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Agus Martowardojo is an
experienced banker and his new position as Bank Indonesia’s (BI) governor
could bring a refreshing change to BI in fulfilling its key challenges
after the establishment of the Financial Services Authority (OJK).
There are two
major challenges to pass.
First, BI has
experienced great losses of power and pride with the removal of the bank
supervisor unit. The organization that was once large has now suddenly
become smaller and public attention has been diverted more to the OJK.
This loss of
power is massive and could be disconcerting for BI. For this reason, the
new governor has to redefine BI’s role and orientation under the new
supervisory architecture and has to instill new motivation among his
staff.
The second
challenge is related to the substantiation of BI’s role after the
transfer. In particular, the governor needs to address macro stability
and macro prudential issues more resolutely.
These central
macro policy areas tend to be the least understood by many relevant
parties, including the House of Representative members who endorsed the
appointment.
Concerning
macro stability, the governor should put more effort into a price
stability policy instead of an exchange rate policy, despite the mention
of the exchange rate in the mission statement and price stability in the
vision statement.
The two
things are difficult in terms of simultaneously being carried out. In
line with an International Monetary Fund report of June 2012, referring
to BI’s ultimate objective, the domestic price target should be a higher
priority than the exchange rate target, since there are periods when
price stability policy and exchange rate policy can potentially be in
conflict.
Price
stability policy is more appropriate since the lower-middle class still
dominates Indonesia’s domestic-oriented economy. High inflation will hurt
purchasing power. The exchange rate policy is more beneficial to
prosperous segments of society depending on imported goods or on having
investment in foreign currencies.
The costs of
artificially maintaining the value of the rupiah could also be very
large, or at the expense of inflation. Meeting the inflation target will
strengthen the rupiah eventually.
An equally
critical issue to address is macro prudential policy. The policy needs to
be strengthened to maintain the stability of the financial system. Why it
this critical? If two or three small banks collapse and the Deposit
Insurance Corporation (LPS) has sufficient funds, the public will not be
worried.
But if
systemic banks collapse, the attendant costs to the economy could be
unprecedented. The cost of the banking crisis in 1997 was more than 50
percent of Indonesia’s GDP, the largest loss in terms of GDP in modern
history.
To argue the
importance of macro prudential policy, the UK government has reinserted
the Financial Services Authority (FSA) back in the Bank of England.
According to
the Bank of England: “The
prudential regulator’s micro prudential and macro prudential
responsibilities will need to work closely together, and that is one
reason why it is sensible that they are both in the central bank.”
This opinion
is also supported by research conducted by Samuel G. Hanson: “The regulatory framework in place
prior to the global financial crisis was deficient because it was largely
‘micro prudential’ in nature. By contrast, a ‘macro prudential’ approach
recognizes the importance of general equilibrium effects, and seeks to
safeguard the financial system as a whole.”
Macro
prudential refers to systematic risk that is critical to address
pro-cyclicality and externality. For example, the Basel Committee finds
that a number of banks continued to make large earning distributions at
the onset of the financial crisis, driven by a collective action problem,
where reductions in distributions were perceived as sending a signal of
weakness.
Incurred
losses in the banking sector can be extremely large when a downturn is
preceded by a period of excess credit growth.
The committee
requests its members, including Indonesia, to encourage banks to build up
buffers in good times that can be utilized in bad times. Indonesian banks
are now in a state of extremely high profitability and it is now time to
build up reserves.
The pro-cyclicality
effect of BI’s regulation loan to value (LTV) should be modified. Banks
are not allowed to grant a home loan of more than 70 percent of the total
value of the object.
However, the
regulation will not work if it is not well carried out due to speculative
excess and inappropriate valuation reports. Consequently, the mortgage
credit in the system can swing excessively. The economies of the Republic
of Ireland and Spain were hurt badly because of the real estate bubble.
Externality
should be addressed appropriately as it can jeopardize the financial
system. Let us take short-term fund interbank lending to enhance this
point.
The fund is
favorable because of the cheapness. If a large number of banks take the
short fund and the interbank market suddenly becomes stagnant, the banks
will have difficulties finding funding.
This will
bring the financial system down. Before the crisis 2008 in the US,
short-term funds dominated the balance sheet of US banks and when the
volume of transactions in the market became very low, banks were
unwilling to lend liquidity to Lehman Brothers, causing this investment
bank to go bankrupt.
Having put
forward the importance of macro prudential responsibilities, the
stability of the banking system cannot only be expected from the OJK,
which will concentrate on individual banks (micro prudential
responsibilities).
BI should
fill the gap to purse strong macro prudential policy. It should team up
with the OJK in implementing the capital requirements of Basel III as
soon as possible. Systematic risk is addressed an important component of
Basel III and if properly implemented, it will cover systematic risks
through additional capital charges.
Basel III
also addresses the high quality of core capital that is required when the
economy weakens.
To ensure the
new role and orientation are fulfilled in due course, Agus should remodel
BI so that it becomes more dynamic, professional and able to support
cooperation with the OJK.
Besides the
need to empower, arising from the new regulatory architecture, the
downsizing of BI should be considered a way of boosting efficiency and
high performance. In fact, BI’s new units do not need much manpower
compared to its bank supervisor unit.
Finally, BI’s
human resources should also be reformed by hiring new staff from the
outside in order to
promote diversity, which is critical in conducting monetary policy and
pursuing macro prudential policy.
The central
bank of Singapore continues with recruitment at all levels from the
private sector. Even Joko “Jokowi” Widodo, Jakarta’s popular governor, is
recruiting village chiefs and district leaders.
BI as an
employer is place of work that should be pursuing important goals, rather
than a place to take shelter. ●
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