Review of Literature and Institutional Background
2.5 Institutional Background – The Indonesian Financial Sector
2.5.3 Overview of the Indonesia FSN
2.5.3.2 Coordination Framework between the Financial Sector Authorities
Learning from its past experience, Indonesia has been developing a crisis management protocol for dealing with a potential crisis in the financial sector. As part of this protocol, the Coordinating Committee was established which comprised of the MoF, the BI, and the LPS as constituted under the LPS Law of 2004. This committee serves as the mechanism for cooperation and coordination to determine the policy for the resolution and handling of a failing bank, particularly one that is predicted to have a systemic effect (Departemen Keuangan, 2010).
In order to support the work of the Coordinating Committee, a joint decree was issued by the MoF, the BI, and the LPS in June 2007 as a legal basis for the establishment of the Financial System Stability Forum (FSSK)24. The FSSK served as a means of cooperation, coordination, and exchange of information at a technical level among these three related agencies for promoting the stability in the Indonesian financial system. This forum was designed to enhance the ability of the MoF, the BI, and the LPS to supply inputs and any information required in a decision-making process by the Coordination Committee. The framework of coordination and sharing of information between these financial sector authorities was developed based on the LPS Law and the joint decree. This can be seen in Figure 2.2.
24 Joint Decree of Finance Minister Number 299/KMK/010/2007, Governor of BI Number 9/27/KEP.GBI/2007, and Commissioner of LPS Number 015/DK-LPS/VI/2007 concerning the Establishment of the Financial System Stability Forum (FSSK).
70 Figure 2.2 Coordination Framework between the Financial Sector Authorities
(2005-2012)
Adapted from the LPS Law of 2004 the Joint Decree of 2007
The FSSK had regular meetings to prepare policy recommendations in dealing with financial stability issues, in particular to prevent and to mitigate a potential systemic crisis (Departemen Keuangan, 2010). Crisis prevention measures could be undertaken by providing temporary liquidity assistance to a financial institution that has a liquidity problem; and by injecting temporary capital into a bank or non-bank financial institution that has a solvency problem.
These two measures can only be provided for a financial institution that is considered as bearing a systemic risk to the whole financial sector (Batunanggar & Santoso, 2007). The temporary liquidity assistance and capital injection are part of the LoLR and bank resolution mechanisms in the FSN framework that will be discussed separately in this chapter.
In conjunction with the establishment of the OJK in 2012, the coordination and sharing of information among the financial sector authorities is conducted via the Coordinating Forum for Financial System Stability (FKSSK). This forum undertakes the monitoring of systemic risks, the design of crisis prevention policy, and the preparation of crisis management protocols on a market wide basis. The forum consists of the MoF as chairman, Governor of BI, Commissioner of OJK, and Commissioner of LPS as members. The structure of the FKSSK is illustrated in Figure 2.3 based on the provisions of OJK Law.
71 Figure 2.3 Coordination Framework between the Financial Sector Authorities
(2013 – current)
Adapted from the OJK Law of 2011
Besides the proposal for the establishment of the OJK, the Amended BI Law of 2004 also proposed the drafting of the Financial System Safety Net Law (FSN Law). This new law specifically governs a crisis management protocol to prevent and to mitigate a potential systemic crisis in a more detailed fashion. This crisis management protocol is designed to provide better defined roles and responsibilities for the institutions that oversee the financial sector during a crisis, and provide a legal basis for the funding of state budgets, if required. The coordination mechanism by the FKSSK, as outlined in Figure 2.3, serves as a temporary medium for coordination and exchange of information until the government and parliament agree to pass the proposed FSN Law25.
25In October 2008, the President promulgated an Ordinance in lieu of the law concerning FSN, establishing the Financial System Stability Committee comprising the MoF as the Chairperson and Member, and the Governor of Bank Indonesia, as Member. However in December 2008, the ordinance in lieu of the law failed to be approved as a law by the Parliament. In January 2009, the government submitted a draft of the FSSN Law, but it was rejected by the parliament. The revised draft of the law is being prepared to be re-submitted to the Parliament.
72 2.5.3.2 Lender of Last Resort
The BI Law has granted the BI the right to provide a LoLR facility both for normal conditions and for preventing a systemic crisis26 (Batunanggar & Santoso, 2007). Under normal conditions, the BI may act as a LoLR to a bank in order to resolve a short-term liquidity problem27. This loan facility can be given in the form of conventional lending or Syariah principle based on financing for a maximum of 90 days. The loan must be guaranteed by high quality collaterals at least of similar value against the received facilities. The types of collateral accepted are government bonds, BI certificates, and loans classified as ‘current’ (where the bank does not possess eligible government bonds or BI certificates). This facility is in addition to the traditional central bank overnight and intraday facilities (International Monetary Fund, 2010).
With respect to the prevention of a systemic crisis, the LoLR facility may be given in the form of an Emergency Lending Assistance (ELA)28. As stipulated in the BI Law, in the event that a solvent bank confronting financial difficulties (liquidity problems) is deemed to be liable to trigger a crisis threatening the wider financial system, BI may provide emergency lending with a guarantee from the government. For systemically important solvent banks, the ELA facility allows for longer term extensions of credit (up to a maximum limit of 180 days). Since the ELA is guaranteed by the government, any losses that may be experienced by BI on such lending will be compensated by the government. However, as described in Section 2.5.3.2, more detailed procedures regarding the decision-making process to determine whether a troubled bank bears a systemic risk will be legalized in a separate law, namely the FSN Law.
Prior to the enactment of the FSN Law, the ELA provisions were applied in accordance with the Memorandum of Understanding (MoU) between the MoF and the Governor of BI, dated 17 March 2005. As stated in this MoU, BI is responsible for analyzing systemic risk that will threaten the stability of the financial system, whereas a decision to provide the ELA will be made by both the Governor of BI and the MoF.
26Law of the Republic of Indonesia Number 23 Year 1999 concerning Bank Indonesia, as amended by the Law of Republic of Indonesia Number 3 Year 2004.
27Short-term Funding Facility (Fasilitas Pinjaman Jangka Pendek or FPJP) as stipulated in article 11 verse 2 of the BI Law.
28Emergency Lending Assistance (Facilitas Pendanaan Darurat or FPD) as stipulated in article 11 verse 3 of the BI Law.
73 2.5.3.3 Bank Resolution
In the Indonesian banking sector, resolution of all failed banks is the responsibility of the LPS.
According to the LPS Law, the settlement of a failed bank depends on whether the failed bank is exposed to systemic risk or not. If the banking supervisor decides that the failed bank is exposed to systemic risk, the LPS is entitled to decide whether to close or rescue the failed bank. If on the other hand the failed bank is deemed to be exposed to systemic risk that threatens the whole banking system, the LPS has no option but to rescue the failed bank.
If a failed bank is considered a non-systemic bank, the decision to rescue or not is determined by the LPS using the least cost approach. Under this approach, the LPS compares the estimated resolution cost and the estimated liquidation cost. This is illustrated in Figure 2.4. The LPS will rescue a failed bank only if the bank has good prospects for strong future performance and the rescuing cost is significantly lower than the liquidation cost. In this case, the existing shareholders have to surrender their rights to the LPS and the management of the entity is transferred to the LPS via a resolution of the general shareholder meeting (GSM). All costs incurred during the rescuing process of the failed bank are recorded in the bank balance sheet as a temporary capital placement from the LPS. Furthermore, the LPS is required to sell its share in the bank within two years, subject to two extensions, each lasting one year, giving a total of four years. Within this four-year period, the LPS law states that the sale price of the bank should at least be equal to the value of the LPS’ temporary capital injection. If after this four-year period the selling price is still below the temporary capital placement, then the LPS must sell the entire shares at the best price offered by the market at the beginning of the fifthyear.
If the LPS decides not to rescue a non-systemic failed bank, the banking supervisor subsequently revokes the bank’s business license. The LPS will then begin the liquidation process of the failed bank, which includes a number of actions, such as: taking over and executing all rights and powers of the shareholders included in the GSM; providing funds for the payment of salaries and advances for employee severance; securing the bank’s assets prior to liquidation; establishing a liquidation team; and declaring the bank’s status as a bank in liquidation.
74 Figure 2.4 Procedure for Handling of a Non-Systemic Failed Bank by IDIC
Source: The Indonesian Deposit Insurance Corporation (2011)
If the banking supervisor believes that the failing entity could have a systemic impact on the whole banking system, the resolution process for this bank requires approval from the MoF and the Governor of BI in the Coordinating Committee meeting as described in Section 2.5.3.2. The Coordinating Committee is called upon to decide whether this bank has a systemic risk or not. If the committee is convinced that there is no threat of systemic risk as a result of the entity in question failing, the failed bank would be handed over to the LPS to make a decision whether to liquidate or to rescue the failed bank. However, if the committee concludes that the failed bank does have a systemic risk, they instruct the LPS to rescue the bank by injecting a temporary capital placement in accordance with the LPS Law. This is illustrated in Figure 2.5.
The handling of systemic failed banks is conducted through a resolution process, which may or may not include previous shareholders (open bank assistance). Previous shareholders may participate in the resolution of the failed bank if they agree to inject a minimum amount of capital equivalent to 20% of the estimated resolution cost. In addition, the existing shareholders have to surrender the rights and authority of the GSM and the management of the bank to the LPS. The resolution of the failed bank will be carried out without the participation of shareholders if the above requirements are not fulfilled.
75 All costs incurred by the LPS to rescue the bank will be recorded as the LPS’ temporary capital placement. The LPS is required to perform divestment within three years, which can be extended up to two times, with each extension lasting one year. The divestment of the bank is carried out in an open and transparent manner with due consideration for the optimal rate of return for the LPS. The optimal rate of return is equal at the very least to the value of the temporary capital invested in the bank. If by the time of the renewal period the LPS does not get back an optimal level of return, the LPS must sell the entire shares belonging to the bank for the best price the following year (the sixth year).
Figure 2.5 Procedure for Handling of a Systemic Failed Bank by IDIC (LPS)
Source: The Indonesian Deposit Insurance Corporation (2011)