During rapid economic growth of the 1990s, many banks and depository institutions were able to manage high loan growth and generate significant fee income, while building a productive asset base, increasing profits, making provisions for losses, and expanding their capital base. However, since the start of the regional contagion effect, the Malaysian banking system has been under considerable strain following the collapse in the stock market and the depreciation of the ringgit. In the fourth quarter of 1997, there had also been a flight-to-quality by depositors who moved substantial funds into foreign and largest domestic banks, thereby creating liquidity problem for some banks. A number of finance companies and stockbrokers experienced financial problems. Events of the past year have highlighted some of the deficiencies and weaknesses inherent in the financial system. The weaknesses are related to the following factors: Rapid credit growth and high exposure to property and stock markets High leverage, with large short-term domestic debt Increasing non-performing loans. The relatively high leverage coupled with the heavy reliance on short-term debt increases the overall solvency risk profile of both the corporate and financial sector, especially when interest rates are increased. The ratio of non-performing loans (NPL) has risen from 3.5 per cent in March 1997 to 9.1 per cent in March 1998 (Figure 7). In an environment of rapid economic growth, the corporate sector would be able to service the increasing amount of debt through increased cashflow. However, with falling economic growth, the corporate sector would face increasing problems in servicing their debts, especially when coupled with a liquidity squeeze, a credit crunch, and an asset price deflation. The Government has introduced various measures to reform the financial sector. This include strengthening finance companies through assisted merger, pre-emptive recapitalisation of core banking system, greater disclosure of information to facilitate better market judgements, and strengthening of prudential regulation and supervision. However, some additional policy measures are required to strengthen the financial markets. The stabilisation of financial markets is an important condition to restore market confidence. Weaknesses in the financial sector should be given urgent attention. Weak but viable institutions should be restructured and recapitalised. The Government will improve prudential regulation and supervision to strengthen banking practices and enforce discipline on individual institutions. The following are other broad measures required to bring stability in the financial markets: Actions Preserve the integrity of the banking system Establish agencies along the lines of RTC and FDIC Recapitalise the banking sector Monitor closely overall credit expansion Improve the capital market Develop the private debt securities market Action 1: Preserve the Integrity of the Banking System One should not overlook the negative impact on the asset quality of the banking system resulting from slower economic growth, higher interest rates, and the depressed stock market on corporate financial position. The slump in the property and construction sector can also create difficulties for some developers who are highly geared to default on their bank loans. The increase in short-term interest rates to which most developersí financing is tied will compound their difficulties. The banking system seems to be able to withstand the current crisis better than those in the region. However, they will be weighted down by their exposure to property, especially loans provided for the construction of condominiums, hotels and shopping complexes. Low demand and falling prices may cause some developers to default on their loans. The high level of domestic debt renders the corporate sector vulnerable to the current economic developments. Difficulties in the corporate sector will raise the banksí non-performing loans as a percentage of total loans and may cause difficulties to the weaker banks. Recommendations The authorities should continue to apply the highest standards in reporting and carrying out prudential supervision. The measures aimed at preserving the integrity of the financial system are as follows: The public has been reassured that the government guarantees the principal amount and accrued interest of deposits placed with banks, finance companies and merchant banks. There should be closer surveillance of banks and improvement in non-performing loans (NPL) reporting for increased transparency and disclosure standards. Mergers are encouraged to consolidate the banking sector in order that they become more competitive internationally. However, the exercise must not be seen as an indirect bail-out of individual institutions with infeasible fundamentals. Deteriorating collateral and non-performing assets in banks would be addressed in order to avoid distortions in the financial sector and a structural credit crunch. Action 2: Establish Agencies Along the Lines of FDIC/RTC The present economic crisis has raised concerns on the vulnerability of Malaysiaís financial sector. Several measures have been taken to strengthen and instil confidence in Malaysiaís financial sector such as Government guarantee of deposits, and mergers and consolidation in the financial sector. Despite these measures, there is general uncertainty over the soundness of the banking system. It is, therefore, suggested that the Government establish agencies along the lines of the Federal Deposit Insurance Corporation (FDIC) or the Resolution Trust Corporation in the United States to maintain stability in the financial sector. In the United States, the FDIC was established by the Banking Act of 1933 to insure deposits at commercial and mutual savings banks, following bank failures in the 1920s and 1930s. The FDIC has three major responsibilities: insurance, supervision and liquidation. The Resolution Trust Corporation (RTC) was established in 1989 to administer the closing or merging of insolvent thrift institutions and was dissolved in 1993 with FDIC assuming its functions. The FDIC continues to play a significant role in maintaining stability in the US financial system. By insuring deposits under the auspices of the US Federal government, backed by the implied support of the US Treasury, the FDIC has successfully eliminated the ërun on the bankí problem by depositors. Currently there is no insurance facility for bank failures. Thus, a bank failure would mean depositors would have to wait to get their deposits until the bank has liquidated and at that time they would be paid only a fraction of the value of their deposits. The FDIC-type of institution will, therefore, guarantee that depositors would be paid off in full no matter what happens to the bank. Malaysia should consider the feasibility of establishing a new institution along the lines of FDIC/RTC to reduce Governmentís financial burden in the case of a bank run. Recommendations It is proposed that an agency be established along the lines of FDIC/RTC concept but with modification to suit local needs. It will be an independent agency created by Parliament to maintain stability and public confidence in the nation's banking system. The main functions of the agency might include ensuring or guaranteeing deposits of banks and other savings institutions; identify, monitor and address risks to deposit insurance funds; and to take over bad loans and non-performing assets from sick banks and financial institutions. The agency could be funded from the issuance of bonds and securitisation of assets. Foreign equity up to a maximum of 20 per cent of total assets may be considered. Action 3: Recapitalise the Banking Sector While the indicators of the soundness of the banking system in the country are satisfactory compared to other countries in the region, there is a growing fragility in the system. In the near-term, fragility will increase due to the economic slowdown, expected downturn in real estate prices, weakening financial position of corporations and individuals, and distress among stock brokerage companies. Bank Negara has implemented several measures to deal with the growing fragility in the banking system such as mergers and strengthen the regulatory regime. The Asset Management Company (AMC) and deposit insurance scheme will raise confidence in the banks. While these measures can strengthen the banking system, they may be insufficient to address potential fragility problems pre-emptively and in quick time. Rather than intermittent regulatory interventions, recapitalisation will restore public confidence quickly in the system by demonstrating that banks are well-capitalised. A core consideration for recapitalisation is the restoration of domestic and foreign confidence in our banking system. By demonstrating that our banks, and especially the domestic banks, are well capitalised to withstand the rising stress due to the increasing NPLs, confidence of Malaysians in domestic banks will rise. The confidence of foreign financial institutions conducting counter-party businesses with domestic Malaysian banks will also be raised significantly. Accordingly, the cost of funds for domestic banks would be lower, thereby helping to reduce the burden of interest rates on borrowers. It is estimated that the total NPL in the banking system will be around RM74 billion (or 15.7 per cent NPL) at the end of 1998, and rising to RM100 billion (19.7 per cent NPL) by end 1999, if nothing is done to address the problem. Recapitalisation also promises to be a quick and effective strategy to increase liquidity and allow Malaysian banks to start giving out loans rather than being preoccupied with defending their capital base in the light of rising NPLs. This will enable domestic banks to continue to play their rightful role in the economy and compete with the foreign banks. Otherwise, while the domestic banks are pre-occupied with managing the rising tide of NPLs and ensuring that their capital adequacy ratios do not get eroded, the foreign banks are gaining market share at the expense of domestic banks. The creation of the AMC will have direct implications on the management of NPLs and the rehabilitation of viable businesses. The AMC will buy a portion of the non-performing assets away from banks. While relieving the banks of the problems of managing non-performing assets and injecting cash into the banking system, the banks will still have to make provisions for writing-off the shortfall in loan value arising from the sale. This will hit their profit and loss statement and balance sheet. The banksí portfolio of NPLs may be reduced, but their capital adequacy ratios will still be eroded and, therefore, require recapitalisation. The following measures are recommended: Recapitalise the banking system and in particular the domestic banks. This measure is critical in restoring confidence in the banking system and the support for the ringgit. The international financial community is aware of the growing problems Malaysian banks will face and has accordingly imposed a very high premium on the ringgit. This fear has prompted currency traders to short the ringgit and cause the weakening of the ringgit exchange rate. The Government should issue RM20 billion worth of long-term bonds to the Employee Provident Fund, PETRONAS and the Insurance Companies. The Government should inject the funds mobilised through the bonds into the banks as subordinated long-term loans carrying the same interest rate and maturity as the long-term bonds issued by the Government. Recapitalisation through the issuance of bonds offers several advantages: The use of bonds to recapitalise banks will make foreign acquisition of domestic banks unnecessary. Liquidity in the economy will start to flow and interest rates should ease without the BNM forcing it down to the discomfort of the financial market and with negative impact on the ringgit. Bond issuance will avoid the controversy of using EPF or Petronas money to rescue ailing banks. The bond exercise can be presented as an immediate solution that will assist the outlook of the currency and stock market. There will be no ëcrowding-outí since the money raised through the bonds is channelled into the banking system for disbursement as loans to the private sector. Financial impact on the Government will be minimal as the coupon rate on the bonds can be covered by interest earned on the loans extended to the banks. Action 4: Monitor Closely Overall Credit Expansion The Malaysian financial sector is much stronger than those of the neighbouring countries, but there was a problem of rapid credit expansion to the private sector, especially during 1995-96. In 1996, the lending to the broad property sector as well as for the purchase of stocks and shares rose by 30 per cent, respectively. The easy credit had not only inflated the private sector indebtedness, but also raised the concern that the funds were channelled into activities such as property development and share purchase, which were considered as less productive sectors. As a prudential step, Bank Negara Malaysia had adopted some pre-emptive measures in March 1997 to limit the extension of credit to these sectors. Following the 1998 Budget speech, monetary policy had been tightened further in 1997. The interest rates were raised and a Credit Plan was adopted to reduce the loan growth of the banking sector. According to feedbacks from the private sector and bankers, there seems to be a mismatch between the providers and the users of funds. Bank Negara has estimated that about RM62 billion of new loans will be available for 1998 (excluding repayments). Despite the availability of undisbursed loans in the financial system, many users of funds are unable to gain access to them. Compared to the level of outstanding loans for the preceding month, there was very little credit growth (0.85 per cent) in December 1997. Credit grew by 5.7 per cent in January 1998 before recording negative growth for February, March and April 1998. Some examples of the credit squeeze are as follows: Increasing interest spread. The spread of interest for overdraft facilities has increased from 2.25 to 4 per cent; trust receipts for the financing of purchases from 1.5 to 3.0 per cent; Bankerís Acceptance commission from 2 to 3 per cent; and Bankersí Guarantee commission from 0.1 to 1.5 per cent per month. Rescheduling of loan payments because the holding company has construction arms Withdrawal of unutilised credit facilities or amending limits on credit facilities Rejection of hire purchase financing on plant and machinery and overdraft on working capital The depreciation of ringgit and the drastic fall in KLSE have severely affected business confidence and profitability. Those badly affected are domestic-oriented industries without export activity and high import-content industries, such as automotive, building materials, and metal-based industries. For the export-oriented industries, the depreciation of ringgit should increase export opportunities and provide manufacturers who are operating at full capacity with the incentive to expand operations. A pre-requisite for business expansion is the availability of loans and financial assistance. The credit squeeze has arisen for the following reasons: Many banks have over committed their funds for 1997, with very few new loans available for 1998 under the Credit Plan. Banks are trimming down their credit facilities as well as increasing interest rates. This is in response to the Credit Plan submitted in accordance with Bank Negaraís guidelines to reduce the rate of loan growth to 20 per cent by March 1998 and 15 per cent by end 1998. While the 15 per cent target corresponds with the broad guidelines, several banks have been instructed to reduce the targets further to as low as 7.5 per cent in some cases. The high effective cost of loan funds places the real sector under pressure. While many banks have already exceeded their lending limit, some others are flushed with funds. Deposits moved to foreign and larger domestic banks, which results in them having excess funds. Banks are cautious about providing new loans under current circumstances. The crash in the stock market and depressed property market. The emergence of the credit squeeze has serious implications for the economy. It stifles private sector growth and dynamism, while preventing the manufacturing sector from performing the much-needed role as the engine of growth when the other sectors are in the decline and increasing exports to improve the balance of payments position. Even more worrisome is that businesses are driven into deep financial straits, which could result in widespread corporate bankruptcies and undermine the stability of financial institutions. Recommendations Accordingly, the following measures should be adopted: Fine-tuning of policies or intervention by Bank Negara Malaysia to ensure that financial resources go to the sectors that require them at the right time and speed to ensure that particular sectors are not starved of credit. This is to avoid the real sector from going into seizure for lack of funds. More flexible implementation of the overall Credit Plan target by banks. Increase the borrowing or lending guidelines to productive sectors. Given the current tight liquidity in the economy, the condition of 40/60 to allow non-resident controlled companies to get more funds from locally-incorporated foreign banks should be reviewed. Reclassify some of the urgent infrastructure projects that do not require imports as productive rather than placing them under the broad property sector category. Develop a bond market for funding of large infrastructure projects rather than using short-term loans to fund projects with long gestation period. Local projects using fees in ringgit will not be subject to currency volatility unlike raising loans in dollars or yen. Another factor favouring a local bond market is that banks cannot keep pace in the large funding requirement of infrastructure projects. Banks are also subject to the lending restrictions in terms of the amount of loans that could be disbursed to a single customer or any one sector. The Government should also consider issuing bonds in order to get money from the public and social security and pension funds that could be recycled into the system to increase liquidity. Action 5: Improve the Capital Market Although there are laws, rules and regulations governing the operations of the equity market, it is important that investors are protected and the market is not manipulated by unscrupulous players. There is a need to introduce a framework for strengthening corporate governance. Malaysian corporations and their advisors must raise the standards of disclosures. Regulatory Framework To strengthen the regulatory framework, the recommended medium-term measures are as follows: An institution such as the Financial Reporting Foundation (FRF) should be entrusted to prepare a new framework for corporate governance within a period of six months and submitted to the Minister of Finance. Market regulators, especially Kuala Lumpur Stock Exchange (KLSE), Securities Commission (SC), and Registrar of Companies (ROC) must act firmly and decisively against breaches of regulations. They must increase their monitoring and enforcement activities. The functions of KLSE, SC, ROC and Foreign Investment Committee (FIC) should be reviewed to streamline the regulatory structure for public listed companies in order to reduce the areas of overlap. SC as the principal regulator of the capital market should review the performance and capabilities of KLSE as a front-line regulator, with respect to the governance of the Exchange as well as its management and enforcement capabilities. As part of the effort to enhance market integrity, KLSE on its own initiative should ensure that the new client asset protection framework is implemented as soon as possible. In addition, it should revise voluntary suspension rules and strictly enforce their application. Controlling shareholders and owners who have committed malpractices in the management of public-listed companies through fraud or manipulation of share trading and asset stripping should be prosecuted expeditiously. Weaknesses of Market Participants Stockbroking companies are facing acute liquidity problems, which could threaten the integrity of stockbroking business as a whole. There is also continued high exposure of the market to the retail segment, which is unsophisticated and highly speculative in behaviour. Current practices in the Malaysian stockbroking industry have significantly increased the risk of a broker defaulting on its obligations. Medium-term measures recommended to address the weaknesses of market participants are as follows: The current stockbroking industry should be consolidated through mergers, take-overs and closures. A more liberal stance should be taken regarding foreign participation and ownership, while strong and well-managed local stockbroking companies should be allowed to open branches. Greater efforts, including a relaxation of bureaucratic and procedural controls, should be undertaken to realise the creation of a vigorous fund management capability in Kuala Lumpur. Weaknesses of Market Activities The private sector and fund managers have expressed concerns about the suspension of securities borrowing and lending and regulated short-selling. Securities borrowing and lending programmes were aimed at improving settlement efficiency in the securities market and assist in the development of the derivatives market. The regulated short-selling programme is an integral function in Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) and enables risk management of derivatives. Immediate Measures: The securities borrowing and lending and regulated short-selling. While the suspension of these activities is necessary under the present market environment, they should be reintroduced when stability and confidence are restored because they promote the long-term development of the capital market. The share buy-back scheme should be reviewed and appropriate amendments made to provide the following:- a. Companies are to utilise their share premium account; b. No compulsion for companies to cancel shares bought back; c. Allowing companies to keep shares as Treasury stocks; d. Introduction of appropriate anti-manipulation rules; and e. Prohibiting the use of financial assistance. Put and call transactions. It is recommended that the relevant authorities, particularly the SC and ROC, should stamp out this abuse. They should also seek to vigorously pursue and punish in the most severe manner all parties involved in the abuse of "put and call" transactions to restore public confidence and deter future recurrence. Gearing ratio for brokers. It is recommended that the gearing ratio for stockbrokers should be relaxed slightly to not more than 2.5 times of their shareholders funds to ensure sufficient liquidity in the equity market. Brokerage rates. To enable the KLSE to compete and to regularise a rampant practice against KLSE rules, it is recommended that the regulated rates currently enforced be liberalised. Problems with warrants and transferable subscription rights (TSRs). It is recommended that the currently enforced restrictions on capital raising be lifted. Circuit breakers. A broader based circuit breaker mechanism should be considered to address the problem of excessive volatility in the market. Corporate exercises. In a dynamic market, corporate exercises and restructuring should be allowed to continue, especially in the productive and strategic sectors of the economy. Restrictions on initial public offerings (IPOs), rights issues and corporate restructuring exercises should be lifted to allow public listed companies to restructure and raise funds in the market. Medium-term Measures: CLOB. As a matter of national interest, the authorities must address the growing domination of Central Limit Order Book International Market (CLOB). An Action Plan must be prepared to restore KLSE as the market place for the trading of Malaysian equities. Restoration of banking custodian services. Effort must be made to encourage custodian services to return to Kuala Lumpur. Review of the Second Board. There is a case to be made for tightening qualitative criteria for admission to the Second Board in order to restoring order, discipline and credibility as well as refocus upon original intentions. Only companies with the best attributes and growth potential ought to be given opportunity to the ëshort cutí route of raising public capital through the Second Board. The authorities should consider reducing the number of companies on the Board by weeding out companies that failed to perform up to the profit forecasts etc. A consolidation and merger exercise can also be encouraged. Action 6: Developing the PDS Market Presently, the total outstanding amount of corporate bonds amounts to RM46 billion, while the worth of outstanding short-term corporate papers is around RM13 billion. More than 200 companies engaged in a wide range of businesses, including construction, manufacturing, engineering, retail, finance, and even stockbroking, use the debt securities market to raise funds. The private debt securities (PDS) market in Malaysia has the potential of meeting the financing requirements of infrastructure projects. However, the development of the PDS market is hampered by the lengthy approval process between 6 to 9 months and the illiquid secondary market due to selling restrictions under the Companies Act. The following measures are recommended to develop further the PDS market: Reduce the inventory cost for the market makers. A big boost to the PDS market can be given if the holdings of Government bonds and PDS by the commercial and merchant banks could be exempted from the requirement of statutory reserves and liquidity ratio. As a quid pro quo for this move, commercial and merchant banks should play a more active role in trading of PDS. At present, when a commercial bank arranges for a PDS issue, the PDS are traded for a while among the discount houses but they inevitably end up quickly in the vaults of EPF and the insurance companies. The PDS should continue to be promoted among foreign fund managers, who should be allowed to purchase PDS irrespective of their sources of ringgit. Foreigners have been active participants in the development of the PDS market. Even PDS issued on an Islamic basis, for instance, the Petronas Islamic bonds, used to be taken up by them. Some other measures include: introducing shelf registration for corporate bonds increasing institutional participation, such as the EPF, Khazanah, Tabung Haji, LTAT and Police Cooperative. increasing liquidity in the secondary market by facilitating a more active repurchase agreements (repo) market reviving the benchmark programme through Khazanah Nasional reducing the time taken to approve the issue of corporate bonds to not more than 3 months.

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