Preliminary investigations that led to the arrest of the former chief executive officer and chairman (shareholder) of Bank Century immediately after its recent bailout revealed how the bank's management and controlling owners had thrown out the window almost all regulations on prudential banking operations.
These findings also showed how the central bank should have acted earlier to close down or nationalize that bank because allowing such a weak bank to continue operating means management resorted to making high-risk, high-return loans -- gambling that if they were lucky, the high interest earnings would return their banks to solvency.
This smacks of inadequate supervision due to either a lack of resources or the integrity of the supervisors.
But the risk of a bank scandal is only one, and not the most major challenge facing the central bank's supervisory system. In the current financial turmoil and uncertainty, the quality of bank assets could deteriorate sharply due to worsening conditions in the corporate sector amid the sharp global economic downturn.
This is because the banking sector is a mirror image of the corporate sector and the quality of assets in the banking system can be no better than the quality of liabilities in the corporate sector. When the corporate sector is vulnerable or fragile -- over leveraged or unprofitable -- the assets of the banking sector are also poor.
Corporate distress which may spread due to weakening economic growth next year is therefore both a symptom as well as a cause of economic weakness.
The central bank -- the sole authority in charge of supervising the banking industry to ensure that this system plays fully by the rules -- needs to step up supervision of the 125 city-based banks and hundreds of secondary (rural) banks.
But that is not an easy task amid the current international financial turmoil and the weak global economic environment.
The suspicions now between large and small banks with regards to soundness reflect in part some doubt in the credibility of the central bank's supervision and the financial uncertainty.
The central bank's surveillance mechanism, which in normal situations consists of ordinary off-site supervision (analysis based on regulatory reports submitted by bank) and on-site examination, is no longer adequate.
Bank Indonesia (BI) should conduct intensive supervision by placing on-site supervisors at most banks. Such vigorous oversight is especially needed at this point in time when our financial sector is so vulnerable to the global financial turmoil.
True, the first line of defense against bank scandal or crime is to secure good and responsible shareholders and management. This is the logic behind BI's screening of people intending to own or sit on a bank's board of directors.
But as past bank failures have shown, share ownership confers only limited rights of control. Moreover, it would also be unreasonable to expect outside shareholders to second-guess bank boards on specific issues of risk management or internal control.
Here lies the vital role of the central bank's oversight system. This system can be effective only if BI's supervisors are capable of assessing, from time to time, the integrity and competence of bank management and understanding the risks taken by banks and their current and future profitability and earnings.
Banking inherently entails taking a wide variety of risks. BI has therefore required all commercial banks to implement an effective management of risks related to credit, market, operations, liquidity, laws, interest rate, compliance, strategy and reputation.
Operational risks are one of the biggest threats to a bank's soundness as they involve breakdowns in internal control and corporate governance which inflict financial losses through errors and frauds.
Credit risk is one of the biggest risks facing the banking industry now in view of the adverse financial and economic environment. Likewise, banks also face risks of losses in on- and off-balance sheet positions arising from movements in market prices -- notably the volatile foreign exchange market.
Bank supervisors should be well informed of these risks to enable them to determine the adequacy of a bank's capital and ascertain whether a bank is simply facing a temporary liquidity problem or already is insolvent.
But this is not an easy task given the large number of banks the central bank has to supervise amid the current international financial volatility, credit crunch and sharp economic downturn.
But the current financial turmoil could also be an opportune time for BI to accelerate consolidation within the industry by forcing small banks to merge with larger ones.