Wednesday, 26 March 2014

New Prudential Authorities

Arisyi Fariza Raz
The Jakarta Post
27 March 2014
Available at:

http://www.thejakartapost.com/news/2014/03/26/new-prudential-authorities.html


The year 2014 has been an important one for Indonesia’s financial system. On Jan. 1 Bank Indonesia (BI), the central bank, transferred its banking supervisory role to the Financial Services Authority (OJK).

Both of these institutions have been given new mandates: To maintain the country’s financial system stability through the implementation of prudential policies, which consist of macro-prudential and micro-prudential policies. After the hand over, Bank Indonesia, which is already charged with price stability, has been given a mandate to take charge of macro-prudential policy. The OJK, meanwhile, is in charge of micro-prudential policy and will focus on individual financial institutions.

According to the Bank for International Settlements, the distinction between macro- and micro-prudential regimes is best drawn in terms of the policy objective and of the conception of the processes influencing economic outcomes.

Simply put, macro-prudential policy aims at limiting the “systemic risk” or the costs to the economy from financial distress. On the other hand, micro-prudential policy works toward minimizing the possibility of failure of individual institutions, which is often referred to as limiting “idiosyncratic risk”.

In terms of conceptions of the mechanisms affecting the economy, a macro-prudential regime is viewed as “endogenous” since it views the system outcome to be determined by the collective behavior of individual institutions. Meanwhile, a micro-prudential regime views those outcomes as related to individual firms and is “exogenous”.

In terms of policy applications, theoretically, macro-prudential and micro-prudential policies should be complimentary and reinforce each other in achieving their respective policy objectives.

For instance, sound individual institutions contribute to system-wide financial stability, while a stable system with minimized systemic risk influences the soundness of individual institutions.

However, a paper by the International Monetary Fund (IMF) in 2013 also notes that conflicts may occur in certain situations due to different policy applications and overlapping policy mandates. By nature, macro-prudential policies are usually counter-cyclical, while micro-prudential policies are pro-cyclical.

Hence, when the financial system is under pressure, micro-prudential policy usually raises its standards to anticipate the shock, while macro-prudential policy tends to loosen its policy, thus increasing the tensions between the two policy regimes.

Even though tensions may arise during a downturn phase or at crucial turning points, the IMF suggests that these can be prevented or, at least, minimized, by conducting information sharing, inter-institution dialogue and joint-risk analysis between macro- and micro-prudential authorities.

In addition, the IMF also recommends both authorities form a jointly coordinated strategy that can be communicated to the market and the public to enhance understanding and policy transparency.

Fortunately, prudential authorities, i.e. BI and the OJK, and the government have realized the importance of establishing close communications to reduce the possibility of differences of opinion between the two institutions.

One notable example is the establishment of the Financial System Stability Coordination Forum (FKSSK). This forum consists of the Finance Ministry, BI, the OJK and the Deposit Insurance Corporation (LPS), which are in charge of fiscal policy; monetary and macro-prudential policy; micro-prudential policy; and deposit insurance respectively. 

This forum consists of multi-level meetings held regularly, whether monthly or quarterly and discusses the country’s economic resilience, including financial-system stability.

In addition, both authorities also have data and information sharing that is easily accessible to avoid data lags and to support the efficiency of policy implementation.

These examples show that appropriate measures have been taken by macro- and micro-prudential authorities in Indonesia in order to minimize the tensions between the authorities and, accordingly, achieve their respective policy objectives.

However, numerous challenges still exist, particularly due to the dynamics and the transforming financial system. Therefore, tensions between the two authorities can be kept to a minimum if they take a flexible approach toward institutional arrangements. In addition, both authorities should exploit policy complementarities through arrangements in order to create productive collaboration between them.

In short, BI and the OJK have followed contemporary global financial policy trends through the establishment of prudential regimes in order to capture the dynamics of the latest financial system characteristics. In addition, in terms of implementation and policy coordination, both authorities have also followed the available standards in order to optimize policy efficiency.

Nevertheless, since prudential policies are relatively new, there is still a lot to learn and thus many challenges have to be overcome. Therefore, policy flexibility is necessary to keep up with the evolving characteristics of the financial system.

The writer is a graduate of the University of Manchester, UK.

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