Islamic bank's woes highlight
problems By Anil Netto
PENANG, Malaysia - The banking regulatory
system in Malaysia has suffered a blow with the
revelation the country's first Islamic bank group
has sunk into the red, a situation that reportedly
has anti-corruption investigators involved.
This comes after a hefty charge of more
than RM774 million (US$195 million) to provide for
non-performing loans (NPLs) , largely from its
operations in Malaysia's offshore financial center
of Labuan.
Bank Islam Malaysia Berhad, the
holding company of Bank Islam, chalked up a loss
before taxation of RM400 million at the group
level for the financial year that ended June 30 -
a sharp plunge from a profit before tax of RM118
million a year earlier.
The scandal has
put the focus on Malaysia's banking system -
consolidating from the 1997-1998 Asian financial
crisis and a string of bank mergers - and its
corporate governance. It also raises question
about political connections in the corporate and
financial world and raises the
crucial question: how strong and autonomous is the
country's regulatory framework in scrutinizing
questionable loans and decisions especially in a
free-rolling offshore financial center such as
Labuan?
Bank Islam's losses were largely
due to unexpected provisions for non-performing
loans, which totaled RM2.2 billion. The scandal
came to light when the bank's Labuan subsidiary
was converted to a branch last December. Closer
supervision and tighter accounting standards for
NPLs revealed that the losses were much larger
than what its Kuala Lumpur head office had
expected.
Of the bank's gross NPLs of
RM2.2 billion, 35% reportedly came from the bank's
Labuan outfit, 30% from the bank's commercial unit
and the balance from consumer and corporate
clients. Second Finance Minister Nor Mohamed
Yakcop told parliament that the losses were not
due to a failure of Islamic banking principles but
were the result of negligence by some officers.
Still, anti-corruption agencies are also
reportedly involved in the investigations.
Noorazman A Aziz, the bank's new
CEO-cum-managing director, immediately made
provisions for most of the NPLs and is now trying
to squeeze out whatever he can from these loans.
The bank will fund a separate vehicle to
concentrate on recovering RM1.7 billion of the
RM2.2 billion in gross NPLs.
But this will
have to wait until late next year after more
capital is injected into Bank Islam to raise its
capital-adequacy ratio. The remaining half a
billion ringgit - mainly housing loans - will be
nursed by Bank Islam itself.
How did these
bad loans come about? The bank's Labuan operations
began in 1997 and loans were disbursed mainly
overseas in US dollars from 1998, many of them in
2002 and 2003, said Noorazman. The Labuan outfit
appeared to have operated without much oversight
when it was a subsidiary. "It had a separate
board. And it had management sitting on the board
as well, which is not right," Noorazman told The
Edge business weekly.
"Loans were given
out generously without sufficient understanding of
the risks involved, including country and project
risks," Bank Islam said in a statement. Poor
bookkeeping practices meant that credit files now
have to be tediously reconstructed while some of
the borrower firms no longer exist.
Noorazman hinted that risk management had
to be tightened; there was also a need for a clear
understanding of sovereign risk and currency
transferability as well as whether the security
for loans could actually be enforced. Many of the
bad loans at the Labuan outfit were reportedly
made to companies in Sarajevo and South Africa.
The new CEO vowed to push for prosecution of the
individuals involved after investigations by the
authorities were completed.
The bank's
woes puts the Labuan Offshore Financial Services
Authority (LOFSA) uncomfortably in the spotlight.
The authority oversees offshore trust companies,
banks, insurance firms and leasing companies on
the 92 square kilometer free port island off the
northern coast of Borneo.
A total of 57
banks are approved to operate in Labuan with
assets worth US$19.9 billion. In LOFSA's annual
report for 2004, its chairperson Zeti Akhtar Aziz,
who is also Malaysia's central bank governor,
said, "Since its inception in October 1990,
[Labuan] has established itself as a
well-regulated offshore jurisdiction supported by
strong legislation and effective supervision."
Suitable legal framework, maybe, but
effective, unhindered supervision?
Established in 1996, LOFSA is a statutory
body that reports to a board (the authority) and
to the finance minister on the overall management
and regulation of Labuan. Board members -
comprising private sector business leaders and
representatives from government and statutory
bodies - are appointed by the finance minister for
a term not exceeding three years, after which they
may be reappointed. Reporting to the board is the
LOFSA director general, responsible for day-to-day
administration.
For the last few years,
the finance minister has also been the prime
minister: first Mahathir Mohamad, who took over
the finance portfolio from 2001 until he stepped
down in 2003, and then Abdullah Badawi. Thus,
purely in terms of organizational hierarchy, the
political executive has a large say in the running
of the regulatory body through its powers to hire
and fire LOFSA board members, while Bank Negara
(the central bank of Malaysia) also exerts
influence especially through the chair of the
LOFSA board, Zeti.
This lack of autonomy
from the executive and the central bank was
highlighted in an International Monetary Fund
assessment report on Labuan released in December
2004 - at about the same time when Bank Islam was
coming under closer scrutiny.
An IMF team
had just conducted an offshore financial center
assessment to gauge the extent to which Labuan's
regulatory and supervisory arrangements complied
with internationally accepted standards and good
practices. "Autonomy of LOFSA within Malaysian
government not fully transparent," said its
report. "Develop memoranda of understanding (MoUs)
between LOFSA and the finance ministry and LOFSA
and BNM [the central bank] spelling out executive
and operational arrangements."
The team
found that Labuan has "all the essential elements
for a suitable framework for financial
supervision", with LOFSA staff well-trained and
experienced and funding adequate. But it noted
that non-performing loans are relatively high in
the banking sector and demand for credit has been
soft.
"Average profitability is low and a
number of banks and insurance companies maintain
only a token presence." The team observed that
although supervision had been stepped up, "LOFSA
staff resources for the compliance function are
currently insufficient to conduct effective on-
and off-site supervision across the whole offshore
industry."
It also noted that "corporate
governance standards for offshore financial
institutions are not well developed" and said
greater corporate and financial disclosure was
required. Quarterly reporting was required for
capital adequacy, asset quality and liquidity
mismatches, said the report, which observed that
there were no internal audit guidelines to assess
country risk.
Crucially, the IMF team
recommended that "loan classification and
provisioning rules should be more rigorous" and
said the capital adequacy risk-weight rule should
be revised to Basel standards (named after the
international Basel committee, which formulates
financial institution standards and guidelines as
well as recommends best practices).
Edmund
Terence Gomez, a University of Malaya political
economist temporarily with the United Nations
Research Institute for Social Development in
Geneva, feels the Ministry of Finance, too, should
share collective responsibility for the regulatory
weaknesses that contributed to Bank Islam's
predicament. "The regulatory bodies can't be held
solely responsible given the questionable issue of
their autonomy," he told Asia Times Online. "The
executive has to be held accountable [as well],
especially since the Ministry of Finance is led
also by the prime minister."
Gomez, who
has researched extensively into political
involvement in business, said the 1997 regional
financial crisis exposed the way banks owned by
the well-connected and the government were abused
to channel loans without proper oversight. The
identities of the borrowers and the other culprits
remain largely outside the public realm to this
day. The government subsequently introduced
corporate reforms to encourage disclosure to
ensure shareholders were aware of how their
companies were being managed and to remind company
directors of their fiduciary responsibilities.
"The problem, however, with institutions
like Bank Islam, which is majority-owned by
government agencies, is that its activities are
monitored and regulated by bodies that have a say
over managerial appointments and presumably, by
extension, over decision-making by the directors,"
he said. The Bank Islam crisis suggests that we
may have a problem of "selective corporate
governance" or worse, outside interference in the
management of this bank, he added.
Given
the extent of power of the executive over other
arms of government, this would suggest that
regulatory bodies may not have enough autonomy to
act independently, he said. "This crisis suggests
that since the government presently has ownership
and control of a large number of publicly listed
firms and banks, it should seriously review a
number of issues including devolution of power to
regulatory bodies and [ensure] that directors of
these quoted firms and banks have the capacity to
act independently and transparently."
Anil Netto is a freelance writer
based in Penang, Malaysia.
(Copyright
2005 Asia Times Online Ltd. All rights reserved.
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