0

Occasional Paper No. 45

EFFECTIVE FINANCIAL SYSTEM STABILITY FRAMEWORK

Wimboh Santoso Sukarela Batunanggar

The South East Asian Central Banks

Research and Training Centre (The SEACEN Centre)

Kuala Lumpur, Malaysia

1

TABLE OF CONTENTS

Foreword

Abstract

2. Introduction

3. What is Financial Stability?

3. Central Banks’ Roles in Maintaining Financial System Stability

3.1 Strategies

4. Promoting Financial Stability in Practice

4.1 Research on the Financial System

4.2 Surveillance on Financial System

4.2.1 Surveillance on the Financial Institutions and Markets

4.2.2 Surveillance on the Markets Infrastructure

4.2.3 The Surveillance on Domestic Finance

4.2.4 The Surveillance on International Finance

4.2.5 Products and Reports of Financial System Stability

5. Coordination and Cooperation

6. Financial Safety Nets and Crisis Management

6.1 Lender of Last Resort

6.1.1 Lender of Last Resort in Normal Times

6.1.2 LLR in Exceptional Circumstances

6.2 Deposit Insurance Scheme

7. Key Challenges and the Way Forward

Selected References

2

Foreword

Rapid expansion in the financial services industry and globalisation of financial markets have enhanced economic growth opportunities. They have also increased the risks in the financial sector heightening challenges in the maintenance of financial system stability and hence, requiring greater attention of the responsible country authorities as well as international organisations. Moreover, recent financial crises have clearly demonstrated the importance of maintaining systemic stability in the financial sector. As a result, financial system stability has become a primary agenda item at the country level as well as international level. Consequently, it has become one of the key objectives of an increasing number of central banks. A stable financial system not only facilitates efficiency in financial intermediation and resource allocation but also provides an effective conduit for transmission mechanism of monetary policies. Meanwhile, absence of financial system stability is costly as it may lead to financial crisis resulting in drastic consequences of lower economic growth, higher fiscal burden, and even social and political instability.

Financial stability is a broad concept which does not have a simple or universally accepted

definition. However, there seems to be a broad consensus that it refers to the smooth functioning of the key elements (i.e., institutions, markets and infrastrucutre, etc) that make up the financial system. As such, the role of the authorities responsible for promoting and maintaining financial stability (i.e., central banks and other financial supervisory authorities) involves monitoring both domestic and international financial developments, identifying areas of concern relevant to the financial system and undertaking necessary measures in coordination with other relevant institutions.

This Occasional Paper analyses financial system stability and how it is practiced as an

important task of a central bank, particularly in the context of Bank Indonesia. The Paper delves into the definition of finanical stability, role of the central bank in maintaining financial stability, promoting financial stability in practice, coordination and cooperation, financial safety nets and crisis management and lastly, key challenges.

The SEACEN Centre gratefully acknowledge the contribution of Dr. Wimboh Santoso, Head

of Financial System Stability Bureau, and Mr. Sukarela Batunanggar, Executive Research, Financial System Stability Bureau, both of Bank Indonesia, for authoring the Paper. The views expressed in this Paper are, however, those of the authors and are not necessarily those of Bank Indonesia and The SEACEN Centre.

Dr. A.G. Karunasena The SEACEN Centre Executive Director Kuala Lumpur

September 2007

3

Abstract

This paper analyses the concept of financial system stability and how it is practiced as one of the key objectives of a central bank. The paper discusses five main topics related to financial system stability: (i) what is financial system stability and why it is important; (ii) central bank function in maintaining financial system stability; (iii) promoting financial system stability in practice. This topic elaborates research and surveillance activities on the financial system, covering financial institutions and markets, financial infrastructure, domestic finance and international finance; (iv) coordination and cooperation in maintaining financial stability; (v) financial safety nets and crisis management. The paper concludes by posing several key challenges faced by related authorities in creating and maintaining financial system stability.

4

Effective Financial System Stability Framework

Wimboh Santoso1 and Sukarela Batunanggar2

1. Introduction

The financial crisis that swept over Southeast Asia in 1997, which included Indonesia, has taught us a very valuable lesson in the importance of maintaining stability of the financial system. During the past few years, financ ial system stability has been the primary agenda at national and international levels. The year 1999 saw the establishment of an international institute and an international forum, namely the Financial Stability Institute3 and Financial Stability Forum (FSF)4, intended to assist central banks and other supervisory authorities in strengthening their financial systems. Similar concerns have also been indicated by IMF and the World Bank, which introduced a Financial Sector Assessment Program (FSAP) to strengthen the financial system of the country being assessed.5

Increase in interest and attention in this area may also be seen by the increase in publications of books, articles and papers as well as seminars and conventions related to financial crisis and financial system stability. In addition, there is a growing number of central banks creating a unit or even groups dedicated to addressing financial system stability issues and financial stability reviews.

Central banks need to maintain financial system stability based on three primary reasons. Firstly, financial institutions, particularly banks, have important roles as financial intermediaries and as a transmission means of monetary policies, in the economy. These institutions are exposed

1Head of Financial System Stability Bureau, Bank Indonesia, e -mail: wimboh@bi.go.id 2Executive Researcher, Financial System Stability Bureau, Bank Indonesia, e-mail: batunanggar@bi.go.id. The views expressed in this paper are those of the authors and do not necessarily reflect the views of Bank Indonesia. The authors express sincerely thanks to Endang Kurnia Saputra, Wini Purwanti and Ita Rulina researcher at the Financial System Stability Bureau, who made large contributions in the preparation of this paper. 3 FSI is established by the Basel Committee on banking Supervision (BCBS) to assist supervisory authorities in strengthening their financial system. For further details visit http://www.bis.org/fsi/index.htm. 4 FSF is meant to improve stability of international financial system through exchange of information and international cooperation in the area of research and surveillance. FSF is composed of members from relevant authorities (finance ministries, central banks, financial supervisory authorities) from 11 countries, as well as international organisations (such as IMF, World Bank, BIS, OECD), international committees and associations (Basel Committee on Banking Supervision/ BCBS), International Accounting Standard Board (IASB), In ternational Association of Insurance Supervisors (IAIS), International Organization of Securities Commissions (IOSCO), Committee on Payment and Settlement System (CPSS), Committee on Global Financial System (CGFS) and European Central Bank. For further details please visit http:// www.fsforum.org/home/home.html. 5 FSAP is a concerted effort of IMF and World Bank which is introduced in May 1999. This program is intended to increase effectiveness in the efforts of improving soundness of financial system in me mber countries. For further details visit http://www.imf.org/external/np/fsap/fsap.asp.

5

significantly to high levels of risks inherent in their operations. Therefore, financial institutions constitute an important potential instability factor to the financial system. Secondly, all financial crises have brought catastrophic implications to the economy, lowering economic growth and income. These eventually create negative impacts on social and political life if prompt measures fail to address the crisis rapidly and effectively. Thirdly, financial instability brings great fiscal costs in the course of its mitigation.

Assessment of financial system stability is conducted by incorporating an early warning system to monitor and analyse trends in the macro-prudential and micro-prudential indicators4. The macro-prudential indicators include figures associated with economic growth, balance of payments, inflation, interest rates and exchange rates; the contagion effects, and all other relevant factors. The aggregated micro-prudential indicators include financial indicators such as Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to Market Risk (CAMELS). The assessment basically contains identification and evaluation of risks that may adversely affect financia l system stability and offers recommendations to the government and relevant authorities to carry out the necessary actions.

4. What is Financial Stability?

Financial system stability is a broad concept. It is built on five interrelated pillars, namely: (i) stable macroeconomic conditions; (ii) sound regulation and supervision of financial institutions; (iii) sound and efficient financial institutions and markets; (iv) safe and reliable financial infrastructures; and (v) effective financial safety nets (McFarlane, 1999).

Existing literatures do not provide a clear-cut definition of financial stability. Duisenberg (2001, p. 38) cites: “monetary stability is defined as stability in the general level of prices, or the absence of inflation or deflation. However, financial stability does not have an easy or universally accepted definition. Nevertheless, there seems to be a broad consensus that financial stability refers to the smooth functioning of the key elements that make up the financial system”.

Crockett (1997) defines financial stability as the stability of the key institutions and markets that make up the financial system. This requires (i) stability of the key institutions in the financial system with high degrees of confidence that enables them to carry on their contractual obligations without intrusion or outside support; and (ii) stability of key markets, in that participants can

Stable macro-economic environment

Well-managed financial institutions

and efficient financial markets

Sound framework of prudential supervision

Stable and sound financial system

Safe and robust payments system

Stable macro-economic environment

Well-managed financial institutions

and efficient financial markets

Sound framework of prudential supervision

Stable and sound financial system

Safe and robust payments system

6

confidently perform at prices that reflect the fundamental forces and that do not fluctuate substantially over short periods and in the absence of fundamentals changes.

Mishkin (1997, p. 62) provides another definition. He focuses more on the link of information problems and financial stability, and defines financial instability as when shocks to the financial system interfe re with information flows so that the financial system can no longer do its job of channeling funds to those with productive investment opportunities.

Some analysts such as MacFarlane (1999) and Sinclair (2001) view the financial system stability or financial stability from what it may prevent by defining financial stability as “the avoidance of financial crisis”, while Schinasi (2004) provides a description of what the achievement of such stability affords us. Shinasi defines financial stability as a situation in which the financial system is : (i) allocating resources efficiently between activities and across time; (ii) assessing and managing financial risks, and (iii) absorbing shocks. A stable financial system is thus one that enhances economic perfo rmance and wealth accumulation while it is also able to prevent adverse disturbances from having inordinate disruptive impacts.

In general there are two approaches in maintaining financial system stability, i.e. the micro-prudential approach and the macro-prudential approach. The macro and micro-prudential perspectives differ in terms of objectives and models used to describe risk (Borio C., 2002). The objective of a macro-prudential approach is to limit the risk of episodes of financial distress with potential significant losses in terms of real output to the economy as a whole. On the other hand, the micro-prudential approach limits the risk of episodes of financial distress at individual institutions, regardless of their impact on the overall economy. The micro-prudential approach is more related to the consumer (depositors and investors) protection area, whereas the objective of the macro-prudential approach stays within the ‘traditional’ macroeconomic fields. In practice, both approaches should be combined and synchronised in order to reduce both endogenous and exogenous risks that could potentially harm the stability of the financial system.

3. Central Banks’ Roles in Maintaining Financial System Stability

Safeguarding financial stability is also a core function of the modern central bank, other than market operation and monetary policy (Sinclair, 2001). Sinclair et. al provides evidence from a detailed survey of 37 central banks drawn from a wide variety of industrial, transitional and developing countries. For central banks that have never regulated or supervised financial institutions, and for those that have moved away from this role, financial stability responsibilities may be shared with other agencies, but the central bank is still very much in the game.

Financial system stability is a public policy which requires the cooperation and interaction of related institutions, namely, the central bank, supervisory authority, ministry of finance, and deposit insurance company. The financial system stability functions of central banks are aimed at promoting

7

a stable financial system that can enhance economic performance and increase wealth by preventing disturbances to the financial system, which in turn may impact negatively on the economy as a whole.

Box 1. CAUSES AND PROCESS OF FINANCIAL CRISIS

Financial crises may originate from problems existing in any of the various correlating components within the financial system, such as financial institutions, banks, non-bank financial institutions or the capital market (the first ring); or they may be caused by one or a combination of problems within the real or fiscal sector, or in the payment system (the second ring). Nevertheless, a crisis may also be sparked by external factors through its contagion effects (the third ring), similar to the one that spilled-over to Asia in 1997.

Learning from the Asian and Indonesia crisis of 1997, the instability of financial system occurs through three major phases (Mishkin, 2001).

Figure 2: Interactions within a Financial System

Firstly, impaired public confidence in the financial system. This may be caused by various problems in the economy or financial system, such as the worsening financial condition of banks, increased interest rates, decreased share prices and increased uncertainty.

Then, in the second phase, impaired confidence of customers and investors toward the economy and the IDR results in the depreciation of the IDR which then prompts a currency crisis.

Finally, such currency crisis would lead to crises in the banking sector. This is prompted by depositors withdrawing their deposits (a systemic bank run) which results in liquidity problems for the banks. In addition, banks sustain losses from non-performing loans, particularly those of corporations with un-hedged overseas borrowings. The cost of overseas loans borne by corporations will skyrocket due to the depreciation of the IDR against the USD. The twin crisis (currency and banking crisis) if not effectively addressed, will result in even wider complications with the potential of economic, social and political instability.

Consequently, the Government will have to bear a huge fiscal cost (in the case of Indonesia, 51% of its Gross Domestic Product) in order to rescue its banking system. The huge fiscal cost will eventually be borne by the taxpayers, i.e. the public . In addition, the prolonged financia l crisis will have adverse impacts on the national economy, such as lower economic growth and output levels , aggravated by financial disintermediation.

Some central banks, such as the Bank of England, Bank of Finland, and the Reserve Bank of Australia have explicit roles and responsibilities with regard to maintaining financial stability which are stipulated in laws. Elsewhere, in Singapore for example, the Monetary Authority of Singapore has a different statement to reflect its role in financial stability which is “promoting a sound financial structure”. In the majority of developing economies, the statutory mandate for central banks does no more than stipulate the regulatory and supervisory functions (Bulgaria, Russia). In some countries

8

where the central bank does not carry out prudential supervision, the statute may specify responsibility to ensure the smooth and/or efficient functioning of the payment system and/or responsibility to monitor developments in the money, credit and foreign exchange markets (Norway, Sweden, Chile, Hungary).

Bank Indonesia incorporates the financial system stability function in its mission in line with the introduction of its amended Law 6. Therefore, even though it is not explicitly stated in the law, Bank Indonesia has a clear role and objective in maintaining financial system stability.

3.2 Strategies

While there is no universal framework for financial stability, in general, a framework would consist of a central bank mission, objective and strategies as well as policy instruments in maintaining its role in financial stability (see Figure 2 below).

In order to achieve financial system stability, a central bank generally adopts four major strategies: (i) implementing regulations and standards including fostering market discipline; (ii) intensifying research and surveillance on financial system; (iii) improving effective coordination and cooperation with relevant institutions; and iv) establishing crisis resolutions and financial safety nets.

Figure 2. Financial System Stability Framework

6 Bank Indonesia’s mission is to achieve and maintain stability of the Indonesian Rupiah through maintaining financial stability and promoting financial system stability for sustainable national development.

9

The strategies could be briefly described as follows: (a) Implementing regulations and standards. Consistent implementation of international prudential regulations and standards are required by regulator s and market players as a sound foundation in conducting their activities. In addition, consistent disciplines of the market players need to be fostered. (b) Intensifying research and surveillance. Development of the financial system in aspects potentially affecting its stability should be assessed and monitored. Risks which may endanger financial system stability are measured and monitored by incorporating an early warning system which is composed of micro-prudential and macro-prudential indicators. Research and surveillance are aimed at producing a policy recommendation for maintaining financial system stability. (c) Establishing a safety net and crisis resolutions framework. Safety net and crisis resolutions framework and mechanism are required for resolving financial crisis once it occurs. These include policy and procedures of the lender of the last resort, and the deposit insurance which will replace the blanket guarantee. Currently, there is no clear legal framework for crisis resolution. (d) Improving coordination and cooperation. Coordination and cooperation with related agencies is very crucial especially in crisis times. The coordination amongst financial safety nets players is usually achieved through forming a committee composed of the central bank, financial supervisory agency, and ministry of finance.

Regarding the adoption of regulation and standards, New Zealand has a different strategy for promoting financial stability which focuses more on promoting self discipline of banks in managing risks and fostering effective market discipline in the banking system. It also seeks to avoid supervisory practices that might erode market discipline and weaken the incentives for bank directors to take ultimate responsibility for the management of risks.

With the possible exception of New Zealand, no country has adopted the position that market

forces can be relied on as the guarantor of financial institutions stability. 4. Promoting Financial Stability in Practice The Bank of England is one of the pioneers in developing and performing the financial stability function. This was especially so just after it transferred its banking supervisory power to the Financial Services Authority (FSA) in 1996. The Bank of England has one of the most comprehensive operation in financial stability and allocates many staff to work on the area.

10

Following the Asian crisis of 1997/1998, there has been growing awareness, particularly in the Asian region, regarding the importance of maintaining financial system stability—an effort closely related to maintaining monetary stability. During the last five years, there has been an increasing trend in the establishment of dedicated units in central banks to perform financial stability functions and publish financial stability reports. For example, Bank Indonesia, following IMF’s recommendation, formulated a framework and established a unit responsible to perform financial system stability function in mid 2003. As was outlined in the previous section, the key activities performed by a central bank in the financial stability area includes carrying-out research and surveillance on the financial system, coordinating with other institutions in maintaining financial stability, and providing financial safety nets and crisis management policy as follows: 4.3 Research on the Financial System

Research and surveillance on the financial system are aimed at identifying, measuring and monitoring risks, both endogenous and exogenous, which can threaten financial stability. These will be used as input in determining policy actions to be taken. These actions could be categorised into three types depending on their impact, i.e. prevention, correction, and crisis resolution.

Research in financial stability is carried out utilising a set of systematic activities based on

scientific methods, aimed at producing analyses on issues and risks on financial stability. Another objective of these activities is to develop tools which include stress testing frameworks to support surveillance function. These tools and stress testing, to some extent, will be used as an early warning indicator of potential threats in the financial system. The coverage of research is mainly identifying and measuring the potential risks faced by the banking industry, non-bank financial industry, household sector, corporate sector and macro-economy conditions.

Bank Indonesia , for example, has conducted research to develop tools to support surveillance functions such as Banks and Corporate Sector Probability Default, Early Indicators of Banking Crises, Cost Intermediation and Macroeconomic Stress Testing.

4.4 Surveillance on Financial System

Surveillance activities are part of the function of the financial stability unit and are carried out to monitor aspects related to financial system stability. This is done by observing all components influencing the stability. The activities are performed on an ongoing basis by analysing and assessing a range of aggregate financial and economic data. This helps measure the soundness of the financial

11

system and the potential threats and vulnerabilities. This will enable necessary action and policy be taken in due course to minimise the negative impacts on the financial system stability.

The surveillance covers all conditions and policy directions of all related institutions, and

includes individual financial institution and markets, market infrastructure, domestic and international finance, supervisory authorities, and the Government.

The analysis and assessment are based on the series of aggregate financial and economic data

gathered from various sources, both internally and externally. The tools comprise of macro-prudential, Financial Soundness Indicators (FSI), and stress tests. Analysing the threats to the financial stability can be accomplished by focusing on risk factors originating within and from outside the financial system. The macro-prudential is an area to analyse risk aggregation of individual institutions in a financial sector, while micro prudential are more concerned with the individual financial institution indicators7. The difference between the two is within the scope of area analysed.

Figure 3. Surveillance Framework

Micro-prudential analyses focus on individual institutions promoting their soundness and protecting their depositors. Thus, they are concerned with reducing and limiting the distress of individual institutions. Meanwhile, macro-prudential analyses focus on a wider aspect, which is the financial system as a whole, mainly concentrating on limiting system-wide distresses and promoting

7 Svein Gjedrem: The macroprudential approach to financial stability; Keynote address at the conference entitled “Monetary Policy and Financial Stability” by the Oesterreichische Nationalbank in Vienna, May 12 th, 2005.

12

the soundness and stability of the financia l system. Systemic risk is an important concept in macro-prudential analyses which place more emphasis in the interlinkage exposures across institutions.

External risk factors may come from the macroeconomic disturbances, asset price bubble or

strong growth in debt. These factors can pose threats to the financial stability. Financial Soundness Indicators (FSI) cover ing most financial and non-financial sectors, including banking, non-banking, household and corporate sectors, are used to identify potential sources of threats and instability and is used widely by many authorities, including Bank Indonesia.

Other approaches also utilised is the stress testing method which is useful to analyse the

potential impacts of adverse macroeconomic shocks on financial stability by examining the tolerance levels of financial institutions. The examination is conducted with different types of shocks, under various economic conditions and with different monetary policy responses. In the case of Bank Indonesia, the stress test methods (both static and dynamic) are developed internally or by other central banks or institutions with the necessary adjustments for domestic conditions. The methods are continuously verified and improved according to developments in the domestic condition, policies and regulations to ensure better outcomes. The results of the analysis are published regularly in the Financial Stability Review (FSR).

Table 1. Financial Soundness Indicators

Economic Growth?Aggregated growth rate?Sectoral slumps Balance of Payment?Current account deficit? FX reserve adequacy?External debt (incl. maturity structure)? Terms of trade?Composition and maturity of capital flowsInflation?Volatility in inflationInterest and exchange rates?Volatility of interest and exchange rates ? Level of domestic interest rates?Exchange rate sustainability?Exchange rate guaranteesContagion effect? Trade spillovers? Financial market correlationOther Factors?Directed lending and investment?Government resource to banking system?Arrears in the economy

Capital Adequacy? Aggregated capital ratio; Freq. distribution of CAR Asset QualityLending institution? Sectoral credit concentration? Foreign currency-denominated lending? Connected lending; NPL and provision; etc.Borrowing entity? Debt-equity ratios; Corporate profitability; etc.Management)Growth in the number of financial institutions; etc.

Earnings? RoA, RoE, Income and Expense ratios, etc.Liquidity? Central bank credit to fin institutions; LDR;maturity

structure of assets and liabilities; Sensitivity to market risk? FX risk; interest rate risk; equity price risk; etc.Market-based indicators? Market prices of financial instruments; credit ratings,

sovereign yield spread; et.

Macroeconomic IndicatorsAggregated Micro-prudential Indicators

Economic Growth?Aggregated growth rate?Sectoral slumps Balance of Payment?Current account deficit? FX reserve adequacy?External debt (incl. maturity structure)? Terms of trade?Composition and maturity of capital flowsInflation?Volatility in inflationInterest and exchange rates?Volatility of interest and exchange rates ? Level of domestic interest rates?Exchange rate sustainability?Exchange rate guaranteesContagion effect? Trade spillovers? Financial market correlationOther Factors?Directed lending and investment?Government resource to banking system?Arrears in the economy

Capital Adequacy? Aggregated capital ratio; Freq. distribution of CAR Asset QualityLending institution? Sectoral credit concentration? Foreign currency-denominated lending? Connected lending; NPL and provision; etc.Borrowing entity? Debt-equity ratios; Corporate profitability; etc.Management)Growth in the number of financial institutions; etc.

Earnings? RoA, RoE, Income and Expense ratios, etc.Liquidity? Central bank credit to fin institutions; LDR;maturity

structure of assets and liabilities; Sensitivity to market risk? FX risk; interest rate risk; equity price risk; etc.Market-based indicators? Market prices of financial instruments; credit ratings,

sovereign yield spread; et.

Macroeconomic IndicatorsAggregated Micro-prudential Indicators

(Evans et.al, “Macroprudential Indicators of Financial System Soundness”, IMF Occasional Paper No.192, 2000.)

13

4.2.1 Surveillance on the Financial Institutions and Markets

This area covers the analysis and assessment of banking, non-bank financial institutions (including insurance companies, pension funds, pawn shops, mutual funds, and leasing companies), financial and capital markets. Financial institutions and markets have a critical role in the development of macroeconomic and financial system stability, thus a deeper and thorough assessment and analysis of this area is crucial in promoting the stability of the financial system.

The main function of financial institutions is to channel financial transactions, or establish an

intermediary function, between lenders and borrowers, and provide financial services. While the financial market is the place for lenders and borrowers to trade financial contracts directly, the banking system in Indonesia dominates the financial sector, accounting for 80% of the system. Hence risks arising from the banking system have the high potential transfer to non-bank financial institutions and disrupt the financial markets, impacting financial system stability. To prevent this from happening, it is essential to identify risks with the potential to ‘transfer’ instability.

Even though non-bank financial institutions only account for around 20% of the total, there is

the possibility for risks to be transfer red from this sector to the banking system or financial markets. A case in point was the mass redemption of mutual funds in mid-2005 which mostly made use of banks as their marketing agents. Risks arising from the development in financial markets may also be transferred to and influence the banking system, such as a new capital market instrument adversely affecting the balance sheet of the banking system.

In the case of Indonesia, banking supervision is under the authorisation of Bank Indonesia,

thus data and information related to banking sector is gathered internally or directly from banks. Meanwhile, the supervision of non-bank financial institutions and capital market is under the authorisation of the Ministry of Finance (Capital Market and Financial Institution Supervisory Agency) and data and information for surveillance activities are gathered from the Ministry of Finance, and also other sources such as newspapers or financial magazines and other publications. Another approach is coordination with the market player, association, academics and experts or by conducting surveys. Meanwhile, non-regulatory central banks acquires data and information from related authorities through coordination and from other external sources, such as in the Reserve Bank of Australia which depends heavily on data from the Australian Prudential Regulation Authority. Financial indicators used as measurement factors in assessing the condition and development of the institutions and markets and analyse the potential risk to the financial stability are stipulated in Table 28.

8 FSI specified by the IMF

14

Risk management is one approach applicable to assess the condition and outlook of the financial institutions and industry, which includes credit risk, market risk, liquidity risk, and operational risk. Other risk factors are legal risk, strategic risk, and reputation risk, which have strong influence on the performance of individual institutions. Bank Indonesia applies this approach along with other assessments regarding the banks’ capital and profitability. Most of the banking ratios used are excerpted from the CAMELS ratio. For instance, one indicator to assess the level of credit risk is non-performing loan ratio (NPL). A higher ratio indicates a higher potential of credit risk disrupting the financial system stability, should the authorities not take any action and policies to prevent the likelihood of instability to emerge. Moreover, to supplement the indicator, Bank Indonesia will evaluate banks’ NPL by its economic sector, type, region, debtors, and currency, in order to identify the source of risk.

Stress testing is mainly applied to banking institutions, and in particular, to assess the ability

of banks’ capital to absorb unexpected losses originating from adverse macroeconomic conditions, such as devaluation or revaluation of domestic currency against hard currency, increased or decreased of central bank rates, increase of NPLs, and the impact of ‘flight to quality’ to banks’ liquidity. These stress tests may be categorised as tests for market risks, credit risks, and liquidity risks.

The analysis and assessment of the financial indicators and risk management is carried out

regularly, on a monthly or a quarterly basis. In the case of Bank Indonesia, the analyses are conducted monthly, while some of the stress tests are conducted quarterly. Tests for the banking sector are usually conducted monthly as banks submit their bank reports to Bank Indonesia also on a monthly basis. However, regular analyses and assessments of non-bank financial institutions, capital and financial markets are carried out quarterly. The analysis output is extended in the weekly report, monthly or quarterly Board Paper and FSR.

4.2.2 Surveillance on the Markets Infrastructure

The payment system, a critical part of market infrastructure, plays a vital role in promoting financial system stability. Failure to settle or deadlocks have the potential to create instability, thus making an agreed effective mechanism necessary. This includes the involvement of the settlement system authority to maintain the confidence of the intermediation function of the financial system. Bank Indonesia is the authority for payment system activities and hence data and information regarding the payment system is gathered internally. However, the evaluation is not carried out by the Financial System Stability Unit in Bank Indonesia , but rather by another Department which will submit quarterly reports on the development of payment system to the FSS Unit. The same case also applies at the Reserve Bank of Australia where the analysis is not the focus of the Unit, but rather, part of a separate Department.

15

The analysis and assessment of the payment system includes the monitoring of implementation of agreed processes in case of failures to settle in the clearing system. This will assist the central bank in predicting whether the failure to settle is no t manageable and the RTGS process is disrupted. The following are types of information used in the analyses and assessments:

? Clearing transaction volume and RTGS ? Current system capacity and further development ? Frequency of failure to settle and deadlock or delayed RTGS processes ? Other information potential to create failures to settle, deadlocks or delayed RTGS

The analysis is carried out quarterly and presented in the quarterly Board Paper and FSR.

4.2.3 The Surveillance on Domestic Finance

As disturbances to financial stability can emerge from outside of the financial system, surveillance of this area is important and increasingly gaining the attention of many authorities. This area covers the real sector which includes households and corporates, with some influencing factors incorporated in the analysis and assessment, such as property development, domestic and external debt, monetary and fiscal policy.

The assessment of this sector is more forward looking. As a vital component of the sys tem,

any potential risk occurring from defaults or negative developments of the real sector, such as increase in unemployment, house prices bubbles, or unsustainable households and corporate debts, may be transferred to the financial sector and thus endangering the system’s stability. Therefore, a more thorough analysis and assessment of the real sector should assist in forecasting the future prospects of financial system stability and prevent instability by implementing appropriate policies and action. Data and information which are related to macroeconomic and monetary policies are gathered internally from newspapers and other publications, from experts and academia, or through coordination with other institutions such as Statistical Bureau or survey results. To facilitate the assessment of the corporate sector, Bank Indonesia has started work in mapping the corporate sector and conglomeration in Indonesia.

The analysis and assessment of domestic finance includes observing the development of the

household and corporate financial condition and its sustainability, household and corporate indebtedness, impact of monetary and fiscal policies to financial institutions and markets, such as inflation rate, interest rate and foreign exchange policies. The financial indicators used as measurements in assessing the development of the domestic finance and analyse the potential risk to the financial stability are illustrated on Table 2.

16

Meanwhile, broad areas of domestic finance to be analysed can be classified into various parts, such as household and corporate balance sheets, household and corporate indebtedness, housing and personal loans, household and corporate finances, house and commercial property prices, unemployment rates, foreign debts, government bonds, inflation rates, interest rates, and foreign exchange policies.

An extensive example of household assessment by the Reserve Bank of Australia may

broaden the understanding of its importance. Household is a big focus for Australia since its indebtedness is currently among the largest in the world and accounts for more then 50% of the banking system’s loan portfolio. Some areas to be analysed include household balance sheets to gauge housing market activity, the level of household sector borrowing, and investor sentiments. Meanwhile, some leading indicators of household stress are employment, credit cards, and bankruptcies. There are ratios to gauge the level of household indebtedness and sustainability, such as (i) Household debt to household disposable income, (ii) Household interest payment to household disposable income; (iii) Household gearing; and (iv) House prices to household income. The unsustainable level of household debt may create a potential for a snap-back in consumption, thus having implications for the macro-economy which may extend to the financial system. The regular analysis and assessment of the impact of development in domestic finance is carried out regularly and presented in the FSR.

Table 2. Financial Soundness Indicator on NBFI & Real Sector

1. Non-bank Financial Institutions? Assets to total financial system assets? Assets to GDP

2. Corporate sector? Total debt to equity? Return on equity (earnings before interest and taxes to average equity)? Earnings before interest and taxes to interest and principle expenses? Corporate net foreign exchange exposure to equity? Number of applications for protection from creditors

3. Households? Households debt to GDP

? Households debt service and principle payments to income

4. Real estate markets? Real estate prices? Residential real estate loans to total loans? Commercial real estate loans to total loans

Aggregate Indicators

1. Non-bank Financial Institutions? Assets to total financial system assets? Assets to GDP

2. Corporate sector? Total debt to equity? Return on equity (earnings before interest and taxes to average equity)? Earnings before interest and taxes to interest and principle expenses? Corporate net foreign exchange exposure to equity? Number of applications for protection from creditors

3. Households? Households debt to GDP

? Households debt service and principle payments to income

4. Real estate markets? Real estate prices? Residential real estate loans to total loans? Commercial real estate loans to total loans

Aggregate Indicators

17

4.2.4 The Surveillance on International Finance

The international financial system is increasingly moving to one that is more liberal, integrated and global. These circumstances may have been associated with changes in the nature of contagion risk. Financia l institutions distribute capital through markets from regions with unattractive yields to those with attractive ones. During normal circumstances, these links will strengthen financial integration. However, under abnormal conditions, they increase risks within the financial system.

Understanding the impact of a distressed financial system on other financial systems is an

important aspect of contagion risk, particularly in a distress situation (Lindgren, Garcia and Saal, 1996). The Asian crisis of 1996-1997 gives valuable insights, demonstrating that distress in one or several financial systems will be transmitted to other financial systems as there are financial linkages across institutions. Contagion occurs when a financial system’s exposures to a distress financial system leave them vulnerable to liquidity problems, losses and in severe conditions, failure. The severity of contagion effects depends on how important the affected financial systems are to the economy. Therefore, contagion between financial systems is a crucial element of systemic risk.

Disruptions to a financial system may arise at the macroeconomic levels, such as oil price

shocks, technological innovations and policy imbalances that affect the whole financial system (Houben, Kakes and Schinasi, 2004). Furthermore, at the microeconomic level, they may come from the failure of large companies which weakens market confidence and creates imbalances. Additionally, there are exogenous disturbances which also should be monitored, such as a sudden withdrawal of capital inflows, trade restrictions removals, political events (including terrorist acts and wars) and natural disasters (earthquakes, floods).

The surveillance process will cover all these sources of risks and vulnerabilities, which require systematic monitoring of individual parts of the financial system (financial markets, institutions and infrastructure) and the real economy (households, firms, the public sector). The analysis must also take into account cross-sector and cross-border linkages, because contagions often arise from a combination of weaknesses from different sources. The financial soundness indicators are sovereign yield spreads, balance of payments items, interest and exchange rates, and oil prices.

Other than surveillance, research in this area will be beneficial as well, for example,

examining the impact of oil price hikes on the banking industry. Macro-stress testing shows how vulnerable a financial institution is due to possible changes in economic conditions (oil price hikes). The variables are Bank Loan Loss Provisions, GDP, Inflation, central bank’s rates, foreign exchange, gasoline prices, diesel fuel prices.

18

4.2.5 Products and Reports of Financial System Stability

The work of the Financial System Stability Unit is becoming increasingly more extensive and over time covers related components. Initially it was limited to the banking industry but the scope has widened to cover non-bank financial institutions and financial soundness counterparties, such as households and corporates.

The reports are produced regularly, according to what is deemed customary by each central bank, which may range from weekly, monthly, quarterly, to semi-annual or annual time frames. In general, most central banks with financial stability function, publish their assessment in the Financial Stability Review (FSR), either semi-annually or annually. The general structure and comparisons of FSR among central banks are summarised as follows 9.

UK (BoE) Finland (BoF)

Austria (ANB) Brazil (BCB) Australia

(RBA)Singapore

(MAS)Hong Kong

(HKMA) Korea (BoK) Indonesia (BI)

? Summary/Overview v v v v v v v v v

? Reports? Economic development and

outlookv v v v v

? Domestic finance v v v v v v v v

? International finance v v CEE countries v v v v

? Non bank financial institution

Insurance v v Insurance v v

? Financial/Capital markets v v v v v v v

? Banking system Credit risk v v v v v v v v

? Financial infrastructure v v v v v v

? Special topics/articles v v v v v v v

FSR Contents

Comparisons of FSR Structure

Similarly, the Financial System Stability Bureau at Bank Indonesia is responsible for research and surveillance work and it produces regular reports on the development and risks to financial stability related areas ranging from financial institutions and markets, market infrastructure, domestic finance and international finance. As part of its role in promoting financial stability, Bank Indonesia publishes the Financial Stability Review semi-annually which contains research and surveillance works on financial stability. In addition, Bank Indonesia is also committed to develop a better understanding of financial stability issues by organising regular seminars, workshops, both at domestic and international levels.

5. Coordination and Cooperation

Given that the promotion of financial system stability is contained within the statutory power of various authorities, it is necessary to have good coordination and cooperation among these authorities. The purpose of coordination and cooperation is to ensure that each policy issued by the

9 Cihak, Martin, (2006), “How Do Central Banks Write on Financial Stability?”, IMF Working Paper (WP/06/163)

19

respective authority does no t give rise to negative impacts on financial system stability. The areas of coordination and cooperation will usually consist of prompt strategic response to potential instability and systemic crises, harmonisation of policy issues, and information sharing.

There are different approaches for ensuring coordination and cooperation for financial stability. First, the use of interlocking management between the central bank and financial services supervisory agency is the model widely applied in the European continent. Second, a joint committee consisting of members from the central bank, the financial services supervisory agency, and ministry of finance manages routine interagency coordination. The third model is interagency coordination and cooperation set out in a Memorandum of Understanding, is used for instance, in the United Kingdom and Australia.

In the context of Indonesia, the manifest coordination and cooperation is the Financial System Stability Forum (FSSF). As stipulated in the Memorandum of Understanding on 30 December 2005, between the Minister of Finance, the Governor of Bank, the FSF is a venue of coordination and information sharing among the authorities (for details, please see Box 3).

6. Financial Safety Nets and Crisis Management

Essentially, financial system stability functions carried out by a central bank are two fold - crisis prevention and crisis resolution. It is essential that financial system stability is maintained to support monetary stability for sustainable economic growth. Although various approaches have been pursued for crisis prevention, there is no guarantee that financial crises will not occur. In the event of a financial crisis, it is necessary to have a procedure for dealing with the crisis and clarifying the roles and responsibilities of relevant institutions as well as coordination mechanism amongst them.

As mentioned above, financial safety nets (FSN) are vital elements for maintaining financial system stability. The comprehensive framework for the financial safety nets clearly prescribes the roles and responsibilities of each agency and the coordination mechanisms amongst them in the prevention and resolution of crisis.

Principally, a comprehensive FSN framework comprises of four core elements: (i) effective and independent supervision; (ii) lender of last resort for normal and systemic crisis periods; (iii) an explicit deposit insurance scheme; and (iv) effective crisis management. Generally, the Ministry of Finance (MoF) is responsible for developing legislations for the financial sector and bears the fiscal cost funds for crises resolution.

The central bank is responsible for maintaining monetary stability and banking industry’s soundness (if banking supervision is within the central bank), as well as safety and efficient working of the payment system. The Financial Supervision Agency (FSA) is responsible for the soundness of the financial industry (in case where the financial or banking supervision is outside the central bank). The Deposit Insurance Company is responsible for insuring bank’s deposits as well as for resolving

20

problem banks. Indonesia for example, has formulated the Indonesian Financial Safety Net (IFSN) framework. IFSN is clearly stating the roles, responsibilities and coordination mechanism of FSN players namely Ministry of Finance (MoF), Bank Indonesia (BI), and the Deposit Insurance Company (DIC). The IFSN policies will be incorporated in the IFSN Law to provide a clear legal basis for relevant authorities in performing their respective roles and in coordinating in maintaining financial system stability. To ensure an effective coordination amongst relevant authorities, a Joint Committee comprising of the Governor of Bank Indonesia, the Finance Minister and the Head of the Board of Commissioners of the Deposit Insurance Institution (DIC) was established. In addition, the Financial Stability Forum (FSF) comprising executive officers from Bank Indonesia, the Ministry of Finance and the Deposit Insurance Institution was also established. Among key responsibilities of the FSF is to provide recommendation to the Joint Committee on crisis management policies.

Box 3. Financial System Stability Forum in Indonesia

Maintaining stability of the financial system requires concerted efforts from the various authorities. Effective coordination and cooperation is urgently required in response to potential instability and systemic crises that frequently require mutual policy-making and harmonisation of policy issues. Currently, there are four authorities with a focal role in financial sector supervision and the financial safety nets: The Ministry of Finance, Bank Indonesia, the Indonesian Securities and Financial Institutions Commission (Bapepam-LK) and DIC. As a vehicle of coordination and information sharing among authorities, on 30 December 2005, a joint decree between the Minister of Finance, the Governor of Bank Indonesia and the Chairman of DIC was signed. The joint decree sets out the establishment of the Financial Stability Forum (FSF).

The main responsibility of FSF is to provide information and recommendations to the joint committee according to the prevailing laws of the Deposit Insurance Company. The committee comprises of the Minister of Finance, Bank Indonesia and the Deposit Insurance Company.

There are four main functions of FSF: a) support the responsibilities of the joint committee in the decision-making process for failing banks that has systemic risk; b) coordinate and share information to synchronise prudential rules and regulations in the financial sector; c) discuss the issues of financial institutions that has systemic risk based on information from the supervisory authority; and d) coordinate initiatives in the financial sector, for instance, Indonesian Banking Architecture (IBA), Indonesian Financial Sector Architecture (IFSA) and Financial Sector Assessment Program (FSAP).

FSF consists of a three-tier system: the Steering Forum is responsible for providing direction to the Executive Forum with regard to the respective functions of FSF mentioned above. The Steering Forum consists of 7 senior officials from the Ministry of Finance, 3 members of the Board of Governors of Bank Indonesia, and 1 senior official from DIC.

The second tier represents the Executive Forum consisting of seven second rank officials from the Ministry of Finance, seven second rank officials from Bank Indonesia, and two directors from DIC. The third tier represents the Working Group and is made up from officials of the Ministry of Finance, Bank Indonesia and DIC.

FSF can form various taskforces to manage initiatives and ad-hoc projects such as the Indonesian Financial System Architecture (IFSA) and Financial Sector Assessment Program (FSAP). The FSF is expected to improve effective coordination between the authorities and, subsequently, bolster efforts to preserve financial system stability.

21

6.1 Lender of Last Resort

Historical experience suggests that successful lender of last resort (LLR) actions have prevented panics on numerous occasions (Bordo, 2002). Similarly, Mishkin (2001) argues that the central bank can encourage the recovery from financial crisis by providing loan in as lender of the last resort. Although there well may be good reasons to maintain ambiguity over the criteria for providing liquidity assistance, He (2000) argues that properly designed lending procedures, clearly laid-out authority and accountability, as well as disclosures rules, will promote financial stability, reduce moral hazard, and protect the lender of last resort from undue political pressure. There are important advantages for developing and transitional economies to follow a rule-based approach by setting out ex ante, the necessary conditions for support, while maintaining such conditions is not sufficient for receiving support. In the same vein, Nakaso (2001) suggests that Japan’s LLR approach has shifted from “constructive ambiguity” towards increasing policy transparency and accountability.

6.1.1 Lender of Last Resort in Normal Times In normal times, LLR assistance should be based on clearly-defined rules. Transparent LLR policies and rules can reduce the probability of self-fulfilling crises, and provide incentives for fostering market discipline. It may also reduce political intervention and prevent any biasness towards forbearance. LLR in normal times should only be provided for solvent institutions with sufficient acceptable collateral while for insolvent banks, stricter resolution measures should be applied such as closure. Therefore, there should be a clear and consistent adoption of a bank exit policy. Once a deposit insurance scheme has been established, the central bank role in LLR in normal time s can be reduced to a minimum since the deposit insurance company will provide bridging finance in the case where there is a delay in closure process of a failed institution10.

6.1.2 LLR in Exceptional Circumstances

In systemic crises, LLR should be an integral part of a well-designed crisis management strategy. There should be a systemic risk exception in providing LLR to the banking system. Repayment terms may be relaxed to support the implementation of a systemic bank restructuring programme. In systemic crises, the disclosure of LLR’s operation may become an important tool for crisis management. The criteria of a systemic crisis will depend on the particular circumstances and thus, it is difficult to clearly state this beforehand in a law. However, the regulations on the LLR facility should clearly set the guiding principles and specific criteria of a systemic crisis and/or a potential bank failure leading to systemic crisis. To ensure an effective decision making process and accountability, there should be a clear institutional framework and LLR procedures. Bank Indonesia should be responsible for analysing the systemic threats to financial stability while the final decision

10See Nakaso (2001) for a discussion on the Japanese LLR model.

22

on systemic crises resolution should be made jointly by Bank Indonesia and the Ministry of Finance. To ensure accountability, an appropriate documentation audit trail should be maintained.

While individual frameworks differ from country to country, there is a broad consensus on the

key considerations for emergency lending during normal and crisis periods (see Box 4) below.

Box 4. Key Considerations of Emergency Lending 1. Have in place clearly laid out lending procedures, authority, and accountability.

2. Maintain close cooperation and exchange of information between the central bank, the supervisory authority (if it is separate from the central bank), the deposit insurance fund (if exist), and the ministry of finance.

3. Decision to lend to systemically important institutions at the risk of insolvency or without sufficient, acceptable collateral should be made jointly by monetary, supervisory, and the fiscal authority.

4. Lending to non-systemically institutions, if any, should be only to those institutions that are deemed to be solvent and with sufficient acceptable collateral.

5. Lend speedily.

6. Lend in domestic currency.

7. Lend at the above average market rates.

8. Maintain monetary control by engaging effective sterilisation.

9. Subject borrowing banks to enhanced supervisory surveillance and restrictions on activities.

10. Lend only for short-term, preferably not exceeding three to six months.

11. Have a clear exit strategy.

Additional Requirements for Systemic Crisis

12. Decision to le nd should be an integral part of crisis management strategy and should be made jointly by monetary, supervisory, and the fiscal authority.

13. Emergency support operations should be disclosed when such disclosure will not be disruptive to financial stability.

14. Repayment terms may be relaxed to accommodate the implementation of a systemic bank restructuring strategy.

15. Emergency support operation should be disclosed when such disclosure will not be disruptive to financial stability.

Source: Dong He (2000) ‘Emergency Liquidity Support Facilities’, IMF Working Paper No. 00/79.

23

Box 5. Lender of Last Resort: The Case of Indonesia

Bank Indonesia in its capacity as lender of the last resort may provide a loan to the Bank to resolve short-term funding difficulty. Lender of the last resort policy is part of the financial safety net essential to financial system stability.

Based on the Law11, BI as lender of last resort can give loans to commercial bank during both normal times and systemic crises to solve liquidity problems. In principle the liquidity facility can only be provided to solvent bank.

There are two types lender of the last resort facilities extended by BI to commercial bank as follows:

(i) The Short-Term Funding Facility (FPJP) extended to Banks experiencing liquidity difficulties at end of day (overnight) to resolve liquidity difficulty under normal conditions. Provision of FPJP must be backed by liquid, high value collateral provided by the Bank to Bank Indonesia.

(ii) The Emergency Financing Facility (EFF) for a Problem Bank that is experiencing liquidity difficulty and has systemic impact, but still complying with the level of solvency prescribed by Bank Indonesia. The extension of the facility is based on a joint decision in a meeting between the Minister of Finance and Bank Indonesia and is funded by the Government. The EFF is a facility for addressing systemic impact or risk in an emergency in order to prevent and resolve a crisis. However, requirements on solvency and collaterals, with several exceptions, are still applicable.

Therefore, funding for the EFF is charged to the State Budget through issuance of Government Securities. To provide assurance of accountability and transparency, the decision making process in determining systemic impact or systemic risk and to extend the EFF to a Bank operates by means of a joint decision by the Minister of Finance and the Governor of Bank Indonesia. The decision to extend the EFF shall be based on assessment of the potential for systemic risk for financial system stability and the negative impact on the economy if the EFF is not extended to the Bank.

A Minute of Agreement between the Minister of Finance and BI’s Governor has been signed regarding stipulations and procedures on decision making in handling a problem bank that has systemic impact, provision of the emergency financing facility, and financing source from the state budget12. For implementing guidelines, MoF and BI have launched a regulation concerning EFF for commercial banks that were incorporated in Minister of Finance Decree and BI Regulation.

6.2 Deposit Insurance Scheme

Experience shows that the deposit insurance scheme is one of the important elements for maintaining financial system stability. In general, deposit insurance is aimed at three interrelated aspects: (i) to protect deposits, particularly small deposits; (ii) to maintain public confidence in the financial system, especially the banking system; and (iii) to maintain financial system stability. Essentially, the main objective of deposit insurance is to avoid bank runs. According to the Diamond-

11The Republic of Indonesia Law No. 23 of 1999 regarding Bank Indonesia as was amended by Law No. 3 of 2004, which has been approved by the People’s Representative on 15 January 2004. 12 The Minutes of Agreement was signed on 17 March 2004,

24

Dybvig model (1983), bank runs are indicated by “self-fulfilling prophecy” where the deterioration of depositors’ confidence can cause banking crisis. The problem is caused by two factors: (i) there is asymmetric information between depositors and bank management; and (ii) depositors’ incapability of assessing bank soundness. In addition, banks are also vulnerable because liquid assets are usually less than liquid liabilities.

Thompson (2004) gives five arguments for deposit insurance: (i) to maintain public confidence in banking systems (Diamond and Dybvig, 1983); (ii) the insured deposit can provide options for small depositors, mobilising savings for investment; (iii) if the supervisory authority is under political pressure to bail-out depositors (where implicit guarantee is adopted), an explicit deposit insurance can help to limit insured liabilities by determining ex-ante what is insured and what is not; (iv) deposit insurance will enable small banks to compete with big banks; and (v) an explicit deposit insurance makes it easier for supervisory authority to supervise banks more intensively. Garcia (1999, 2000) identified the best practices of explicit systems of deposit insurance based on surveys in 68 countries. These include good infrastructure, avoidance of moral hazard, avoidance of adverse selection, reduc tion of agency problems and ensur inge financial integrity and credibility. Based on a study of deposit insurance systems in Asian countries, Choi (2001) argues that it is reasonable to establish and maintain an explicit and limited deposit insurance system in order to prevent further possible financial crisis. Pangestu and Habir (2002) suggest that deposit insurance schemes should be designed on two key aspects. First, it should provide incentive s to better performing banks by linking the annual premium payment to their risk profile. Second, it should be self- funded in order to foster market discipline and reduce the fiscal burden. In order to prevent a disturbance on the banking system, Garcia (2000) suggests that ideally, a partial guarantee should not be introduced until: (i) the domestic and international crisis has passed; (ii) the economy has begun to recover; (iii) the macro-economic environment is supportive of bank soundness; (iv) the banking system has been restructured successfully; (v) the authorities possess, and are ready to use, strong remedial and exit policies for bank that in the future are perceived by the public to be unsound; (vi) appropriate accounting, disclosure, and legal systems are in place; (vii) a strong prudential regulatory framework is in operation; and (viii) public confidence has been restored. Currently, it would seem that Indonesia does not have all these requirements.

Demirguc-Kunt and Kane (2001) suggest that countries should first assess and remedy the weaknesses of their international and supervisory environments before adopting an explicit deposit insurance system. In line with this, Wesaratchakit (2002) reported that Thailand decided to adopt a gradual transition from a blanket guarantee to a limited explicit deposit insurance scheme. It was considered that there are some preconditions that should be met – particularly the stability of banking

25

system and the economy as a whole, effectiveness of regulation and supervision as well as public understanding – before shifting to an explicit limited deposit insurance system.

It is important to prepare a contingency plan before removing the blanket guarantee in order to anticipate worst-case scenarios such as a loss in public confidence. If such conditions occur, the central bank may have to extend liquidity support to illiquid but solvent banks. In addition, there should be a clear legal framework for the deposit insurance scheme. To reduce moral hazards and to induce market discipline, the authorities should impose tough sanctions on financial institutions and players which violate rules and create problems for the banking system and also ensure that law enforcement is in place.

Before the 1997 crisis, none of the crisis hit countries with the exception of the Philippines,

which was least affected by the crisis, had an explicit deposit insurance scheme. As part of their efforts to strengthen the financial safety nets and financial stability, some East Asian countries such as South Korea, Malaysia, Indonesia and Thailand , have been shifted from blanket guarantee – adopted as response to financial crisis - to an explicit and limited deposit insurance scheme.

There is an issue of how depositors will react to the introduction of a limited scheme. In January 2001, Korea replaced its blanket guarantee with a limited deposit insurance system with an insurance limit of 50 million won per depositor per institution. There was a noticeable migration of funds from lower rated to sounder banks. Also, large depositors actively split their deposits into several accounts in banks and non-bank financial institutions. However, there has been no bank runs in the Korean financial system as a whole. Interestingly, there is no significant deposit migration (flight to quality from perceived bad banks to perceived sound banks) in Indonesia since the gradual adoption of a limited deposit insurance in Indonesia.

However, as was argued by Batunanggar (2003), the Indonesian case suggests that a very limited deposit insurance scheme was not effective in preventing bank runs during the 1997 crisis. This was due to the fact that large deposits (denomination of more than Rp 20 millions) which was uninsured, accounted for about 80% of total deposits. Others such as Furman and Stiglitz (1998), Stiglitz (1999,2002), Radelet and Sachs (1998), argue that if the blanket guarantee had been introduced earlier, before some banks had been liquidated, the damage and costs of the crisis would have been much less.

26

Box 5. Shifting from Blanket Guarantee to Limited Deposit Insurance Scheme:

The Case of Indonesia

The government blanket guarantee programme, which came into effect because of the crisis that started in 1998, has indeed been successful in recovering public confidence in the banking sector. However, research shows that the blanket guarantee has spurred moral hazard by bank managers and customers that has the potential to create crises in the long-run.

Against this backdrop, Indonesia established the Deposit Insurance Corporation (DIC) to provide an explicit and limited deposit insurance scheme. DIC was established based on Law No. 24 of 2004, with two primary functions: (i) to provide an explicit limited deposit insurance scheme up to a particular amount; and (ii) to carry out the resolution of failing banks.

Membership of DIC is mandatory for all commercial and rural banks (BPR) in Indonesia. Insurance coverage includes demand deposits, certificate of deposits, time deposits and other equally defined deposits.

In order to prevent a negative impact on financial stability, the implementation of the deposit insurance scheme will be made in stages. Up to March 2005, the liabilities of banks will still be guaranteed by DIC. After that time, starting March 2007, deposit insurance will be limited up to Rp100 million per customer per bank.

In the case of a bank failure, DIC will insure customer deposits up to a certain amount while, noninsured deposits will be resolved through the bank liquidation process. DIC is expected to preserve public confidence in the Indonesian banking industry.

The management of DIC is based on a two-tier system with a Board of Commissioners and Executive Officers. The Board of Commissioners consists of two ex-officio staff (one BI senior official and one senior member of staff from the Ministry of Finance) and two non ex-officio staff (external). Bank Indonesia is supportive of DIC and has already assigned some of its staff members to the institution.

To ensure effective coordination and information exchange mechanism between Bank Indonesia and DIC, a Memorandum of Understanding is being drawn up. As was previously mentioned, the deposit insurance is only one financial safety nets and to be effectively implemented, it must be supported by other nets, especially an effective banking supervision.

However, systemic bank runs in Indonesia at the outset of the 1997 crisis cannot be attributed

solely to the absence of a blanket guarantee. Inconsistency and the lack of transparency in bank liquidation policies of the authorities and political uncertainties towards the end of Suharto’s regime, all played a part, as documented by Lindgren et al. (1999) and Scott (2002). The introduction of the blanket guarantee programme at the outset of the crisis may be necessary to prevent larger potential economic and social costs of a systemic crisis (Lindgren et al. 1999). However, the scheme should be replaced as soon as possible with one that is more appropriate to normal conditions and which does not create moral hazard (Batunanggar, 2003).

27

7. Key Challenges and the Way Forward

Experience has shown that financial crises are very difficult to predict. Even though they are often repeated, there are no two similar crises. In addition, resolving financial crises are not only very difficult but also very costly. The saying that “prevention is better that cure” holds very true. The resilience of the financial system to absorb a crisis once it occur s, must be strengthened through various strategies and policy measures as discussed in this Paper.

Capability in identifying, measuring and monitoring risks to the financial system should be

continuously improved. Coordination and cooperation both on domestic, regional and international levels should also be further developed in order to prevent and to resolve financial crises. In this regard, areas that could be further explored are joint researches on specific topics on financial stability, development of tools for surveillance such as macro stress-tests and early warning systems, establishment of a regional forum on financial stability.

One of the best ways to understand the causes of and management of a financial cr isis is by

learning from experiences of other countries. By promoting more effective coordination and cooperation both at the domestic level as well as at the regional and international level, we will hopefully gain better understanding and capability in improving financial stability and managing financial crisis once it occurs.

28

Selected References

Batunanggar, S. (2007), ‘Financial Safety Nets: Review of Literature and Its Practice in Indonesia’, Financial Stability Review, March, Bank Indonesia.

_____(2005), ‘Indonesia’s Banking Crisis Resolution: Process, Issues and Lessons Learnt’, Financial Stability Review, May, Bank Indonesia.

_____(2003), Redesigning Indonesia’s Crisis Management: Deposit Insurance and Lender of Last Resort, Financial Stability Review, June, Bank Indonesia.

_____(2002), Indonesia’s Banking Crisis Resolution: Lessons and the Way Forward, Research Paper prepared at Center for Central Banking Studies (CCBS), Bank of England and presented at the Banking Crisis Resolution Seminar at CCBS, Bank of England, December 2002.

Bordo, Michael D. and Anna J. Schwartz (2002), ‘Charles Goodhart's Contributions to the History of Monetary Institutions’, NBER Working Paper No. 8717.

Choi, Jang-Bong (1999), ‘Structuring a Deposit Insurance System from Asian Perspective’, in Rising to the Challenge in Asia: A Study of Financial Markets, Vol.6, Asian Development Bank.

Cihak, Martin (2006), ‘How Do Central Banks Write on Financial Stability? ’, IMF Working Paper (WP/06/163), June.

Crockett, Andrew (1997), ‘Why is Financial Stability a Goal of Public Policy?’, Paper presented at Maintaining Financial Stability in a Global Economy Symposium, the Federal Reserve Bank of Kansas City, August 28-30.

Demirguc–Kunt, Asli, Enrica Detragiache, and Poonam Gupta (2000), ‘Inside the Crisis: An Empirical Analysis of Banking Systems in Distress’, World Bank Policy Research Paper No. 2185, August.

Diamond, D.W. and P.H. Dybvig (1983), ‘Bank Runs, Deposit Insurance and Liquidity’, Journal of Political Economy No.91.

Dong, He (2000), ‘Emergency Liquidity Support Facilities’, IMF Working Paper No. 00/79, April.

Duisenberg, Willem F. (2001), ‘Developments in International Financial Market’, Speech Before the Inauguration Ceremony of the Second Swedish National Pension Fund, Gothenburg, 26 September.

Freixas, Xavier, Curzio Giannini, Glenn Hoggarth, Farouk Soussa (1999), ‘Lender of Last Resort: A Review of the Literature’, Financial Stability Review , Bank Of England, November.

Furman, J. and J.E. Stiglitz (1998), ‘Economic Crisis: Evidence and Insights from East Asia”, Brooking Papers on Economic Activity.

Garcia, Gillian G.H. (1999), ‘Deposit Insurance: A Survey of Actual and Best Practice’, IMF Working Paper No.99/54, April.

Garcia, Gillian G.H. (2000), ‘Deposit Insurance and Crisis Management’, IMF Working Paper No.00/57, March.

Gjedrem, Svein (2005), ‘The Macroprudential Approach to Financial Stability’, Monetary Policy & Financial Stability Conference of the Oesterreichische Nationalbank, Vienna, 12 May.

29

Houben, Aerdt, Jan Kakes, and Garry Schinasi, ‘Toward a Framework for Safeguarding Financial Stability? ’, IMF Working Paper (WP/04/101), June.

Kane, Edward J. and Asli Demirguc-Kunt (2001), ‘Deposit Insurance Around the Globe: Where Does it Work?’, NBER Working Paper No. 8493.

Lindgren, Carl-Johan, Garcia G., and Matthew I. Saal (1996), ‘Bank Soundness and Macroeconomic Policy’, Washington, DC: International Monetary Fund.

Lindgren, C.J., T.J.T. Balino, C. Enoch, A.-M. Gulde, M. Quintyn and L.Teo (1999), ‘Financial Sector Crisis and Restructuring: Lessons from Asia’, IMF Occasional Paper No.188 (Washington: International Monetary Fund).

McFarlane, I.J. (1999), ‘The Stability of Financial System’, Reserve Bank of Australia Bulletin, August.

Mishkin, F.S. (1997), ‘The Cause and Propagation of Financial Instability: Lessons for Policymakers’, in Maintaining Financial Stability in a Global Economy: A Symposium, U.S. Federal Reserve Bank of Kansas City.

Mishkin, Frederick (2001), ‘Financial Policies and the Prevention of Financial Crises in Emerging Market Countries’, NBER Working Paper No. 8087, January.

Nakaso, Hiroshi (2001), ‘The Financial Crisis in Japan during the 1990s: How the Bank of Japan Responded and the Lessons Learnt’, BIS Papers No.6, October.

Pangestu, Mari, and Habir Manggi (2002), ‘The Boom, Bust and Restructuring of Indonesian Banks’, IMF Working Paper No. 02/56, April.

Radelet, S. and J. D. Sachs (1998), ‘The East Asian Financial Crisis: Diagnosis, Remedies, Prospects’, Brooking Papers on Economic Activity, 1.

Scott, David (2002), ‘A Practical Guide to Managing Systemic Financial Crises, A Review of Approaches Taken in Indonesia, the Republic of Korea, and Thailand’, World Bank Policy Research Paper No.2843, May.

Sinclair, Peter (2001), ‘Financial Stability and Central Banks’, Central Bank Governors’ Symposium, 29 May.

Stiglitz, Joseph (1999), ‘Lesson from East Asia’, Journal of Policy Modeling 21(3) pp. 311–330.

_____ (2002), Globalization and Its Discontents, W.W. Norton & Co.

Wesaratchakit, Worawut (2002), ‘The Future of Deposit Insurance System in Thailand’, Bank of Thailand Quarterly Bulletin, March.