THE ROLES OF BANK INDONESIA
Bank Indonesia carries a three-fold responsibility as monetary authority and the regulatory and supervisory authority for the banking system and payment system. As such, BI's most important task is not only to safeguard monetary stability, but also financial system stability. Whatever BI may achieve in monetary stability without commensurate financial system stability will be of little value in supporting sustainable economic growth. Monetary stability and financial system stability are like two sides of the same coin. Monetary stability has significant impact on financial system stability. Conversely, financial system stability is the pillar of effective monetary policy. The financial system provides a channel for monetary policy transmission and any financial system instability will prevent monetary policy transmission from operating normally. Conversely, monetary instability will fundamentally impact financial system stability, because the financial system will be unable to operate effectively. This is the background to the inclusion of financial system stability within the responsibilities of Bank Indonesia.
What, therefore, is Bank Indonesia's role in maintaining financial system stability? As the central bank, Bank Indonesia has five major roles:
First, Bank Indonesia safeguards monetary stability through the use of interest rates in open market operations, while also employing other instruments. Bank Indonesia is required to establish an appropriate, well-balanced monetary policy. The reason is that any disruption to monetary stability has immediate impact on all aspects of the economy. Excessively tight monetary policy applied through high interest rates will tend to stifle economic activity, and vice-versa. Therefore, to create monetary stability, Bank Indonesia has adopted a policy known as the inflation targeting framework.
Second, Bank Indonesia has a vital role in building the sound performance of financial institutions, particularly in the banking sector. The performance of banking institutions is promoted through the supervisory and regulatory mechanism. Like in other countries, the banking sector plays a dominant role in the financial system. For this reason, any failure in this sector could lead to financial instability and disruption of the economy. To prevent such failure, it is essential to uphold an effective system for bank supervision and banking policy. In addition, market discipline must operate through supervisory and regulatory powers, as well as law enforcement. Evidence suggests that countries applying market discipline benefit from robust financial system stability. Law enforcement actions are also intended to protect the banking system and stakeholders while promoting confidence in the financial system. To build a sustainable level of stability in the banking sector, Bank Indonesia has developed the Indonesian Banking Architecture and plans for implementation of the Basel II Accords.
Third, Bank Indonesia’s powers include the maintenance of a robust payment system. Failure to settle by any one participant will lead to serious risk of disruption in the payment system. This could trigger contagion and in turn systemic risk. To mitigate this risk in the payment system, Bank Indonesia has developed a specific regulatory framework and launched new mechanisms for payment system operation. One of these mechanisms is the Real Time Gross Settlement (RTGS) system, which offers vastly improved security and speed of payment system transactions. In its position as payment system authority, Bank Indonesia also has access to the necessary information and expertise to identify potential risks in the payment system.
Fourth, Bank Indonesia is able to tap its research and monitoring capabilities to access information on threats to financial stability. Bank Indonesia employs macroprudential monitoring to monitor vulnerabilities in the financial sector and detect potential shocks that could impact financial system stability. These indicators have been developed at BI, using in-house research capabilities. The information generated by this monitoring is then used to produce recommendations to inform the decisions by the relevant authorities on the most appropriate actions for dealing with disturbances in the financial sector.
Fifth, Bank Indonesia operates the financial system safety net under the central bank lender of last resort (LoLR) function. The LoLR function is a traditional role exercised by Bank Indonesia as the central bank in crisis management with the primary objective of preventing financial system instability. The LoLR function includes provision of liquidity under normal and crisis conditions. This support is extended only to banks faced with liquidity problems that could potentially trigger a systemic crisis. Under normal conditions, the LoLR function may operate for banks experiencing temporary liquidity mismatch, which must still possess adequate repayment capability. In operating the LoLR function, Bank Indonesia must steer clear of moral hazard. For this reason, liquidity can only be provided under strict requirements and subject to assessment of systemic risk.