Indonesia’s banks aren’t exactly welcoming foreign investors with open arms these days. Just ask DBS.
The Singapore bank registered an unwelcome record in July when it was responsible for the largest-ever withdrawal of an M&A deal in Asia’s financial sector ex-Japan.
DBS had long been hopeful that its attempt to buy a majority share in Bank Danamon from Singaporean state investor Temasek would be allowed. Instead the deal, which would have been worth IDR66.4 trillion (US$6 billion), was a casualty of new bank-ownership rules imposed by Indonesia’s central bank.
In July 2012 Bank Indonesia (BI) reduced the stake that any single foreign shareholder can acquire in a bank from 99% to 40%, while dropping the cap for domestic bank ownership to 30% and 20% for local individuals.
DBS had hoped that the central bank would give it a waiver, particularly given that it had registered its desire to buy the stake before the new regulation was announced.
It’s true that there is some flexibility to the rule. BI said it would consider a foreign lender that bought a 40% stake in a local bank taking majority control if it judged the local institution to be well managed after an as-yet unspecified period of time, and provided the acquirer remained publicly listed and financially healthy.
The trouble for DBS is the lack of certainty surrounding the process. This regulatory route has not yet been tested, so it was unclear what constituted ‘well managed’ or how long it would take to gain clearance to take a majority stake in Danamon. DBS eventually decided the risk was too high, allowing the agreement to buy Temasek’s stake to expire on July 31.
“DBS would have had to pay a significant amount of capital to acquire a bank – albeit a good bank – with no certainty over whether it could get control, which is why that deal effectively fell,” says the head of M&A for Southeast Asia at an international bank.
The deliberate ambiguity of BI’s foreign-bank investment rules has more than just DBS concerned.
Dutch house Rabobank put its Indonesian unit up for sale in November last year, and has received bids of around US$300 million from Japan’s Sumitomo Mitsui Banking Corp. as well as from China Construction Bank. But that mooted sale has also fallen through as buyers have shied away in light of the fact that they may not be able to gain control.
BI’s hostility to international takeovers may play well with locals, a not-unimportant consideration less than a year before a presidential election. But its willingness to change the ground rules for foreign banks could have unforeseen consequences for Indonesia’s banking sector.
“[This] could hold back interest from other overseas banks in Indonesia in the near term,” says Alfred Chan, financial ratings analyst at Fitch Ratings. “If there is a limited chance of ultimately gaining majority control, this may deter some long-term investors from looking to establish and build a local franchise through the inorganic route.”
It looks a short-sighted development at a time of rising economic uncertainty for Indonesia. The country could do with foreign-bank capital to help consolidate its banking sector and balance its current account deficit. The last thing it should be doing is placing unnecessary obstacles in the path of such money.
Market appeal
It’s easy to understand the desire of foreign banks to enter Indonesia, and their frustration that the central bank is making it harder.
The country is one of Asia’s fastest growth markets, with real gross domestic product (GDP) forecast to increase by up to 6% a year for the next three years, despite the central bank’s struggle with the currency and with inflation (see separate story on page 56).
PricewaterhouseCoopers’ (PwC) publication World in 2050 predicts that Indonesia’s economy in purchasing power parity (PPP) terms could be bigger than that of Germany, France or the UK by 2050. In addition, Indonesia made it for the first time into the top-10 overseas growth destinations in PwC’s annual global CEO survey for 2013.
“Indonesia remains an attractive banking market. The country has low credit penetration relative to other fast-growing markets such as India and China, an expanding middle class, a resilient economy and high net interest margins at around 5% to 6%,” says Fitch’s Chan.
Indonesia’s low banking penetration rate is particularly attractive to foreign players. More than half of the country’s population of 246.9 million did not have access to a formal financial channel in 2012, according to a World Bank survey.
The country’s low credit-to-GDP ratio is rising, but at 33% remains well below regional peers. The ratio is more than 100% in Malaysia, Singapore, Thailand and Vietnam. No wonder the country is so appealing to foreign banks.
Basel III
In the past, international lenders may have been willing to accept a minority stake in a local bank, at least initially, just to get their toes in the door and gain access to Indonesia’s attractive demographics and relatively under-banked market.
But Basel III has added a new dimension to such considerations. The new bank-capital regulations are punitive when it comes to a bank holding associate or minority stakes in other lenders, with the owning institution having to make a full deduction of the stake against core capital. Owning 10%-50% in another institution therefore becomes a costly proposition from a capital standpoint.
If DBS had bought a 40% stake in Bank Danamon, for example, the acquisition could have taken 150 basis points (bp) off its core Tier I capital. This compares to around a 60bp reduction if it had bought a 99% share, according to Barclays research.
Accordingly, international banks have become less interested in Indonesian banks if they are not allowed majority positions.
“If you take into consideration the latest regulatory development in Indonesia and overlay it with the Basel III treatment of subsidiaries, overall it means that cross-regional M&A [into the country’s banking sector] will slow down,” says Ivan Tan, a financial credit analyst at Standard & Poor’s (S&P).
Australia provides a litmus test for Basel III-related divestment, as the country’s regulator has implemented the new guidelines ahead of others in the region.
The impact of the new rules is clear: ANZ is selling out of its Asian minority investments. In January 2012 it sold its 9.6% stake in Vietnam’s Saigon Thuong Tin Commercial Joint Stock Bank (Sacombank) to Vietnam Export Import Commercial Joint Stock Bank (Eximbank). Then last July its stake in China’s Bank of Tianjin fell to 17.6% from 20% after it declined to take part in an equity raising.
The Australian bank is now trying to sell its 39.2% stake in Bank Pan Indonesia (Panin Bank), Indonesia’s seventh-largest bank. It is in the early stages of talks with Mizuho Financial Group to sell the stake (see box on page 64).
Mass of minnows
Bank Indonesia is unlikely to be overly worried about the ramifications of its 40% investment threshold on foreign-bank interest. After all, the country’s top lenders don’t really need foreign capital. They enjoy an average return on equity of 23% – more than double the 9% return in the US.
“Foreign acquirers certainly add a lot of value, helping improve governance, systems and best practices, together with providing access to their global network,” says the Southeast Asia head of M&A. “But a lot of banks are already well managed and are trading at pretty healthy valuations when you compare them to the rest of the world.”
Additionally, few targets exist among the top-10 banks. Three out of the four biggest banks in Indonesia – Bank Mandiri, Bank Rakyat Indonesia and Bank Negara Indonesia – are state-owned. A policy that state ownership cannot fall below 51% should ensure they remain that way. Bank Central Asia (BCA) is the only one of the big-four that is privately owned.
Foreigners already own almost all the next level of lenders. Bank CIMB Niaga is Malaysian-owned, Temasek holds most of Bank Danamon, Maybank owns Bank Internasional Indonesia (BII) and OCBC Indonesia and UOB Indonesia are both owned by Singaporean banks.
But beneath the top-10 strong banks are hundreds of weaker ones. In addition to 120 commercial banks, the country is home to 1,660 rural banks and 197 finance companies.
The sheer quantity of these institutions is a problem.
“The Indonesian banking sector needs more consolidation. The number of banks is too many and could create possible volatility risk during crises,” says Destry Damayanti, chief economist at Bank Mandiri.
“The sheer number of financial institutions, many of which are small, strains regulatory resources and hampers effective supervision. In particular, smaller banks often have rudimentary risk management and weak corporate governance,” agrees Tan. “History has shown that they don’t fare well when credit cycles turn sour.”
BI’s preference to stimulate economic activity over prudent lending hasn’t helped either.
Consolidating the number of banks would bring tangible benefits. Firstly it would enlarge the customer base and open opportunities to reduce banking costs by increasing competition, economies of scale and efficiency. Banks could then assemble more savings and allocate them to more productive investment, which would increase total productivity and boost growth, according to the Asian Development Bank in a recent report on financial integration.
The need for a sector overhaul has been obvious for years. The government has long had plans to consolidate the country’s plethora of smaller banks, but so far its attempts have had little impact.
More worryingly, early warning signs in Indonesia’s banking sector are emerging. Loan growth has exceeded 20% a year since 2007 on the back of good business sentiment.
Special mention loans – those loans overdue for up to 90 days but yet to become non-performing – have been increasing since 2011. It’s not a typical trend, and suggests that borrowers are increasingly having repayment problems.
The rating agencies consider credit risk in Indonesia to be of increasing concern. S&P classifies banking systems on a riskiness scale, on which 10 is the riskiest. Singapore and Hong Kong are rated two, Malaysia is four, India and China are five to six, and Indonesia is seven. Only Vietnam and Cambodia, both ranked nine, are deemed more risky in Asia.
Risks on the rise
These risks could be brought into focus sooner than anyone anticipated.
The anticipated end of quantitative easing in the US has resulted in capital outflows across emerging markets. In Asia, Indonesia and India have been hit hardest.
The rupiah has swiftly fallen in value against the US dollar. Regulators are struggling to rekindle market confidence and inflation looks likely to reach double digits before the end of the year.
Yet despite these concerns loan growth currently remains strong, leaving smaller banks with little interest in merging with their rivals.
“If you leave it to commercial forces, the pace of consolidation will remain slow. Even the small banks are quite profitable right now and while there is some underlying risk in the banking system, if you look at the reported NPLs [non-performing loans] they are quite low,” says Tan. “Very few of the banks are under financial stress right now, and without financial distress the drive or the need for mergers is much less.”
In addition, domestic shareholders in the same country don’t always see eye to eye. “Family one may not want to sell to family two, but they’re happy to sell to a foreign acquirer for whatever reason,” says the Southeast Asia head of M&A.
Foreign banks could help this process if they are prepared to look at the country’s smaller lenders. There are signs that this is beginning to happen.
“That’s where a lot of interest is gathering. They are much smaller, and it’s not as expensive as buying out one of the top-10 banks. A large number of them are owned by businessmen, conglomerates and local investors, and they could be sold to international players,” says Chan.
There is a greater likelihood of BI allowing foreign majority ownership if international banks prove willing to look at the country’s smaller lenders. Doing so would accelerate the central bank’s goal of making the sector more competitive, without threatening its autonomy or posing a nationalistic threat.
Foreign-bank ownership could also reduce the number of domestic majority shareholders with unwarranted control of a bank. The local-ownership caps have not been grandfathered, meaning many smaller banks are held by individuals with other businesses, creating conflicts of interest.
“[If] a majority shareholder has undue control of a bank, it may result in bad practices. This is typically the case where the shareholders are also the owners of other non-banking businesses, and may abuse some of the practices at the bank,” says Chan.
Securing market sentiment
Indonesia has traditionally been the most open banking market in the region. It should stay true to that role and not allow political or nationalistic concerns to overshadow the vital need for regional development.
Bank Indonesia’s foreign-bank ownership rules may be more prohibitive than they used to be but the new rules still include scope to let foreign banks upgrade to majority ownership. And Singaporean, Malaysian and Japanese banks, as well as those from further afield, are still willing to come onshore to offer both capital and expertise.
The central bank and government should take advantage of this interest to direct foreign capital to where it is most needed. And they should do so soon. The gloss could yet come off Indonesia’s economy, while incoming Basel III rules are set to make it a less appealing place for minority investment.
Bank Indonesia may have been willing to stymie DBS’ ambitions, but it would be unwise to take the interest of all foreign banks for granted. It should demonstrate its openness to foreign banks by expediting the process for one of the institutions bold enough to test the waters.
Without such a gesture, Bank Indonesia risks closing itself to foreign-bank interest for good.