Financial System Stability Assessment-Press Release and Statement by the Executive Director for Indonesia

Abstract

Financial System Stability Assessment-Press Release and Statement by the Executive Director for Indonesia

Executive Summary

Since the 2010 FSAP, Indonesia’s macroeconomic performance has been robust and the financial system has been stable. Recently, the financial system has weathered well a simultaneous economic and credit deceleration. Corporate vulnerabilities have remained broadly in check, though debt-at-risk is elevated in some sectors and external refinancing risk persists. The banking system remains sound even though, as economic growth has slowed, banks’ high profitability has fallen somewhat and problem loans have risen. Banks’ capitalization remains strong and well above regulatory minima.

Indonesia’s financial system is relatively shallow and dominated by banks belonging to financial conglomerates. Total financial system assets equal about 72 percent of GDP, three quarters of which reflect banks’ assets. Financial conglomerates play a key role in the financial system and pose a challenge for effective oversight. Capital markets are relatively shallow, and external financing is important for long-term financing due to a small domestic investor base.

Systemic risk is low and the banking system appears generally resilient to severe shocks. Market based indicators point to relatively low levels of systemic risk. Under severe stress test scenarios, banks experience sizable credit losses, particularly from corporate exposures, but high capital and strong profitability help to absorb most of these losses and the resulting capital shortfalls are modest. Many banks face relatively small shortfalls in liquidity stress tests, including in foreign-currency, and these appear manageable for Bank Indonesia (BI).

The authorities have been pursuing an ambitious agenda to strengthen financial oversight and crisis management. Although the financial system is relatively shallow and appears resilient to shocks, it is likely to grow as the authorities are actively promoting financial deepening and inclusion and, in that context, it is important to strengthen further also the oversight and crisis management frameworks. Since the last FSAP, the authorities have implemented Basel III, adopted a new insurance law, and improved supervisory practices across sectors. Importantly, in 2011, the Financial Services Authority (OJK) was established as an integrated regulator to oversee the entire financial sector. In addition, BI has developed analytical tools to assess systemic risk and has introduced several macroprudential instruments. The framework for crisis management and resolution, and safety nets was revamped in 2016 under the new Prevention and Resolution of Financial System Crisis Law (PPKSK Law). In 2016, BI also started reforming its liquidity management framework to spur money market deepening.

The FSAP identified several areas where further improvements will be needed. The following are particularly important:

  • Mandates and legal protection. The mandates for OJK and BI should be amended to give clear primacy to financial stability over developmental objectives. Clearer division of labor and responsibilities across agencies would also help reduce redundancies and foster collaboration across agencies. Furthermore, although legal protection for staff, agencies, and contractors involved in oversight and crisis management has been strengthened with recent reforms, it still needs to be brought in line with best international practice.

  • Supervision. OJK has managed its initial transition period well but further effort is needed to break internal silos in OJK and this will require a change in the structure of its Board of Commissioners. OJK also needs to promote a more intrusive supervisory approach across sectors, including rigorous evaluation of financial institutions’ risk management and internal audit functions. For effective oversight of financial conglomerates, it needs to be able to oversee conglomerates regardless of their organizational structure. There is also a need to improve governance and risk management in financial conglomerates.

  • Safety nets. The new crisis management and resolution framework, particularly the creation of a high-level Financial System Stability Committee (KSSK), is an important improvement. However, the KSSK should focus on coordination and it should not have the power to direct member agencies in their respective areas of responsibility. Also, the new framework rules out the use of public funding in resolution which might be overly constraining in certain circumstances. Further, the President of Indonesia has a central role in crisis management—the President decides whether Indonesia is experiencing a financial crisis and whether the deposit insurance corporation (LPS), which is also the bank resolution agency, should be allowed to use a broader set of resolution tools (e.g., bail-in). To avoid diluting the responsibility of LPS and the KSSK to deal swiftly with resolution, the authorities should consider revising the new law to narrow the role of the President to issues involving public funding. Finally, the emergency liquidity assistance framework needs to be adjusted to ensure its effectiveness.

The authorities’ objective to deepen financial markets while protecting stability would be well served by an integrated roadmap. The roadmap could draw on the different plans that already exist, complemented with measures focusing on strengthening the institutional framework, such as creditor rights, tax issues, and debt restructuring practices. Such a roadmap would help coordination among the various agencies involved in promoting financial deepening and inclusion.

Table 1.

FSAP Key Recommendations

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Background

A. The Macrofinancial Context

1. Macroeconomic performance since the 2010 FSAP has been robust, supported by a sound policy framework. Growth has remained strong at around 5-6 percent. Macroeconomic imbalances have been kept in check, capital flows have remained generally supportive despite bouts of volatility, and financial stability has been preserved. The exchange rate and bond yields have been allowed to adjust broadly in line with market conditions but with Bank Indonesia (BI) occasionally intervening in foreign exchange and bond markets to prevent disorderly conditions. Monetary policy has responded to inflationary and balance of payments pressures, and macroprudential policy was tightened to contain rapid mortgage loan growth and moderate housing price increases. The government has kept the fiscal deficit below the statutory 3 percent of GDP ceiling.

2. In recent years, the economy has navigated well a simultaneous economic and financial cyclical deceleration. The slowdown began in 2013, led by a decline in commodity prices, and bottomed out in 2015; a small rebound in 2016 is projected to continue over the medium term (Appendix I). As inflationary pressures eased, BI relaxed monetary policy in 2016. Credit growth peaked in 2011, and the credit-to-GDP gap has been falling steadily since 2013 (Figure 1). In line with the easing credit cycle, housing prices have decelerated (and appear to be in line with fundamentals) and loan quality has deteriorated, and BI partly unwound the earlier macroprudential policy tightening. Household bank debt has remained low at 17 percent of GDP.

Figure 1.
Figure 1.

Credit-to-GDP Ratio and Gap

(in percent)

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: BIS and IMF staff calculations.

3. The government launched an ambitious infrastructure program in 2015 that will require substantial financing. The plan entails investments of roughly US$450 billion (about 50 percent of GDP) in 2015-19. To finance it, the government is seeking to mobilize a broad investor base, including domestic institutional investors, and introduce new financial instruments, e.g., long-term infrastructure bonds. Fostering financial deepening without compromising prudential standards is a key challenge for Indonesia.

B. Financial Sector Structure

4. The financial system is relatively small and dominated by banks. At end-2015, financial sector assets equaled 72 percent of GDP, smaller than in emerging market (EM) peers (Figure 2). Bank assets equal 55 percent of GDP, while assets of insurance companies, the second largest category, equal 7 percent of GDP (Table 2). However, nonbank financial institutions (NBFIs) are growing fast: in the ten years to 2015, total assets of financial institutions grew by some 8 percentage points of GDP, with more than half of the increase contributed by NBFIs, particularly insurance companies. Life insurance accounts for the largest share of the insurance market.

Figure 2.
Figure 2.

Selected Countries: Size of Financial System and Financial Development

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: BIS Debt Securities Statistics; Bloomberg; FSB 2015 Global Shadow Banking Report; IMF World Economic Outlook database; Statistics Indonesia; IMF Staff Discussion Note 15/08; and IMF staff estimates.1/ Sahay and others (2015) developed two sets of three sub-indices that summarize how developed financial institutions and financial markets are in terms of their depth, access, and efficiency, culminating in a composite index of financial development, so called Financial Development Index. It is in the range between 0 and 1, with a higher value representing more advanced stages of financial development.2/ Peers include Brazil, China, India, Malaysia, Mexico, the Philippines, Poland, Russia, South Africa, Thailand, and Turkey.
Table 2.

Financial System Structure

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Sources: OJK; Bloomberg; BIS Debt Securities Statistics; and IMF staff estimates.

One foreign bank branch was closed at the end-February 2017, and the number of commercial banks is now 117.

5. Financial conglomerates (FCs) play a key role in the financial system. Forty-nine FCs account for 70 percent of aggregate assets of financial institutions. Bank-led FCs hold over 90 percent of FC assets, and include insurance companies, securities firms, and finance companies. More than half of FCs have a horizontal structure with an unregulated holding company that controls the group.

6. Indonesia’s banking system is not as highly concentrated as those in other EMs but it features large state-owned commercial banks. The four largest banks—three of which are majority-owned by the government—account for almost half of banking system assets, and most other banks are medium-sized or small (Table 3). Banks designated as domestic systemically important banks (D-SIBs) account for about 65 percent of banking system assets. It takes slightly more than 20 banks to account for a market share of 80 percent. Four state-owned banks and 26 regional development banks (partly owned by regional governments) account for nearly half of banking system assets. Private banks are diverse in terms of size, business models, and ownership, with nine foreign subsidiaries and 31 foreign branches.

Table 3.

Structure of the Banking System

(In percent of banking system assets; as of 2016Q3)

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Sources: OJK; and IMF staff estimates.

Medium-size, small-size, and micro-size banks comprise banks whose total assets are between 40 billion and 100 billion, 10 billion and 40 billion, and less than 10 billion rupiah as of 2016Q3, respectively.

7. Direct exposures across banks are limited, and the unsecured interbank and repo markets are thin. Banks manage their liquidity through operations in the unsecured interbank market and the repo market. Banks with licenses to operate in foreign currency rely on operations in the foreign exchange swap market (dominated by foreign banks). However, these markets are shallow (interbank market exposures amount only to 3 percent of banks’ assets) and many (mostly smaller) banks lack the capacity to engage in repo transactions and lack access to the foreign exchange swap market. Banks also place excess liquidity in various BI instruments and facilities, and the volume of BI liquidity absorbing operations dwarfs interbank market turnover.

8. Local capital markets are relatively shallow and have a strong foreign presence, making them sensitive to shifts in global market sentiment. At end-2015, outstanding domestic debt securities and stock market capitalization equaled 16 and 41 percent of GDP. The local bond market is dominated by rupiah-denominated government securities and foreign investors hold 38 percent of government securities, higher than most EMs (the average for Asia is 26 percent). This combination of shallow markets and high foreign participation can act as an amplifier of financial market volatility.

Systemic Risk Assessment

A. Banks’ Financial Health

9. Reported capital ratios have increased in recent years and are well above regulatory minima. The capital ratio for the system was 20.6 percent in the third quarter of 2016, comfortably above regulatory requirements (Table 4 and Appendix II). D-SIBs hold a similar level of regulatory capital and, despite being subject to higher regulatory requirements, still enjoy buffers of some 10 percentage points of risk-weighted assets (RWA). Over 90 percent of bank capital is in the form of high-quality common equity tier-1 capital.

Table 4.

Banking Financial Soundness Indicators

(In percent)

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Sources: IMF, Financial Soundness Indicator database; BI; and IMF staff estimates.

10. Profitability is high and has evolved in line with the economic cycle. With return on assets averaging 2.7 percent over the past decade, Indonesian banks are very profitable compared with banks in other EMs (Figure 3). Profits are driven largely by net interest income, and vary markedly across banks. The four largest banks and public regional banks are among the most profitable, likely reflecting the former’s extensive banking network and the latter’s business relations with regional governments. At the other end of the spectrum, some D-SIBs and a large group of micro-sized banks (about 50 banks accounting for 3½ percent of banking system assets) have low profitability. Profitability has declined recently as the economy has slowed; system-wide return of assets was 1.7 percent in 2016Q3, down by 0.5 percentage point from a year earlier.

Figure 3.
Figure 3.

Banking Financial Soundness Indicators among Emerging Market Peers1

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: IMF, Financial Soundness Indicators database; and IMF staff estimates.1/ As of 2016Q3, except Brazil (2016Q2), China (2016Q1), and Turkey (2016Q1).

11. Asset quality has deteriorated as economic activity decelerated, and headline numbers may understate the extent of the deterioration. Nonperforming loans (NPLs) have increased, particularly in the commodity-related and manufacturing sectors, from 1.7 percent in 2013 to 3 percent in late 2016. In addition, special-mention loans have remained high in recent years (around 4-5½ percent of total loans), and there has been an increase in restructured loans of about 2½ percent of total loans since June 2015, most of which are not classified as NPLs (Figure 4).

Figure 4.
Figure 4.

Problem Assets, 2010-16

(In percent of total loans)

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: OJK and IMF staff estimates.

12. Bank’s liquidity ratios have been largely stable through the economic and financial cycles. Liquid assets relative to short-term liabilities have fluctuated around 33 percent in recent years with no clear trend. The system-wide loan-to-deposit ratio has also been stable since mid-2013, reflecting banks’ reliance on deposits for funding. Structurally, banks rely on short-term deposits for funding; nearly 90 percent of deposits have a maturity of less than 90 days.

13. There are important differences in financial soundness indicators (FSIs) across banks (Figure 5). Larger banks, on average, tend to have lower NPLs and stronger profits, although the profitability of some D-SIBs is relatively low. Liquidity indicators of the larger banks, including state-owned banks, also appear solid, while those of smaller banks look weaker on average (with a relatively large dispersion). Overall, the wider dispersion of FSIs among medium-sized and smaller banks points to potential pockets of vulnerability in those segments.

Figure 5.
Figure 5.

Banking Financial Soundness Indicators by Group of Banks

(In percent; as of 2016Q3)

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: BI; and IMF staff calculation.

B. Corporate Vulnerabilities

14. Corporate vulnerabilities have remained broadly in check, but some risks remain. Corporate leverage remains moderate and has declined further in 2016, along with a slight decline in foreign-currency denominated debt, partly aided by the implementation of BI hedging regulations (Figure 6). Profitability has rebounded somewhat and the share of loss-making firms has declined. Still, important vulnerabilities remain in the form of relatively high debt-at-risk—particularly in the commodities, construction, and transportation sectors, a high share of foreign currency-denominated debt securities, and an increase in rollover needs in coming years.

Figure 6.
Figure 6.

Corporate Sector Performance

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: Bloomberg L.P.; CEIC; Orbis Database; and IMF staff estimates.1/ In percent of assets2/ Quick ratio = (Cash + Marketable Securities + Accounts Receivable)/Current Liabilties × 100.3/ The ratio of current assets to current liabilities.4/ In percent of assets; with the current ratio less than 100.5/ Interest coverage ratio (ICR) = EBIT/interest expenses.

C. Market Perceptions of Systemic Risk

15. Market data suggest that systemic risk is low. Figure 7 shows indices of systemic risk and its main drivers calculated using market data for 32 financial institutions. While the probability that several financial institutions experience distress simultaneously has risen recently, the tail-risk indicator, which measures the magnitude of the expected losses in the event of distress, has remained broadly unchanged at a low level. These findings, which should be interpreted with caution given the shallowness of Indonesia’s stock market and the low float rates of some financial institutions’ shares, suggest that the financial institutions perceived as experiencing higher levels of stress are small.

Figure 7.
Figure 7.

A Bird’s-Eve View on Systemic Risk1

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: Bloomberg; Moody’s KMV; and IMF staff estimates.1/ The analysis is based on the “Surveillance of Systemic Risk and Interconnectedness” approach. See Segoviano and Goodhart (IMF WP/09/4) and Technical Note on Systemic Risk and Interconnectedness Analysis, 2016 United Kingdom FSAP (IMF Country Report No. 16/164). The sample includes 17 banks, 7 insurance companies, 4 finance companies, and 4 securities/investment companies.

16. Large banks are the main drivers of systemic risk but some appear to play a stabilizing role in periods of stress. The systemic importance of the four largest banks is illustrated by their potential to generate stronger cascade effects (i.e., the ability to bring other institutions under distress) than other D-SIBs and nonbanks in absolute terms. While most banks’ contributions to systemic risk are in line with their size, the contribution of the largest four banks is smaller than their size, suggesting that they tend to mitigate rather than amplify risks in times of stress. Spillovers from nonbanks to banks, though increasing over time, remain limited.

D. Banking Sector Stress Tests

17. The analysis of financial sector resilience focused on banks, given their dominant role in the financial system, and was underpinned by three adverse scenarios (Figure 8 and the Risk Assessment Matrix, Appendix III). Each scenario is driven mainly by external shocks, which may affect the Indonesian economy through cross-border trade and banking linkages and international financial markets. Their initial impacts are amplified by domestic structural factors (particularly shallow capital markets with a strong presence of large foreign investors) and existing vulnerabilities. The analysis includes solvency stress tests (top-down covering all 117 banks and bottom-up administered by OJK for the D-SIBs), three types of liquidity stress tests, contagion and interconnectedness analyses, and corporate vulnerability analysis (Appendix IV). The stress test results presented below are based on the most severe scenario in which real GDP deviates by 17 percentage points from the baseline by 2018 (equal to 2.4 standard deviations).

Figure 8.
Figure 8.

Macrofinancial Scenarios for the Risk Analysis1

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: IMF, World Economic Outlook database; and IMF staff estimates.1/ The baseline scenario is based on October 2016 WEO projections. The adverse scenarios are simulated using the Global Macrofinancial Model.

18. The banking system is broadly resilient to the shocks even under the most adverse scenario (Figure 9). Under this scenario, and as analyzed later, the corporate sector would experience significant stress and contribute to an increase in the NPL ratio to almost 19 percent in 2018. The banking system would experience sizable losses (13 percent of RWA), driven by credit losses (12 percent of RWA). Thirty-eight banks accounting for a third of banking system assets would fail to meet the hurdle (minimum capital requirements, and Pillar II and D-SIB surcharges as relevant). However, the aggregate capital shortfall is relatively small at 0.7 percent of GDP.

Figure 9.
Figure 9.

Solvency Stress Test Results

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Source: IMF staff estimates.

19. However, these results are sensitive to the stress tests’ concept of problem loans and the assumption on net interest rate margins. As mentioned earlier, headline NPLs may understate the extent of asset quality deterioration. The FSAP team therefore ran an additional test (Table 5), which assumes that all restructured loans not classified as NPLs as well as all special-mention loans become NPLs, and brings the loan-loss reserve coverage of loans to the high level observed in 2009. With these assumptions, eight more banks would fail to meet the hurdles, and the capital shortfall would increase from 0.7 to 1.3 percent of GDP. Further, to test the sensitivity of the results to the assumption of continued high net interest margins, the FSAP team conducted a second test under which these margins narrow by 100 basis points throughout the forecast horizon. In this test, 12 additional banks (to the 38 in the previous paragraph) would fail to meet the hurdles, bringing the overall capital shortfall from 0.7 to 1.2 percent of GDP.

Table 5.

Sensitivity Test Results

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Source: IMF staff estimates.

20. Although at the system-wide level there is ample liquidity, stress tests show that many banks may experience liquidity shortfalls, including in foreign currency (Table 6). There are important differences across banks in their capacity to withstand significant liquidity shocks. The simplified liquidity coverage analysis, which covers all banks, shows that in a severe scenario many banks (most of them small) would face difficulties meeting a deposit withdrawal of 30 percent (comparable to the most severe idiosyncratic shocks experienced by some parts of the banking system over the past decade) but the aggregate liquidity shortfall would be small (5 percent of system assets). D-SIBs, for which three liquidity tests were conducted, would be able to manage overall liquidity stress but their foreign currency liquidity buffers may not be sufficiently large. Nonetheless, the aggregate foreign currency liquidity shortfall under stress would represent just 2.7 percent of system assets, or about only 6 percent of BI’s foreign currency reserves.

Table 6.

Liquidity Stress Test Results 1/

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Source: IMF staff estimates.

The FSAP conducted three liquidity tests. The cash-flows-based analysis, the most sophisticated test, captures all cash inflows and outflows. The LCR-based test while accounting for some cash inflows focuses on cash outflows based on overall liquidity with no currency differentiation up to 30 days. The simplified liquidity coverage analysis, which demands the least amount of data and could thus be carried out for all banks, only considers cash outflows as a proportion of outstanding liabilities.

Up to a 6-month horizon.

21. Domestic contagion through interbank or common exposures is limited. Based on the interbank network analysis, the hypothetical failure of a large bank would have a rather limited impact on other banks. When credit losses related to interbank exposures are incorporated into the solvency stress test (the most severe scenario), the additional reduction in the total capital ratio is around 0.3 percentage points in 2018 (Figure 10). The banking system does not appear to be vulnerable to common exposures.

Figure 10.
Figure 10.

Capital Adequacy Ratio

(in percent)

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Source: IMF staff calculations.

22. Corporate stress tests show that the sector would experience significant distress in an adverse scenario. Under the most severe scenario, the median default probability could rise above the levels observed during the global financial crisis (Figure 11). As in the bank stress tests, heightened financial volatility together with a decline in economic activity would have an adverse effect on corporates.

Figure 11.
Figure 11.

Corporate Probability of Default

(in basis points)

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Sources: National University of Singapore; and IMF Staff estimates.

23. Overall, the banking system appears generally resilient under extreme events. Solvency resilience comes mostly from banks’ high capital and strong profitability that allow them to absorb sizeable credit and market losses. Although aggregate capital shortfalls relative to the hurdles appear manageable, many banks (including some D-SIBs) would experience a significant reduction in capital, which could trigger a broad-based credit crunch if banks were to deleverage aggressively to re-build capital buffers. Under the most severe liquidity stress test, many (mostly smaller) banks may not have sufficient liquidity to meet potential deposit outflows, but, reassuringly, the tests show that the needed amounts, including in foreign currency, are manageable. Still, to contain liquidity risk, the authorities should consider introducing a liquidity coverage ratio (LCR) requirement by significant currencies. The authorities should also induce smaller banks to strengthen liquidity risk management capacity (see ¶51).

24. The authorities should continue strengthening their capacity to monitor systemic risk. BI should continue strengthening its capacity to conduct systemic risk analyses, and OJK should strengthen further the analytical basis of its supervisory stress tests. For stress tests, key priority areas are (i) strengthening data management systems to improve the timeliness of the exercises; (ii) adapting the stress testing models to an expected-loss-approach); (iii) continuing to strengthen its liquidity stress testing framework; and (iv) improving further the monitoring of the corporate sector, especially non-listed corporates of conglomerates.

Financial Sector Oversight

A. Main Institutional Challenges

25. The authorities have made important changes in the supervisory architecture since the last FSAP. In 2011, OJK was established as an integrated regulator to oversee the entire financial sector. OJK assumed oversight responsibilities over capital markets and NBFIs at end-2012, and over banks at end-2013; previously these responsibilities were held by Bapepam-LK and BI, respectively. As the integrated financial sector supervisor, OJK’s responsibilities include prudential and conduct oversight of banks, insurers, pension funds, finance companies, and securities firms. Furthermore, since the last FSAP, Basel III implementation has begun, a new insurance law has been adopted, and supervisory practices have been strengthened across sectors.

26. The FSAP’s assessment of financial sector oversight covered several areas, including supervisory architecture and the supervision of FCs. The 2010 FSAP undertook a formal assessment against the Basel Core Principles for Effective Banking Supervision (BCP), which highlighted important areas for improvement. Relatively little progress was made in some of these areas, so the recommendations were followed up in the current FSAP (Appendix V). In addition, the current FSAP undertook a detailed assessment of the Insurance Core Principles (ICP), since none had been done before. The FSAP also assessed the framework for conglomerate supervision, since most banks belong to conglomerates and this area had not been assessed thoroughly before. To support this analysis, the FSAP also assessed the corporate governance of conglomerates, with attention to the quality of group-wide risk management practices. Further, the FSAP looked closely at the organizational arrangements of the newly created OJK and identified areas for improvement.

27. The main challenges to effective supervision stem from the complex structure and weak governance practices of FCs, and the still evolving organization of OJK. The size, complexity, and diversified activities of FCs, which span several financial sectors, make them difficult to manage and oversee. Further, while OJK has been making meaningful progress to improve conglomerate supervision, the processes required to assess FC risks are still evolving.

28. The structure of FCs inhibits OJK’s ability to regulate them and understand their risk profile on a group-wide basis. Most FCs have a horizontal structure with an unregulated holding company controlling the group (Figure 12). The lack of a regulated entity with clear ascendance over all the entities that form the conglomerate poses important challenges to consolidated supervision. OJK has been trying to address this problem by nominating a financial institution, usually a bank, as the lead entity of such groups. However, this approach has limitations. The lead entity lacks legal authority to impose OJK’s regulatory requirements on the group and company law requirements may hinder information flows. The law should be amended to provide OJK, in such cases, the power to require the establishment of, and to license and supervise, a non-operating financial holding company above the financial institutions to give it supervisory reach over the financial group.

Figure 12.
Figure 12.

Types of Financial Conglomerates

Citation: IMF Staff Country Reports 2017, 152; 10.5089/9781484303559.002.A001

Source: OJK.

29. Weak governance of FCs further complicates the task of supervisors (Box 1). Despite the adoption of regulation establishing a minimum corporate governance framework for FCs and subjecting the entities to integrated risk and capital management, FCs do not yet have effective group-wide risk management structures. Also, the legal framework blurs the roles of the Board of Commissioners (BoC) and Board of Directors (BoD) of companies, thus weakening the responsibility and accountability of these bodies.1 In practice, the BoC does not seem to be charged with or have the capacity to oversee the risk management framework. OJK should elevate and strengthen corporate governance practices within the financial system, including the BoC’s oversight roles and responsibilities. FCs should be required to create plans to ensure integrated governance, risk management, and capital management across the group.

30. OJK has made good progress towards integrated supervision but transition challenges remain. OJK successfully managed the initial settling-in period and avoided the loss of supervisory continuity and clashes of cultures that can weaken supervisory efforts in transitions to integrated supervision. However, OJK has recently lost one-third of its bank supervisors as they exercised the option of returning to BI at end-2016, and although OJK has been active recruiting staff with industry experience, the departure implies a loss of important human resources. Furthermore, it will be important to reduce the current overlap in supervisory activities among OJK, BI, and the deposit insurance corporation (LPS) that risks straining resources and blurring accountability lines, and to agree on supervisory data management and sharing across agencies.

Integrated Corporate Governance in Financial Conglomerates

OJK has made progress in promoting good governance within the banking industry. OJK regulations have accomplished the important objective of requiring FCs’ BoC and BoD to reform how FC risks are governed, measured, and managed. Still, FCs have a long way to go to effectively implement consistent good governance.

The FSAP found governance shortcomings across several areas. Reputation, related party and intragroup transaction risks, for instance, are not well understood in many FCs and plans to address these risks remain unclear. Scenario analysis and contingency planning in the case of business interruption or failure in the group are also not well developed. Such analysis and planning are key for complex FCs. And they should consider how the financial arm of the group, or surviving companies, would respond and be safeguarded in case of failure of another entity.

These challenges are compounded by weaknesses in the legal framework:

  • Lack of regulated holding companies. The lack of a regulated entity with clear legal ascendance over all the other financial institutions that form the conglomerate hinders the implementation of group-wide policies, creating challenges not only for supervisors but also for managers.

  • Blurring roles of administrative bodies. The legal framework for companies introduces challenges regarding the responsibility and accountability of the administrative bodies (i.e., BoC, BoD, and shareholders) with the effect that their roles are blurred.

Specifically, the Company Law restricts the BoC’s authority to appoint the BoD, to approve and supervise key BoD decisions, and to hold the BoD accountable. While the Law defines the duties of BoD and BoC members, in practice the role of BoCs is not in line with international best practice, particularly regarding the nomination, choice and performance evaluation of the BoD as well as holding the BoD accountable for the prudent day-to-day management of the entity.

Importantly, risk management functions and the Internal Auditor formally report to both the BoD and the BoC, but in practice their relations are stronger with the BoD than with the BoC. This compromises the independence of critical control functions and undermines the BoC’s ability to independently evaluate management performance and be apprised of risk issues. Consequently, the capacity of both OJK and the FC itself to ensure consistent group-wide oversight and risk management is further diminished.

31. To become an effective integrated supervisor, OJK needs to tackle the silos in its organizational and governance structure. While OJK has aimed at developing an integrated supervisory approach, supervision is still effectively undertaken separately for banks, NBFIs, and securities, and this practice is rooted in the OJK Law, which gives responsibility for these three sectors to three different Commissioners. This approach shapes the organization of the agency, so that activities such as regulation, licensing, and supervisory framework development are performed mostly independently for banks and NBFIs. To become a more effective integrated supervisor, OJK needs to develop a supervisory approach that looks through the structure of financial entities. Fulfilling this objective and providing greater organizational flexibility requires the removal of the responsibilities of individual Commissioners for the supervision of specific sectors and the creation of cross-sector teams, harmonized regulations, and integrated supervisory processes that treat similar risks in a similar manner across sectors.

32. OJK’s mandate needs to be further clarified and legal protection strengthened to ensure timely supervisory action. OJK’s mandate and practices place priorities on macroeconomic management, financial development, and financial stability goals. Financial sector supervisors should have financial stability clearly established as their primary goal to ensure timely action when needed. Moreover, inadequate legal protection of OJK and its staff undermines conditions for effective supervision. The OJK Law should be revised to establish financial stability as OJK’s primary goal and to improve legal protection of supervisors in line with global standards.

B. Sectoral Supervision

Banks

33. Progress has been mixed in implementing the recommendations of the last FSAP on banking supervision. Important regulatory improvements include implementation of Basel III and a new set of regulations to improve risk management and corporate governance. Nevertheless, recommendations on issues such as related-party exposures, asset classification and provisioning regulation, legal protection of supervisors, and interest rate risk in the banking book were only partially implemented.

34. While the OJK’s supervisory approach is broadly adequate, improvements are needed in following key areas:

  • Intensity of supervision. There is scope for supervisors to further enforce regulations by challenging more consistently and rigorously industry practices in areas such as risk management, corporate governance, credit classification process, and capital adequacy.

  • Holistic view of risk management controls. In some cases, the results of supervisory reviews of the effectiveness of a bank’s risk control systems are not adequately integrated into the conclusions about the adequacy of the control environment and the ability of the BoC and BoD to effectively oversee their firm’s operations.

  • Validation of banks’ supervisory information. The processes that generate such information should be more regularly reviewed during onsite examinations, and the information and risk control process explicitly tested and validated. The results of such testing and validation should feed into the supervisor’s assessment of the adequacy of corporate governance oversight and the supervisory strategy for the institution.

  • Focus of supervisory examinations. Examinations are not always clearly linked to the key risks identified in the risk assessment and do not consistently evaluate the bank’s ability to identify and address emerging risks.

35. Regulation on credit risk is appropriate, but implementation and enforcement need to be strengthened. OJK regulations require banks to have all the elements of a sound system of risk management. Nevertheless, review of implementation of the regulations by banks revealed shortcomings such as inadequate oversight by the BoC and weaknesses in the assessment of the accuracy and integrity of credit quality reports generated by business lines. In this regard, the function and organizational position of credit risk management within banks needs to be strengthened to guarantee accurate loan classification and provisioning. These shortcomings raise concerns about the accuracy of the current headline NPL numbers and the appropriate classification of the increased amount of restructured loans. Against this backdrop, the authorities should monitor closely restructured and special-mention loans and their proper classification to guard against evergreening.

Insurance

36. Insurance regulation and supervision have improved since the establishment of OJK and the enactment of the new Insurance Law in 2014. OJK has gradually introduced risk-based supervision through active use of its supervisory powers and it has taken decisive actions against several insurers with material deficits. OJK has also enhanced regulations for corporate governance and risk management (see the Report on the Observance of Standards and Codes: IAIS Core Principles for Effective Supervision in Annex I).

37. However, important weaknesses remain, particularly in the regulation and supervision of insurance companies that belong to FCs. Some deficiencies are due to the lack of effective group regulation and supervision of insurance groups discussed earlier. Given the interconnectedness and contagion risks through FCs and domestic reinsurance programs, the authorities are also encouraged to enhance macroprudential surveillance by integrating conglomerate analysis. Also, intra-group transactions need to be considered more comprehensively to preclude possible double gearing within FCs. Furthermore, to strengthen its supervisory capacity, OJK needs to address skills shortages in some areas, like actuarial assessments. In addition, the authorities will need to revise their supervisory framework to allow for corrective measures to be required more promptly and to ensure timely supervisory actions more broadly. Finally, suspending mark-to-market valuation, as the authorities did in 2015 for some companies, should have been allowed only under extreme conditions and accompanied by enhanced oversight. The authorities are encouraged to review what was done and develop strict criteria for suspension of mark-to-market valuation to strengthen credibility and certainty in the marketplace.

C. Macroprudential Oversight

38. The current macroprudential policy framework is broadly adequate but some aspects need to be strengthened. The current setup derives from the OJK Law of 2011, which makes BI responsible for macroprudential policy. BI has (i) issued regulations to guide macroprudential policy; (ii) made organizational changes, including creating a macroprudential policy department; (iii) developed analytical tools to assess systemic risk; and (iv) introduced macroprudential instruments, such as limits on loan-to-value ratios and loan-to-funding ratio-linked reserve requirements, over which it has direct control by regulation. It recently introduced a countercyclical capital buffer on banks, with value currently set at zero, in line with credit developments. However, the framework has shortcomings that need to be addressed. Importantly, the BI Law should be amended to include a macroprudential mandate, focused on systemic risk and covering the entire financial system, not just banks. Provisions should be made to grant BI access to the nonbank financial data needed for systemic risk monitoring.

39. Closer cooperation between BI and OJK is needed. BI and OJK currently coordinate their operations in the context of a technical micro-macroprudential forum. Effective coordination between BI and OJK is required to ensure that the implementation of each institution’s respective mandates and tools does not lead to conflicting or counterproductive policies. To this end, BI and OJK should finalize the operating procedures for carrying out their respective tasks and enhance coordination. Over the medium term, the authorities should consider elevating the micro-macroprudential forum to a policy level forum. BI would be responsible for providing regular assessments of systemic risks and proposing macroprudential policy actions. BI could have the power to issue recommendations on macroprudential policy on a comply-or-explain basis to OJK regarding prudential tools under OJK’s authority. BI would report to the Financial Stability Committee (KSSK) periodically on macroprudential issues.

D. Financial Integrity

40. The authorities have made substantial progress in addressing AML/CFT deficiencies identified in the 2008 Mutual Evaluation Report of the Asia Pacific Group on Money Laundering (APG).2 Amendments to the AML law in 2010 and passage of the CFT law in 2013 broadly addressed key deficiencies, including by criminalizing money laundering (ML) and terrorist financing (TF) in line with the revised Financial Action Task Force (FATF) standard, and extending AML/CFT requirements to money value transfers services (including remittance service providers). New procedures for freezing terrorist assets under United Nations Security Council Resolutions contributed to Indonesia’s exit from the FATF’s monitoring in 2015. The authorities also completed a comprehensive National ML/TF Risks Assessment in 2015 with broad participation from relevant stakeholders, and co-led a multi-country risk assessment on TF for the South-east Asian region. The APG is scheduled to assess Indonesia’s AML/CFT regime in late 2017.

41. But some shortcomings remain, including aligning the AML/CFT framework more closely with the revised FATF standard. Specifically, AML/CFT supervision should be conducted on a risk basis and relevant agencies need to align their AML/CFT priorities according to the identified ML/TF risks. The authorities should enhance the capabilities of law enforcement agencies to conduct financial investigations and strengthen mechanisms for exchanging information with foreign counterparts. The authorities are also encouraged to introduce a legal requirement for reporting entities to identify, assess, and understand their broader ML/TF risks. Finally, the targeted financial sanctions-regime for terrorism and TF should be implemented without delay.

Financial Safety Net and Crisis Management

A. Institutional Setting

42. The authorities have revamped the framework for crisis management and resolution. In 2016, Parliament approved the Prevention and Resolution of Financial System Crisis Law (PPKSK Law), which clarifies the responsibilities of the agencies involved in crisis management. It also establishes the KSSK, comprising the Finance Minister (coordinator) and the heads of BI, OJK, and the LPS (as a non-voting member). The KSSK has responsibility for, among other matters, determining and coordinating the response to the distress or failure of D-SIBs and systemic banking crises, and recommending to the President of Indonesia to declare a status of financial system crisis that in turn would open a wider range of resolution powers (particularly bail-in). The framework is still work-in-progress, and at the time of the FSAP the authorities were working on regulations required under the new law, including on emergency liquidity assistance (ELA), recovery planning, systemic bank resolution, the Bank Restructuring Program (BRP), and non-systemic bank resolution.

43. The new framework represents a substantial improvement over previous arrangements but requires important adjustments to support its effectiveness in crisis management and resolution. To this end, the framework should be better aligned with international principles (particularly the Key Attributes for Effective Resolution Regimes for Financial Institutions):

  • Mandates. The agencies involved in crisis management and resolution should have strong and clear financial stability mandates established in their respective laws. To this end, the OJK Law should give unambiguous primacy to OJK’s financial stability objective (consistent with the PPKSK Law); the LPS Law should specify more clearly LPS’ statutory objectives, focusing on the maintenance of financial stability and continuity of critical functions, protection of insured depositors and minimization of the costs associated with resolution; and the BI Law should include financial stability assessment and macroprudential policy as part of BI mandates.

  • Legal protection. Inadequate legal protection creates a risk of crisis management decisions being delayed or even avoided due to concerns over potential liability. Although the PPKSK Law has strengthened legal protection across the agencies involved in crisis management, further strengthening is needed, including in the relevant agencies’ laws, to provide legal protection to the extent advocated in the Key Attributes (and BCP and ICP). The main shortcomings in the PPKSK Law are that the test for legal protection is “misuse of authority” rather than “good faith”, that it applies only to actions taken in situations of near-crisis or crisis, and it does not extend to the institution itself and persons acting on its behalf.

  • Role of the KSSK. The FSAP team understands that the KSSK is not only a coordination body but it also has the role of designing the resolution strategy and guiding and directing member agencies in their implementation of that strategy. This creates a risk of diluted responsibility and accountability for each agency and the potential for delays in decision-making. It is recommended that the Law be amended to limit the role of the KSSK to solely that of a coordination body and remove its power to direct member agencies in their respective areas of responsibility. It would also be desirable to set out more detailed guidance on the role of KSSK and each agency in a decree, as the authorities have proposed.

  • Role of the President. The PPKSK Law gives an important role to the President of Indonesia in crisis management. The President, on recommendation from the KSSK, decides whether Indonesia is experiencing a financial system crisis and whether the LPS should be allowed to use a broader set of resolution tools. Such an involvement of the President risks diluting the responsibility of LPS and the KSSK to deal swiftly and effectively with resolution issues, and could also create a risk of politicizing resolution decisions. Thus, the authorities should consider revising the PPKSK Law to focus the role of the President to decisions on the use of public funding (as discussed later).

B. Crisis Management and Resolution

44. OJK is able to respond promptly to emerging stress and it has new powers to implement regulations for D-SIB recovery planning. OJK has many of the elements needed to respond promptly to emerging stress in banks, insurers and financial market infrastructures (FMIs), including a range of corrective action powers (FMIs refer to central clearing counterparties and custodians). It has developed early warning indicators (EWIs) to detect emerging stress in banks and, to some degree, insurers and FMIs, and the FSAP team encourages further refinement of this framework, including further integration of EWIs into corrective action frameworks and extending EWIs to FCs. Furthermore, as required by the PPKSK Law, OJK has implemented the regulation on recovery planning for D-SIBs. The mission suggests that, over the medium term, recovery planning be extended to FCs and medium-sized banks and, in the longer term, also to large and medium-sized insurers, FMIs, and remaining banks.

45. The LPS has many of the powers needed for the resolution of banks, but the framework can be improved in several areas. The PPKSK Law and the LPS Law should be amended to specify triggers for invoking resolution, empower LPS to require banks to implement changes to facilitate resolution in accordance with resolution plans, and enable LPS to apply bail-in without Presidential approval. There is also a need to strengthen the resolution powers over FCs and to establish robust safeguards for the application of resolution powers (including compensation for creditors left worse off than under a winding up). Moreover, attention needs to be given to the framework for using bail-in. Currently, D-SIBs and medium-sized banks rely on deposits for funding, with only a small amount of market funding that would better support bail-in. This funding structure and the lack of a clear creditor hierarchy will make bail-in challenging to implement. The recovery planning regulation for D-SIBs will help reduce this problem by requiring D-SIBs to issue debt capable of contractual bail-in. Building on this, the authorities will need to develop guidance on how bail-in powers might be applied in respect of deposits and other instruments without bail-in clauses. More broadly, the authorities should develop guidance on resolution options applicable to banks (differentiating by size as appropriate), and develop policy and operational frameworks for implementing resolvability assessments and resolution plans for D-SIBs.

C. Safety Nets

46. Indonesia has an established system of deposit insurance, managed by LPS, but there is a need to improve the payout process and to reduce the high deposit insurance coverage ceiling. LPS has the power to make payouts to insured depositors. However, LPS needs stronger legal and technical capacity to be able to calculate reliably and quickly the eligible amounts for payout and to process the payouts rapidly. Moreover, at Rp 2 billion (about US$150,000), the deposit insurance limit is excessively high relative to average retail deposits and per capita GDP, giving rise to moral hazard risks and weakening market discipline on banks. The high limit also increases the risk of funding shortfalls relative to LPS obligations and reduces the scope for bail-in. The FSAP team recommends that the authorities reduce the deposit insurance limit to a level more consistent with international norms while still covering the vast majority of household deposits.

47. The authorities should consider changes to the framework for resolution funding of banks. The new crisis management framework rules out the use of public funding in resolution, other than in a limited context related to LPS funding. Instead, the new framework will involve a new LPS-administered funding mechanism (under development) that would be used for systemic bank resolution situations once the BRP has been triggered, and that would be based on a bank levy. While the FSAP team shares the moral hazard concerns that motivated precluding the use of public funds, eliminating this option altogether is overly constraining. Although the development of an industry-financed resolution funding mechanism is desirable, a public funding mechanism, subject to robust safeguards, recognizes that some systemic bank resolutions could require public funding or the provision of guarantees. The FSAP team therefore recommends that the PPKSK Law be amended to allow for the use of public funding in limited circumstances justified by systemic stability considerations and subject to the President’s approval and robust safeguards, including preconditions for use and processes for recovery from the banking industry. In addition, to increase the practical feasibility of a levy-funded systemic resolution fund, the PPKSK Law should be amended to enable levies to be made on the banking industry to build up a systemic resolution fund without the need for the BRP to be invoked.

48. The ELA framework will need to be modified to ensure its effectiveness. An effective ELA framework is important given the liquidity risks discussed earlier. BI can, under the BI Law and the PPKSK Law, provide ELA to any solvent bank but the criteria for providing liquidity to banks experiencing funding difficulties are too restrictive and risk making it ineffective. Consideration needs to be given to the ELA eligibility criteria to allow extending emergency lending to a bank that is assessed by OJK as viable even if its capital is temporarily below minimum requirements. Further work is also needed on the coordination among agencies (OJK, BI, and LPS) on solvency assessment and on the eligible collateral to ensure that ELA is practicable when it is likely to be needed. In this connection, the framework should also enable BI, in situations where it is not satisfied with a bank’s solvency and viability, or with the collateral, to request an indemnity from the government, subject to appropriate safeguards.

Developmental Challenges

A. Overview

49. A deepening of Indonesia’s relatively small financial sector can help in tackling the country’s large development needs. Promoting financial deepening is a priority of the government, and it has created a high-level committee to coordinate efforts across agencies. OJK is implementing a Financial Services Sector Master Plan (2015-19) and the government has also adopted an ambitious financial inclusion strategy with a steering committee chaired by the President.

50. Policies for achieving financial deepening and greater inclusion in a manner that does not give rise to undue stability risks should focus on fundamentals. Several recent policy initiatives are unlikely to be effective, however, and are likely to have unintended consequences. These include caps on deposit rates, allegedly to discourage aggressive pricing behavior by some banks; moral suasion to induce banks to lower lending rates to single digit levels, particularly for the corporate and mortgage segments; requirements for all banks to meet minimum lending exposures quotas to micro, small and medium-sized enterprises (MSMEs); and guarantees and interest rate subsidies as part of the “People’s Business Loan” (KUR) program. Rather, the authorities are encouraged to develop an integrated roadmap for promoting financial deepening and inclusion in a manner that does not give rise to undue stability risks. The roadmap should be on improving fundamentals, such as creditor rights, efficiency, legal and regulatory frameworks, financial services taxation, and financial literacy. In this connection, the authorities should assess the effectiveness of the KUR program—the main instrument for promoting MSME loans—including its potential fiscal costs and whether it is achieving increased lending to new borrowers (deepening).

B. Financial Markets

51. The short-term funding markets are shallow and segmented. Segmentation, coupled with chronic excess liquidity, limits the effectiveness of monetary policy, complicates BI liquidity management, and constrains the development of money markets. In 2016, BI started reforming its liquidity management framework to spur money market deepening. A coordinated process of supporting smaller banks to develop their capacity to manage liquidity, stronger enforcement of prudential regulations in this segment, and continuation of ongoing efforts to improve the framework for repo and monetary operations would go a long way in improving the stability and efficiency of money markets.

52. Capital markets are relatively shallow and foreign presence is strong in some segments. Stock market capitalization has increased steadily in the last 6 years but remains small at 41 percent of GDP in 2016, well below the peer median of 74 percent. The government bond market—government debt equals about 27 percent of GDP, with nearly three-quarters denominated in rupiah—appears relatively developed but its liquidity still compares unfavorably with peers, reflecting the small size of issuance across a variety of diverse instruments (T-bills, T-bonds, Sukuk products) and large holdings by buy-and-hold investors. The corporate bond market, though growing fast, remains small at only 2½ percent of GDP, two-thirds of which is accounted for by financial institutions. The domestic institutional investor base is also small compared to peers, with pension fund and insurance company assets at around 2 and 7 percent of GDP, compared to 5 and 15 percent in peer countries. Foreign investors have a strong presence in government bond (particularly long end) and equity markets, but limited participation in corporate bond markets.

53. The development of financial markets will require comprehensive efforts, including in legal, regulatory, and tax elements. Priorities would include: (i) improving the efficiency of the yield curve by consolidating the number of instruments issued and prioritizing the issuance (and re-issuance) of benchmark maturities for T-bonds and increasing the issuance of T-bills; (ii) removing legal obstacles to the development of structured non-recourse products, critical for infrastructure financing; (iii) reforming the taxation of financial products (including by replacing the tax applied to the gross value of transactions with one more closely linked with firms’ performance, (iv) strengthen insolvency procedures and creditor rights to improve expected recovery rates; and (v) promoting the development of derivative instruments to enable risk hedging.3

C. Financial Inclusion

54. The authorities have launched an ambitious strategy to improve the low access to the formal financial system. According to the World Bank’s Findex Survey, only 39 percent of adults have a transaction account with a formal financial institution, up from 20 percent in 2011, but significantly lower than the 69 percent average for the region. The National Financial Inclusion Strategy launched in November 2016 has set the ambitious goal of reaching 75 percent by end-2019. The development of digital financial services is a central element of this strategy.4 E-money issuers (banks and nonbanks) and banks providing basic bank accounts and other financial services can engage agents to expand service delivery, and such agents are now present in all Indonesian provinces. They provide access to bill payments and transfers services, among other things, and can facilitate financial transactions. However, the cost of servicing these basic bank accounts, given the current volume of transactions and fee structure, exceeds receipts. Keeping costs in check will require eliminating regulatory barriers that require direct interaction between providers and consumers and leveraging the use of telecom and ecommerce companies to optimize the size of networks.

Appendix I. Selected Economic Indicators

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Sources: Data provided by the Indonesian authorities; and IMF staff estimates and projections.Note:

Includes NPISH consumption.

Contribution to GDP growth.

Includes changes in stocks.

Short-term debt on a remaining maturity basis.

Appendix II. Detailed Financial Soundness Indicators

(In percent)

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Sources: IMF, Financial Soundness Indicator database; Bank Indonesia; and IMF staff estimates.

Appendix III. Risk Assessment Matrix (RAM)

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Appendix IV. Banking Sector Stress Testing Matrix (STeM)

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Appendix V. Implementation of 2010 FSAP Recommendations

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Annex I. Report on the Observance of Standards and Codes: IAIS Core Principles for Effective Supervision

Information and Methodology Used for Assessment

1. The assessment of insurance regulation in Indonesia was carried out as part of the 2016-17 FSAP. The assessment was made against the ICPs issued by the International Association of Insurance Supervisors (IAIS) in October 2011, as revised in November 2015. It was conducted by Nobuyasu Sugimoto (IMF) and Antony Randle (World Bank) from September 21 to October 4, 2016.

2. The assessment is based solely on the laws, regulations, and other supervisory requirements and practices that were in place at the time of the assessment in September 2016. While this assessment does not reflect new and on-going regulatory initiatives, key proposals for reforms are summarized by way of additional comments in this report. The authorities provided a full and comprehensive self-assessment, supported by examples of actual supervisory practices and assessments relating to unidentified insurance entities, which enhanced the robustness of the ICP assessment.

Institutional Framework and Arrangements

3. The OJK is responsible for the regulation and supervision of the entire financial sector, including banking, capital markets, insurance, and pension funds. OJK was established in 2011 to take over the role of Bapepam-LK (Supervisory Agency of Capital Market and Financial Institutions under the Ministry of Finance (MoF)) in regulating and supervising the capital markets and non-bank entities, as well as that of BI in regulating and supervising banks. OJK has three missions, 1) to ensure activities in the financial sector are fair, transparent, and accountable, 2) to promote growth in a sustainable and stable manner and 3) to protect the interests of consumers and the public.

4. The new insurance law became effective in October 2014, and since then OJK has made significant improvements to its insurance regulation and supervision. Since 2014, OJK has improved insurance regulation and supervision by adopting a number of new regulations. In the last three years, OJK has issued more than 100 new regulations, including those relating to risk based supervision, enhanced fit and proper requirements, governance and risk management requirements.

5. The financial sector regulatory framework is still in transition. Bank supervision and regulation were moved from BI to the OJK in 2014, while BI retained regulatory responsibility for macroprudential policy. There is a need to align the legislation pertaining to the financial sector agencies to the new institutional arrangement. In addition, there are some gaps in areas such as the bank liquidity assistance and resolution frameworks, and legal protection for supervisors for actions arising out of acts done in good faith. The authorities have submitted to Parliament a bill to remedy these matters. OJK is developing a framework for consolidated supervision of banks and nonbanks (including insurance) and upgrading risk-based supervision.

6. The 2016 PPKSK Law established the KSSK. This Committee is tasked with the prevention and resolution of financial system crises. The membership of the Committee comprises the Minister of Finance, as coordinator, the Governor of BI, the Chairman of the Board of Commissioners of OJK, all with voting rights, and the Chairman of the Board of Commissioners of LPS, without voting rights. The Committee, among other things, has the authority to recommend to the President to declare a systemic crisis status in the financial system and on resolution measures.

Main Findings

7. The insurance sector is rapidly growing through conglomeration, bancassurance and increased sales of investment products. While the insurance sector is still smaller than the banking sector, it has grown rapidly at an average of 20 percent per year over the last 5 years. About the half of insurers belong to conglomerates, typically led by banks but with a number of other financial and non-financial entities within the group. Because of regulations on intra-group transactions from insurance entities, some insurance entities could have material exposures to the affiliates. Bancassurance plays a very important role in the insurance distribution, mainly in relation to investment products, such as unit-linked products.

8. The insurance sector is still vulnerable to a number of material risks. A number of insurers have failed in the last 10 years. After its establishment, OJK has taken prompt action to reduce the loss to policyholders by taking strong actions against four insurers with material deficits. OJK has monitored the capital adequacy of insurers through its risk based supervision scheme.

9. The recent economic slowdown and the current low interest rate environment also affected the insurance sector. The economic slowdown has affected the growth of the insurance sector through lower growth in premiums. As the life sector has a significant exposure to equity and mutual funds, the performance has been affected negatively. In addition, the low interest rate environment has reduced the insurance investment return. In 2015, OJK allowed insurers to abandon mark-to-market valuation for solvency purpose (RBC calculation) temporarily. OJK followed up with the firms that needed to use this temporary suspension to ensure that their treatment was, in fact, temporary. OJK has subsequently removed this suspension to avoid moral hazard in the industry and the expectation that it would accommodate further concessions in the future. There were a few insurers that utilized the policy and OJK stringently monitored these insurers.

10. The insurance industry is exposed to significant catastrophic risks with domestic concentrations through mandatory domestic reinsurance programs. Indonesia is prone to landslides, floods, storms, earthquakes, tsunamis, and volcanic eruptions. Insurers are required to set aside a catastrophe reserve and also have mandatory reinsurance arrangements with domestic reinsurers. One reinsurer is owned by all of general insurance companies, thus creating potential contagion in case of significant catastrophe events. According to the OJK, risk in excess of domestic reinsurer capacity is retroceded to international reinsurers.

11. Insurance regulation and supervision have been remarkably improved since the establishment of OJK and the enactment of the new Insurance Law. OJK was established in 2011 as an independent and integrated regulator. Since the new Insurance Law became effective in October 2014, OJK has made significant regulatory reforms, by issuing number of new regulations, introducing risk based supervision through the active usage of its supervisory powers including revocation of licenses, and by enhanced regulations for corporate governance and risk management.

12. However, the assessment has identified a significant number of shortfalls in observance with the Insurance Core Principles. Some deficiencies are due to the lack of effective group regulation and supervision of insurance groups. While OJK has implemented regulations related with risk management and group capital, intra-group transactions are not well taken into account and thus double gearing within the insurance entities and investment arbitrage between insurance entities and non-financial entities may be possible. Including a capital calculation for catastrophic risk and a framework for the imposition of capital add-ons can tighten the capital regime.

13. The FSAP team identified that the laws need to be amended to enhance the clarity of legal protection and the primary objective of the supervisor. ICP requires that primary objective of supervisors should be the protection of policyholders. However, OJK has other objectives and particularly the objective of market development seems to have caused conflict with the objective of policyholder protection. Setting the protection of policyholders as the primary objective of OJK will enhance the operational independence of OJK. The law also needs to provide clear and robust legal protection of OJK and its staff acting in good faith. Improvement of legal protection of OJK with clearer internal guidance for applying sanctions will help it to take more prompt and effective regulatory actions to problem insurers.

14. The FSAP team recommends that OJK improve the effectiveness of supervision. Thematic reviews of reserving practices will encourage more conservative reserving. Close dialogue with the industry and clearer guidance on adequacy, independence and reporting lines of key control functions will improve the effectiveness of corporate governance and risk management of insurance groups significantly. OJK is encouraged to increase the expertise of its human resources, in particular actuaries, and facilitate communication with the industry participants which will assist the industry and OJK itself to transition smoothly from a compliance based culture to more risk based supervision. OJK also needs to revise the “three strikes” approach to ensure timely supervisory actions. Given the possible high interconnectedness and contagion risks through conglomerates and domestic reinsurance programs, the authorities are encouraged to enhance macroprudential surveillance by integrating conglomerate analysis to identify possible contagion among conglomerates and sectors.

15. While OJK has introduced a risk-based capital and reserving framework, the framework still need some improvements. The capital framework covers a number of risks, such as default risk of investments, asset and liability mismatch (ALM), FX mismatch, premium and claim risk, operational risk and mutual fund related risk. OJK has introduced guarantee risk associated with unit-linked products. However, some material risks (such as catastrophe risk addressed through reinsurance, and contagion risk from related parties) need further improvements. OJK has not conducted thematic reviews for each risk in RBC calculation.

16. There is a need for more focus on the regulation of insurance intermediaries and market conduct. OJK has made tremendous efforts to ensure efficiency and fairness in claims payment and complaints handling, which will continue to be important especially in the non-life sector. However, the rapidly increasing life insurance sector and complex unit-linked products make conduct regulations even more important. Enhanced disclosure requirements for intermediaries and close coordination with the insurance associations will improve the quality of intermediaries.

Summary Observance of Insurance Core Principles
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Recommended Actions
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