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Banks merger must be followed by governance reforms

President Joko Widodo virtually inaugurated the establishment of PT Bank Syariah Indonesia (Persero) Tbk as a result of the merger of three Himbara Islamic banks (the Association of State-Owned Banks), on Monday, February 1, 2021, at the State Palace, Jakarta.

In his remarks, the Head of State said that Indonesia as a country with the largest Muslim population in the world, it is only natural to be able to become the leading country in terms of sharia economic development. Therefore, the establishment of Bank Syariah Indonesia (BSI) could be a new milestone for the development of the Islamic economy in Indonesia.

Banks are a crucial component of any country’s economy. Corporate governance is extremely vital particularly, for banks that are recently undergoing the process of merger and acquisition.

The emphasis of corporate governance of banks is great because of the following reasons:

  1. Banks have an overpoweringly prevailing position in its economy’s financial systems, and are extremely important engines of economic growth.

  2. Banks are usually the main depository for the economy’s savings.

Many believe that reducing the number of state-owned banks will improve the collective performance of the banking system. It will bring economies of scale through optimal use of capital and resources, have higher technical efficiency and hopefully will lead to higher profitability. Resources available can be used hiring external experts and enhancing workforce, the absence of which is partly responsible for the nonperforming assets. This is quite logical because bigger and well-managed banks are better equipped to respond to long-term needs that can support growth. However, bear in mind that improvement in profitability is not an automatic consequence of a merger and that bigger banks does not necessarily safer than small ones.

Such grand plan can only work if governance matters are also well addressed.

Corporate governance as a risk factor

Corporate governance issues have always been integral to business practices. In recent years, it has grew to become a specific area of risk. Governance failures is not just a concern for financial markets, but also an issue of political economy. We have seen efforts to build governance frameworks development of many country-specific and region-specific codes of better practices as well as reforms in the legal and regulatory system. These initiatives represent efforts to manage and mitigate governance-related risk by providing enabling environment for good governance practices. However, they do have limitations. Compliance to laws and regulations per se is at the very basic of governance practice, but it is not equal to good governance practice.

The most challenging limitation is that those reforms does not necessarily ensure a culture of governance and not truly embraced as value to many companies' shareholders. You can put vegetables in your kids' plate, but you cannot make them eat it, even though sometimes they pretend to eat it. There is also risk of companies ''gaming'' the system by creating an image of adopting good governance standards while hiding something beneath the surface. This gives superficial comfort to regulators, investors, and stakeholders at large that focus on ''box-ticking'' approach to governance assessment.

Critical areas for consideration

Shareholding structure. Appropriate regard should be taken to bank's depositors. Ideally, no single shareholder should be in position to to exercise undue influence over the policies and operations. When that is the case, it should be managed so that such shareholding structure will not be a source of weakness to the bank, especially with regard to contagion risk from activities conducted by shareholders in other entities owned.

Nature of business. To ensure that bank do not affiliate with companies engaged in undesirable practices and should engaged in activities considered to be closely related to banking (not to diversified business into non-banking related practices).

Management structure. It is common knowledge that one key cause of bank failures is bad management. Banking supervision authority is not to be involve in bank's daily operational activity - it was never meant to be. Thus it relies heavily on management integrity and competence. A proven ability and integrity to pursue the interests of shareholders without harming the interests of depositors is fundamental. The evaluation of the competence and the integrity should include a system of following up references, enquiry from other regulators, accessing publicly available data and reportable offences. Management should at all times put the interests of the bank and its depositors before their own and should act in the best interest of depositors. New management of a merged bank should has the ability to identify the risks associated with the merger in the shortest possible time.

Internal control. To ensure smooth operations, management rely on internal controls because they could not be everywhere at the same time. Controls that mitigate risks need to be established, and there should be an internal as well as an independent evaluation on a periodic basis. This will also provides comfort to the supervision authority and gives credibility to the bank. Inadequacy of and failure in internal processes, people, and systems will pose significant operational risk threats.

Capital adequacy. Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% under Basel III. POJK 03/2016 set the minimum ratio from 8% to 14% depending to the bank's risk profile ratings. Based on data from the Financial Services Authority (OJK) that was quoted by the news in September 2020, the capital adequacy ratio (CAR) of Islamic banking at the end of the first semester of 2020 was at 21.20%, up from the same period last year, which was 19.56%. Minimum capital-adequacy ratios are necessary to reduce the risk of loss to depositors, creditors and other stakeholders and for the overall stability of the banking system.

Risk concentration. Bank should manage their credit risk prudently to ensure that there are no undue concentrations of risks to individual entities, associates, industries areas, sectors or banking products. The risks of a merged entity should not be more than the risk of stand-alone entity. Therefore attention should be placed on credit exposures to the new merged entity.

Information system integration. Information systems should be able to provide management information that is accurate, timeous and relevant to manage risks. The bank’s system should be integrated, there should be minimal manual intervention. In any merger, the time taken to merge various systems can be detrimental to business. Implementation of systems is one of the biggest risks for a merged entity.

The merging of culture. Management often neglect the importance of culture in a merger and acquisition activity. Different entities with different set of culture are now blend into one. Cultural differences are a very important factor that could lead to failures in mergers. People dissatisfied with how the culture merging process handled can take different routes such as slowing down business either intentionally or non-intentionally, burning out morale, or some might just leave the organization taking their knowledge and experience with them.

In sum

As Indonesia is a global market, bank supervisory authority in Indonesia should take corporate governance as crucial.

The management team of the new merged bank should try to address the above stated governance matters for consideration and perform a truthful self-assessment to enable identification of any risks, weaknesses and improvement that might be needed to make the merged bank successful. It is imperative that management team demonstrate its ability, desire and commitment to maintain appropriate corporate governance, management, internal control and risk-management systems, including internal audit and compliance process.


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