OJK takes the helm

Farid Harianto

Amid the looming uncertainty in the global financial markets, optimism and hope are brewing in Jakarta. Recent data from the Central Bureau of Statistics shows that Indonesia’s GDP grew at 6.5% in 2011, slightly above the consensus of multilateral agencies.

Moody’s Rating Agency has upgraded its sovereign rating of Indonesia to the lowest end of the investment grade, following the same upgrade by Fitch in December last year. Reports about a new wave of foreign direct investment abound, despite the acute inadequacy of infrastructure in the country.

All seems to bode well with the stability – politically as well as macro-economically — that the country is offering, in tandem with the rapidly increasing wealth and purchasing power of the average Indonesian.

This is a stark contrast with the conditions of the peripheral economies of the eurozone.  Ireland suffers mostly from a private sector crisis hitting the banking sector, while the housing sector induced the crisis in Spain. To provide life-support for their private sectors, the two countries run large deficits that effectively transform private debts into public debts. This is similar to Indonesia during the Asian crisis of 1997.

In Greece, public finances run amok: the combination of high public spending and low tax revenues has led to accumulation of debt and diminishing confidence of foreign investors. The prolonged debates in the EU to bail out Greece, which in March will face a potential default on its substantial debt payment, and the domestic revolt against EU-proposed fiscal austerity have made Greece the basket case of the EU debt crisis.

Indonesia is in a much better shape today in coping with any external shock. Its ratio of public debt to GDP is relatively low at about 25%, much less than the 107% after the banking sector bail-out in 1999. Foreign exchange reserves are relatively high, at $115 billion, providing a comforting cushion.

System-wide, the banking sector is sound and healthy. With the capital adequacy ratio of 16.7% and a non-performing loans ratio of about 2.7%, the banking sector booked a respectable return on assets of about 3.1% in 2011. All of these factors are the fruit of the deleveraging of the economy in the wake of the 1997 crisis through the massive bank recapitalization program of 1999.

Indeed, the financial crisis of 1997 has changed the landscape of the political economy of the affected countries. The cost of the crisis, measured as the amount required to bail out the banking sector, ranged from 22% of GDP for Malaysia to 71% for Indonesia. Indonesia became the basket case, the recipient of the most expensive bail out in history so far. Compare this to the massive trillion-dollar bailout in the US post-2008 crisis that was “only” less than 15% of the US GDP.

The 1997 crisis also showed that the regulatory and institutional frameworks were lacking to deal with the explosion of the banking growth after its deregulation in the early 1980s. This has led to the revamping of the banking regulatory framework. This includes the call for an independent central bank, and the consolidation of the financial market supervisory role under the newly formed Financial Services Authority (Otoritas Jasa Keuangan or OJK).

The law on OJK was ratified in 2011, amid the pros and cons of consolidation, given that many countries are back-tracking while others succeed. The OJK is now entering a critical stage of selecting its first executive board, to manage the transition of the consolidation, and to chart the direction of financial market development in Indonesia.

The debate about the necessity of OJK is over, and the task at hand is how to make it work best, by learning from global best practices as well as from our own past mistakes
 
Regulatory capture

Prior to the 1997 crisis, Asian specialists emphasized the association between rapid economic growth and wide-ranging state intervention in Korea, Taiwan, Singapore and later in Malaysia, Thailand and Indonesia — all in apparent dissent to the Washington consensus. Such a relationship often involved political patronage and a close albeit complex relationship between the state and businesses.

This relationship was manifest through either industrial policy or directed bank loans to well-connected borrowers. The borrowers, usually members of the elite group, were then able to accumulate capital very rapidly, resulting in the concentration of wealth and of corporate ownership in the country. It has been well documented that such a concentration of ownership is associated with a high level of corruption and an ineffective legal system.

The politics of patronage in Indonesia pre-1997 were manifested very strongly in the banking sector. In private banks, lending to group-related companies reached to, in many cases, 60%-90% of their total lending. The very fact that banks could blatantly violate the legal lending limit for so many years indicated that banking supervision was very weak, and that the qualities of bank management and human resources were very poor. This resulted in the most expensive banking bail-out in history, at least to date.

The situation today has of course is markedly different as a result of the banking sector restructuring beginning in 1999. Over 50% of banking assets are now under the control of foreign ownership with credible reputation and financial standing, providing extra stability to the system. Risk management within the system has improved considerably, and lending concentration to companies is in check. Banking supervision is also much stronger today.

Yet, many structural weaknesses remain. The Bank Century bail out in 2008 and the re-emerging case of subordinated loans provided by BI prior to the 1997 crisis opened old wounds and showed that old habits die hard. The banks and bank supervisors at Bank Indonesia seem to linger in their comfort zone of complacency. Human capital in the banking sector remains problematic to support inevitable future expansion.

Regulatory capture seems to persist today. Many politically-linked companies seem to enjoy certain privilege in the capital markets. Their palpable corporate actions are simply ignored, creating a milieu of silent conspiracy.

In the meantime, the banking assets in the country only represent about 25% of GDP, a very low ratio compared to our neighboring countries. There is clearly ample room for the banking sector to mobilize savings and to intermediate between saving and investment in the country.

The banking products being offered are also relatively simple plain vanilla, lacking sophistication in terms of allowing market participants to tailor and fine tune the risk they want to assume or to avoid. But this will be about to change sooner or later.

For one, the country will go for financial deepening that will require the provision of secondary liquidity through the securitization or repackaging of existing loans. For another, with the government initiative to push the provision of various social security programs, the demand for new type of securities and asset classes, including their derivatives will only grow.

The growth of these shadow-banking activities will require a new regulatory framework, as well as new institutional capacity for supervision. This will eventually be under the purview of the newly-established OJK.
 
Hide and seek

In the early 1990s, I had a chance to work for Sylvia Ostry of the University of Toronto. This prominent Canadian economist served, among others, as a member of the G-30, an international body of leading academics and financiers that aims to deepen understanding of economic and financial issues and to examine consequences of decisions made in the public and private sectors related to these issues.

At that time, one of the particular focuses of the G-30 was to identify a particular trend or innovation in the financial markets – such as specific financial products — and then to examine the implication of such an innovation (to promote, or to deter), and to propose the regulatory policy and framework to deal with the innovation.

In 1990s, the G-30 reckoned that the market was always ahead of the regulatory framework. Often, it took between one and four years after a financial innovation took place in the market before a proper regulation was enacted to promote or to tame it. By the time such a regulation was in place, another and more advanced innovation had already emerged, and the regulatory bodies were constantly playing a cat-and-mouse game.

Luckily for Indonesia, innovation in the financial market is very slow, and we mostly become the recipient of innovations developed somewhere else. Often, such proliferation takes decades if not generation before coming to the Indonesian financial market. Apart from a lack of demand, such innovation often requires a legal framework (such as trust law to facilitate securitization) that is noticeably absent in the country.

As such, Indonesia has the luxury of ‘lag time’ to deal with any important financial innovation. Rather than inventing new policy and regulatory framework for addressing new phenomenon in the financial market, such as the ones advocated by the G-30, Indonesia can simply learn from other countries and adopt the best global practices.

But change is imminent. The creation of government bonds to recapitalize banks in 1999 and their subsequent expansion to finance budget deficits has energized the fixed-income market in the country.

These fixed-income securities will offer a promise to spin off future periodic payments of interest and a final return of capital. All fixed-income securities can generally be viewed as a derivative of the market’s underlying interest rates. In developed markets, interest rate modeling has advanced far and become a de facto mother of invention in the theory of derivatives.

Once such a development starts, an arms race begins. Competitive pressure and tightening margins will force banks and securities firms to improve their modeling. The financial innovation will become more complex, and the need for a sophisticated regulatory framework will only increase. This will inevitably blur the line between commercial and investment banking — the basic argument for the consolidation of financial market supervisory under the single roof of OJK.

Thence, the newly-born OJK cannot be complacent and needs to equip itself to tame the market and to help the next financial innovation act in the best way for the economy.
 
Taming the beast

The OJK will inherit salient legacy issues. Banking supervisory needs to be beefed up and so does capital market supervision. With only one exception, there has been no major criminal conviction in the capital market. Yet the market knows that many major violations of the BAPEPAM rules take place without punishment from the authority. So far, there is no single case of insider trading being tried despite the perceived presence of the practice. The first major challenge for OJK is, therefore, the enforcement of the rule of law.

Definitely, there is also a strong need to consolidate and further strengthen both the banking and the securities companies. The financial health of our insurance companies is such that they are suspected to need major overhaul. Securities and insurance companies can, in this case, learn from their counterparts in the banking sector in terms of consolidation through mandatory capital requirement, and by instilling risk management within the organization.

The newly established OJK will practically have a blank paper to draw upon and write its own path in the future. It should learn from past mistakes and from global best practices. It shall have the bravery to distance itself from political meddling as well as from state capture. It needs to instill integrity and build credibility.

The current selection committee for the executive board of OJK is facing a few nemesis to tame the beast. The first is ignorance and incompetence. The members of the board need strong expertise and track records to build the organization. Amateurs and opportunists will not do. Likewise, bureaucrats with unproven experience will only hurt.

Another nemesis pertains to political intrusion. Our experience with regulatory and state capture in the 1997 crisis indicates that OJK must distance itself from political interference. The stakes are simply too high to allow politicians to become members of the board. One cannot imagine what would happen if politicians became involved in the decision to close or to rescue a bank during a looming financial crisis. That would be a recipe for disaster.

The final enemy is ‘experts’ of known dishonesty. The very currencies for the financial markets are integrity, trust and credibility. This is so self-evident that there is no need to elaborate further.

The very success of OJK will finally hinge upon the quality and performance of its people, hence the paramount importance of OJK’s human capital. The sectors that OJK regulates — the banking, securities, insurance and multi-finance sectors — touch the lives of virtually everyone in Indonesia. So the stakes are very high. Let the best of the best Indonesians run OJK for all of us.