, and will not represent minority

shareholders and creditors. Korea has also strengthened the Korean Fair

Trade Commission’s supervisory function, by granting it the authority for 2

years to request financial information from the financial institutions, to

give it the ability to investigate unfair inter-affiliate transactions of

chaebols.

Korea reformed its insolvency laws in early 1998, with World Bank

assistance. Korea established (1) economic criteria to judge a company’s

viability; (2) creditors’ committees to strengthen the creditor role and set

time limits on making court decisions; and (3) a special administrative

body to provide expertise to the courts (such as in evaluating a company’s

financial situation and viability, nominating a receiver, and approving

rehabilitation plans). New procedures to simplify market exit have

important implications for corporate workouts, in that an expeditious exit

scheme allows for more efficient negotiations for the workout programs

between the creditor banks and the firms.

Korean officials noted the revision of Korea’s Labor Standards Act, which

legalized layoffs for managerial reasons, as a landmark achievement. It

was common practice for Koreans to have employment for life. Social

acceptance has not been easy, demonstrated by labor disputes between
Appendix III

Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

Page 53 GAO/GGD-99-157 Asian Financial Sector Reforms

some of the troubled commercial banks and their labor unions as well as

labor strikes at other companies. Korea has expanded its social safety net

to allow for unemployment protection. Korea’s employment insurance

system has also been expanded to cover all regular, temporary, and daily

employees, according to Korea’s Ministry of Finance and Economy.

The Government of Thailand reformed its bankruptcy laws twice since the

onset of the crisis, in April 1998, and again in March 1999. In addition, the

Government of Thailand has made some changes to laws relating to

privatizing state enterprises and liberalizing foreign ownership of

buildings. Other laws, relating to liberalizing key areas of the economy to

foreign investment and changes to the bank regulatory system are still

being considered by Parliament.

The bankruptcy laws in Thailand’s 1940s Bankruptcy Act, which was in

effect during the crisis, gave creditors and debtors only limited and drastic

alternatives for dealing with problems. For example, liquidation was

generally the only solution because foreclosure was almost impossible—it

could take up to 10 years to go through court proceedings to foreclose and

collect assets from a company. In addition, companies did not have the

option to reorganize in an attempt to become viable or have protection for

new financing to the company.

The Bankruptcy Act was modified in April 1998, and some of the problems

associated with the law were addressed. The new legislation passed

included bankruptcy procedures and a plan for reorganization that

followed closely the U.S. and British practice on court jurisdiction. Under

this new law, the courts and judges were given the power to guide the

process very closely to the end. It was estimated that any reorganization

plan would take 3 to 6 months for court approval. The law also added

provisions to protect creditors who advance new money to debtors in the

process of reorganization. However, after the passage of this law, it could

still take 5 to 7 years to liquidate companies’ solid assets and up to 10 years

to collect assets, according to an international banker. On March 17, 1999,

the Thailand Parliament revised the Bankruptcy Act to address issues

raised by the amended 1998 act and passed a new bankruptcy courts bill

and foreclosure–related bills (amendments to the Code of Civil

Procedure). The passage of this legislation was delayed for months

because senate members had personally guaranteed loans and were

concerned that they would be held liable for them under the new laws and

were therefore blocking passage of the new laws, according to various

officials. In addition, parliament members were also concerned about

increasing foreign ownership of Thailand owned corporations. Elements of

Thailand
Appendix III

Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

Page 54 GAO/GGD-99-157 Asian Financial Sector Reforms

the new laws include reducing the time for bankruptcy status from 10 to 3

years, creating bankruptcy courts, and streamlining foreclosure

procedures to limit postponement of legal proceedings and to limit the

number of appeals.

Several closely related laws, including bankruptcy and foreclosure laws,

were passed by Parliament, as of April 1999. However, there have also

been delays and nonpassage of other closely related legislation important

to the economy. The other laws that have been passed by Parliament were

an effort to open the market, particularly to foreign investment and

ownership and to encourage privatization. These laws, the Condominiums

Act, the Land Code, and the Lease Act, were all passed by Parliament by

April 1999. The purpose of the Condominiums Act is to liberalize foreign

ownership of buildings. The purpose of the Land Code is to liberalize

foreign ownership of land. The purpose of the Lease Act is to deal with

foreigners leasing property. According to IMF documents, the propertyrelated laws were passed in an effort to revive the troubled property sector

in Thailand. The “Corporatizations Law,” also passed by Parliament, would

facilitate the privatization of state enterprises. However, it is awaiting

clearance from the constitutional courts to be enacted.

Three key and closely related bills are still being drafted and reviewed.

They include (1) a bill revising the Financial Institutions Law, which

concerns commercial banking and finance companies; (2) a bill revising

the Deposit Insurance Law; and (3) a bill revising the Central Bank Law.

The revision of the Financial Institutions Law, which has been delayed

repeatedly, would create the framework for important revisions to

prudential regulations, including foreign exchange exposure, lending

limits, accounting standards, and disclosure standards. The revision of the

Deposit Insurance Law would eventually replace the blanket deposit

guarantee currently in place, and the revision of the Central Bank Law

would strengthen the powers, independence, and accountability of the

Bank of Thailand.

Other proposed laws include the Currency Act, which would free up

excess foreign exchange backing of the currency. The passage of the

Currency Act has been delayed. The proposed Secured Lending Law,

which aims to expand securitizable1

 assets, is to be submitted by the end of

1999. The proposed Foreign Investment Act, which would liberalize foreign

participation in certain business sectors, has not yet been passed, although

 

1

 Securitization is the conversion of assets into marketable securities for sale to investors.
Appendix III

Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

Page 55 GAO/GGD-99-157 Asian Financial Sector Reforms

it was sent to the lower house of Parliament after the committee work had

been completed on March 5, 1999.

Thailand has also completed preliminary work for the privatization of (and

share divestiture from) public enterprises in the areas of energy, utilities,

communications, and transport, according to IMF documents. In addition,

the Thailand government established a secretariat for privatization and

proposed legislative measures to facilitate privatization of

“noncorporatized” public enterprises.
Appendix IV

Comments from the Department of the

Treasury

Page 56 GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix V

Comments from The World Bank

Page 57 GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix V

Comments from The World Bank

Page 58 GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix VI

GAO Contacts and Staff Acknowledgments

Page 59 GAO/GGD-99-157 Asian Financial Sector Reforms

Thomas J. McCool (202) 512-8678

Susan S. Westin (202) 512-4128

Patrick S. Dynes, Nima P. Edwards, Debra R. Johnson, James M.

McDermott, John H. Treanor, Desiree W. Whipple

GAO Contacts

Acknowledgments
Page 60 GAO/GGD-99-157 Asian Financial Sector Reforms
Ordering Information

The first copy of each GAO report and testimony is free.

Additional copies are $2 each. Orders should be sent to the

following address, accompanied by a check or money order made

out to the Superintendent of Documents, when necessary. VISA

and MasterCard credit cards are accepted, also. Orders for 100 or

more copies to be mailed to a single address are discounted 25

percent.

Order by mail:

U.S. General Accounting Office

P.O. Box 37050

Washington, DC 20013

or visit:

Room 1100

700 4th St. NW (corner of 4th and G Sts. NW)

U.S. General Accounting Office

Washington, DC

Orders may also be placed by calling (202) 512-6000 or by using

fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and

testimony. To receive facsimile copies of the daily list or any list

from the past 30 days, please call (202) 512-6000 using a touchtone phone. A recorded menu will provide information on how to

obtain these lists.

For information on how to access GAO reports on the INTERNET,

send e-mail message with “info” in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov
United States

General Accounting Office

Washington, D.C. 20548-0001

Official Business

Penalty for Private Use $300

Address Correction Requested

Bulk Rate

Postage & Fees Paid

GAO

Permit No. G100

(233580)