Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

Financial Safety Nets:

Review of Literature and Its Practices in Indonesia

Sukarela Batunanggar1

Abstract

In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essential
to foster financial system stability, predominantly in banking sector. Financial system stability and monetary
stability are mutually dependent and, therefore, must be preserved for sustainable economic growth. To
safeguard financial stability - particularly banking system - a financial safety nets is key pilar in addition to
effective supervisory and regulatory frameworks. As a chief conduit to sustainable economy growth, financial
system and monetary stability - both intertwined - must be well-preserved. A well-designed and comprehensive
financial safety nets mitigates risks to financial system and as a tool of crisis management to eliminate adverse
impacts of crisis when they occur. Albeit its scheme varies, FSN fundamentally consists of four elements : (i)
independent as well as effective regulation and supervision; (ii) effective lender of last resort; (iii) explicit
deposit insurance scheme; and (iv) clear crisis management. The Government and Bank Indonesia have drafted
a comprehensive framework for a Financial Safety Nets (FSN). The FSN framework clearly defines objectives
and elements of FSN, roles and responsibilities of relevant authorities, and coordination mechanism among
the authorities involved in the FSN: Ministry of Finance, Bank Indonesia, and the Deposit Insurance Corporation.
Equipped with a lucid legal framework for FSN and integrated implementation, effective preventive measures
and crisis resolution are possible.

1. INTRODUCTION contraction. Crises showed us that deposit insurance

Financial Safety Nets (FSN) is a key building block
of financial system stability. It prevents bank run,
limits probability of financial instability, as well as
minimizes frequency and adverse impact of economy
1 Executive Bank Researcher at Bank Indonesia. The views expressed in this paper are
those of the author and do not necessarily reflect the views of Bank Indonesia. E-mail
address: batunanggar@bi.go.id
scheme, discount facilities, emergency liquidity
assistance of central banks offer security and liquidity
to banks. Notwithstanding, FSN has negative
consequences unless it is well-designed. It may trigger
distortion in price signal used for resource allocation,
provoke risk taking and moral hazard that ultimately
call for for effective supervision and regulation.

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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
Graph 1:
Financial Safety Nets
Stable and Sound
Financial System
Regulation Lender of Deposit
and
Supervision
Last Resort
Policy
Insurance
System
System
Central Bank Central Bank DIC
(as Bank
(as LoLR)
Supervisor)
Solid legal framework, clear division of roles and responsibilities
and effective coordination mechanism
Until recently, there is no universal definition of
FSN. In general, FSN is public policy provided by
government to foster economy growth and financial
stability. Albeit its scheme varies, FSN fundamentally
consists of four elements : (i) independent as well as
effective regulation and supervision; (ii) effective
lender of last resort; (iii) explicit deposit insurance
scheme; and (iv) effective bank resolution and crisis
management. Typically, FSN has been succinctly
associated with lender of last resort and deposit
insurance. In this paper, on the other hand, the term
FSN refers to a broader definition.
2. REGULATION AND SUPERVISION
The ultimate objective of regulation and
supervision is to foster security and soundness of
financial institutions via evaluation and continous
surveillance. These include assessment on quality of
risk management, financial conditions, and
compliance with laws and regulations. Effective
regulation and supervision is the first safety nets
aiming at creating and promoting sound financial,
predominantly banking system.
Lack of supervisory capability is often cited as
one of the reasons for financial system weaknesses
62
(Mayes, Halme dan Liuksila, 2001). As Mishkin (2001)
argued, asymmetric information leads to adverse
selection and moral hazard problems that have an
important impact on financial systems and justifies
the need for prudential supervision.
Crisis
Management
Policy
The main focus of determining condition of a
bank pre-crisis is to rapidly help supervisor
MoF, differentiate banks having probability to survive from
Central Bank,
and DIC
those having probability to fail in a crisis. The main
characteristic of systemic crisis is that financial
condition of a bank will rapidly deteriorate as a result
of adverse economy and or widespread bank run.
Along with the rapid advancement, increasing
complexity, and greater risks confronting finance
industry, some multilateral agencies have developed
internationally accepted standards and supervisory
principles. The reference of standards and regulation
for banking industry is The 25 Basel Core Principle
for Effective Banking Supervision which is published
by the Basel Committee of Banking Supevision
(BCBS). For insurance industry, the standard refers
to The Principles of Insurance Supervision.
Some scholars including Goodhart (1998) and
Llewellyn (1999) have set up guiding principles of
banking regulation. Aside from the Basel Core
Principles, they set up principles of the importance
of incentives for bank management, effective
financial safety net which fosters prudential behavior
of bank management and stakeholders, market
discipline, and good corporate governance.
Financial system stability will exist should there
is power balance among various stakeholders,
shareholders, depositors, debtors, creditors, and
supervisors. Therefore, good corporate governance
is the key element in a supervisory framework (Mayes
et al., 2001). With respect to good corporate
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
governance, it is important to adopt regulatory
regime that is more market-based. Within this
context, transparency improvement through
enhanced disclosure must be the top agenda. New
Zealand is the country more adopting market-based
regime.
Drawbacks in governance and supervision have
been cited by experts as one of factors exacerbating
the Asian financial crises in 1997-1998, particularly
in Indonesia (Halim (2000), Nasution (2000),
Batunanggar (2002)). Hence, Bank Indonesia has
been strongly committed to enhance effectiveness
bank supervision comprehensively along with the
post-crisis bank restructuring program. Despite the
progress that has been made, challenges remain to
be seriously dealt with. From the supervision side, it
is essential to continuously enhance quality and
quantity of bank supervisors as well as enhance
quality of supervision information system in
proportion to the increasing complexity of business
and risks banks are confronting. From the banking
industry side, it is essential that banks exercise good
corporate governance, robust risk management, as
well as consistent and effective internal control.
Beside, to bolster the structure of banking industry,
banking consolidation initiative via merger is
indispensable.
The other important issue us the plan to unite
supervisory function of central bank and various
authorities into an independent mega regulator as
in the case of the United Kingdom, Australia, Japan,
and Korea in the last decade. In general, two
rationales for unification are to enhance supervision
efficiency and to effectively supervise financial
conglomerates. However, no empirical evidence has
been found concerning benefits of the unification
particularly from both micro-prudential and financial
system stability. In fact, Abram and Taylor (2000) and
Goodhart (2001) provide excellent discussions on the
issues in the unification of financial sector supervision.
Goodhart argues that banking supervision in less
developed countries is better to be kept within the
central bank because it will be better funded, more
independent and more expert and reliable. Hence, it
is important to rigorously consider the unification to
prevent potential problems from occurring, which
may deteriorate financial stability.
3. LENDER OF THE LAST RESORT (LLR)
LLR is discretionary provision of liquidity to a
financial institution (or the market as a whole) by
the central bank in reaction to an adverse shock
which causes an abnormal increase in demand for
liquidity which cannot be met from an alternative
source (Freixas et al., 1999).
The LLR concept was born in the19th century
by Henry Thornton (1802) who explicated the
fundamental elements of good central banking
practice in the light of emergency lending. Then,
Walter Bagehot (1873), more widely known as the
founding father of modern LLR, developed the
concept of Thornton (even though he did not
mention his name). Bagehot stated three principles
of LLR: (i) provide the lending against sufficient
collaterals (for solvent bank only); (ii) provide the
lending with penalty rate (for liquid banks only); (iii)
announce commitment to lend witout limit (to ensure
credibility).
Historical experience suggests that successful
lender of last resort actions have prevented panics
on numerous occasions (Bordo, 2002). Similarly,
Mishkin (2201) argues that central bank can
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
encourage the recovery of financial crisis by providing
loan in as lender of the last resort. Although there
may well be good reasons to maintain ambiguity over
the criteria for providing liquidity assistance, He
(2000) argues that properly designed lending
procedures, clearly laid-out authority and
accountability, as well as disclosures rules, will
promote financial stability, reduce moral hazard, and
protect the lender of last resort from undue political
pressure. There are important advantages for
developing and transitional economies to follow a
rule-based approach by setting out ex ante the
necessary conditions for support, while maintaining
such conditions is not sufficient for receiving support.
In the same vein, Nakaso (2001) suggests that Japan»s
LLR approach has shifted from ≈constructive
ambiguityΔ towards increasing policy transparency
and accountability.
As argued by Sinclair (2000) and Goodhart
(2002), within the time scale allowed, it is often
difficult, if not impossible, for central banks to
distinguish between a solvency and a liquidity
problem. Similarly, Enoch (2001) argued that there
should be restrictions against protracted use of such
lending, since this is likely to be an indicator of
solvency difficulties.
LLR activities by a central bank in a emerging
market countries with substantial foreign-
denominated debt, may not be as successful as in
an industrialised countries. Therefore, the use of the
LLR by a central bank in countries with a large amount
of foreign-denominated debt is trickier because
central bank lending is now a two edged sword
(Mishkin, 2001).
While individual frameworks differ from country
to country, there is a broad consensus on the key
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considerations for emergency lending during normal
and crisis periods (see Box A1.1).
Lender of Last Resort in Normal Times
In normal times, LLR assistance should be
based on clearly defined rules. Transparent LLR
policies and rules can reduce the probability of self-
fulfilling crises, and provide incentives for fostering
market discipline. It may also reduce political
intervention and prevent any bias towards
forbearance. LLR in normal times should only be
provided for solvent institutions with sufficient
acceptable collateral, while for insolvent banks
stricter resolution measures should be applied such
as closure. Therefore, there should be a clear and
consistent adoption of a bank exit policy. Once a
deposit insurance scheme has been established, the
central bank role in LLR in normal time can be
reduced to a minimum since the deposit insurance
company will provide bridging finance in the case
where there is a delay in closure process of a failed
institution2 .
LLR in Exceptional Circumstances
In systemic crises, LLR should be an integral part
of a well-designed crisis management strategy. There
should be a systemic risk exception in providing LLR
to the banking system. Repayment terms may be
relaxed to support the implementation of a systemic
bank restructuring programme. In systemic crises the
disclosure of the operation of LLR may become an
important tool of crisis management. The criteria of
a systemic crisis will depend on the particular
circumstances, thus, it is difficult to clearly state this
2 See Nakaso (2001) for a discussion on the Japanese LLR model.
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
beforehand in a law. However, the regulations on
the LLR facility should clearly set the guiding principles
and specific criteria of a systemic crisis and or a
potential bank failure leading to systemic crisis. To
ensure an effective decision making process and
accountability, there should be a clear institutional
framework and LLR procedures. Bank Indonesia
should be responsible for analysing the systemic
threats to financial stability while the final decision
on systemic crises resolution should be made jointly
by Bank Indonesia and the Ministry of Finance. To
ensure accountability, an appropriate documentation
audit trail should be maintained.
Box A1.1 Key Considerations of Emergency Lending
1. Have in place clearly laid out lending procedures,
authority, and accountability.
2. Maintain close cooperation and exchange of
information between the central bank, the
supervisory authority (if it is separate from the
central bank), the deposit insurance fund (if exist),
and the ministry of finance.
3. Decision to lend to systemically important
institutions at the risk of insolvency or without
sufficient, acceptable collateral should be made
jointly by monetary, supervisory, and the fiscal
authority.
4. Lending to non-systemically institutions, if any,
should be only to those institutions that are deemed
to be solvent and with sufficient acceptable
collateral.
5. Lend speedily.
6. Lend in domestic currency.
7. Lend at the above average market rates.
8. Maintain monetary control by engaging effective
sterilization.
Criticism on LLR
Experts criticized the classic doctrine of LLR.
Goodhart (1999) argued the impossibility to make a
clear distinction between the illiquid and insolvent
banks. Given the modern inter-bank money markets
are generally available, the solvent banks will be able
to obtain money market borrowings. Solow (1982),
stated that a central bank is also responsible for
financial system stability. In the light with financial
stability maintenance, he added, in most cases a
central bank must rescue insolvent banks to prevent
a financial system from systemic crisis. In addition,
Kauffman (1991), criticized LLR practice in which the
9. Subject borrowing banks to enhanced supervisory
surveillance and restrictions on activities.
10.Lend only for short-term, preferably not exceeding
three to six months.
11.Have a clear exit strategy.
Additional Requirements for Systemic Crisis
12.Decision to lend should be an integral part of crisis
management strategy and should be made jointly
by monetary, supervisory, and the fiscal authority.
13.Emergency support operations should be disclosed
when such disclosure will not be disruptive to
financial stability.
14.Repayment terms may be relaxed to accommodate
the implementation of a systemic bank
restructuring strategy.
15.Emergency support operation should be disclosed
when such disclosure will not be disruptive to
financial stability.
Source: Dong He (2000), «Emergency Liquidity Support Facilities», IMF Working Paper
No. 00/79.
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
government intervention will lead to a potential
political pressure and deteriorate regulation. Discount
window is obscurely granted to rescue insolvent
banks. Goodhart and Huang (1999) also argued a
dilemma between systemic risk avoidance and moral
hazard by bank management predominatly in the
rescue of large insolvent banks (too big to fail).
The other means to prevent moral hazard as
recommended by Bagehot more than a century ago
is via penalty rates. Yet, according to Freixas et al.
(1999) this may: (i) aggravate problem confronting
banks; (ii) indicate erroneous signal to market that
exacerbate bank run; and (iii) provide incorrect
incentives to bank managers to adopt higher risk-
reward strategy to pay higher interst rates. Hence,
to prevent the moral hazard from occurring, Freixas
et al. (1999) recommended that intervention be made
conditionally on the lending that is not fully
collateralized. The constructive ambiguity is expected
to thwart moral hazard, providing that it is furnished
by strong law enforcement on managers and
management of banks which are lacking of
prudential attitude when operating bank.
LLR Policy in Indonesia
3
As stipulated in the Law , Bank Indonesia may
provide LLR facility both for normal conditions and
for preventing systemic crisis. According to article 11
verse 1 and 2 of the Law, in a normal condition, Bank
Indonesia may provide LLR to a bank for resolving
short term liquidity problem in the form of
conventional lending or Syariah based principle
financing for maximum of 90 days. These facilities
are guaranteed by high quality and liquid collaterals,
3 The Act of the Republic of Indonesia number 23 1999 concerning Bank Indonesia as
amended by The Act of Republic of Indonesia number 3 2004
66
at least of the similar value against the received
facilities.
Furthermore, according to the above mentioned
article, stipulated ≈in case of a bank confronts
financial difficulties deemed to be systemic and may
trigger a crisis threatening financial system, Bank
Indonesia may provide emergency liquidity lending
whose source of funds will come from the
governmentΔ. Regulations of decision making to
determine whether a crisis systemic, provision of
Emergency Liquidity Assistance (ELA), and source of
funds from the state budget are stipulated in a
separate law.
Prior to the enactment of the ELA regulations,
temporarily the ELA provision was stipulated in the
Memorandum of Understanding between the
Minister of Finance and the Governor of Bank
Indonesia dated March 17, 2005. As stipulated in
the MoU, Bank Indonesia is responsible for analysing
systemic risk that will threat financial system stability,
whereas decision to provide the ELA will be made
by both the Governor of Bank Indonesia and
Minister of Finance. The procedure of ELA provision
will be technically stipulated in the Regulation of
Bank Indonesia and Regulation of the Minister of
Finance.
Learning from the case of Bank Indonesia
Liquidity Support, at least two basic issues need to
be clearly made in a regulation to ensure
accountability in providing the ELA. First, collateral
issue, it is essential to determine whether the ELA is
secured or unsecured lending. Refer to best practices,
in general ELA is seen as unsecured lending from a
central bank and, therefore, some exceptions may
be applied. Second, the decision making needs to
be anticipated and clearly defined in the law should
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
disagreement between the Minister of Finance and
the Governor of Bank Indonesia occurs.
4. DEPOSIT INSURANCE
In general, deposit insurance have three
interlinked objectives: (i) to guarantee less
sophisticated depositors; (ii) to preserve public
confidence on the financial system, particularly
banking system; and (iii) to safeguard financial
stability. Fundamentally, deposit insurance system is
aimed at preventing bank runs. Refer to the model
of Diamond-Dybvig (1983), bank runs has a feature
≈self-fulfilling prophecyΔ, in which the erosion of
depositors may trigger banking crisis. This is due to
two factors: (I) information assimetry between
depositors and bank management; and (ii) in general,
depositors are lacking capacity to assess financial
soundness of a bank. Besides, banks are also
susceptible to liquidity risk as their liquid assets are
far less than their liquid assets.
In more detail, Thompson (2004) explained five
arguments to implement deposit insurance: (i) to
foster banking system stability that is susceptible to
bank runs during a crisis that would pose contagion
effect to sound and solvent banks (Diamond and
Dybvig, 1983); (ii) protected deposits provide
options to small depositors and, consequently, help
raise savings for investment purpose; (iii) if a
supervisory authority is under political pressure to
bail-out depositors (when an implicit deposit
insurance scheme exists), explicit deposit insurance
will be able to limit guranteed liabilities by
determining ex-ante what is or what is not
guaranteed; (iv) a deposit insurance scheme
empowers small banks to compete against large
banks; (v) explicit deposit insurance help supervisory
authority to exercise more rigorous supervision on
banks.
Before the 1997 crisis, none of the East Asian
crisis countries except the Philippines, which was least
affected by the crisis, had an explicit deposit insurance
scheme. Bank Indonesia provided both liquidity and
capital support to problem banks on an ad-hoc basis
and in non transparent ways4. The support was also
not based on any pre-existing formal guarantee
mechanism but rather on a belief that some of the
banks that needed support were too big to fail or
the failure of a bank could cause contagion.
A limited deposit guarantee in Indonesia was
first applied when the authorities closed down Bank
Summa at the beginning of the 1990s which was
considered unsuccessful5 . After then, there were no
bank closures until the authorities closed down 16
banks in November 1997 and introduced a limited
guarantee. However, this failed to prevent systemic
bank runs.
To restore domestic and international
confidence in the economy and the financial system,
the government signed the second agreement with
the IMF on 15 January 1998. However, market
perceptions and reactions to the government
commitment and capacity to resolve the crisis were
still negative. There was a huge amount of capital
flight of around $600 million to $700 million per
day. On 22 January, the rupiah plummeted to a record
low of Rp16.500.
To prevent a further slide and to maintain public
confidence in the banking system on 27 January, the
government issued a blanket guarantee. It covered
4 However, this was done primarily for domestic rather than foreign banks.
5 The plan for establishing a deposit insurance scheme has been discussed quite intensively
since the early 1990s. However, the authorities declined the proposal because they
considered that it would create moral hazard.
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

all commercial banks liabilities (rupiah and foreign the likelihood of future banking crises. Therefore, he
currency), including both depositors and creditors. It suggested that Indonesian should develop an
was an interim measure pending the establishment incentive-compatible deposit insurance system -
6
of the Deposit Insurance Agency . Initially, the along the lines of FDICIA in the United States - which
administration of the blanket guarantee was a joint should be a permanent part of the financial
task between Bank Indonesia and IBRA. From June infrastructure.
2000 it has been the responsibility of IBRA alone7 . However, systemic bank runs in Indonesia at the
The Indonesian case suggests that a very limited outset of the 1997 crisis cannot be attributed solely
deposit insurance scheme was not effective in to the absence of a blanket guarantee. The
preventing bank runs during the 1997 crisis. Deposits inconsistent and non transparent bank liquidation
denominated of more than Rp20 millions - the policies applied by the authorities and some political
uninsured component - accounted for about 80% uncertainties during the end of Suharto»s regime also
of total deposits. Therefore, if a blanket guarantee played their part, as Lindgren et al. (1999) and Scott
had been introduced earlier at the outset of the crisis, (2002) document. The introduction of the blanket
the systemic runs might have been reduced. guarantee programme at the outset of the crisis
There was a controversy over the adoption of a might be necessary in order to prevent larger potential
blanket guarantee. Some commentators such as economic and social costs of the systemic crisis
Furman and Stiglitz (1998), Stiglitz (1999,2002), (Lindgren et al. 1999). However, the scheme should
Radelet and Sachs (1998) argue that the if the blanket be replaced as soon as possible with one that is more
guarantee had been introduced earlier, before some appropriate to normal conditions and does not create
banks had been liquidated, the damage and costs of moral hazard.
the crisis would have been much less.
In contrast, others criticised the blanket Best Practices
guarantee for being too broad. Goldstein (2000) Garcia (1999, 2000), based on surveys in 68
argued that had all bad (insolvent) banks been closed countries, identified the best practices of explicit
at the beginning of the crisis then even with the systems of deposit insurance principally should have
limited deposit guarantee scheme in place there good infrastructure, avoid moral hazard, avoid
would not have been widespread deposit adverse selection, reduce agency problems and
withdrawals because the remaining banks would ensure financial integrity and credibility. Based on a
have been «good» ones. He believed that with a study of deposit insurance systems in Asian countries,
blanket guarantee, the government ended-up Choi (2001) argues that it is reasonable in Asia to
providing ex-post deposit insurance at a higher fiscal establish and maintain an explicit and limited deposit
cost and with adverse moral hazard effects increasing insurance system in order to prevent further possible
financial crisis. Pangestu and Habir (2002) suggest
6 Initially it was to be retained for a minimum of two years, with a provision for an automatic
six months extension in the absence of an announcement of termination of the scheme.
that Indonesia»s deposit insurance scheme should be
7 BI retains the role of administering the guarantee scheme to trade finance, inter-bank
debt exchange and rural banks. designed on two key aspects. First, it should provide

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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
incentive to better performing banks by linking the
annual premium payment to their risk profile. Second,
it should be self-funded in order to foster market
discipline and reduce the fiscal burden.
In order to avoid a disruption to the banking
system, Garcia (2000) suggests that a partial
guarantee should not be introduced ideally until: (1)
the domestic and international crisis has passed; (2)
the economy has begun to recover; (3) the macro-
economic environment is supportive of bank
soundness; (4) the banking system has been
restructured successfully; (5) the authorities possess,
and are ready to use, strong remedial and exit policies
for bank that in the future are perceived by the public
to be unsound; (6) appropriate accounting,
disclosure, and legal systems are in place; (7) a strong
prudential regulatory framework is in operation; and
(8) public confidence has been restored. It seems that
currently Indonesia does not meet all these
requirements.
Demirguc-Kunt and Kane (2001) suggest that
countries should first assess and remedy the
weaknesses of their international and supervisory
environments before adopting an explicit deposit
insurance system. In line with this, Wesaratchakit
(2002) reported that Thailand decided to adopt a
gradual transition from a blanket guarantee to a
limited explicit deposit insurance scheme. It was
considered that there are some preconditions that
should be met - particularly the stability of banking
system and the economy as a whole, effectiveness
of regulation and supervision as well as public
understanding - before shifting to an explicit limited
deposit insurance system.
There is an issue of how depositors will react to
the introduction of the limited scheme. In January
2001, Korea replaced its blanket guarantee with a
limited deposit insurance system with an insurance
limit of 50 million won per depositor per institution.
There was a noticeable migration of funds from lower
rated to sounder banks. Also, large depositors actively
split their deposits to several accounts in banks and
non-bank financial institutions. But there has been
no bank run on the Korean financial system as a
whole.
It is important to prepare a contingency plan
before removing the blanket guarantee in order to
anticipate the worst-case scenarios such as a loss of
public confidence. If such conditions occur, the central
bank may have to extend liquidity support to illiquid
but solvent banks. In addition, there should be a clear
legal framework for the deposit insurance scheme.
To reduce moral hazard and to induce market
discipline, the authorities should set a tough sanctions
to the financial institutions and players which are
violate the rules and cause problems into banks and
ensure that law enforcement are in place.
Criticism on Deposit Insurance
Arguments in favor of explicit deposit insurance
scheme for financial deepening and financial stability
has been widely accepted by policy makers, even IMF
has recommended it to many countries (Folkerts-
Landau and Lindgren, 1997; Garcia, 1999).
Notwithstanding, some experts remain skeptical. Cull
(1998) is unconvinced about the argument that
deposit insurance fosters financial deepening by its
ability to expand deposit base as well as it lay solid
ground for more advanced banking system. Cull et
al. (2000) also argued that explicit deposit insurance
does not have strong effect on sectoral concentration
- that is likely to promote keener competition. Kane
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
(2000) concluded that based on study in 40 countries
in deposit insurance scheme, the weaker information
condition, ethics, and governance of a country, the
more detrimental effect of explicit deposit insurance
scheme on banking system stability. Corresponding
to the study, in a more comprehensive study, Kane
and Demirguc-Kunt (2001) concluded that whenever
law enforcement is feeble and creditors» rights are
not well-protected,explicit deposit insurance will likely
to spur financial instability.
Honohan and Klingebiel (2000), based on
sample of 40 developed and emerging market crises,
found that unlimited deposit guarantees, open-
ended liquidity support, repeated recapitalisation,
debtors bail-out and regulatory forbearance
significantly and sizeably increase the resolution costs.
Moreover, based on evidence from 61 countries in
1980-97, Demirguc-Kunt and Detragiache (1999),
find that that explicit deposit insurance tends to be
detrimental to bank stability, the more so where bank
interest rates are deregulated and the institutional
environment is weak. Similarly, Cull et al. (1999)
based on a sample of 58 countries also find that
generous deposit insurance leads to financial
instability in the presence of a weak regulatory
environment.
Greenspan (2002) explained two contradictory
implications of deposit insurance. On one side,
deposit insurance prevents bank runs disturbing
short-term financial structure. On the other hand, it
may erode market discipline and incite moral hazard
that is most likely trigger future systemic risks. A
deposit insurance scheme helps banks raise fund
more efficiently and take greater risks without
worrying of losing customers. In other words,
deposit insurance foster resources misallocation by
70
cutting correlation of risk and reward in particular
markets. Hence, it is imperative to have effective
supervision to protect tax payers and avoid cost of
crisis resolution.
Deposit Insurance Practice in Indonesia
To restore public confidence on banking sector
following the financial meltdown in 1997, the
Indonesian government was compelled to issue
blanket guarantee program. Under this program, all
deposits at banks are insured. The program
successfully restore public confidence on domestic
banking industry. Nonetheless, the all-inclusive
created burden on the state budget and triggered
moral hazard by management and bank customers.
Bankers were lacking of incentives to conduct
business prudently, whereas customers overlooked
financial conditions of bank when making
transaction. Beside, in general, blanket guarantee is
a temporary measure to restore public confidence
during a crisis.
Finally, Indonesia has a Deposit Insurance
Instition (Lembaga Penjamin Simpanan or LPS)
following a long and painstaking debates in the
Parliament. The Parliament enacted Deposit Insurance
Law number 24 year 2004 on September 22, 2004.
As stipulated by the law, the Deposit Insurance
Institution has two core functions: (1) provide
guarantee on customer deposits and (2) implement
resolution over failing bank. The law also stipulates
legal status, governance, asset and liabilities
management, reporting system and accountability
of the Deposit Insurance Institution as well as lay legal
basis for cooperation with other authorities. This is
important to ensure that the Deposit Insurance
Institutions is independent, transparent, and
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
accountable in performing its roles and
responsibilities.
The Deposit Insurance Institution carries out a
limited and explicit deposit insurance scheme. The
rationales behind the selection of this scheme are to
purge the burden of crisis resolution on the state
budget and to prevent moral hazard. This scheme is
mandatory for all banks operating in Indonesia, both
commercial and rural banks. The insured items are
saving accounts, demand deposits, certificate of
deposits, time deposits, and other similar type of
deposits.
For effective implementation, a two year
transition period was introduced prior to a full fledge
deposit guarantee scheme:
September, 22 2005 - March, 21 2006 : all
deposits
March 22, 2006 - September 21, 2006 : all
deposits up to Rp 5 billion
September, 22 2006 - March 21, 2007 : all
deposits up to Rp 1 billion
March 22, 2007 - onwards : all deposits up to
Rp 100 million
Some challenges remain. First, coordination
system between the Deposit Insurance Institution and
other authorities, in particular Bank Indonesia needs
to be clearly defined. The foremost challenging effort
is to foster coordination in handling and
implementing resolution on a failing bank. The
procedure of coordination can be set up by referring
to the best practices in other countries, including
using a Memorandum of Understanding.
Nonetheless, the practice is not so simple, as gaining
agreement between the respective authorities is
frequently a lengthy process. Notwihstanding,
interlocking structure of the Board of Commisioner
involving ex-officio member from Bank Indonesia and
the Ministry of Finance should help resolve the
coordination issue. Also, to cultivate more effective
coordination in the operational layer, some staff
members of the Deposit Insurance Institution are
seconded from central bank and ministry of finance.
This option is adopted by the Indonesian Deposit
Insurance Institution. Second, capital adequancy of
the Deposit Insurance Institution must be well-
mainted to ensure public confidence. Considering
the capital base of the Deposit Insurance Institution
is reasonably modest, it is essential to anticipate the
probability of bank failure demanding a substantial
amount of resolution cost in the short-term that will
substantially erode the capacity of the Deposit
Insurance Institution to perform effective resolution.
Third, it is essential to anticipate the probability of
flight to quality from the perceived less sound banks
to the perceived sounder banks. This is a sensitive
issue considering the concentrated structure of
banking deposits, in which around 50% of bank
depositors are those having balance exceeding Rp100
million. Hence, it is recommended that the flight to
quality issue be empirically studied or surveyed to
formulate accurate policy response. Fourth,
considering the lack of public awareness, the Deposit
Insurance Institution and Bank Indonesia need to
intensively make public the Deposit Insurance
Institution and its scheme.
5. CRISIS MANAGEMENT
In the last decade, the vast majority of countries
hit by systemic banking crises demanded expensive
and unavoidable cost of crisis to restore their banking
system. Shareholders of the shut down banks were
indeed reluctant to bear the crisis cost and, therefore,
71
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
how to solve the problem? In many countries, all
costs were borne by taxpayers. For instance, fiscal
cost of Indonesian banking resolution in 1997 and
1998 was Rp654 trillion or about 51% of GDP, the
highest in Asia. Indonesia ranked second after
Argentina which booked cost or 55.1% of GDP when
a crisis hit the country in 1980-1982.
Empirical study by Honohan and Klingebiel
(2000, 2002) revealed findings that unlimited deposit
insurance, open-ended liquidity support, repetitive
bank recapitalization, bail out, and regulatory
forbearance, augment fiscal cost of crisis substantially.
The case of Indonesia revealed five factors behind
high cost of crisis: (i) long delay of crisis resolution,
particularly bank closure and recapitalization
program; (ii) lack of understanding about the root
and the magnitude of crisis resulting in incorrect
strategy of crisis resolution (for instance partial
approach in bank closure); (iii) sub-effective
coordination and lack of consensus among
authorities with regard to crisis management; (iv) lack
of commitment to make prompt decision to solve
the crisis, for instance to close down insolvent banks
in the eve of the crisis and to avoid political
intervention; and (v) sub-optimal law enforcement
and drawbacks in legal and supervisory frameworks,
which in turn, incite moral hazard. Indonesia would
have been better should prompt corrective actions
were taken; however, it was extremely difficult as
due to rampant political intervention.
Along with the increasingly integrated global
financial system, responsive supervision and crisis
management policies are vital. The ultimate objective
of supervision is obvious; yet, challenges in crisis
management differ significantly. For instance,
resolution for globally operating large banks needs
72
a clear crisis management policy, cost sharing, as well
as effective inter government coordination (Gulde
and Wolf, 2005).
Considering the substantial cost of crisis and its
serious magnitude, robust crisis management is vital.
Crisis management should be supported by legal
framework and clear crisis resolution policies that
clearly define roles and responsibilities as well as
effective coordination of respective authorities. Also,
it is critical to have effective organization and
leadership and, hence, strategies and corrective
measures can be promptly made.
To bolster financial system stability, the
Government and Bank Indonesia have prepared a
comprehensive framework of Financial Safety Net
(FSN). The FSN framework clearly defines objectives
and elements of FSN, roles and responsibilities of
relevant authorities, and coordination mechanism
among the authorities. The FSN has four elements:
effective supervision and regulation; (ii) lender of last
resort; (iii) deposit insurance; and (iv) effective crisis
management. Currently, a task force composed of
staff members of Ministry of Finance, Bank Indonesia,
and Deposit Insurance Corporation, is drafting the
FSN Law. The law will be a solid legal basis for
respective authorities to preserve financial stability,
particularly for crisis management.
6. CONCLUSION
To enhance the Indonesian financial safet net,
two principal policies are recommended. First,
gradually replace blanket guarantee with a limited
explicit deposit insurance scheme. Second, formulate
and implement a transparent lender of last resort
policy both for normal and crisis times. Nevertheless,
both policies must be implemented comprehensively
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
and linked with banking prudential supervision and
market discipline to prevent a banking crisis.
For effective coordination, Coordination
Committee consisting of Minister of Finance, Bank
Indonesia and the Deposit Insurance Corporation was
established. In addition, Financial System Stability
Forum (FSSF) as a venue of coordination and
information sharing to discuss financial stability issues
among fiancial safety nets player was created.
Learning from the 1997 crisis, some crisis
management issues remain challenging. First, it is
imperative to: (i) lay a clear legal basis clearly defining
effective coordination means; (ii) clearly define
responsibilities of respective authorities, and (iii) foster
trust and cooperative culture among respective
authorities. This needs strong leadership and political
support from the parliament. Third, it is vital to
enhance operational capacity of resources from
respective authorities. Crisis management should be
promptly and accurately made. In some countries,
authorities set up «crisis management team» which
regularly meet to discuss financial stability issues and
exercise crisis management simulation as a part of
efforts to enhance organizational capacity.
Crisis episodes in some countries in the last two
centuries remind us two important lessons: first,
financial crisis repeatedly occurs; and two, a financial
crisis is difficult to predict and, therefore, difficult to
avoid. Hence, it is easier to prevent than to cure.
Referring to the principles, it is imperative to enhance
financial system stability via implemention of effective
supervision and regulation, robust risk management,
effective internal control - the first line of defense in
banking industry.
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
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