Coordinate monetary policy, supervision

Fajar Hidayat, MBA, Int'l Banking & Finance, Birmingham University, UK

According to Central Bank Law No. 23/1999, Bank Indonesia (BI) will no longer be responsible for supervising banks by the end of 2002. This task will be transferred to a separate agency responsible for the supervision of all types of financial institutions, including banks, insurance agencies, securities companies and pension funds. There is an ongoing process to establish the Financial Services Authority, although its establishment might not be on schedule due to the amendment process to the law.

Particularly in banking supervision, an agreement has been reached between BI and the government about authority allocation. Basically, the central bank continues to have the authority to supervise the macro-banking system, while the Financial Services Authority would supervise banks individually or the micro-banking system. The central bank concentrates on the monetary policy and payment system. The Financial Services Authority would focus on the banks' compliance in following prudential banking regulations and sound banking examinations.

This allocation of authority reflects an apparent separation between the central bank and the Financial Services Authority in banking supervision. When the separation is accomplished, the remaining question will be how can the monetary policy and micro- banking supervision be synchronized to achieve sustainable monetary and banking stability?

The broad objective of a monetary policy is to achieve stable prices. Price stability means that changes in the general level of prices in the economy are relatively small and gradual, or in other words, prices do not rise much from month to month and from year to year. In practice, price stability equates to low and stable inflation. Central bank conduct on the monetary policy fits within some sort of regime, such as money targeting, exchange rate targeting or inflationary targeting. The policy can be implemented by open market operations, determination of interest rates and minimum reserves requirements.

The aims of micro-banking supervision are to insure banks comply with banking law and regulations; to examine the soundness of banks; and to prevent bank management from undertaking excessive risks to the disadvantage of existing depositors and creditors. The expected magnitude of micro-banking supervision is banking stability, in which banks have good quality assets and liabilities, adequate liquidity and capital solvency.

Monetary policy and micro-banking supervision are closely related. The transmission mechanism of monetary policy instruments, e.g. the effect of short-term interest rates on inflation, flows largely through the intermediation of the banking system. Tradeoffs between monetary stability and micro- stability of the banking system could occur when there is a conflict of interest between the monetary policy and the micro- banking supervision.

For example, in a period of high inflation or exchange rate volatility, in the view of the monetary authority, increasing the interest rate is a proper policy to decrease the circulation of money, reduce inflation or to stabilize the exchange rate. While from the view of micro-banking supervision, a higher interest rate could have an adverse effect on banking stability due to the possibility of it deteriorating the banks' quality of assets, profitability, liquidity and solvency.

On the other hand, the monetary authority would prefer to conduct an expansionary policy by providing more funds to the economy and speeding up its recovery, hence it might demand a temporary relaxation of the bank's lending standards. These tradeoffs occurred during the nation's financial crisis in 1997 and 1999.

Will a separation between macro-banking (the monetary policy) and micro-banking supervision be more effective in resolving the tradeoffs or, in the worst case, to resolve the financial crisis? How can the monetary policy and micro-banking supervision be synchronized?

These questions are very difficult to answer due to a lack of empirical evidence or test cases in Indonesia.

However, the practice conducted in the United Kingdom, where, since 1997, there has been a separation between the Bank Of England as the monetary authority and the Financial Services Authority as the micro-banking supervisor, could become a conceptual framework.

In the UK, synchronization between the monetary policy and micro-banking supervision is carried out by the Tripartite Standing Committee arrangement that was established under the 1997 memorandum of understanding between the authority, the treasury and the Bank of England. The memorandum not only contains the allocation of authority, but also the assurance of a smooth and reliable flow of information and crisis management protocol.

Ensuring a smooth and reliable flow of information is maintained by regular meetings among representatives of the three institutions in the committee. So far, the committee has worked very well in enabling a much fuller and quicker exchange of information and views. The arrangements have proved highly valuable in helping the UK to respond quickly to the events of Sept. 11.

In the immediate aftermath, a lot of business was switched from New York to London, which required a rapid response to the regulatory changes and adaptation to UK's market infrastructure. For the most part, those changes were smoothly handled under a tripartite overview. In crisis management protocol, the Bank of England and the Financial Services Authority are committed to informing each other as soon as they consider that there is a threat to financial stability. Based on the allocation of authority, the Financial Services Authority is the sole prudential supervisor; hence, an assessment of solvency would largely depend on it. The Bank of England would automatically take the lead in managing threats to monetary stability.

Both institutions would manage the situation and coordinate the authorities' response and share the responsibility. The form of the response would depend on the nature of the event and would be determined at the time. In all cases, the Bank of England and the Financial Services Authority would immediately inform their course of action to the treasury, to give the minister of finance the option to accept or refuse the action. Thereafter, they would keep it informed about the developing situation.

For a long time, the UK has benefited greatly from a well- capitalized banking system and its good track record in macroeconomics and price stability has strengthened the fundamentals of the UK's financial market in general.

For Indonesia, where stability in the monetary and banking systems remain fragile, the separation between the monetary authority and micro-banking supervision has to be absolutely guaranteed by a solid collaboration among the central bank, Financial Services Authority and the government. A tripartite arrangement as implemented in the UK could be a suitable model for it.