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Chris Stowers for Asiaweek.
Many bank loans are used to buy shares, so a falling Taiwan bourse could weaken the system.
Taiwan's Ticking Clock
Why the island is worried about its banks

Named Taiwan's vice premier just last week, Lai In-jaw lost no time in declaring that banking reform was one of the new cabinet's priorities. "Overbanking and vicious competition forced many banks to take greater risks to compete in lending," said the Harvard-educated former deputy finance minister. "As a result many banks suffer from problem loans." Earlier, planning official Chen Po-chih told Reuters news agency that two or three private banks were in trouble, but added that they were talking with potential rescuers. "I know of at least one set of negotiations that is going on," he said. In testimony before legislators Oct. 9, Central Bank Gov. Perng Fai-nan declared: "Salvageable banks must be rescued to prevent a banking crisis."

What's going on here? Isn't Taiwan's banking system supposed to be strong and resilient? At the height of the Asian Crisis in 1998, its non-performing loans were reported to account for 4.5% of outstanding debt, lower than Singapore's 11.4%. Lately, though, warning bells have begun to ring. "The banking sector in Taiwan is quite weak," says John Caparusso of Salomon Smith Barney in Taipei. "There are relatively few good banks and they tend to be small. We need to see consolidation in the banking sector and a cleaning up of balance sheets." In gauging financial soundness, Moody's Investors Service gives four major Taiwan banks a D rating, with a fifth receiving E+. Last year, the lowest grade it gave was a D+.

In a report released last month, Moody's said the major risks in Taiwan include "policy lending and political influence, which still undermine the banks' financial fundamentals." Politicians and businessmen have traditionally used Taiwan banks as cheap funding sources for pet projects. Some loans are granted on the basis of relationships, not the viability of the project and the quality of collateral. These weaknesses were overlooked because the KMT, the party that governed Taiwan for 55 years before Chen Shui-bian won the presidency this year, placed government's considerable financial resources behind the banks. But the new administration has signalled that it will crack down on these practices. Two months ago, government prosecutors raided Chang Hwa Commercial Bank in an effort to find evidence of fraud involving a non-existent project.

Officially, the central bank pegs the current non-performing loans of Taiwan's 52 banks at $23 billion, 5.3% of total outstanding loans. But the actual level could be much higher. "If Hong Kong or Singapore banking rules were applied, non-performing loans in Taiwan banks would be closer to 15%," says one banking analyst in Taipei. Other estimates run as high as 20%. The 5.3% is based on a definition of a soured loan as one overdue for at least six months, not three months as in Hong Kong and Singapore. Taiwan may also be understating its bad-loan numbers because it does not consider rescheduled and restructured loans as non-performing. And it does not require banks to report their exposure to troubled companies. In Hong Kong, such loans are classified as "substandard" even if the debtor is still repaying.

No one is saying that Taiwan's financial system is on the brink. "The major banks in Taiwan aren't insolvent, although they are not as strong as they appear on paper," says Deborah Schuler of Moody's in Hong Kong. "Overall, the banking system is sound." But confidence could wane as more banking problems like those involving Chang Hwa Commercial Bank come to light. A steep decline in real estate and stock values could be bad too because people who borrowed money to invest in property and the stock market will be hard-pressed to repay their bank loans. The Taiwan bourse recently hit a 20-month low after Tang Fei resigned as premier. Chen had named the KMT party stalwart to the post to allay fears of instability.

The president is moving on bank reforms. The new cabinet plans tax breaks for merging institutions and permission for foreigners to take over local banks. At the moment, a local or foreign institution can own only 15% of a bank. But a mergers law could be blocked by the KMT, which still dominates the legislature. While talking for years about the union of three state-owned banks, the KMT never followed up its words with action. "If you were to put the big three banks in Taiwan together, basically you could put well over half the people out of jobs without compromising service or coverage," says Salomon's Caparusso. As to private banks, many are controlled by families that do not want to give up their stake. Those persuaded to sell are likely to demand unrealistically high prices.

Still, consolidation is not a bad thing in a globalizing world. "Small banks can't make the information-technology investments needed in the Internet Age," says Caparusso. "And they don't have the pricing power, profit spreads and servicing capabilities [to compete]." Mergers can also clean up balance sheets, revitalize ailing institutions and build world-class banks. "I believe there will be two or three unions over the next year or so," says Caparusso. "But that will not drive systemic change." For Taiwan, the challenge is to continue the financial housecleaning without spooking investors — and precipitating a banking crisis.

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