Coordinate monetary policy, supervision
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.