Optimal bank regulation and risk management for Indonesia

This research has studied bank risk management in relation to efficient bank regulation in the form of optimal bank financial reorganization. Efficient banking regulation can be achieved only if it includes closure policies which prevent moral hazard behaviour; in turn, they should enhance bank regulators' accountability. Yet, Basel II gives more discretion to domestic banking authorities and focuses more on the implementation of best practices of risk management. This creates a gap between the needs of efficient banking regulation and the objectives of Basel II, on the one hand, and Indonesian bank regulation on the other. To fill the gaps, the Fries, Mella-Barral, Peraudin (FMP) model, under a robust regulatory regime concept, is used to provide a framework for banking regulation. Optimal bank reorganization aims at achieving efficient bank regulation, where bank regulators are assumed to act as social planners. In this thesis, optimal bank reorganization is analysed within the concept of a "robust regulatory regime". Optimal bank reorganization comprises closure rules and bailout policies arising endogenously through the interaction of two factors, namely regulators' attempts to minimize discounted, expected bankruptcy costs, and equity-holders' incentives to recapitalise banks. The shareholders will be allowed to continue to control the bank if the bank is well capitalized. The cash flow approach to optimal bank financial reorganization is adopted. The subsidy policies for financially ailing banks consider the implementation of socially-optimal closure rules at minimum financial cost to regulators and which reduce moral hazard. The FMP model implies that optimal bank reorganization requires a deposit insurance scheme. The FMP model involves capital and risk management as crucial factors. This research includes an empirical study of the implementation of the FMP model in Indonesia using the American call option approach. Maximum likelihood estimates in VAR and GARCH are applied to monthly data on the market return and equity and deposit values for relatively-large Indonesian banks, including regional banks and foreign banks. The results indicate that the authorities can establish an optimal closure rule for each bank, levy fair deposit insurance premiums that can be adjusted to take account of quantitative and qualitative factors, estimate optimal subsidies at different deposit insurance premiums, and identify the banks' imminence to bankruptcy. (Continues...).