Financial reform: Achievements, problems

This is the first of a three-part article based on a keynote address given by presidential advisor Ali Wardhana at the Indonesia Update 1994 seminar at the Australian National University in Canberra, Australia, on Aug. 19.

CANBERRA: Some of the early writers in the field of finance and development, such as Edward Shaw and Ron McKinnon, emphasized almost exclusively the elimination of certain controls as the key to the development of the financial system. They called this process "financial liberalization."

Today, we would call it "deregulation." But as the experience of several Latin American countries in the late 1970s and the United States' savings and loan industry in the 1980s have made clear, reforming a financial system is fundamentally a two- pronged process. On the one hand, it involves removal of direct controls over prices and quantities, combined with an easing of the process that governs the entry and exit of firms. The result should be that economic choices will be determined mainly through the interaction of market forces. On the other hand, it requires the imposition of prudential regulations that ensure that clear and sufficient information is available to all, reducing excessive risk and minimizing opportunities for fraud and manipulation at the expense of the general public.

It is probably correct to characterize the very first steps taken by the Indonesian government in June 1983 as "deregulation." These initial steps consisted of the removal of direct central bank controls over interest rates and credit allocation. The subsequent measures affecting the financial system involved a two-pronged change: measures were introduced that further reduced direct control, while steps were also taken to introduce a reliance on indirect rule or action, either by strengthening prudential regulations or by improving the system of indirect monetary management. This later stage is best characterized as "regulatory reform."

The reforms that the Indonesian government has implemented over the past decade have, on the whole, reflected a consistent intent to achieve three basic objectives:

* to move word a predominantly market-based financial system;

* to provide effective protection as needed for the general public so that they could benefit from the services offered by the financial system; and

* to build a financial system that would support stable and healthy growth of the national economy.

I do not mean to suggest that these reforms reflected a fully worked-out master plan nor would I claim that every measure implemented over the past decade has been fully consistent with these three objectives. But I do think it is fair to say that these have been the guiding principles, and that those of us who have been involved in the development of financial policies and regulations have done our best to follow them.

In any attempt to evaluate the achievements of a reform process, it is useful to begin by establishing a framework within which to judge the impact of deregulatory policies. Traditional theory of regulation states that government interventions to correct market failures will serve the public interest. The presence of natural monopolies, externalities, either positive or negative, and the prevalence of asymmetric information, are all standard indications of market failures. They have been taken as valid reasons for government intervention. Yet even here a word of caution is in order. While it is easy to show that in the presence of market failures social welfare will not be at a maximum, the conclusion that regulations to deal with these market failures will necessarily improve social welfare rests upon an assumption that those managing the regulations, or running the regulated firms, have the ability, and foresight, to manage the assets under their control in such a way as to raise social welfare. Policy makers and economists have become increasingly aware that even where market failures exist, it is no easy task to devise a regulatory framework that will improve economic efficiency and welfare. Government regulators are not always wise, fair, and efficient.

A major concern for any government is that the financial sector not be characterized by severe instability, and that reform measures not increase the instability of the system. Periodic financial upheavals and bank failures, common in many nineteenth century economies, are not unknown today. The savings and loan debacle in the United States, the collapse of Bank Credit Lyonaise, the bank failures in Japan and elsewhere, are but a few examples of how potential instability continues to haunt many financial systems. Indonesia is of course no exception. The recent failure of Bank Summa has now been followed by a substantial swindle involving one of our state banks, Bapindo. All such upheavals create uncertainty in the financial market, raising costs and perceived risks. Given the pervasive nature of finance as an input into all economic activities, then failures in the financial market will not only reduce profits in the financial sector but they may also impair the performance of the entire economy. A question to be addressed is whether, given the important role assigned to the financial system and the persistence of bank failures, the government should play a stronger regulatory role in the financial sector than one would assign to it in other sectors?

It has also been suggested that financial transactions are different from other economic transactions in that they involve an initial period of lending or investment, followed by subsequent periods when there are repayments and earnings. Inherent in any financial transaction is the fact that the lender is likely to have less complete information about the borrower and of the intended use of the borrowed funds. This condition, referred to as asymmetric information, places a premium on obtaining accurate information for financial transactions. Because of the difficulties of appropriating the returns to information and because the expenditures incurred on obtaining information can be viewed as a fixed cost, the presence of asymmetric information is in fact another instance of market failure.

Any evaluation of the financial deregulation in Indonesia should thus attempt to identify the efficiency gains. But any such assessment must overcome a fundamental problem: regulated and deregulated environments always exist side by side. Since the process of deregulation proceeds over time, the shift from a more regulated regime to a less regulated regime may occur over several years and it never becomes totally deregulated.

Because of this, simply comparing the economic changes that some groups undergo as a result of greater deregulation is not enough. Among other limitations, such comparisons fail to account for the effects of simultaneous changes in the economy as a whole. Since it is generally impossible to isolate all other effects, the appropriate approach is to estimate the affect of a regulatory change on some group, say savers, at any point in time and compare that with the affect the alternative policy of a regulated financial system, might have had on them during the same time. Difficult as such assessments might be, they are the best available means of evaluating the costs and benefits of deregulation.