Emergency liquidity loans

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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