Banking Soundness and Monetary Policy


Charles Enoch, and J. Green
Published Date:
September 1997
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Governor Djiwandono’s presentation demonstrates the very considerable progress that Indonesia has made over the past fifteen years to develop a competitive banking system. Key steps include the abolition of ceilings on bank interest rates and lending activities from 1983; the liberal granting of licenses for new banks from 1988; and the implementation of a modern prudential regulatory and supervisory system from 1991.

The measures were entirely consistent with the needs of a rapidly expanding economy that is largely free of controls on current and capital international transactions. While the authorities adopted a gradualist approach—despite the more advanced financial structures that were in place in some neighboring ASEAN countries—their pursuit of reforms has strengthened the banking structure and enhanced the role of Jakarta as a financial center.

These comments focus on three aspects of the reforms, each of which has implications for other emerging market economies. First, the linkage between macro stability and banking soundness, especially the possibility of overheating because of excessive credit growth. Second, the benefits of a well-developed regulatory framework, including transparency to promote market discipline. Third, the outstanding issues that need to be addressed to enhance bank soundness, including methods to deal with problem banks.

Macroeconomic Stability and Banking Soundness

The Indonesian authorities have pursued prudent financial policies and structural reforms for the past three decades. This has helped to secure annual real GDP growth of 7-8 percent, with low inflation and a sound external payments position. Indonesia’s banking system has clearly benefited from this, reinforcing a key lesson that banking sector crises can generally be avoided in the absence of serious macro-economic imbalances.

Savings and investment in excess of 30 percent of GDP contributed to the impressive growth performance. Notwithstanding recent growth of the equity and securities markets, intermediation conducted through the banking system remained high, as in other emerging-market countries. Bank deregulation promoted efficiency and lowered transaction costs, facilitating better terms for savers and more efficient allocation of investable funds.

The authorities recognized early that the scope for direct controls and government intervention would become circumscribed as reforms were implemented. Some indirect instruments of monetary control were introduced, including central bank certificates to permit open market operations. However, the authorities continued to rely also on moral suasion to restrain credit growth.

Another problem was that the quality of loan portfolios deteriorated, as banks gave inadequate attention to risk appraisal. State-owned banks continued to lend in response to political direction; private banks established by industrial conglomerates provided intragroup finance; and many banks expanded lending to the real estate sector. The difficulties were initially masked by an easy monetary stance, but were exposed when monetary conditions were tightened and higher interest rates led to an increase in nonperforming loans.

Indonesia’s experience in the 1980s does not suggest, however, that reforms were premature or too fast. Rather, it underlines the need to develop concurrently with liberalization effective market-based instruments of monetary control and prudential rules to prevent unduly rapid credit growth or risk taking that could undermine banking soundness.

The openness of Indonesia’s financial markets contributed to large increases in foreign private capital inflows during the 1990s. This further underscored the importance of banking soundness to reduce the possible impact of external shocks, especially the need to contain foreign exchange risk.

Bank Regulatory and Supervisory Framework

Bank Indonesia’s capacity to prevent banking problems was greatly enhanced with the adoption of prudential rules and the reorganization of its own supervisory departments in the early 1990s, in accordance with IMF recommendations. Measures included limits on lending to individual borrowers and net open foreign exchange positions, more stringent internal audit procedures, the adoption of higher minimum capital requirements and capital adequacy rules that exceed the Basle standards, and the use of a CAMEL-type rating system to detect stress in banks. As a result, the nonperforming loans of the banking system have been reduced over the past several years.

Nevertheless, a generally satisfactory regulatory system does not by itself ensure banking soundness; it is crucial that, in addition, supervisors have sufficient authority to ensure observance of the agreed standards. In particular, they must be able to undertake the comprehensive evaluation of bank assets to assess solvency and determine that problems are not concealed by poor accounting practices. While the extent of nonperforming loans has been contained in Indonesia, the classification system may still mask the quality of credit portfolios, including restructured loans.

The regulatory system must also be continuously updated and adapted to meet evolving needs. Refinements in Indonesia might include better monitoring of risks associated with new banking products, including options and derivatives, and regulation of those financial institutions affiliated with banks that may be used to circumvent prudential rules. Another issue is how to provide greater incentives for improved behavior by bank managers, in combination with penalties for the failure to fulfill their legal responsibilities, so that greater self-regulation reduces the need for central bank control. Transparency and disclosure are key mechanisms to change the incentive structure for better performance, and the New Zealand experience (see Chapter 16) provides useful guidance.

Remaining Issues

A key challenge now facing Bank Indonesia is how to take firm control over the resolution of problem banks. In the past, the clear expectation that the authorities would not allow failures reduced the impact of market forces. The policy of nursing weak banks created opportunities for lending without due regard to risk assessment and raised concerns that the impact of tighter policies on their cost of funds and loan portfolios could delay policy actions, as well as undermine the fiscal position. Regulators should strive for market-friendly rules that allow competitive banks to prosper and avoid favoring particular institutions or protecting the weak.

A welcome initiative was the issuance in December 1996 of the presidential regulation containing detailed procedural guidelines for the closure of banks. A firm bank exit policy—with protection for small depositors—will eliminate deficiencies in the internal governance of banks and moral hazard by allowing the central bank to modify its role as a guarantor. The Polish experience (see Chapter 14) demonstrates the benefits that accrue from adopting a clear exit strategy for deficient banks.

Competition in the banking sector is still constrained by the support for state banks and restrictions on the operations of foreign banks. The government’s backing of state banks creates an uneven playing field; divestiture of shares in one of the largest state banks in late 1996 was a success and opportunities for further sales should be exploited. Removal of the limitations on foreign ownership of local banks and on the branch structures of foreign banks would further promote the development of a fully efficient banking system. However, now that steps have been taken to improve the prudential system, the optimum structure of the banking system will best be determined by market forces.

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