Tom McCawley, Jakarta – In the end, Indonesia's banking reform was more like amputation than elective surgery. But nearly everyone agreed a radical step was necessary to save the patient. Jakarta announced March 13 that it was closing 38 banks, taking over seven others and recapitalizing nine. Although the closures grabbed the immediate headlines, it was the last group that represented the most significant development. Together with state banks, these nine account for more than two-thirds of lending within Indonesia. The fate of Indonesia's economy depends on the success of the program. Indonesia's banks were paralyzed in 1998. Commercial lending was virtually impossible with interest rates often above 40%. Savings, production, exports – activities critical to job generation – froze to a standstill.

And Indonesia's economy contracted by about 16%. "There can be no recovery without a working financial system," said the Jakarta-based World Bank director Dennis de Tray.

The nine banks to be recapitalized will be eligible to receive from the government 80% of the funds they need, provided they can come up with the remainder by April 21. Many observers think it is unlikely that the government will get really tough because the banks involved are simply too big to fail. But Subardjo Djojosumarto, the director of Bank Indonesia, the nation's central bank, insists the government will not bend: "If they fail [to get financing], the banks will be closed." For the past week, rumors have swirled that some of the nine might merge to form a new institution called "Power Bank." Bank Lippo, Bank Bali and Bank Universal – all among Indonesia's 20 largest banks and named as eligible for recapitalization funds – are said to be possible partners.

One immediate benefit of the bank reform plan was the expected release by the International Monetary Fund of the remaining $2.3 billion of the $11.3 billion portion of Indonesia's bailout package. An additional $1 billion from the IMF is under consideration. The fund's lending to Indonesia had been suspended until bank restructuring and liquidation were resolved.

The bank plan was originally to have been announced on Feb. 27. But at the time, senior economics minister Ginandjar Kartasmita said the closures would be postponed for "technical reasons." However, one official with the Indonesian Bank Restructuring Agency (IBRA) acknowledged that the delay "was political." Many observers feared the ultimate plan would not be tough enough.

In fact, many powerful Indonesians were connected to the 38 banks slated for closure. Bank Arya Panduarta, which is owned by timber tycoon and Suharto crony Mohamad "Bob" Hasan, was on the list. The Suharto kids also took a beating. Youngest son Tommy's Bank Pesona Kriyadana was shut down.

Second son Bambang saw his Bank Andromeda ordered liquidated – the second failure for the bank, which was ordered shut under the name Alpha but was given a reprieve. Daughter Tutut's Bank Yama is also going down. Not to say the announcement looked interference-free. One bank to be nationalized is Bank Nusa Nasional, which is owned by Ginandjar ally Aburizal Bakrie. IBRA sources say audits of Bank Nusa revealed that non-performing loans represented more than 90% of its portfolio.

Although there were some initial signs of depositor trouble in Surabaya, the announced bankruptcies produced nothing like the panic that followed the closures of 16 banks in November 1997. The US debt-rating agency Standard and Poor's said the program was a positive step but wasn't enough.

The agency was critical that Indonesia had classified 73 banks as healthy even though they had achieved capital-adequacy ratios of only 4%. The world standard is 8%. The lower benchmark is "inadequate given the operating risks facing banks in Indonesia," according to S&P.

A next major step is restructuring state-owned banks. The March announcement marked the near-nationalization of the banking sector. The government now has control over about three-quarters of the entire industry. It is not an enviable position. Indonesian banks are bedeviled by a vicious cycle in which their cost of funds is invariably higher than the interest they receive on loans – a negative interest spread. Economist Syahrir warns that if the negative spreads continue and bank losses balloon, the government may be tempted to print money as a palliative, which would spur inflation. And a coming election may only increase the pressure. Jakarta may find out soon the dangers of owning so many banks.