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Occasional Paper No.

45

E FFECTIVE F INANCIAL S YSTEM STABILITY F RAMEWORK

Wimboh Santoso
Sukarela Batunanggar

The South East Asian Central Banks


Research and Training Centre
(The SEACEN Centre)
Kuala Lumpur, Malaysia

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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

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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 vie ws 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

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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.

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Effective Financial System Stability Framework

Wimboh Santoso 1 and Sukarela Batunanggar 2

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 Institute 3 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

1
Head of Financial System Stability Bureau, Bank Indonesia, e -mail: wimboh@bi.go.id
2
Executive 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.
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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.

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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
Stable macro- Sound framework definition of financial stability. Duisenberg
economic of prudential (2001, p. 38) cites: “monetary stability is defined
environment supervision
as stability in the general level of prices, or the
absence of inflation or deflation. However,
Stable and sound
financial system financial stability does not have an easy or
universally accepted definition. Nevertheless,
Safe and robust Well-managed there seems to be a broad consensus that financial
payments system financial institutions
and efficient financial
stability refers to the smooth functioning of the
markets 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

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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 significa nt 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 synchronis ed 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 func tion of the modern central bank, other than
market operation and monetary policy (Sinclair, 2001). Sinclair et. al provide s 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

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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

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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

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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.

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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.

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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

Resea rch 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

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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 indicators 7 . 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

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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.

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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

Aggregated Micro-prudential Indicators Macroeconomic Indicators


Capital Adequacy Economic Growth
? Aggregated capital ratio; Freq. distribution of CAR ? Aggregated growth rate
Asset Quality ? Sectoral slumps
Lending institution Balance of Payment
? Sectoral credit concentration ? Current account deficit
? Foreign currency-denominated lending ? FX reserve adequacy
? Connected lending; NPL and provision; etc. ? External debt (incl. maturity structure)
Borrowing entity ? Terms of trade
? Debt-equity ratios; Corporate profitability; etc. ? Composition and maturity of capital flows
Management) Inflation
Growth in the number of financial institutions; etc. ? Volatility in inflation
Earnings Interest and exchange rates
? RoA, RoE, Income and Expense ratios, etc. ? Volatility of interest and exchange rates
Liquidity ? Level of domestic interest rates
? Central bank credit to fin institutions; LDR;maturity ? Exchange rate sustainability
structure of assets and liabilities; ? Exchange rate guarantees
Sensitivity to market risk Contagion effect
? FX risk; interest rate risk; equity price risk; etc. ? Trade spillovers
Market-based indicators ? Financial market correlation
? Market prices of financial instruments; credit ratings, Other Factors
sovereign yield spread; et.
? Directed lending and investment
(Evans et.al, “Macroprudential Indicators of Financial System ? Government resource to banking system
Soundness”, IMF Occasional Paper No.192, 2000.) ? Arrears in the economy

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4.2.1 Surveillance on the Financial Institutions and Markets

This area covers the analysis and assessment of banking, non-bank financial institutions
(including in surance 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 bank ing 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.

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FSI specified by the IMF

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Risk management is one approach applicable to assess the condition and outlook of the
financial institutions and industry, which include s 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.

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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 household s 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
measurement s in assessing the development of the domestic finance and analyse the potential risk to
the financial stability are illustrated on Table 2.

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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
exc hange 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


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

16
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 yield s 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 Sc hinasi, 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.

17
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 .
Comparisons of FSR Structure

Finland Austria Australia Singapore Hong Kong Indonesia


FSR Contents UK (BoE)
(BoF) (ANB)
Brazil (BCB)
(RBA) (MAS) (HKMA)
Korea (BoK)
(BI)

? Summary/Overview v v v v v v v v v
? Reports
? Economic development and v v v v v
outlook
? Domestic finance v v v v v v v v
? International finance v v CEE countries v v v v

? Non bank financial Insurance v v Insurance v v


institution
? 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

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)

18
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 legislatio ns 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

19
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 Financ e (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.

20
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

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

21
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.

22
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 budget 12 . 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-

11
The 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,

23
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

24
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 syste m 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 limit ed 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.

25
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).

26
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.

27
Selected References

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

28
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
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