Cover Story: A Marathon, Not A Sprint
Pushed forward by both market realities and government reforms, Taiwan's financial restructuring seems to have begun in earnest. But the process will not be a quick one.
by Matthew Smith
It is unlikely that a Taiwanese cabinet minister and a former vice president of the United States would meet simply for an idle chat. So when Minister of Finance Lee Yung-san sat down with Dan Quayle in the minister's office in March, there was little chance that their conversation would focus on golf alone. In fact, Quayle's purely private role was to provide some political punch for his employer, U.S.-based Cerebus Capital Management, which had set up an asset management company (AMC) to purchase problem loan assets from Taiwanese financial institutions. The meeting seems to have been a success for both sides: days later, state-controlled First Commercial Bank sold Cerebus a portfolio of non-performing loan (NPL) assets with a face value of NT$13 billion.
The transaction was the first such batch of bad loans sold to an AMC in Taiwan, making it a watershed event for the nation's troubled banking system. Previously, Taiwanese bankers' reluctance to sell their assets at the price levels offered by the would-be buyers had prevented the AMCs from becoming an active weapon in combating the financial system's rising level of NPLs. The First Commercial deal broke the AMC logjam, opening the way for more banks to use the mechanism to reduce their problem assets. First Commercial went on to unload an additional US$4.6 billion to a separate AMC funded by Lehman Brothers, and several of the nation's largest commercial banks have said that they will follow suit. Insiders say that more deals are now in the works, and should be announced in upcoming months.
While the First Commercial portfolio's selling price was rumored to be 24% of the face value of the loans, the composition of the loans, final price, and other terms have not been made public. Nevertheless, the deal has provided bankers with some indicators for evaluating other problem assets, a vital step for either selling them off or writing off losses on their books. "Suddenly, we have a mark to market on the loan portfolios of many of these banks, and the fact that we have such a mark and the bank stock prices haven't collapsed is very encouraging," says Peter Kurz, chairman of Insight Pacific.
The burgeoning sell-offs of bad debt to AMCs underline both the government's growing recognition of the extent of the problems in the financial system and its apparent willingness to act on reform. In general, analysts give regulators high marks for their role in activating the AMCs and for other positive steps taken so far this year. This movement contrasts with what one local expert calls "last year's show," in which, he says, the Ministry of Finance (MOF) only created the appearance of handling the problem. "It was only after Lee Yung-san took over the MOF that the government started to tackle the right issues," such as pressing banks to write off and sell off their bad loans, sell collateral, and recapitalize, he adds.
Gary Tseng, director general of the MOF's Bureau of Monetary Affairs (BOMA), explains the apparent change of regulatory heart: "Last year we designed the system, and this year we told the banks to act on it, and act quickly. I personally think this year will be a good year for the decline of NPLs." Indeed, at the very least the ratio of problem loans is unlikely to continue growing at last year's alarming rate, if only because the MOF has ordered banks to reduce their NPLs to 5% of total outstanding loans within two years. "We have conveyed this message very clearly, so there is no reason for [bank executives] to doubt it," says Tseng. The overall negative growth in bank loans and a generally weak economy will present obstacles to reaching that goal, but NPL levels are nonetheless expected to stabilize under the government pressure to reduce their size, interviewees say.
The Korean Example
Despite the positive developments, many issues remain to be tackled by the government and the banking industry itself - both to dig Taiwan out of the current financial mess and to raise the financial industry's sophistication so that it can play a leading role as a driver of economic growth rather than merely shoring up the dwindling manufacturing sector. "Taiwan has to diversify its economic base from electronics manufacturing," notes Michael McGregor, vice president of Primasia Securities. "One way to do that is to provide better financial services, especially to Taiwanese customers that have already moved to mainland China. So they've got to fix their financial system."
The benefits of having a healthy financial sector are apparent from a quick glance at Korea's economy, which - like Taiwan's - has been struck by the high-tech export slump yet nevertheless posted 2001 GDP growth of 2.88%, a figure that is forecast to rise to 6.2% this year. Korea's performance stands in stark contrast to Taiwan's GDP growth of -1.91% last year, which is expected to recover to 3.1% in 2002. The difference in the economies can largely be attributed to domestic spending in Korea, where consumer lending grew by 25% last year and now accounts for roughly half of total loans. "Korea has really shaken up their financial system" since the crisis of 1997-1998, notes Damian Gilhawley, senior economist at KGI Securities. "It's fair to credit their banking reforms for the marked improvement in current consumption levels and the overall health of the Korean economy."
Given that Korea is a major competitor for Taiwan's export industries, allowing the problems of the financial system here to fester would obviously create a competitive disadvantage for Taiwan. Regulators should "follow the Korean road, otherwise they will not move ahead," says Michael McGregor. But the path blazed in Korea is likely to prove too rocky for Taiwan to follow without a few detours. As Peter Kurz points out, when Korea restructured its financial sector, in many cases the shareholders' equity of the financial institutions was virtually wiped out before government-funded recapitalization occurred. "Taiwan is trying to do it in a manner that preserves the capital value of the original investors while bringing in new capital," he says, adding that the perception of insufficient dilution of the original shareholdings partly explains why some recent issues of European convertible bonds by Taiwanese financial holding companies (see "Picking the Winners", page xx) were not well received in the market.
Recent research reports and conversations with analysts make it clear that while foreign investors approve of the financial reforms implemented so far, they also consider that more work is needed. "Foreign institutional investors are not fully pleased, because consolidation of the sector really hasn't come full circle yet," says Neal Stovicek, strategic adviser for SinoPac Securities. In addition to reducing the number of banks and local credit cooperatives, global investors are looking for further writing down of bad debt, signs of cross-border securitization, and double-digit return on equity, he adds.
Indeed, real consolidation in the fragmented financial industries has been insignificant. The merger of three state-owned institutions - the Central Trust of China, Land Bank of Taiwan, and Bank of Taiwan - that was announced in March 2001 was officially scrapped this July, a decision that analysts attribute to labor opposition. "These kinds of mergers have to be done gradually," says Norman Yin, a professor of banking who is now a member of the Legislative Yuan representing the People First Party. "You can't just order them to do it." Meanwhile, what was billed as the first merger of financial holding companies fell apart just a week following its June announcement, after one of the firms reported that it would post a net annual loss this year.
Considering the unsuccessful record for mergers so far, it is perhaps too early to expect much aggressive acquisition activity, despite the discussions that insiders say are underway. Price differences are one roadblock to consolidation, as is the inadequate transparency that makes valuing institutions something of a guessing game. The difficulty of acquiring a controlling stake in the banks licensed after deregulation, of which no single shareholder originally could own more than a 5% stake, will also slow consolidation. And the lack of an effective legal authority for regulating financial holding companies means that there is no sense of urgency. "Several laws have been passed, but so far nobody's been prepared to make a move because the governing legal framework is still not in place," notes Damian Gilhawley, who adds that any near-term acquisitions are likely to be of the non-aggressive variety.
Certainly, foreign investors would applaud if reform were to extend beyond financial institutions to the troubled corporations that have been unable or unwilling to repay their debts. Chen Chung-hsing, president of Taiwan Ratings Corp., notes that setting up a rational system of corporate restructuring "has not really been recognized as an issue," despite being a necessary part of reforming the banking system as a whole. "If you aren't able to restructure these companies and their debts, how can it be possible to improve the banks' performance?" Chen asks rhetorically.
Still In Murky Water
Taiwan's financial sector continues to struggle under record levels of bad loans. According to official Central Bank statistics, NPLs reached 8.38% of all outstanding loans by domestic banks at the end of March. But given Taiwan's narrow definition of NPLs, forced debt restructurings, and other means of concealing the problem, most analysts judge the actual figure to be 15 to 20%. According to an analysis by Taiwan Ratings, problem loans reached 15% of total outstanding loan assets as of yearend 2001. Assuming that this number is correct and also that the system's loan-loss ratio is 50%, recapitalizing the sector would require NT$1 trillion, or about 10% of last year's GDP. (For variations on that scenario, see chart, page xx)
Clearly, the government allocation of NT$140 billion to the Resolution Trust Corp.'s Financial Restructuring Fund (RTC fund), of which NT$62.4 billion remained as of mid-July, is not sufficient to address the problem in a significant way. Chen Chung-hsing points to the political will shown in Korea, where authorities have reportedly pumped 152 trillion won (about US$130 billion) of taxpayer-financed capital into the financial system. "Korean regulators realized the size of the problem, and had the determination to appropriate the money to fix it. But in Taiwan, recognizing the size of the problem is an area in which the government has failed."
Although they might not want to admit the extent of the system's problems, in fairness the regulators' hands have been tied by a shortage of funds. The revised Banking Law of 2000 gives them the authority to take emergency action and remove the management of financial institutions that have negative equity, and the July 12 takeover of another seven grassroots farmers' and fishermen's credit cooperatives shows yet again that they are not afraid to use it.
But what happens after the takeover of such institutions is often dictated by funding limitations, and results in the dangerous and destabilizing approach of ordering larger institutions to absorb distressed ones. Gary Tseng of the BOMA notes that in order to be effective, the government must move quickly when handling institutions that it has taken over, and must have adequate funds to cover the difference between assets and liabilities so that the buyers of bankrupt institutions are not weakened as a result. "That is why we are trying to persuade our parliament of the importance of increasing the RTC fund," he says. "Having enough financial resources is extremely important when dealing with troubled financial institutions as quickly as possible." As shown by the continuing quagmire of Chung Shing Bank, the failure to handle troubled financial institutions quickly can result in devastating losses.
During the spring legislative session, the administration asked the Legislative Yuan to allocate an additional NT$180 million for the RTC fund, a request that the opposition-controlled parliament turned down. While the additional money would have covered only a fraction of the cost of recapitalizing the entire sector, one foreign observer who has been following the issue closely expresses criticism of the legislature for withholding the funds for "purely political" reasons. But Norman Yin, who sits on the Legislative Yuan's finance committee, says that in the absence of a crisis, it will be difficult for the funding to be increased "because the government is so poor." Yin says that members of his committee suggested raising taxes to fund the additional allocation, which the administration refused to allow. "If they allowed a tax hike for this issue, it would be seen as a violation of the president's promise not to raise taxes." Nevertheless, Yin says that most legislators "understand that the means at regulators' disposal are far short of what's needed."
Good Money After Bad
Critics of Taiwan's financial regulators cite the Chung Shing Bank case as a textbook lesson in how not to handle a troubled financial institution. When managerial malpractice at the bank was reported to the MOF in February 2000, officials at the ministry chose to wait until April, after the presidential election, before taking action. At that time, the bank had equity of NT$7.6 billion but faced a run on deposits and a liquidity crunch. According to Norman Yin, regulators then ordered 12 banks and three bills finance companies to chip in a combined NT$100.5 billion to bolster Chung Shing's liquidity. The postal savings system added another NT$30 billion to $40 billion, while the Central Bank itself put in NT$10 billion, for a grand total of nearly NT$150 billion.
Two years later, the bank continues to operate under Central Deposit Insurance Corporation supervision, despite having amassed NT$61 billion to $80 billion in liabilities. "The real losses are NT$200 billion," says Yin. "With that kind of money, they could have bought 20 Chung Shing Banks two-and-a-half years ago." And closing down the institution now would force the 15 financial institutions involved in the bailout two years ago to realize their losses. So Chung Shing Bank remains open for business - and continues to generate new losses.
Convincing another institution to purchase Chung Shing outright proved to be impossible in two auction attempts earlier this year, as potential buyers - reportedly both domestic and foreign institutions - questioned the accuracy of the CDIB's valuation of the bank. The government again tried to auction it off beginning on July 17, this time on a purchase-and-assumption (P&A) basis. Under the proposed terms of the P&A buyout, the purchaser would have acquired whatever parts of the bank were deemed as having value, with the CDIB reimbursing the buyer in the amount of NT$61 billion from the RTC fund. According to the MOF, there were two potential buyers in the latest auction, which had not concluded as of press time. But sources in the financial sector say that the reimbursement will likely prove too low to attract a buyer. Perhaps the only way out, notes Norman Yin, is to nationalize the bank and foist the problem onto the nation's taxpayers.
A Need for Leadership
There are other several other problem banks in need of regulatory solutions, and Taiwan cannot afford to continue to handle them in the manner of Chung Shing Bank. "The biggest challenge for the MOF this year is how to deal with weak banks," says Chen Chung-hsing. Clearly political leadership and determination will be needed to establish an effective mechanism for closing down problem banks, and the same can be said for other reforms.
"The actions taken over the past six months have been prudent, but what's needed right now in terms of resolving banking and corporate problems requires a higher level of leadership to make these decisions and overcome the vested interests that are involved," says Chen. "I would caution and urge the premier and the president to recognize that these issues have profound implications [for Taiwan]."
That seems like wise advice, particularly in light of what will emerge as a contentious issue in upcoming months: the establishment of a Financial Supervisory Authority (FSA). This agency, which is expected to combine the functions of the BOMA, the Department of Insurance, the Securities and Futures Commission, and the Central Deposit Insurance Corp., would streamline the nation's regulatory functions and allow its financial holding companies (FHCs) to perform to their full potential by better exploiting the synergies of their subsidiaries. Insiders stress the importance of ensuring that the FSA be imbued with the authority to impose proper corporate governance on the companies it regulates, and that it not be subject to MOF authority. Minister Lee confirmed that current plans call for the FSA to be an independent body, akin to the Central Bank.
Norman Yin predicts a law setting up the FSA will be enacted in the next legislative session, although he expects a partisan fight over defining the process for appointing its top-level officials. Establishing the FSA could be an opportunity to set up a regulatory structure with the skills, resources, independence, and enforcement teeth to ensure a basis for the gradual yet continuing recovery of the nation's financial sector. But that will only be possible if the issue is accorded an appropriate level of recognition, attention, and hard work by leaders at the highest levels of the Taiwan government.
