International Finance: Actions Taken to Reform Financial Sectors in Asian
Emerging Markets (Letter Report, 09/28/1999, GAO/GGD-99-157).

Financial crises limit emerging countries' economic growth and foreign
trade and strain their ability to repay international obligations.
Developed nations, including the United States, have felt the
repercussions of these crises through loans to and investments in
emerging markets and through diminished exports to these countries. This
report focuses on three countries--Indonesia, South Korea, and
Thailand--that had been receiving large capital flows, were experiencing
financial crises, and were making changes in their financial systems.
GAO focuses on the banking sectors in these countries because their
economies, like those in most developing and transition countries,
relied more heavily on bank financing than on stock or bond issuance or
other types of market financing. GAO discusses (1) the nature of the
weaknesses in the countries' financial sectors, (2) the extent to which
the countries have achieved reforms in their financial systems, (3) the
extent to which the countries have implemented international principles
for banking supervision, and (4) efforts by the U.S. government and
multilateral institutions to bring about changes the financial sectors
of these emerging markets.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-99-157
     TITLE:  International Finance: Actions Taken to Reform Financial
	     Sectors in Asian Emerging Markets
      DATE:  09/28/1999
   SUBJECT:  International economic relations
	     Foreign governments
	     Bank failures
	     Foreign financial assistance
	     Bank examination
	     Banking regulation
	     International cooperation
	     Bank management
	     Accounting standards
	     Economic analysis
IDENTIFIER:  Indonesia
	     South Korea
	     Thailand

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United States General Accounting Office
GAO

Report to Congressional Requesters

September 1999

GAO/GGD-99-157

INTERNATIONAL FINANCE
Actions Taken to Reform Financial Sectors in

Asian Emerging Markets

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Contents
Page 401GAO/GGD-99-157 Asian Financial Sector Reforms
Letter                                                                      1
                                                                             
Appendix I                                                                 42
Objectives, Scope, and
Methodology
                                                                             
Appendix II                                                                44
Weaknesses in the
Financial Systems of
Indonesia, Korea, and
Thailand
                           Indonesia                                       44
                           Korea                                           46
                           Thailand                                        48
                                                                             
Appendix III                                                               51
Legal, Administrative,
and Judicial Changes in
Indonesia, Korea, and
Thailand
                           Indonesia                                       51
                           Korea                                           51
                           Thailand                                        53
                                                                             
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
                                                                             
Tables                     Table 1:  Countries Efforts to Improve          13
                           Their Financial Systems
                           Table 2: Implementation of Selected             25
                           International Supervisory Principles
                           in Indonesia, Korea, and Thailand
                                                                             

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

B-281526

Page 26GAO/GGD-99-157 Asian Financial Sector Refor
ms
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
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.

Results in Brief
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 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.

Background
     With their central role in making payments
and mobilizing and distributing savings, banks are
a key part of a country's economy and the
international 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 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 developing
countries' governments, developed countries are
likely to feel repercussions.

Weaknesses in the Countries' Financial Systems
     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.

Characteristics of Robust Financial Systems
     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
experiencing rapid economic growth and undergoing
substantial changes in their financial systems. 17
The G-10 calls for, among other things,

ï¿½    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;
ï¿½    comprehensive and well-defined accounting
principles that command international acceptance
and provide accurate and relevant information on
financial performance;
ï¿½    standards for disclosure of key information
needed for credit and investment decisions that
are high quality, timely, and relevant;
ï¿½    effective systems of risk management and
internal control with strict accountability of
owners, directors, and senior management;
ï¿½    financial institutions that have capital that
is commensurate with the risks they bear;
ï¿½    openness and competitiveness in banking and
financial markets subject to essential prudential
safeguards;
ï¿½    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;
ï¿½    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
ï¿½    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.

Characteristics of Effective Banking Supervision
     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 principles for
banking supervision in September 1997.19 The Core
Principles provide operational guidance for

ï¿½    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;
ï¿½    licensing and structure-clearly defined
permissible activities; licensing authority with
the right to set criteria and reject applications;
ï¿½    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;
ï¿½    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;
ï¿½    information requirements-satisfaction that a
bank has adequate records and financial statements
that fairly reflect a bank's condition;
ï¿½    formal powers of supervisors-adequate
supervisory measures to bring about corrective
actions against a bank;
ï¿½    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 home-
country 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.

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.

Weaknesses in the Financial Systems of Indonesia,
Korea, and Thailand
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 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

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.

Countries Are Taking Steps to Improve Operation of
Their Financial Sectors
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.

Countries Have Begun To Close and Merge Financial
Institutions; Sell Bad Assets; and Recapitalize
Remaining Institutions
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.

Table 1:  Countries Efforts to Improve Their
Financial Systems
Action Closed and/or  Liquidity supporta and          Selling bad assets
taken  merged         recapitalization of financial
      financial      institutions
      institutions
Indone As of July     Bank runs in Indonesia led to   In January 1998, the
sia    1999, 66 banks stepped-up liquidity support    Indonesian Bank
      have been      from Bank Indonesia.b In June   Restructuring Agency
      closed, the    1998, Bank Indonesia was        was established to take
      state has      providing $22.7 billionc or 17  over and rehabilitate
      intervened in  percent of GDP in liquidity     ailing banks and manage
      30 banks, and  support.                        nonperforming assets of
      banks have                                     intervened banks. The
      exited through The government of Indonesia     book value of assets to
      merger.        developed a recapitalization    be liquidated by the
                     scheme for private banks by     Indonesian Bank
                     categorizing banks depending on Restructuring Agency
                     capital levels. Seventy-three   (IBRA) was $3 billion.
                     banks with capital to asset     Each state bank has
                     ratios of 4 percent or better   targeted its 20 largest
                     did not need to participate.    delinquent corporate
                     Thirty-eight banks had ratios   borrowers for loan
                     below 4 percent but above       recovery,
                     negative 25 percent; 21 of      restructuring, or
                     these 38 banks were closed.     bankruptcy filing.
                     Seventeen banks with even lower Recoveries from sales
                     capital did not qualify for     of assets are to be
                     recapitalization and were       used to buy back
                     closed. Bank recapitalization   government shares in
                     was to be financed through (1)  banks.
                     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.
Korea  As of January  According to Korean official    Expanded the Korea
      20, 1999, 86   sources, the government has     Asset Management
      financial      provided about $53.3 billiond   Corporation's charter
      institutions   or 15 percent of GDP, to        to be similar to the
      (including     recapitalize intervened banks   former U.S. Resolution
      commercial     and purchase nonperforming      Trust Corporation. As
      banks,         loans from distressed financial of June 30, 1999, the
      merchant       institutions. The Bank of Korea Korea Asset Management
      banks,         (central bank) provided foreign Corporation had issued
      insurance      exchange support to commercial  20.3 trillion won worth
      firms, and     banks as foreign creditors      or about $16.9 billion
      nonbank        reduced their exposure on short-of government-
      financial      term lines of credit. During    guaranteed bonds to
      institutions)  November and December 1997, the purchase nonperforming
      had been       Bank of Korea placed about $23  loans acquired from
      closed or      billion of official reserves in distressed banks. It
      suspended      deposit at foreign branches and announced plans to sell
      operations.    subsidiaries of domestic        over 50 percent of
                     foreign institutions to cover   nonperforming loans by
                     the banks' short-term lines of  end-2001. It also plans
                     credit, a portion of which has  to dispose of over 97
                     since been repaid, according to percent of the total
                     IMF documents.                  amount of acquired
                                                     nonperforming loans
                     Established the Korea Deposit   within the next 5
                     Insurance Corporation, modeled  years; the sales price
                     after the U.S. Federal Deposit  is to be determined by
                     Insurance Corporation. Korea    market conditions.
                     Deposit Insurance Corporation,  According to OCC, asset
                     by the end of 1998, issued      disposition by the
                     about $17.5 billion of its      Korea Asset Management
                     government-guaranteed bonds for Corporation has been
                     recapitalizating the banks and  very slow to date.
                     depositor protection.
Thaila As of August   By early 1998, the Bank of      In October 1997, the
nd     1999, the Bank Thailand's Financial            Financial Restructuring
      of Thailand    Institutions Development Fund   Agency was established
      closed 1       had committed approximately     to review suspended
      private bank   about $20 billione of liquidity finance companies and
      and 57 finance support to private banks and    liquidate finance
      companies. In  finance companies to keep them  company assets by
      addition, 3    operational. The Bank of        auction. The Asset
      private banks  Thailand made allowance for     Management Corporation
      and 12 finance issuing about $7.5 billion of   was set up to act as
      companies were bonds with a 10-year maturity   bidder of last resort
      merged.        to support the recapitalization for bad assets. Several
                     effort. Private banks and       auctions took place
                     finance companies are to be     between June 1998 and
                     recapitalized through Bank of   August 1999. The
                     Thailand's recapitalization     Financial Restructuring
                     program to provide capital to   Agency sold over 70
                     banks based on banks meeting    percent of closed
                     certain requirements, including finance companies'
                     writing down bad loans. State   assets, of which
                     banks are to be recapitalized   roughly 25 percent was
                     through the Financial           acquired by the Asset
                     Institutions Development Fund.  Management Corporation.
                     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.
aLiquidity support is the amount of funds provided
by a central bank to a country's banks.
bBank 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.
cWe use an exchange rate of $1 for 7,500 rupiah.
dWe use an exchange rate of $1 for 1,200 won.
eWe 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 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.

Governments Are Facilitating Corporate Debt
Workouts, but Difficulties Remain
     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 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

ï¿½    adoption of combined financial statements
from fiscal year 1999,
ï¿½    compliance with international accounting
standards,
ï¿½    reinforcement of voting rights of minority
shareholders,
ï¿½    mandatory appointment of outside directors,
ï¿½    establishment of external auditors committee,
ï¿½    prohibition of cross-subsidiary debt
guarantees from April 1998, and
ï¿½    resolution of all existing cross-debt
guarantees by the year 2000.

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 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.

Countries Have Initiated Legal and Administrative
Changes
     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

ï¿½    transparent forms of ownership that clearly
define liability of borrowers;
ï¿½    judicial and alternative dispute resolution
procedures to enforce contracts;
ï¿½    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
ï¿½    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
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 cross-
guarantees 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.

Indonesia, Korea, and Thailand Are Taking Steps
Towards Adoption of International Accounting
Standards
     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 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

Koreans Adopting International Accounting
Standards
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 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 Have Made Accounting
Changes
     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 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.

Countries Have Eased Some Restrictions on
Competition From Foreign Banks
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 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.

International Bank Supervisory Principles
Partially Implemented
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

ï¿½    the difference between "having a regulation
in place and having the regulation effectively
implemented,"
ï¿½    the inability to attract and retain qualified
staff to fully implement the Core Principles, and
ï¿½    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.

Table 2: Implementation of Selected International
Supervisory Principles in Indonesia, Korea, and
Thailand
 International         Indonesia             Korea            Thailand
    standard
Preconditions
Operational      According to the     Korea established   Bank of Thailand's
independence:    Banking Act of 1992  the Financial       operational
International    and its amendments   Supervisory         independence is to
standards call   and the Bank         Commission          be strengthened in
for an effective Indonesia Act of     effective April 1,  a future Central
bank supervisory 1999, Bank Indonesia 1998, and the       Bank Act.
system with      has its independence Financial
clear            as the sole banking  Supervisory
responsibilities supervision          Service in Jan.
for each agency  authority in         1999, combining
involved and     Indonesia. Bank      existing banking,
with operational Indonesia has the    securities, and
independence for right to supervise   insurance
the supervisors  both commercial and  supervisory
to take actions  rural banks. The     agencies to
in good faith,   right to supervise   provide (1)
free from        banks comprises the  consistent
political        right to license,    oversight to all
pressure.        the right to         financial
                 regulate, and the    industries, and
                 right to impose      (2) operational
                 sanctions.           independence from
                                     the Ministry of
                                     Finance and
                                     Economy.
Licensing and structure
Licensing:       Bank licensing       Licensing           Issued regulations
International    authority was moved  authority was       regarding finance
standards call   from the Ministry of granted to the      company
for applicants   Finance to Bank      Financial           entitlement to a
to be qualified  Indonesia to lessen  Supervisory         banking license.
as a way to      political influence. Commission in       The Ministry of
better ensure    Conditions for       April 1999. Prior   Finance is the
that a bank is   establishing new     to this, the        licensing
operated in a    banks have been      authority for       authority.
safe and sound   tightened: sources   licensing and
manner.          of capital are to be revoking licenses
                 scrutinized; bank    had been with the
                 owners and managers  Ministry of
                 must pass a fit and  Finance and
                 proper test;         Economy.
                 organization,
                 ownership structure,
                 and operating plans
                 and projected
                 financial condition
                 are assessed.
                 Foreigners may now
                 own up to 99 percent
                 of Indonesian banks.
Prudential regulation
Capital          Bank Indonesia has a The Financial       The capital
Adequacy:        set of capital       Supervisory         adequacy ratios
International    requirements based   Commission has      were changed in
standards set by on international     adopted the Basel   1998 to comply
the Basel        standards.           Capital Accord for  with Basel Capital
Committee        Indonesian banks are internationally     Accord. Capital
provide for      to hold capital      active banks,       adequacy standards
minimum capital  equal to 4 percent   phasing them in by  in Thailand are to
levels that      of risk-weighted     Dec. 2000.          be based on
reflect, in      assets by end-1999   -by March 1999,     classification and
part, the risks  and 8 percent at end-banks were to have  provisioning
that a bank has  2001, which is       at least a capital  standards that are
in its loan      consistent with the  ratio of 6 percent  to come into full
portfolio.       Basel Capital        (using              effect in 2001.
                 Accord.              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.
                                     
                                     
                                     
                                     
                                     
                                     
Loan                                                       
classification
Loan loss        The five loan        Provisions for      Regulations
provisioning:    classification       "precautionary      reflected an
International    categories are pass, assets" were        increase in loan
standards call   special mention,     increased from 1    loss reserves for
for banks to     substandard,         percent of assets   5 categories.
establish and    doubtful, and loss,  to 2 percent. For   -Pass is 1
adhere to        with respective      substandard loans,  percent,
policies for     provisioning of 1    reserves are to be  -Special mention
evaluating the   percent, 5 percent,  20 percent; for     is 2 percent,
adequacy of loan 15 percent, 50       doubtful loans, 75  -Substandard is 20
loss reserves.   percent, and 100     percent; and for    percent for
                 percent. The general loss, 100 percent.  unsecured loans,
                 loan loss reserve                        -Doubtful is 50
                 was increased from   Korea revised its   percent for
                 0.25 percent of the  criteria for the    unsecured loans,
                 loan portfolio to    calculation of      and
                 1.0 percent.         capital ratios to   -Loss is 100
                                     prevent counting    percent for
                                     reserves for loans  unsecured loans.
                                     classified as       
                                     substandard or      The substandard
                                     lower as part of a  classification
                                     bank's capital by   historically had
                                     deducting the       no provisioning-it
                                     provisions of       was changed to 15
                                     those classified    percent in 1997
                                     as substandard or   and to 20 percent
                                     lower from a        in 1998.
                                     particular class    
                                     of capital.         The provisioning
                                                         for the doubtful
                                     Loan-loss           loans changed from
                                     provisions will     100 percent to 50
                                     also be required    percent for
                                     for payment         unsecured loans.
                                     guarantees of
                                     commercial banks.
Lending limits:  Bank Indonesia's     To address Korea's  A new law on
International    rules on legal       corporate networks  commercial banking
standards call   lending limits are   of cross-           and financial
for lending to   the same as          guarantees, Korea   institutions that
related          international rules. set banks' equity   includes lending
companies and    Bank Indonesia has   capital limit to    limits is being
individuals on   said that it will    25 percent for      drafted.
an arm's-length  enforce a limit on   lending to large
basis and limits loans to one         shareholders and
restricting bank borrower or one      their affiliates,
exposures to     group of borrowers.  and other
single borrowers For a single         restrictions on
or groups of     borrower or group of connected lending.
related          borrowers related to The excess over
borrowers.       a bank there is a 10 the 25 percent
                 percent rule-lending limit is to be
                 can be no more than  progressively
                 10 percent of bank   reduced and
                 capital. For         eliminated by Jan.
                 borrowers not        1, 2001.
                 related to the bank  
                 the rule is a        On directed
                 maximum of 30        lending, Korea
                 percent from         requires banks to
                 December 1998 to     provide 35 percent
                 2001, a maximum of   of new won-
                 25 percent by 2002,  denominated
                 and 20 percent by    lending to small
                 2003.                and medium-sized
                                     companies.
Foreign exchange Banks are to limit   Introduced control  As of October
exposure:        net open foreign     systems on funding  1998, banks were
International    exchange positions   and maturity gaps   limited to net
standards call   (i.e., unhedged      of banks' foreign   open foreign
for banks to     exposures) to 20     exchange exposure   exchange positions
have adequate    percent of capital   and expanded its    of 15 percent.
ways to manage   by June 2000. Bank   monitoring of       
international    Indonesia also       foreign exchange    
risks and        increased reporting  exposures to        
adequate         requirements on      include offshore    
reserves against foreign exchange     accounts.           
these risks.     transactions so that                    
                 exposure is to be                       
                 reported daily in a                     
                 consolidated form.                      
Methods of ongoing supervision
On-site          Bank Indonesia has   The Financial       Examination
supervision:     about 400 bank       Supervisory         guidebooks are
International    examiners for        Commission was      being revised and
standards call   regular examinations revising its        supervisors are
for independent  and, when necessary, guidebooks on       being provided
validation of    can employ public    examination         with additional
supervisory      accounting firms to  regulations and     training. A World
information      examine banks.       providing           Bank official
either through                        additional          noted that
on-site                               training for its    considerable
examinations or                       supervisors.        technical
use of external                                          assistance is
auditors.                                                planned in this
                                                        area.
Off-site         Bank compliance      The Financial       The Bank of
supervision:     directors are to     Supervisory         Thailand requires
International    analyze compliance   Commission is       banks to file
standards call   with banking         expanding its off-  reports on their
for supervisors  regulation and       site surveillance   balance sheets,
being able to do report monthly.      system to capture   capital levels,
off-site         Enforcement warnings more data in a      loan
monitoring to    can only be issued   more timely         classification,
identify         twice prior to       manner.             changes in lending
potential        removal of bank                         or borrowing, and
problems,        management.                             loans over 5
thereby                                                  million baht
providing early                                          (about $125,000).
detection and                                            It plans to
prompt                                                   develop an early
corrective                                               warning system for
action before                                            financial system
problems become                                          risks.
more serious.
Formal powers of supervisors
Supervisory      Indonesia will       Korea established   Independence
authority:       establish an         the Financial       remains a problem
International    independent bank     Supervisory         for bank
standards call   supervisory body no  Commission to       supervisors.
for bank         later than 2002 to   separate            Thailand law
supervisors to   take over the task   supervisory power   provides that a
have at their    of supervising banks from the Ministry   bank supervisor
disposal         in the Indonesian    of Finance and      can be held
adequate         banking system. Bank Economy and gave    personally liable
supervisory      Indonesia will       authority to the    for loss to the
measures to      retain its           Financial           state; supervisory
bring about      privileges to        Supervisory         staff has
corrective       examine banks if     Commission to       expressed concerns
action.          deemed necessary.    order prompt        that the law could
                                     corrective actions  be broadly
                                     in cases of         interpreted and
                                     unsound financial   its enforcement
                                     institutions.       could be subject
                                                        to political
                                                        influence.
Information requirements
Financial        Reliability of bank  Korea is phasing    The Bank of
statements:      financial statements in international    Thailand completed
International    is still             accounting          a review of
standards call   questionable. Bank   standards and       current
for banks and    Indonesia is making  requiring firms to  accounting,
other financial  an effort to improve report audited,     auditing, and
institutions to  the system of bank   consolidated        disclosure
prepare reliable reporting and check  financial           requirements for
financial        the accuracy of      statements.         financial
statements.      reported data.                          institutions and
                 Indonesia has made                      finance companies.
                 some moves towards                      New rules on
                 internationally                         accounting,
                 accepted accounting                     external audits,
                 standards.                              and disclosures
                                                        are to be issued
                                                        by Dec. 1999.
Cross-border banking
Global           Bank Indonesia       The Financial       While foreign bank
consolidated     follows the          Supervisory         branches are
supervision:     international        Commission          supervised in the
International    standard for cross-  increased the       same way as
standards call   border banking.      frequency of its    domestic banks,
for adequately                        monitoring from     prior approval
monitoring and                        quarterly to        from their home
applying                              monthly and         supervisors is not
appropriate                           enlarged the scope  required and
prudential norms                      of monitoring to    Thailand
to all aspects                        include overseas    supervisors are
of the business                       subsidiaries and    not authorized to
conducted by                          off-shore           share information
banking                               accounts.           with other
organizations                                            national
worldwide,                                               supervisors. The
including their                                          commercial banking
foreign branches                                         law, in draft
and                                                      form, would allow
subsidiaries.                                            such information
                                                        sharing.

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 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 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.

Bilateral and Multilateral Approaches to the
Challenges of Financial Sector Reform in Emerging
Markets
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:

ï¿½    promoting financial stabilization and
addressing the immediate causes of the financial
crises affecting these countries, and
ï¿½    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.

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.

Promoting Financial Stabilization
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

ï¿½    closure of insolvent financial institutions,
with their assets transferred to a resolution or
restructuring agency, merger of other
institutions, recapitalization of some
institutions;
ï¿½    announcement of limited use of public funds
for bank restructuring, with actual funds made
explicit in country budgets;
ï¿½    measures to significantly strengthen
prudential regulations, including loan
classification and provisioning requirements, and
capital adequacy standards;
ï¿½    measures to strengthen disclosure, accounting
and auditing standards, and the legal and
supervisory frameworks;
ï¿½    efforts to liberalize  foreign investment in
ownership/management of banks;
ï¿½    the introduction of more stringent conditions
for official liquidity support;
ï¿½    strengthening prudential regulation on loan
exposure;
ï¿½    the introduction of a funded deposit
insurance scheme; and
ï¿½    restructuring domestic and external corporate
debt and closing nonviable firms.

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.

Promoting Reforms to Minimize the Likelihood of
Recurring Crises
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

ï¿½    formulating and implementing the strategy for
dealing with commercial banks, finance companies,
and for specialized institutions;
ï¿½    assessing the solvency of the banking system
and the standing of main institutions, based on
bank audits;
ï¿½    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;
ï¿½    improving the overall financial
infrastructure including strengthening bank
supervision and redesign of prudential regulation
according to the Basel standards;
ï¿½    providing expertise on instituting deposit
insurance schemes;
ï¿½    updating banking laws to include provisions
that had been lacking, including limitations on
cross-ownership between banks and enterprises; and
ï¿½    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 self-regulation.

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

ï¿½    completing portfolio reviews for banks,
ï¿½    establishing an independent review committee
to verify the sound and transparent functioning of
the Indonesia Bank Restructuring Agency, and
ï¿½    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

ï¿½    dealing with owners and managers of problem
institutions,
ï¿½    using the media and rating agencies to
increase public understanding of risks and issues,
ï¿½    insulating the supervisor from personal legal
risk,
ï¿½    keeping politicians abreast of potential
risks in the system,
ï¿½    promoting change within the supervisor's
institution, and
ï¿½    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

ï¿½    assess the financial status and, where
feasible, restructure existing banks;
ï¿½    strengthen the supervisory capacity of Bank
Indonesia;
ï¿½    rationalize the supervision and regulation of
nonbank financial institutions;
ï¿½    rationalize the legal and regulatory
environment to facilitate debt recovery and
structural adjustment; and
ï¿½    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
to assess bank business plans prepared for the
bank recapitalization program.

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

ï¿½    restructuring financial institutions,
ï¿½    recapitalizing financial institutions,
ï¿½    strengthening prudential regulation and
supervision, and
ï¿½    capital market liberalization and
development.

In Thailand, the ADB approved the Financial
Markets Reform Program Loan to address a variety
of issues, including

ï¿½    undertaking immediate resolution of finance
company nonperforming loans and rehabilitation of
unliquidated finance companies;
ï¿½    establishing institutional structure for
resolution and/or rehabilitation;
ï¿½    undertaking financial restructuring of
finance companies;
ï¿½    strengthening market regulation and
supervision, particularly focused on the Stock
Exchange of Thailand (SET) and the Securities and
Exchange Commission (SEC);
ï¿½    improving risk management;
ï¿½    facilitating investor-issuer access to the
domestic financial market; and
ï¿½    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.

Self-Reporting on Countries' Implementation of
International Standards
     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.

Multilateral Institutions Are Coordinating
Assistance Efforts
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 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.

Conclusion
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.

Agency Comments and Our Evaluation
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.

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
_______________________________
1The 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.
2We 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.
3See 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).
4We will refer to South Korea, officially named
the Republic of Korea, as Korea throughout this
report.
5See Bank Soundness and Macroeconomic Policy, Carl-
Johan Lindgren, Gillian Garcia, and Matthew Saal,
International Monetary Fund, (Wash., D.C.: 1996).
6See 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).
7See The Asian Financial Crisis: Causes, Cures,
and Systemic Implications, Morris Goldstein,
Institute for International Economics, (Wash.,
D.C.: 1998).
8See International Capital Markets: Developments,
Prospects, and Key Policy Issues, International
Monetary Fund, (Wash., D.C.: Sept. 1998).
9See International Financial Crises: Efforts to
Anticipate, Avoid, and Resolve Sovereign Crises
(GAO/GGD/NSIAD-97-168, July 7, 1997).
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).
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.
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 (G-10), 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.
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.
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.
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 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.
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.
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.
27"Systemic Bank and Corporate Restructuring:
Experiences and Lessons for East Asia," Stijn
Claessens and Margery Waxman, The World Bank
Group, 1998.
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.
29For more information on IMF's data dissemination
standards see GAO/GGD/NSIAD-97-168.
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.
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.
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.
34See International Banking: Strengthening the
Framework for Supervising International Banks
(GAO/GGD-94-68, Mar. 21, 1994).
35See International Monetary Fund: Approach Used to
Monitor Conditions for Financial Assistance
(GAO/GGD/NSIAD-99-168, June 22, 1999).
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.
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/GGD-94-68, Mar. 21, 1994).

Appendix I
Objectives, Scope, and Methodology
Page 43GAO/GGD-99-157 Asian Financial Sector Refor
ms
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 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 50GAO/GGD-99-157 Asian Financial Sector Refor
ms
Indonesia
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.

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 self-
enrichment.

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 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
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
well-developed 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.

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 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.

Thailand
The onset of the financial crisis in Thailand
highlighted and exacerbated many of the weaknesses
that existed in the banking system, such as weak
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.

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.

_______________________________
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.
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.
5 Disclosure is the release by banks and companies
of all information, positive or negative, that
might bear on an investment decision.
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.

Appendix III
Legal, Administrative, and Judicial Changes in
Indonesia, Korea, and Thailand
Page 55GAO/GGD-99-157 Asian Financial Sector Refor
ms
Indonesia
     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

ï¿½    lifting restrictions on debt for equity
conversions,
ï¿½    removing tax disincentives for restructuring,
ï¿½    streamlining procedures and approval
requirements applicable to the admission of
foreign direct investment,
ï¿½    a new arbitration law, and
ï¿½    measures to provide for the registration of
collateral.

Korea
Korea has made several legislative changes to
strengthen its financial regulatory system and
corporate governance, open its financial
institutions 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 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.

Thailand
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 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 property-related 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 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.

_______________________________
1 Securitization is the conversion of assets into
marketable securities for sale to investors.

Appendix IV
Comments from the Department of the Treasury
Page 56GAO/GGD-99-157 Asian Financial Sector Refor
ms

Appendix V
Comments from The World Bank
Page 58GAO/GGD-99-157 Asian Financial Sector Refor
ms

Appendix VI
GAO Contacts and Staff Acknowledgments
Page 59GAO/GGD-99-157 Asian Financial Sector Refor
ms
GAO Contacts
     Thomas J. McCool (202) 512-8678

Susan S. Westin (202) 512-4128

Acknowledgments
     Patrick S. Dynes, Nima P. Edwards, Debra R.
Johnson, James M. McDermott, John H. Treanor,
Desiree W. Whipple

*** End of Document ***