Financial Stability Review June 2003

Transcription

1 Financial Stability Review June 2003

2 Published by: Financial System Stability Bureau Directorate of Banking Research and Regulation Bank Indonesia Jl. MH Thamrin No.2, Jakarta Indonesia This Financial Stability Review (FSR) is one the reports Bank Indonesia provides to public in order to achieve its mission to achieve and maintain stability of the Indonesian Rupiah through maintaining monetary stability and promoting financial system stability for safeguarding long-term and sustainable national development. FSR is issued biannually and has the following objectives: To foster public vision on financial system stability issues, both domestically and internationally; To analyze potential risks to financial system stability; and To recommend policies to relevant financial authorities for promoting a stable financial system Information and Order: This FSR document is also made in pdf format and is accessible at Bank Indonesia s website at All inquiries, comments and advice may be addressed to: Bank Indonesia Directorate for Banking Research and Regulation Financial System Stability Bureau Jl. MH Thamrin No. 2, Jakarta, Indonesia Tel: (+62-21) , 7353 Fax: (+62-21) BSSK@bi.go.id

3 fsr Financial Stability Review No. 1, June, 2003

4 CONTENTS FOREWORD, vii EXECUTIVE SUMMARY, ix Chapter 1 INTRODUCTION, 1 Chapter 2 THE IMPORTANCE OF MAINTAINING FINANCIAL SYSTEM STABILITY, 4 LESSONS LEARNT FROM THE 1997 CRISIS, 4 FINANCIAL SYSTEM STABILITY: WHAT AND WHY IS IT IMPORTANT?, 4 CORE COMPONENTS OF A STABLE FINANCIAL SYSTEM,5 CENTRAL BANK S ROLE IN FINANCIAL SYSTEM STABILITY, 5 CENTRAL BANK S ROLE IN FINANCIAL SYSTEM STABILITY, 7 CONCLUSIONS, 8 Chapter 3 EXTERNAL FACTORS, 11 INTERNATIONAL ECONOMY, 11 DOMESTIC ECONOMY, 12 Monetary Conditions, 12 Government s Finance, 13 Government Bonds, 14 Foreign Debts, 15 Market Confidence, 15 Maturity Profile, 16 REAL SECTOR CONDITION, 17 Small and Medium Enterprises, 17 Pulp and Paper Industry, 19 Chapter 4 PERFORMANCE AND PROSPECT OF INDONESIA S BANKING INDUSTRY, 21 THE STRUCTURE OF BANKING INDUSTRY, 21 ASSETS STRUCTURE, 21 CREDIT RISK, 22 Non-Performing Loans (NPLs), 23 Loan Restructuring, 25 Lending Growth, 25 LIQUIDITY RISK, 27 Liquidity Assets, 28 Exchange Offer, 29 Core Deposit, 29 Interbank Call Money, 29 Liquid Assets to Cash Outflow (COF), 30 Corporate Funds, 30 Household Savings Pattern, 30 Maturity Profile, 31 MARKET RISK, 31 Capital Charge for Market Risk, 32 CAPITAL, 32 BANKS PERFORMANCE, 34 Profile of Banks at Stock Exchanges, 36 Comparative Performance with Other Selected Countries, 36 ii

5 Chapter 5 CAPITAL MARKET, 38 CONFIDENCE TO CAPITAL MARKET, 38 Mutual Funds, 39 Impacts on Financial System Stability, 42 Bond Market, 46 Stocks Market, 46 Chapter 6 PAYMENT SYSTEMS IN INDONESIA, 51 RISKS IN PAYMENT SYSTEMS, 48 Clearing System, 49 Realtime Gross Settlement (RTGS), 49 ROLE OF PAYMENT SYSTEMS IN THE STABILITY OF FINANCIAL SYSTEM, 49 Payment Systems Oversight, 50 Risks in Clearing System, 50 Risks in RTGS, 50 Chapter 7 CONCLUSION, 54 ARTICLES 1. Redesigning Indonesia s Crisis Management S. Batunanggar 2. Market Risk in Indonesia Banks Wimboh Santoso & Enrico Hariantoro 3. An Empirical Analysis of Credit Migration In Indonesian Banking Dadang Muljawan 4. New Basel capital Accord : Its likely impacts on the Indonesian banking industry Indra Gunawan, Bambang Arianto, G.A. Indira & Imansyah iii

6 Tables 3.1. Stress Test on Goverment budget (APBN) Foreign Debt Indicators 3.3. Indonesia Corporate yankee Bonds (Dec 2002) 4.1. Selected Items of Banks Balance Sheets 4.2 Details of Loan 4.3. NPL Stress Test 4.4. Distribution of Loans by Sector Large Banks Liquidity 4.6. Maturity Profile of Assets and Liabilites of 13 large Banks, December Large Exchange Rate Stress Test of Large Bank to CAR 4.8 Interest Rates Stress Test of large of Large Bank to CAR Figures 3.1. Non-oil and Gas exports by Country Destination 3.2. US and JAPAN : GDP-Inflation 3.3 US and JAPAN : Current Account 3.4. US and Japan : Discount interest Rate and DJIA & NIKKEI Indices 3.5. Direct and Portfolio Investments 3.6. Domestic Economic Indicators 3.7. Jakarta Composite and Property Sector Indices 3.8. Maturity Profile of Government Bonds 3.9. Fixed Rate Government Bond vs SBI Indonesia Government Bonds Rating and Yields Maturity Profile of Corporate Foreign Debt Loans to SME and Non-SME Lending growth to SME By Type of Banks SME Loans by Type of Business Uses GDP by Sectors to Total GDP NPL by Sector 4.1. Total Bank and Asset 4.2 Bank Securities and Loans 4.3. Total Loans and NPL 4.4. NPL and Provisions for Loan Losses 4.5. Non Performing Loan 4.6. NPL Stress Test 4.7. Loan Restructuring 4.8 Loan to Deposit Ratio 4.9. Trends of IDR and Foreign Exchange Loans New Lending Loans by Business Uses Property Loan Deposit Growth Liquid Assets Core & Non Core Deposit Stock Liquid Ratio iv

7 4.17. Maturity Profile of Time Deposit Stress Test Exchange Rate Interest Rates Stress Test Capital ratios CAR Evolution Source of Interest Income Net Earnings and ROA Paid-up Capital and ROE Interest Income Asian Banks ROA Asian Banks NPL Asian Banks CAR 5.1. Market Liquidity and Jakarta Composite Index 5.2. Development of Mutual Funds and Bank Deposit 5.3. Mutual Funds Growth 5.4. Development of Deposit vs Public Funds in Mutual Funds 5.5 Development of YTM of Some Fixed-Rate Bonds and SBI rate 5.6. Government Bonds by Portfolio 5.7. Financial Sector Stock Index 6.1 Real Time Gross Settlements, Clearing and Noncash Transactions Boxes 1. Causes and Process of Financial Crisis 2. Bank Indonesia s Strategy in Maintaining Financial Stability 3. Pulp and Paper Industry 4. Market Risks 5. Yield Curve of Government Bonds 6. Mutual Funds 7. Risks in Payment Systems 8. Failure to Settle Scheme v

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9 FOREWORD The financial crises that took place in almost all corners of the world, Indonesia included, have driven growing awareness on the importance of financial system stability. Instability in a financial system brings in adverse implications such as lower economic growth, loss of domestic productivity and gigantic fiscal cost. Based on these adverse experiences, it is imperative that financial system stability is maintained for the interests of the public. Financial stability is basically avoidance of financial crisis. Maintaining financial system stability is one of the primary functions of Bank Indonesia, which is not less important compared to maintaining monetary stability. Financial system stability is a prerequisite for monetary stability. This issue is in line with Bank Indonesia s mission to attain and maintain stability of Rupiah by maintaining monetary stability and promoting financial system stability to secure sustainable long-term national development. However, maintaining financial system stability is not the sole responsibility of a central bank. Rather it is also mutual responsibility of relevant government authorities including Ministry of Finance, Financial Supervisory Authorities, Deposit Insurance Corporation beside the central bank. In accordance with the above, Bank Indonesia assesses and monitors trends and issues surrounding stability of Indonesia s financial system and provides recommendations to maintain stability of the financial system. Results of such assessments and monitoring is laid down in a regularly updated Financial Stability Review (the FSR). Unlike such other reports issued by Bank Indonesia, the FSR focuses on such potential risks which may weaken stability of national financial system, and is more forward-looking orientation. Every section of this report also describes the prospects of national financial system. During the course of 2002, Indonesia s financial system is relatively stable and is expected to remain so in the years to come. However, alert needs to be maintained particularly on some pertinent issues including delays in the recovery of loan quality and performance of the banking sector, as well as external issues such as low growth in the global economy and the government budget deficit due to the huge obligations from domestic as well as overseas borrowings. This FSR is addressed to all stakeholders, Bank Indonesia and relevant financial authorities in particular, and the public in general. The review and recommendations offered in this FSR are hopefully useful to the Government as well as all other relevant authorities in the efforts of maintaining stability of national financial system. In addition, this review will encourage concerns of all stakeholders to the adverse movements in the financial system within their jurisdictions so that proactive measures can be taken. vii

10 The Board of Governor must be grateful and give its appreciation to the DPNP, all relevant units and personnel for their dedications, contributions and collaboration for the completion of this first edition of Financial Stability Review. Finally, we will appreciate all advice, commentaries as well as critics from any and all parties for further improvements of this review in the future. Jakarta, April 2003 Maman H. Somantri Deputy Governor viii

11 EXECUTIVE SUMMARY Indonesian financial system during the course of 2002 is stabilized. This is made possible by the effective policies in stabilizing exchange rates and controlling inflation as well as the progress made through the micro-prudential policies covering restructuring program of the banking sector as well as improvement in banking supervisory and regulatory frameworks. However, certain aspects, the endogenous and exogenous risks, need to be closely observed as they can potentially disturb financial system stability. The weakening economy of the major trade partners of Indonesia is one of the driving factors contributing to the slower growth of exports. As the results, exporting companies, particularly those whose activities are financed by banks confront augmenting financial risks reducing their capacity to pay their obligations in timely manner. Such condition is the major driving factor leading to decreasing a quality of earning assets of banks. Meanwhile, huge domestic fiscal obligations and international debts have prevented higher economic and real sector growth. The yet to complete corporate debt restructuring also impedes domestic corporations to expand their businesses and has brought in adverse impacts to the balance of payment which may potentially prompt debt crisis and eventually jeopardizing stability of financial system. Indonesia s banking structure has not yet changed as the results of the banking crisis back in 1997 that led to the recapitalization of hard-hit banks, all of which have significant impacts to the economy. Indonesia s banking system is very much concentrated on the 13 large banks with combined assets of 74.9% from the total assets in banking system. In general, the condition of the banking industry has been improving following the recap program introduced since Aggregate ROE stays at 14.8% and CAR at 21.7%. However, the capitalization capacity of the banks, particularly the recap banks, remains weak as the results of the low loan growth. Main revenues of the 13 large banks are from bond coupons since their assets are mostly in the form of recap bonds. Moreover, increased capital at some banks has not been able to absorb the potential losses, particularly those arising from credit, market and operational risks. With the introduction of the market risk capital charge, a number of banks will notice a slight capital decrease, although it will remain above the minimum Capital Adequacy Ratio (8%). In the course of 2002, the risks surrounding the banking system remain high and with stable trend. Bank credit risks are high but decreasing. Meanwhile, market risks and banks liquidity risks are moderate with stable trend. The high credit risk is characterized by high percentage of non-performing loans, ix

12 which is at 8.1% (gross) or 2.1% (net). The decrease in non-performing loans, including those created during the outbreak of the crisis in 1997, is mainly attributable to the assignment of such non-performing loans to IBRA, while others are restructured and written off. The primary constraints in lending are: (i) loan restructuring has been delayed due to non-conducive economic environment; (ii) low absorption by real sector, particularly corporations, since most of them are still being restructured; (iii) low growth in new lending, dominated only by small and consumers loans. Monitoring shall be focus on the increasing possibility that restructured loans as well as non-restructured loans, sold by IBRA to banks, will new non-performing loans. Stress test indicates that when NPL stays as high as 23.8%, the conditions that will lead to solvability constraints in some large banks. The market risks encountered by banking system during 2002 is relatively moderate with stable trends. This is the result of IDR appreciation against the United States Dollar and the decreasing trend of interest rates. In general the net open position of 14 large banks is in short position (up to 3 months) such that the USD depreciation and the lower interest rates have brought positive impacts to their capital. The short positions reflect bank expectations of declining trends in the interest rate. Banks may conduct repricing strategy due to the macroeconomic changes. However, future exposure of market risks, resulting from pressures against the Indonesian Rupiah due to market volatility and political instability, must be watched. Indonesian banks have adequate liquidity. This condition is reflected in the sufficiency of liquidity of the 13 large banks and their independence from interbank call money. However, the funding structure of some large banks, particularly state-owned banks is mostly in the form of corporate deposits (owned by state-owned and large companies). In order to address such liquidity risk, the 13 large banks need to balance their funding structure in terms of concentration type as well as maturities. Meanwhile, there has been improved efficiency in national payment system, particularly attributable to the successful implementation of Real Time Gross Settlement (RTGS). Under RTGS, risks associated to settlement, liquidity and operations have been mitigated and are monitored in compliance with international standards, i.e. Core Principles For Systematically Important Payment System. In order to further improve efficiency and security of national payment system, future efforts shall be focused on two primary strategies, namely: (i) minimizing moral hazards and (ii) optimizing policies between security and efficiency considerations. Therefore, it is necessary to review the roles of Bank Indonesia in the operations of the payment system and as lender of last resort. In addition, there are needs for failure-to-settle mechanism in order to reduce systemic risks. In order to help promote a stable financial system, Bank Indonesia has improve the effectiveness of x

13 its roles, especially in monitoring and evaluating potential risks that may adversely affect financial stability. Bank Indonesia also has drafted a blue print on Indonesia s financial system stability including policies and framework for Crisis Resolution, which is a prerequisite for the future financial stability. Now that more defined and comprehensive policies are in place and with the effective coordination between Bank Indonesia, Government and all stakeholders, a sound and more stable financial system will be maintained and in order to encourage faster economic growth in Indonesia. xi

14 CHAPTER 1 INTRODUCTION Introduction The financial crisis that swept over Southeast Asia, Indonesia included, in 1997 has taught us a very valuable lesson concerning the importance of maintaining stability of financial system. During the past few years, financial system stability has always 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 1 and Financial Stability Forum (FSF) 2, intended to assist central banks and other supervisory authority in strengthening their financial system. Similar concerns have also been indicated by IMF and World Bank, who then introduced a Financial System Assessment Program (FSAP) in order to strengthen the financial system of the country being assessed. 3 Meanwhile, there has been increasing number of publications in the forms of books, articles and papers as well as seminars and conventions discussing financial crisis and financial system stability. In addition, there is 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 significantly exposed to high risks inherent in their operations. Therefore, financial institutions constitute one of the instability factors most harmful to the financial system. Secondly, all financial crises have brought in catastrophic implications to the economy, lowering economic growth and income. These eventually create negative impacts to social and political life if prompt measures fail to address the crisis rapidly and effectively. Thirdly, financial instability brings in very expensive fiscal cost in the course of mitigating the crisis. 1. FSI is established by Basel Committee on banking Supervision (BCBS) to assist supervisory authorities in strengthening their financial system. For further details visit 2. 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 such members from relevant authorities (finance ministries, central banks, financial supervisory authorities) from 11 countries, as well as international organizations (such as IMF, World Bank, BIS, OECD), international committees and associations (Basel Committee on Banking Supervision / BCBS), International Accounting Standard Board (IASB), International 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 FSAP is a concerted effort of IMF and World Bank which is introduced in May This program is intended to increase effectiveness in the efforts of improving soundness of financial system in member countries. For further details visit fsap.asp. In this extent, Bank Indonesia has designated financial system stability as a complimentary objective to achieve price stability. Considering the importance of financial system stability in the course of achieving the primary objectives, Bank Indonesia is to give more priority and attention to addressing this issue. In order to achieve financial system stability, Bank Indonesia has adopted four major strategies: (i) fostering effective coordination and cooperation with others; (ii) improving research and surveillance; (iii) strengthening regulations and market discipline; and iv) establishing crisis resolutions and financial safety net. These will be 1

15 Chapter 2 described in details in Chapter 2. Furthermore, the function of maintaining financial system stability is conducted by Bank Indonesia through two major activities. First, by assessing and monitoring any and all aspects affecting financial system stability. The activities under this category are attributable to crisis prevention. Second, by coordinating and cooperating with relevant supervisory authorities, particularly when dealing with crisis resolution. Assessment of the financial system stability is conducted by incorporating an early warning system to monitor and analyze trends in the macro-prudential and micro-prudential indicators 4. The economic macroprudential indicators include figures associated with economic growth, balance of payment, inflation, interest rate and exchange rate ; the contagion effects, and all other relevant factors. The 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 financial system stability and recommendations made to the government and relevant authorities to carry out actions necessary to address the matter. The analysis and recommendations are documented and publicized on regular basis by Bank Indonesia in a Financial Stability Review (FSR). The FSR has three basic characteristics: (i) assessment on conditions and current developments in the financial system; (ii) reviews are based on risks which may adversely affect financial system stability; (iii) a more forward-looking approach by presenting 4 Based on such indicators developed by IMF (Evans et al., 2002) assessments on the prospects of the financial system for the year to come. With regard to these characteristics, the format and focus of analysis of this FSR may change from one edition to the next in line with the prevailing conditions, issues, and trends affecting the economic and financial system. In general, this first edition of the FSR contains three primary subjects as described below. Firstly, the concept and practice at maintaining financial system stability as presented in a short article entitled The Importance Of Maintaining Financial System Stability in Chapter 2. This concise article discusses the definition and the importance of achieving and maintaining financial system stability, prerequisites for stable financial system, and the role of Bank Indonesia in promoting financial system stability. Secondly, external and internal factors that adversely affect Indonesian financial system stability are presented in Chapters 3 and 4. Chapter 3 contains analysis on developments in the international and national economies that may affect stability of national financial system. This chapter also discusses in more detail domestic financial issues covering foreign debts and fiscal sustainability. Chapter 4 discusses in detail the conditions, constraints and risks confronting the banking system in Indonesia. This issue is very important considering that the banking sector is the dominant player with 75% market segment in national financial system. This chapter also discusses structural issues confronting the banking system including the remaining high credit risks due to the slow pace of loan restructuring programs, the low lending growth, liquidity and market risks, and the performance of the banking industry. Chapter 5 discusses in detail capital market issues. Chapter 6 identifies recent developments 2

16 Introduction and risks in payment system with focus on Real Time Gross Settlement [RTGS] and clearing system. Chapter 7 provides the conclusion. Thirdly, it contains four articles. The first article is entitled Redesigning Indonesia s Crisis Management: Lender of Last Resort and Deposit Insurance (S. Batunanggar). This article argues fundamental issues on crisis management: (i) absence of comprehensive and clearly defined crisis management policies; (ii) the weakness of the blanket guarantee creating moral hazards and adding potential to future financial crises; and (iii) the obscure function of Bank Indonesia as Lender of Last Resort in the events of systemic crisis. To redefine Indonesia s crisis management, two primary steps are proposed: (i) to gradually replace the blanket program to limited explicit deposit insurance; and (ii) to put in place a more transparent policy regarding lender of last resort for both normal conditions as well as during systemic crisis. A more transparent LLR policy will not only function as a more effective instrument in addressing crisis management but will also put in place more defined accountability thereby increasing credibility of central bank, reducing political interventions and moral hazards, and encouraging market discipline in order to eventually encouraging financial system stability. The second article, Market Risks In Indonesian Banks (by Wimboh Santoso and Enrico Hariantoro) compares the results of CAR calculation to market risk between the standard model BIS and the alternative models, which uses the Exponential Weighted Moving Average (EMWA) both have been widely used by banking practitioners. This review is intended to measure as to how far market risk will adversely affect Indonesia s banks in terms of their capital condition. A significant decline of capital would adversely affect the stability of Indonesia s financial system. This review will give some pictures of how far banks would benefit from lower capital charge if internal model is applied. This review proves that the incentive obtained by banks will be very much dependent on the volatility of the risk factors. The higher the volatility, the higher capital charge is. Based on data on volatility of exchange rate and interest rate, this review concludes that incorporation of market risk will not reduce a bank s CAR to a level below the minimum threshold and therefore will not create distortions which would otherwise impair financial system stability. In addition, application of internal model will generate lower capital charge considering that volatility of Indonesia s exchange rate and interest rate are relatively lower. The third article, Empirical Analysis on Loan Migrations in Indonesia s Banking Sector (by Dadang Muljawan), looks into the relations between industries performance and the dynamic lending at certain banks. From the statistics, two interesting phenomena were found. Firstly, industrial performance significantly affects credit migration process. Secondly, there is an irreversible process in credit migration. This analysis will provide more analytical information for the supervisory authority in evaluating banking risks and efficacy of external oversight. The last article New Basel Capital Accord: What And How It Affects Indonesia s Banking Sector (by Indra Gunawan, Bambang Arianto, Indira & Imansyah), explores the New Basel Accord and its implications on Indonesian banking sector. 3

17 CHAPTER Chapter 2 2 THE IMPORTANCE OF MAINTAINING FINANCIAL SYSTEM STABILITY LESSONS LEARNT FROM THE 1997 CRISIS There are two most important lessons learned from the 1997 crisis. Firstly, the crisis was very complicated to resolve. And secondly, it was very costly. The fiscal costs borne by the government for restructuring problem banks is huge, at 51% of annual GDP. Indonesia s crisis is the second worst, after Argentina crisis ( ), which is 55% of annual GDP. The crisis not only devastated the national economy but also affected social and political stability in Indonesia. However, the crisis has also fostered a realization of the importance of maintaining a sound financial institutions and a stable financial market. Basically, the crisis was caused by two factors. Firstly, the weak fundamentals of Indonesia s economy coupled with inconsistent policies (internal factors). Secondly, the contagion effects of the financial crisis started in Thailand on July 1997 (external factors). In general, the financial system fragility was initiated by huge un-hedged foreign debts by corporations, imprudent lending activities, violation of the legal lending limit to affiliated parties, poor risk management and governance, and weak bank supervision. FINANCIAL SYSTEM STABILITY: WHAT AND WHY IS IT IMPORTANT? Basically, the term financial system stability or financial stability pertains to the avoidance of financial crisis (MacFarlane [1999] and Sinclair [2001]). To be more specific, financial system stability means the stability of financial institutions and financial markets in the financial system (Crockett, 1997). Mishkin (1991) defines financial crisis as disruption to financial markets where adverse selection and moral hazards worsen so that financial market is unable to channel funds efficiently to parties having the best potential productivity to invest 1. From these definitions, it can be concluded that a stable financial system will create stable financial institutions and financial markets capable of avoiding a financial crisis that may adversely affect national economic infrastructure. There are three main reasons as to why this financial system stability [FSS] is important. Firstly, a stable financial system will create trusting and enabling environment favorable to depositors and investors in investing their money in financial institutions as well as to secure interests of small depositors. Secondly, a stable financial system will encourage efficient financial intermediation which will eventually promote investment and economic growth. Thirdly, a stable 1 Adverse selection takes place prior to the choosing of a transaction when a bank would select a potential borrower with greater chances that the loan is going to become non-performing. Since adverse selection factor has great potential of becoming non-performing loans, lenders would not lend to potential borrowers which have low risks. Moral hazard occurs after the transaction, where lender will be potentially injured by borrowers which tend not to pay their obligations. Moral hazard occurs as the result of asymmetrical information in which lenders do not know much the activities of the borrowers which will allow borrowers to give rise to moral hazard. Conflicts of interest between borrower and the lender due to the moral hazard (agency problem) indicate that most lenders decide not to lend, so that lending and investment activities fail to be optimized, thus resulting in credit crunch. 4

18 The Importance of Maintaining Financial System Stability financial system will encourage an effective operation of markets and improve distribution of resources in the economy. On the contrary, an unstable financial system will bring in harmful implications, such as higher fiscal cost to resolve troubled financial institutions and decreasing of gross domestic product due to currency and banking crisis. A series of developments which took place in the past few years have placed maintenance of financial system stability as a top agenda of the central bank, supervisory authorities as well as the government, namely: (i) significant growth in financial transactions; (ii) growing number of non-bank financial institutions including the products and services they offer; (iii) increased complexity and risks in banking activities; and (iv) huge fiscal cost required to remedy the banking crisis. In addition, there are other constraints such as changes of policies, financial instruments and others faced by banking sector as well as real sector, all of which will make the duty of maintaining financial system stability to be complicated. CORE COMPONENTS OF A STABLE FINANCIAL SYSTEM The stability of financial system depends on five components which are associated one with another, namely: (i) a stable macroeconomic environment; (ii) well governed financial institutions; (iii) efficient financial market; (iv) sound prudential oversights; and (v) safe and reliable payment system (MacFarlane, 1999). Crisis may be prompted by various risks originating from the elements in the financial system. The process leading to a financial crisis is described in Box 1. Financial system stability can be maintained by improving resilience of financial institutions and money market against external volatility. A number of measures may be taken, such as by applying prudential standards and good corporate governance within financial institutions and capital markets, conducive monetary and fiscal policies, and real sector capable of promoting economic growth. Considering that internal weakness within financial institutions and fragility in capital market, crisis management policy needs to be put in place. Therefore, a safety net mechanism and contingency plan are required to address crisis. For this purpose, central banks play a very important role in maintaining stability of financial system, as well as in taking preventive and corrective actions against crisis. This is due to the fact that powers to regulate and supervise as well as to enforce policies of financial institutions are held by central bank. CENTRAL BANK S ROLE IN FINANCIAL SYSTEM STABILITY Safeguarding financial stability is a core function of the modern central bank, no less important than maintaining monetary stability (Sinclair, 2001). Both are closely correlated and affected one another. Effectiveness of financial policies will only manifest itself in an environment in which there is sound financial system because financial institutions serve as medium for monetary policy transmission. There are two major approaches generally adopted by central bank in maintaining financial system stability. Firstly, reliance on market forces and market 5

19 Chapter 2 Box 1. CAUSES AND PROCESS OF FINANCIAL CRISIS Financial crisis may originate from problems existing within any of the various correlating components within the financial system such as financial institutions, banks, non-bank financial institutions or capital market (first ring); or may be caused by one or a combination of problems within the real sector, fiscal or in the payment system (second ring). Nevertheless, a crisis may also be spark by some external factor with its contagion effect that spillover Asia in 1997 (third ring). Learning from the Asian and Indonesia crisis in 1997, instability of financial system may be occurred through three major phases (Mishkin, 2001). Firstly, impaired public confidence in the financial system. This may be caused by various problems in the economy or in financial system Figure: INTERACTIONS WITHIN A FINANCIAL SYSTEM Monetary Real Sector Financial Institutions, Markets and Financial Infrastructure International Economy Fiscal such as worsening financial condition of banks, increased interest rate, decreased share prices and increased uncertainty. Then in the second phase, impaired confidence of customers and investors toward the economy and the IDR result in the depreciation of the IDR which then prompts currency crisis. And finally, such currency crisis would entail crises of the banking sector prompted by depositors drawing up their deposits (systemic bank run) which results in liquidity problem to banks. In addition, banks would sustain losses from non-performing loans particularly those of corporations with unhedged 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, as well as social and political instability. Consequently, the Government will have to pay huge of 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 public, the taxpayers. In addition, the prolonged financial crisis will bring in adversely impacts to national economy, such as lower economic growth and output aggravated by financial disintermediation. 6

20 The Importance of Maintaining Financial System Stability discipline similar to that adopted by Reserve Bank of New Zealand. Secondly, reliance on regulations. The latter approach is adopted by wider supervisory authorities or central banks in both developed and developing countries. During the past few years, there has been growing awareness that both approaches need to be applied more consistently in order to achieve a better stability in the financial system. In practice, the definition of financial system stability [FSS] varies among central banks. Most central banks state it explicitly in their statutory regulations. But some rely on joint arrangements such as those among Bank of England, Financial Services Authority and HM Treasury. In general, the role of central banks in stabilizing financial system covers three primary activities: a. Research and surveillance Trends and risks, both internal and external, affecting the financial system need to be closely assessed and monitored. Research and surveillance activity are intended to produce a policy recommendation for maintaining financial system stability. b. Payment systems oversight Regulation and oversight are required to ensure a safe and reliable payment systems. The adverse risks to the payment system, which may lead to systemic failure and financial crisis, may be avoided. c. Crisis resolution While the latter two activities are related to crisis prevention, the third activity is taken by the central bank to address crisis when it actually occurs. Usually two instruments are used: (i) providing lending facility to the financial institutions by the central bank as the lender of the last resort (LLR); and (ii) to provide deposit insurance. LLR facilities by central bank may be given either during normal situation as well as during systemic crisis. During normal situation, such facility is provided only to address liquidity problem for illiquid but solvent banks, and with sufficient collateral. During systemic crisis, LLR facility is provided to restructure the banking system. CENTRAL BANK S ROLE IN FINANCIAL SYSTEM STABILITY Currently, there is no formal legal basis stating about Bank Indonesia s function in maintaining financial system stability. The function, in fact, is performed simultaneously with its core tasks of performing monetary policy, bank supervision and payment system. Following the 1997 crisis, there has been growing awareness in the importance of maintaining financial system stability. In line with the introduction of Law No. 23 of 1999, Bank Indonesia incorporates the financial system stability aspect in its mission: to achieve and maintain stability of the Indonesian rupiah through maintaining financial stability and promoting of financial system stability for sustainable national development. In line with its mission and vision, Bank Indonesia has formulated a framework that contains the goals, strategy and instruments required for maintaining the financial system stability. The roles of maintaining monetary stability and promoting financial system stability are closely related. 7

21 Chapter 2 Both roles are aiming at the same objectives which is price stability. In order to achieve a stable financial system, Bank Indonesia adopts four strategies, namely: (i) implementing regulation and standards to foster market discipline; (ii) intensifying research and surveillance; (iii) improving coordination and cooperation; and (iv) establishing safety net and crisis resolution framework (see Box 2). CONCLUSIONS Stability of financial system much depends on the soundness of financial institutions, particularly banks that dominate the financial system. This will also rely on the effectiveness bank supervision. Therefore, it is imperative to have an independent and competent bank supervisor capable of assessing bank risks and taking preventive and corrective actions on the problems faced by banks effectively. To achieve a stable financial system, effective coordination must be in place among relevant authorities. Therefore, there must be a clear division of roles and responsibilities of each authority. More importantly is the commitment of the stakeholders to cooperate in achieving and maintaining financial system stability. In addition, effective supervision and consistent law enforcement will foster market players and the general public to play their roles responsibly. 8

22 The Importance of Maintaining Financial System Stability Box 2. BANK INDONESIA S STRATEGY IN MAINTAINING FINANCIAL SYSTEM STABILITY In order to achieve financial system stability, Bank Indonesia adopts four strategies: (1) Implementing regulations and standards. Consistent implementation of international prudential regulations and standards are required as a sound basis for both regulator and the market players in conducting their business. In addition, consistent discipline of the market players need to be fostered. (2) Intensifying research and surveillance. Development of financial system the relevant aspects 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 macroprudential indicators. Research and surveillance are aimed at producing a policy recommendation for maintaining financial system stability. (3) Establishing 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 Financial System Stability (FSS) Framework BI s Mission FSS Objective Achieving and maintaining the stability of Rupiah value by maintaining monetary stability and promoting financial system stability for sustainable national development. An active involvement in creating and maintaining a sound and stable national financial system. FSS Strategies Implementing Regulation & Standards Intensifying Research & Surveillance Establishing Financial Safety Nets & Crises Resolution Improving Coordination & Surveillance Instruments Regulation & Standard e.g Basle principles, CPSIP, IAS, ISA, dsb. Market Discipline Early Warning Systems Macro prudential Indicators Micro-Prudential Indicators (aggregate) Lender of last resort - Normal - Systemic Crisis Crisis Resolution - Safety Nets - Internal Coordination External Coordination & Cooperation 9

23 Chapter 2 a clear legal framework for crisis resolution. According to Law No. 23/1999, Bank Indonesia is only allowed to provide lending to address liquidity problem faced by banks during normal times, but not for systemic crisis situation. Therefore, there is an urgent need to formulate this policy in the law which clearly stipulates the roles of Bank Indonesia as the lender of the last resort in the events of crisis. (4) Improving coordination and cooperation. Coordination and cooperation with related gencies is very crucial especially in crisis times. Usually, the coordination was formed in a national committee which is composed of the Bank Indonesia Governor, Finance Minister and related agencies including the Head of Deposit Insurance Agencies to be established. 10

24 CHAPTER 3 EXTERNAL FACTORS External Factors INTERNATIONAL ECONOMY Along with globalization in economics, Indonesia s financial system will be affected by instability in regional and global economies. It occurs through international trade and money market channels. During the last few years, global economy tends toward a downturn condition. This is provoked by decreasing economic performances of the industrial countries in the world, namely the United States and Japan. Ultimately, this situation will influence Indonesia s financial system considering that the United States and Japan are the largest markets for Indonesia s exports. Indonesia s trade account states with the United States and Japan reach 17.44% and 22.99% respectively of total exports. In addition, both countries are also primary lenders. The slowdown condition of those industrial countries is expected to continue (2) (4) (6) GDP (Percent) FIGURE 3.2: US and JAPAN : GDP-INFLATION following terrorists attacks at some places within the United States in The declining economic conditions of these two major economies was indicated by decreasing Gross Domestic Products (GDP), increasing in inflation, and the current account deficit. Inflation (Percent) GDP-US GDP-Japan Inflation-US Inflation-Japan (1) (2) Percent FIGURE 3.1: NON-OIL AND GAS EXPORTS By COUNTRY OF DESTINATION U S ASEAN Japan (20) (40) (60) (80) (100) (120) (140) FIGURE 3.3: US andjapan : CURRENT ACCOUNT Miliar USD U S Japan 11

25 Chapter 3 At the end of 2002, United States and Japan s GDP slightly increased by 2.1% and 0.5% respectively. This was mainly due to the lower discount rate policies introduced by monetary authorities of both countries. Compared to , their GDP in 2002 has not fully recovered and monetary authorities continue their low interest policies. The fact that both economies were not improved in 2002 caused Indonesia s exports to decrease. This adversely affect borrower s financial performance which will eventually cause a negative impact on banks assets quality FIGURE 3.5: DIRECT AND PORTFOLIO INVESTMENTS Million USD Million USD Direct Investment Portfolio Investment truly bring negative impacts to the money market due Figure 3.4: US and Japan : Discount interest Rate and DJIA & NIKKEI Indices Percent U S Japan DJIA NIKKEI 25,000 20,000 15,000 10,000 5,000 The continuing recession in United States and Japan also affects their capital markets adversely. This was illustrated by the fall in composite indices of the Dow Jones and Nikkei. In fact, such conditions should have encouraged capital inflows to Indonesia. Unfortunately, it is not the case, since Indonesia s investment environment is not yet conducive, as evidence by a decision of a restructured corporation in Japan to close their factories in Indonesia. Such policies to the decreasing of bank s lending portfolio in respect to Japanese corporations. DOMESTIC ECONOMY Monetary Conditions During 2002, monetary condition is quite conducive as reflected by lower interest rate and stability of exchange rates. Hopefully, such condition will prevail so as to stimulate economic growth in Unlike the condition in 2000 and 2001, the SBI interest rate tends to decrease in This condition indicates that Bank Indonesia has started to ease its monetary policy as inflation rate is still in control, while the rupiah exchange rate remains relatively stable. However, the lower trend of SBI interest rate is not immediately followed by a reduction in lending rates. The declining trend of SBI interest rate will hopefully encourage more lending to real sectors. In spite of such increase in lending, the amount is relatively small and is mostly given to small and medium enterprises. This reflects banks caution in lending and 12

26 External Factors 14,000 12,000 10,000 8,000 6,000 4,000 2,000 the low level of absorption by corporations due to ongoing restructurings. The lower interest rate in fact is not followed with migration of third party capital to capital market or property sector. However, there are indications that banks third party funds have migrated to mutual funds FIGURE 3.6: DOMESTIC ECONOMIC INDICATORS Rp/USD JCSI FIGURE 3.7: JAKARTA COMPOSITE and PROPERTY SECTOR INDICES Percent Exchange Rate SBI (%) Interbank (%) Credit /GDP Ratio (%) Jakarta Composite Stock Index Property Stock Index 2003 PSI relatively secure. 6 However, we can expect to see further pressures in fiscal during 2003 and 2004, particularly in connection with budget deficits. Debt to GDP ratio decreased from 88.4% as of June 2002 to 70.4% as of December However, Indonesia s debt ratio was much lower than that of other countries such as Argentina (49.4%), Mexico (69.1%) and Turkey (54.2%) before these countries descended to financial crisis. If the debt is not carefully managed, debt crisis will adversely affect balance of payment and financial performance of the Government. Eventually the condition will also adversely affect financial system stability. One potential issue for the government is refinancing of government bonds (refinancing risks), considering the huge amount of the bonds to mature within a few years (IDR 36.3 trillion in 2004 and IDR 45.8 trillion in 2007). Maturity dates of government bonds prior to and after re-profiling is shown in Figure FIGURE 3.8: MATURITY PROFILE OF GOVERNMENT BONDS 0 Trillion Rp Before Reprofiling After Reprofiling Government s Finance Bank Indonesia s review on medium term fiscal resilience indicates that fiscal condition is 6 Policy Analysis and Planning Division (2002), Indonesia s Medium-Term Fiscal Sustainability. 13

27 Chapter 3 Government Bonds From the Government Budget [APBN] simple stress test, re-profiling of Government bonds has not fully taken pressure off the government financial condition. There are potentials for budget deficit which will eventually adversely affect the government s ability in paying principal and interests of government bonds. In order to address the obligation to pay principal and interest of maturing government bonds, issued in connection with banks re-capitalization program, the Government restructure of maturities and interest rates of the government bonds. As for an initial step, the government re-profile the government bond in 4 State- Owned Banks portfolio involving a sum of IDR 22.8 trillion. By considering the process and other fiscal assumptions, the stress test shows a negative difference between new debt and maturing debts at 1.37% of GDP or amounting to around IDR 29 trillion in The condition needs to be resolved with another re-profiling and other strategy such as conducting buy back, boosting additional income from selling assets etc. On the other hand, re-capitalization banks should work in sectors and economy. Sound and liquid government bond market will help government in reducing refinancing risks and arranging bonds maturity profile. % of GDP Table 3.1 Stress Test on Goverment budget (APBN) APBN RAPBN RAPBN State Revenues State Expenditures Primary Balance Surplus (+) / Deficit (-) A. Financing of Government Debentures 1. Maturing Government Debentures Reprofiling of Government Debentures at 4 State-Owned Banks Sub Total B. Overseas Borrowings a. Program Loans b. Project Loans Sub Total C. Installments of Overseas Loan Principal Financing (A+B+C) Maintaining the government s ability to pay recap bonds principal and interest at maturing date is critical. Bonds sold at high discount rate may reflect an overcrowded of bonds in similar maturity, investors efficient manner and also improve their capital by this means reducing dependence on government financial FIGURE 3.9: Fixed Rate GOVERNMENT BONDS vs SBI support. 120 Government Bond Price S B I (%) 18 A developed and efficient government bond market will encourage liquidity. The liquidity is needed to further improve market confidence and capability reduce risks if there is negative shock to the market Otherwise, market participants will rely on Bank Indonesia s liquidity support when crisis occurs. The role of Bank Indonesia should be limited only in crisis condition which have systemic impact to the financial 20 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Average Fixed-Rate SBI 1 month