This Selected Issues paper assesses Indonesia’s trade integration relative to underlying country characteristics. The paper analyzes Indonesia’s vulnerabilities, especially compared with the eve of the crisis in 1997. Various indicators suggest that the underlying fundamentals are significantly stronger. The paper examines key features of the financial safety net (FSN) in view of international standards and concludes that the current system is capable of timely addressing bank problems. It looks at determinants of, and constraints to, credit growth in recent years.

Abstract

This Selected Issues paper assesses Indonesia’s trade integration relative to underlying country characteristics. The paper analyzes Indonesia’s vulnerabilities, especially compared with the eve of the crisis in 1997. Various indicators suggest that the underlying fundamentals are significantly stronger. The paper examines key features of the financial safety net (FSN) in view of international standards and concludes that the current system is capable of timely addressing bank problems. It looks at determinants of, and constraints to, credit growth in recent years.

IV. Building a Financial Safety Net in Indonesia27

The introduction of a financial safety net (FSN) in Indonesia was completed in March 2007 with the phasing-out of the blanket deposit guarantee introduced at the time of the crisis. The FSN is aimed at preventing financial instability by clarifying responsibilities in the provision of lender-of-last resort facilities, the administration of the explicit limited deposit protection, the management of bank resolution processes, and the monitoring of systemic risks. Next steps include improving information flows, eliminating overlaps, and enhancing legal certainty.

A. Background

60. The absence of a preventive framework prior to the 1997-98 financial crisis contributed to its severity. In the decade prior to the crisis, financial liberalization resulted in easy entry of new participants and inadequate exit provisions for failed institutions. Over time, governance problems in the corporate and banking sectors became widespread in the context of poor enforcement of prudential regulations. In handling the crisis, weak institutions, the absence of a preventive framework, and protracted delays in implementing measures conspired against generating public trust in the authorities’ plans.

61. Specific problems related to the absence of an FSN during the crisis were the following:

  • Weak prudential regulation and supervision did not allow for a timely identification of bank problems. Serious institutional and governance shortcomings hampered the effectiveness of prudential monitoring. Once the extent of delinquent loans and connected lending became evident, it was found that “state banks had been used as vehicles for directed lending to noncommercial ventures, and private banks as vehicles for channeling deposits to the owners.” 28

  • Difficulties in distinguishing between illiquid and insolvent banks led to an indiscriminate use of Lender-of-Last-Resort (LOLR) facilities. Once problems erupted, Bank Indonesia (BI) provided massive liquidity support without being in the position to discern between illiquid and insolvent institutions. By mid-1998, the use of BI’s Lender-of-Last-Resort Facility (BLBI) reached the equivalent of 14 percent of GDP, mostly extended against personal guarantees (in the absence of usable collateral), in a process plagued with irregular practices.

  • The absence of a framework for the provision of deposit guarantees contributed to depositors’ uncertainty. Limited ad-hoc deposit refunds applied to closed banks failed to inspire confidence.29 By the time a bank-restructuring plan based on a blanket guarantee was introduced, a large share of deposits had already been moved out of the domestic banking system.

  • undue delays in making and implementing decisions regarding bank restructuring led to higher than necessary loss of banks’ asset value. Although a bank resolution package was announced at the beginning of November 1997, Indonesia introduced a bank restructuring process only in January 1998, managed by the Indonesia Bank-Restructuring Agency (IBRA), a combined bank-restructuring and centralized public asset management agency. That stopped the drain of deposits, but the costs in terms of fiscal resources reached about 40 percent of GDP. IBRA itself did not always manage the process in a timely manner.30

  • An unclear allocation of responsibilities in the absence of an appropriate legal framework, led to inconsistent decisions in handling banks’ failure. For example, the authorities’ reluctance to close banks that later proved insolvent led BI to turn LOLR outstanding obligations into long-term low-interest subordinated loans. On banking resolution, the absence of legal liquidation provisions specific to banks slowed down unnecessarily the recapitalization of problem banks.

62. Following the crisis, the authorities decided to introduce a preventive framework in the form of an FSN supported by an explicit limited deposit guarantee.31 The 1998 banking law already anticipated the introduction of a deposit guarantee scheme, and revisions to the central bank law in 2004 facilitated the re-introduction of LOLR capabilities for BI. The latter had been removed in 1999 following BLBI mismanagement problems. The intended purpose of the FSN was to establish the roles of different institutions (BI, Ministry of Finance, Deposit Guarantee Agency)in the monitoring of systemic risks and the handling of financial problems. With the introduction of the FSN, ad-hoc arrangements are not necessary, and therefore fewer opportunities forpolitical interference are available. Other countries in the region also moved towards introducing FSNs, with features consistent with the specific situation of their financial systems (Box IV).

Financial Safety Net: International Experience and Regional Developments Following the Asian Financial Crisis

Financial safety nets in different countries have evolved in line with specific financial and institutional circumstances. In the US, the disastrous savings-and-loans experience in the 1980s motivated stricter FDIC regulations and provisions for Federal Reserve emergency lending. In the EU, major bank failures (BCCI in 1991 and Barings in 1995) led to agreement on a basic framework to resolve financial institutions and their branches as a single entity (2001 Directive on the Reorganization and Winding-Up of Credit Institutions). In Japan, the banking resolution framework has been revised several times to incorporate lessons from the prolonged experience in dealing with troubled banks. In Australia, a highly concentrated banking system has allowed authorities to handle bank failures case-by-case, but the government has plans to introduce formal procedures for handling bank distress.

The Asian crisis influenced decisions regarding the FSN in several countries in the region:

  • Some pre-existing FSN arrangements were used at the time of the crisis. Korea used extensively the emergency liquidity assistance facility. The Philippines, where the impact of the banking crisis was relatively mild, basically maintained the deposit guarantee scheme instituted in 1963.

  • In countries where the crisis hit more strongly, transitional arrangements were necessary.Korea replaced its then recently introduced partial deposit insurance scheme with a blanket deposit protection system, to reintroduce the original scheme again in 2001 with broader prudential monitoring capabilities for the Korean Deposit Insurance Corporation. The Thailand Financial Institutions Development Fund administered a temporary general guarantee to depositors between October 1997 and December 2004, when a new deposit insurance agency was created.

  • Specific country circumstances explain different priorities among countries in the region.In the Philippines, the authorities focused on handling rising nonperforming loans by using incentives introduced in the 2002 Special Purpose Vehicles Act. The Hong Kong Monetary Authority formalized in 1999 a LOLR facility funded by the Exchange Fund under their quasi-currency board arrangements.

  • Most countries in the region have introduced deposit protection schemes and systemic monitoring arrangements. Deposit insurance institutions have been established in Hong Kong (2004), Singapore (2005), and Malaysia (2005). Institutional arrangements to monitor systemic risk have been implemented in Hong Kong (Financial Stability Committee and the Council of Financial Regulators), and in Singapore the Monetary Authority of Singapore has in place a crisis management framework covering a range of possible contingencies.

63. Ten years after the crisis, the main components of a comprehensive financial safety net are in place. The blanket guarantee used at the time of the financial crisis as a short-term crisis management tool has been phased out, and the roles of participating institutions have been established (Figure IV.1):

  • The necessary regulations to make LOLR facilities operational have been introduced.

  • A deposit guarantee agency (LPS) is now functioning, and a new deposit guarantee scheme is in place following the transition period completed in March 2007. A bank resolution framework was introduced in the LPS law, and is now operational.

  • A Financial Stability Forum (FSF), with participation of BI, the Ministry of Finance (MoF) and the LPS, has been established to coordinate the government’s actions with regard to systemically important institutions experiencing difficulties.

Figure IV.1.
Figure IV.1.

Indonesia: Financial Safety Net

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

64. The introduction of the FSN has been accompanied by significant improvements in banking supervision, in an environment of overall macroeconomic and financial stability. This is consistent with good practices.32 Critical regulatory measures were adopted in the aftermath of the crisis, including improved loan-loss provisioning regulations; a timetable to phase out regulatory forbearance on capital requirements, bringing back capital adequacy requirements from 4 percent to 8 percent of risk-weighted assets by 2001; and narrowing legal lending limits. The 1999 central bank law granted BI additional regulatory and enforcement authority, which allowed BI to introduce the gradual adoption of risk-based supervision; measures to improve banks’ transparency; enhanced on-site supervisory capacities; and fit-and-proper tests for controlling shareholders and bank management. In recent years, the supervisory framework has been further improved by introducing good corporate governance regulations; and exercising surveillance more closely through teams of bank supervisors.

65. This paper aims at assessing the suitability of the new framework to respond to possible bank problems. In this regard, the paper discusses the different components of the FSN, especially design issues and potential costs, and evaluates the main sources of risks and corresponding challenges, taking into account international experience.

B. Components of the Financial Safety Net

Liquidity assistance

66. The 2004 central bank law reinstated standard LOLR capabilities to BI. The Law states that BI can extend credit via an emergency loan facility (FPD), funded by the government, to solvent banks with liquidity problems and of systemic importance. If necessary, the government can issue government securities to finance FPD funding following standard budget procedures. A Joint Coordinating Committee decides on the systemic importance of banks with MoF making the formal decision.33

67. The LOLR capabilities in Bank Indonesia is a key element of the financial safety net. Banks entitled to draw on this facility must meet a 5 percent minimum capital adequacy ratio and pledge liquid assets as collateral, accompanied by personal or corporate guarantee from their controlling shareholders. All available bank assets can be used as collateral. They can be supplemented by other assets, including those belonging to the controlling shareholder, and/or by registered shares from the controlling shareholder in the bank. The facility is available for 90 days, and can be extended once for another 90-day period (Figure IV.2).

68.The LoLR facility in indonesia is available only to systemically-important institutions. BI has also a Short-Term Liquidity Facility (FPJP) available to all banks with sufficient liquid and high-value collateral (government and central bank securities) to finance payment system obligations. This credit can be renewed for up to 90 days, although in practice, it has been rarely used and never for more than two days.34

Figure IV.2.
Figure IV.2.

Indonesia: Lender of Last Resort

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

Deposit protection

69. Depositors’ confidence remained unaffected throughout the gradual introduction of a limited deposit guarantee. After the creation of LPS in 2004, the blanket deposit guarantee was phased out in four stages between March 2006 and March 2007.35 The new limited deposit guarantee coverage was set at Rp 100 million per depositor per bank (about US$11,000). This amount provides full coverage to about 98 percent of all depositors and to 38 percent of deposits, based on information as of March 2007. Participant banks pay premiums of 0.1 percent of total deposits twice a year.

70. All financial institutions supervised by BI are members of the Deposit Guarantee System. Member institutions comprise 130 commercial banks and 1,880 local development banks (BPR). Currently, LPS resources invested in securities (equivalent to 0.54 percent of total deposits) would be sufficient to finance deposit refunds for 30 percent of small domestic private banks or 45 percent of all rural banks (Figure IV.3). The new framework for deposit protection has already been successfully tested following the failure of six rural banks in the last two years.

Figure IV.3.
Figure IV.3.

Indonesia: Features of Deposit Coverage Under Deposit Insurance Scheme,

December 2006

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

1/ The average deposit for the rural banks is 8.4 billions Rupiah.Source: BI and Fund staff calculations.

71. LpS has a broad mandate. In addition to providing a limited guarantee to bank deposits, it is responsible for the resolution and management of failing banks.36 To avoid adverse-selection problems, the system is compulsory for all commercial and rural banks, and is partly funded with government resources, in line with most newly established deposit guarantee schemes.37 LPS has operational independence and is accountable to the President of the Republic. The guaranteed deposit limit may be raised with Parliament’s approval in the event of acceleration of inflation, decline of coverage to below 90 percent of depositors, or substantial bank deposit withdrawals (Figure IV.4).

Figure IV.4.
Figure IV.4.

Indonesia: Deposit Guarantee Scheme

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

72. LpS financial arrangements are generally conservative. Assets can only be invested in securities issued or guaranteed by the government or BI. As in most countries, foreign banks also contribute to the fund in the understanding that they also benefit from enhanced confidence. Reserves have an explicit target of 2.5 percent of total deposits, with the idea of building reserves only up to the level of expected contingencies. Unlike most countries, contribution is based on total deposits, ensuring simplicity in collecting premiums.38 Simplicity and maximum premium collection potential are important considerations in countries with high coverage per depositor like Indonesia. Like most other countries, Indonesia does not have a risk-based premium system in place (where banks pay premium based on risk assessments by third parties) (Figure IV.5). However, the Deposit Guarantee Law opens the possibility to eventually move to a risk-based premium system.

Figure IV.5.
Figure IV.5.

Selected Economies: Features of Deposit Insurance Schemes, 2006

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

Source: IMF.

73. The Deposit Guarantee Law clearly states when claims can be declared ineligible by LPS. This can occur if claims cannot be corroborated in bank records, as well as if depositors were responsible for the insolvency situation of the banks or are parties that benefited from bad prudential practices. In applying the latter provision, LPS announces every month a ceiling deposit interest rate that banks cannot exceed in order to ensure eligibility for deposit protection.

Bank resolution

74. In case of solvency problems, BI’s Banking Supervision Department (BI-BS) hands over the resolution of the bank to LPS. A coordinating committee (whose members are currently the Ministry of Finance, Bank Indonesia and LPS) will determine if a failed bank is of systemic importance.39 Liquidation is not an option in the case of failing banks of systemic importance, but shareholders can only participate in the recapitalization of assisted banks if they inject at least 20 percent of additional capital requirements. Alternatively, LPS will take over all the corresponding rights and powers. In the case of non-systemically important banks, LPS will choose between recapitalization or liquidation based on an assessment of the costs of bank assistance versus the costs of liquidation (lower cost approach). LPS must dispose of banks’ shares within a period of 2 years for banks of no systemic importance and 3 years for banks of systemic importance, renewable for no more than 2 additional years.

75. LPS legal capabilities are generally sufficient to carry out banking resolution duties. LPS is empowered to: take over and exercise all rights and powers of shareholders; possess and manage assets and liabilities of the failing bank; review, annul, terminate and/or alter any contracts between the failed bank and third parties; and, sell and/or transfer failing bank assets and liabilities without debtor or creditor consent.

76. Information sharing agreements between LPS and BI are not yet firmly established. Information arrangements need to be put in place to properly monitor the risks that problem banks pose to the deposit guarantee fund. The lack of information sharing arrangements may potentially delay key decisions at the time of bank resolution, making the process unduly costly. Currently, BI-BS must notify the LPS about problem banks under special supervision. However, given that LPS regulations stipulate that a decision on the modality of banking resolution should be made in one day, it is critical that relevant information is made available early in the process (Figure IV.6).

Figure IV.6.
Figure IV.6.

Indonesia: Banking Resolution Framework

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

77. In the case of liquidation, LPS will repay the guaranteed claim to depositors and dissolve the bank. Following a public announcement of a bank’s liquidation, LPS will appoint a liquidation team, which may include one member of the board of directors, commissioners or shareholders. The liquidation team has ample powers to act on behalf of the bank under liquidation in every aspect pertaining to the settlement of the rights and liabilities of the bank. This includes requesting from a commercial court the cancellation of transactions that had an impact on the reduction of assets and increasing liabilities within one year prior to the revocation of the bank’s license. The process of liquidation must be completed within 2 years from the establishment of the liquidation team, to be extended no more than twice for a maximum of one year each time.

Financial stability forum

78.The Financial System Stability Forum (FSF) is a vehicle for cooperation, coordination, and information exchange, with the objective of monitoring and preserving financial system stability. Since its main purpose is to facilitate coordination between the MoF, Bank Indonesia and LPS on monitoring systemic risks, it is not expected to constitute a separate and distinct entity.40 However, provisions in the MoU signed in December 2005 establish additional roles to the FSF such as taking actions to ensure consistency in financial acts and regulations, developing an early warning system to detect potentially systemic problems, and interacting with managers of individual financial institutions to discuss systematically important developments (Figure IV.7).

Figure IV.7.
Figure IV.7.

Indonesia: Financial Stability Forum

Citation: IMF Staff Country Reports 2007, 273; 10.5089/9781451818413.002.A004

C. Conclusions and Macroeconomic Stability Considerations

79.The FSN in Indonesia provides a framework to address the kind of problems that emerged at the time of the crisis. In addition, significant improvements in banking regulation and supervision and progress in disclosure by firms should help identify the nature of bank problems at an early stage. Features of the new financial safety net that make it capable of timely addressing bank problems are the following:

  • A framework to decide on the solvency and on the systemic importance of a bank in distress has been formalized. This will help prevent the abuse of regulations to unduly support failing banks. It will also help minimize uncertainty about alternative courses of action, which was a major problem at the time of the crisis. Accountability for determining systemic importance appropriately falls on the Minister of Finance, BI’s Governor, and LPS’s Chairman. The definition of systemic importance within a “constructive ambiguity” approach remains appropriately open, to avoid moral hazard behavior by banks falling within a particular definition. Current arrangements leave no room for discretion in determining the use of LOLR to attend emergency liquidity needs of banks deemed as solvent.

  • Clearly established procedures, clear allocation of responsibilities and legal certainty about key roles facilitates the adoption of timely decisions. This applies to the provision of emergency liquidity, banking resolution processes, deposit refunds, and liquidation. Changes in the central bank law and the enactment of the Deposit Guarantee Law provide legal support to these arrangements. In turn, the favorable environment for timely decisions would be conducive to maintaining potential costs at a minimum.

  • The establishment of new specialized institutions should help focusing on systemic risks on an ongoing basis. The LPS, in charge of administering the deposit guarantee, will remain vigilant about potential use of deposit protection. Building up LPS’s credibility will help enhance the perception of safety by depositors, contributing to minimize the probability of deposit runs. The FSF, in charge of assessing systemic risks, will help alert about emerging risks, favoring the activation of self-correcting adjustments by regulators and market players.

80. The FSN would be further strengthened by continuous improvement in legal and judicial systems, market-based discipline, accounting standards, and enhanced disclosure.41 While progress on addressing these structural issues can only be gradual, a complementary effort to minimize potential moral hazard costs seems appropriate. It is widely accepted that the benefits of FSNs come at the cost of undermining market discipline to some extent, which is made worse when many financial institutions are regarded as too important to fail.42 In this regard, the following features of the FSN could impose high moral hazard costs: (i) higher than average deposit coverage; (ii) the significant presence of state-owned banks in the system; (iii) the possibility to use payment liquidity facilities for up to 90 days; and (iv) the potential conflicts of interest if a member of the board of directors, commissioners or shareholders participates in liquidation teams. Moral hazard costs could be minimized by continuously improving the prudential framework, introducing stricter governance requirements in state-owned banks, and limiting the use of legal provisions with potential moral hazard implications.

81. The authorities may consider reassessing periodically elements of the FSN to further improve the framework,in particular in the following areas:

  • The FSN should be supported by full legal certainty to ensure effectiveness. The government plans to submit an FSN law to parliament to reinforce legal certainty for some of the main regulations already in place. The new law could usefully assess consistency in the identification of a systemic problem, which currently takes place in two separate moments.43 Also, provisions in the Deposit Guarantee Law allowing for coverage adjustments at times of financial turmoil may lead to the perception that a “quasi-”blanket guarantee is still in place.44

  • Market-based mechanisms should take preference over administrative procedures. In particular, the deposit guarantee ceiling rate does not seem to play the role of discouraging bad prudential practices by preventing weak banks from bidding for deposits to finance liquidity problems, since these institutions still pay a rate that is significantly higher than market rates at times. A mechanism used in other countries, and more in line with the intention of the LPS law, would entail relating the deposit guarantee rate to an average market rate plus a reasonable margin.45 Also, risk-based premiums could be introduced when BI has a reliable and objective way to assess banks’ differential risks, for example based on external ratings. On banking resolution, consideration could eventually be given to allow the use of other market-friendly alternatives tried successfully in other countries (bridge banks, purchase and assumption), not contemplated in the current Deposit Guarantee Law.

  • The risk of higher resolution costs arising from undue delays in decisions on handling bank failures should be minimized. Appropriate information exchange between regulators and LPS would help better informed decisions. An MoU should be signed in line with the LPS Law, which establishes that the LPS must obtain customer’s deposit data, as well as bank soundness reports and financial statements and banks’ examination reports to the extent that banks’ secrecy is preserved.

  • The monitoring of systemic vulnerabilities should be carried out with emphasis on inter-institutional coordination. Regarding the Financial Stability Forum, it seems advisable to keep its infrastructure to a minimum, in line with international experiences. The FSF should focus on facilitating coordination, rather than on functions that potentially overlap with other regulators, such as interacting directly with financial institutions.

27

Prepared by R. Armando Morales (APD). Special thanks to Steven Seelig, who provided guidance and background information, and to Edo Mahendra and Wiwit Widyastuti (IMF Jakarta Office) for their valuable research assistance.

28

Enoch, Charles; B. Baldwin; O. Frecaut; and A. Kovanen. Indonesia: Anatomy of a Banking Crisis: Two Years of Living Dangerously; IMF Working Paper No. 01/52, Washington D.C., 2001.

29

Batunanggar, Sukarela; Financial Safety Nets: Review of Literature and its Practice in Indonesia, in Financial Stability Review II-2006, Bank Indonesia, Jakarta, 2006.

30

Some delays also occurred because of overall institutional deficiencies rather than IBRA-specific problems.

31

The government’s plan to introduce a financial safety net was incorporated into the 2000 EFF program with the Fund.

32

See Garcia, Gillian G. H.; Deposit Insurance: Actual and Good Practices, IMF Occasional Paper No. 197, Washington, DC, 2000.

33

The precedent for this arrangement is the assumption of BLBI obligations by the government in exchange for recapitalization bonds. Other arrangements under which the Minister of Finance participates in LOLR decisions are in place in Japan, where the Minister of Finance may ask the central bank to provide loans to prevent financial turmoil, and in Jordan, where the cabinet approves the use of emergency credit facilities by the central bank.

34

A problem may arise if the provision of LOLR assistance delays the closure of institutions, thereby increasing the resolution costs for the deposit guarantee agency. The US introduced legislation in 1991 to limit the ability of the Federal Reserve to lend to insolvent banks even when collateral was available, in light of excessive use of these facilities in previous years.

35

Coverage was reduced to Rp. 5 billion in March 2006, Rp. 1 billion in September 2006, and Rp. 100 million in March 2007.

36

Asian and Western Hemisphere countries favor comprehensive deposit guarantee schemes, unlike European countries where central banks or regulatory bodies other than the deposit insurance agency have had clearly defined banking resolution responsibilities for a long time (Garcia, 2000).

37

Initial capital participation of the government amounts to Rp 4 trillion (about US$ 400 million).

38

Premiums are applied only to covered deposits in most countries. However, some countries are considering shifting the application of premiums to total deposits for simplicity.

39

This decision is independent of the one made about the use of LOLR facilities for systemically important banks.

40

The Australian Council of Financial Regulators operates as an informal body where members share information and views, discuss regulatory reforms or issues where responsibilities overlap and, if the need arises, co-ordinate responses to potential threats to financial stability. The Norwegian Contingency Committee for Financial Infrastructure is chaired by the central bank, which provides a secretariat, and its main responsibility is to coordinate measures for preventing and resolving crisis situations that may lead to major disruptions in financial infrastructure.

41

See Mishkin, Frederic; Financial Policies and the Prevention of Financial Crises in Emerging Market Countries. NBER Working Paper No. 8087, Boston, 2001.

42

Schinasi, Garry; B. Drees and W. Lee, Managing Global Finance and Risk, Finance and Development, Volume 36, Number 4, Washington D.C., December 1999.

43

There may be a legal gap in the unlikely but not impossible case that different decisions are made regarding the systemic importance of the same institution at the time of the provision of LOLR financing and at the time of the decision on what resolution approach is chosen.

44

A blanket guarantee could still be used, if deposit runs are not stopped by the use of emergency liquidity facilities (See Lindgren et al, Financial Sector Crisis and Restructuring: Lessons from Asia, IMF Occasional Paper No. 188, Washington D.C., 1999).

45

In fact, in Indonesia, the ceiling was set at a fixed margin above the average deposit rate for the largest banks between 1998 and 1999. Similar arrangements are in place in Argentina, Ecuador and Thailand. Other countries use narrower approaches: Bulgaria, Germany and Portugal regard as ineligible only individual deposits receiving preferential interest rates.

Indonesia: Selected Issues
Author: International Monetary Fund