Urgency Of Good Corporate Governance

01/06/2006

By DR. Rofikoh Rokhim

Today, evidence shows that business ownership concentration in East Asian countries exists through family business groups such as conglomerates in Indonesia, laoban in Taiwan, caebol in South Korea, and keiretsu/zaibatsu in Japan.  Most of these family business groups own firms and hundreds of enterprises, and ever since the banking liberation in 1980s, they also own more than one banks.

Huge corporations in Indonesia entered into financial and non-financial sectors with the purpose of providing trade finance to their own business groups, to facilitate expansion in industrial sectors. The banks, as formed by certain family business groups, usually provided loans to corporations within their groups, with the aim of financing projects, many of which become precarious projects. Assets of such banks seemed to grow rapidly, and therefore, created cumbersome illusions that Indonesian banking were in excellent financial conditions. Often, beneficiaries of the loans utilized such projects as collaterals for obtaining the loans, or in worst case scenario, they tended not to use the entire loan to fund the original proposed projects. Instead, the disbursed loans were exploited to finance unapproved personal projects or increase personal capital. This is why the banks’ financial statement recorded non performing loans derived from the precarious projects as part of the banks’ asset.

Agency Problem

Existence of dominant control in various business activities by several family business groups made the path easier toward banks’ insider abuse. Close relationship between loan providers and debtors tends to result in insider lending.  Deficiency in transparency and control creates agency problems such as: misappropriation of investment resources, related-parties transactions, use of transfer pricing, assets stripping and other forms of ’tunneling’ of assets and revenues from the firms.

Agency problems occur particularly due to common ownership in non-financial and financial firms, being the sectors which bore the brunt of the financial crisis in Indonesia.[i] My research using 143 banks as samples (whether liquidated, survivor or newly incorporated banks) for twelve periods (1991-2002) shows that credit channelling to related parties presents negative impact for banking soundness[ii]. The reason of which is due to the fact that shareholders of the banks are also involved the banks’ management, and therefore enjoys full discretion to act in their own interest, instead of the depositors’, namely credit channelling to related parties with no profound credit analysis or providing loans to finance precarious projects.

Consequently, when monetary crisis hit Indonesia in 1997, Indonesian banks announced a state of crisis. This dramatically advertised enormous consequence of poor corporate governance in banking, and in a wider scope, crippled economies, destabilized governments and intensified poverty in Indonesia.

However, banks still continued to play an important role in financing economic activities; which makes Indonesia be considered as a bank-based country[iii]. Banks dominate the development of financial system due to under-development in capital market and financial market sectors; for instance, most companies in Indonesia depending its growth/expansion on bank loans.

Application of Good Corporate Governance

Since banks are a significant factor in financial system, good corporate governance is essential in conducting banking activities. Levine (1997)[iv] argues that application of good corporate governance in banking activities will bring efficiency in allocating funds, lower the cost of capital firms, boost capital information, and stimulate productivity growth; and thus eventually will effect in firm operations and national prosperity.

In order to apply good corporate governance in banking industries, we should consider the different characteristic between banks and firms. Banks assets are mainly loans (long term characteristic) and liabilities which substantially contain deposits (short term characteristic). The problem arises if the loan is non-performing. Non-performing loan often results from negligence in channeling credits to related parties without applying prudent banking principles. In addition, non disclosure of non-performing loan in a long period will cause banks to become vulnerable.

As to ownership concentration issue, currently most private banks are a part of family business group. Because of the aforementioned impacts of this matter, it is important to apply a more diversified ownership structure in Indonesian banking industry, reduce domination of single ownership and/or improve prudential regulations substantially, including requirements to strengthen disclosure of information. Across the globe, there are 41 countries that allow single entity shareholding in banks only up to less than 50% and 38 countries limit it only up to less than 25%.[v] In addition, banks are generally not widely held, whereby 75% of banks around the world have a shareholder that holds more than 10% of the voting rights, and more than half of such controlling owners are family business groups.[vi]

In reducing banks’ over-exposure by large business groups, financial authorities in Indonesia should impose certain limitations or even prohibitions for banks in granting loans to affiliated parties. Furthermore, with the aim of battling historical problems of excessive lending by own business groups, it is necessary for banks to assign independent commissioners and independent directors, form an audit committee, to limit the shareholding percentage of a business group, and ensure that no single entity could have a majority vote in banks.

Moreover, it is salient for Indonesian financial authority to strictly apply International Accounting Standards and good governance measures to both financial and non-financial firms such as regulation from Bank International Settlement and principles of corporate governance that considers the interests of stakeholders (which definition includes employees, creditors and in general, the community affected by the banks operation). Early warning system and law enforcement are in fact crucial in order to realize good governance applications. In this way, financial authority is empowered to demand accurate disclosure of information and punish perpetrator of any law violation. 

In line with this context, on 30 January 2006, Bank Indonesia issued Bank Indonesia Regulation (Peraturan Bank Indonesia-PBI) No.8/4/PBI/2006 regarding implementation of Good Corporate Governance for Commercial Bank (as the realization of Indonesian Banking Sector Code, which was issued by National Committee for Corporate Governance in January 2004).

Under the Bank Indonesia Regulation, good corporate governance is defined as commercial bank management procedures, which apply the principles of:  

in order to improve commercial bank’s performance, protect shareholders interests and increase commercial banks’ compliance to the prevailing laws and regulations as well as code of conduct in the banking industry.

Good corporate governance is all about corporate culture, management behaviour, and transparency in decision making process. It will take some time to apply good corporate governance; however, the markets that start the process immediately will be rewarded. Good corporate governance should be an integral part of the business culture, and not something to be taken for granted. Implementation of these objectives may harm extremely powerful groups in society and thus reduce the probability of successfully initiating reforms to boost information disclosure. If that is the case, Indonesian government need to enforce operation of legal and bankruptcy system.

Levine (2004)[vii] mentions that traditional corporate governance mechanism relies on well-functioning legal and bankruptcy system that effectively support the rights of shareholders and creditors. But these institutions do not operate well in most countries. Thus, it is not too early to begin the long process of building sound legal and bankruptcy systems.

Stick and carrot mechanisms should be introduced. Those who comply with good corporate governance should feel that their good intention is worth something. Good corporate governance should become a company asset -- a solution and not a problem.

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[i].  Ftzpatrick, Daniel. 1998. ‘Corporate Governance, Economic Crisis and the Indonesian Banking Sector.  ” Australian Journal of Corporate Law 178, 184-188

[ii].  Rokhim, Rofikoh. 2005 ‘Related Lending and Banking Fragility.’’ Working Paper TEAM-CNRS, Universite Paris 1 Pantheon-Sorbonne.

[iii].  Demirguc-Kunt, Asli and Vojislav Maksimovic. 2000. ‘’Funding Growth in Bank-Based and Market-Based Financial System : Evidence for Firm Level Data.’’ Working Paper, World Bank.

[iv].  Levine, Ross. 1997. ‘’Financial Development and Economic Growth : Views and Agenda,’’ Journal of Economic Literature 35, page 688-726.

[v].  Barth, J.R., Gerard  Caprio and Ross Levine. 2003. ‘’Is Corporate Governance different for banks holding companies ?’’ Federal Reserve Bank of New York, Economic Policy Review 9, page 123-142.

[vi].  Caprio, Gerard, Luc Leaven and Ross Levine. 2003. ‘’Governance and bank valuation’’. Mimeo,  University of Minnesota.

[vii].  Levine, Ross. 2004. ‘’The Corporate Governance of Banks : A Concise Discussion of Concepts and Evidence’’. World Bank Policy Reserach Working Paper 3404.

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