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Batunanggar, Financial Safety Nets: Review of Literature and Its Practices in Indonesia

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In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essentialto foster financial system stability, predominantly in banking sector. Financial system stability and monetary stability are mutually dependent and, therefore, must be preserved for sustainable economic growth. To safeguard financial stability - particularly banking system - a financial safety nets is key pilar in addition to effective supervisory and regulatory frameworks. As a chief conduit to sustainable economy growth, financial system and monetary stability - both intertwined - must be well-preserved. A well-designed and comprehensive financial safety nets mitigates risks to financial system and as a tool of crisis management to eliminate adverse impacts of crisis when they occur. Albeit its scheme varies, FSN fundamentally consists of four elements : (i) independent as well as effective regulation and supervision; (ii) effective lender of last resort; (iii) explicit deposit insurance scheme; and (iv) clear crisis management. The Government and Bank Indonesia have drafted a comprehensive framework for a Financial Safety Nets (FSN). The FSN framework clearly defines objectives and elements of FSN, roles and responsibilities of relevant authorities, and coordination mechanism among the authorities involved in the FSN: Ministry of Finance, Bank Indonesia, and the Deposit Insurance Corporation. Equipped with a lucid legal framework for FSN and integrated implementation, effective preventive measures and crisis resolution are possible.
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  Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia 61 Financial Safety Nets:Review of Literature and Its Practices in Indonesia Sukarela Batunanggar 1 1. INTRODUCTION Financial Safety Nets (FSN) is a key building blockof financial system stability. It prevents bank run,limits probability of financial instability, as well asminimizes frequency and adverse impact of economy In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essential to foster financial system stability, predominantly in banking sector. Financial system stability and monetary stability are mutually dependent and, therefore, must be preserved for sustainable economic growth. To safeguard financial stability - particularly banking system - a financial safety nets is key pilar in addition to effective supervisory and regulatory frameworks. As a chief conduit to sustainable economy growth, financial system and monetary stability - both intertwined - must be well-preserved. A well-designed and comprehensive financial safety nets mitigates risks to financial system and as a tool of crisis management to eliminate adverse impacts of crisis when they occur. Albeit its scheme varies, FSN fundamentally consists of four elements : (i) independent as well as effective regulation and supervision; (ii) effective lender of last resort; (iii) explicit deposit insurance scheme; and (iv) clear crisis management. The Government and Bank Indonesia have drafted a comprehensive framework for a Financial Safety Nets (FSN). The FSN framework clearly defines objectives and elements of FSN, roles and responsibilities of relevant authorities, and coordination mechanism among the authorities involved in the FSN: Ministry of Finance, Bank Indonesia, and the Deposit Insurance Corporation.Equipped with a lucid legal framework for FSN and integrated implementation, effective preventive measures and crisis resolution are possible. contraction. Crises showed us that deposit insurancescheme, discount facilities, emergency liquidityassistance of central banks offer security and liquidityto banks. Notwithstanding, FSN has negativeconsequences unless it is well-designed. It may triggerdistortion in price signal used for resource allocation,provoke risk taking and moral hazard that ultimatelycall for for effective supervision and regulation. 1Executive Bank Researcher at Bank Indonesia. The views expressed in this paper arethose of the author and do not necessarily reflect the views of Bank Indonesia. E-mailaddress: batunanggar@bi.go.id Abstract   Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia 62 Stable and SoundFinancial System Solid legal framework, clear division of roles and responsibilitiesand effective coordination mechanismRegulationandSupervisionSystemCentral Bank (as BankSupervisor) Lender ofLast ResortPolicy (as LoLR) DepositInsuranceSystemD I CCrisisManagementPolicyMoF,Central Bank,and DICCentral Bank Graph 1:Financial Safety Nets Until recently, there is no universal definition ofFSN. In general, FSN is public policy provided bygovernment to foster economy growth and financialstability. Albeit its scheme varies, FSN fundamentallyconsists of four elements : (i) independent as well aseffective regulation and supervision; (ii) effectivelender of last resort; (iii) explicit deposit insurancescheme; and (iv) effective bank resolution and crisismanagement. Typically, FSN has been succinctlyassociated with lender of last resort and depositinsurance. In this paper, on the other hand, the termFSN refers to a broader definition. 2. REGULATION AND SUPERVISION The ultimate objective of regulation andsupervision is to foster security and soundness offinancial institutions via evaluation and continoussurveillance. These include assessment on quality ofrisk management, financial conditions, andcompliance with laws and regulations. Effectiveregulation and supervision is the first safety netsaiming at creating and promoting sound financial,predominantly banking system.Lack of supervisory capability is often cited asone of the reasons for financial system weaknesses(Mayes, Halme dan Liuksila, 2001). As Mishkin (2001)argued, asymmetric information leads to adverseselection and moral hazard problems that have animportant impact on financial systems and justifiesthe need for prudential supervision.The main focus of determining condition of abank pre-crisis is to rapidly help supervisordifferentiate banks having probability to survive fromthose having probability to fail in a crisis. The maincharacteristic of systemic crisis is that financialcondition of a bank will rapidly deteriorate as a resultof adverse economy and or widespread bank run.Along with the rapid advancement, increasingcomplexity, and greater risks confronting financeindustry, some multilateral agencies have developedinternationally accepted standards and supervisoryprinciples. The reference of standards and regulationfor banking industry is The 25 Basel Core Principlefor Effective Banking Supervision which is publishedby the Basel Committee of Banking Supevision(BCBS). For insurance industry, the standard refersto The Principles of Insurance Supervision.Some scholars including Goodhart (1998) andLlewellyn (1999) have set up guiding principles ofbanking regulation. Aside from the Basel CorePrinciples, they set up principles of the importanceof incentives for bank management, effectivefinancial safety net which fosters prudential behaviorof bank management and stakeholders, marketdiscipline, and good corporate governance.Financial system stability will exist should thereis power balance among various stakeholders,shareholders, depositors, debtors, creditors, andsupervisors. Therefore, good corporate governanceis the key element in a supervisory framework (Mayeset al., 2001). With respect to good corporate  Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia 63 governance, it is important to adopt regulatoryregime that is more market-based. Within thiscontext, transparency improvement throughenhanced disclosure must be the top agenda. NewZealand is the country more adopting market-basedregime.Drawbacks in governance and supervision havebeen cited by experts as one of factors exacerbatingthe Asian financial crises in 1997-1998, particularlyin Indonesia (Halim (2000), Nasution (2000),Batunanggar (2002)). Hence, Bank Indonesia hasbeen strongly committed to enhance effectivenessbank supervision comprehensively along with thepost-crisis bank restructuring program. Despite theprogress that has been made, challenges remain tobe seriously dealt with. From the supervision side, itis essential to continuously enhance quality andquantity of bank supervisors as well as enhancequality of supervision information system inproportion to the increasing complexity of businessand risks banks are confronting. From the bankingindustry side, it is essential that banks exercise goodcorporate governance, robust risk management, aswell as consistent and effective internal control.Beside, to bolster the structure of banking industry,banking consolidation initiative via merger isindispensable.The other important issue us the plan to unitesupervisory function of central bank and variousauthorities into an independent mega regulator asin the case of the United Kingdom, Australia, Japan,and Korea in the last decade. In general, tworationales for unification are to enhance supervisionefficiency and to effectively supervise financialconglomerates. However, no empirical evidence hasbeen found concerning benefits of the unificationparticularly from both micro-prudential and financialsystem stability. In fact, Abram and Taylor (2000) andGoodhart (2001) provide excellent discussions on theissues in the unification of financial sector supervision.Goodhart argues that banking supervision in lessdeveloped countries is better to be kept within thecentral bank because it will be better funded, moreindependent and more expert and reliable. Hence, itis important to rigorously consider the unification toprevent potential problems from occurring, whichmay deteriorate financial stability. 3. LENDER OF THE LAST RESORT (LLR) LLR is discretionary  provision of liquidity to afinancial institution (or the market as a whole) bythe central bank in reaction to an adverse shockwhich causes an abnormal increase in demand forliquidity which cannot be met from an alternativesource (Freixas et al., 1999).The LLR concept was born in the19th centuryby Henry Thornton (1802) who explicated thefundamental elements of good central bankingpractice in the light of emergency lending. Then,Walter Bagehot (1873), more widely known as thefounding father of modern LLR, developed theconcept of Thornton (even though he did notmention his name). Bagehot stated three principlesof LLR: (i) provide the lending against sufficientcollaterals (for solvent bank only); (ii) provide thelending with penalty rate (for liquid banks only); (iii)announce commitment to lend witout limit (to ensurecredibility).Historical experience suggests that successfullender of last resort actions have prevented panicson numerous occasions (Bordo, 2002). Similarly,Mishkin (2201) argues that central bank can  Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia 64 encourage the recovery of financial crisis by providingloan in as lender of the last resort. Although theremay well be good reasons to maintain ambiguity overthe criteria for providing liquidity assistance, He(2000) argues that properly designed lendingprocedures, clearly laid-out authority andaccountability, as well as disclosures rules, willpromote financial stability, reduce moral hazard, andprotect the lender of last resort from undue politicalpressure. There are important advantages fordeveloping and transitional economies to follow arule-based approach by setting out ex ante  thenecessary conditions for support, while maintainingsuch conditions is not sufficient for receiving support.In the same vein, Nakaso (2001) suggests that Japan»sLLR approach has shifted from ≈constructiveambiguityΔ towards increasing policy transparencyand accountability.As argued by Sinclair (2000) and Goodhart(2002), within the time scale allowed, it is oftendifficult, if not impossible, for central banks todistinguish between a solvency and a liquidityproblem. Similarly, Enoch (2001) argued that thereshould be restrictions against protracted use of suchlending, since this is likely to be an indicator ofsolvency difficulties.LLR activities by a central bank in a emergingmarket countries with substantial foreign-denominated debt, may not be as successful as inan industrialised countries. Therefore, the use of theLLR by a central bank in countries with a large amountof foreign-denominated debt is trickier becausecentral bank lending is now a two edged sword(Mishkin, 2001).While individual frameworks differ from countryto country, there is a broad consensus on the keyconsiderations for emergency lending during normaland crisis periods (see Box A1.1). Lender of Last Resort in Normal Times   In normal times, LLR assistance should bebased on clearly defined rules. Transparent LLRpolicies and rules can reduce the probability of self-fulfilling crises, and provide incentives for fosteringmarket discipline. It may also reduce politicalintervention and prevent any bias towardsforbearance. LLR in normal times should only beprovided for solvent institutions with sufficientacceptable collateral, while for insolvent banksstricter resolution measures should be applied suchas closure. Therefore, there should be a clear andconsistent adoption of a bank exit policy. Once adeposit insurance scheme has been established, thecentral bank role in LLR in normal time can bereduced to a minimum since the deposit insurancecompany will provide bridging finance in the casewhere there is a delay in closure process of a failedinstitution 2 . LLR in Exceptional Circumstances In systemic crises, LLR should be an integral partof a well-designed crisis management strategy. Thereshould be a systemic risk exception in providing LLRto the banking system. Repayment terms may berelaxed to support the implementation of a systemicbank restructuring programme. In systemic crises thedisclosure of the operation of LLR may become animportant tool of crisis management. The criteria ofa systemic crisis will depend on the particularcircumstances, thus, it is difficult to clearly state this 2See Nakaso (2001) for a discussion on the Japanese LLR model.
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