THE 3 rd Annual Conference From the Breakdown of the Bretton Woods System to a New Era of Macro Prudential Oversight?

THE 3 rd Annual Conference From the Breakdown of the Bretton Woods System to a New Era of Macro Prudential Oversight? SESSION VII: THE QUEST FOR A NEW ERA OF MACRO PRUDENTIAL OVERSIGHT BUDI MULYA DEPUTY GOVERNOR of BANK INDONESIA A conference hosted by Reinventing Bretton Woods Committee and Central Reserve Bank of Peru CUSCO, July 18-19, 2011 First of all, let me thank the Central Bank of Peru and the Reinvesting Bretton Woods Committee for inviting me to join this strategic conference. I am both delighted and honor to exchange views amongst distinguished speakers, experts and authorities in discussing the most intriguing issues subsequent to the most recent global financial crisis. I believe that this two days dialogue, that address themes ranging from the debate around international monetary system, exchange rate regime to the conduct of healthier macroeconomic policy in general, will eventually give us a concrete benefit in better handling the individual as well as global economy in the future. In this very special occasion, I would like to share some of my views, by firstly, highlighting some aspects characterizing the macro prudential oversight issue, before touching base on Indonesia s experience and perspective. Introduction: Highlights from the Recent Global Financial Catastrophe On the aftermath of global financial system in 2008, the term macro prudential has become one of the major themes among the world economic policy makers, as well as academicians. Despite no clear agreement on its definition thus far, its area of concern is more obvious. Thus, its substance and scope can be seen as somewhat converging. The focus area of macro prudential is referring to an effort to ensure the stability of macroeconomic condition by preventing serious disruption in financial system stability. In this respect, one of the mounting issues is that central bank has to be confronted with supposed to be more explicit and wider scope of responsibility compare with its common mandate which is price stability. In particular, the challenge for the central bank is with regard to the so-called asset price bubble phenomenon. From my perspective and as a self corrective point of view, what has been occurred recently is, partly, attributed to the excessive reliance of authorities on assumption of effectual market discipline and the believe that economic agents, financial market players in particular, will 1

truly execute reasonable risk management practice. Some may view that this is as an inherent consequence of the typical central bank approach of can t lean but can clean practice (White, 2009). However, it is un-doubtful evidence that the current approach has resulted to the society has to bear too expensive cost of stabilization. Other aspect that also emerges from the recent global financial crisis is the factual tendency of misused of some financial market instruments. That is, derivative transaction for instance, that supposed to be a tool to reduce risk turns out to add risk. The main lesson learnt from the 2008 catastrophe is that authorities, central bank in particular, can no longer respond merely by cleaning up when things go wrong. However, to do so, it is also acknowledged the need to have a kind of adjustment in political consensus with regard to the central bank mandate. This because to be able to shift from a practice of preemptive easing into preemptive tightening, central bank has to be confronted with a sort of tested or assumed indicators to act. A situation where the cost of doing so, most likely, will dominate its potential benefit. At least, from public perception. In all respects, the recent focus of macro prudential issues are falling into effort to seek out convincing indicators that could reveals weaknesses or potential distortion to financial stability, as well as to find the most probable instrument of policy mix to mitigate risk without putting additional cost to the price stability. Thus, in short but broader sense, it becomes a big challenge for the authority to accomplish a healthier and more sustain economic growth. The key would be how to ensure the prudent practice of financial market and economic activities in general. In essence, these acknowledgements have also become a great challenge for authority s, especially for central bank, to improve their competency. Also, to have more explicit collaboration framework among relevant domestic authorities. As well as to have a more concrete regional and global cooperation. I would like to also highlights the central bank role in terms of the inter-linked between monetary stability mandate and financial stability matter. This particularly refers to the necessity to redefine the old terminologies that classically viewed as an inherent role of a 2

central bank. They are lender of the last resort function; banking liquidity ratio ; and liquid assets as central bank s eligible collateral. With regards to the first issue, the so-called illiquid but solvent bank/financial institution seem no longer serves as a clear guiding principle. This was as shown particularly from what major central banks has been taken during the peak of the 2008 crisis, where the looks like a problem of illiquid banks/financial institutions has been argued by many observers that the problem was actually more serious, tended to as a solvency problem. Further, its difficulty also in relation with the systemic criteria, which its meaning can be varied considerably in different situation. For this particular issue, despite that the rule of constructive ambiguity has to be kept in place, there should be available more common acceptable systemic criteria. On the issue of liquidity ratio and its corresponding liquid assets, there is clearly a need to revise the definition of the so-called liquid assets, in which it commonly refers to the risk-free assets, considering the recent debt market crisis in some regions. From the recent sovereign debt crisis in some countries, there is a rising concerns that the government debt is no longer considered as a risk free assets in a certain circumstance. Thus by substance, can no longer serve as a liquid assets both from their valuation perspective, as well as their exchangeability into cash. Accordingly, the valuation of the so-far commonly considered as a liquid asset has to also need to consider market development. Of course, this should be carefully taken without necessarily trigger further panic selling. But, more importantly is to encourage banks or financial institutions to have their own version of scenario to deal with liquidity problem. Indonesia Experience: Coping with a macro prudential issues The Indonesian economy and financial industry can be considered less develop compare with what in some major countries, including those of among G-20 members. However, Indonesia has been experiencing structural changes since more than a decade. Indonesia is now entering a transition period within a more growing democratic environment. From macroeconomic framework perspective, what is now happening in Indonesia is a foundation mostly inherited by the 1998 crisis. A period that gave a concrete hard lesson learnt for Indonesian people in handling the crisis. 3

The major lesson for us is that macroeconomic policy, fiscal and monetary, must be consistently held prudently. Then, it is followed by the need to establish a more explicit national framework of crisis prevention and resolution scheme. However, the later is proven to be somewhat easier to be said than done. The plan of the so-called financial safety net law has been as an explicit mandate since the establishment of the new central bank law in 1999. Yet, the law is available until today. In the meantime, the governor of the central bank and the ministry of finance signed a Memorandum of Understanding (MOU) as a bridging legal arrangement. As a legal base, this MOU has proven to have a weakness in dealing with the banking/financial distress, as can be seen in 2008/09 crisis period. Despite that the Indonesia s economy as well as its financial industry, including the banking sector can be fairly judged as sailing well during the peak of the recent global turmoil, the crisis has highlighted some urgent agendas must be addressed. In particular, the need to strengthen domestic financial market and to consistently adopt a stronger banking and financial market prudential policy. This includes effort to have a better monitoring system with regard to overthe-counter financial market transaction. In respond to the negative impact of the most recent global financial crisis, some measures have also been taken aiming at maintaining money market stability, to avoid spreading panic among banking sector in the wake of counterparty risk and highly uncertain global environment. Those measures were apart from monetary policy perspective in which Bank Indonesia reduced interest rate of 300 bps, from 9.50% to 6.50% during December 2008 to August 2009 period. In this regards, Bank Indonesia s measures mainly took form of loosening the inter-bank money market liquidity tightness. These were done by reducing the required reserve ratio for both domestic and foreign currency, as well as lengthening the maturity of repo instrument. During the peak of the global crisis, Bank Indonesia viewed that it was important to maintain the smooth correction in the foreign exchange market. On this area, Bank Indonesia undertook symmetrical foreign exchange intervention. This was done for the purpose of maintaining confidence and by taken into account the memory of the 1997/98 currency crisis which still relatively attached to some of domestic mindset. 4

As the global economy entering the recovery path, and the implication of global imbalance observed to become more materialize, Bank Indonesia decided to undertake further policy mix. This was done by combining the traditional monetary policy tools and the recently known as part of macro prudential measures. The policy mix was calibrated by taking into account the increase policy choices complexity, brought by the rapid global capital inflows into the emerging markets. In principle, all measures, including some tactical modification of central bank s liquidity management instruments, are aimed at: o avoiding excessive risk taking, both from domestic and foreign investors; o preventing exchange rate from extreme volatility; o enhancing and strengthening banks liquidity risk management; and o increasing the effectiveness of monetary management, while simultaneously deepening and increasing the liquidity of domestic financial market Those measures include: o Imposing a certain period of holding requirement in central bank s bill ( SBI ) instrument (one month holding period, and recently lengthened to six months); o Lengthening the duration of absorption surplus liquidity in the inter-bank money market, by lengthening the maturity of SBI (recently up to 9 months); o Enlarging portion of non-tradable liquidity absorption instrument (term-deposit); o Raising reserve requirement (RR) for both domestic and foreign currency, which in principle part of the normalization of the policy respond during the crisis, and o Introducing RR linked to loan-to-deposit (LDR) start in March 2011. Commercial Banks LDR will be within 78%-100% ratio. This RR-LDR is specifically aimed at maintaining banks lending practice within prudential corridor area. As part to this RR-LDR policy, Bank Indonesia will closely monitor the type and the quality of the bank lending. In addition, Bank Indonesia has also taken measure to enhance consumer protection to increase public risk awareness with regard to banking products. Certainly, one important issue derived from the recent global turmoil is how the authorities can precisely put the traditional central bank policy tools into more explicit inter-linked among banking/financial institution, financial market stability and the rest of the economy. From 5

practicality perspective, it is also important to have better clarity in the role of each domestic relevant authority, as well as their coordination mechanism. With respect to macro prudential oversight, the crucial part would be effort to find the most relevant indicators and to arrive at a common perception amongst relevant authorities, both in terms of macroeconomic and financial stability perspective. In some developing economies, in particular with immature financial market, the search might become even more challenging. In Bank Indonesia specific case, the challenge becomes more intense. In the midst the increasing awareness of the need to enhance coordination, Bank Indonesia s banking supervision function has to be transferred into the new financial supervision institution as mandated in the central bank law. This reasonably will require a new set of a more complex coordination. Finalization of the new financial sector supervision body is so far under discussion by the parliament. Another possible constraint that can be derived from recent experience is that by existing law, Bank Indonesia has no explicit function to address financial stability or in a broader sense, to conduct macro prudential oversight. It also becomes more and more crucial to enable a more effective collaboration with other country s authorities, both in regional and global. This collaboration is important not only in terms of developing better surveillance method, but also in aligning the course of policy response execution. However, again, it is crucial for to arrive first at the clarity role of each relevant domestic authorities, as well as the mechanism of information sharing and coordination. Despite the need to improve mechanism to become a more executable framework, regional coordination within Asia region has been a notable improvement in recent years. So far, closer coordination within the technical level is also important, particularly in the area of financial market monitoring and financial institution/banking sector supervision. The establishment of Asean+3 Macroeconomics Research Office (AMRO) on May 4, this year, is a form of regional cooperation step to strengthen the East Asian region economic surveillance and expected to provide a more timeliness and accurate surveillance for the region. The AMRO is intended to further support the operational of regional cooperation, such as Chiang-Mai 6

Initiative Multilateralism (CMIM), and also can be considered as a complement to the multilateral collaboration. In addition, in face with a more integrated financial sector and to maintain financial stability in Asia region, recently the regional cooperation is also focusing toward effort to enhance the regulatory and banking/financial institution supervisory coordination and harmonization. What emerging market learns from what were in advance countries is that developing financial market has to be closely and carefully guided so as to serve a more sustain economic development. In this respect, it is crucial to ensure that financial market has to be linked closely with real economic activity in a more balance way, and that cheap borrowing cost is not always represents the efficient economic financing. Challenge Ahead Although macro prudential tools have already been acknowledged as part of the central bank s traditional responsibility, there is a proven evident from the recent global financial catastrophe that they cannot adequately address system-wide risk. Thus, the current financial system oversight needs to be enhanced to broader capture the possible risk inter-linked within the whole economy. To do so, it unarguably requires improvements in governance arrangement to better incorporate the principles of independency and objectiveness, as well as clarity and accountability for every relevant authority. This clarity of responsibility and coordination mechanism has become more crucial. The effort to maintain macro prudential stability is actually a shared responsibility as it deals with a broader risk into the whole economy. Thus, a better workable oversight macro prudential framework amongst relevant institution is required. This principle should be put above the issue of separation or share of responsibility among authorities within any single country. As the economy and financial market has increasingly inter-linked globally, it is also crucial to have a more executable and more efficient mechanism of coordination of macro prudential policy among authorities in the region, as well as globally. This objective has to become the main orientation of various international forum and initiatives. Although, there may be a 7

reasonable country specific consideration at the implementation stage. To this respect, we welcome and fully support the on-going initiatives and works on macro prudential policies, which primarily focus on ensuring the healthy banking and financial market practice, taken by IMF, BIS, and FSB as requested by G-20 Leaders. In addition, from global perspective focus should also be put into the root cause of the recent global problem. Since its implication for emerging market, such as in a small open economy like Indonesia, is critically linked with the excessive global liquidity phenomena. In this regard, partial approach will not only be incorrect, but also will be not effective. Thus, it requires stronger conviction and a more concrete solution to address this specific issue of global excess liquidity. As the global economic recovery will take years ahead, and accordingly adjustment in global financial market will also take a long process, the risk of still vulnerable global financial market need to be carefully monitored. On this regard, one urgent aspect need to be dealt with is, to have a stronger global SIFIs oversight, and Asian region need to involve more actively in this SIFIs supervisory. Also, Asia region need to identify their regional SIFIs and to effectively jointly monitor them. Finally, as part of regional macro prudential oversight collaboration, Asia region has also reasonably need to have its own regional crisis prevention facility scheme to reduce the likelihood of the contagion effect of crisis to emerge in the region. However, to be able to effectively serve as a crisis prevention mechanism, this regional arrangement should be developed in a more efficiently executable structure. 8

References: Bank for International Settlement (BIS). Central Bank Governance and Financial Stability. A Report by a Study Group. May 2011. Bank for International Settlement (BIS). Macroprudential instruments and frameworks: a stocktaking of issues and experiences. Committee on the Global Financial System (CGFS). Paper No. 38. May 2010. Bank Indonesia. The Central Bank Law. The Law No. 23/1999, as in the latest amendment of the Law No. 6/2009 of Bank Indonesia. Bank Indonesia. Press Release. Various editions. Kawai, Masahiro. Working together for Asian Financial Regulation and Stability. A presentation at ADBI- OREI Joint Seminar, Asian Development Bank (ADB) Annual Meetings. Hanoi, Vietnam. 4 May 2011. Mishkin, Frederic S. How Should Central Bank Respond to Asset-Price Bubbles? The Lean versus Clean Debate after the GFC. An article written as a visiting scholar at the Reserve Bank of Australia. June 2011. Mulya, Budi. Managing Risk in the New Landscape. Address at Banker Association for Risk Management (BARa) seminar on Managing Risks in Uncertain World, Jakarta. 26 October 2009. Mulya, Budi. The Need to Strengthen Indonesian Financial Market. A speech delivered at Japan International Cooperation Agency (JICA) Seminar on The Challenge in Developing Indonesia s Financial Market, held in Nikko Hotel, Jakarta. 11 December 2009. Nasution, Darmin. Global Imbalances, Volatile Capital Inflows and Proposed further IMF Roles. An article in Banco de France - Financial Stability Review No.15. February 2011. Osinski, Jacek. Macroprudential Policy What an Animal is That?. Advisor, Monetary & Capital Markets Department, IMF. A Presentation at FSB-IMF-BIS Roundtable on Macroprudential Policy, Basle. 21-22 June 2011. Shin, Hyun Song. Macroprudential Policies Beyond Basel III. A Policy Memo. Princeton University. November 2010. Takagi,Shinji. Responding to Currency Crises in Emerging Market Economies: The IMF in Indonesia, Korea, and Brazil. Advisor, Independent Evaluation Office, International Monetary Fund (IMF). November 2004. Vinals, Jose. The Do s and The Don ts of Macroprudential Policy. IMF Financial Counsellor and Director, Monetary and Capital Markets Department in European Commission and ECB Conference on Financial Integration and Stability. Brussel. 2 May 2011. White, William R. Should Monetary Policy Lean or Clean?. Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute, Working Paper No. 34, August 2009. 9