Comparative Study of the Economic Determinants of FDI in Pakistan, India and Indonesia

Journal of Indonesian Economy and Business Volume 26, Number 1, 2011, 10 – 24 THE POLITICS OF BANK SUPERVISION Widigdo Sukarman Universitas Gadjah Mada and Universitas Negeri Manado ([email protected]) ABSTRACT The bank supervision function and efficacy of monetary policy are often a trade-off for the central bank. An increasingly integrated financial system and the occurrence of bank crises during the 1980s raised the question: are central banks efficient in overseeing banks and is there a requirement for integrated supervision, either under the central bank or separate? The debate among academics and policymakers has never been settled without the guarantee that one alternative will ensure optimal bank supervision. This development has led to periodic changes in the form of supervision chosen. As the basic economic choice has been unsatisfactory, this study approaches the problem using path-dependence theory, which observes historical factors of bank development as well as the constellation of domestic politics in choosing these alternatives. Keywords: path-dependence, bank supervision, politics, country-specific INTRODUCTION Economic development, which changed rapidly among industrial countries during the Why are banks so special? Banks occupy second half of the 20th century, led to a special place in the economy because of their integrated bank, securities and insurance ability to transform short-term savings, which institutions and, therefore, the emergence of constitute public assets, into long-term loans. financial conglomerates. This situation Furthermore, banks also effectuate the necessitated a response in terms of financial payment system of a country and between reforms that would bring changes in countries. In the event of a bank rush, the bank institutionalization, competition and innova- cannot readily conduct a reverse transforma- tion in products and services such as tion, thereby triggering a liquidity crunch, securitization. The growth in funds, which which can spread and become a systemic could not be absorbed by these markets, liquidity crisis that threatens the national searched for broader markets. Concomitantly, economy (Diamond and Dybvig, 1983). markets in emerging countries were Consequently, public intervention is required, performing well despite their economies being for example through a deposit insurance protected from new entries, hence, the corporation, lender of last resort, prudential industrial countries sought to open these regulations and bank supervision from the emerging markets. The Washington Consen- central bank. Bank regulation and supervision sus 1989 was used as a reference to release the are a complicated issue, namely the problem regulatory shackles in emerging markets for regulators is that there is no single optimal through reforms. Various sweeping reforms way to regulate banking (Smith, 1990; that spanned nearly the entire globe during the Bhattacharya and Thakor, 1993). 1980 striggered instability and, as forewarned 2011 Sukarman 11 by Davis (1995), the resulting dynamics gave Governors’ Symposium 2000, opinion ofex- grounds for expecting a permanent increase in Governor of BI Sudradjad Djiwandono, early instability. 2000). It is noteworthy that although Goodhart Numerous crises struck during the 1980s (2000: 34-42); Cihak and Podpiera (2006) as a result of reforms as well as other triggers. opine that bank supervision should be This instability precipitated distrust in central independent from the central bank in industrial banks as bank overseers due to the lack of countries. They further more argue that it bank crisis prediction and handling, which should come under the auspices of the central threatened monetary stability. An idea bank in emerging countries due to a number of emerged at around the same time in industrial reasons. One of the more salient reasons, countries that central banks should be according to the findings of Peek, Rosengreen independent and, therefore, isolated from and Tootell (1999), is that credit markets in short-term political pressures when carrying emerging countries are usually bank-centric. out their primary purpose of maintaining price This choice of bank supervision structure stability (Goodman, 1992; Maxfield, 1997; has remained the subject of debate ever since Bernhard, 2005). Consequently, the task of among academics as well as policymakers bank supervision should be outsourced. without conclusive results. In practice, several However, the financial services industry is countries have separated the supervision integrated. Therefore, supervision is more function from the central bank and formed an efficient if kept under one roof, without integrated supervisory body. Separation has distinguishing whether it remains at the central occurred in UK (1997), Japan (1998), Korea bank or elsewhere. (1998) and Australia (1998) with various The notion that supports the separation of supervision structures considered appropriate bank supervision from the central banks terms to their respective requirements. Several from avoiding a conflict of interest with Scandinavian countries have historically monetary policy (Heller, 1991; Goodhart and separated supervision from the task of the Schoenmaker, 1992; Goodhart, 2000). Con- central bank, meanwhile in US despite versely, proponents for unifying the two insistence to form a supervisory body outside functions under the central bank argue the of the Federal Reserve Bank, the Fed remains complementarity between supervisory and adamant to retain bank supervision (for example read the speech of Governor Ben monetary policy responsibilities, at a th minimum because the conduct of monetary Bernanke in front of the US Senate, 10 policy requires full access to supervisory January, 2010). information in order to obtain timely and However, circumstances can change reliable data (Peek, Rosengreen and Tootell, rapidly. The global banking crisis in 2008, 1999; Mishkin, 1992; de Krivoy, 2000).The which stemmed from the subprime debt majority of central bankers also defend the debacle at US banks, forced many countries to unification of supervision under the central rethink their current systems of bank bank as an umbrella (Haubrich and Thomson, supervision, to either return to the original 2005; opinion of ex-Governor of BI system or modify their reforms (Masciandaro Burhanuddin Abdullah, 2009; Grenville, 2009; and Quintyn 2008). In 2009, UK restored bank Bernanke, 2010). supervision to the central bank after the FSA A third opinion states that it is not failed to handle the Northern Rock crisis in important where supervision is located as long 2007. Meanwhile, Indonesia continues to as its task is implemented efficiently (see prepare legislation for the Otoritas Jasa Bank of England’s 7th Central Bank Keuangan (OJK) (Financial Services 12 Journal of Indonesian Economy and Business January Authority) that will be separate from Bank economics, path dependence or “lock-in by Indonesia pursuant to the mandate of The BI historical events” means that equilibrium Act no. 23/1999 article 36. The introduction of allocations depend on history (Arthur, 1989). this legislation, which has been delayed many It offers what is perhaps the best times, must be completed by year end expression of the alleged importance of path 2010.The question that now emerges is dependence for economics. The lock-in in path whether the establishment of OJK should dependence is a lock-in to something bad, or actually be continued or whether it should be at least a lock-out of something better. It reconsidered as in the case of numerous other constitutes an inferior economic outcome such countries that have subsequently abandoned as an inferior standard or product where the idea of separation? superior alternatives exist, are known, and where the costs of switching are not high RESEARCH METHODOLOGY (Liebowitz and Margolis, 1999). Even when Hitherto, the existing panoply of empirical path dependence considered as a qualitative research has offered no optimal or definitive approach, the path-dependence effect (PDE) of supervision structure, and the basic economic bank supervision in some European countries arguments used have not yielded any had been empirically tested by Masciandaro convincing results. Therefore, it is necessary and Quintyn (2008) with robust result. to seek other reasons, non-economic reasons, In this paper, this heterodox approach which determine the choice of supervision states that decisions made today are system. Some research has concluded that the inseparable for a previous decision (or no- choice of bank supervision structure is decision) taken, which were influenced by the country-specific, appropriate to local banking environment at that time. Past political history, culture and politics (Haubrich, 1996; decisions restrict the flexibility of current Masciandaro and Quintyn, 2008).As was also decision-makers in their choices. Data for this mentioned by Smith (1971) in the context of study is obtained from a literature review and choosing free banking or central banking, the through interviews with those involved in choice is not a factor of economy but more a decision making, which is subsequently combination of historical incidents and contrasted against the experiences of several political motives. Here politics refers to countries using purpose sampling. bureaucratic politics (Allison and Zellikov, 1971), which infers that a decision is made THEORETICAL FRAMEWORK based on a process of negotiation and compromise,

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