International Finance: Actions Taken to Reform Financial Sectors in Asian Emerging Markets

Published by the Government Accountability Office on 1999-09-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to Congressional Requesters

September 1999

                 Actions Taken to
                 Reform Financial
                 Sectors in Asian
                 Emerging Markets

GAO   United States
      General Accounting Office
      Washington, D.C. 20548

      General Government Division


      September 28, 1999

      The Honorable Spencer Bachus
      Subcommittee on Domestic and International Monetary Policy
      Committee on Banking and Financial Services
      House of Representatives

      The Honorable Michael N. Castle
      Subcommittee on Domestic and International Monetary Policy
      Committee on Banking and Financial Services
      House of Representatives

      This report responds to your request that we analyze efforts to improve the
      financial sectors of emerging market countries, most of which
      experienced crises since 1980. Financial crises limit emerging countries’
      economic growth and foreign trade and strain their abilities to service and
      repay international obligations. Developed countries, including the United
      States, have felt the repercussions of these crises through losses on loans
      to and investments in emerging markets and through diminished exports
      to these countries.

      To address your request, we focused on three countries—Indonesia, South
      Korea, and Thailand. We chose these countries, among other reasons,
      because when we began our review, they had been receiving large capital
      flows, were experiencing financial crises, and were making changes in
      their financial systems. We focused on the banking sectors in these
      countries because their economies, like most developing and transition
      countries, relied more heavily on bank financing than on stock or bond
      issuance or other types of market financing. Specifically, our objectives
      were to determine (1) the nature of weaknesses in the countries’ financial
      sectors, (2) the extent to which the countries have achieved reforms in

       The financial sector of a country’s economy is the complex of financial markets on which financial
      instruments are traded and financial institutions that create and trade financial instruments.
       We use the term “emerging markets” broadly to include countries that others classify as “developing
      countries” or “countries in transition” as well as newly industrialized economies such as, for example,
      See Strengthening Financial Systems in Developing Countries: The Case for Incentives Based
      Financial Sector Reforms, Biagio Bossone and Larry Promisel, World Bank, (Wash., D.C.: 1998).
          We will refer to South Korea, officially named the Republic of Korea, as Korea throughout this report.

      Page 1                                             GAO/GGD-99-157 Asian Financial Sector Reforms

                   their financial systems, (3) the extent to which the countries have
                   implemented international principles for banking supervision, and (4) U.S.
                   government and multilateral institutions’ efforts to effect changes in the
                   financial sectors of these emerging markets.

                   We conducted our work in Washington, D.C.; New York City, New York;
                   Jakarta, Indonesia; Tokyo, Japan; Seoul, Korea; Basel, Switzerland; and
                   Bangkok, Thailand, between September 1998 and August 1999, in
                   accordance with generally accepted government auditing standards.
                   Appendix I describes our methodology.

                   The governments of Indonesia, Korea, and Thailand are implementing
Results in Brief   multiple changes to reform their financial institutions and markets and
                   banking supervisory structures. Many of these changes are being
                   undertaken in response to a financial crisis. Some regulatory and legal
                   changes have been implemented in the short term, while other objectives
                   may take many years to accomplish due to the extent of the problems and
                   the enormity of the changes required. Currently, how robust the countries’
                   financial systems are to future disruptions is an open question, given the
                   risks to the financial systems posed by the continued weaknesses of the
                   corporate sectors of all three countries.

                   Although the structure of the banking systems and related weaknesses in
                   the three countries differed prior to the crises, they had some fundamental
                   similarities. The economies of each country relied heavily on debt
                   financing and restricted the access of foreign financial institutions. At the
                   same time, the countries’ legal systems did not provide adequately for the
                   enforcement of contracts or provide mechanisms for resolving defaulted
                   corporate debt. Moreover, the financial data of many businesses were not
                   reliable for credit or investor analysis because accounting practices in
                   those countries were weak. The countries did not have adequate legal and
                   institutional frameworks ensuring their bank supervisors’ independence
                   and enforcement authority. The countries did not have deposit insurance
                   systems that forestalled runs on bank deposits.

                   Indonesia, Korea, and Thailand have made or are making changes to
                   address banking system and related weaknesses, with early priority given
                   to resolving nonviable banks and debtor companies. Some insolvent or
                   weak banks have been closed or merged. Ongoing efforts include the sale
                   of assets of failed banks and the recapitalization of banks, with the latter
                   partially dependent on the corporate debt workout process. All three
                   countries are changing laws to expedite resolution of loans in default.
                   Also, Korea and Thailand have changed or strengthened accounting

                   Page 2                              GAO/GGD-99-157 Asian Financial Sector Reforms

             practices by adopting internationally accepted accounting standards. Most
             changes have been made only recently, allowing little time for assessment
             of their effect on improving the transparency and independence of the
             financial systems. The changes implemented or planned should, if applied
             fully, serve to reduce the vulnerability of the financial systems of these
             countries to currency depreciation and a reversal of credit and capital

             Each of the three countries has partially implemented international
             principles for effective bank supervision, but it is too early to determine
             the effect of this on actual bank management or supervisory practices.
             Implementation has involved, among other things, (1) increasing bank
             supervisors’ independence and enforcement authority, (2) adopting more
             stringent standards for capital adequacy of financial institutions, (3)
             stricter rules for identifying loans at risk of default and determining loan
             loss reserves for these loans, and (4) limits on foreign exchange exposure.
             However, an examination staff that can fully implement revised
             examination standards is widely expected to require years to develop. A
             key indicator in determining the effectiveness of adopting these
             supervisory principles is whether bank supervisors will take prompt
             corrective actions concerning poorly performing or insolvent banks in the

             Efforts of the U.S. and multilateral institutions (the International Monetary
             Fund (IMF), the World Bank, and the Asian Development Bank (ADB)) to
             effect changes in emerging markets have focused on the countries’
             immediate needs to resolve nonviable banks and debtor companies as well
             as long-term goals to improve financial systems. In responding to the
             countries’ immediate needs, IMF has made financial sector reform a key
             condition for financial assistance. The World Bank has been providing
             financial and technical assistance for implementing specific reforms in the
             financial and corporate sectors, such as assistance in writing banking
             regulations, in these three countries. ADB has provided loans in the three
             countries to focus on banking sector reforms that included streamlining
             their regulatory frameworks and improving transparency in the banks. The
             U.S. Treasury Department is supporting financial sector reform by working
             through the multilateral institutions. In addition, the Federal Reserve and
             the U.S. Treasury, including the Office of the Comptroller of the Currency
             (OCC), are providing bilateral assistance through financial system
             technical advisors and bank supervisory training for all three countries.

             With their central role in making payments and mobilizing and distributing
Background   savings, banks are a key part of a country’s economy and the international

             Page 3                             GAO/GGD-99-157 Asian Financial Sector Reforms

financial system. Weaknesses in a country’s banking system can threaten
financial stability both within that country and internationally. These
problems are not limited to emerging markets. Persistent problems in
Japan’s banking system, for instance, have limited that country’s economic
growth and prospects for growth elsewhere.

The financial crises in Indonesia, Korea, and Thailand began in the second
half of 1997. Banking systems in many Asian emerging markets were at the
core of the region’s financial crisis. The crises resulted in sharp declines in
the currencies, stock markets, and other asset prices. By December 1997,
the Korean won (Korea’s currency) had depreciated by 55 percent in
relation to the U.S. dollar. By January 1998, the Indonesian rupiah
(Indonesia’s currency) had fallen by 81 percent and the Thai baht
(Thailand’s currency) by 56 percent. During the second half of 1997, dollar
returns on Asian equity markets yielded a loss of 56 percent. The crises
threatened the countries’ financial systems and disrupted their real
economies. Private capital flows via short-term international bank credit
and investment flows to Asia declined by about $100 billion during 1997
from 1996 levels. Most of the decline in capital flows to the Asian region
reflected declines in flows to the three study countries plus Malaysia and
the Philippines where net inflows of $73 billion in 1996 were replaced by
net outflows of $11 billion in 1997. Most of the turnaround in these
countries arose from a $73 billion turnaround in net bank lending flows—
with the largest share of outflows recorded from Thailand and Korea at
some $18 billion each.

Financial crises in emerging markets have either been precipitated by or
exacerbated by problems in banking systems. Countries with weak and
ineffectively regulated banking systems are less able to manage the
negative consequences of volatile capital flows and exchange-rate
pressures. Establishing a strong framework of regulatory policies and
institutions to underpin the financial sector is key to maintaining financial
See Bank Soundness and Macroeconomic Policy, Carl-Johan Lindgren, Gillian Garcia, and Matthew
Saal, International Monetary Fund, (Wash., D.C.: 1996).
See Preventing Bank Crises: Lessons From Recent Global Bank Failures, Gerard Caprio Jr., William
Hunter, George Kaufman, and Danny Leipziger, World Bank, (Wash., D.C.: 1998).
 See The Asian Financial Crisis: Causes, Cures, and Systemic Implications, Morris Goldstein, Institute
for International Economics, (Wash., D.C.: 1998).
See International Capital Markets: Developments, Prospects, and Key Policy Issues, International
Monetary Fund, (Wash., D.C.: Sept. 1998).
 See International Financial Crises: Efforts to Anticipate, Avoid, and Resolve Sovereign Crises
(GAO/GGD/NSIAD-97-168, July 7, 1997).

Page 4                                          GAO/GGD-99-157 Asian Financial Sector Reforms

stability. The task of bank supervision is to ensure that banks operate in a
safe and sound manner and that they hold sufficient capital and reserves to
support the risks that arise in their business.

The costs associated with financial sector problems, particularly in
emerging markets, have been very large in terms of foregone growth,
inefficient financial intermediation, and impaired public confidence in
financial markets. The resolution costs have been largely borne by the
public sector. The United States had its own financial sector problems in
the 1980s and early 1990s with savings and loan institutions. We estimated
a direct cost to the economy for resolving these problems of about $153
billion or two to three percent of gross domestic product (GDP). The
estimated fiscal cost of systematic bank restructuring in Mexico since 1995
is on the order of 12 to 15 percent of GDP. Resolving banking crises may
cost between 45 to 80 percent of GDP in Indonesia, 15 to 40 percent of
GDP in Korea, and 35 to 45 percent in Thailand, according to central bank
or market estimates. In early 1997, one financial expert suggested that
since 1980, the resolution costs of banking crises in all developing and
transition economies had approached $250 billion dollars. Most of the
resolution costs in Asian crisis countries have yet to be incurred, and
taxpayers in Indonesia, Korea, and Thailand will largely foot the bill.

Financial crises in emerging economies can be costly for developed
countries, particularly as the importance of emerging countries in the
world economy and in international financial markets has grown.
Developing countries now purchase one-fourth of developed countries’
exports. Thirteen percent of global stock market capitalization comes from
emerging market countries. The share of emerging market securities in
portfolios in developed countries is relatively small but has been
increasing. To the extent that financial crises depress developing
countries’ growth and foreign trade, strain their abilities to service and to
repay private capital inflows, and eventually add to the liabilities of
 See p. 13 of Financial Audit: Resolution Trust Corporation’s 1994 and 1995 Financial Statements
(GAO/AIMD-96-123, Jul. 2, 1996).
 See Banking Crises In Emerging Economies: Origins And Policy Options, Morris Goldstein and Philip
Turner, BIS Economic Paper No. 46, Bank for International Settlements, (Basel, Switzerland: Oct.
   The cost of restructuring will depend on factors such as domestic and external macroeconomic
conditions, the effectiveness of corporate restructuring, and the efficiency with which bank
restructuring is implemented, according to an IMF document. Private market estimates of resolution
costs exceed official government estimates.
 Banking System Failures In Developing Countries: Diagnosis and Prediction, Patrick Honohan,
Working Paper No. 39, Bank for International Settlements, (Basel, Switzerland: Jan. 1997).

Page 5                                         GAO/GGD-99-157 Asian Financial Sector Reforms

                            developing countries’ governments, developed countries are likely to feel

                            The financial systems of Indonesia, Korea, and Thailand are different from
Weaknesses in the           systems in many industrialized countries in several ways. Contrasting their
Countries’ Financial        financial systems with the U.S. financial system is particularly illustrative.
Systems                     The U.S. financial system emphasizes arms-length relationships between
                            businesses and institutions that provide financing, whether through debt
                            or equity markets, or other forms of financing. Indonesia, Korea, and
                            Thailand place greater emphasis on debt financing through bank loans
                            than on equity financing, have closer relationships between banks and the
                            companies that borrow from them, and have greater government direction
                            in credit allocation decisions.

                            While these nations experienced years of strong economic growth, their
                            financial systems have not been resilient when facing large capital
                            outflows and currency depreciations. Reasons for this lack of resilience
                            vary, but certain weaknesses in their financial systems appear as common
                            themes. These weaknesses included (1) weak credit analysis, problems
                            that banks faced in enforcing loan agreements in the case of defaults; (2)
                            weak accounting practices that precluded effective credit analysis by
                            banks or investors; (3) lack of hedging against foreign currency exposure
                            by corporate borrowers; and (4) weaknesses in bank supervision that
                            limited the governments’ ability to respond to financial problems.

Characteristics of Robust   While countries financial systems do not need to be mirror images of one
                            another, several characteristics are widely viewed as crucial to making a
Financial Systems           financial system robust or able to weather shocks. These characteristics
                            were set forth in April 1997 by Deputy Finance Ministers of the Group of
                            Ten (G-10) in its strategy for fostering financial stability in countries

                             Reliance on debt financing per se is not necessarily a weakness. As we noted in Competitive Issues:
                            The Business Environment in the United States, Japan, and Germany, (GAO/GGD-93-124, Aug. 9, 1993),
                            Japanese and German businesses have relied more heavily on debt financing than U.S. businesses. In
                            Indonesia, Korea, and Thailand, however, the inability or unwillingness of creditor banks to rollover
                            short-term loans during the East Asian financial crisis was a key to the severity of this crisis.
                               World Bank officials told us that banks historically encouraged corporations to borrow without
                            hedging to achieve the illusion of lower interest costs.
                               The G-10 is made up of 11 major industrialized countries that consult on general economic and
                            financial matters. The 11 countries are Belgium, Canada, France, Germany, Italy, Japan, the
                            Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.

                            Page 6                                          GAO/GGD-99-157 Asian Financial Sector Reforms

                                 experiencing rapid economic growth and undergoing substantial changes
                                 in their financial systems. The G-10 calls for, among other things,

                               • a legal environment where the terms and conditions of contracts are
                                 observed and where legal recourse, including taking possession of
                                 collateral, is possible without undue delay;
                               • comprehensive and well-defined accounting principles that command
                                 international acceptance and provide accurate and relevant information on
                                 financial performance;
                               • standards for disclosure of key information needed for credit and
                                 investment decisions that are high quality, timely, and relevant;
                               • effective systems of risk management and internal control with strict
                                 accountability of owners, directors, and senior management;
                               • financial institutions that have capital that is commensurate with the risks
                                 they bear;
                               • openness and competitiveness in banking and financial markets subject to
                                 essential prudential safeguards;
                               • safety net arrangements—deposit insurance, remedial actions, and exit
                                 policies—that provide incentives for depositors, investors, shareholders,
                                 and managers to exercise oversight and to act prudently;
                               • supervisory and regulatory authorities that are independent from political
                                 interference in their execution of supervisory tasks but are accountable in
                                 the use of their powers and resources to pursue clearly defined objectives;
                               • authorities with the power to license institutions, to apply prudential
                                 regulation, to conduct consolidated supervision, to obtain and
                                 independently verify relevant information and to engage in remedial
Characteristics of Effective     In June 1996, the G-7 heads of government called for the Basel Committee
                                 on Banking Supervision—a committee of banking supervisory authorities,
Banking Supervision              which was established in 1974 by the central bank governors of the G-10
                                 countries—to participate in efforts to improve supervisory standards in the
                                 emerging markets. In response, the Basel Committee issued core

                                    See “Financial Stability in Emerging Market Economies: A Strategy For The Formulation, Adoption
                                 and Implementation of Sound Principles And Practices To Strengthen Financial Systems,” by the
                                 Working Party on Financial Stability In Emerging Market Countries, Deputies of the Group of Ten (G-
                                 10), April 1997. Representatives of Argentina, France, Germany, Hong Kong, Indonesia, Japan, Korea,
                                 Mexico, the Netherlands, Poland, Singapore, Sweden, Thailand, the United Kingdom, and the United
                                 States participated in this work.
                                    The G-7 consists of seven major industrialized countries that consult on general economic and
                                 financial matters. The seven countries are Canada, France, Germany, Italy, Japan, the United Kingdom,
                                 and the United States.

                                 Page 7                                         GAO/GGD-99-157 Asian Financial Sector Reforms

  principles for banking supervision in September 1997. The Core
  Principles provide operational guidance for

• preconditions for banking supervision—bank supervisory agencies with
  clear responsibilities, operational independence, and adequate resources;
  legal protections for supervisors; legal powers to authorize banks and
  address compliance and safety and soundness concerns;
• licensing and structure—clearly defined permissible activities; licensing
  authority with the right to set criteria and reject applications;
• prudential regulations and requirements—minimum capital requirements
  that reflect the risks undertaken by banks, independent evaluation of bank
  practices relating to granting loans and making investments, adequate
  practices for evaluating the quality of assets and the adequacy of loan loss
  provisions and reserves; identification of loan concentrations to single
  borrowers or groups of related borrowers, lending on arms-length basis;
  procedures for controlling country risk, transfer risk, and market risk;
• methods of ongoing banking supervision—on-site and off-site supervision;
  regular contact between bank supervisors and bank management;
  independent evaluation of information supplied by banks; and ability to
  supervise on a consolidated basis;
• information requirements—satisfaction that a bank has adequate records
  and financial statements that fairly reflect a bank’s condition;
• formal powers of supervisors—adequate supervisory measures to bring
  about corrective actions against a bank;
• cross-border banking—practicing global consolidated supervision,
  adequately monitoring and applying prudential norms to the banking
  organization’s foreign operations; establishing contact and information
  exchange with other countries’ supervisors; requiring local operations of
  foreign banks to operate at the same high standards as required of
  domestic institutions and having powers to share information with home-
  country supervisors to supervise on a consolidated basis.

  These core principles are intended to serve as standards against which
  countries may evaluate the adequacy of their supervisory systems as well
  as guidance to countries that are changing their systems. Bank supervisors
  from Indonesia, Korea, and Thailand participated in developing the Core
  Principles. The G-10 central bank governors endorsed these principles.

     See “Core Principles for Effective Banking Supervision,” Basel Committee on Banking Supervision,
  (Basel, Switzerland: Apr. 1997). The document was prepared by a group containing representatives
  from the Basel Committee (Belgium, Canada, France, Germany, Italy, Japan, Luxembourg,
  Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) and representatives
  from Chile, the Czech Republic, Hong Kong, Mexico, Russia, and Thailand. Also associated with the
  work were Brazil, Hungary, India, Indonesia, Korea, Malaysia, Poland, and Singapore.

  Page 8                                         GAO/GGD-99-157 Asian Financial Sector Reforms

                              Deficiencies in capital adequacy regulation are a problem area in the
                              financial sectors of emerging markets in which international standards for
                              prudential regulation have been particularly visible. In 1988, the member
                              countries of the Basel Committee on Banking Supervision agreed to a
                              method of ensuring capital adequacy, called the Basel Capital Accord,
                              which has since been expanded. The corresponding core principle states

                              “banking supervisors must set minimum capital requirements for banks that reflect the
                              risks that the banks undertake, and must define the components of capital, bearing in mind
                              its ability to absorb losses. For internationally active banks, these requirements must not be
                              less than those established by the Basel Capital Accord.”

                              Many countries adopted this standard for internationally active banks.
                              However, differences among the countries in accounting practices, such as
                              classifying and reserving for delinquent loans, can affect a bank’s level of
                              capital. Differences in accounting rules can make capital levels appear
                              higher than if the country followed stricter international rules. For
                              example, in Thailand, an unsecured loan had been considered substandard
                              after it was 6 months past due, while best practices in international
                              accounting classify a loan as substandard when it becomes 90 days past
                              due. Because reserves against specific substandard loans do not count as
                              part of a bank’s capital, banks would not have reserves for loans that are
                              overdue 90 days but less than 6 months, thus overstating their capital
                              reserves when compared to international best practices.

Weaknesses in the Financial   Prior to their financial crises, all three countries we studied fell short of
                              meeting several of the criteria for a robust financial system and the
Systems of Indonesia,         principles for effective bank supervision. While these three countries’
Korea, and Thailand           economies relied heavily on debt financing, they had inadequate
                              procedures for the enforcement of loan contracts and workouts, according
                              to IMF and World Bank documentation. In Indonesia, for instance, legal
                              problems impeded banks’ abilities to enforce loan contracts and sell loans.
                              Banks did not have ready access to collateral on their loans and had
                              limited rights to liquidate the collateral. Korean bankruptcy laws and
                              procedures lacked clear economic criteria in judging a company’s viability
                              and did not allow for creditor participation in designing a company’s
                              restructuring plan. In Thailand, family groups generally controlled banks,
                              and the result was that these banks loaned to their owners’ business

                               For more information on capital adequacy and capital standards for banks see Risk-Based Capital:
                              Regulatory and Industry Approaches to Capital and Risk (GAO/GGD-98-153, July 20, 1998).
                                   A secured loan was considered past due at 12 months.

                              Page 9                                            GAO/GGD-99-157 Asian Financial Sector Reforms

interests. With the increasing defaults on bank loans, Thailand’s weak legal
frameworks for foreclosure and bankruptcy of the debtor often meant that
it could take up to 10 years to foreclose on an institution and collect

Similarly, since accounting practices in these three countries were weak,
financial data on borrowers in these countries were not transparent or
reliable enough to support credit or investment analysis. Korea’s
corporations (called chaebols), for example, had a complex system of
cross-guarantees that made it difficult to identify the entity that would
ultimately be responsible for a loan.

Bank supervision in these three countries was hindered by aspects of the
countries’ legal system. In Indonesia, few banks were closed or merged
because of unclear legal authority to do so, according to IMF
documentation. In December 1996, a governmental directive was issued to
provide a firmer basis for Bank Indonesia (the central bank and
supervisory agency) to close insolvent banks, but political considerations
inhibited action. In Thailand, bank supervisors could be held personally
responsible for causing losses to the state. The fear of legal liability
limited their willingness to take corrective actions or, in certain
circumstances, to close failing institutions, according to a World Bank

Although Korea had a deposit insurance system and Indonesia and
Thailand did not, existing arrangements were inadequate in the face of the
financial crises that began in 1997. Prior to the crisis, in Indonesia, Korea,
and Thailand, the perception was that a large part of the deposit base was
covered by implicit government guarantees. This perception changed when
the crises broke. For example, initial efforts during the financial crisis to
bolster confidence in banks through partial government guarantees of
deposits were not successful in Indonesia. Indonesia promised
compensation only to small depositors of the banks that were closed at the
beginning of the program. The guarantee was not widely publicized, and no
announcement was made regarding the treatment of depositors in other
institutions that remained open. After several waves of deposit runs, a
comprehensive scheme covering all bank depositors and creditors was

   According to IMF, although the deposit insurance system in Korea may have been inadequate at the
onset of the crisis in late 1997, a blanket guarantee on all deposits of financial institutions until the year
2000 was provided in November 1997. This was largely successful in preventing a run on deposits as
nonviable banks were closed. Later, in order to reduce moral hazard problems, the deposit insurance

Page 10                                            GAO/GGD-99-157 Asian Financial Sector Reforms

                       Deficiencies in the corporate governance of individual financial
                       institutions were another weakness. Prior to the crisis, poor credit-risk
                       management led to the weak condition of financial systems in Indonesia,
                       Korea, and Thailand. Inadequately managed banks failed to undertake
                       adequate credit appraisals. Lax credit risk management led to
                       deterioration in the quality of loan portfolios. For example, excessive
                       lending to borrowers with limited ability to service foreign exchange
                       denominated loans in the event of a large depreciation or devaluation.

                       Appendix II provides a more detailed discussion of weaknesses in the
                       financial systems of each country.

                       The governments of Indonesia, Korea, and Thailand have taken or are
Countries Are Taking   taking a variety of actions in response to their ongoing financial crises.
Steps to Improve       They have begun to close banks that are insolvent, merge weak banks with
Operation of Their     stronger banks, sell bad assets, and assist the recapitalization of banks that
                       have not been targeted for closing or merger; many of these actions are
Financial Sectors      ongoing. They also have created frameworks involving various degrees of
                       government mediation to facilitate corporate debt workouts. Financial
                       sector restructuring in Indonesia, Korea, and Thailand has involved
                       efforts to restore confidence in the countries’ banking system by
                       guaranteeing deposits, strengthening regulatory structures, adopting
                       internationally accepted accounting standards, and creating legal
                       frameworks for bankruptcy and governance. Countries are also attempting
                       to ease barriers to competition from foreign banks. The challenges posed
                       by the financial sector and corporate debt restructuring in East Asia have
                       been considerable, however, and many of the problems that led to
                       financial crisis persist. The corporate and financial sectors in all three
                       countries are interwoven, so restructuring them is inherently a complex
                       and lengthy process.

                       system was amended with the provision that only principal for accounts of 20 million won (about $16.7
                       thousand) or more would be protected for accounts opened after August 1, 1998. We used the
                       conversion rate of exchange of $1 to 1,200 won.
                        We use the term “restructuring” broadly to capture the reform efforts that these countries were
                       making to their financial sectors and financial aspects of their corporate sectors.

                       Page 11                                        GAO/GGD-99-157 Asian Financial Sector Reforms

Countries Have Begun To          As the crisis developed, the three countries had to take actions to limit the
                                 damage to their banking systems. Similar approaches were taken in each
Close and Merge Financial        of these countries to bolster these systems. Each of the countries moved to
Institutions; Sell Bad Assets;   close and/or merge failing institutions. Each set up an institutional
and Recapitalize Remaining       arrangement to sell the loans of these banks as well as nonperforming
Institutions                     loans from banks that remained open. In general, the proceeds from the
                                 sale of assets from distressed institutions are to go towards repaying the
                                 cost to the governments of restructuring the financial systems. Finally,
                                 each country moved to recapitalize those banks that remained open
                                 through various financial arrangements. While the capital levels of these
                                 banks generally were reported to be below the standards for
                                 internationally active banks, the levels are now generally higher than
                                 during the crisis.

                                 According to the World Bank, the initial reform programs in these three
                                 countries were (1) directed at reducing instability and uncertainty in the
                                 domestic financial markets, and (2) assisting governments in developing
                                 an institutional framework to restructure and resolve nonviable financial
                                 institutions in a cost-effective manner. Because of the magnitude of the
                                 immediate financial problems these three countries faced, the initial
                                 reforms were carried out while considering the stress of the reforms on
                                 the local economies. Indonesia, for instance, faced a situation where
                                 almost all the banks were insolvent. Thailand faced several episodes of
                                 bank runs during 1997. In December 1997, about half of Korea’s merchant
                                 and commercial banks were insolvent or did not meet capital adequacy
                                 standards. Over the longer-term, the goal is to build stronger and more
                                 competitive financial systems and accompanying regulatory systems to
                                 minimize the likelihood of future problems in the financial sector. Table 1
                                 outlines several of the efforts these countries have undertaken so far to
                                 improve their financial sectors.

                                 Page 12                            GAO/GGD-99-157 Asian Financial Sector Reforms

Table 1: Countries Efforts to Improve Their Financial Systems
Action    Closed and/or merged      Liquidity support and recapitalization of financial
taken     financial institutions    institutions                                                  Selling bad assets
Indonesia As of July 1999, 66       Bank runs in Indonesia led to stepped-up liquidity            In January 1998, the Indonesian Bank
          banks have been closed, support from Bank Indonesia.b In June 1998, Bank                Restructuring Agency was established
          the state has intervened Indonesia was providing $22.7 billionc or 17 percent of        to take over and rehabilitate ailing
          in 30 banks, and banks    GDP in liquidity support.                                     banks and manage nonperforming
          have exited through                                                                     assets of intervened banks. The book
          merger.                   The government of Indonesia developed a                       value of assets to be liquidated by the
                                    recapitalization scheme for private banks by                  Indonesian Bank Restructuring Agency
                                    categorizing banks depending on capital levels.               (IBRA) was $3 billion. Each state bank
                                    Seventy-three banks with capital to asset ratios of 4         has targeted its 20 largest delinquent
                                    percent or better did not need to participate. Thirty-eight   corporate borrowers for loan recovery,
                                    banks had ratios below 4 percent but above negative           restructuring, or bankruptcy filing.
                                    25 percent; 21 of these 38 banks were closed.                 Recoveries from sales of assets are to
                                    Seventeen banks with even lower capital did not qualify       be used to buy back government shares
                                    for recapitalization and were closed. Bank                    in banks.
                                    recapitalization was to be financed through (1) private
                                    capital injected by bank owners and (2) the issuance of
                                    government bonds.

                                       The long-term cost of bank restructuring is estimated to
                                       be $85 billion, or 51 percent of GDP, according to
                                       national authorities and IMF staff estimates.
Korea      As of January 20, 1999,     According to Korean official sources, the government       Expanded the Korea Asset
           86 financial institutions   has provided about $53.3 billiond or 15 percent of GDP,    Management Corporation’s charter to
           (including commercial       to recapitalize intervened banks and purchase              be similar to the former U.S. Resolution
           banks, merchant banks,      nonperforming loans from distressed financial              Trust Corporation. As of June 30, 1999,
           insurance firms, and        institutions. The Bank of Korea (central bank) provided    the Korea Asset Management
           nonbank financial           foreign exchange support to commercial banks as            Corporation had issued 20.3 trillion won
           institutions) had been      foreign creditors reduced their exposure on short-term     worth or about $16.9 billion of
           closed or suspended         lines of credit. During November and December 1997,        government-guaranteed bonds to
           operations.                 the Bank of Korea placed about $23 billion of official     purchase nonperforming loans acquired
                                       reserves in deposit at foreign branches and subsidiaries   from distressed banks. It announced
                                       of domestic foreign institutions to cover the banks’       plans to sell over 50 percent of
                                       short-term lines of credit, a portion of which has since   nonperforming loans by end-2001. It
                                       been repaid, according to IMF documents.                   also plans to dispose of over 97 percent
                                                                                                  of the total amount of acquired
                                       Established the Korea Deposit Insurance Corporation,       nonperforming loans within the next 5
                                       modeled after the U.S. Federal Deposit Insurance           years; the sales price is to be
                                       Corporation. Korea Deposit Insurance Corporation, by       determined by market conditions.
                                       the end of 1998, issued about $17.5 billion of its         According to OCC, asset disposition by
                                       government-guaranteed bonds for recapitalizating the       the Korea Asset Management
                                       banks and depositor protection.                            Corporation has been very slow to date.

                                              Page 13                                   GAO/GGD-99-157 Asian Financial Sector Reforms

Action     Closed and/or merged        Liquidity support and recapitalization of financial
taken      financial institutions      institutions                                                       Selling bad assets
Thailand   As of August 1999, the      By early 1998, the Bank of Thailand’s Financial                    In October 1997, the Financial
           Bank of Thailand closed     Institutions Development Fund had committed                        Restructuring Agency was established
           1 private bank and 57       approximately about $20 billione of liquidity support to           to review suspended finance companies
           finance companies. In       private banks and finance companies to keep them                   and liquidate finance company assets
           addition, 3 private banks   operational. The Bank of Thailand made allowance for               by auction. The Asset Management
           and 12 finance              issuing about $7.5 billion of bonds with a 10-year                 Corporation was set up to act as bidder
           companies were merged.      maturity to support the recapitalization effort. Private           of last resort for bad assets. Several
                                       banks and finance companies are to be recapitalized                auctions took place between June 1998
                                       through Bank of Thailand’s recapitalization program to             and August 1999. The Financial
                                       provide capital to banks based on banks meeting                    Restructuring Agency sold over 70
                                       certain requirements, including writing down bad loans.            percent of closed finance companies’
                                       State banks are to be recapitalized through the                    assets, of which roughly 25 percent was
                                       Financial Institutions Development Fund. Through the               acquired by the Asset Management
                                       recapitalization program, two private banks have                   Corporation.
                                       received capital support. Five state banks were to be
                                       recapitalized by the Financial Institutions Development
                                       Fund. In addition, at least six private banks and several
                                       finance companies have raised about $6 billion from
                                       private instruments through market-led recapitalization.
                                                  Liquidity support is the amount of funds provided by a central bank to a country's banks.
                                              Bank Indonesia is the central bank of the Republic of Indonesia. The Governor of Bank Indonesia
                                              and its seven Managing Directors are normally appointed by the president for terms of five years.
                                                  We use an exchange rate of $1 for 7,500 rupiah.
                                                  We use an exchange rate of $1 for 1,200 won.
                                                  We use an exchange rate of $1 for 40 baht.
                                              Source: GAO analysis of documents from the governments of Indonesia, Korea, Thailand and IMF
                                              and the World Bank as well as interviews of officials.

                                              The process for resolving troubled financial institutions has been difficult
                                              and contentious in the three countries, and progress has varied. For
                                              example, prior to the crisis, Indonesia did not have an agency with the
                                              authority to resolve failing financial institutions. Therefore, it established
                                              the Indonesian Bank Restructuring Agency (IBRA) in January 1998 to take
                                              over and rehabilitate ailing banks, as well as manage the nonperforming
                                              assets of banks requiring government assistance. As part of its efforts to
                                              resolve failing banks, Korea had experienced delays in its plans to sell two
                                              of the largest banks of which the government had taken control. While
                                              Korea had committed to selling these banks as part of its agreement with
                                              IMF for financial assistance, Korea requested a waiver to allow a delay in
                                              accepting bids for these sales because the government had not reached
                                              agreement with foreign bankers on the terms to purchase the banks.
                                              Thailand officials reported that selling the assets of closed finance
                                              companies has been a lengthy and political process. To deal with the
                                              selling of assets, the Thailand government set up two agencies—the
                                              Financial Sector Restructuring Authority and the Asset Management

                                              Page 14                                            GAO/GGD-99-157 Asian Financial Sector Reforms

                              Corporation. The asset sales have resulted in lower returns than originally
                              anticipated, though returns in the most recent auction have been
                              significantly higher, according to the IMF. According to Thailand officials,
                              debtors have been suspected of purchasing back their nonperforming
                              loans (at a discount) through intermediaries at the Financial Sector
                              Restructuring Agency auctions. World Bank officials told us that these
                              allegations have not been substantiated.

Governments Are               The governments of Indonesia, Korea, and Thailand are facilitating the
                              workout of loans that are not being repaid and are instituting frameworks
Facilitating Corporate Debt                                      25
                              for voluntary debt restructuring. The approach, level of progress, and
Workouts, but Difficulties    degree of government involvement in corporate debt restructuring differ
Remain                        between the three countries for a variety of reasons. Common goals,
                              however, include removing nonperforming corporate loans from bank
                              portfolios to allow new lending to corporations and sharing the cost
                              among lenders, borrowers, and the governments. In general, corporate
                              debt restructuring in all three countries has been hindered due to the lack
                              of tax, legal, and regulatory infrastructures needed for debt restructuring
                              and the limited institutional experience in the region with debt workouts,
                              according to IMF documentation. The restructuring process has also been
                              complicated by the complex nature of corporate and banking sector
                              relationships and the large number of participants (creditors and debtors)
                              involved in these efforts. The delay in corporate restructuring has affected
                              the economic recovery of the three countries because of the resulting high
                              debt servicing costs, higher interest rates, and the lack of available credit
                              to small and medium-sized companies. Continued weaknesses in the
                              corporate sector pose risks to these financial systems, according to a
                              Federal Reserve official and others that we spoke with.

                              The corporate sector in Indonesia was hard hit by the economic crisis and
                              a large part of it was insolvent. The government of Indonesia announced a
                              workout structure for creditors and debtors called the Jakarta Initiative in
                              September 1998. Under this initiative, the Indonesian government
                              envisages that workouts of debt to foreign commercial creditors will take
                                 A loan workout is an agreement between the lender and borrower to take remedial measures.
                              Remedial measures could be, for example, the rescheduling of principal and interest payments over a
                              longer period, forgiveness, or an equity for debt swap. A loan workout may temporarily take the place
                              of a foreclosure in which the lender attempts to sell at auction any collateral pledged by the borrower.
                                 The voluntary debt restructuring approach draws on the London Approach, which is an informal and
                              adaptable framework for private debt workouts that relies on voluntary agreement. The principles are
                              (1) if a corporation is in trouble, banks maintain credit facilities and do not press for bankruptcy; (2)
                              decisions about the firm’s future are made only on the basis of comprehensive information shared
                              among all parties; (3) banks work together; and (4) seniority of claim is recognized, but there is an
                              element of shared pain.

                              Page 15                                          GAO/GGD-99-157 Asian Financial Sector Reforms

    place voluntarily on a case-by-case basis. The initiative provides general
    principles for the out-of-court voluntary restructuring of domestic and
    foreign debt with a view to accelerating debt restructuring, promoting
    interim financing to borrowers, and providing company information so
    that creditors can evaluate restructuring proposals. Indonesia established
    the Indonesian Debt Restructuring Agency and the Jakarta Initiative Task
    Force to implement this initiative. The Indonesian Debt Restructuring
    Agency is designed to facilitate foreign exchange payments made by
    Indonesian companies to their foreign creditors. The task force has a
    mandate to facilitate negotiations between creditors and debtors and is to
    provide a forum for one-stop approval of regulatory filings that are
    required in the context of corporate restructuring. The task force may
    recommend that the public prosecutor initiate bankruptcy proceedings in
    the public interest. These measures were complemented by strengthened
    bankruptcy law. The potential threat of foreclosure and initiation of
    bankruptcy proceedings provides an important incentive for the successful
    conclusion of restructuring agreements under the Jakarta Initiative. In May
    1999, the Indonesian finance minister announced a more intensive
    program for corporate restructuring that called for, among other things,
    identification and publication of the names of noncooperating debtors,
    starting with the largest debtors. As of July 1999, 22 of 234 insolvent
    companies had reached agreements, and about 10 percent of foreign and
    domestic debt of the Indonesian companies involved in the process had
    been restructured. Creditors have generally not been willing to meet
    debtors’ requests for partial forgiveness.

    Korea’s corporate sector restructuring is being led by creditor banks under
    principles agreed to by the government and business leaders in early 1998.
    The government assisted the private sector initiative by strengthening
    Korea’s legal and institutional framework for financial and corporate
    restructuring. In addition, the government formed the Corporate
    Restructuring Coordination Committee to act as an arbitrator. In
    December 1998, Korea’s largest chaebols, or business groups, announced
    their intent to undertake corporate restructuring and debt workouts. The
    agenda for corporate reform includes

•   adoption of combined financial statements from fiscal year 1999,
•   compliance with international accounting standards,
•   reinforcement of voting rights of minority shareholders,
•   mandatory appointment of outside directors,
•   establishment of external auditors committee,
•   prohibition of cross-subsidiary debt guarantees from April 1998, and
•   resolution of all existing cross-debt guarantees by the year 2000.

    Page 16                            GAO/GGD-99-157 Asian Financial Sector Reforms

In May 1998, Korean creditor banks began to assess the viability of large
client firms showing signs of financial weakness. According to Korea’s
Ministry of Finance and Economy, creditor banks listed 55 firms as
nonviable, with outstanding loans of approximately 5 trillion won or about
$4.2 billion, and denied new credit to them, effectively putting them out of
business. Corporate workout programs also were extended to small- and
medium-sized Korean firms.

Although there are signs of more corporate workouts taking place, there
remain impediments in Korea to restructuring the large corporations
(chaebols). Large Korean chaebols are reported to still wield considerable
power and have cross-shareholdings that complicate liquidation. For
example, bank managers and financial analysts we met with in Korea said
that different companies within a chaebol or industrial group have
guaranteed each other’s loans, making it difficult to determine who
ultimately was responsible for repayment or to resolve any delinquent
loan. In addition, the chaebols have reported raising additional foreign
financing due to the economic recovery, and Korean banks have continued
to provide lending to the chaebols, according to the Korean Ministry of
Finance and Economy and the Financial Supervisory Commission.

To encourage banks to restructure their holdings of corporate debt,
Thailand’s government relaxed classification rules for nonperforming
loans. Under the relaxed rules, nonperforming loans are classified as
performing immediately upon restructuring, subject to certain conditions,
instead of after what was previously a 3-month wait. In addition, it granted
more favorable tax treatment to both borrowers and creditors for
forgiveness of indebtedness and transfers of loan collateral, which is to be
in place until December 1999.

To mediate debt workouts, the government of Thailand established a
Corporate Debt Restructuring Advisory Committee with representatives
from the financial and corporate sectors and chaired by the Bank of
Thailand. Thailand’s voluntary approach, called the “Bangkok Approach,”
is a noncompulsory framework, that companies are encouraged to follow
in corporate workouts involving multiple creditors. Some financial market

   Korea established the Financial Supervisory Commission to handle the majority of restructuring
related responsibilities during the crisis. Korea also established the Financial Supervisory Service in
January 1999 as a universal financial system supervisor that combines the former banking, nonbanking,
insurance and securities supervisors. The Financial Supervisory Commission governs the Financial
Supervisory Service. At the time of our visit to Korea, the reform activities were referred to broadly
under the auspices of the Financial Supervisory Commission. Throughout the report, we will refer to
their activities as the Financial Supervisory Commission, which includes the Financial Supervisory
Service. To date, distinctions between the two were becoming more apparent.

Page 17                                        GAO/GGD-99-157 Asian Financial Sector Reforms

                             experts have viewed progress as being slow. As of May 1999, the
                             Committee’s efforts resulted in approximately 137 successfully
                             restructured cases out of the 680 companies focused on and had several
                             hundred more cases still pending. To expedite the process of restructuring,
                             a binding debtor-creditor plan and intercreditor agreement have emerged
                             from the private sector. The debtor-creditor plan is a binding agreement,
                             that commits signatories to follow a set framework for debt restructuring.
                             As of June 1999, 84 local and foreign financial institutions, including all
                             Thailand banks, finance companies, all foreign banks, and 300 debtor
                             firms, had signed the agreements and begun the process, according to IMF.

Countries Have Initiated     As part of the IMF and World Bank reform programs to strengthen the
                             financial sector, the three countries needed to make changes in their legal
Legal and Administrative     and administrative systems. The nature of the changes differed among the
Changes                      countries, however, reflecting each country’s legal, administrative, and
                             judicial systems that existed before the changes began. Because of their
                             importance in resolving loans to insolvent borrowers, changes to
                             bankruptcy laws have been among the most important changes in the legal
                             structure underlying the financial systems of these countries.

                             The World Bank has encouraged the three countries we reviewed to
                             provide the necessary legal framework for systemic restructuring.
                             Rebuilding the legal system at the same time that the banking system and
                             corporate sector are being restructured, according to the World Bank,
                             means establishing

                           • transparent forms of ownership that clearly define liability of borrowers;
                           • judicial and alternative dispute resolution procedures to enforce contracts;
                           • a modern regime of secured lending, including the possibility of secured
                             interests in all forms of property as well as accurate, maintained, and
                             publicly available registries for all properties used as collateral; and
                           • procedures and institutions to permit foreclosure on collateral in a timely
                             and efficient manner.

                             Without such solid legal foundations, the World Bank warned that any
                             systemic bank restructuring, no matter how successful it appears, will
                             stand only until the next banking crisis.

                             Changes in foreclosure procedures and bankruptcy law were important for
                             all three countries. These laws are intended to provide a credible and

                              “Systemic Bank and Corporate Restructuring: Experiences and Lessons for East Asia,” Stijn Claessens
                             and Margery Waxman, The World Bank Group, 1998.

                             Page 18                                       GAO/GGD-99-157 Asian Financial Sector Reforms

                            transparent way to resolve the debts, including bank loans, of insolvent
                            borrowers, according to IMF documentation. For example, in Thailand, the
                            law provided few options—a foreclosure could take up to 10 years in the
                            courts. In 1998 and 1999, Thailand changed its bankruptcy law, although
                            there was substantial political opposition because some of the legislators
                            feared that they would become liable for loans that they had personally
                            guaranteed, according to various officials. Indonesia also changed its
                            bankruptcy laws, which dated back to Dutch colonial rule, but problems
                            remain in the ability of the courts to enforce the newly established
                            commercial law. Whether or not the new commercial court can
                            expeditiously process bankruptcy applications is an open question,
                            according to a State Department official. Indications of success in
                            implementing changes in the laws of Indonesia and Thailand would
                            include faster resolution of bankruptcy cases in a more transparent

                            The countries also changed other laws affecting the structure and
                            operation of businesses. In Korea, a change in the law to eliminate cross-
                            guarantees within subindustry groups by the end of March 2000 could have
                            substantial effects on corporate governance. Indonesia also eliminated
                            some restrictive marketing arrangements.

                            Appendix III discusses these changes in greater detail.

Indonesia, Korea, and       To improve data disclosure and transparency, the countries we studied are
                            taking steps towards adoption of international accounting standards. It has
Thailand Are Taking Steps   been broadly recognized that there is a need for international accounting
Towards Adoption of         standards. Two broad overlapping approaches include standards
International Accounting    developed by (1) the Financial Accounting Standards Board, which are
Standards                   followed in the United States, called the U.S. Generally Accepted
                            Accounting Principles (GAAP) and (2) the International Accounting
                            Standards Committee, which are followed by many other industrialized
                            countries, called the International Accounting Standards (IAS).

                            Accounting, which is the primary method of recording economic
                            transactions and provides the information required for businesses to
                            operate, is vital for a developed market economy. The lack of good
                            accounting data adds an element of risk (and cost) to all economic
                            transactions, especially for the banking system, which relies on financial
                            statements for credit decisions. A set of accounting standards provides a
                            first step to providing this information; further steps (not addressed in this
                            report) would include developing a strong, independent audit function to
                            verify that businesses’ financial data are prepared in accordance with

                            Page 19                             GAO/GGD-99-157 Asian Financial Sector Reforms

                                 these standards. World Bank officials told us that there is a need not only
                                 for international accounting standards but for use of truly independent
                                 international auditors as opposed to state auditors or local franchisees of
                                 international firms.

                                 For example, the Business Advisory Council of the Asia-Pacific Economic
                                 Cooperation (APEC) organization has reported that

                                 “ [I]nformation is a crucial ingredient for investor confidence and participation. Building
                                 long-term investor participation depends on transparent financial information based on
                                 clear accounting rules and full disclosure of material information. Lax accounting and
                                 disclosure standards impede capital formation by damaging the credibility of an economy’s
                                 capital market and reducing participation in it . . . . Use of recognized accounting standards
                                 attracts investors and enhances the ability to tap debt and equity markets for new capital.”

                                 The World Bank requires the use of international accounting standards in
                                 preparing financial statements to improve comparability between projects
                                 and countries. If a country’s accounting practices do not meet
                                 international accounting standards, it must disclose any material
                                 departures from those standards and the impact of those departures on the
                                 financial statements presented.

                                 The recent economic crisis highlighted the need to adhere to international
                                 accounting standards. For example, Korea had not adopted international
                                 accounting standards prior to the 1997 crisis. A complicating factor in
                                 Korea’s financial crisis was that the level of usable reserves at the central
                                 bank, the amount of short-term debt of commercial banks, and the
                                 magnitude of corporate cross-guarantees were not readily apparent from
                                 publicly available data.

Koreans Adopting International   As Korea began its financial sector reforms, it became necessary for Korea
Accounting Standards             to modify its accounting standards. Many officials we spoke with in Korea
                                 said they considered the improvement of accounting standards in Korea to
                                 be a major reform. In December 1998, as an effort to improve
                                 transparency, credibility, and international comparability of financial
                                 information, Korea’s Financial Supervisory Commission issued guidance to
                                 upgrade accounting standards to the level of international standards.
                                 Among others, the IMF and World Bank required the Korean government

                                    According to Treasury officials and IMF documents, a leak of IMF documents to the press revealed
                                 specific information on two Korean banks as well as the low levels of usable international reserves that
                                 had not been readily available from public sources.

                                 Page 20                                         GAO/GGD-99-157 Asian Financial Sector Reforms

                              to upgrade accounting standards and disclosure rules to meet international
                              standards, including meeting IMF’s data dissemination standards.

                              Korea’s accounting reform process has proceeded in several areas,
                              including (1) defining which financial accounting standards will be the
                              primary sources of Korean generally accepted accounting principles, (2)
                              establishing accounting standards for financial institutions, and (3)
                              establishing accounting standards for combined financial statements.
                              According to Korean government documents, Korea set international
                              accounting standards established by the International Accounting
                              Standards Committee as its benchmark. Where international accounting
                              standards do not exist or are not sufficient to address particular
                              accounting issues, Korea plans to adopt U.S. standards as an alternative
                              benchmark. For example, the Financial Supervisory Commission
                              established accounting standards for combined financial statements for
                              firms subject to external audit for fiscal years starting on or after January
                              1, 1999. Korea also revised its standards to eliminate the alternative
                              treatment for the foreign currency gains or losses. As a result, firms must
                              recognize any gains or losses arising from foreign currency translation in
                              the current income statement, regardless of its source. However,
                              according to OCC, improvement is still needed in many areas, including
                              financial statement disclosure and nonperforming loan classification.

                              The Korean government also announced in November 1998 that it had
                              implemented several improvements in its debt reporting system, based on
                              recommendations by the IMF and the World Bank. For example, the
                              Korean government adjusted its reporting of total external liabilities to
                              consider the results of a comprehensive loan-by-loan survey of outstanding
                              external liabilities and the introduction of several methodological
                              improvements to incorporate best international practices. Some of these
                              changes included improved sectional classification, exchange rate
                              valuation adjustments, consolidated reporting of preshipment export
                              financing liabilities, and comprehensive reporting on residents’ holding of
                              offshore foreign debt instruments.

Thailand and Indonesia Have   Thailand and Indonesia also had to modify their accounting standards to
Made Accounting Changes       meet international standards. However, there was less emphasis on
                              improving accounting standards in Thailand because the quality of
                              financial information was better than in the other East Asian countries,
                              according to an IMF official. The Bank of Thailand has completed a review
                              of current accounting, auditing, and disclosure requirements for financial
                                   For more information on IMF’s data dissemination standards see GAO/GGD/NSIAD-97-168.

                              Page 21                                         GAO/GGD-99-157 Asian Financial Sector Reforms

                              institutions; and new specific rules on accounting, external auditing, and
                              financial disclosure are expected to be issued for banks and finance
                              companies and other financial institutions by the end of December 1999. In
                              Indonesia, the IMF conducted a review concerning Indonesia’s adopting
                              and implementing accounting and auditing rules that meet international
                              standards. As of July 1999, Indonesia had not made substantial changes to
                              its accounting practices, according to a World Bank official. However, in
                              recent months, as part of the IMF supported program, audits based on
                              international standards by international firms were initiated for key
                              financial institutions, including the central bank. Decisions on bank
                              closures and recapitalization have been made on the basis of these audits.
                              World Bank officials told us that, although work remains to be done on
                              accounting issues, Indonesia’s use of an international approach in
                              classifying loans and provisioning for losses has dramatically improved the
                              accuracy of bank financial statements.

Countries Have Eased Some     As part of their commitment to overhaul the weak and noncompetitive
                              financial system, the study countries have eased some restrictions so that
Restrictions on Competition   foreign banks are more free to compete with domestic banks for the
From Foreign Banks                                            30
                              provision of financial services. The over-reliance of debt financing from
                              domestic banks and restrictions on financing through foreign financial
                              institutions contributed to the weak financial systems in these countries.
                              Obstacles remain, hindering full participation by foreign financial services

                              Although foreign banks can offer a full range of banking services in
                              Indonesia, U.S. banks reported some restrictions relating to ownership,
                              computation of capital, personnel, and directed lending, according to U.S.
                              Treasury documentation. The government of Indonesia is easing
                              restrictions on foreign bank participation in the market for Indonesian
                              financial services. The Indonesian government promised, in its June 1998
                              letter of intent with IMF, to lift all restrictions on foreign ownership of
                              banks as it amended the banking law. Foreign ownership of publicly listed
                              banks was limited to 49 percent of outstanding shares. The government
                              promised to eliminate discriminatory capital requirements for joint venture
                              banks by the end of 1998. Under prior rules, these banks were required to
                              have twice the capital of domestic banks, and capital was computed using

                                 A U.S. Treasury official told us that although foreign banks are receiving some benefit from relaxed
                              restrictions, other financial services providers, such as securities and insurance firms, have not
                              benefited from the easing of restrictions.
                               Joint venture banks have been permitted since 1988, provided that the local joint venture partner has
                              an equity interest of at least 15 percent.

                              Page 22                                          GAO/GGD-99-157 Asian Financial Sector Reforms

only capital of the branch and not the capital of the parent bank. There are
restrictions on the number of work permits a foreign company could
obtain for foreign nationals. Also, foreign banks are limited to opening
branches in Jakarta and seven other cities in Indonesia. Finally, U.S. banks
reported difficulties complying with a government regulation requiring 20
percent of new lending to go to small- and medium-size enterprises,
according to the U.S. Treasury Department. On March 25, 1999, Indonesia
issued regulations for implementing the banking law amendments,
clarifying that all legal and administrative restrictions to the entry of
foreign investment into the banking system had been removed.

Korea has undertaken reforms that substantially liberalize its capital
markets, well beyond commitments undertaken when Korea joined the
Organization for Economic Cooperation and Development in 1996. In
addition, restrictions on foreign investment in Korea have been largely
dismantled. Korea, under its IMF program, allowed foreign banks to
purchase equity in domestic banks without restriction, provided that the
acquisitions contributed to the efficiency and soundness of the banking
sector. Korea also made changes to allow foreign financial institutions to
participate in mergers and acquisitions of domestic institutions. Despite
improvements, according to the U.S. Treasury’s National Treatment Study,
foreign banks operating in Korea continue to face competitive barriers.
The major problem continues to be the requirement to consider local
branch rather than parent company capital. This affects foreign banks’
funding and lending operations.

The presence of foreign banks in Thailand has increased in recent years
and now accounts for about 13 percent of commercial bank assets,
according to the Bank of Thailand. Until the 1997 financial crisis, there
were several restrictions on foreign banks operating in Thailand, according
to U.S. Treasury documentation. For example, foreign banks had a 25
percent ceiling on their ownership of domestic banks. After the crisis,
Thailand relaxed foreign bank ownership regulations to allow majority
foreign ownership for banks for a 10-year period to facilitate
recapitalization of the financial sector. However, after a 10-year period the
foreign banks cannot increase their existing holdings in Thailand banks,
according to IMF. Other restrictions also limit the expansion of foreign
banks in Thailand, including a limit on the number of branches, legal
lending limits based on locally held capital of the foreign branch, and limits
on the number of expatriate managers, according to U.S. Treasury

Page 23                             GAO/GGD-99-157 Asian Financial Sector Reforms

                           All three of the countries we examined have begun changing their bank
International Bank         supervisory and regulatory systems to meet international standards. In
Supervisory Principles     particular, the countries have begun to change their supervisory systems to
Partially Implemented      align them with the Core Principles for effective supervision developed by
                           the Basel Committee on Bank Supervision, as discussed earlier. Similarly,
                           they have adopted or are currently implementing capital adequacy
                           regulations for banks that are based on the framework developed by the
                           Basel Committee, the Basel Capital Accord. Like most countries, however,
                           Indonesia, Korea, and Thailand do not adhere to all of the principles.

                           While these changes are being made, the impact that they will have on the
                           business of banking in the three countries is not yet clear. Changes in
                           supervision and regulation are only part of the necessary changes affecting
                           banking and financial services—legal and accounting changes, among
                           other “preconditions” for effective bank supervision, are also important.
                           Further, some of the changes in supervision and regulation are inherently
                           long term. For example, it will take time to develop a cadre of bank
                           examiners who have experience with the new standards.

                           A survey by the Basel Committee found that many nations have not fully
                           implemented the Core Principles. Relying on self-assessments by the 124
                           member countries, the Committee noted several common themes that we
                           also observed in the three study countries, including

                         • the difference between “having a regulation in place and having the
                           regulation effectively implemented,”
                         • the inability to attract and retain qualified staff to fully implement the Core
                           Principles, and
                         • not having a framework setting limits on concentration of lending and on
                           connected lending.

                           Table 2 profiles the steps that Indonesia, Korea, and Thailand have made in
                           adopting selected international standards for bank supervision and

                              Connected lending concerns loans extended to bank owners or managers and their related
                           businesses. The associated risks are the lack of objectivity in credit assessment and undue
                           concentration of credit risk.

                           Page 24                                        GAO/GGD-99-157 Asian Financial Sector Reforms

Table 2: Implementation of Selected International Supervisory Principles in Indonesia, Korea, and Thailand
   International standard                       Indonesia                            Korea                                Thailand
Operational independence:         According to the Banking Act of      Korea established the Financial Bank of Thailand’s operational
International standards call      1992 and its amendments and the      Supervisory Commission               independence is to be
for an effective bank             Bank Indonesia Act of 1999, Bank     effective April 1, 1998, and the     strengthened in a future Central
supervisory system with clear Indonesia has its independence as        Financial Supervisory Service in Bank Act.
responsibilities for each         the sole banking supervision         Jan. 1999, combining existing
agency involved and with          authority in Indonesia. Bank         banking, securities, and
operational independence for Indonesia has the right to supervise insurance supervisory agencies
the supervisors to take           both commercial and rural banks.     to provide (1) consistent
actions in good faith, free       The right to supervise banks         oversight to all financial
from political pressure.          comprises the right to license, the  industries, and (2) operational
                                  right to regulate, and the right to  independence from the Ministry
                                  impose sanctions.                    of Finance and Economy.
Licensing and structure
Licensing: International          Bank licensing authority was moved Licensing authority was granted Issued regulations regarding
standards call for applicants from the Ministry of Finance to Bank to the Financial Supervisory             finance company entitlement to
to be qualified as a way to       Indonesia to lessen political        Commission in April 1999. Prior a banking license. The Ministry
better ensure that a bank is      influence. Conditions for            to this, the authority for licensing of Finance is the licensing
operated in a safe and sound establishing new banks have been          and revoking licenses had been authority.
manner.                           tightened: sources of capital are to with the Ministry of Finance and
                                  be scrutinized; bank owners and      Economy.
                                  managers must pass a fit and
                                  proper test; organization, ownership
                                  structure, and operating plans and
                                  projected financial condition are
                                  assessed. Foreigners may now own
                                  up to 99 percent of Indonesian
Prudential regulation
Capital Adequacy:                 Bank Indonesia has a set of capital The Financial Supervisory             The capital adequacy ratios
International standards set       requirements based on international Commission has adopted the            were changed in 1998 to comply
by the Basel Committee            standards. Indonesian banks are to Basel Capital Accord for               with Basel Capital Accord.
provide for minimum capital       hold capital equal to 4 percent of   internationally active banks,        Capital adequacy standards in
levels that reflect, in part, the risk-weighted assets by end-1999     phasing them in by Dec. 2000.        Thailand are to be based on
risks that a bank has in its      and 8 percent at end-2001, which is —by March 1999, banks were to classification and provisioning
loan portfolio.                   consistent with the Basel Capital    have at least a capital ratio of 6 standards that are to come into
                                  Accord.                              percent (using international         full effect in 2001.
                                                                       accounting standards);
                                                                       —by March 2000, banks’ capital
                                                                       ratio is to be at least 8 percent;
                                                                       —by Dec. 2000, banks’ capital
                                                                       ratio is to be at least 10 percent.

                                               Page 25                                     GAO/GGD-99-157 Asian Financial Sector Reforms

   International standard                   Indonesia                               Korea                             Thailand
Loan classification
Loan loss provisioning:        The five loan classification            Provisions for “precautionary        Regulations reflected an
International standards call   categories are pass, special            assets” were increased from 1        increase in loan loss reserves
for banks to establish and     mention, substandard, doubtful, and     percent of assets to 2 percent.      for 5 categories.
adhere to policies for         loss, with respective provisioning of   For substandard loans, reserves      —Pass is 1 percent,
evaluating the adequacy of     1 percent, 5 percent, 15 percent, 50    are to be 20 percent; for            —Special mention is 2 percent,
loan loss reserves.            percent, and 100 percent. The           doubtful loans, 75 percent; and      —Substandard is 20 percent for
                               general loan loss reserve was           for loss, 100 percent.               unsecured loans,
                               increased from 0.25 percent of the                                           —Doubtful is 50 percent for
                               loan portfolio to 1.0 percent.          Korea revised its criteria for the   unsecured loans, and
                                                                       calculation of capital ratios to     —Loss is 100 percent for
                                                                       prevent counting reserves for        unsecured loans.
                                                                       loans classified as substandard
                                                                       or lower as part of a bank’s         The substandard classification
                                                                       capital by deducting the             historically had no
                                                                       provisions of those classified as    provisioning—it was changed to
                                                                       substandard or lower from a          15 percent in 1997 and to 20
                                                                       particular class of capital.         percent in 1998.

                                                                       Loan-loss provisions will also be The provisioning for the doubtful
                                                                       required for payment                loans changed from 100 percent
                                                                       guarantees of commercial            to 50 percent for unsecured
                                                                       banks.                              loans.
Lending limits: International Bank Indonesia’s rules on legal          To address Korea’s corporate A new law on commercial
standards call for lending to lending limits are the same as           networks of cross-guarantees, banking and financial institutions
related companies and         international rules. Bank Indonesia      Korea set banks’ equity capital that includes lending limits is
individuals on an arm’s-      has said that it will enforce a limit on limit to 25 percent for lending to being drafted.
length basis and limits       loans to one borrower or one group large shareholders and their
restricting bank exposures to of borrowers. For a single borrower affiliates, and other restrictions
single borrowers or groups of or group of borrowers related to a       on connected lending. The
related borrowers.            bank there is a 10 percent rule—         excess over the 25 percent limit
                              lending can be no more than 10           is to be progressively reduced
                              percent of bank capital. For             and eliminated by Jan. 1, 2001.
                              borrowers not related to the bank
                              the rule is a maximum of 30 percent On directed lending, Korea
                              from December 1998 to 2001, a            requires banks to provide 35
                              maximum of 25 percent by 2002,           percent of new won-
                              and 20 percent by 2003.                  denominated lending to small
                                                                       and medium-sized companies.
Foreign exchange exposure: Banks are to limit net open foreign         Introduced control systems on       As of October 1998, banks were
International standards call  exchange positions (i.e., unhedged funding and maturity gaps of              limited to net open foreign
for banks to have adequate    exposures) to 20 percent of capital      banks’ foreign exchange             exchange positions of 15
ways to manage international by June 2000. Bank Indonesia also exposure and expanded its                   percent.
risks and adequate reserves increased reporting requirements on monitoring of foreign exchange
against these risks.          foreign exchange transactions so         exposures to include offshore
                              that exposure is to be reported daily accounts.
                              in a consolidated form.

                                               Page 26                                      GAO/GGD-99-157 Asian Financial Sector Reforms

   International standard                 Indonesia                                  Korea                               Thailand
Methods of ongoing supervision
On-site supervision:          Bank Indonesia has about 400 bank          The Financial Supervisory        Examination guidebooks are
International standards call  examiners for regular examinations         Commission was revising its      being revised and supervisors
for independent validation of and, when necessary, can employ            guidebooks on examination        are being provided with
supervisory information       public accounting firms to examine         regulations and providing        additional training. A World
either through on-site        banks.                                     additional training for its      Bank official noted that
examinations or use of                                                   supervisors.                     considerable technical
external auditors.                                                                                        assistance is planned in this
Off-site supervision:          Bank compliance directors are to          The Financial Supervisory        The Bank of Thailand requires
International standards call   analyze compliance with banking           Commission is expanding its off- banks to file reports on their
for supervisors being able to regulation and report monthly.             site surveillance system to      balance sheets, capital levels,
do off-site monitoring to      Enforcement warnings can only be          capture more data in a more      loan classification, changes in
identify potential problems,   issued twice prior to removal of          timely manner.                   lending or borrowing, and loans
thereby providing early        bank management.                                                           over 5 million baht (about
detection and prompt                                                                                      $125,000). It plans to develop
corrective action before                                                                                  an early warning system for
problems become more                                                                                      financial system risks.
Formal powers of supervisors
Supervisory authority:         Indonesia will establish an               Korea established the Financial      Independence remains a
International standards call   independent bank supervisory body         Supervisory Commission to            problem for bank supervisors.
for bank supervisors to have no later than 2002 to take over the         separate supervisory power           Thailand law provides that a
at their disposal adequate     task of supervising banks in the          from the Ministry of Finance and     bank supervisor can be held
supervisory measures to        Indonesian banking system. Bank           Economy and gave authority to        personally liable for loss to the
bring about corrective action. Indonesia will retain its privileges to   the Financial Supervisory            state; supervisory staff has
                               examine banks if deemed                   Commission to order prompt           expressed concerns that the law
                               necessary.                                corrective actions in cases of       could be broadly interpreted and
                                                                         unsound financial institutions.      its enforcement could be subject
                                                                                                              to political influence.
Information requirements
Financial statements:              Reliability of bank financial         Korea is phasing in international    The Bank of Thailand completed
International standards call       statements is still questionable.     accounting standards and             a review of current accounting,
for banks and other financial      Bank Indonesia is making an effort    requiring firms to report audited,   auditing, and disclosure
institutions to prepare reliable   to improve the system of bank         consolidated financial               requirements for financial
financial statements.              reporting and check the accuracy of   statements.                          institutions and finance
                                   reported data. Indonesia has made                                          companies. New rules on
                                   some moves towards internationally                                         accounting, external audits, and
                                   accepted accounting standards.                                             disclosures are to be issued by
                                                                                                              Dec. 1999.
Cross-border banking
Global consolidated            Bank Indonesia follows the                The Financial Supervisory            While foreign bank branches are
supervision: International     international standard for cross-         Commission increased the             supervised in the same way as
standards call for adequately border banking.                            frequency of its monitoring from     domestic banks, prior approval
monitoring and applying                                                  quarterly to monthly and             from their home supervisors is
appropriate prudential norms                                             enlarged the scope of                not required and Thailand
to all aspects of the business                                           monitoring to include overseas       supervisors are not authorized
conducted by banking                                                     subsidiaries and off-shore           to share information with other
organizations worldwide,                                                 accounts.                            national supervisors. The
including their foreign                                                                                       commercial banking law, in draft
branches and subsidiaries.                                                                                    form, would allow such
                                                                                                              information sharing.

                                                 Page 27                                     GAO/GGD-99-157 Asian Financial Sector Reforms

Source: GAO analysis.

In each country, progress in implementing international standards for bank
supervision and regulation has to be understood in the context of the
business practices impeding adoption of these measures. The practice of
directed and/or connected lending illustrates these barriers. In all three
countries, directed and or connected lending was a long-standing practice.
In Korea, for instance, connected lending occurred within the chaebol or
industry groups woven together by cross-ownership and loan guarantees
among the companies forming the group. A bank within a group was
expected to provide funding to other companies within the group that held
shares in the bank, in the same manner that the bank is expected to hold
shares in companies to which it made loans. The government would at
least tacitly approve such lending as a means of increasing the economy’s
growth rate. In Indonesia, directed and connected lending were problems,
with many state bank loans going to projects favored by the government
and many private bank loans going to large business conglomerates
associated with private banks.

Connected and directed lending also reflected the inability of banks in the
three countries to analyze the creditworthiness of many borrowers. In the
United States and other industrial countries, credit analysis is possible
because the borrowers’ financial statements are prepared and audited
according to defined and accepted accounting principles. In the United
States, “generally accepted accounting principles” for private companies
are defined by the Financial Accounting Standards Board. Using financial
data prepared under such consistent guidelines allows a bank to
understand the creditworthiness of borrowers. When there are no such
consistent guidelines, however, credit analysis is difficult. Financial
analysts in these countries noted that bank managers had not relied on
credit analysis to lend. Rather, lending decisions in these countries had
been made by the reputation of the borrowers—those who were “well
connected” would be considered better credit risks than other borrowers
because it was considered likely that the government would guarantee the
loan. Progress in implementing rules against connected and directed
lending, and in seeing bank loan decisions based on credit analysis, thus,
depends on progress in implementing accounting standards.

Another reform effort undertaken in these three countries included
strengthening the authority and operational independence of their
financial supervisors. The Basel Committee reported that the responses to
its survey on the protection of supervisors revealed that approximately

Page 28                            GAO/GGD-99-157 Asian Financial Sector Reforms

one-third of the respondents have yet to develop legal protection for their
supervisors, although some were drafting new regulations to do so.
Supervisors lacking operational independence from political pressure and
having inadequate supervisory powers to bring about corrective actions
were contributing factors to the recent financial crisis in the three
countries we studied.

The international standards require a clear, achievable, and consistent
framework of responsibilities and objectives be set by the government for
the supervisors. However, the standards also require that supervisors have
operational independence to pursue their objectives, free from political
pressure and with accountability for achieving them. Banking supervisors
also must have at their disposal adequate supervisory measures to bring
about corrective action when banks fail to meet prudential requirements,
such as minimum capital adequacy ratios, when there are regulatory
violations or where depositors are threatened in any other way.

Implementing these standards has posed challenges for the three countries
studied. For example, a major reform in Korea was its establishment of the
Financial Supervisory Commission in April 1998 and the Financial
Supervisory Service in January 1999 to provide consistent oversight to all
financial industries (banking, securities, insurance, and nonbank
institutions). Korea strengthened the formal powers of its financial
supervisors by granting them operational independence from the Ministry
of Finance and Economy and consolidating financial supervision into one
agency (formerly four). However, according to Korean officials, 10 to 12
positions at the newly established agency were filled with former Ministry
officials, who could rotate back to their Ministry positions after a few
years. In addition, the Financial Supervisory Service was staffed with the
same supervisors who had previously been at the Bank of Korea.
According to officials we spoke with in Korea, this raised questions about
the independence of the new Financial Supervisory Commission. They
asserted that it would take time for the new agency to operate
independently of the Bank of Korea and the Ministry of Finance and

Korea also adopted prompt corrective action procedures to strengthen its
financial supervisory powers. For example, the Financial Supervisory
Commission established a three-step corrective measure to be imposed on
unsound financial institutions, according to the seriousness of problems.
For unsound financial institutions, the Financial Supervisory Commission
can now order a management improvement that includes the merger of
banks, the firing or suspension of senior managers, appointment of an

Page 29                            GAO/GGD-99-157 Asian Financial Sector Reforms

acting manager, transference of operations, and merger or purchase and
assumption, among other measures. Korean officials we met with said that
one sign of progress would be if the Financial Supervisory Commission
took corrective action against a Korean bank. There has been one such
action recently. According to a Ministry of Finance and Economy press
release in June 1999, the Financial Supervisory Commission designated a
bank as a nonviable financial institution under provisions of the new law.
The bank is to be subject to an order, whereby funds are to be sought
through the Korea Deposit Insurance Corporation and the Korea Asset
Management Corporation to purchase the bank’s nonperforming loans and
recapitalize the bank. According to Korean documents, additional funding
may be needed in the course of selling the bank to a foreign buyer or to
add more provisioning as the bank reclassifies its loans.

Bank supervisors in Thailand may be held personally liable for loss to the
state without immunity for their job performance under the Government
Enterprise Act. This act effectively states that if a supervisor causes loss to
a government entity through the course of his work, he/she can be
criminally prosecuted. Both the issues of losses and application of the law
are broadly defined and could potentially be subject to political influence.
While bank supervisors want to change this law, many of the legal staff at
the Bank of Thailand opposed the change, reasoning that a supervisor who
is properly performing his/her duties would not be subject to liability.
According to a World Bank official, this issue was still unresolved.

Progress in fully implementing some of the international standards will
take time. The ability to conduct effective onsite examinations is a key
component of adherence to the Basel Core Principles. The effectiveness of
the examination, in turn, depends on the qualifications of the examiner
staff and its experience. In the United States, for instance, while the bank
supervisory agencies have extensive formal training programs for
examiner staff, they rely heavily on on-the-job training for developing
qualified examiners. Officials at these agencies said that, as a rule of
thumb, it takes about 8 years for an examiner to become fully qualified.
While the United States and other governments have provided training and
technical assistance to the bank and financial supervisory agencies in
Indonesia, Korea, and Thailand, the supervisors in these three countries
have not had time to develop an examiner staff with experience operating
under the international standards that the countries have recently adopted.

   The Korea Deposit Insurance Corporation provides capital to banks in return for an equity stake in
the bank. The Korea Asset Management Corporation purchases and sells nonperforming loans from
distressed banks.

Page 30                                         GAO/GGD-99-157 Asian Financial Sector Reforms

                           While national authorities have the primary authority for addressing
Bilateral and              banking problems, the United States and other industrial nations have
Multilateral               provided assistance to Indonesian, Korean, and Thailand efforts to
Approaches to the          improve their financial supervisory systems. Much of this assistance has
                           been provided through international financial institutions, such as the
Challenges of Financial    World Bank or IMF. The assistance has two related components:
Sector Reform in
Emerging Markets       • promoting financial stabilization and addressing the immediate causes of
                         the financial crises affecting these countries, and
                       • promoting reforms to build a stronger framework for financial supervision
                         and regulation to minimize the likelihood of a recurrence.

                           In promoting financial stabilization and addressing immediate causes and
                           consequences of the financial crises, the United States and the
                           international financial institutions have provided technical assistance and,
                           in the case of international financial institutions, funding to enable the
                           countries to close nonviable banks, to resolve nonperforming loans, and to
                           restructure and/or recapitalize open institutions. The United States and the
                           international financial institutions also support longer-term efforts to
                           increase the competency of the supervisory agencies in the three
                           countries. Finally, when possible, the United States and international
                           financial institutions have sought to promote the political independence of
                           the regulatory process.

                           While the Basel Committee does not provide direct assistance to countries
                           that are changing their systems, its standards for bank supervision and
                           regulation provide guidance both to the countries and to the international
                           organizations that provide assistance. It counts on countries to adopt and
                           implement its principles voluntarily. However, the Basel Committee does
                           not assess international compliance with these standards. Rather, it relies
                           on self-reporting by countries on how they have implemented the bank
                           supervisory standards. In 1994, we recommended that federal bank
                           regulators seek an expanded role for the Basel Committee in fostering
                           greater international implementation of the supervisory standards. We
                           suggested that Basel Committee could facilitate a peer review process for
                           bank supervisors that would provide independent, expert assessments of
                           implementation of the Core Principles and guidance on possible

                            See International Banking: Strengthening the Framework for Supervising International Banks
                           (GAO/GGD-94-68, Mar. 21, 1994).

                           Page 31                                       GAO/GGD-99-157 Asian Financial Sector Reforms

                        IMF, the World Bank, and other international financial institutions that
                        provide direct assistance use the Basel principles in assisting countries to
                        strengthen their supervisory arrangements in connection with their work
                        aimed at promoting financial stabilization and supporting improved
                        supervisory qualifications. To the extent that Basel principles for banking
                        supervision are conditions of funding, then these international financial
                        institutions judge compliance with these principles by countries receiving
                        financial assistance.

Promoting Financial     In each of the three countries we examined, the immediate objective of
                        international assistance to restructure the financial systems was to assist
Stabilization           the countries efforts to close nonviable banks, resolving nonperforming
                        loans, and restructuring and recapitalizing remaining institutions.

                        In the aftermath of the financial crises in Indonesia, Korea, and Thailand,
                        IMF has been providing financial assistance to these three countries. IMF
                        assistance, however, is conditioned on a country undertaking policy
                        reform intended to address the underlying cause of the crisis. In each of
                        the three countries, weaknesses in their financial systems were major
                        elements leading to the crises, according to the IMF, so each country’s
                        agreement with IMF stipulated actions that the country was to take to
                        address these weaknesses. These conditions covered

                      • closure of insolvent financial institutions, with their assets transferred to a
                        resolution or restructuring agency, merger of other institutions,
                        recapitalization of some institutions;
                      • announcement of limited use of public funds for bank restructuring, with
                        actual funds made explicit in country budgets;
                      • measures to significantly strengthen prudential regulations, including loan
                        classification and provisioning requirements, and capital adequacy
                      • measures to strengthen disclosure, accounting and auditing standards, and
                        the legal and supervisory frameworks;
                      • efforts to liberalize foreign investment in ownership/management of
                      • the introduction of more stringent conditions for official liquidity support;
                      • strengthening prudential regulation on loan exposure;
                      • the introduction of a funded deposit insurance scheme; and
                      • restructuring domestic and external corporate debt and closing nonviable

                         See International Monetary Fund: Approach Used to Monitor Conditions for Financial Assistance
                        (GAO/GGD/NSIAD-99-168, June 22, 1999).

                        Page 32                                      GAO/GGD-99-157 Asian Financial Sector Reforms

                             In Indonesia, for instance, conditions for financial assistance included
                             closing banks with capital ratios worse than negative 25 percent, and those
                             between negative 25 percent and positive 4 percent that did not submit
                             acceptable plans for their revitalization, merging four large banks and
                             transferring their problem loans to IBRA, and submitting a draft law to the
                             Parliament to institutionalize Bank Indonesia’s autonomy.

                             The IMF has also supported the process of coordinating workout efforts
                             between international creditors and debtors in resolving severe private
                             sector financing problems. Included in this process is IMF’s pursuit of
                             more effective bankruptcy laws at the national level. Bankruptcy reform
                             has been a particularly contentious issue in Thailand, for instance.

Promoting Reforms to         In addition to assisting the immediate need to foster financial stability,
                             international assistance sought to promote longer-term improvements in
Minimize the Likelihood of   bank and financial market supervision. The assistance sought to help the
Recurring Crises             countries strengthen supervisory institutions so that they would be
                             independent of political interference and would have adequate authority to
                             achieve their goals. International assistance also sought to increase the
                             technical qualifications of the supervisors through training programs.

                             IMF has also provided technical assistance on banking sector issues. In
                             Indonesia, for instance, IMF has provided a long-term advisor to Bank
                             Indonesia from the Bank of France as well as a payments system expert
                             from New Zealand. IMF has provided technical assistance in drafting the
                             new Bank Indonesia law. IMF has funded training of bank supervisors by
                             finance officials from Australia, Japan, and the United States. In Thailand,
                             IMF has taken the lead role in such areas as strategies for commercial
                             banks, legal frameworks for the central bank law, laws for supervisory
                             agencies and deposit insurance, and other banking laws.

                             The World Bank is also currently providing financial assistance for
                                        36      37               38
                             Indonesia, Korea, and Thailand. Part of the overall assistance package
                             is directed at supporting financial sector reform and principles for a
                             framework for restructuring corporate debt. In the financial sector the
                             World Bank played an especially important role in

                                  In Indonesia, the World Bank disbursed $899 million in 1997 and $1.2 billion in 1998.
                                  In Korea, the World Bank disbursed $3 billion in 1997 and $2 billion in 1998.
                                  In Thailand, the World Bank disbursed $365 million in 1997 and $700 million was approved for 1998.

                             Page 33                                             GAO/GGD-99-157 Asian Financial Sector Reforms

• formulating and implementing the strategy for dealing with commercial
  banks, finance companies, and for specialized institutions;
• assessing the solvency of the banking system and the standing of main
  institutions, based on bank audits;
• developing plans for dealing with insolvent institutions, for disposing of
  the assets of closed banks, and for handling the nonperforming assets of
  banks that were to be publicly supported;
• improving the overall financial infrastructure including strengthening bank
  supervision and redesign of prudential regulation according to the Basel
• providing expertise on instituting deposit insurance schemes;
• updating banking laws to include provisions that had been lacking,
  including limitations on cross-ownership between banks and enterprises;
• stengthening the development of money markets and capital markets
  through the encouragement of new institutional investors, asset
  securitization, standardization of government bond issues, and
  improvement of securities market prudential regulation and self-

  The World Bank is seeking to promote more sound, more competitive, and
  better supervised banking systems. The goal of one loan was to rebuild an
  efficient financial sector, contain further bank losses, and protect
  productive assets of corporations by

• completing portfolio reviews for banks,
• establishing an independent review committee to verify the sound and
  transparent functioning of the Indonesia Bank Restructuring Agency, and
• establishing a framework that defines the government’s participation in
  restructuring of private corporate debt.

  The World Bank and IMF also mare seeking to effect change through a
  joint effort with the government of Canada to create the Toronto
  International Leadership Center for Financial Sector Supervision. The
  objective of this center is to strengthen financial markets by enhancing the
  leadership capabilities of public sector executives whose responsibilities
  include banking supervision. The center uses a program of classroom
  sessions where financial supervisors share their experiences about
  financial institution and systemic failures and rescues with other financial
  authorities. Program components include

• dealing with owners and managers of problem institutions,

  Page 34                            GAO/GGD-99-157 Asian Financial Sector Reforms

• using the media and rating agencies to increase public understanding of
  risks and issues,
• insulating the supervisor from personal legal risk,
• keeping politicians abreast of potential risks in the system,
• promoting change within the supervisor’s institution, and
• developing reporting procedures that keep information flowing up.

    The World Bank is also providing technical assistance for financial sector
    reform in Indonesia, Korea, and Thailand. In Indonesia, the World Bank
    financed a firm of international consultants to advise the Indonesia Bank
    Restructuring Agency. The World Bank financed the hiring of a number of
    international accounting firms to perform portfolio reviews of IBRA banks
    and state banks. It also financed the hiring of a legal team to assist in
    drafting the regulation for establishing IBRA and for the guaranteeing
    depositors and creditors. The World Bank also supported the Jakarta
    Initiative framework for encouraging debtors to workout their debts with

    The World Bank has been assisting Korea’s corporate workout program.
    The World Bank provided Korea with expertise and a technical assistance
    loan of about $33 million to employ outside experts as advisors for the
    design and implementation of corporate workout programs. In Thailand,
    the World Bank has been involved jointly with the IMF in many of the
    financial sector restructuring and supporting policy issues. The World
    Bank has taken the lead in coordinating asset disposal, bank audits and
    restructuring, and strategies for specialized institutions. In addition, the
    World Bank is also developing and revising policies for bank supervision,
    prudential regulations, and corporate debt restructuring.

    ADB was active in the three-study countries. In Indonesia, the ADB
    approved a $1.5 billion loan for Indonesia. Among other actions and in
    coordination with the IMF and the World Bank, the loan was directed to

• assess the financial status and, where feasible, restructure existing banks;
• strengthen the supervisory capacity of Bank Indonesia;
• rationalize the supervision and regulation of nonbank financial institutions;
• rationalize the legal and regulatory environment to facilitate debt recovery
  and structural adjustment; and
• improve accountability and transparency in both the public and private

    ADB has provided financing for the portfolio reviews of the banks not
    under IBRA’s control and is to provide expert assistance to Bank Indonesia

    Page 35                            GAO/GGD-99-157 Asian Financial Sector Reforms

    to assess bank business plans prepared for the bank recapitalization

    In Korea, ADB approved a $4 billion financial sector program loan to

•   restructuring financial institutions,
•   recapitalizing financial institutions,
•   strengthening prudential regulation and supervision, and
•   capital market liberalization and development.

    In Thailand, the ADB approved the Financial Markets Reform Program
    Loan to address a variety of issues, including

• undertaking immediate resolution of finance company nonperforming
  loans and rehabilitation of unliquidated finance companies;
• establishing institutional structure for resolution and/or rehabilitation;
• undertaking financial restructuring of finance companies;
• strengthening market regulation and supervision, particularly focused on
  the Stock Exchange of Thailand (SET) and the Securities and Exchange
  Commission (SEC);
• improving risk management;
• facilitating investor-issuer access to the domestic financial market; and
• developing long-term institutional sources of funds by promoting pension

    U.S. agencies have provided bilateral and technical assistance to the
    financial supervisory agencies in the three countries, as have other
    national governments. Treasury and Federal Reserve officials told us that
    they have bilateral meetings with their counterparts in these countries to
    encourage changes in their financial systems. U.S. bank supervisors have
    been providing technical assistance and training to banks and bank
    regulators in these countries, covering such areas as corporate
    governance, credit and market risk management, information technology,
    and bank supervisory and examination techniques. The Department of the
    Treasury, for example, has advisors working with IBRA. OCC and the
    Federal Reserve System also provide training for bank supervisors in these

    Page 36                           GAO/GGD-99-157 Asian Financial Sector Reforms

Self-Reporting on Countries’    The Basel Committee does not independently assess the extent to which
                                countries have adopted international standards for bank supervision,
Implementation of               either in their laws or in practice. The committee’s information on
International Standards         implementation is based on self-reporting by countries on their actions. In
                                1998, the committee surveyed countries on their implementation of the
                                Core Principles and published a report on the survey results.

                                In 1994, we recommended that U.S. bank supervisors seek to increase the
                                Basel Committee’s role in encouraging and monitoring international
                                implementation of standards for bank supervision. One way we suggested
                                for increasing the committee’s role was to have it perform as a
                                clearinghouse for information on international supervisory practices. The
                                committee’s report on its survey of countries is an example of this
                                clearinghouse role.

                                We also suggested that the committee could facilitate peer reviews for
                                bank supervisory agencies desiring such reviews and that the committee’s
                                role could include providing guidance on the conduct of the reviews,
                                including safeguarding confidential supervisory information. A U.S.
                                Treasury official told us that peer review is unlikely to happen and that
                                monitoring the implementation of bank supervisory and other standards
                                will most likely be performed by IMF, the World Bank, or another new
                                entity. We continue to believe that peer reviews could provide a
                                mechanism for expert, independent assessments of the implementation of
                                the standards.

Multilateral Institutions Are   The IMF and the World Bank set up a Financial Sector Liaison Committee
                                to coordinate their efforts and minimize overlap. In general, IMF focuses
Coordinating Assistance         on macroeconomic and stabilization issues while the World Bank focuses
Efforts                         on long-term economic development, structural and sectoral economic
                                reforms. The Liaison Committee seeks to avoid inconsistent advice and
                                duplicative efforts as well as to help optimize resources and facilitate joint
                                work—including identification and dissemination of standards and good
                                practices. However, according to IMF and World Bank officials and
                                documents, the collaboration, particularly in the early stages of the crisis,
                                has not always worked. Initially, there were problems in operational
                                coordination between the World Bank and IMF staffs due to lack of
                                continuity and differences of opinion. For example, in the early stages of

                                 “Results of the Survey on the Core Principles for Effective Banking Supervision,” Basel Committee on
                                Banking Supervision, Basel, Switzerland, 1998 (BS/98/103).
                                 International Banking: Strengthening the Framework for Supervising International Banks (GAO/GGD-
                                94-68, Mar. 21, 1994).

                                Page 37                                        GAO/GGD-99-157 Asian Financial Sector Reforms

                      responding to the Asian crisis, the IMF undertook a lead role in bank
                      restructuring—an area of primary responsibility of the World Bank. Letters
                      of intent, covering financial sector policies that the World Bank was to
                      take the lead, were negotiated with country governments and IMF staff
                      without the full involvement of the World Bank staff. However, according
                      to IMF and World Bank documents, efforts undertaken to resolve these
                      problems through regular meetings have been generally successful.

                      Full implementation of the reform agenda will take many years to
Conclusion            accomplish due to the extent of the problems and the enormity of the
                      changes required. To date, the three countries were still finalizing bank
                      closings and bank recapitalizations and disposing of assets from distressed
                      institutions. Accurate accounting is vital for a developed market economy,
                      and changes in accounting systems are under way. Major challenges lie
                      ahead in completing the financial sector reforms. More needs to be done to
                      ensure that bank supervisors have the authority to take prompt corrective
                      action against failing or insolvent banks. Concerns have been expressed,
                      by officials in these countries and others, that once IMF and World Bank
                      money is disbursed, the countries will have less incentive to continue
                      politically unpopular financial reforms. If the lack of reform results in
                      diminished access to international capital markets there still may be
                      sufficient pressure for reform. However, if such access does not diminish,
                      these countries may continue to be destabilizing influences on the
                      international financial system.

                      We requested comments on a draft of this report from the Department of
Agency Comments and   the Treasury, the Department of State, the Board of Governors of the
Our Evaluation        Federal Reserve System, the Federal Reserve Bank of New York, OCC,
                      IMF, and the World Bank. In written comments, Treasury generally
                      concurred with our analysis of current reform and restructuring efforts in
                      the financial sectors of Indonesia, Korea, and Thailand (see app. IV). In
                      written comments, the World Bank found the draft informative and
                      balanced and described its ongoing initiatives to strengthen financial
                      sectors (see app. V).

                      We also received technical comments on a draft of this report from the
                      Treasury, the Federal Reserve Bank of New York, OCC, IMF, and the
                      World Bank. These comments were included in this report where
                      appropriate. The Board of Governors of the Federal Reserve System did
                      not comment on the draft report. State Department officials told us they
                      concurred with our report.

                      Page 38                            GAO/GGD-99-157 Asian Financial Sector Reforms

As we agreed with your offices, we plan no further distribution until 30
days from the date of this letter unless you publicly release its contents
sooner. We will then send copies of this report to Representative Jim
Leach, Chairman, and Representative John LaFalce, Ranking Minority
Member, House Committee on Banking and Financial Services;
Representative Benjamin Gilman, Chairman, and Representative Sam
Gejdenson, Ranking Minority Member, House Committee on International
Relations; Senator Phil Gramm, Chairman, and Senator Paul Sarbanes,
Ranking Minority Member, Senate Committee on Banking, Housing, and
Urban Affairs; and Senator Jesse Helms, Chairman, and Senator Joseph
Biden, Ranking Minority Member, Senate Committee on Foreign Relations.
We are sending copies of this report to: the Honorable Madeleine K.
Albright, Secretary of State; the Honorable Lawrence H. Summers,
Secretary of the Treasury; the Honorable John D. Hawke, Jr., Comptroller
of the Currency; the Honorable Alan Greenspan, Chairman of the Board of
Governors of the Federal Reserve System, and William J. McDonough,
President of the Federal Reserve Bank of New York. We are also sending
copies to IMF, the World Bank, the Asian Development Bank, and the
embassies of Indonesia, the Republic of Korea, and Thailand. Copies will
be made available to others upon request.

This report was prepared under the direction of Susan S. Westin, Associate
Director, International Relations and Trade. Major contributors to this
report are listed in appendix VI. If you have any questions please contact
me on (202) 512-8678 or Susan Westin on (202) 512-4128 if you or your
staff have any questions about this report.

Thomas J. McCool
Financial Institutions and Markets Issues

Page 39                           GAO/GGD-99-157 Asian Financial Sector Reforms

Letter                                                                          1

Appendix I                                                                     42

Objectives, Scope, and
Appendix II                                                                    44
                         Indonesia                                             44
Weaknesses in the        Korea                                                 46
Financial Systems of     Thailand                                              48

Indonesia, Korea, and
Appendix III                                                                   51
                         Indonesia                                             51
Legal, Administrative,   Korea                                                 51
and Judicial Changes     Thailand                                              53

in Indonesia, Korea,
and Thailand
Appendix IV                                                                    56

Comments from the
Department of the
Appendix V                                                                     57

Comments from The
World Bank
Appendix VI                                                                    59

GAO Contacts and

                         Page 40     GAO/GGD-99-157 Asian Financial Sector Reforms

Tables   Table 1: Countries Efforts to Improve Their Financial                           13
         Table 2: Implementation of Selected International                               25
           Supervisory Principles in Indonesia, Korea, and


         ADB           Asian Development Bank
         GDP           gross domestic product
         IBRA          Indonesian Bank Restructuring Agency
         IMF           International Monetary Fund
         OCC           Office of the Comptroller of the Currency

         Page 41                               GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix I

Objectives, Scope, and Methodology

              Our objectives were to determine (1) the nature of weaknesses in the
              financial sectors of the three countries, (2) the extent to which the
              countries have reformed their financial systems, (3) the extent to which
              international principles for banking supervision have been implemented by
              the countries, and (4) U.S. government and multilateral efforts to effect
              changes in the financial sectors of these emerging markets.

              To select case study countries, we analyzed emerging market countries
              based on several criteria, including U.S. bank exposure, private capital
              flows, direct foreign investment, bank intermediation in the economy, and
              the history of banking crises to determine how the countries differed. We
              selected Indonesia, Korea, and Thailand because they (1) had received
              larger capital flows compared with other emerging market countries, (2)
              participated in developing the Basel Core Principles for effective
              supervision, (3) were geographically proximate, and (4) were receiving
              assistance from IMF and the World Bank.

              To meet our objectives, we interviewed and obtained documents from U.S.
              government officials from the Federal Reserve System and the Federal
              Reserve Bank of New York; the Department of the Treasury, including the
              Office of the Comptroller of the Currency; the Department of State in
              Washington, D.C., and embassy officials in Indonesia, Japan, Korea, and
              Thailand. In the United States, we interviewed officials of an association
              representing international banks, four U.S.-based banks, and two
              European-based banks. We also interviewed officials from international
              organizations, including IMF; the World Bank, in Washington, D.C.,
              Indonesia, and Thailand; the Asian Development Bank in Indonesia; and
              U.S. representatives to the Basel Committee on Banking Supervision in
              Basel, Switzerland.

              In Indonesia, we interviewed and obtained documents from Indonesian
              government officials from Bank Indonesia, the Ministry of Finance, the
              Indonesian Bank Restructuring Agency, the Planning Agency, and the
              Capital Markets Supervisory Agency. We also interviewed officials in
              Inondesia from six U.S.-based commercial and investment banks, five
              Indonesian Banks, one Canadian-based bank, one industrial group, and a
              business school.

              In Korea, we interviewed and obtained documents from U.S. Embassy
              officials and Korean government officials from the Ministry of Finance and
              Economy, the Bank of Korea, the Finance Supervisory Commission, and
              the Bank Supervisory Authority. We also interviewed officials in Korea
              from four U.S.-based commercial and investment banks, four Korean

              Page 42                           GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix I
Objectives, Scope, and Methodology

banks, the Korean Institute of Finance, the Korea Development Institute,
and the Korea Securities Dealers Association.

In Thailand, we interviewed and obtained documents from government
officials from the Bank of Thailand, the Financial Institutions Development
Fund, the Financial Sectors Restructuring Authority, the Asset
Management Corporation, and the Ministry of Finance. We also
interviewed officials from five U.S.-based commercial and investment
banks, five banks and finance companies based in Thailand, and
representatives of the Thailand Bankers Association.

We also reviewed and analyzed documents collected from U.S.,
Indonesian, South Korean, and Thailand government organizations,
international organizations, and private firms. These documents included
books, official correspondence, legislation, memorandums, regulations,
reports, IMF and World Bank assessments of policies on financial sector
reforms, letters of intent (public and nonpublic), World Bank project
documents, Department of State cables, and testimony. Information,
observations, and conclusions regarding foreign laws mentioned in this
report do not reflect our independent legal analysis but are based on our
interviews and documentation provided by those that we met with.

We requested comments on a draft of this report from the Department of
the Treasury, the Department of State, the Board of Governors of the
Federal Reserve System, the Federal Reserve Bank of New York, OCC,
IMF and the World Bank. In written comments, Treasury generally
concurred with our analysis of current reform and restructuring efforts in
the financial sectors of Indonesia, Korea, and Thailand (see app. IV). In
written comments, the World Bank found the draft informative and
balanced and described its ongoing initiatives to strengthen financial
sectors (see app. V).

We also received technical comments on a draft of this report from the
Treasury, the Federal Reserve Bank of New York, OCC, IMF, and the
World Bank. These comments were included in this report where
appropriate. The Board of Governors of the Federal Reserve System did
not comment on the draft report. State Department officials told us they
concurred with our report.

We conducted our work in Washington, D.C.; New York City, New York;
Jakarta, Indonesia; Tokyo, Japan; Seoul, Korea; Basel, Switzerland; and
Bangkok, Thailand, between September 1998 and August 1999, in
accordance with generally accepted government auditing standards.

Page 43                              GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix II

Weaknesses in the Financial Systems of
Indonesia, Korea, and Thailand

               Prior to Indonesia’s financial crisis, there were a variety of problems in
Indonesia      Indonesia’s banking system. Many of Indonesia’s large business
               conglomerates owned at least one bank. State-owned enterprises and
               pension funds also established banks and increased the potential for
               connected lending. Since the late 1960s, entry of foreign banks into
               Indonesia was limited in that they were required either to form joint
               ventures with Indonesian banks, with a maximum of 85 percent foreign
               ownership, or buy shares of domestic banks on the stock exchange where
               the maximum foreign holding of stock in an Indonesian banks was set at
               49 percent, according to IMF documentation.

               Capital in Indonesian banks was typically overstated, because of
               inadequacies in loan classification and loan loss provisioning. Banks’
               assets were exposed to high risk because of, among other factors,
               concentrated and directed lending, and unhedged foreign currency
               borrowings by corporations. Between 1988 and 1994, the number of banks
               more than doubled from 111 to 240. There was a lack of information about
               the financial condition of most banks and corporations. Bank lending was
               influenced by business connections and political pressures and was based
               on collateral or “names” rather than cash flow analysis.

               Banks had many overdue loan payments. In mid-1997, the Bank Indonesia
               reported overall level of nonperforming loans—10 percent—was high and
               approached levels witnessed in other countries before and during banking
               crises. IMF officials told us that the reported nonperforming loans were
               higher than 10 percent. Particularly problematic was the long-standing
               high level of nonperforming loans for state-owned banks that was
               attributed to politically directed lending. Rapid credit growth, foreign
                                       1                 2
               exchange borrowing, and related party lending had been inadequately
               managed. In addition, there was a growing exposure to the real estate
               market where prices tended to fluctuate and collateral was illiquid. For
               example, real estate lending grew 40 percent from mid-1996 to mid-1997.
               Banks’ lending to a small number of large borrowers was also very high.
               Prior to the crisis, there was large-scale growth in connected and group.
               Most major banks were associated with corporate borrowers through a
               common majority owner.

                Foreign exchange borrowing is borrowing in a currency other than the currency of the country in
               which the company or bank is located.
                Related party lending is lending to businesses that are associated with one another. We use the terms
               related party lending, connected lending, and group lending interchangably.

               Page 44                                        GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix II
Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Legal lending limits on loan to deposit ratios were violated by a number of
banks. Depositors and bank owners were convinced that the government
would never allow a bank to go bankrupt. Exit mechanisms for failed
banks were not established. Prior to the crisis there were a number of
insolvent banks whose resolution was postponed. Some problem banks
had a negative net worth. State banks had a poor track record on loan
repayments, especially on loans extended to the largest and most
influential Indonesian conglomerates.

Indonesian bank supervision, conducted by Bank Indonesia, was
ineffective because of lack of independence and weak enforcement. The
Bank of Indonesia’s Bank Supervision Department needed to be
strengthened to effectively implement risk-based oversight of the banking
system, according to government of Indonesia documents. Violations of
Bank Indonesia’s prudential principles were widespread. Compliance with
prudential regulations was low. Violations of prudential regulations were
sometimes met with regulatory forbearance. Prudential regulation needed
to be strengthened, with respect to patterns of related party lending and
the classification of nonperforming loans, according to IMF. For example,
classification guidelines understated the level of nonperforming loans
because of the liberal granting of options for restructuring and the ability
to reclassify a loan back to performing status as soon as one payment was
made and irrespective of anticipated future payments. Concentrated
ownership and connected lending made it difficult for bank supervisors to
evaluate the risk characteristics of a substantial part of the outstanding
credit portfolio of private banks. On-site inspections yielded limited
additional insight into the actual number of problem loans. Inadequate
bank management contributed to a more concentrated credit extension to
only a limited number of debtors, particularly to individuals or business
groups that had close ties with the banks, according to Bank Indonesia. In
some cases, bank supervisors allegedly abused their power for self-

The absence of a deposit insurance scheme led to the provision of a
central bank implicit guarantee for the survival of commercial banks that
had systemic implications. Problem banks were more likely than healthy
banks to have a strong political lobby. State banks were more immune to
failure than private banks, while private banks with strong political

    Resolution is the closing or merging of insolvent financial institutions.
    See Bank Indonesia. Report for the Financial Year 1997/1998. Jakarta: Indonesia, 1998.

Page 45                                             GAO/GGD-99-157 Asian Financial Sector Reforms
        Appendix II
        Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

        connections were less vulnerable to closure than private banks without
        strong political connections. No effective bank closure and exit regulation
        was in place, and few banks were closed or merged. Failed banks were
        generally absorbed into Bank Indonesia. In mid-1997, several banks with
        negative capital continued to operate. The reluctance to allow failures and
        enforce stringent disclosure rules had reduced the impact of market
        forces and created opportunities for lending without due regard to risk
        assessment, according to IMF. The unclear resolution mechanism for
        problem banks led to a high-risk attitude among bankers.

        Korea’s favorable economic performance for the past 30 years masked
Korea   weaknesses that contributed to the current crisis. Korea has a long
        tradition of government control of the financial sector, directing credit and
        preferential interest rates to promote key industries. The World Bank
        reported that in 1990, 46.3 percent of Korea’s domestic credit was policy
        loans, or directed loans, extended by banks. Commercial banks have
        played a significant role in Korea’s banking system. Assets of Korea’s
        nationwide commercial banks totaled approximately $318 billion, at the
        end of 1997. Because of government-directed credit decisions, commercial
        banks lacked a commercial orientation (i.e., they focused on increasing
        market share over improving profitability) and did not have a well-
        developed system of credit-risk management.

        The close links between business, the banking sector, and the government
        encouraged the chaebols to expand boldly and to diversify and induced the
        banks to ignore the risk associated with their highly leveraged clients.
        Korean firms had made substantial investments, leaving Korea with excess
        production capacity and large debt burdens for Korean firms. Most of
        Korea’s corporate debt was comprised of either short-term borrowing or
        from issuing promissory notes. At the end of 1997, it was not uncommon
        for a Korean conglomerate to be leveraged about 400-600 percent. At the
        end of December 1997, the 30 largest conglomerates owed about $58.6
        billion, in loans and payments to Korean banks, according to Korea’s
        Office of Bank Supervision. The conglomerates’ current liabilities (less
        than 1 year) accounted for 60 percent of total liabilities and roughly half of
        nominal gross domestic product (GDP) in 1996. Banks in Korea had also
        focused on short-term lending, in part, due to more favorable costs for
        short-term financing and limited access to the long-term capital markets.

         Disclosure is the release by banks and companies of all information, positive or negative, that might
        bear on an investment decision.

        Page 46                                         GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix II
Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

The structure of the chaebols and the diversity of their holdings have been
a strength in Korea because it could overcome capital market
imperfections and benefit from managerial economies and vertical
integration in a semi-industrialized economy. However, according to the
Bank of Korea, the Korean economy has faced a “high-cost, low-efficiency”
industrial sector and could not operate properly in a socioeconomic
environment characterized by overregulation and “government meddling”
in the financial and corporate sectors. A complex web of shareholdings
and cross-guarantees between different firms (including the banks) within
a chaebol has not only retarded transparency regarding ownership and
financial health but also jeopardized the entire conglomerate as individual
companies began to fail, according to World Bank documents.

The heavy debt burden increased bankruptcies. According to the Bank of
Korea, the increase in bankruptcies contributed to the problems of an
already weak banking system. Large Korean companies had not had much
experience with bankruptcies prior to the crisis, and when Hanbo Steel
was allowed to fail in January 1997, it caused considerable speculation
about other corporations that may be allowed to fail. Prior to the crisis,
Korea had a system of bankruptcy law, but its procedures for handling
bankruptcies were weak. Korean laws permit both reorganization and
liquidation under two processes, court mediation and court receivership,
according to IMF documents. Korea’s court-supervised process for
mediation was originally designed to help small companies settle debts
without initiating the full bankruptcy process. The process allowed
nonviable companies to postpone debts, continue to operate with their
current management structure, and obtain new financing at lower interest
rates. Since the beginning of 1997, many large companies registered for
mediation under this process. Financial experts that we met with in Korea
told us the mediation process was very slow, and the court system was
unable to handle the additional workload. In addition, the IMF also noted
that Korea’s bankruptcy laws and proceedings lacked clear economic
criteria in judging a company’s viability and did not allow for creditor
participation in designing a company’s rehabilitation plan.

The health of the financial system was further affected by deregulation
that started in 1993, with World Bank assistance. Deregulation led to a
removal of restrictions on cross-border capital flows, allowing greater
financial innovation, increasing competition in financial services, and
blurring distinctions between the various financial intermediaries. These
changes were accompanied by a sharp increase in international borrowing
by the corporate sector. The easing of financial prohibitions on debt
financing encouraged borrowing that in many instances proved to be

Page 47                                  GAO/GGD-99-157 Asian Financial Sector Reforms
           Appendix II
           Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

           unsustainable. The financial sector was further compromised by the
           Korean system of promissory notes (cross-guarantees) that were
           unsupported by sufficient credit analysis. In the absence of strengthened
           prudential supervision, these developments led to the accumulation of
           substantial loan losses. The Korean government estimated that
           nonperforming loans at the end of 1997 were about $18.4 billion.

           The weak state of the banking sector led to successive downgrades by
           international credit rating agencies and a sharp tightening in the
           availability of external financing. External creditors began to reduce their
           debt exposure to Korean banks in the latter part of 1997, causing a sharp
           decline in Korea’s usable reserves. A large amount of these reserves were
           being used to finance the repayment of the short-term debt of Korean
           commercial banks’ offshore branches. Historically, Korean authorities had
           a policy of not letting private banks go into default. Consequently, the
           Bank of Korea was providing foreign exchange support to commercial
           banks as foreign creditors reduced their exposure on short-term lines of
           credit. The total amount of foreign currency reserves that the Bank of
           Korea held at the end of December 1997 was $20.4 billion, the usable
           portion of which was $8.9 billion. As of December 31, 1997, the total
           amount of Korea’s private and governmental external liabilities was $154.4
           billion, calculated under IMF standards. The Korean government estimated
           that at the end of December 1997 external payments of about $27.3 billion
           were due by the end of the first quarter in 1998. The ability of Korea to
           repay its short-term debts was dependent on the willingness of foreign
           lenders to extend the terms of existing loans and to offer new financing.

           Korea continues to experience weaknesses in its financial and corporate
           sectors. Recent noteworthy events in Korea have been particularly
           illustrative of the difficulties Korea faces in addressing these weaknesses.
           These events include the breakdown in negotiations to sell intervened
           banks, the near bankruptcy of the Daewoo Group (a major Korean
           conglomerate) in July 1999, and recent allegations of stock price
           manipulation by Hundai Securities.

           The onset of the financial crisis in Thailand highlighted and exacerbated
Thailand   many of the weaknesses that existed in the banking system, such as weak
             Under the IMF program, Korea tightened its definition of usable reserves and has reported its reserves
           under this stricter definition. Korea reported that its usable foreign exchange reserves as of end-June
           1999 were $60.4 billion. Previously, Korea had included its deposits with overseas branches of Korean
           financial institutions when reporting its foreign exchange reserves, thus overstating its usable reserves.
           Usable foreign currency reserves equal the total foreign currency reserves less the amounts on deposit
           with overseas branches of Korean financial institutions and swap positions between the Bank of Korea
           and other central banks. For more information on Korea’s IMF program, see GAO/GGD/NSIAD-99-168.

           Page 48                                          GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix II
Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

supervision and regulation, lending to related entities and weak
management. The Bank of Thailand’s supervision of Thailand banks and
finance companies was considered weak because supervisors lacked
adequate resources and training and had an unclear framework for
supervision. Generally, the process for supervision that existed did not
focus on risk-based approaches that analyzed the risks facing the bank but
focused on a compliance-based approach where satisfaction of certain
regulatory rules was determined by bank supervisors.

Weak credit analysis also existed in Thailand, and bankers tended to focus
on the available collateral, rather than the ability to repay. This absence of
credit analysis, combined with a generally low standard of transparency
and disclosure of financial information led to a fragile financial system in
Thailand. Weak legal frameworks pertaining to foreclosure and bankruptcy
often meant that it could take up to 10 years to foreclose on an institution
and/or collect collateral as court proceedings were lengthy and expensive.

According to local bank officials, before the crisis, Thailand tightly
regulated banks by making it difficult for banks to engage in higher risk
financing and leasing. Therefore, according to these officials, banks
created finance companies to engage in higher risk financing and leasing
through a loophole in the banking laws. According to an international
banker, over 100 finance companies were established before the Bank of
Thailand implemented a law to regulate finance companies. According to
another international banker, there was a finance company crisis in the
mid-80s that should have required the Thailand government to set stricter
regulatory requirements or “trip wires.” However, this was not done. In the
end, the Bank of Thailand facilitated the bailout of those finance
companies—91 remained—by allowing banks to inject capital and take
over finance company management. This set the stage for “moral hazard”
problems in the future, wherein financial market participants expected
that the government of Thailand would not allow failures of finance

According to Bank of Thailand documents, this expectation by financial
sector participants was an important weakness in the financial system. The
lack of a clearly stated policy on allowing financial institutions to fail gave
a misleading sense of security to market participants. Along with other
countries in the region, Thailand’s financial system was often
characterized as “no entry, no exit,” meaning that it was as difficult to get a
banking license as it was to let an institution fail.

Page 49                                  GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix II
Weaknesses in the Financial Systems of Indonesia, Korea, and Thailand

Loan classification and loan loss provisioning practices were not done
according to internationally accepted norms. For example, uncollected
interest income was allowed to accrue for 12 months, thereby overstating
banks’ income and capital. These factors, combined with weak accounting
standards, made transparency a problem that needed to be addressed.

Family groups generally control Thailand’s banks, resulting in family
lending, on a connected basis, to other family business interests. Since
these other nonbank commercial interests have also been affected by the
crisis, their financial problems have undermined confidence in the banking
system. In addition, Thailand’s system of interlinked family controlled
companies has created particular problems for corporate restructuring.
Creditors tend to associate restructuring of a parent company with
restructuring of either related companies or unrelated companies with
similar shareholders, despite the absence of cross-guarantees or other
formal links between corporations.

Weak middle management was evident in domestic banks, according to a
rating agency report. Bank management personnel at the very senior levels
were experienced and competent; however, the middle and lower levels
lacked quality staff. In addition, senior level staff recruits were often
discouraged because of the family controls over the business and the
consequent limits on promotions.

In addition, according to World Bank officials, although the Bank of
Thailand is technically independent, its officials had been subject to
political pressure. The pressure, combined with an unclear exit and entry
strategy, resulted in the unwillingness of senior officials at the central
bank to make “unfavorable” decisions, for example, to close insolvent
institutions. Other sources stated that Bank of Thailand also made
fundamental errors and at times, Bank of Thailand officials “turned a blind
eye” to ill advised, (at times criminal) lending. According to a Thailand
domestic bank official, in the precrisis days, supervision was soft and
banks could “negotiate” with supervisors—within reason—if there was a
problem. In addition to the supervisors’ lack of authority of to close banks,
they also did not (and currently do not) have any immunity for their job
performance. That is, if supervisors cause losses to a government
institution, by, for example, providing liquidity support that is not repaid,
they can be held personally liable.

Page 50                                  GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix III

Legal, Administrative, and Judicial Changes in
Indonesia, Korea, and Thailand

                 Indonesia has proposed and made changes to a variety of laws, with the
Indonesia        intent of strengthening its financial system. A new bankruptcy law became
                 effective on August 20, 1998. The bankruptcy law was considered an
                 essential component of the framework for restructuring the enormous
                 debt burden of the private sector, according to IMF documentation.
                 Amendments to the banking law were passed by Parliament in October
                 1998. These amendments eliminated restrictions on foreign investment in
                 publicly held banks; amended bank secrecy law,with regard to
                 nonperforming loans, so that debtors could be publicly identified; and
                 enabled bank mergers and privatization. The Central Bank Law—designed
                 to increase the Bank of Indonesia’s autonomy—was submitted to
                 Parliament in March 1999 and became operational in May 1999.

                 To implement the bankruptcy law, a Special Commercial Court to process
                 bankruptcy applications was opened on August 20, 1998. The government
                 of Indonesia has (1) appointed experts as ad hoc judges to the Commercial
                 Court, (2) implemented an ongoing program of continuing education for
                 judges, (3) developed a transparent court fee to generate increased
                 resources for the court system that could be used for higher salaries for
                 judges, and (4) made decisions of the court publicly available. Officials of
                 the U.S. Department of State said that how well this court functions is
                 viewed as an indicator of whether or not financial sector reforms are
                 progressing and that initial decisions of the court lead to a mixed
                 assessment. The first final ruling was controversial because the court
                 dismissed the petition against the company because a related petition was
                 pending against its subsidiary. The second final ruling was the court’s first
                 order of bankruptcy against a debtor company. By mid-February 1999, the
                 Commercial Court had received 42 petitions. There have been concerns
                 that the amended bankruptcy law is not being implemented according to
                 either its letter or spirit and that the bankruptcy law is not working
                 effectively, according to IMF documentation.

                 Other legal and administrative reforms are to include

               • lifting restrictions on debt for equity conversions,
               • removing tax disincentives for restructuring,
               • streamlining procedures and approval requirements applicable to the
                 admission of foreign direct investment,
               • a new arbitration law, and
               • measures to provide for the registration of collateral.

                 Korea has made several legislative changes to strengthen its financial
Korea            regulatory system and corporate governance, open its financial institutions

                 Page 51                            GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix III
Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

to foreign competition, and revise its labor laws. To strengthen its financial
regulatory system, Korea revised its Bank of Korea Act to provide central
bank independence, with price stability as its prime mandate. Korea also
passed legislation to consolidate supervision of commercial banks,
merchant banks, securities firms, and insurance companies into one
agency, the Financial Supervisory Commission. This agency was given
operational autonomy and has broad powers to deal with troubled
financial institutions. To deepen Korea’s capital markets, Korea also made
several revisions to liberalize capital in Korea’s bond and equity markets.

In an effort to improve corporate governance and the transparency of data,
Korea passed legislation requiring that corporate financial statements be
prepared on a consolidated basis and be certified by external auditors.
Related legislative changes included provisions in Korea’s Fair Trade Act
that eliminated cross-guarantees by April 2000. According to Korean
government documents, to reinforce management transparency and
accountability, the top thirty chaebols (industry conglomerates) and all
publicly held companies were required in February 1998 to organize an
“independent audit committee” to represent minority shareholders and
creditors. However, according to the World Bank, the independent audit
committees will have two-thirds of its members from outside the company
and one-third of its members from within, and will not represent minority
shareholders and creditors. Korea has also strengthened the Korean Fair
Trade Commission’s supervisory function, by granting it the authority for 2
years to request financial information from the financial institutions, to
give it the ability to investigate unfair inter-affiliate transactions of

Korea reformed its insolvency laws in early 1998, with World Bank
assistance. Korea established (1) economic criteria to judge a company’s
viability; (2) creditors’ committees to strengthen the creditor role and set
time limits on making court decisions; and (3) a special administrative
body to provide expertise to the courts (such as in evaluating a company’s
financial situation and viability, nominating a receiver, and approving
rehabilitation plans). New procedures to simplify market exit have
important implications for corporate workouts, in that an expeditious exit
scheme allows for more efficient negotiations for the workout programs
between the creditor banks and the firms.

Korean officials noted the revision of Korea’s Labor Standards Act, which
legalized layoffs for managerial reasons, as a landmark achievement. It
was common practice for Koreans to have employment for life. Social
acceptance has not been easy, demonstrated by labor disputes between

Page 52                                   GAO/GGD-99-157 Asian Financial Sector Reforms
           Appendix III
           Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

           some of the troubled commercial banks and their labor unions as well as
           labor strikes at other companies. Korea has expanded its social safety net
           to allow for unemployment protection. Korea’s employment insurance
           system has also been expanded to cover all regular, temporary, and daily
           employees, according to Korea’s Ministry of Finance and Economy.

           The Government of Thailand reformed its bankruptcy laws twice since the
Thailand   onset of the crisis, in April 1998, and again in March 1999. In addition, the
           Government of Thailand has made some changes to laws relating to
           privatizing state enterprises and liberalizing foreign ownership of
           buildings. Other laws, relating to liberalizing key areas of the economy to
           foreign investment and changes to the bank regulatory system are still
           being considered by Parliament.

           The bankruptcy laws in Thailand’s 1940s Bankruptcy Act, which was in
           effect during the crisis, gave creditors and debtors only limited and drastic
           alternatives for dealing with problems. For example, liquidation was
           generally the only solution because foreclosure was almost impossible—it
           could take up to 10 years to go through court proceedings to foreclose and
           collect assets from a company. In addition, companies did not have the
           option to reorganize in an attempt to become viable or have protection for
           new financing to the company.

           The Bankruptcy Act was modified in April 1998, and some of the problems
           associated with the law were addressed. The new legislation passed
           included bankruptcy procedures and a plan for reorganization that
           followed closely the U.S. and British practice on court jurisdiction. Under
           this new law, the courts and judges were given the power to guide the
           process very closely to the end. It was estimated that any reorganization
           plan would take 3 to 6 months for court approval. The law also added
           provisions to protect creditors who advance new money to debtors in the
           process of reorganization. However, after the passage of this law, it could
           still take 5 to 7 years to liquidate companies’ solid assets and up to 10 years
           to collect assets, according to an international banker. On March 17, 1999,
           the Thailand Parliament revised the Bankruptcy Act to address issues
           raised by the amended 1998 act and passed a new bankruptcy courts bill
           and foreclosure–related bills (amendments to the Code of Civil
           Procedure). The passage of this legislation was delayed for months
           because senate members had personally guaranteed loans and were
           concerned that they would be held liable for them under the new laws and
           were therefore blocking passage of the new laws, according to various
           officials. In addition, parliament members were also concerned about
           increasing foreign ownership of Thailand owned corporations. Elements of

           Page 53                                   GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix III
Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

the new laws include reducing the time for bankruptcy status from 10 to 3
years, creating bankruptcy courts, and streamlining foreclosure
procedures to limit postponement of legal proceedings and to limit the
number of appeals.

Several closely related laws, including bankruptcy and foreclosure laws,
were passed by Parliament, as of April 1999. However, there have also
been delays and nonpassage of other closely related legislation important
to the economy. The other laws that have been passed by Parliament were
an effort to open the market, particularly to foreign investment and
ownership and to encourage privatization. These laws, the Condominiums
Act, the Land Code, and the Lease Act, were all passed by Parliament by
April 1999. The purpose of the Condominiums Act is to liberalize foreign
ownership of buildings. The purpose of the Land Code is to liberalize
foreign ownership of land. The purpose of the Lease Act is to deal with
foreigners leasing property. According to IMF documents, the property-
related laws were passed in an effort to revive the troubled property sector
in Thailand. The “Corporatizations Law,” also passed by Parliament, would
facilitate the privatization of state enterprises. However, it is awaiting
clearance from the constitutional courts to be enacted.

Three key and closely related bills are still being drafted and reviewed.
They include (1) a bill revising the Financial Institutions Law, which
concerns commercial banking and finance companies; (2) a bill revising
the Deposit Insurance Law; and (3) a bill revising the Central Bank Law.
The revision of the Financial Institutions Law, which has been delayed
repeatedly, would create the framework for important revisions to
prudential regulations, including foreign exchange exposure, lending
limits, accounting standards, and disclosure standards. The revision of the
Deposit Insurance Law would eventually replace the blanket deposit
guarantee currently in place, and the revision of the Central Bank Law
would strengthen the powers, independence, and accountability of the
Bank of Thailand.

Other proposed laws include the Currency Act, which would free up
excess foreign exchange backing of the currency. The passage of the
Currency Act has been delayed. The proposed Secured Lending Law,
which aims to expand securitizable assets, is to be submitted by the end of
1999. The proposed Foreign Investment Act, which would liberalize foreign
participation in certain business sectors, has not yet been passed, although

    Securitization is the conversion of assets into marketable securities for sale to investors.

Page 54                                             GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix III
Legal, Administrative, and Judicial Changes in Indonesia, Korea, and Thailand

it was sent to the lower house of Parliament after the committee work had
been completed on March 5, 1999.

Thailand has also completed preliminary work for the privatization of (and
share divestiture from) public enterprises in the areas of energy, utilities,
communications, and transport, according to IMF documents. In addition,
the Thailand government established a secretariat for privatization and
proposed legislative measures to facilitate privatization of
“noncorporatized” public enterprises.

Page 55                                   GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix IV

Comments from the Department of the

              Page 56      GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix V

Comments from The World Bank

             Page 57     GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix V
Comments from The World Bank

Page 58                        GAO/GGD-99-157 Asian Financial Sector Reforms
Appendix VI

GAO Contacts and Staff Acknowledgments

                  Thomas J. McCool (202) 512-8678
GAO Contacts
                  Susan S. Westin (202) 512-4128

                  Patrick S. Dynes, Nima P. Edwards, Debra R. Johnson, James M.
Acknowledgments   McDermott, John H. Treanor, Desiree W. Whipple

                  Page 59                           GAO/GGD-99-157 Asian Financial Sector Reforms
Page 60   GAO/GGD-99-157 Asian Financial Sector Reforms
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