Towards A Competitive Malaysia #63

Chapter 9 Institutions Matter

Strengthening Financial Intermediaries

The bane of Third World economies is the inefficiency of their banking system specifically and financial intermediaries generally. Many countries lack financial intermediaries other than banks. The foundation of a successful and vibrant economy is an efficient system of financial intermediaries, including but not exclusively banks.

The Asian economic crisis of 1997 was essentially a crisis of the banking system. Show me an economically backward country, and I will show you one without a sound banking system and efficient financial intermediaries.

A constant and major task of regulatory agencies is to keep bankers on the straight path. Bankers are not immune to greed or playing loose with the rules. The major banks can be particularly egregious, shielded by the arrogance of their size. Governments are reluctant to close them and risk widespread economic ramifications.

It is precisely these banks that must be taught a lesson and taught early, lest lesser ones might be tempted to follow suit.

Nick Leeson, a trader stationed in Singapore, caused the collapse of Baring PLC, a 300-year-old institution and banker to the Queen of England. Malaysia saw the collapse of Bank Bumiputra, the pride of Malays, a casualty of the 1997 crisis. Conveniently forgotten in that debacle were the bank’s executives playing loose with the rules long before the crisis. On each occasion the regulators tolerated them because the bank was deemed “too important and too big to fail.” Had the authorities rapped the knuckles of those executives the first time they strayed, they would have learned a very important lesson, and the bank would still be around today.

An important function of regulators is finding ways to improve the efficacy and efficiency of the system. Conditions change, and banks must adapt to meet new challenges.

Canada goes through periodic (once every decade) reviews of its banking system to ensure that it meets the needs of the economy. Every financial crisis leads to improvements. The bank runs and failures of the Depression led to the establishment of the Federal Depositors Insurance Corporation. That boosted public confidence. The government also introduced a host of new regulations that prevented banks from direct ownership of companies to whom they extend credits. American banks have been strengthened and made more efficient through the diligence of the regulators.

Another stimulus to the enhanced competitiveness of American banks is the intense marketplace competition. This is what separates American banks from their Japanese counterparts. In the past, banks monopolized the banking needs (credit and deposit) of the public. Today money market accounts of mutual funds offer near-bank services and take substantial business away from traditional banks. These accounts are not Federally insured, but their customers are sophisticated; they would not hesitate withdrawing their funds at the slightest hint of trouble. Consequently, these money market managers are even more prudent than banks in order to maintain their customers’ confidence.

Other institutions like finance companies also aggressively compete with banks in giving out loans. This competition forces the banks to be even more responsive to their customers’ needs.

Bank’s credit lines were once reserved only for big companies; today they are available to retail and small business owners. With my credit line, which in effect is a ready standby loan, I could drive a hard bargain in buying a car, as I would be paying cash to the dealer, a powerful negotiating tool. Major borrowers also benefit from the increased competition. In the past they were stuck with the banks. Today major corporations borrow money directly from money market funds through the issuance of Commercial Papers, bypassing banks and effecting considerable savings.

As banks are prudent in their lending practices, they ignore the needs of those with less-than-pristine credit risks. In the Third World such individuals would be at the mercy of chettiars, Ah Longs, and other loan sharks with their unsavory and often deadly debt collection tactics. In America, there are financial institutions that cater to these “sub-prime” borrowers. Sure they would have to pay higher interest rates, but that would be less then what loan sharks charge, besides being spared their ruthless collection tactics.

When financial institutions are efficient, everybody—customers, companies, and the economy—would benefit. When they are not, everyone would pay. The function of the government is not to go directly into the business of banking, but to ensure that the country’s banks and other financial intermediaries are safe and efficient.

Following the 1997 economic crisis, the government aggressively pushed for consolidation of the banks believing that there were too many of them competing unnecessarily. How such a conclusion was arrived at was not revealed. The presumption was that through consolidation, the country would have few but strong banks that could withstand the inevitable international competition. To me, combining small, weak and inefficient banks would create only large, weak and inefficient ones, a situation that would pose even greater vulnerability and danger to the economy.

The manner of the consolidation too was suspect. Instead of letting market forces drive the process, the government embarked on a “guided merger” with the all-knowing Central Banker picking the lucky winners. The others better find suitable suitors among those chosen few.

The assumption for the consolidation remains unproven. How does Bank Negara presume to know that Malaysia would be better served by having a few major banks instead of many smaller ones? Only the market could determine that. If those banks fail to meet the needs of their customers, it does not matter what their size, they will fail.

It may well be that Malaysia would need both the small local banks as well as

the major ones. Americans are well served by having the friendly local neighborhood

bank where the manager knows each client personally, as well as the major

money centers like Citibank.

While banks link owners and users of liquid capital (cash), others link the users and owners of other capital. Venture capital companies connect those with money with those with intellectual capital. I may have a great idea on how to make the Internet more efficient and user-friendly, but to get my ideas to work would require money, which I do not have. So I go to the venture capitalists. If they like it, they will fund my project and take partial ownership of my enterprise in return. When (or if) my company is successful, they would sell their share and recoup their investments, plus (to be hoped) some hefty profits. With those fresh funds they would look around for other new entrepreneurs and start the cycle again.

Of course the venture capitalists could easily lose their investments if my company were to go bust. Thus they have to be prudent.

Malaysia is copying this idea by having its own venture capital companies to encourage new enterprises especially in ICT. Unlike the venture capitalists in Silicon Valley who raised their money privately (or use their own funds), the government owns the venture capital funds. Their managers are former civil servants; they still have that civil service mentality, the very antithesis of the venture capitalist. As they are not risking their own funds, they are not as prudent. If they pick losers, the worst punishment would be that they would be transferred to the Housing Department. Likewise, if they were to pick spectacular winners, their salary increases would still be dependent on their set salary scheme.

A government-funded venture capital fund is an anomaly. The government has no business risking precious public funds on risky commercial ventures. That is the role of the private sector.

Stocks and bonds also link savors with investors. These are more sophisticated instruments and involve greater risks than the simple lending and depositing activities of banks, and as such require more informed consumers.

The Malaysian stock market is well developed, the largest in ASEAN (sixth in Asia) in terms of capitalization (value of shares). It may look impressive but there are many issues still not resolved. Forty percent of the market (by value) is made up of GLCs like Tenaga Nasional and Telekom Malaysia. With the government a major player, how realistic can the KLSE be in terms of becoming truly open and competitive? Besides, there are other issues like transparency of corporate governance and protection of minority shareholders’ rights that remain problematic.

Another important institution is real estate developers. They link landowners with investors. Imagine that I have a piece of land but I have no money to build on it. Enter the developer. He has the expertise and capital to build a condominium complex. He and I could go into a partnership, akin to that of the venture capitalist and the entrepreneur, to build the complex. Depending on the value of my land and the cost of construction, we would share accordingly in the owner ship of the final project. With this arrangement, my land would be developed, the developer’s employees would have work, and society would have additional residential units.

A major issue in Malaysia is the lack of development of properties owned by Malays. Often these properties cannot be sold or their ownership transferred to non-Malays. Many such valuable properties as in Kampong Baru within Kuala Lumpur are left idle, akin to putting money underneath the mattress, useless and non-productive because their owners are cash-poor and lack expertise to develop them.

With some ingenuity and the proper intermediaries, such properties could be readily developed. These parcels could be leased on a long term basis to developers without there being any transfer of title. This is done in Hawaii where most of the land is owned by the Hawaiian royal family and thus cannot be sold. Through the issuance of 100-year leases, the land could be developed, with the trust collecting regular lease payments. That could be one solution to the quandary facing Malay landowners in Kampong Baru and other areas under the Malay Reservations Act.

The solution to the problem of poverty lies in creating institutions that could productively link the owners of capital (land, money, knowledge) to its users. We need not invent new ones, merely adopt and adapt the ones now functioning well in modern economies.

Next: Insurance and Risk Management