International financial markets have now been highly volatile for a year, as the repercussions of the euro zone debt crisis drag relentlessly on. Meanwhile, weak economic data coming out of the United States have also taken their toll on investor confidence and growth projections worldwide.

Just as at the start of the Global Financial Crisis in 2008, once again Indonesia will not be immune to a more pronounced downturn, especially as the economies of China and India also start to slow. Despite Indonesia’s relatively strong recent economic performance, and its sound positioning to absorb short-term shocks with conservative fiscal policies and foreign exchange reserves at twice the levels seen in 2008, the question on many people’s minds today is: can Indonesia weather the slowing world economy and financial market turbulence as it successfully did in 2008-2009, or  could its financial sector start to buckle under the strain, as it did during the Asian Financial Crisis of 1997-1998?

Indonesia has devoted great attention to improving the stability of its financial sector since the 1997-1998 crisis and the flaws that it exposed, and it is fair to say that a great deal has been accomplished. The banking sector is much stronger and more resilient to crises now than it was in 1997, and the market turbulence during 2008-2009 tested the system and showed that Indonesia could come through with flying colors.

The main reasons Indonesia’s financial sector passed that test unscathed were its sound macroeconomic policies, greatly improved banking supervision and regulation, prudent banking on the part of bankers themselves and the timely response of authorities at times of stress.

The question is whether Indonesia has done enough to secure the soundness of its financial sector going forward in the current volatile global environment. Of course, this depends to an extent on just how bad that external environment becomes. Are we looking at a possible Greek exit from the euro, or a major euro zone banking crisis, or both of these mixed in with a stalled recovery in the US?

The answer is that Indonesian policymakers need to assume the worst-case scenario when strengthening the financial sector, not because it will happen but simply because there is a risk it could happen. Indonesia’s strong recent financial sector performance has acted as a buffer against real spillovers from recent market instability and demonstrates that no repeat of the 1997 financial sector meltdown will happen this time. However, further strengthening the ability of authorities to address risks to the sector would be prudent and potentially crucial in view of the risks that lie ahead.  

Already, a number of policies have been put in place to deal with capital outflows, including a bond stabilization fund to purchase domestic government bonds, lengthening maturities and extending the minimum holding period on Bank Indonesia certificates (SBIs), and the central bank’s policy to get exporters to repatriate their export earnings to Indonesian banks.

However, more measures are necessary to bolster Indonesia’s defenses at this uncertain time. First, Indonesia needs to put into place a stronger legal basis for the protocol for crisis management, and this would in turn require a financial system safety net (FSSN) law to be passed by parliament. So far, a memorandum of understanding has been signed by Bank Indonesia, the Indonesian Deposit Insurance Agency (LPS) and the Ministry of Finance, which gives support to the current informal arrangements and enables information-sharing and coordination between authorities through the Financial System Stability Coordination Forum, as stated in the Indonesian Financial Services Authority (OJK) Law.

In the past, the challenge has been to ensure effective cross-institutional coordination at times of financial sector stress. An FSSN law passed by parliament would provide a stronger legal framework for such coordination and rapid decision-making processes to prevent and manage any crisis situation in future.

Such a legal mandate is all the more critical in view of the uncertainty created in the wake of the government bailout of Bank Century during the 2008 crisis, and the hesitation that this might cause among senior government decision-makers were there to be a similar situation now. Passage of the FSSN law would provide more assurance that a future crisis situation could be speedily resolved without incurring high costs for the economy.

In practical terms, a FSSN law needs effective coordination by a committee, namely a Financial System Stability Forum, consisting of the minister of finance, the central bank governor and the chairs of the LPS and OJK (in the future). The FSSN law would also provide clarification on how and when emergency liquidity assistance to failed banks could be provided during a crisis. This would help to mitigate the misuse of emergency credit that occurred on a wide scale in Indonesia during the 1997-1998 Asian Financial Crisis.

Second, Indonesia needs to continue to implement the Basel II accords across its banking sector. Basel II aims to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of risks that they face.

By standardizing the regulations at an international level, sufficient consistency is maintained so that this does not become a source of competitive inequality among internationally active banks. Having made good progress so far, Indonesia still has some way to go in this area to ensure that its banking sector conforms to Basel II standards.

At the same time, Basel III has now been published by the Basel Committee. G20 countries, including Indonesia, have committed to implement this next stage of international banking regulations beginning Jan. 1, 2013, including transitional arrangements until Jan. 1, 2019.

Third, in Indonesia’s capital markets there is a need for regulators to have adequate enforcement powers, with meaningful sanctions for those who digress so that powerful market players cannot unduly influence markets. These continue efforts to strengthen investor protection through regulation and enforcement, as they would help to improve investor confidence and ensure that Indonesia’s capital markets remain attractive even during the most uncertain of times, when foreign investors tend to become most risk-averse.  

Fourth, in view of the continuing uncertainty in global financial markets, it is even more important for authorities controlling Indonesia’s financial sector to avoid policy uncertainty at all costs. Any hint of doubt, hesitation or overreaction among decision-makers is likely to undermine already fragile investor confidence. The more institutionalized mechanisms that are in place, the less likely it will be for policy uncertainty to become apparent. One thing seems to be clear: in the current volatile environment, although applause for good policy may be muted, there are likely to be serious penalties for bad policy.  

Lastly, the decision to establish an Indonesian Financial Services Authority to take over the current regulatory and supervisory functions in capital markets and non-bank financial institutions of the Financial Institution Supervisory Agency (Bapepam-LK) at the end of 2012, followed by the transfer of Bank Indonesia’s responsibilities for the supervision and regulation of banks at the end of 2013, potentially poses risks at such an uncertain time.

So far, Indonesia is to be congratulated on the successful selection of a credible board of commissioners for the OJK. But the greatest risks and real challenges lie in the implementation of the transition. For example, critical supervisory competences could be lost in the transition.

It is therefore crucial to ensure there is legal and operational clarity on roles and responsibilities, and close coordination between the OJK and Bank Indonesia, LPS and Bapepam-LK. In addition, it is important to ensure that the human capital and institutional knowledge built up by the central bank and Bapepam-LK is not lost, but transferred to the OJK.

As the experience of 2008 has already confirmed, Indonesia has made great strides in strengthening its financial sector, thereby protecting its real economy from global financial turmoil. However, more remains to be done in bolstering the financial sector if Indonesia is to give itself the best possible chance of successfully navigating the turbulence which lies ahead, regardless of the external shocks that may come its way.  

PS Srinivas is lead financial economist at the World Bank in Jakarta.