ProdukHukum BankIndonesia

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Indonesian Financial Architecture: Designing an Appropriate Market
for the Financial Sector
Synopsis
The Global Financial Crisis (GFC) has demonstrated the failure of both the
regulatory framework and the operation of financial markets. While the
opportunity for more effective regulation clearly exists (especially in the
USA), there are intrinsic limitations on what prudential regulation can
achieve. Thus the response to the GFC should be on two fronts. Concurrent
with efforts to strengthen regulation, the structure of the financial sector
should be made more robust and resilient.
For the past quarter-century, the logic of deregulation has resulted in light
prudential rules focused on market imperfections. But financial markets
need to be designed to meet specific characteristics. Financial sectors
require regulation, in the same way that other aspects of the economy work
best if their operation is embedded in carefully-designed rules, rather than
relying just on “the magic of the market”.
Indonesia, with its financial sector dominated by banks and with the process
of conglomeration still at an early stage, has the opportunity to design a
simpler but stronger approach, not available in mature financial systems

where conglomeration is, to the regret of many, too entrenched to change.
The advantage of a simple system is that it would be robust and easier to
supervise.
The suggestion made here is that banks should specialise in domestic
deposits and loans, and payments services: no more universal banks. The
“core” financial sector would offer simple products backed by strong
intrusive prudential regulation and government protection for
depositors/investors. Outside this core sector , there would be the “buyer
beware” institutions, with risks prominently disclosed.
Where macro-prudential issues are important, the logical candidate to do
bank prudential supervision is the central bank because of its macro-focus.
In addition, there needs to be a high-level over-arching body which oversees
three areas: system architecture and regulatory consistency; high-level
system stability (especially interconnectedness and endogenous risk); and

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crisis coordination. KSSK should evolve over time to do this job, in the
process becoming the OJK.

Introduction: the Global Financial Crisis Reveals Weaknesses
The Global Financial Crisis is bringing about significant changes in the
international financial landscape. Market-making investment banks have
essentially disappeared. Banks which relied heavily on wholesale funding
have a limited future. Complex universal banks have been shown to be
unmanageable. At the same time the crisis has delivered a warning to all
those responsible for financial stability (central banks, finance ministries and
regulators). It is now painfully clear that deficiencies in the financial sector
can generate dramatic shocks and that these shocks can be transmitted
quickly and profoundly to other countries, even countries which are in good
shape.
(a) Lessons
First, was the failure of financial markets. The core economic paradigm –
efficient markets – was hopelessly at variance with the real world. This
failure manifested itself in two different ways: in the way market
participants behaved; and in the regulatory framework in which they
operated.
The efficient markets theory perceived a benignly beneficial world. Current
prices incorporate all available information, thus providing the appropriate
signals for resource allocation. Prices are anchored by fundamentals.

Arbitrage will swiftly eliminate price anomalies. Speculation would be
stabilising. Risk has a well-defined probability distribution (measured as
short-term price volatility) and so could be effectively managed.
Diversification would not only spread risk (as merchants in former times
spread their cargoes among different ships), but would also reduce it through
bundling uncorrelated assets.
In practice things worked differently. Animal spirits were more important
than some text-book notion of efficient markets. Endogenous risk proved to
be more important than conventional exogenous risk. Endogenous risk is
reflected in the sharp movements of financial prices, not driven by any
„news‟ (the conventional explanation for price changes), but by the internal

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dynamic of the market itself. All the market players had the same mindset
(„while the music is playing, you have to dance‟). They assumed that they
could sell their assets without affecting the price, but when the downturn
arrived, they all found themselves selling into „crowded markets‟ because
their similar risk systems had the same triggers for sale. At the same time
collateral, funding covenants and hedging insurance requirements forced

asset-owners to sell, into markets where there were no buyers. As prices fell,
more forced sellers entered the market. The market reacted with price
movements which, as one participant ruefully observed, would be expected
only once in the lifetime of the universe -- and they occurred on successive
days. The risk model is comprehensively broken1.
These problems were exacerbated by the interconnectedness of markets and
institutions. There was so much layering, securitisation and multiple stages
in transactions, with the complexity ensuring that when things went wrong
counterparty risk suddenly became paramount. The underlying collateral
could not be identified. Uncertainty was greatly heightened, so risk margins
blew out and previously-liquid markets dried up. The market pressured
banks to add to their capital, just at the moment when this was hardest to do
(and least logical: reserves and capital are there to be used in a downturn),
and when the banks‟ attempts to strengthen their balance sheets would cause
maximum damage to the real economy.
This is failure of markets in one of their primary functions: in price
discovery. This failure (specifically, in producing a set of prices which was
far below the longer-term underlying prices dictated by fundamentals) set in
train a dynamic which had serious allocation effects as well. In
Schumpeter‟s view, business downturns are beneficial because „creative

destruction‟ clears out the weaklings among economic enterprises. But this
downturn has not been very discriminating: it also weeded out good firms
which relied on markets for ongoing funding, or those balance sheets which
This interview with Myron Scholes highlights the problem neatly: „Some economists
believe that mathematical models like yours lulled banks into a false sense of security,
and I am wondering if you have revised your ideas as a consequence.
I haven‟t changed my ideas. A bank needs models to measure risk. The problem,
however, is that any one bank can measure its risk, but it also has to know what the risk
taken by other banks in the system happens to be at any particular moment.‟ New York
Times 14 May 2009
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contained assets whose market price fell sharply. It is hard to argue that the
investment process worked well when it was driven by risk-ignorant
euphoria in the upswing, and the downswing saw official interest rate
settings (the base for cost of capital) close to zero. In the previous GlassSteagall world, banks served as the „guardians on the gateway‟ for
investment. They were able to keep their balance sheets in reasonable shape
through the downswing because they provisioned rather than marked-tomarket, and because their core funding (from ordinary household deposits)

did not dry up precipitately. But they were replaced by „shadow banking‟
intermediaries with an „originate and distribute‟ business model, who didn‟t
care much whether the investment they funded was good, and who were
unable to go on funding longer-term illiquid real assets during the
downswing.
The disturbing question that this raises is just how much benefit we got in
terms of resource allocation and productivity in return for the substantial
resources taken by the bloated financial sector of recent years (Friedman,
2009).

Second, the failure of the regulatory framework. The efficient markets
view had a profound effect on the supervisory framework as well. Despite a
long history of business cycles and serial financial crises, the deregulation
era of the past quarter-century embodied a strong presumption that
regulation should be minimal. This is hardly surprising: efficient markets
have no need for constraining rules or intrusive supervision. It suited market
participants (even those who understood that their bonuses depended on
significant market anomalies) to adopt the „efficient markets‟ model as a
self-serving mantra. They acted as a powerful lobby group (not only in the
US, but in Basel where the international banking rules were formulated) in

inhibiting the regulators from putting in place adequate supervision with the
necessary political backing.
The efficient-markets hypothesis not only served as an intellectual tool for
the market participants in lobbying for the light supervision regime that
suited them: it was also adopted as an intellectual lode-stone by those
designing the regulatory framework. For example, the Wallis Committee,
which provided the foundations not just for APRA in Australia but also the
FSA in the UK, saw the main function of regulators as being to address
market imperfections (anti-competitive behaviour, market misconduct,

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asymmetric information and externalities from failed promises of financial
institutions). The deregulated financial sector would evolve in the direction
of capital markets, in which all financial instruments would be traded in
liquid markets. All that was needed was a level playing field in regulation:
consolidation and similar risk treatment for all institutions.
This view fostered “light touch” (some say “soft touch”) prudential
supervision confined to individual banks. This is most clearly and
comprehensively seen in the case of the USA, where regulators were

fragmented and weak. But there was wide-ranging failure, even in the UK,
which had put in place comprehensive „best practice‟ arrangements. Action
at the international level was similarly inadequate. Basel II took almost ten
years of intensive discussion to put in place, but the risk pillar, relying on
credit rating agencies, is fundamentally flawed and the market discipline
pillar has shown itself to be grossly pro-cyclical.
Crisis management was seen as largely a matter for central banks (liquidity
facilities and lender-of-last-resort), calling for prompt corrective action (so
that the bank shareholders took the hit), and requiring deposit guarantees
(largely self-funding). But if the crisis is systemic, this self-sufficient lowcost view of crisis resolution is naively simplistic. When the financial
system is at risk, unpalatable political choices have to be made, to rescue the
very people who are to blame for the problems. Moral hazard concerns have
to be put to one side. Deposit guarantees are invariably widened in coverage.
Risks are shifted from private individuals to the public purse. Pressure has to
be brought on parties to facilitate necessary outcomes. Substantial
(sometimes huge) funding is required from general budget revenue: i.e. from
taxpayers who were innocent bystanders. Sorting this out is not a job for the
technocrats of central banks, supervisors and deposit agencies: the political,
coordination and strategic issues are central. The ministry of finance has to
take a key role, not just in providing the funding, but in acting as the

political interface 2.
2

In the US, where the regulatory system is disjoined, cooperation has been achieved by
the close working relationship between the Treasury Secretary and the central bank
Chairman. But the damage done by disjoined and inadequately-resourced regulators
(monolines, insurance, investment banks) is clear. As the crisis unfolded, it was clear that
there were no well-developed plans or conceptual framework in place and “suck it and
see” was the order of the day. Doctrinal baggage (fear of moral hazard, reluctance to
nationalize systemically-important but failed institutions) constrained policy thinking and
actions.

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What are the implications for Indonesia?
The Indonesian financial sector is coming through the GFC in pretty good
shape but there are important policy implications 3. Both here and overseas,
part of the post-crisis response will be in the form of different and stronger
regulation. While not all regulators failed as comprehensively as those in the
US, there is room for enhancement in most countries, Indonesia included.

But many of the weaknesses of regulation are intrinsic and ubiquitous.
Regulators everywhere will always be “bloodhounds chasing greyhounds”,
inevitably behind the pace of financial innovation. The political constraints
on them are always likely to be formidably inhibiting, as are the pressures of
vested interests. The in-built delays in recognition and action make
forbearance the norm: prompt corrective action an ideal rather than a reality.
Regulators may be congenitally cautious people anyway. Thus, for Indonesia
and elsewhere, regulatory reform will not be enough.
Part of the answer must be in modifying financial sector market design (the
financial architecture), to make it more resilient. The GFC has delivered a
powerful indictment of the efficient markets view. The financial sector
should no longer be exempt from the regulatory norms that we see, say, on
the roads and in construction sites: in these areas short-term “efficiency” has
to be weighed against the need for systems to be safe and robust. We don‟t
let drivers decide what risks they are going to take on public roads, nor
airlines decide how much training their pilots need.
Thus this paper looks at how the GFC might influence the Indonesian reform
agenda in two areas. First, the financial structure (Indonesia‟s Financial
Sector Architecture or ASKI): second, the regulatory framework.
(a) The Structure of the Financial Sector

The mind-set of the existing architecture (BankIndonesia, 2009) is that the
Indonesian financial system should look like a smaller version of the
financial sector in mature countries. The centre-piece to this approach to
market design is universal banks. While the universal or conglomerate
nature of these banks is still at an early stage, the links between banks, on
3

For some earlier suggestions, see GRENVILLE, S. (2004) What Sort of Financial Sector Should
Indonesia Have? Bulletin of Indonesian Economic Studies.

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the one hand, and mutual funds, investment-type banking activity
(underwriting and finance facilitation), brokers, finance companies and
insurance companies, on the other hand, already presents a vulnerability to
the Indonesian banking system. If one of the lessons of the current crisis is
that financial institutions should be simple, very transparent and robust, then
Indonesia may be on the wrong track in allowing its banks to have strong
conglomerate links with other types of financial institutions (Haldane, 2009).
At the same time, it is not realistic, in the newly-revealed dangerous
international financial world, to see Indonesian banks as having the potential
to become international banks like HSBC or the Singapore banks, as is
envisaged in the current ASKI. Iceland demonstrates, in extreme form, the
dangers of relatively small countries having relatively large international
banks. As Mervyn King noted, „banks live internationally but die at home‟
(to the cost of the domestic taxpayers). The regulators should be ready to
rein in the international ambitions of these banks 4.
An alternative starting point is to recognize that Indonesia‟s conditions and
requirements are different from the mature economies. Indonesia is more
likely to be subject to sudden foreign capital reversals, large falls in the
exchange rate, inflation and asset price shocks, big terms-of-trade shifts and
large NPL experiences, as well as micro problems such as financial sector
fraud, mis-selling and gross mismanagement. There is more opportunity
(and likelihood) for sharp swings in opinion and confidence. Markets are
not deep and liquid (foreign investors are flighty rather than “sticky”), there
is no well-established history of what a normal price is and how it behaves
over the course of the cycle, market “price discovery” is imperfect, company
information is unreliable and the legal system is questionable. Prudential
4

Indover is another reminder.
The case against allowing Indonesian banks to have ambitions to become international
banks is made in Buiter‟s “inconsistent quartet” - (1) a small open economy; (2) a large
internationally exposed banking sector; (3) a national currency that is not a major
international reserve currency; and (4) limited fiscal capacity BUITER, W. (2009)
Lessons from the global financial crisis for regulators and supervisors. Paper presented
at the 25th anniversary Workshop " The Global Financial Crisis: Lessons and Outlook"
of the
Advanced Studies Program of the IFW, Kiel on May 8/9 ..
One consequence: if Indonesia is not going to have international banks, it doesn‟t have to
worry so much about having the same set of rules (e.g. Basel) if they don‟t suit.

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supervision will inevitably be weaker, with more problems of enforcement.
Consolidated supervision, for example, is hard to do properly.
At the same time the demands on the financial sector – what is expected to
achieve - are greater and more taxing than in developed countries. The
Indonesian government is expected to protect depositors who are
inexperienced with sophisticated institutions and instruments: that is a
legitimate expectation. The financial sector must fund a faster pace of
development, in more uncertain conditions (where the availability of foreign
funding is likely to be seriously curtailed), and provide funding to the full
range of investments, including high-risk/high profit ventures (providing not
only working capital but longer-term illiquid funding of specialized assets).
SMEs have to be supported; SoEs have to be funded; SoBs have to be
maintained [reference to Malang paper], if only for historical and
sentimental reasons, with their ambivalent objectives; and even rural banks
and tiny micro financing have to be promoted. The full range of risk funding
has to be available: in a high-risk environment, there should be provision for
identifying and funding the high-return projects amongst the dross.
These key characteristics provide the parameters for financial sector market
design. They suggest that there should be a sharp dichotomy between a safe
core sector where small-scale risk-averse savers can safely leave their
money, on the one hand, and the “buyer beware” non-core sector which
funds risky ventures, on the other. The safe core should be structurally
simple and transparent, so that it is easy to supervise effectively, and the
taxpayers‟ funds (in the form of depositors‟ guarantees and lender of last
resort) are not put at too great a risk. For simplicity, it should be structured
as basic banks (i.e. Glass-Steagall-style banks, separated from other types of
financial institutions, and in particular separated from the market-maker and
investment-banks institutions). This core should contain the basic payments
system, so that this would be maintained during a crisis. It should also have
enough capacity to provide a minimal level of credit (including trade credit)
during a crisis: the process of financial intermediation must be maintained
even when the financial sector is under pressure and the funding of risky
investments ceases. Within this core sector, deposits would be guaranteed up
to a generous level, protecting household deposits.
This core could also include the government bond sector, with small
denomination bonds available and a liquid market maintained by the
government (in the same way the exchange rate is broadly protected by the

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government, without a fixed commitment to a specific rate), to give small
investors an opportunity for longer-term safe investment (safe in the sense
that the nominal value will be returned on maturity).
Another category of financial arrangement is needed to supply the funding
for relatively safe but illiquid long-term assets (notably, infrastructure). Such
assets cannot guarantee liquidity for investors. There are, however, various
institutional arrangements that might be devised to meet the need for long
term funding from those investors who can afford to sit out the cyclical
downturns in asset values, while at the same time offering them some
assurance that their investment will be safe and will provide fair long-term
returns. Insurance and superannuation funds might invest a significant
proportion of their funds in this way. Development banks (private or
government) are another possibility. Real Estate Investment Trusts and
infrastructure bonds are other possibilities 5. The key element here is that the
investors understand that they are funding long-term illiquid assets: their
money is not in a liquid instrument and they have to be patient, particularly
for the return of their capital. Such instruments have downside for investors
(how can they be sure that the fall in value of their underlying asset is
merely cyclical, especially as such instruments should not be obliged to
mark-to-market?). The development of such a longer-term funding market
is, nevertheless, very important as this kind of funding should not be done
from the balance sheet of banks, whose depositors legitimately demand
immediate liquidity.
Outside this safe core, the full range of financial services could be
encouraged (although still with regulations and a degree of supervision).
Innovation would be encouraged6. Careful thought needs to go into the ruledesign but the presumption is that regulation should be „light‟. The
important distinction is that investors in this non-core sector should
understand (and be constantly reminded) that their money is at risk. „Very
5

Provision of government guarantees on underlying income flows and/or the capital
value could well be part of this arrangement. In many cases the government ends up
bearing the risk in a crisis, so it is better to acknowledge this at the start (and have the
benefit of the government guarantee reflected in the funding costs).
6
An analogy might be useful here. In yachting, there are one-design classes and
unrestricted innovation classes (with broader design parameters). Both have their
followers, and both serve their users with a product that suits. Innovation passes
gradually to the one-design classes, but at a pace which doesn‟t inflict large capital losses
through design obsolescence.

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explicit disclosure to consenting adults‟ is the key concept here. There
should be the equivalent of a cigarette health warning (“your money is not
safe here”) on every institution and every agreement/contract. If these
products are sold in banks, it should be absolutely clear that the bank does
not in any way guarantee the product.
For complex products, there might be a case for requiring new products to
get a „tick‟ from the regulators. No one, however, should rely on this.
Regulators will always be reluctant to admit that they don‟t fully understand
(nor, on past experience, did the promotors of the products) and will not
want to seem too „fuddy-duddy‟ and conservative. Regulators might be
guided by a general admonition that finance is not the same as gambling.
Products which are analogous to betting should be left in the casino. In
practice, to distinguish these from legitimate risk-management products,
there might be a requirement that the purchaser of the risk insurance should
have an „insurable interest‟ (i.e. something at stake that needs to be insured).
Is it fair that different products are subject to different degrees of prudential
supervision? A deposit offered by a bank is not the same as a deposit-like
product offered by an insurance company or a mutual fund, and there needs
to be strong and specific disclosure to make this clear to potential investors.
Why should we be reluctant to impose a degree of product-specialisation on
financial institutions, when we make similar requirements that prevent, say,
surgeons from offering financial advice to the public?
There are difficult practical issues not addressed here (how to ensure that the
border between the safe core and the non-core institutions is clearly and
securely maintained: how to shift from the present embryonic universal
banks to basic banks). But the starting point in addressing these issues is to
recognize that the current approach to market design has the wrong centrepiece: universal banks7.
Others are exploring the same territory. “The modern financial services industry is a
casino attached to a utility. The utility is the payments system, which allows individuals
and non-financial companies to manage their daily affairs. The utility allows them to
borrow and lend for their routine activities and allocates finance in line with the
fundamental value of business. … The better response is to separate the utility from the
casino. Financial conglomerates are, as Senators Glass and Steagall recognized, a bad
idea. A new Glass-Steagall Act will not work… . Instead, structural rules should firewall
the casino from the utility, by giving absolute priority to retail depositors. KAY, J. (2009)
The Long and the Short of it, London, The Erasmus Press.P218,224

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2. The Regulatory Framework
If the market design suggested here were to be followed, then the logic for
the regulatory framework would be conceptually simple. Bank Indonesia
would have operational responsibility for the core sector. The residual noncore sector could be under a single regulator („LK‟). In this non-core sector,
there will be different promises for different institutions (the protection and
promises for insurance will be different from that relating to pensions), but
the clear starting point in all cases is that there is no promise for immediate
return of a specific nominal sum. The key message, to be repeated ad
nauseam, is „read the fine print of the contract‟. Market conduct regulation
(what some people might call capital markets regulation i.e. Bapepam)
would be in a separate grouping. Consumer protection for the non-core
institutions might well be here also.
Overarching this, there is a need for a high-level coordinator with three
functions: architecture and regulatory-consistency coordination for the
whole financial sector; overall financial sector stability; and crisis resolution.
This body has to have undoubted authority: it should be made up of the most
senior representatives of the supervisors (BI governor 8, head of Bapepam,
head of LK). Most important, it should be chaired by the Minister of Finance
or the Coordinating Minister, providing the political interface to make the
non-technical social/distributional judgments that will be necessary in a
crisis9.
One of the lessons of the past year is the necessity for close coordination
between the various financial authorities (e.g. with Northern Rock in the
UK). In Indonesia, while the existing embryonic coordination framework
(the Financial Sector Stability Forum (FSSK) and the Financial Sector
Stability Committee (KSSK)10) were still not fully operationalised, the work
to develop Crisis Management Protocols seems to have helped in the
resolution of Bank Century. There is MUCH more to be done here, but a
8

Given the importance of the banking system, the Senior Deputy Governor, as effective
head of supervision, should be included also.
9
There is no conflict there with central bank independence. The BI governor is here in
his capacity as financial sector guardian. Monetary policy is made, as usual, by the BI
Board. Note how Bernanke and Geithner cooperate closely in addressing the financial
crisis without this compromising Fed monetary policy independence.
10
KSSK is essentially a re-badging of the FSSK

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good start has been made. It will be necessary for all the institutions
involved to fully accept the coordinating role of KSSK, and to put in place
monitoring systems which ensure that this coordinating role can be
implemented quickly if needed.
What seems clear from the Northern Rock experience (and perhaps also
illustrated in the Bank Century case) is that problems can remain with the
supervisor for too long, without being subjected to a wider scrutiny. Active
information-gathering and high-level monitoring of potentially-troubled
institutions by the overarching committee might force less forbearance,
quicker escalation, and prompter corrective action.
At the same time, if the front-line supervisor has to explain to the
overarching committee just how a new innovative financial product works
and what effect it will have on system stability, they might be less ready to
simply tick the product and hope for the best.
The overarching systemic regulator should be able to recognize growing
dangerous trends, products which are not risky in themselves but which
become risky through the fallacy of composition. If such a systemic
regulator had existed in the USA, it should have identified the emergence of
the „shadow banking system‟, the growing problems in the housing sector,
and the false promise of securitization, with seemed to offer liquidity for a
body of underlying assets which were fundamentally illiquid.
In countries where there has been a separation of the central bank from the
prudential supervision function, the task of systemic stability has fallen
uncomfortably between the two institutions. In most countries where this has
happened, the central bank was left with the task of systemic stability, but
with no instrument to pursue this task. The central bank‟s only instrument
was the short-term interest rate, and in many cases the paramount (often
sole) objective of policy was to maintain CPI price stability. Central banks
generally wrote a Financial Stability Report to cover their system-stability
obligations, and left it at that. So, generally, central banks found themselves
unable to respond to the main symptom (and driving force) of the boom
phase of the cycle – asset price inflation. Their limited remit forced them to
do nothing in the face of credit expansion that was not threatening CPI

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inflation, even though this was inevitably going to lead to trouble 11. If they
saw some systemic problems (concentration of insurance risk in institutions
which would be unable to meet systemic problems, such as AIG or the
monolines), they had no instrument of response. They need some microlevel instruments – such as the ability to enforce a counter-cyclical capital
ratio, cyclically-varying liquidity requirements and loan-to-valuation ratios.
In many countries this problem was exacerbated by the “best practice”
doctrine among prudential regulators that their remit was purely microeconomic and mainly focused on the health of individual banks. The result
was pro-cyclical prudential policy: as asset prices rose, this raised capital of
both banks and borrowers, raised collateral values and lowered loan-tovaluation ratios, all encouraging more borrowing. But it was not in the remit
of these stand-alone regulators to add up the individual risks in institutions
and respond to the systemic threat.
As well, these stand-alone regulators were new institutions, relatively weak
in withstanding the pressures of the vested interests in the financial sector. It
was hard to disallow “innovations” and various methods used to circumvent
prudential regulations. They were not strong enough to insist on the
accounting and taxation changes which were needed to make provisioning
for non-performing loans cyclically neutral, at a minimum.
The basic message here – applicable to Indonesia -- is that the systemic
regulator needs instruments to achieve its objectives. What should system
stability focus on? The instruments should address the difficulties that made
the system pro-cyclical and on the endogenous dynamic and
interconnectedness that turned idiosyncratic problems into system-wide
problems. Thee difficulties included:
 Ratings downgrades
 Collateral and covenant issues
 Mark-to-market accounting requirements
 Valuations and loan-to-valuation ratios
 Market demands that banks increase capital in the downturn.
Their impotence was articulated in the Greenspan Doctrine, that central banks couldn‟t
do anything about an asset-price bubble (in his view, they couldn‟t even identify one ex
ante): all they could do it try to clean up the mess later (and it is Greenspan‟s attempt to
clean up the mess of the Tech-wreck that had interest rates so low in 2001-2005, one of
the prime causes of the current troubles).

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Indonesia should not be rushing into the complexities of securitisation and
complex hedging products. But as it moves in this direction, it could require
there to be a “lead securitiser” with obligations to keep track of the
underlying collateral assets and to retain a substantial amount of the
securitization on its own balance sheet. It seems sensible to tightly limit
over-the-counter tailor-made hedging products and require these to be in a
standard form that can be traded through a central counterparty exchange.

Finally, a vexed issue. Should bank supervision be split out from BI into a
separate APRA or FSA-like institution? Elsewhere this institutional
arrangement – the separation of the central bank from the prudential
authorities – was the result of a number of factors. Some factors were
political (to cut the power of the central bank). Others were simply
misguided. The argument that central banks‟ monetary settings would be
distorted by their prudential obligations seems absurd as we watch central
banks around the world dramatically lower interest rates in response to the
crisis. The single valid argument was that conglomeration was already so
complete that all financial institutions had to be supervised by the one body
in order to get an accurate measure of consolidated risk. But if, as suggested
here, there is a clear separation between the “core” institutions and the “noncore” institutions, there is no issue of consolidation across different types of
financial institutions. The main potential systemic risks would be in the core
sector, subject to the intensive supervision of BI. This separation – with the
core and non-core areas supervised by different institutions -- would
emphasise the key distinction: some parts of the financial sector are
protected and other parts are „buyer beware‟.
The more recent recognition across the world of the importance of macroprudential concerns argues strongly for leaving prudential supervision with
the central bank. The central bank‟s expertise in macro-economics links
logically with this, and its macro focus makes it much more likely to
recognize endogenous risk and problems of interconnectedness.
This logic is supported by the increasing practice (greatly accelerated during
the current crisis) of widening the scope of open-market operations so that
these operations are not much different, in practice, from lender-of-lastresort. If the central bank is using open-market operations in this way, it

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needs the detailed information on individual banks that comes only with the
supervisory function.
In the end, the issue is mainly a pragmatic one. In the United Kingdom the
FSA and the BoE are not going to be put back together, whatever the merits
of doing so might be, because it would be too hard. Conversely, in
Indonesia, it would be a serious misallocation of priorities to undertake the
traumatic job of splitting BI. There are enough challenges in building a
resilient financial sector without taking on any unnecessary ones.
A much higher priority is to ensure that the coordinating framework should
be more fully articulated than at present. The KSSK needs the resources to
analyse and monitor high-level systemic risk. There should be on-going
permanent exchange of information between the agencies responsible for
supervision (BI for banks, Bapepam for non-bank financial intermediaries)
and the MoF. The logic of this suggests that the KSSK should, over time,
become the Financial Services Authority (OJK) (fulfilling the Parliamentary
requirement to do this by 2010).
Conclusion
I want to finish by supporting my argument for a core financial sector
populated by simple institutions, with both a quote and a misquote. First, the
quote, from Bagehot: “The business of banking ought to be simple,” he
wrote. “If it is hard it is wrong. The only securities which a banker, using
money that he may be asked at short notice to repay, ought to touch, are
those which are easily saleable and easily intelligible.” Now the misquote
(only slightly), from Warren Buffet: we should only allow banks that are so
simple that they could be run by a fool, because one day they will be 12.

Stephen Grenville
May 2009

The original quote is: “we should only invest in companies that could be run by a fool,
because one day they will be”
12

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References
BANKINDONESIA (2009) Indonesian Financial Architecture.
BUITER, W. (2009) Lessons from the global financial crisis for regulators and
supervisors. Paper presented at the 25th anniversary Workshop " The Global
Financial Crisis: Lessons and Outlook" of the
Advanced Studies Program of the IFW, Kiel on May 8/9 .
FRIEDMAN, B. (2009) The Failure of the Economy & the Economists. New York
Review of Books, 56.
GRENVILLE, S. (2004) What Sort of Financial Sector Should Indonesia Have? Bulletin
of Indonesian Economic Studies.
HALDANE, A. (2009) Rethinking the financial network. Speech delivered at the
Financial Student Association, Amsterdam.
KAY, J. (2009) The Long and the Short of it, London, The Erasmus Press.