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Batunanggar, Financial Safety Nets: Review of Literature and Its Practices in Indonesia

Batunanggar, Financial Safety Nets: Review of Literature and Its Practices in Indonesia

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In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essentialto 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.
In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essentialto 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.

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Published by: Muhammad Arief Billah on Jul 14, 2008
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05/09/2014

 
Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
61
Financial Safety Nets:Review of Literature and Its Practices in Indonesia
Sukarela Batunanggar
1
1. INTRODUCTION
Financial Safety Nets (FSN) is a key building blockof financial system stability. It prevents bank run,limits probability of financial instability, as well asminimizes frequency and adverse impact of economy
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.
contraction. Crises showed us that deposit insurancescheme, discount facilities, emergency liquidityassistance of central banks offer security and liquidityto banks. Notwithstanding, FSN has negativeconsequences unless it is well-designed. It may triggerdistortion in price signal used for resource allocation,provoke risk taking and moral hazard that ultimatelycall for for effective supervision and regulation.
1Executive Bank Researcher at Bank Indonesia. The views expressed in this paper arethose of the author and do not necessarily reflect the views of Bank Indonesia. E-mailaddress: batunanggar@bi.go.id
Abstract 
 
Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
62
Stable and SoundFinancial System
Solid legal framework, clear division of roles and responsibilitiesand effective coordination mechanismRegulationandSupervisionSystemCentral Bank
(as BankSupervisor)
Lender ofLast ResortPolicy
(as LoLR)
DepositInsuranceSystemD I CCrisisManagementPolicyMoF,Central Bank,and DICCentral Bank
Graph 1:Financial Safety Nets
Until recently, there is no universal definition ofFSN. In general, FSN is public policy provided bygovernment to foster economy growth and financialstability. Albeit its scheme varies, FSN fundamentallyconsists of four elements : (i) independent as well aseffective regulation and supervision; (ii) effectivelender of last resort; (iii) explicit deposit insurancescheme; and (iv) effective bank resolution and crisismanagement. Typically, FSN has been succinctlyassociated with lender of last resort and depositinsurance. In this paper, on the other hand, the termFSN refers to a broader definition.
2. REGULATION AND SUPERVISION
The ultimate objective of regulation andsupervision is to foster security and soundness offinancial institutions via evaluation and continoussurveillance. These include assessment on quality ofrisk management, financial conditions, andcompliance with laws and regulations. Effectiveregulation and supervision is the first safety netsaiming at creating and promoting sound financial,predominantly banking system.Lack of supervisory capability is often cited asone of the reasons for financial system weaknesses(Mayes, Halme dan Liuksila, 2001). As Mishkin (2001)argued, asymmetric information leads to adverseselection and moral hazard problems that have animportant impact on financial systems and justifiesthe need for prudential supervision.The main focus of determining condition of abank pre-crisis is to rapidly help supervisordifferentiate banks having probability to survive fromthose having probability to fail in a crisis. The maincharacteristic of systemic crisis is that financialcondition of a bank will rapidly deteriorate as a resultof adverse economy and or widespread bank run.Along with the rapid advancement, increasingcomplexity, and greater risks confronting financeindustry, some multilateral agencies have developedinternationally accepted standards and supervisoryprinciples. The reference of standards and regulationfor banking industry is The 25 Basel Core Principlefor Effective Banking Supervision which is publishedby the Basel Committee of Banking Supevision(BCBS). For insurance industry, the standard refersto The Principles of Insurance Supervision.Some scholars including Goodhart (1998) andLlewellyn (1999) have set up guiding principles ofbanking regulation. Aside from the Basel CorePrinciples, they set up principles of the importanceof incentives for bank management, effectivefinancial safety net which fosters prudential behaviorof bank management and stakeholders, marketdiscipline, and good corporate governance.Financial system stability will exist should thereis power balance among various stakeholders,shareholders, depositors, debtors, creditors, andsupervisors. Therefore, good corporate governanceis the key element in a supervisory framework (Mayeset al., 2001). With respect to good corporate
 
Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
63
governance, it is important to adopt regulatoryregime that is more market-based. Within thiscontext, transparency improvement throughenhanced disclosure must be the top agenda. NewZealand is the country more adopting market-basedregime.Drawbacks in governance and supervision havebeen cited by experts as one of factors exacerbatingthe Asian financial crises in 1997-1998, particularlyin Indonesia (Halim (2000), Nasution (2000),Batunanggar (2002)). Hence, Bank Indonesia hasbeen strongly committed to enhance effectivenessbank supervision comprehensively along with thepost-crisis bank restructuring program. Despite theprogress that has been made, challenges remain tobe seriously dealt with. From the supervision side, itis essential to continuously enhance quality andquantity of bank supervisors as well as enhancequality of supervision information system inproportion to the increasing complexity of businessand risks banks are confronting. From the bankingindustry side, it is essential that banks exercise goodcorporate governance, robust risk management, aswell as consistent and effective internal control.Beside, to bolster the structure of banking industry,banking consolidation initiative via merger isindispensable.The other important issue us the plan to unitesupervisory function of central bank and variousauthorities into an independent mega regulator asin the case of the United Kingdom, Australia, Japan,and Korea in the last decade. In general, tworationales for unification are to enhance supervisionefficiency and to effectively supervise financialconglomerates. However, no empirical evidence hasbeen found concerning benefits of the unificationparticularly from both micro-prudential and financialsystem stability. In fact, Abram and Taylor (2000) andGoodhart (2001) provide excellent discussions on theissues in the unification of financial sector supervision.Goodhart argues that banking supervision in lessdeveloped countries is better to be kept within thecentral bank because it will be better funded, moreindependent and more expert and reliable. Hence, itis important to rigorously consider the unification toprevent potential problems from occurring, whichmay deteriorate financial stability.
3. LENDER OF THE LAST RESORT (LLR)
LLR is
discretionary 
provision of liquidity to afinancial institution (or the market as a whole) bythe central bank in reaction to an adverse shockwhich causes an abnormal increase in demand forliquidity which cannot be met from an alternativesource (Freixas et al., 1999).The LLR concept was born in the19th centuryby Henry Thornton (1802) who explicated thefundamental elements of good central bankingpractice in the light of emergency lending. Then,Walter Bagehot (1873), more widely known as thefounding father of modern LLR, developed theconcept of Thornton (even though he did notmention his name). Bagehot stated three principlesof LLR: (i) provide the lending against sufficientcollaterals (for solvent bank only); (ii) provide thelending with penalty rate (for liquid banks only); (iii)announce commitment to lend witout limit (to ensurecredibility).Historical experience suggests that successfullender of last resort actions have prevented panicson numerous occasions (Bordo, 2002). Similarly,Mishkin (2201) argues that central bank can

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