Financial deregulation in Indonesia and the continuing policy issues
Date
1995
Authors
Suwandi, Titin Ayu Asih
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Abstract
In many countries, different degrees of banking instability occurred following a
complete financial deregulation, although the reasons for the instability varied. It was
widely recognised that macroeconomic instability was responsible for the failure of
financial deregulation in several countries. Another important reason for banking
instability was the moral hazard problem that emerged after financial deregulation. Under
central bank guarantees of bank deposits, the complete removal of traditional regulations
led banks to take on excessive risk. Several other reasons for the banking failure such as
inappropriate sequencing of economic reform and inadequate supervision of banks were
identified.
Responding to concerns about banking instability, this thesis examines the
positive and negative effects of financial deregulation on the development of banking in
Indonesia. The Indonesian experience is a classic example of the trade-off between
financial deepening and banking instability under financial deregulation with central bank
guarantees and without adequate supervision of banks. The presence of externalities
associated with the use of money on the one hand, and systemic risk such as the risk of a
run on the payments system on the other, makes free market competition in banking,
without central bank intervention, not feasible.
This thesis, therefore, models the relationship between the central bank and
commercial banks in the context of a loan insurance scheme. The model extends the
literature on optimal risk-sharing contracts to the banking sector. In so doing, different
utility functions, which are more representative of the banks' utility functions, are
introduced. The model aims at allowing the central bank to eliminate the moral hazard
problem in bank lending and at the same time give assurance or confidence to depositors.
As the model is a theoretical exposition of the relationship between a central bank and
commercial banks, it stops short of providing a 'blueprint' for such an optimal risk-sharing
contract. To achieve this, simulations of the theoretical model will need to be
done, and this is the subject of further work in the future.
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Thesis (PhD)
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