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Keynote Speech
MANAGING RISK IN CHANGING ERA1
BUDI MULYA
Deputy Governor of Bank Indonesia
Ladies and Gentlemen,
I would like to thank Thomson Reuters, the organizer of today’s dialogue, for inviting me to share and to exchange views with all of you – key persons of the Indonesian financial market industry. It is now increasingly important for all of us to have a common understanding in certain areas in financial market, for the benefit of all society despite that we have different interest. Therefore, the dialogue amongst market participants as well as with the relevant authority, like today’s event would become more relevant since we are facing a structural change, both in financial market and in broader aspect of the economy globally in the aftermath of the most recent global financial market turmoil.
The latest global market turbulence give us some lessons learn. As in other catastrophe, the cause was multi facet. However, all possible causes lie with, or closely relate to, human being behavior. More specifically they lie on how, both market players and regulators/authorities, perceive risk. This phenomenon is somewhat in contrasts with the fact that during the last decade, risk management has become one important topic in financial market discussion. One most important factor we learn is that market players tends to have ‘return illusion’. The terminology in which I refer to is a tendency of not assessing risk properly in ‘peaceful’ situation, where the risk tends to be covered by its high potential return, and that we – as human being - tend to be easily trapped in complacency.
On the other hand, regulators have also too much confidence in expecting that market discipline to work. On this respect, many have observed that financial market regulation is considered to be too loose in particular with regard to ‘over the counter’ (OTC) transaction. Thus, traditional wisdom to prevent from a repeating tragedy is to ensure the properness and fairness in financial market business.
In line with the tendency I just mentioned, the adoption of international financial reporting standard is un-doubtfully should become our priority agenda, to increase transparency and comparability of financial reporting and hence to encourage market discipline. In turn, this will lead to better risk measurement and risk management.
I personally do hope that we all support and have a proper preparation toward the adoption of the international accounting standard, such as PSAK 50 and 55 in due time, that is January 2010. Today, I will not go into detail on discussing those two accounting
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standard. But I would rather addressing more on the surrounding aspect we have learnt from the recent crisis which I believe become more important and increasingly relevant with the substance of PSAK 50 and 55.
Ladies and gentlemen,
I intentionally mention the behavior aspect in banking industry and in financial market behind the biggest financial crisis in post World War II era, as a prologue of my speech today to always remind us that the financial market failure will always be too costly for society. This is also true in our domestic economy as we observed the 1997/98 crisis.
I will turn into what are the impacts of the global financial turmoil to our economy after describing at glance what has been happening in global economy, to give a background on references for our next agenda to fix and to improve our banking industry, as well as our domestic financial market to be best fit with our economy’s need.
As we are all aware the emerge of US Sub-prime mortgage crisis about twenty months ago, and in particular the collapse of Lehman Brother in September 2008, has a global impact – of course with different magnitude. The impact on every economy depends on the structure of the economy and its domestic financial market inter-linkage with global financial market. However, we have been witnessing that the decoupling theme almost disappear in the era of global economy, while trade and financial market integrate. On the other side, the recent crises also prompt the change of global financial market landscape and adjustment of the authority approach in regulating and supervising banking industry and financial market in particular.
From a macro economy point of view, global economy growth has contracted dramatically and trade activities squeezed. Major advanced countries have experienced negative growth, including some of our neighboring countries in Asia. This has led to a massive fiscal spending from countries globally which increase fiscal deficit significantly. These measures and also some various blanked guarantee program is nothing but intended to prevent from further deterioration of the economy and to safeguard the financial institution/ banking industry, as the best possible and politically feasible effort to ensure the economy enters into the recovery path.
Central bank in almost all over the world has also taken dramatic measure in monetary policy stance by reducing policy rate in a never seen magnitude and speed with major central banks’ policy rate close to reach ‘zero’ level. This monetary policy measure has then been followed by various measures in its implementation via central banks’ market operation ranging from expanding eligible assets and central banks’ counterparties, lengthening the maturity of market operation, including assets outright buying operation and increase the size of liquidity.
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confidence is to some extent reflecting the overreacting behavior of market. This means a dramatic swing of risk measuring practice from less prudent in ‘normal’ time into ‘too rigid’ and almost paranoid when the situation in reverse, as I previously mention. We also can observe a similar situation in our domestic market.
Meanwhile, the fiscal measures as I mention are taken not without consequence as it basically represent the heighten dilemma faced by authorities between managing deflation risk in the short-term needed to pull the economic recovery and its long-term consequence of potential inflation risk. The long-term potential risk tends to rise as many parties have started to ask the possible ‘exit strategy’ from both the fiscal authority and central bank, and it has also been reflected in the tendency of the steepening yield curve we observe globally. This highlights that the uncertainty ahead is still quite high.
Ladies and gentlemen,
From the financial market perspective, I would like to specifically focus on one aspect that contributes significantly on the deepness of the recent financial crisis that is, derivative transaction. Derivative transaction, that was originally created to help in managing risk, namely to hedge, has evolved too far. It has become too complex and has deviated too far from its link with real economic underlying transaction, which eventually serves in the opposite direction.
Indeed, it has become more as a ‘tool’ to enhance return, thus adding risk. Some market players have maneuvered in this kind of transaction that tends to be traded in over-the-counter transaction, non-standardized, lack of disclosure and relatively distance from authority’s monitoring. But, now the regulators approach with regard to this specific transaction has started to reverse toward ‘flight to simplicity’.
The regulation of the over-the-counter market has become one agenda in overhauling financial market. The US authority for example, has started to enhance its supervision by introducing new regulation on derivative transaction, including centralized clearing and exchange trading for standardized derivative product. This just show the spirit of having a more transparent and efficient market, as well as to ensure that the risk always being assessed fairly.
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Ladies and gentlemen,
I will now turn into our domestic economy. In general, our economy so far can be said somewhat sheltered from global economic downturn. Though weakening, our economy grows 4.4% in the first quarter of 2009 and along with of China and India, mark as one of the rare economy that are still experiencing positive growth. In our case, the positive growth is mainly because our economy is less dependent to export compare with other export driven neighboring countries. Our domestic demand, which contribute more than 60% of GDP is quite resilience and partly supported by election spending. Against this backdrop, we expect the economy to grow around 3.0%-4.0% for the whole 2009. We have also observed a much better perception toward our economy which has been so pessimist since last October 2008. Last week, IMF revised up their forecast of our economic growth prospect in 2009 from previous 2.5% to 3%-4%. In line with the weakening demand, inflation also drops to 6.04% in May 2009 from around 11% in 2008. For the whole 2009, we expect inflation to subdue to the lower end of the 5%-7% range.
Our Balance of Payment has also rebalanced to a surplus of USD 4.2 billion in the first quarter of 2009 as both export and import demand shrinks, while favorable market sentiments invites capital inflows. We expect these conditions to continue forward. For the whole 2009, we expect the overall balance to be in surplus of USD 6.5 billion supported by current account surplus of USD 0.9 billion and capital and financial account surplus of USD5.8 billion. Based on this development, the level of international reserves would be around $56 billion in 2009, hence supportive for the stability of rupiah exchange rate.
Rupiah exchange rate that has been undervalued since the last October 2008 performs well in the recent months. Along with other regional currencies, rupiah has been moving on an appreciating trend as the market’s risk perception toward emerging market’s assets improves. This development is also consistent with improvements of our economic fundamental. The rupiah appreciation recently is considered to not negatively impact our external balance since it comes along with the Balance of Payment surplus.
Ladies and gentlemen,
Our domestic financial market has also experienced high volatility during the development of the global financial crisis. On this area, I will focus on the impact on our money market and banking industry. We have observed that our domestic banking sector could be considered strong and relatively resilience, at least from a normative measurement perspective. Their capital adequacy ratio is still around 17% in average, far above the regulation requirement. NPL, despite showing an increasing trend is still below 5%. However, we have learnt that during the crisis, a higher CAR will benefit individual bank.
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distortion during the global crisis as shown in some money market indicators. The JIBOR 1 m spread over BI Rate has widened significantly since September last year, showing the similar pattern with LIBOR 3 m spread in international money market. The JIBOR 1 m spread which in normal situation below 20 bps, reach as high as 225 bps between end of September to early of January this year. The similar situation also can be seen in spread between Base Lending Rate (BLR) – in particular for consumer loans - over BI Rate, the spread has increased significantly since the mid of September 2008 of around 900 bps now. BLR has started to reach above 16% level since September 2008, despite that BI Rate has declined 250 bps to 7% now.
Those two indicators tell us the perception of increasing liquidity risk in banking industry, which limit the flow of liquidity amongst banks despite that the stock of surplus liquidity in inter-bank money market is quite high as reflected in Bank Indonesia OMO instrument of around 270 trillion now. Considering this facts, I would like to note at least three aspects of our banking practices.
First, since 1998 our banking operates in surplus money market liquidity. Thus in contrast with inter-bank money market in advance economy where they have daily liquidity shortage. Hence, banking in advance economy has to borrow liquidity from central bank through central bank open market operation. In this regard, I observe our banking industry tend to be too complacent on liquidity risk management as they observe that there will always be cash available in daily money market.
Second, the environment as I describe above has also led into the too much reliance on unsecured lending/borrowing in inter-bank money market for liquidity management purpose. Therefore, when the counterparty risk increase as we observe since the development of the recent crises, the flow of inter-bank transaction could drop significantly and liquidity stop to flow in money market. Each bank prefers to hold huge amount of cash balance and place them in central bank OMO instrument. This phenomenon has also discouraged the need to develop secured or collateralized inter-bank transaction, such as repo market. In this regard, Bank Indonesia has actually initiated the development of standardized repo agreement since 2005 by inviting fixed income market participants to establish standard repo agreement. The Indonesian version of MRA is already available in June 2005, but the respond from market is quite marginal.
Third, the recent development in global financial market has also pointed the potential risk in domestic banking funding strategy. Their too much reliance on traditional third parties funding (DPK), such as current account, saving account and term deposit should also be companied by some money market instrument in measurable manner. The dependence on that traditional funding is reasonably fragile in liquidity management, partly due to the increasing availability of financial market instrument and in turn lead to unhealthy competition amongst banks.
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rationally would be declining from time to time in line with increasing economic activity and changing strategy of government cash and debt management.
Another aspect that we should also aware off is the increasing need to have an international standard of transparency and disclosure level. This includes the adoption of International Financial Reporting Standard and International Accounting Standard, such as PSAK 50 and PSAK 55. The lack of transparency has contributed to deepen the financial crisis and exaggerate panic behavior in financial market.
Ladies and gentlemen,
Before I conclude my speech today, I will again remind us to always act in proper manner, in particular with regard to risk management.
We have seen some early indications of global economic stabilization, as well as in financial market but there are still some uncertainty ahead. However, we have also seen indication that some market players do not change the way they do business in financial market as indicate in the way they respond to the better than expected ‘news’. The better than expected indicators will raise confidence amongst market players. But history told us that confidence tends not to reflect fundamental improvement. Rather, it reflects market gains or losses. If market indices go up regardless the speed of the movement, people feel better and vice versa.
Thus, in respond to the recent improvement indicators we have to always keep in mind to respond wisely. Be cautiously optimistic will possibly be much better for us to have a more sustainable better future, rather than showing a too optimistic behavior. With regard to domestic banking, I do hope that they can now start to adopt better risk measurement. Hence, not to avoid risk by stop lending but to be able to prudently select the potential business to lend. Lending into business sector is ‘what the banking is for’ to our economy.
Finally, I do hope we have a fruitful discussion today and stance ready to have a well preparation of the adoption PSAK 50 and 55, and look forward to see the better practice in risk management in the challenging period ahead.
