Emergency liquidity loans

We greatly welcome the government's effort to draw a clear-cut agreement with Bank Indonesia on the definition of the central bank's role as lender of last resort to the banking industry.

The government, Bank Indonesia and the House of Representatives should indeed learn carefully from the 1997 to 1999 banking crisis, to prevent a protracted dispute over which banks are eligible for emergency liquidity support from the central bank and which should be allowed to go under.

Their wrangle over the sharing of the costs of the banking crisis, which was resolved only last August, indicates how imperative and urgent is now the need for clear-cut rules and procedures for the extension of liquidity credit by Bank Indonesia to commercial banks in financial distress.

The recent amendment of the law on Bank Indonesia, which strengthened the function of the central bank as lender of last resort to the banking industry, has removed the uncertainty regarding contingency programs to bail out banks facing severe liquidity crises.

But this stronger mandate should be based on higher standards of accountability; that requires clear-cut rules on the extension of emergency liquidity support to prevent the recurrence of protracted disputes such as those that took place between 1998 and 2003.

The central bank's role as lender of last resort requires it to provide promptly temporary support to illiquid banks to prevent panic and massive runs that could lead sound institutions to financial distress and consequently precipitate their insolvency.

This was what Bank Indonesia did between late 1997 and early 1999 when the public lost trust in the banking industry. But the absence of clear-cut procedures and rules for such emergency support and inadequate banking supervision made the bailout program highly vulnerable to abuse.

The basic rules of such emergency liquidity support stipulate that the central bank help only illiquid banks but not insolvent ones and that the loans be secured by adequate collateral.

However, as the bitter experiences in 1997 to 1999 clearly show, the central bank found it extremely difficult to distinguish an illiquid bank from an insolvent one, especially during the height of the crisis. The panicky situation made it well-nigh impossible for the central bank to verify each of the thousands of clearing transactions it conducted daily with commercial banks.

The problems were made even worse because before May 1999 the central bank was part of the government and was thus highly vulnerable to cronyism and corruption. As the Supreme Audit Agency discovered in 2000, many commercial banks misused the huge support loans they received from the central bank.

As Bank Indonesia has been politically independent since mid- 1999 it is no longer vulnerable to intervention from vested interests within the government or the House. But this autonomy alone is not sufficient to prevent misuse of emergency liquidity loans. There are at least two other conditions needed to safeguard the bailout program.

First, as earlier suggested, the finance ministry, Bank Indonesia and the House should formulate clear-cut rules and procedures for the extension of such emergency loans, covering basic requirements, step-by-step procedures for disbursement, security to back up such loans and tenure.

The other requirement is that the central bank should further strengthen the capability of its bank supervision system to keep it adequately informed on the up-to-date situation with regard to all commercial banks. Effective supervision will enable the central bank to distinguish illiquid from insolvent banks, thereby preventing the misuse of its emergency liquidity support.

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