By Dr Mohamed Ariff

                  No one can deny or ignore the pivotal role played by financial institutions in a
                  modern economy.

                  It is no exaggeration to say that the health of the economy is critically
                  dependent on that of the banking system.

                  The East Asian crisis has exposed the dark side of the interface between the
                  financial and the real sectors.

                  What began as currency crisis devolved rapidly into financial crisis before
                  transforming itself into a full blown economic crisis, with banks taking the
                  centre stage as the drama unfolded.

                  It is a fact that the currency crisis was fuelled by concerns about the health of
                  the banking system in the crisis-hit countries.

                  Excessive lendings without adequate safeguards have been the main drawback
                  of the financial institutions, resulting in soaring non-performing loans (NPLs) and
                  gross capital inadequacy.

                  The rest is history.

                  The banking system in the stricken countries took a severe beating with some
                  folding up altogether, while the real sector in these economies suffered badly as
                  a consequence.

                  Malaysia was less unfortunate than Indonesia, Thailand or South Korea. None
                  of the Malaysian banks caved in.

                  Hindsight suggests that good central-bank supervision and surveillance must
                  have had much to do with the remarkable resilience of the Malaysian banking
                  system.

                  Timely action by the central bank also saved some financial institutions as in
                  the case of MBf Finance.

                  What is more, the NPL problem in Malaysia during the current crisis pales in
                  comparison with that of other crisis-hit East Asian countries.

                  It also pales in comparison with Malaysia's own previous crisis experience in
                  1985 whe NPLs rose as high as 33 per cent of total loans.

                  This time around, the NPL ratio was at most roughly one-half of what it was
                  during the last crisis.

                  The establishment of the Special Purpose Vehicles, i.e. Danaharta and
                  Danamodal, has also been very helpful.

                  While Danaharta could buy up bad loans and take over the supporting assets,
                  Danamodal managed to inject sizeable capital into the banks which had to bear
                  the losses resulting from the sale of NPLs.

                  By the end of June 1999, the nominal value of NPLs bought over by Danaharta
                  stood at RM28 billion, while Danamodal had pumped in RM6.2 billion.

                  Resources available to these two agencies (RM15 billion for Danaharta and
                  RM16 billion for Danamodal) are considered adequate even under the worst
                  case scenario, as shown by the stress tests carried out by the central bank.

                  Thanks to various measures taken by the Government, the NPL problem has
                  not gone out of hand.

                  Based on the six months classification, NPLs currently hover around only 8 per
                  cent.

                  Going by the international three months definition of bad loans, the NPL ratio is
                  only slightly above 13 per cent.

                  All this is a far cry from what is going on in the neighbourhood.

                  Risk-weighted capital ratio (RWCR) is also at fairly comfortable levels, partly
                  due to new capital injections and partly due to the tendency for banks to avert
                  high-risk lendings.

                  The RWCR of the Malaysian banking system exceeds 12%, way above the 8%
                  critical minimum set by the Bank of International Settlement (BIS).

                  Evidently, Danaharta and Danamodal have performed fairly well thus far.
                  However, there is still much more to be done.

                  The arduous task of buying up bad loans at reasonable discounted prices and
                  financing it with zero-coupon bonds may seem like child's play compared with
                  the more daunting task of managing the assets that have been acquired in the
                  process.

                  Apparently, Danaharta has emerged as the biggest owner of real estates in the
                  country.

                  Disposing these properties in an orderly fashion without upsetting the market is
                  not going to be easy under the present circumstances, given the huge supply
                  glut.

                  And, understandably, there are not many takers at home right now.

                  Corporate debt restructuring has progressed somewhat at a slow pace.

                  It has been reported that out of some 60 companies which have approached the
                  Corporate Debt Restructuring Committee (CDRC) with an aggregate nominal
                  loans value of over RM30 billion, only RM13 billion loans involving 13 companies
                  have been sorted out.

                  There may well be more applicants in the future.

                  The trouble with the CDRC is that it has no muscles to flex. Without
                  empowerment, there is little that the CDRC can do, apart from playing a
                  facilitating role by bringing the creditors and debtors to the negotiating table.

                  The overhang of corporate debts is certainly a cause for concern.

                  Banks and finance companies are still saddled with roughly two-thirds of the
                  NPLs, as Danaharta could absorb only one-third.

                  Although Malaysia's external debts are not large relative to gross domestic
                  product (GDP) by developing country standards, its total domestic debt is very
                  huge by any yardstick.

                  Bank loans, which represent the largest chunk of domestic debt, amount to
                  145% of GDP, much higher than the pre-crisis peak level of 135%, by far the
                  largest in Southeast Asia.

                  The high profile of domestic debt, which has often been cited as one of the
                  weaknesses of the Malaysian economy, presents a dilemma as it does not jive
                  well with the central bank's call for higher loans growth to stimulate the
                  economy.

                  For higher loans growth will raise the loans-GDP ratio which is already too high,
                  thereby weakening the country's macroeconomic fundamentals.

                  Fortunately, a redeeming feature is that the central bank reserves have
                  increased significantly from RM58 billion in August 1998 to RM118 billion at the
                  end of June 1999.

                  The ratio of M2 (a proxy for short-term liabilities) to total reserves has fallen from
                  4.7 on the eve of the currency crisis to 2.6 in June 1999, a clear plus point.

                  Banking reform in Malaysia entails not only restructuring bad debts and
                  refinancing the weak financial institutions but also strengthening the banking
                  system as a whole through mergers.

                  The number of finance companies was reduced from 39 to 25 upon central bank
                  intervention in the initial phase of the crisis.

                  In addition, RHB Bank has taken over Sime Bank, while Bank Bumiputra and
                  Bank of Commerce have merged to form Bumiputra Commerce Bank.

                  At present, Malaysia has 21 commercial banks, 25 finance companies and 12
                  merchant banks, too many for a small population of 22 million people, not to
                  mention the presence of several foreign-owned banks.

                  The central bank has again called on the Malaysian financial institutions to
                  accelerate mergers, this time "ordering" them with a clear deadline which ends
                  in September.

                  The agenda is to reduce the number of financial institutions of six, comprising
                  commercial banks, finance companies and merchant banks.

                  To be sure, the merger exercise will not include locally incorporated foreign
                  banks.

                  The central bank has also identified six "anchor banks", namely Malayan
                  Banking, Bumiputra Commerce Bank, Public Bank, Southern Bank,
                  Multipurpose Bank, Perwira Affin Bank.

                  Malayan Banking, the country's largest bank, is expected to merge with Pacific
                  Bank and EON bank, with a combined asset of about RM105 billion.

                  Bumiputra Commerce Bank, the second largest bank in the country, would take
                  over Hong Leong Bank and the International Bank of Malaysia, with an
                  estimated RM95 billion in combined assets.

                  Public Bank, the fourth largest now, is slated to absorb its own finance
                  company unit, Public Finance, and to take over two banks in Sarawak, Wah Tat
                  Bank and Hock Hua Bank.

                  Southern Bank, a medium-sized entity, would merge with Ban Hin Lee Bank
                  and take over United Merchant Finance and Perdana Finance.

                  Perwira Affin Bank, currently the sixth-largest, would buy control of state-owned
                  BSN Commercial Bank and merge with Arab-Malaysian Bank, Arab-Malaysian
                  Finance, Arab-Malaysian Merchant Bank, with the merged group taking over
                  Asia Commercial Finance, and buying control of Utama Banking Group, the
                  largest bank in eastern Malaysia.

                  Multi-Purpose Bank, now the 12th-largest bank in the country, would become
                  the third-largest after taking over bigger rivals, comprising RHB Bank, Oriental
                  Bank, Sabah Bank, Phileo Allied Bank, MBf Finance and Bolton Finance, with
                  over RM70 billion in combined assets.

                  The above merger plan looks pretty impressive.

                  Ostensibly, the two main objectives of the consolidation process are: (a) to
                  enlarge the capital bases that would ensure a better management of risks and
                  enhance the resilience of the banking system and, (b) to cut costs and improve
                  the competitiveness of Malaysian financial institutions.

                  Interestingly, ethnic considerations are not ignored in the exercise. At present,
                  there are 8 Chinese-owned commercial banks out of a total of 21, roughly
                  one-third.

                  Under the proposed new structure, there will be two Chinese-owned banks out
                  of a total of six, again one-third.

                  The merger scheme is by no means final and there is still room for changes in
                  the groupings, as the central bank would allow the financial institutions some
                  leeway to choose their partners, should there be any serious incompatibilities
                  during the consolidation.

                  However, it is still unclear how the proposed consolidation will be funded,
                  whether through share swaps or from the debt market.

                  Where would the hundreds of retrenched bank employees (with the closing
                  down of some branches) go also remains a moot question.

                  More worrisome is the implications of this ambitious consolidation for the
                  day-to-day management of banks, with attention being diverted away from such
                  pressing problems as bad loans to the mega merger exercise.

                  The need for bank mergers is duly recognised. Malaysia's banking system is
                  over-fragmented.

                  A consolidation can lead to the emergence of larger, stronger financial
                  institutions capable of competing in increasingly globalised markets.

                  A small number of large banks would make prudential supervision easier and
                  systemic risks lesser than is the case with a large number of small banks.

                  Be all that as it may, one wonders if the strategy adopted by the central bank is
                  indeed most appropriate.

                  For one thing, it is a top-down stick approach to forge forced mergers which
                  may smack of uneasy marriages of inconvenience. A bottom-up carrot
                  approach would probably work better.

                  For another, the September deadline is somewhat impractical. A more
                  generous but firm time frame would be more down-to-earth.

                  While a reduction in the number of financial institutions would certainly make
                  considerable sense, as it would allow banks to enjoy economies of scale and
                  scope, one wonders why the magic number six?

                  Why can it not be less than six or more than six, say, five or seven?

                  Curiously, the central bank did announce as recently as March that the number
                  of banks would be reduced to 16. Why six now?

                  Perhaps, the newly proposed six is a solemn figure arrived at presumably
                  through the identification of "anchor banks" by the authorities.

                  Needless to say, in a bottom-up approach, the configurations may well be
                  significantly different.

                  Finally, a word of caution is in order. Mergers alone cannot transform the
                  banking system into a formidable force.

                  For everywhere, there are some weak large banks, just as there are some
                  strong small ones.

                  This is not to deny that size does matter. But size has little to do with
                  professionalism and competence or the level of sophistication and efficiency.

                  All this has much to do with the competitive environment within which banks
                  operate.

                  This observation underscores the importance of deregulation and liberalisation
                  in the banking reform exercise.

                  The merger exercise will become all the more meaningful, if the banking reform
                  includes an agenda to expose the banking sector to increased international
                  competition.

                  Hopefully, mergers will pave the way for a greater opening of the banking sector
                  to foreign competition.

                  Dr Mohamed Ariff is Executive Director of the Malaysian Institute of
                  Economic Research. The views expressed here are those of the writer in
                  his personal capacity.