Financial reform: Achievements, problems

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.