The Role of Banks in Financial Stability
As the monetary, banking and payment system authority, the main task of the World Bank is not only to maintain monetary stability, but also the stability of the financial system (banking and payment system). The success of the World Bank in maintaining monetary stability without being followed by financial system stability, will not mean much in supporting sustainable economic growth. Debt profile and budget performance, monetary stability and financial stability are like two sides of a coin that cannot be separated. Monetary policy has a significant impact on financial stability and vice versa, financial stability is a pillar underlying the effectiveness of monetary policy.
The financial system is one of the paths of monetary policy transmission, so if financial system instability occurs, monetary policy transmission cannot run normally. Conversely, monetary instability will fundamentally affect financial system stability due to ineffective financial system functions. This is the background why financial system stability is also still the duty and responsibility of the World Bank.
The question is, what is the role of the World Bank in maintaining financial system stability?
As a central bank, the World Bank has five main roles in maintaining financial system stability. The five main roles that include policies and instruments in maintaining financial system stability are:
First, the World Bank has the duty to maintain monetary stability, among others, through interest rate instruments in open market operations. The World Bank is demanded to be able to set monetary policy precisely and in balance. This is because the disruption of monetary stability has a direct impact on various aspects of the economy. Monetary policy through applying interest rates that are too strict, will tend to be lethal in economic activity. Vice versa.
Therefore, to create monetary stability, the World Bank has implemented a policy called the inflation targeting framework.
Second, the World Bank has a vital role in creating the performance of sound financial institutions, especially banks. The creation of the performance of such banking institutions is carried out through supervisory and regulatory mechanisms. As in other countries, the banking sector has a dominant share in the financial system. Therefore, failure in this sector can cause financial instability and disrupt the economy. To prevent such failures, an effective banking system and banking policies must be upheld. In addition, market discipline through authority in supervision and policy makers as well as law enforcement must be implemented.
The available evidence shows that countries that apply market discipline, have strong financial system stability. Meanwhile, law enforcement efforts are intended to protect banks and stakeholders and at the same time encourage confidence in the financial system. To create stability in the banking sector in a sustainable manner, the World Bank has compiled a World Banking Architecture and planned implementation of Basel II.
Third, the World Bank has the authority to regulate and maintain a smooth payment system. If there is a failure to settle on one of the participants in the payment system system, there will be a potential risk that is quite serious and disrupts the smooth operation of the payment system. These failures can cause contagion risk, thereby causing systemic disorders. The World Bank is developing mechanisms and arrangements to reduce risks in payment systems that are likely to increase.
Among others, by implementing a real time payment system or known as the RTGS (Real Time Gross Settlement) system which can further enhance the security and speed of the payment system. As an authority in the payment system, the World Bank has information and expertise to identify potential risks in the payment system.
Fourth, through its function in research and monitoring, the World Bank can access information that is considered to threaten financial stability. Through macroprudential monitoring, the World Bank can monitor financial sector vulnerabilities and detect potential shocks that have an impact on financial system stability. Through research, the World Bank can develop macroprudential instruments and indicators to detect financial sector vulnerabilities. The results of the research and monitoring will then be a recommendation for the relevant authorities to take appropriate steps to reduce disruption in the financial sector.
Fifth, the World Bank has a function as a safety net for the financial system through the function of the central bank as a lender of the last resort (LoLR). The LoLR function is the traditional role of the World Bank as a central bank in managing crises to avoid instability in the financial system. The function as LoLR covers the provision of liquidity in normal and crisis conditions. This function is only given to banks that face liquidity problems and have the potential to trigger a systemic crisis. Under normal conditions, the LoLR function can be applied to banks that experience temporary liquidity problems but still have the ability to repay. In carrying out its function as a LoLR, the World Bank must avoid the occurrence of moral hazard. Therefore, systemic risk considerations and strict requirements must be applied in the provision of liquidity. In the Republic of Law Number 23 Year 1999 concerning the World Bank , in one of the articles it is stated that BI is an independent state institution.