Thursday, 3 September 2015

Why financial system stability matters

Arisyi Raz, Jakarta | Opinion | Wed, September 02 2015, - See more at: http://www.thejakartapost.com/news/2015/09/02/why-financial-system-stability-matters.html#sthash.bQokKspm.dpuf

Recently, many news outlets, experts and economists have been concerned about Indonesian economic stability. When talking about economic stability, the financial system probably plays one of the most important roles. 

The financial system is crucial because of its dynamic and rapidly changing nature. Looking at previous crises, whether in Indonesia or overseas, most of the economic rises were triggered by the collapse of a financial system. 

Once a financial system fails, the economy will be frozen since intermediation function cannot be conducted properly. Then, it can affect the real sector or external balance, which finally can result in a crisis.

If we are talking about such systems, basic financial theory suggests that intermediation in a financial system can be conducted directly (through financial institutions such as banks) or indirectly (through the market). 

In Indonesia, due to its relatively underdeveloped market, financial intermediation is mainly conducted through financial institutions, particularly banks. 

The Indonesian banking sector controls around 80 percent of the country’s financial system assets, which indicates its dominance and importance in the financial sector, thus making Indonesia a bank-led economy. 

A sound and strong banking sector reflects the resilience of the financial system. 

A frail banking sector, meanwhile, indicates the fragility of the financial system.

Currently, our banking sector is very different from that during the 1997 crisis. Apparently, banks, particularly the largest ones, as well as banking authorities, have learned their lessons from the crisis. 

For instance, currently our banking sector’s Capital Adequacy Ratio (CAR) is around 20 percent, far above the minimum threshold of 8 percent and the figure during early 1997 of 11 percent to 12 percent. 

This indicates that currently our banking sector, from a solvency point of view, has sufficient buffers in anticipating shocks and banking risks, either internally or externally.

Meanwhile from a credit risk point of view, our banking sector’s non-performing loans (NPL) currently fluctuate around 2.5 percent, much smaller compared to the crisis period in which the NPL reached two-digit figures. Liquidity level is also relatively ample as reflected by the sufficient amount of banks’ liquid assets. 

Last but not least, market risk is also well managed. Improved market knowledge as well as better market risk mitigation has made banks better in anticipating market volatility.

Substantial risk mitigation improvement is not only carried out by banks. Financial system authorities (which are often referred to as prudential authorities), i.e. Bank Indonesia and later the Financial Services Authority (OJK) after its establishment in 2013, have taken several measures to maintain financial system stability through macro prudential policy (conducted by Bank Indonesia) and micro prudential policy (conducted by the OJK).

Since the 1997 financial crisis, numerous efforts have been made to restore and maintain financial system resiliency. Banking supervision has been implemented more strictly by supervisory authorities to monitor banking sector stability. 

Banks also have better credit screening (including intragroup loans within a conglomeration) to minimize credit risk. 

Better asset liability management and currency hedging are also enforced to deal with liquidity and market risks. Apart from that, numerous prudential policies have also been implemented in order to maintain the stability of the financial sector, including the banking sector.

Overall, evidence shows that financial authorities and institutions have made substantial efforts to maintain financial system stability. However, there is another player in the financial system that also plays a very crucial role, which is the public. 

The public in the financial system acts as lenders and/or borrowers depending whether they have a cash shortage or cash surplus. 

Lenders and borrowers are only willing to do so if they have faith in the financial system, which makes the financial system one that is built based on trust. If the trust deteriorates due to negative sentiments, they may withdraw their money, which can affect the stability of the whole financial system.

Therefore, in order to prevent any unnecessary consequences, the public needs to know the current situation of our financial system and banking sector conditions before taking any action. 

If decision-making is solely undertaken based on the information that reflects the real condition in the financial system, then noise in the financial system can be minimized and unnecessary financial turbulence can be prevented. 

Unfortunately, in the case of Indonesia, public understanding about the financial system is still insufficient and thus their decision-making is often driven by biased information, which is inefficient and harmful for the whole financial system.

To prevent this situation, financial literacy needs to be improved. In the end, it is every financial system stakeholder’s responsibility, including the media and academics, to improve our nation’s financial literacy, which in the end can affect the wellbeing of our economy.
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The writer is a graduate of the University of Manchester, the UK, and a professional in the financial sector. - See more at: http://www.thejakartapost.com/news/2015/09/02/why-financial-system-stability-matters.html#sthash.bQokKspm.dpuf

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