What sort of financial sector should Indonesia have?

Abstract

At the time of the 1997 Asian crisis, Indonesia's financial sector had serious weaknesses. This made it vulnerable to the key element of the crisis: massive reversal of foreign capital flows. Despite huge expenditures on restructuring, many of these weaknesses remain and the current strategy does not seem likely to overcome them. The alternative strategy explored here advocates the creation of ‘savings banks’, holding government bonds as their principal asset. With these safe assets, deposits in such institutions would be secure, even in the event of a major economic crisis. With this safe ‘core’, the rest of the financial system could develop on conventional lines (allowing removal of the current blanket guarantee, and making it more feasible to close banks without this causing a run on the system as a whole). The inherent risk to the taxpayer of another expensive bail-out would be greatly diminished.

Notes

The most extreme version of this occurred in Thailand, with the Bangkok International Banking Facility (see, for example, International Monetary Fund 1998: 35).

In its January 2004 ‘Review under the Extended Arrangements’, the IMF described the situation in this way: ‘The mission expressed concerns … with the continued fragility in the state banks. In addition to general concerns about the condition of the state banks, serious questions have been raised about Bank BNI … The mission urged the authorities to maintain close oversight over the other state banks … Concerns about state banks' performance remain, particularly with regard to the pace of corporate lending. In this regard, the authorities agree with the need to monitor closely Bank Mandiri's compliance with its action plan … [The mission] encouraged the authorities to expedite work on the development of a strategic plan for the future of Mandiri (and the other state banks) that would provide a framework for increasing private sector participation.’ [Bank Mandiri is Indonesia's largest state bank, formed through the merger in 1999 of four state banks, Bank Dagang Negara, Bank Bumi Daya, Bank Exim and Bank Pembangunan Indonesia.]

It may be true that, with the 20/20 vision of hindsight, it would have been better to allow some of the private banks to close immediately, even if their depositors had to be paid out in full. At least this would have stopped the banks from continuing to fund capital outflow and further loans to bankrupt companies, which had the effect of shifting more of the losses from the private sector to the public.

If the commercial banking system were to collapse again it would be desirable to have some banks that can keep export finance going. This kind of lending is relatively safe and simple to operate.

In order to carry out their payments functions and to provide trade finance, they would need a small amount of other assets.

For a recent discussion of the case for narrow banks, see Bossone (2001).

They are even safe against interest-rate risk, provided the bonds have a floating interest rate; given that the government is the main determinant of the rate of inflation, this is a proper way of ensuring that the risk lies with the entity capable of controlling it.

Of course they may still complain, but it should be easier for the government to resist these complaints if it has ensured that there is an alternative safe repository, and that the risks were transparent.

This is legally possible (and indeed foreigners have participated in some of the sales). But there is strong resistance from both the parliament and the public (mainly the staff and management of the banks being sold), which slows the process and discourages foreigners from bidding.

Alternative suggestions are provided by McLeod (2004) and Frécaut (2004).