ASIAN DEVELOPMENT BANK RRP: INO 33399

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON A

PROPOSED CLUSTER,

FIRST LOAN AND TECHNICAL ASSISTANCE GRANT

TO THE

REPUBLIC OF INDONESIA

FOR THE

FINANCIAL GOVERNANCE AND

SOCIAL SECURITY REFORM PROGRAM

November 2002

CURRENCY EQUIVALENTS (as of 15 November 2002)

Currency Unit − Rupiah (Rp) Rp1.00 = $0.000111

$1.00 = Rp9,030

ABBREVIATIONS

ADB – Asian Development Bank Asabri – Asuransi Social ABRI Bapepam – Badan Pengawas Pasar Modal (Capital Market Supervisory Agency) BI – Bank Indonesia DGFI – Directorate General of Financial Institutions DPLK – financial institution pension fund DPPK – employer pension fund FATF – Financial Action Task Force on Money Laundering FGRSDP – Financial Governance Reforms: Sector Development Program FGSSR – Financial Governance and Social Security Reform Program GDP – gross domestic product IT – information technology Jamsostek – PT Jaminan Sosial Tenaga Kerja MJHR – Ministry of Justice and Human Rights MIS – management information system MOF – Ministry of Finance MOJHR – Ministry of Justice and Human Rights NCCT – noncooperative countries and territories OCR – ordinary capital resources OJK – Otoritas Jasa Keuangan (financial services authority) PPATK – Pusat Pelaporan Analisis Transaki Keuangan

(Financial Transaction Analysis and Reporting Center) RBC – risk-based capital TA – technical assistance Taspen – Tabungan dan Asuransi Pegawai Negari

NOTES (i) Until 2000, the fiscal year (FY) of the Government ended on 31 March. With

effect from 1 January 2001, the fiscal year coincides with the calendar year. (ii) In this report, “$” refers to United States dollars. This report was prepared by a team consisting of J. Rogers (team leader), M. Ryan, R. O’Sullivan, L. Kulp, T. Hla, and H. Purnomo.

CONTENTS

Page LOAN AND PROJECT SUMMARY iii I. THE PROPOSAL 1 II. THE MACROECONOMIC CONTEXT 1 III. THE SECTOR 2 A. Sector Description and Performance 2 B. Sector Issues 8 C. Lessons Learned from Asian Development Bank

Operations in the Sector 11

IV. THE PROPOSED PROGRAM 12 A. Objectives and Scope 12 B. Policy Framework and Actions for Phase I 13 C. The Loan 17 D. Implementation Arrangements 18 V. TECHNICAL ASSISTANCE 22 A. Objectives 22 B. Scope 22 C. Implementation Arrangements 23 VI. PROGRAM BENEFITS AND RISKS 23 A. Benefits 23 B. Risks 24 VII. ASSURANCES 24 VIII. RECOMMENDATION 25 APPENDIXES 1. Sector/Subsector Analysis 26 2. Development Policy Letter and Policy Matrix 32 3. Program Framework 45 4. Technical Assistance Cost Estimates and Financing Plan 49 5. Technical Assistance Terms of Reference for Consultants 50 6. Summary Poverty Reduction and Social Strategy, and

Poverty Impact Assessment 54

7. Environmental Analysis 60

SUPPLEMENTARY APPENDIX (available on request) Estimated Cost to Establish Otoritas Jasa Keuangan (OJK)

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LOAN AND PROGRAM SUMMARY Borrower The Republic of Indonesia

The Proposal Support to the Government for the Financial Governance and Social

Security Reform Program (FGSSR) through a program loan of $250 million as Phase I of a cluster. Specifically, the proposal is for: (i) A cluster comprising two loans to support policy reforms for

financial governance and social security. The first loan (Phase I) will consist of three tranches and will be implemented during 2002 to 2003. Subject to satisfactory progress under Phase I, the second loan (Phase II) will proceed and be implemented over 2003 to 2005.

(ii) Technical assistance for Phase I for financial governance and

social security reform. Cluster Rationale

The Asian economic crisis highlighted Indonesia’s weak regulatory and supervisory framework and the risks associated with vulnerable financial structures in a financially integrated world. Vulnerabilities in Indonesia stemmed from strategic weaknesses including (i) excessive dependence on bank financing characterized by imprudent lending; (ii) a small and underdeveloped nonbank financial sector; (iii) lack of accountability, independence, and adequateness of regulation and supervision; and (iv) weak corporate governance. To promote the soundness and stability of Indonesia’s financial system and promote economic growth, the Government needs to launch broad-based financial sector reforms, strengthen frameworks for financial sector regulation and supervision, and establish an effective anti-money laundering regime. During the crisis, a large proportion of the population dropped below the poverty line and a significant proportion currently remain there, highlighting the need to establish adequate social protection systems and retirement income. To address this need, the Government needs to improve the governance and design of mandatory pension and retirement schemes, improve fiscal sustainability of programs, establish a national law for social security to provide a unified framework for social security reform, and increase coverage of social security systems to a broader segment of the population.

Objectives and Scope The FGSSR will build upon the core reforms of INO-Loan 1618:

Financial Governance Reforms Sector Development Program.1 Phase I will support a broad framework for the overall strengthening of the financial sector and promote the development of sound financial institutions necessary to support good governance and economic growth. It also aims to improve social protection through

1 Approved in 1998 for $1.4 billion.

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improved governance, supervision, and regulation of pension funds and mandatory social insurance programs. Sustainable economic development and growth in Indonesia depend on strengthening governance, financial supervision, and regulation. Robust economic growth will also help the country create jobs, raise standards of living, and reduce poverty. To promote consistency, efficiency, and harmonization of supervision across financial services and products, Phase I will support the establishment of a consolidated regulatory and supervisory authority (OJK) for the financial sector. In the pre-OJK transition period of 2002–2004, Phase I will (i) support preparation of comprehensive legal reform necessary to transfer regulatory and supervisory powers to OJK; (ii) support development of an effective anti-money laundering regime; (iii) strengthen financial sector regulation and supervision under existing authorities; (iv) improve corporate governance; and (v) promote adoption of international best practices and standards for regulation and supervision. To strengthen the national social security system, Phase I will (i) support the development of a law for a national social security system; (ii) improve supervision and governance of mandatory social insurance and social security programs by bringing the related entities under the jurisdiction of OJK; (iii) support measures to improve fiscal sustainability of mandatory programs; (iv) improve programs to provide adequate retirement income; (v) support development of a unified identification system for social security to improve administration of benefits; (vi) assess potential options for expanding coverage of social security systems to the informal sector; and (vi) undertake a special audit of the mandatory social insurance scheme for formal sector workers and independent financial reviews of insurance firms to support reforms and restructuring. Phase II will continue support for Phase I reforms, and include measures to support broader social security reform and restructuring as needed.

Classification Economic growth Environment Assessment

Category C

Loan Amount and Terms

It is proposed to support Phase I in three tranches of $100 million, $50 million, and $100 million from the ordinary capital resources (OCR) under the LIBOR-based lending facility of the Asian Development Bank (ADB). The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB's LIBOR-based lending facility; a commitment charge of 0.75% per annum; a front-end fee of 1.0%; conversion options that may be exercised in accordance with the draft loan agreement, the loan regulations, and ADB’s conversion guidelines; and such other terms and conditions set forth in the loan agreement.

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Phase II will be presented for Board consideration, based on satisfactory implementation of Phase I. Policy actions for Phase II are subject to revision depending upon ADB’s reassessment of the macroeconomic environment, further sector information and analyses conducted, lessons learned under Phase I, and status of implementation and readiness of the Government to undertake the proposed policy reform actions.

Program Period and Tranching

The Government will be able to withdraw funds from the Phase I account during a period of 1 year from loan effectiveness. Phase I loan will be disbursed in three tranches. The first tranche, equivalent to $100 million, will be made available upon the Government meeting the conditions of loan effectiveness. An additional incentive tranche of $50 million and the second tranche of $100 million, which is expected to be released within eight months of loan effectiveness, will be released upon satisfactory compliance with agreed-upon conditions.

Executing Agency The Coordinating Ministry for Economic Affairs (CMEA) will act as

the Executing Agency for the FGSSR to facilitate (i) the necessary coordination across multiple implementing agencies for implementation of reforms and (ii) a smooth transition from Phase I to Phase II as regulatory and supervisory powers are transferred from existing authorities to OJK.

Procurement and Disbursement

In accordance with the simplified disbursement procedures and related requirements for program loans, procurement of goods and services produced in and originating from ADB's member countries will be made with due consideration to economy and efficiency in accordance with standard Indonesian public sector procedures and normal private sector commercial practices acceptable to ADB. Disbursement of the loan proceeds will be permitted on the basis of a certification provided by the Borrower, confirming that in each year in which proceeds of the Phase I loan are expected to be disbursed, the value of total Indonesian imports minus (i) imports from nonmember countries, (ii) ineligible imports, and (iii) imports financed under other official development assistance, will be equal to or greater than the amounts expected to be disbursed during that year. ADB reserves the right to audit the use of loan proceeds and verify the validity of the certification issued by the Government with each withdrawal application.

Counterpart Funds The counterpart funds to be generated out of the loan proceeds will

be used to finance the cost of structural adjustments and activities consistent with the FGSSR.

Risks and Safeguards The implementation of the FGSSR could be affected by various

factors. The principal risk relates to the potential for continuing political uncertainty, civil conflict or unrest, and their effect on the pace of structural reforms. However, there is a firm commitment to financial governance and social security reform at the highest levels

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of Government, and consequently the risk of the Program being diluted or abandoned is reduced. The other risk stems from resistance by vested interests to the reforms, particularly since the FGSSR covers sensitive areas, such as social security reform, restructuring and consolidation of the insurance industry, and anti-money laundering. The Government has been gradually overcoming resistance in these areas as necessary steps for reform are being undertaken. Delays may also occur in the implementation of reforms due to lack of capacity. TA support will be provided under the FGSSR to help address this risk, and the Government has identified areas where it will require assistance.

Technical Assistance Technical assistance will be provided, at the request of the

Government, for $1.0 million financed from ADB’s TA funding program to support implementation of the FGSSR, including a feasibility study for social security reforms, options for restructuring existing public social insurance schemes, and assistance in the development of a new law for national social security.

I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on (i) the proposed cluster for the Financial Governance and Social Security Reform Program (FGSSR) in the Republic of Indonesia and (ii) the proposed loan to the Republic of Indonesia for Phase I of the FGSSR. The report also describes technical assistance (TA) to support the implementation of the FGSSR, and if the Board approves the proposed loan, I, acting under the authority delegated to me by the Board, shall approve the TA.

II. THE MACROECONOMIC CONTEXT1 2. Reflecting weak external demand, the Indonesian economy posted a modest economic performance in the first half of 2002, growing by 2.9% year on year. External demand is expected to remain weak during the remainder of 2002, and the impact of the Bali bombings will further serve to dampen growth prospects through their impact on the tourist industry (which accounted for 3.7% of gross domestic product [GDP] in 2001) and on investor confidence. The economic fallout from the bombings will also directly and significantly add to an already high and rising unemployment rate, as the tourist industry alone employs some 9 million people. Any significant reduction in unemployment will require a return to precrisis growth rates of 6–7% per annum. 3. A return to a higher growth path is also crucial if Indonesia is to significantly reduce its heavy debt burden. Decentralization has shifted control over much revenue to local governments and the state budget for 2002 relies heavily on external financing—projecting a deficit of 2.5% of GDP. Indonesia's debt burden, ballooned by the crisis, remains heavy and debt service obligations constitute the largest single item of government expenditure, at 5.5% of GDP. Any significant reduction in the public debt will require, among other things, a sustained return to higher growth rates. 4. The financial sector clearly has a central role to play in the country’s economic performance through its role in stimulating savings and investment and in supporting productivity growth. Undermining the potential for growth, however, are continued weaknesses in financial sector governance due to distortions in incentives created by the existing regulatory and institutional framework. Weak and uneven regulation and supervision have contributed to the development of a fragile, structurally unbalanced, financial sector characterized by bank dominance and underdeveloped capital markets. Bank lending to the corporate sector, moreover, has been constrained by the dead weight of nonperforming loans accumulated since the crisis. The sound development of alternative channels of financial intermediation (e.g., contractual savings, capital markets) has been hindered by weaknesses in the regulatory framework and in supervisory capacity. The need for regulatory and institutional reforms is fundamental if financial sector stability is to be strengthened and the sector is to effectively play its crucial role in facilitating long-term economic growth.

1 This section provides a brief update on recent economic developments. It should be read in conjunction with ADB.

2002. Country Economic Review: Indonesia. Manila.

2

III. THE SECTOR A. Sector Description and Performance 5. The financial sector in Indonesia is characterized by bank dominance and underdeveloped capital markets. Combined assets of commercial and state banks in 2001 were over six times as great as the Jakarta Stock Exchange market capitalization (Table 1). In hindsight, one of the indicators signaling Indonesia's vulnerability to the crises might have been found in the heavily unbalanced composition of its financial sector. Postcrisis reforms in the banking sector have focused on consolidation and recapitalization of the sector. Of the 239 banks operating prior to the crisis, Indonesia closed 70 insolvent banks and initiated restructuring of seven state banks, 12 regional development banks, and 20 private national banks. Financial sector regulation and supervision are under the authority of three regulatory and supervisory authorities. Banks are regulated and supervised by the central bank, Bank Indonesia (BI); the capital markets by the Capital Market Supervisory Agency (Bapepam) under the Minister of Finance; and insurance, pension, finance, and venture-capital companies by the Directorate General of Financial Institutions (DGFI) in the Ministry of Finance. Appendix 1 includes additional sector information.

Table 1: Selected Financial Sector Data

(Rp trillion)

Item 1997 1998 1999 2000 2001 Insurance Companies and

Private Pension Funds (assets)a

Life Insurance 12.3 13.7 16.8 18.7 24.1Nonlife Insurance (includes reinsurance) 8.2 10.7 11.3 12.6 15.7Social Insurance Programs 11.5 14.6 10.0 10.2 11.4Employer Pension Funds 15.8 21.5 25.9 28.7 29.5 est.Financial Institution Pension Funds 0.4 0.7 1.0 1.3 1.5 est.

Finance Companies (assets)a 30.8 24.3 17.4 19.1 18.6

Venture Capital Companies (assets)a 1.4 1.6 2.0 1.9 2.7 est.

Stock Market Capitalization Jakarta Stock Exchange (JSX)b 159.9 175.7 451.8 259.6 239.3

Banks Commercial Bank Assetsc 528.9 762.4 789.4 984.5 1,039.9State Bank Assetsc 201.9 304.8 391.5 505.1 517.1NPLs as % of Total Creditc 8.4 25.4 43.8 28.5 12.1NPLs as % of GDP (including NPLs in asset management companies)d

— 56.3 49.8

— = not available, NPL = nonperforming loan. Sources: a Ministry of Finance and Insurance Council of Indonesia, b Jakarta Stock Exchange Statistics, c Bank Indonesia, d Asia Recovery Information Center, Asian Development Bank.

1. Capital Markets 6. Like many emerging markets, the capital markets in Indonesia are small and underdeveloped in comparison to the banking sector. By the end of 2001, there were 189 securities companies licensed to act as broker-dealers, 116 licensed to act as underwriters, and 47 licensed to act as investment managers. In terms of institutional investors, there were 347 employers pension funds, 31 financial institution pension funds, 109 nonlife insurance companies, 61 life insurance companies, 60 venture capital funds, 108 mutual funds, and 5 social insurance companies, including two public pension schemes and one mandatory provident fund (Table 2).

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Table 2: Selected Financial Sector Data (number of market participants)

Item 1997 1998 1999 2000 2001 Insurance Companies and Private Pension Fundsa

Life Insurance 62 62 62 62 61Nonlife Insurance (includes reinsurance) 110 113 114 111 109Social Insurance Programs 5 5 5 5 5Employers Pension Funds (DPPK) 278 308 325 344 347Financial Institution Pension Funds (DPLK) 23 25 25 28 31 Finance Companiesa 232 223 216 245 245 Venture Capital Companiesa 60 61 60 60 60 Stock Market (number of listed companies) Jakarta Stock Exchangeb 282 288 277 287 316

Banksc 222 208 173 164 159

Sources: a Ministry of Finance and Insurance Council of Indonesia, b Jakarta Stock Exchange Statistics, c Bank Indonesia. 7. Under the existing Capital Market Law, stock exchanges in Indonesia are required to be in the mutual form, so only those who are members have trading access. The ability of firms to raise funds from Indonesia's capital markets has been limited by the small size and low liquidity of these markets. Market capitalization of the Jakarta Stock Exchange was only 16% of GDP in 2001, among the lowest in the region (Table 3).2 Apart from setbacks due to political and macroeconomic instability, growth and development of capital markets in Indonesia has also been hindered by highly concentrated share ownership patterns that contribute to low market liquidity and weak corporate governance.3

Table 3: Selected Capital Market Indicators (Rp billion, unless otherwise indicated)

1997 1998 1999 2000 2001 Market Capitalization (JSX) Value (Rp trillion) % of GDP

159.925.5

175.718.4

451.840.7

259.6 20.1

239.316.0

Composite Index (JSX) 401.7 398.0 676.9 416.3 392.0Average Daily Trading Value (JSX) 489.4 403.6 598.7 513.7 396.4Number of Listed Companies (JSX) 282 288 277 283 315Initial Public Offerings Number Value

343,950.5

368.1

12805.2

25

1,772.2 32

1,096.8Bond Issuance Number Value

247,205.0

1150.0

94,284.0

19

5,613.0 6

2,875.0JSX = Jakarta Stock Exchange.

Sources: Jakarta Stock Exchange, Capital Market Supervisory Agency.

2 By way of comparison, stock market capitalization as a percentage of GDP in the Philippines was 77.6% in 2000. 3 Most listed companies are majority owned by the founding shareholders with the general public holding 20–30% of

the total shares.

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8. Research indicates that prospective local investors still view the capital market as a complicated industry.4 Many view the capital markets as high risk and in general, investor preference is for bank deposits. This is particularly pronounced among institutional investors, whose portfolios are dominated by bank instruments. State-owned pension programs have over 90% of their assets invested in bank deposits while the corresponding figure for private pension funds is around 70%. Portfolio investment in the stock market from the insurance sector is also very small. Of the Rp32 trillion investment portfolio of the insurance industry in 2000,5 time deposits accounted for almost 59% of investments, followed by private placements (11.4%), bonds (10.9%), and stocks (3.6%). Other factors impacting the size of the Indonesian capital markets include (i) a small institutional investor sector—the combined assets of the pensions and insurance sectors were Rp51.2 trillion or 3.4% of GDP in 2001; (ii) lack of a developed government bond market with suitable benchmarks for corporate bonds and private issues of securities;6 (iii) access to funds through connected lending among industrial groups that include banks; and (iv) availability of lower cost offshore financing for multinationals and some large domestic firms. In addition, the increasing correlation among national markets due to globalization has reduced the incentive for industrial country investors to diversify into emerging markets. Overall, the trend in foreign investment in Indonesia has shown a decline from a roughly equal split between local and foreign investors in 1996 to about 10% foreign participation in 2001.

2. Pension and Provident Funds

9. The old age or retirement benefit system in Indonesia targets formal sector workers exclusively. There is no “first pillar” providing a minimum pension to the population. Approximately 25 million people are currently covered under mandatory programs through state-run monopolies, and there are an additional 1.0 million participants in voluntary pension schemes. The Indonesian social insurance system includes three mandatory programs covering formal private sector workers, civil servants, and the armed forces. Jamsostek (Jaminan Sosial Tenaga Kerja) is not a pension scheme, but a mandatory savings scheme that provides coverage for employees of private sector and state-owned enterprises (SOEs) with 10 or more employees or a monthly wage cost of at least Rp1 million. Taspen (Tabungan dan Asuransi Pegawai Negari) covers all civil servants and Asabri (Asuransi Social ABRI) covers the police, and civilian and military defense personnel. These mandatory schemes can be supplemented by voluntary pensions (dana pensiuns) of two types, employer pension funds (DPPKs) and financial institution pension funds (DPLKs). A summary overview of pension programs’ membership, assets, liabilities, and cash flow is shown in Table 4. 10. The mandatory programs were established by separate laws7 and are under the purview of separate ministries. The Jamsostek program is under the purview of the Ministry of Manpower and Transmigration, the Taspen program is controlled by the Ministry of Finance, and the Asabri program is controlled by the Ministry of Defense. The Ministry of Finance Pensions Directorate has authority to supervise voluntary pension schemes, but not the mandatory programs of Asabri or Jamsostek, which are considered effectively unsupervised. Asabri is funded from current contributions and the Government’s general budget, and Taspen is partially funded from current

4 Jakarta Stock Exchange, 2000-2004 Strategic Outlook. 5 Indonesia Insurance in 2000, published by the Directorate of Insurance, Ministry of Finance and the Insurance Council

of Indonesia. 6 Until the crisis, Indonesia had a balanced budget policy that did not allow for treasury bills and government bonds.

The first bond issue to finance recapitalization was in May 1999. 7 Law No. 3 1992 on Employees’ Social Security for Jamsostek; Law No. 11 1969 on Pension Benefits for Civil

Servants and their Beneficiaries; and Law No. 6 1966 for police and civilian and military defense personnel pensions.

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and accumulated contributions, but is largely funded from the general budget. Voluntary pension schemes come under separate legislation from mandatory programs and varying regulations.

Table 4: Pension and Provident Funds in Indonesia (Rp trillion)

Programs Jamsosteka Taspenb Asabri Voluntary Plansc Membership (millions)d Total: Contributing:

19.0e 10.0

5.8 4.0

0.57 0.55

1.3f 0.4g

Contributing Members as % of Labor Forceh

10.5 4.2 0.60 1.8

Assets 14.0 7.8 Nil 29.5f 1.5g

Existing Unfunded Debt (past service)

342 38.3

Additional Liability for Increasing Salaries by 20% for Next 5 Years

135 17.0

Contributions: Payments: Net cash flow (deficit)

0.4 0.2 0.2

0.6 14.1

(13.5)

0.08 0.11

(0.03)

Type of Plan Defined contribution Defined benefit Defined benefit Defined contribution or defined benefit

a Source: PT Jamsostek, 2001. b Membership and assets as at 31 December 2001. c Includes state-owned enterprise as well as nonstate-owned enterprise pension funds. Estimated 2001 data. d Includes contributing and retired members. e Includes unemployed/noncontributing members. f Employer pension funds. g Financial institution pension funds. h The total labor force in 2001 was estimated at 94.8 million. 11. There is an increasing public awareness in Indonesia of the importance of voluntary, supplemental pensions in providing adequate income during retirement, and participants in financial institution pension funds have increased by 55% from 260,277 in 1999 to 400,000 in 2001. The employer-sponsored voluntary plans have also shown increases but on a lesser scale. Although still a small component of Indonesia’s overall system, voluntary pension schemes can play an important role in providing long-term security. Improvements in the supervisory and tax frameworks are needed. There are no formal licensing or training requirements for private fund managers, supervision needs improvement, and industry disclosure is slow. 12. The Jamsostek old age benefit is a mandatory savings scheme that pays a lump-sum benefit upon (i) attaining the age of 55 years; (ii) death before the age of 55 years; or (iii) total and permanent disability. The program provides insufficient retirement income, representing a long-term potential burden on the Government as workers become poor in old age. The low wage replacement ratio (i.e., small retirement income) stems from factors including low contribution rates and poor investment performance. The monopoly status of the program has precluded development of more effective schemes. In spite of its mandatory status, the compliance rate is only around 45% due to a lack of confidence in Jamsostek and concerns over lack of transparency, disclosure, and governance. In 2001, Jamsostek used an independent auditor for preparation of its annual statements. However, in July 2002, Indonesia’s Supreme Audit Agency (BPK) asked a number of accounting firms to revise their audit reports on a group of state-owned enterprises as they did not meet generally accepted accounting standards. This included Jamsostek. Jamsostek

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has operated with high overhead costs and many Jamsostek members have multiple identity numbers, resulting in unconsolidated accounts and poor administration of benefits.

13. Improving the social security system has become a priority of Government in the aftermath of the Asian economic crisis. Participation in formal pension arrangements decreased along with the rise in unemployment, as people focused on fulfilling immediate needs rather than saving for retirement. During the crisis, calls for better management of Jamsostek increased. Some employers pulled out from the fund, others stopped contributions, and some firms pooled their contributions to manage themselves. Although the compulsory nature of the program is not often argued, elimination of the monopoly of its management by a government company is constantly challenged. Privatizing the management of a provident fund can be supported with the view that government should not be the market when the private sector can provide the products or services on a competitive basis. In April 2002, a presidential team was established8 to lead development of national policy on social security and to prepare a new law for a national social security system. The team is evaluating the potential scope of the law including extending coverage to the informal sector.9 The law will act to unify social insurance schemes and provide a framework for integrating the voluntary pensions sector.

3. Insurance Sector 14. The Indonesian insurance industry is characterized by a large number of companies in both the life and nonlife sectors. At 31 December 2001, there were 61 life insurance companies, 109 nonlife insurance companies, and 5 social insurance companies (mandatory programs under state monopolies).10 Approximately 25.3 million life policies were issued at year-end 2001, or one for every eight members of the population. During the period 1996–2001, the number of life and nonlife insurance firms remained fairly stable, and combined assets increased over this time from Rp12.9 trillion to Rp39.9 trillion (Table 1). Recent years have also shown rapid growth in gross premiums for the sector. These statistics, however, do not reveal the current condition of the insurance sector and the urgent impending consolidation facing this industry. 15. A life insurance company can continue to operate in a deficit situation, vulnerable to a financial shock, for many years if the deficit is not apparent and policyholders continue to pay sufficient premiums to meet current claims. Many insurance firms now suspending business or closing were likely unsound before the crisis due to factors such as insufficient capital base, overoptimistic product pricing, inadequate reserves, asset-liability mismatches, lack of management expertise and technical skills, and weak internal governance. Lax enforcement of regulations, weak supervision, and lack of independence of the Ministry of Finance Insurance Directorate to carry out its regulatory and supervisory functions were also factors. Insurance regulating monitoring systems had been developed to provide sufficient advance information to the Insurance Directorate to avoid a situation of an insurer failing to meet obligations to policyholders,

8 Decrees include: (i) August 2000 Coordinating Minister for Welfare and Poverty Alleviation Decree No.

25/KEP/MENKO/KESRA/VIII/2000 Concerning the Team for Improvement of the National Social Security System; (ii) March 2001 Decree of the Secretary to the Vice President No. 7 of 2001 regarding Working Group of the National Social Security System; and (iii) April 2002 Decree of the President No. 20 of 2002 regarding National Social Insurance System Team.

9 The presidential team has been consulting with ADB, and ADB has provided some initial support. 10 Social insurance includes the mandatory pension and savings schemes. It also includes basic protection programs for

workers and their families against social risks in connection with industrial relations such as work accidents, death, health, and old age, and is carried by the five state monopolies: Jamsostek, Jasa Raharja, Taspen, Askes, and Asabri.

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but political will has been lacking to take early action, and in some cases it was already too late for remedial measures. 16. Revised paid-up capital requirements were issued in 1999 and risk-based capital (RBC) requirements were also introduced, with an allowance to phase in requirements up to 2004. This allowed firms adequate time to come into line with standards and aimed to encourage the industry to rehabilitate itself through rationalization and consolidation. To improve transparency of the insurance industry to the public, the DGFI issued a decree in December 2001 requiring publication of insurance companies’ financial position, solvency ratios, ownership of the firm, and names of directors. Although financial and solvency information may be difficult for an average policyholder to assess, this public disclosure provides a means to accelerate owners’ and directors’ actions to improve conditions. It also facilitates enforcement by the Insurance Directorate by bringing the information into the public forum. The requirement for first publication of this information was in June 2002. 17. In August 2002, DGFI announced that six insurance firms had failed to meet the RBC requirements, are under government order to restrict their operations, and may be closed by year-end. Five of these firms are in the life sector. Three additional firms, including two nonlife firms, have voluntarily ceased business. DGFI also stated that another 30 firms have been put under its surveillance. The first quarter 2002 data reported to the Insurance Directorate indicate that 25 life insurance firms, representing 59% of market share in terms of gross premiums, have negative solvency margins. This negative solvency represents a total capital deficiency of Rp5.86 trillion ($651 million at an exchange rate of Rp9,000 = $1) in the life sector, compared to the nonlife sector, with 27 firms having negative solvency margins amounting to Rp59.8 billion ($6.6 million). One major insurer accounts for over 85% of the capital deficiency among life insurance firms and continues to write new policies. 18. Policyholders under the five life firms slated for closure in 2002 totaled 440,638 at year-end 2001. However, the number of policyholders affected by firms reporting negative solvency margins amounts to 21,474,876, or 85% of policyholders. DGFI has not announced any measures to address policyholder concerns or potential losses. Law No. 8 of 1999 regarding Consumer Protection provides for the establishment of a consumer protection agency and a consumer disputes resolution body; however, neither has yet been established. Dispute resolution in the insurance sector has been limited and controversial. In 2000, there were 121 complaint cases regarding claims settlement, though only 17 cases were settled in the corresponding year. From January to July 2001, 72 claim settlement complaints were filed. Issues included claim denials, settlements, interpretation of policies, the amount of claims, timely issuance of policies, and unclear explanation on provisions in the policies. 19. In looking forward to address the capital needs of the insurance sector, firms may consider potential resources from foreign investors. There are presently 22 joint ventures operating in the life sector and 23 in the nonlife sector. However, in 2002 a well-publicized bankruptcy case against a solvent insurance firm brought international attention to the serious deficiencies in Indonesia’s legal framework and judicial process, and the adverse impact this has on investor confidence. Government actions and the Indonesian supreme court’s decision to overturn the commercial court declaration demonstrated Indonesia’s commitment to act against corrupt judicial practices; however, the legal framework requires amendment to provide for supervisory authorization in filing petitions against insurance firms for bankruptcy or liquidation. This issue was raised in connection with the Financial Governance Reforms: Sector Development Program (FGRSDP) third tranche discussions of progress in governance in Indonesia. It was discussed that the FGSSR program would address this deficiency.

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B. Sector Issues

1. Inadequate Financial Sector Regulation and Supervision and Multiple Agency Framework

20. Indonesia has suffered from historically weak regulatory implementation and a lack of supervisory resources and capacity in the financial sector. The effectiveness of agencies in carrying out their roles has been largely undermined by weak accountability and a lack of independence. The multiple agency framework encompassing BI, Bapepam, and DGFI, lacks good governance, efficiency, and the resources and capacity to effectively enforce laws and regulations. Although the mandatory social insurance companies report data to the Insurance Directorate in DGFI, the Insurance Directorate does not supervise any of these mandatory programs—they remain unsupervised in a regulatory framework. Indonesia is still in the process of building human capital, and the small trained cadre of professionals has been dispersed among many organizations. Lack of resources is, in particular, a factor for DGFI; lack of independence affects DGFI and Bapepam; and weak accountability and poor governance are factors impacting all three agencies. In addition, the existing legal framework and multiple agency structure is not conducive to the supervision of companies engaging in connected lending. Weak coordination and information sharing among the supervisory agencies have made it difficult to supervise and assess consolidated risk exposure in the absence of harmonized prudential standards, financial reporting, or joint inspections programs. Although only a few Indonesian companies have succeeded in offering a broad range of financial services, banks may set up subsidiaries in insurance, securities broking, or leasing. The potential remains for regulatory arbitrage and increasing risk exposure. Improvements have been made in the regulatory and supervisory frameworks across agencies over the past decade; however, changes have often come in a piecemeal fashion and have taken a long time. Further improvements in the regulatory and supervisory framework could benefit from a consolidated effort among agencies in lifting the level of supervision and good governance. 2. Lack of Anti-Money Laundering Regime 21. Indonesia’s weak financial sector governance and supervision encompass frameworks for fighting money laundering. Until recently, money laundering was not a crime in Indonesia. Money laundering also increases vulnerability to other kinds of crimes, such as drug trafficking, trafficking in people, fraud, and corruption. This vulnerability leads to poor governance, further undermining state institutions and sound economic development. Indonesia was placed on the Financial Action Task Force on Money Laundering (FATF) list of Non-Cooperative Countries and Territories (NCCT) in June 2001 due to its lack of an anti-money laundering regime. It was classified in FATF’s June 2002 review to identify NCCTs as among the jurisdictions that have made progress in enacting legislation to address deficiencies following its adoption of an anti-money laundering law. Further improvements are, however, required to avoid imposition of FATF countermeasures that could severely impact Indonesia’s progress in recovery. Key issues have been identified, including a high rupiah threshold for reporting suspicious transactions and a 14-day period before suspicious transactions must be reported. The law allows up to 1 year following enactment of the law to appoint the Chairman and deputies of the financial intelligence unit, and an additional 6 months to start implementing functions. In October 2002, the President appointed the Chairman and Vice Chairman of PPATK11 indicating key progress in this area, however, additional staff are required to make PPATK operational. ADB is providing a TA to support development of an anti-money

11 Presidential Decree No. 201/2002 dated 8 October 2002.

9

laundering regime,12 and is coordinating closely with other agencies in this area including the Australian Agency for International Development, United States Agency for International Development, Department for International Development of the United Kingdom, International Monetary Fund, World Bank, United Nations, and Asia-Europe Meeting Anti-Money Laundering Initiative (ASEM). Discussion of ADB’s TA is included under the proposed program.

3. Need for Advancement of Sector Reforms in Transition to the Financial

Services Authority

22. The Government is committed to moving toward the establishment of a consolidated regulatory and supervisory authority for financial services (OJK) to strengthen regulatory and supervisory frameworks and more efficiently utilize regulatory resources. However, this process of transition is projected to span a period of 18–24 months, and it is important to continue to advance sector reforms for the long-term strength and stability of the financial system. In this regard, BI, Bapepam, and DGFI will need to continue to implement measures to improve supervision and enforcement of appropriate prudential safeguards and standards. Areas to be addressed include licensing, qualifications for experts, procedures for onsite and offsite examinations, training for supervisors and examiners, implementation of RBC requirements, and adoption of a risk-based regulatory approach. Full conversion to a scripless trading and settlement, adoption of measures for an early warning system, and prompt revocation of licenses of broker-dealer companies not in compliance with RBC and reporting requirements are among key required actions. 23. The recent government announcement of insurance sector insolvencies and the large number of unsound firms placed under DGFI surveillance raise questions on the viability of the sector. Major industry consolidation is anticipated, and some analysts have projected a reduction in the number of companies to as few as 20 firms.13 The closure of firms and consolidation raise questions as to the adequacy of consumer protection and the impact on employment. Although the Consumer Protection Law mandates establishment of an agency and disputes resolution body, neither has yet been established and it is unclear when these will be in operation and how they will be engaged in the financial sector. Policyholders are currently unprotected. An evaluation of the impact on employment of rapid industry consolidation has not yet been undertaken. There are over 100,000 workers in the insurance sector.14 The Government believes that the new Rp100 billion capital requirement for new entrants to the insurance sector will provide an adequate level of capital for new businesses and will also serve as a barrier to entry for firms with inadequate resources. What remains a central issue is how to manage the existing firms now to avoid major market disruption and to minimize losses among policyholders. One major life insurer alone has a capital deficiency of over $500 million. The Insurance Directorate has proposed a possible new insurance guarantee institution for life insurance customers in 2004; however, such an institution could only be effectively established after financial health has been restored to the sector and, based on recent data, this would likely be beyond 2004. In the meantime, plans for restructuring and/or mergers need to be urgently developed. There is also a need to train actuaries and develop the actuarial profession in Indonesia to increase their number as well as the capacity and skills required to support the insurance industry, as it comes into line with international best practices.

12 ADB. 2002. Technical Assistance to the Republic of Indonesia for the Development of an Anti-Money Laundering

Regime. Manila 13 Djaelani, Firdaus. Life Insurance Review of Regulatory Practices and Developments. Paper presented at the

Managing Regulatory Change in Life Insurance and Pensions International Symposium, Beijing, People’s Republic of China, 8–9 November 2000.

14 Includes 39,591 employees, 70,446 individual insurance agents, and 447 legal entity insurance agents reported in 2000.

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4. Inadequate National Social Security 24. Improving governance and supervisory frameworks for pensions and insurance are fundamental first steps in strengthening the social security system. However, significant reforms will be required to provide adequate retirement income. There is no unified policy, supervisory, regulatory, or legal framework for the pension sector or social security. Multiple ministries are involved in the control and regulation of pension programs. Mandatory programs target formal sector workers exclusively, leaving the majority of the working population uncovered, and there is no first pillar providing a minimum pension. Fiscal sustainability of the mandatory programs of Taspen and Asabri is also a critical issue as unfunded pension liabilities are presently estimated at Rp380.3 trillion. Future funding problems are inevitable as unfunded liabilities mount under the current pay-as-you-go basis, and the Government is reluctant to take the necessary measures to increase funding in view of its current immense debt burden. 25. In 2002, the President established a team to lead the policy development of national social security. This team has been given a mandate to prepare a new national law addressing social security in 2002.15 However, additional resources and assistance are needed to meet these ambitious goals. Key issues in the present system include (i) insufficient governance of mandatory pension and provident funds, (ii) lack of fiscal sustainability of mandatory pension programs, (iii) inadequate retirement incomes for formal sector workers and limited coverage of the population, (iv) lack of a unified national identification system for administering social security and facilitate portability, and (v) no unified social security framework or law. For Jamsostek (a defined contribution plan), the primary concern is that the plan does not provide sufficient retirement income, potentially burdening the Government in years ahead. Encouraging competition and eliminating state monopolies will be important factors in strengthening the social security system. Gradual reduction or elimination of the option for one-off lump-sum benefits at retirement is also important. Taking lump-sum benefits, a common practice in Indonesia, leaves room for myopic spending by retirees with that could significantly reduce or eliminate retirement savings. Additional concerns include low wage replacement ratio, underreporting of wages, lack of enforcement, lack of a common national identification number, lack of governance, and lack of government-directed investment. Inadequate management information systems also make it more difficult to address problems related to underreporting or misallocation of contributions. Under the PT corporate structure,16 the mandatory schemes are required to operate on a profit-seeking basis and to pay dividends and taxes to the Government (the only shareholder). This further diminishes members’ investments and strengthens the impression that the state schemes are an additional form of taxation. Profit for owners is not generally accepted to be an appropriate objective for insurance provided on a monopoly and mandatory basis. Surpluses should be applied to the benefit of those insured. Reforms under the FGSSR will focus on the pension and provident funds components of the social insurance companies.17

5. Poor Corporate Governance 26. Indonesia's corporate and commercial system is not working under a robust system of corporate governance. Existing rules and regulations have not been rigorously enforced. External mechanisms and enforcement through banks and capital markets, which are a feature of corporate discipline in other countries, have not functioned well. There has been little incentive for internal 15 ADB provided support to a delegation from the presidential team to establish a national social insurance system in

Manila in June 2002, in connection with preparatory work for establishing a national social insurance law. 16 The Indonesian equivalent of the incorporated limited liability company is the perseroan terbatas or PT. 17 Health, accident and other insurance are not planned to be addressed under the FGSSR given the need to maintain a

more focused program.

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mechanisms or voluntary best practices to be adopted. Essential legislation establishing adequate auditors’ liability for audits and commissioners’ liability for misleading or false public information and board decisions needs to be put in place. Comprehensive disclosure in corporate reporting, independent directors or commissioners safeguarding the rights of minority shareholders, and transparency in financial dealings with related parties are still lacking. Stock exchanges in Indonesia are required to be in the mutual form, limiting trading access to members. The option to demutualize should be allowed by law and promoted to separate ownership from trading access to improve corporate governance and provide a framework for eliminating conflicts of interest and raising the necessary capital for development and growth. C. Lessons Learned from Asian Development Bank Operations in the Sector 27. ADB has had major financial sector operations in Indonesia addressing banking, capital markets, pensions, and insurance for over 15 years. Three major program loans undertaken during this time are the Financial Sector Program, for $200 million, approved in 1988; the Second Financial Sector Program, for $250 million, approved in 1992; and the Financial Governance Reforms Sector Development Program, for $1.4 billion, approved in 1998. The thrust of financial sector reforms over this period moved from a focus on deregulation of the banking sector and capital markets as a means of increasing competition, efficiencies, growth, and diversification of the financial system to a period of implementation of a comprehensive set of reforms aimed at strengthening potential safeguards while encouraging market forces and market efficiency. The rapid dramatic growth that occurred following deregulation, and the subsequent problems from deregulation, highlighted inadequacies in the legal, regulatory, and supervisory frameworks. Basic laws for the operation of insurance companies and pension funds were approved in 1991 and 1992 and Bapepam was divested in 1991 of its dual and conflicting responsibility of both regulating and managing the Jakarta Stock Exchange. Although basic legislative frameworks were established, regulatory and supervisory frameworks remained weak and enforcement was lax. The Asian crisis exposed those weaknesses, and subsequent reforms have concentrated on strengthening regulation and supervision, improving corporate governance, and adopting international best practices and standards for prudential regulation and supervision. Based upon ADB program completion reports and a special evaluation study,18 all of the noted programs were considered successful, though not without difficulties and incomplete attainment of some reforms. Lessons relevant to this program learned from prior programs include:

(i) More time was needed than envisaged to meet some of the targets, particularly in the area of legislative reform. This reality should be factored into future program designs; (ii) Effective loan designs require not only an understanding of the sector, but also of the overall policy environment and the macroeconomic and structural forces at work; (iii) Programs concentrating on deregulation need to ensure that adequate supervisory and regulatory frameworks are in place to prevent subsequent sector weakening or collapse; (iv) Programs are often only one phase of a continuing process of reforms and adjustments. Further measures are often necessary to ensure that the gains from the programs are consolidated and retained;

18 ADB. 2001. Special Evaluation Study on the Asian Development Bank’s Crisis Management Interventions in

Indonesia. Manila.

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(v) Financial sector programs can require comprehensive policy measures that may not all be achieved within the time frame, but that still result in meaningful reform and progress; and (vi) Government ownership of programs is essential for sustainable reforms.

IV. THE PROPOSED PROGRAM

A. Objectives and Scope 28. The FGSSR will build upon core reforms in Loan 1618: Financial Governance Reforms Sector Development Program,19 by refocusing on improving governance through increased disclosure, transparency, and enforcement of regulations; audit of enterprises; and the development of legal frameworks for anticorruption and anti-money laundering efforts. Phase I will support a broad framework for the overall strengthening of the financial sector and promote the development of sound financial institutions necessary to support good governance and economic growth. It also aims to improve social protection through improved governance, supervision, and regulation of pension funds and mandatory social insurance programs. Sustainable economic development and growth in Indonesia depend on strengthening governance, financial supervision, and regulation. Robust economic growth can help the country create jobs, raise standards of living, and reduce poverty.

29. To promote consistency, efficiency, and harmonization of supervision across financial services and products, Phase I will support the establishment of Otoritas Jasa Keuangan (OJK), a consolidated regulatory and supervisory authority for financial services. In the pre-OJK transition period of 2002–2003, Phase I will (i) support comprehensive legal reform necessary to transfer authorities to OJK; (ii) support development of an anti-money laundering regime; (iii) continue strengthening regulation and supervision in the relevant institutions; (iv) improve corporate governance; (v) promote adoption of international best practices and standards for prudential regulation and supervision; and (vi) strengthen the soundness of financial institutions. 30. To improve national social security, Phase I will (i) bring the entities related to mandatory social insurance and social security programs under OJK’s jurisdiction; (ii) improve governance of mandatory pension and provident funds; (iii) undertake measures to improve fiscal sustainability of mandatory programs including assessment of unfunded pension liabilities and preparation of plans to reduce liabilities and operating costs; (iv) support improvements to programs to provide adequate retirement income; (v) support development of a unified identification system for national social security to improve administration and portability of benefits; (vi) assess potential options for expanding coverage of the social security system to the informal sector; (vii) develop a new law and agency for national social security; and (viii) undertake a strategic audit, company valuations, and reviews to identify necessary reforms and restructuring. Phase II would continue support for Phase I reforms, and include measures to support broader social security reform, restructuring, and consolidation of enterprises as needed. Appendix 2 is the development policy letter of the Government on the envisaged sector reforms, together with the policy matrix. Appendix 3 provides the program framework.

19 ADB. 1998. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the

Republic of Indonesia for Financial Governance Reforms: Sector Development Program. Manila.

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B. Policy Framework and Actions for Phase I 20

1. Strengthen Frameworks for Financial Sector Regulation and Supervision through Consolidation of Regulatory and Supervisory Authorities

31. To improve governance and to strengthen the regulatory and supervisory frameworks in the financial sector, Law No. 23 of 1999 concerning Bank Indonesia mandated the establishment of a consolidated supervisory authority for financial services. The passage of this central bank law was a condition under FGRSDP. In line with this mandate, the Government will establish OJK, the planned consolidated regulatory and supervisory authority, with the support of two ADB TAs.21 To effectively improve such regulation and supervision, essential levels of accountability and independence of OJK must be maintained by law. It is in this respect – the achievement of a higher level of accountability and independence – that OJK can offer a fundamental and significant change in the regulatory and supervisory framework for the financial sector. OJK’s mandate for consumer protection in the financial sector will also be supported. OJK is also important in that a consolidated regulatory and supervisory authority will (i) provide a structure that can more effectively utilize the scarce regulatory resources and skilled staff in Indonesia; and (ii) promote consistency and harmonization across financial services and products (i.e. regulatory neutrality). 32. The development of OJK also provides a critical opportunity to improve the quality of supervision of specific sectors. Sector reforms can be accelerated through a coordinated effort among supervisory agencies for adoption and amendment of relevant sector laws and through the development of the OJK framework. One example of an important reform with respect to the insurance sector, is the requirement for written authorization from OJK for filing petitions for bankruptcy or liquidation (see discussion in para. 19). 33. Under Phase I, the draft OJK law will be prepared with ADB assistance, lodged with the State Secretary Office and submitted by the President to Parliament for enactment. To ensure effective transfer of authority to OJK, the Government will support all necessary amendments to existing legislation. To enable effective operations of OJK, the Government will support the preparation of comprehensive legislation and implementing rules and regulations that adequately define OJK’s role, functions, powers, responsibilities, appropriate governance and organizational structure, policy and terms for staff, and capacity-building and training needs. The Government will provide budgetary support to enable OJK to make transitional arrangements to begin operations and integrate operations within one or two years of enactment of the law. OJK’s purview will include banking, capital markets, pensions, insurance, and other financial services companies. OJK will also have jurisdiction over social insurance and social security programs including Jamsostek, Taspen, and Asabri as described in paras. 38–39. To promote greater transparency, accountability, disclosure, and compliance, OJK will adopt and promote best practices in corporate governance and international standards for prudential regulation and supervision. 34. The emergence of a single agency with integrated regulatory and supervisory powers over different types of financial institutions first gained recognition in the 1980s in northern Europe in response to banking crises. There has been an increasing interest and adoption of this approach in other regions including Asia. The institutional responsibilities and powers have varied across regulatory models, and the motivations for moving toward regulatory integration have ranged, with efficient use of regulatory resources, regulatory neutrality, and the opportunity to improve 20 See policy matrix in Appendix 2. 21 ADB. 2001. Technical Assistance to the Republic of Indonesia for the Development of a Financial Services

Supervisory Institution. Manila, and ADB. 2002. Technical Assistance to the Republic of Indonesia for the Establishment of a Financial Services Authority. Manila.

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supervision of specific sectors as common motivations. Appendix 1 includes additional summary information on consolidated regulatory and supervisory authorities, and provides a comparison of regulatory responsibilities and powers among nine integrated regulators.

2. Establish an Effective Anti-Money Laundering Regime 35. Under the FGRSDP, an anti-money laundering law was developed and signed by the President in 2002. The FGSSR will provide further support to accelerate reforms and establish an effective anti-money laundering regime. This assistance will be provided in close coordination with other agencies (see para. 21). The Government will continue to place priority on taking the necessary measures to address deficiencies in its anti-money laundering regime as identified by FATF until Indonesia is removed from the NCCT list. The Government will adopt and amend as necessary the anti-money law, and issue regulations and guidelines, and provide the necessary frameworks for institutions to support implementation of the new law. In support of this regime, sector decrees will also be issued including “Know Your Customer Principles” by BI and Bapepam for banks and securities markets respectively. Adequate budgetary support will be provided to enable set-up and operations of the financial intelligence unit (PPATK) mandated under the law. To facilitate the start of operations of PPATK, the President appointed the Chairman and Vice Chairman of PPATK in October 2002 and BI is planning the appointment/secondment of additional staff to PPATK on an interim basis. Additional staff will be key to ensuring operational capacity of PPATK, and a Presidential Decree will be issued on the organizational structure and operations of PPATK. 36. BI will assume financial intelligence unit functions for the banking sector until PPATK is operational, and will provide interim reports on monitoring of suspicious transactions. Systems for suspicious transactions reporting and analysis will be developed and guidance notes issued for those institutions subject to the anti-money laundering law for reporting suspicious transactions. Capacity building and training will be conducted for PPATK, related financial institutions, the judiciary, law enforcement officers, and prosecutors. Workshops will be held in Jakarta and major provinces to increase awareness of money laundering as a crime and understanding of the new law. PPATK will issue semiannual reports on its work to the President, Parliament, and related agencies. PPATK will undertake all necessary measures to enter into operational memorandum of understandings with other relevant Government agencies and institutions, and begin dialogue to enter into information-sharing and cooperation arrangements with regulatory institutions in the Asia and Pacific region.

3. Advance Core Sector Reforms in Transition to OJK 37. During the transition to OJK, core sector reforms will be advanced over the transition period of 2002–2004. These reforms build upon initial actions taken under FGRSDP and fall broadly into the following categories:

(i) strengthen supervision and regulation; (ii) promote adoption of international best practices and standards; (iii) strengthen capital base and implement RBC standards; and (iv) provide institutional capacity building and public education.

38. DGFI and Bapepam will continue to improve enforcement efforts and raise standards, including actions to implement the risk-based prudential standards for insurance companies and strengthen and simplify escalation procedures for dealing with problem companies; issue time-bound warnings to brokers not in compliance with existing rules and regulations; and develop standards for qualifications and licensing requirements for fund managers, insurance specialists

15

and companies, agents, and brokers in line with international best practices. Amendments to accounting, insurance, pension, company and capital market laws will be undertaken both to strengthen supervision and regulation and provide for international best practices and standards. DGFI and Bapepam will continue to develop criteria and issue legislation with regard to independent directors, commissioners, and auditors, as well as liability for their actions. Increased sanctions for noncompliance and higher levels of enforcement will also be undertaken. Guidelines and standards for onsite and offsite examinations will be developed as well as software systems to support effective examination. Bapepam and DGFI will improve prudential supervision and regulation by enforcing provisions requiring greater transparency in operations. To build institutional capacity, Bapepam and DGFI will promote human resources development through core training. 39. To improve market efficiencies and increase capacity to support economic growth, Bapepam will monitor the move to a fully scripless trading system in 2002 with appropriate operational clearance and settlement, central depository systems, and bank settlement systems. To ensure sound capital market operations, all firms that are members of the Indonesian Clearing and Guarantee Corporation, that extend margins, or that keep custody of customer securities will maintain Rp5 billion net adjusted working capital, and all fund managers will be licensed to meet ongoing requirements. Bapepam will also introduce stringent procedures to enforce RBC requirements on a consistent and transparent basis. DGFI and Bapepam will also continue to support professional and company associations to improve qualification standards in line with international best practices. 40. To promote accountability and increase consumer protection, DGFI issued a decree requiring insurance companies to publicly disclose solvency positions, names of company owners and board of directors and commissioners. To determine the potential systemic risk in the insurance sector, a strategic assessment will be undertaken by the Insurance Directorate to determine the financial condition of insurance companies, and strategic options including restructuring, consolidation, or closure. High priority, at-risk insurance firms will be targeted by the Insurance Directorate for immediate action. The Government will establish a plan for the insurance sector for an orderly market transition, including possible assistance. ADB will provide TA to support this action (see para. 61). The insurance industry will be required to comply with the increasing RBC requirements in line with the staged escalation to 2004, and to seek appropriate merger partners if they are unable to independently increase capital to required levels. The Government will enforce sanctions, including suspension of licenses, against firms not in compliance.

4. Improve National Social Security 41. Improving financial sector governance and regulatory and supervisory frameworks for pensions and insurance are fundamental first steps to strengthening social security. However, significant reforms will be required to provide adequate retirement income. Phase I will concentrate on improving social security in the following areas:

(i) entities related to mandatory social insurance or social security programs will come under the jurisdiction of OJK and be subject to OJK’s regulatory and supervisory authority; (ii) a new law for national social security will be developed to unify programs and improve social security frameworks, management, and administration; (iii) governance of mandatory pension and retirement schemes will be improved;

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(iv) the financial condition, operations, and fiscal sustainability of mandatory programs will be assessed, and options developed for restructuring and reducing unfunded pension liabilities; (v) the management of voluntary pension plans will be improved through certification requirements for private pension fund managers and licensing requirements; and (vi) proposals for a realistic scope of expansion of social security systems to the informal sector in the near and medium term will be examined.

42. The Government will conduct an independent special audit of Jamsostek including an audit of the investment portfolio and company assets, a current fair market valuation of the assets, and an assessment of inadequacies and potential problems of the mandatory program for formal private sector workers and SOEs. As Jamsostek is a defined contribution plan (savings scheme) it does not have the problem of unfunded pension liabilities. Problems to be addressed include lack of transparency and public disclosure, weak internal corporate governance structures, historical directed investments under political pressure, poor returns, high operating costs, segregation of assets, and cross-subsidization of programs. Options and recommendations for improving governance and operations will be developed, including restructuring and elimination of monopolies. Taspen will assess the unfunded pension liabilities of its mandatory pension plans for civil servants and prepare options to reduce unfunded liabilities (accumulated liabilities in the pay-as-you-go system from existing debt from past service has been assessed at Rp342 trillion for Taspen).22 Regular independent actuarial assessments of unfunded liabilities of mandatory programs will be supported. To provide efficient administration of benefits and to allow for portability of benefits, the Government will develop a unified identification system for national social security. To provide adequate stakeholder inputs into the development of such a system, a series of public seminars and workshops will be conducted among stakeholder groups, and a public education campaign will be conducted to inform the public of social security system and reform issues.

5. Strengthen Corporate Governance 43. The Government will take actions to improve governance in the corporate and commercial system in Indonesia in line with FGRSDP requirements and the FGSSR objectives. This includes enforcing existing rules and regulations, issuing new legislation, and increasing sanctions. Legislation will be prepared to establish significant liability of auditors for negligence and liability of commissioners for misleading or false public information and board decisions. A draft public accountants law will be expanded to include adequate provisions for liability for auditors23 for negligence, to be submitted to the State Secretary Office in 2003. As an interim measure, the Ministry of Finance issued a decree for Public Accountants in September 200224 including provisions establishing liability of auditors for negligence and expanding the scope of coverage to include financial audits, performance audits, and special audits. 44. The Ministry of Justice and Human Rights (MOJHR) will expand draft amendments to the Company Law of 1995 to include provisions for liability for commissioners and directors for false and misleading public information and board decisions. In Indonesia, the Board of Commissioners 22 ADB. 1998. Technical Assistance to the Republic of Indonesia for Reform of Pension and Provident Funds. Manila. 23 The previous law prepared in 2001/2002 lacked sufficient provisions. See discussion in ADB. 2002. Progress Report

on the Release of Third Tranche Financial Governance Reforms Sector Development Program (Loan 1618-INO) to Indonesia. Manila.

24 Minister of Finance Decree No. 423/KMK.06/2002 dated 30 September 2002.

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is the group responsible for company policy and oversight of company operations.25 Board of Directors in Indonesia means the officers with the day-to-day operational responsibility. To address this two-board system and to further expand the legislative scope for imposing liability on management with a view to strengthening corporate governance, the FGSSR has expanded FGRSDP conditionality to apply to both Boards of Commissioners and Boards of Directors.26 The draft Company Law will be submitted with the draft OJK law in a package of laws for consideration by Parliament in 2003. As an interim measure, Bapepam will exercise its regulatory power by imposing sanctions as applicable to boards of commissioners and directors of listed companies. The Government will submit laws as a package to facilitate coordination of multiple legislative reforms in the financial sector, streamline the process in Parliament and provide an integrated approach to support the establishment of OJK.27 45. Additional measures by Bapepam include preparation of a rule in 2002 on independence of accountants providing audit services in the capital market to be issued by year-end. Bapepam will also amend the Capital Market Law including provisions to (i) establish liability for directors in violation of the Capital Market Law; (ii) establish responsibility of lawyers involved in the preparation of legal audit for reporting violations of the Capital Market Law; and (iii) allow demutualization of stock exchanges. The draft Capital Market Law will be submitted with the package of laws with OJK.

6. Phase Two 46. Phase II is anticipated to be $150 million, and will continue support for Phase I reforms and include measures to support broader and deeper social security reform and restructuring as needed. Reforms are outlined in the policy matrix. Phase II will be presented for Board consideration, based on the progress of implementation of Phase I. Policy actions for Phase II are subject to revision depending upon ADB’s reassessment of the macroeconomic environment, further sector information and analyses conducted under Phase I, lessons learned during Phase I, and status of implementation and readiness of the Government to undertake the proposed policy reform actions. C. The Loan

1. Amount of Phase I Loan and Source of Funds 47. A $250 million program loan is proposed from ADB's ordinary capital resources to support Phase I as described in the attached development policy letter and the policy matrix. The Borrower will be the Republic of Indonesia. The loan will be utilized over a period of 12 months from the date of its effectiveness. The loan size has been determined by the complexity of the program, the program’s development impact, the importance of the sector, and the potential adjustment costs related to the structural reforms. The estimated costs of reforms under Phase I are:

(i) costs to establish OJK (the consolidated regulatory and supervisory authority for financial services), including capacity building and retrenchment/redeployment ($22.0 million) (Supplementary Appendix);

25 Equivalent to Board of Directors in some countries. 26 FGRSDP conditionality pertained to liability only at the commissioner level. 27 ADB has supported this approach as a practical matter, given the large number of bills to be considered in Parliament

and the desirability of an ambitious and coherent approach to amending legislation governing regulatory institutions.

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(ii) costs to establish PPATK (the financial intelligence unit for the anti-money laundering regime), capacity building for PPATK and related government institutions, and support for the regulatory compliance costs associated with the new anti-money laundering law ($25 million);28 and (iii) costs relating to restructuring the insurance sector ($200 million).

48. The adjustment costs to the economy could significantly exceed the amount of the program loan. The capital deficiency of one troubled life insurer alone is in excess of $500 million, and other firms have been identified as financially weak or unsound.

2. Interest, Maturity, and Utilization Period 49. The Phase I loan will have a 15-year term, including a grace period of 3 years, an interest rate determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility; a commitment charge of 0.75% per annum; a front-end fee of 1%; conversion options that may be exercised in accordance with the terms of the draft Loan Agreement, the loan regulations, and ADB’s conversion guidelines; and other terms and conditions set forth in the draft Loan Agreement. The Government has provided ADB with (i) reasons for Indonesia’s decision to borrow under ADB’s LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were its own independent decision and not made in reliance on any communication or advice of ADB. D. Implementation Arrangements

1. Procurement and Disbursements 50. Upon loan effectiveness, ADB will have the right to withdraw from the loan account and pay itself, on behalf of the Government, the front-end fee charged on the loan in the amount of $2.5 million. The proceeds of the balance of the loan will be utilized to finance the foreign exchange costs of items produced in, and procured from, ADB’s member countries. The Government will certify that, if (i) the proceeds of the loan will finance imports already made, the value of eligible imports in the period concerned exceeds the amount of the requested withdrawal; or (ii) the loan proceeds are to finance goods to be imported, the value of eligible imports in the immediately preceding year period is equal to or greater than the amount of the requested disbursement plus all other amounts expected to be withdrawn from the loan during the succeeding 1 year. ADB will have the right to audit the use of the loan proceeds and to verify the accuracy of the Government’s certification.

2. Counterpart Funds 51. The policy matrix for Phase I includes specific components that bear distinct costs of structural adjustments (Appendix 2). The counterpart funds to be generated out of the loan proceeds will be used by the Government to finance the cost of such structural adjustments, as well as other activities consistent with the program.

28 As reference, the compliance cost assessment for the United Kingdom in the Money Laundering Regulations 1993

Explanatory Note estimated initial compliance costs at £30 million. Although the larger institutions should be able to absorb compliance costs, smaller institutions may need some initial support from the Government for timely implementation. Government support is to be repaid by institutions.

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3. Monitoring and Tranching 52. The first loan of the FGSSR is to be released in three tranches. The first tranche equivalent to $100 million will be made available upon the Government meeting conditions of loan effectiveness. An additional incentive tranche of $50 million and the second tranche of $100 million will be released upon satisfactory compliance with agreed upon conditions. The second tranche is expected to be released within eights months of loan effectiveness. The progress of implementation of specified policy actions set out in the policy matrix (Appendix 2) will be reviewed by ADB with the Government on an ongoing basis with respect to the incentive tranche, and about 3 months prior to the scheduled second tranche release. 53. The first tranche release conditions include the following:

a. First Tranche (i) DGFI, Bapepam, and MOJHR to complete the technical preparation of the following draft laws and/or amendments to the relevant principal laws:

(a) OJK law, including (i) provisions for the independence and accountability of OJK, as outlined in Appendix 2, Attachment 1; (ii) provisions for OJK to exercise jurisdiction over entities related to existing and future mandatory social insurance or social security programs which will be subject to OJK’s prudential and consumer protection mandate; and (iii) provision requiring OJK’s written approval for filing petition of winding-up/bankruptcy cases initiated against entities under OJK’s jurisdiction;

(b) Capital Market Law; (c) Pensions Law, including provisions for the management of pension funds to

be legally responsible for establishing anti-money laundering procedures; (d) Insurance Law, including provisions that (i) life insurance companies can

manage employer-sponsored pension plans; and (ii) written approval of the Minister of Finance must be obtained prior to filing a petition of winding-up/ bankruptcy;

(e) Company Law, including provisions imposing liability of commissioners for false and misleading public information and board of commissioners’ decisions; and

(f) Public Accountants Law, including provisions imposing liability on auditors for negligence in audits.

(ii) As an interim measure, DGFI will issue a decree imposing liability on auditors. (iii) DGFI to launch a special audit of Jamsostek to include (a) an audit to confirm existing portfolio and company assets and a provide a valuation of the current fair market value of assets; (b) an audit to determine whether there is an appropriate segregation of assets of each program; and (c) provide an assessment and actuarial valuation of the sufficiency of technical reserves, including the actuarial methods, assumptions, and accuracy of data utilized by Jamsostek. (iv) DGFI to launch an independent financial review of a major unsound insurance company as agreed with ADB.29 The Ministry of Finance Insurance Directorate will provide

29 Review to be funded under TA Loan 1620.

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ADB with current insurance sector financial data and RBC ratios, analysis, and reports on an ongoing basis.

b. Incentive Tranche

(i) DGFI, Bapepam, and MOJHR to submit the draft laws and/or amendments to the relevant principal laws specified in first tranche [(i) above] approved by MOJHR, to State Secretary office; (ii) BI, as acting financial intelligence unit, to provide interim report on monitoring of suspicious transactions; (iii) Appoint or second additional staff to PPATK to ensure operational capacity. PPATK to have appropriate operating budget available for 2003; (iv) MOJHR to prepare amendments to the AML Law to address deficiencies identified by FATF; (v) MOJHR to begin preparation of implementing regulations for the AML Law; (vi) Bapepam to prepare a rule to ensure that securities companies, brokers and dealers' securities sub-accounts identify the beneficial ownership of securities held in the sub-accounts; (vii) DGFI to enforce sanctions against firms not in compliance with insurance regulations; (viii) Taspen to complete valuation of unfunded pension liabilities and begin preparation of financing options to reduce its liabilities for submission to MOF.

54. The second tranche release conditions include the following:

c. Second Tranche

(i) DGFI to complete the technical preparation of draft Public Accountants Law, including provisions imposing liability on auditors for negligence in audits and submit to State Secretary Office. (ii) The President will endorse draft laws and/or amendments to the relevant principal laws and submit to Parliament for enactment:

(a) OJK law, including (i) provisions for the independence and accountability of OJK, as outlined in Appendix 2, Attachment 1; (ii) provisions for OJK to exercise jurisdiction over entities related to existing and future mandatory social insurance or social security programs which will be subject to OJK’s prudential and consumer protection mandate; and (iii) provision requiring OJK’s written approval for filing petition of winding-up/bankruptcy cases initiated against entities under OJK’s jurisdiction;

(b) Capital Market Law, including (i) provisions requiring public companies to have independent commissioners and audit committee; and (ii) provisions for allowing demutualization of exchanges;

21

(c) Pensions Law, including provisions for the management of pension funds to be legally responsible for establishing anti-money laundering provisions;

(d) Insurance Law, including provisions that (i) life insurance companies are allowed to manage employer-sponsored pension plans; and (ii) written approval of the Minister of Finance must be obtained prior to the filing of a petition of winding-up/bankruptcy;

(e) Company Law, including provisions imposing liability of commissioners and directors for false and misleading public information, and liability of commissioners for board decisions; and

(iii) Satisfactory progress of (a) the special audit of Jamsostek, (b) the assessment of the insurance sector, and (c) financial review of an unsound major insurance company, as agreed with ADB.

55. ADB will closely monitor the progress of implementation and will assess the impact of the reforms on financial governance and social security sectors. ADB will also give close attention to the poverty impact of policy reforms and costs of adjustment relating to any retrenchment in the insurance industry. The Government will make available the necessary information for ADB to be able to conduct a public expenditure review to ascertain that these policies are being implemented. 56. ADB will, in cooperation with the Coordinating Ministry for Economic Affairs (CMEA) and the relevant implementing agencies, carry out quarterly reviews of progress in program implementation. The Government and ADB will continue to engage in active policy dialogue throughout FGSSR implementation that includes issues that may affect financial sector development, and additional reforms that may be considered necessary or desirable for the sustainable development of the financial and social security sectors. The Government will keep ADB informed of outcomes of the policy discussions with multilateral and bilateral funding agencies that have implications for FGSSR implementation. 57. The Government will provide ADB with monthly reports on (i) FGSSR implementation, in particular on policy actions set out in the policy matrix; (ii) accomplishment of FGSSR objectives; and (iii) Program Performance Management System (PPMS) data, in such form and in such detail and within such period as ADB may request, and must include progress made and problems encountered during the month in review, steps taken or proposed to be taken to remedy problems encountered, and the proposed detailed activity for FGSSR implementation and expected progress during the next 3 months. On completion of the first loan, an interim report will be provided within three months. On completion of the FGSSR, but in any event not later than 6 months of completion of the FGSSR, the Government will prepare and furnish to ADB a comprehensive report on the overall impact of the policy reforms implemented. Monitoring indicators and mechanisms will be mutually agreed.

4. Executing Agency 58. CMEA will act as the Executing Agency for the FGSSR to facilitate (i) the necessary coordination across multiple implementing agencies for implementation of reforms and (ii) a smooth transition from Phase I to Phase II as regulatory and supervisory powers are transferred from existing authorities to OJK. A program director will head the program implementation unit. Measures are being undertaken to ensure program readiness. Implementing agencies will be primarily responsible to carry out the program.

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V. TECHNICAL ASSISTANCE A. Objectives 59. The TA will support (i) insurance sector restructuring and (ii) the development of a national social security system. B. Scope 60. The scope of the TA is divided into the following two components.

1. Insurance Sector Restructuring 61. An international insurance sector expert and/or senior insurance regulators with experience in insurance sector restructuring and familiarity with the insurance sector in Indonesia will work with the Government to assess the financial condition of the sector, and determine options for restructuring and consolidation, along with the level and type of government support needed to implement recommended options. The expert/senior regulator will also facilitate industry dialogue and input as necessary, and provide a realistic timebound plan for sector restructuring over the 2003-2005 period.

2. Development of a National Social Security System

62. This component will provide assistance for the development of national social security in line with key policies and priorities established by the Presidential Team for National Social Security and other agencies. This component will:

(i) conduct a feasibility study for social security reform which will provide, among others: (a) options for restructuring existing public social insurance schemes to improve governance and programs; (b) recommendations for contribution rates and other factors to improve retirement income under existing and proposed schemes; and (c) proposals for a realistic scope of expansion of social security systems to the informal sector in the near and medium term, and potential sequencing of reforms given existing constraints; (ii) conduct a series of stakeholder consultations through public workshops to provide inputs from stakeholders for formulation of a national social security system; (iii) assist in the preparation of legislation and regulations for a new law for a national social security system; (iv) support development of a unified identification system for national social security to improve social security administration and management; (v) support a public education campaign on social security and socialization of the new draft law on national social security through a range of media and public workshops and seminars; (vi) provide training for key officials in core concepts of social security system management, administration, and governance; and (vii) support development of the actuarial profession by identifying and assessing options and incentives necessary to increase the number and qualifications of actuaries.

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C. Implementation Arrangements 63. The combined cost of this TA is estimated at $1,250,000 equivalent, comprising $705,000 in foreign exchange and $545,000 equivalent in local currency. ADB will provide $1,000,000 equivalent to cover the foreign exchange cost of $705,000 and part of the local currency cost equivalent to $295,000. The TA will be financed on a grant basis from ADB's TA funding program. The Government will provide the balance in local currency cost as in-kind provision of experienced counterpart staff, office space, information and data collection, and communications. The detailed cost estimates and financing arrangements are provided in Appendix 4. 64. CMEA, as the Executing Agency, will coordinate the TA. It will provide the necessary qualified counterpart staff, office space, and secretarial and related services for the consultants. A senior official will be appointed to serve as the TA project manager. The implementing agencies will include DGFI, Ministry of Manpower and Transmigration, and other relevant agencies. 65. The TA will be implemented over a 12-month period and is planned to commence by March 2003 and to be completed by March 2004. Consulting services will include (i) 22 person-months of international consultants with expertise in the insurance industry including restructuring, company valuations, and financial analysis; social security development; legislative reform; public education; and identification and administration systems for social security; and (ii) 31 person-months of local consultants with expertise in social security, social development, public education, institutional and legal analysis, public administration, and the actuarial profession to facilitate research, consultation, and public education. The consultants will be recruited individually in accordance with ADB’s Guidelines on the Use of Consultants, using the biodata proposal procedure and/or simplified technical proposal procedures. Appendix 5 provides the terms of reference of the consultants. All equipment will be procured in accordance with ADB’s Guidelines for Procurement.

VI. PROGRAM BENEFITS AND RISKS A. Benefits 66. Strengthening the governance of financial markets and social security in Phase I is expected to have wide-ranging and sustained benefits including the following:

(i) The primary benefits are promoting financial soundness, market stability, and restoration of investor confidence. These objectives will be addressed through the implementation of reforms to strengthen regulation, supervision, and governance frameworks, with the potential to broaden and diversify the markets and encourage domestic and foreign investment in Indonesia. Asset diversification away from the banking sector, especially given continued weakness in this sector, will support more resilient domestic markets able to withstand exogenous shocks and currency contagion. The establishment of an effective anti-money laundering regime will also add to the stability of Indonesia’s financial system, and reduce vulnerabilities to other types of crimes including drug trafficking, trafficking in people, fraud, and corruption. (ii) Improved frameworks for effectively dealing with financial crises will also help the economy protect vulnerable groups that fall below poverty lines during a crisis, as currency depreciation triggers unemployment and impacts lower income levels disproportionately.

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(iii) Other major benefits include increased protection of consumers, policyholders, and workers and more transparent, sustainable, social insurance programs with improved governance, regulatory, and supervisory frameworks that can provide better social security and reduce the potential for poverty in old age. The Summary Poverty Reduction and Social Strategy and the Poverty Impact Assessment are in Appendix 6. The FGSSR is considered to be environmentally neutral and an environmental impact assessment is in Appendix 7.

(iv) An additional benefit is that the FGSSR provides an essential platform to carry forward the FGRSDP agenda.

B. Risks 67. The implementation of Phase I could be affected by various factors:

(i) The principal risk relates to the potential for continuing or escalating political uncertainty, civil conflict or unrest, and their effect on the pace of structural reforms. However, there is a firm commitment to financial governance and social security reform at the highest levels of Government and consequently the risk of the FGSSR being diluted or abandoned is reduced; (ii) The other main risk stems from resistance by vested interests to the reforms, particularly since Phase I covers sensitive areas, such as social security reform, restructuring consolidation of the insurance industry, and development of an anti-money laundering regime. The Government has been gradually overcoming resistance in these areas through public information campaigns and socialization of reforms through seminars and workshops; and (iii) Delays may also occur in the implementation of reforms due to lack of capacity. The Government has identified areas where it will require assistance.

VII. ASSURANCES 68. The Government has given the following assurances in addition to the standard assurances, which have been incorporated in the legal documents:

(i) The policies adopted and measures taken before the date of the Loan Agreement as described in the development policy letter and the policy matrix will continue in effect as necessary; (ii) The Government will adopt the other policies and actions included in the FGSSR and specified in the development policy letter and the policy matrix in a timely manner and will ensure that the policies and measures will continue in effect as necessary; (iii) The Government will undertake up-front policy reforms by implementing some of the policy measures envisaged under the second loan, whenever it deems it feasible; (iv) The Government will provide ADB with the opportunity to comment on relevant studies and draft regulations that are likely to impact on program objectives and implementation;

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(v) The Government will ensure that adequate and timely funds are made available to the relevant implementing agencies to facilitate implementation of the FGSSR; and (vi) The Government will ensure that counterpart funds will be used to support the financial sector and the reforms to be implemented under the FGSSR.

VIII. RECOMMENDATION

69. I am satisfied that the proposed program cluster concept and loan would comply with the Articles of Agreement of ADB and recommend that the Board approve:

(i) the program cluster concept for the Financial Governance and Social Security Reform Program to the Republic of Indonesia; and (ii) the loan of $250,000,000 from ADB’s ordinary capital resources to the Republic of Indonesia for Phase I of the Financial Governance and Social Security Reform Program, with a term of 15 years, including a grace period of 3 years, and with interest to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board.

TADAO CHINO President

18 November 2002

Appendix 1 26

SECTOR/SUBSECTOR ANALYSIS A. Pension and Provident Funds 1. The pension system in Indonesia targets formal sector workers exclusively, is not redistributive, and there is no “first pillar” providing basic social security pension coverage.1 Approximately 25 million people are currently covered under mandatory programs through state-run monopolies, and there are an additional 1.0 million participants in voluntary pension schemes. The Indonesian social insurance system includes three mandatory programs covering (i) formal private sector workers, (ii) civil servants, and (iii) the armed forces. Jamsostek (Jaminan Sosial Tenaga Kerja) is not a pension scheme, but a mandatory savings scheme that provides coverage for employees of private sector and state-owned enterprises (SOEs) with 10 or more employees or a monthly wage cost of at least Rp1 million. Taspen (Tabungan dan Asuransi Pegawai Negari) covers all civil servants and Asabri (Asuransi Social ABRI) covers police, and civilian and military defense personnel. These mandatory schemes can be supplemented by voluntary pensions (dana pensiuns) of two types, employer pension funds (DPPKs) and financial institutions pension funds (DPLKs). A summary overview of pension programs’ membership, assets, liabilities, and cash flow is shown in Table 4 in the main text.

2. There is no unified policy, supervisory, regulatory, or legal framework for the pension sector or social security at present. Multiple ministries have been involved in the control and regulation of pension programs in Indonesia. The Jamsostek program is under the purview of Ministry of Manpower and Transmigration, the Taspen program is controlled by the Ministry of Finance, and the Asabri program is controlled by the Ministry of Defense. The Ministry of Finance Pensions Directorate has authority only to supervise voluntary pensions, not the mandatory state-monopoly pension programs, which are, effectively, unsupervised.

3. The Government pension schemes of Taspen and Asabri suffer from significant future funding problems stemming from increasing unfunded liabilities under the pay-as-you-go basis. Existing debt from past service is Rp342 trillion and Rp38.3 trillion for Taspen and Asabri, respectively. Asabri is funded from current contributions and the Government’s general budget. Taspen is partially funded from contributions and a small accumulation, but is largely funded from the general budget. In 2000, contributions to Taspen are estimated to have covered only Rp0.6 trillion of the Rp14.1 trillion pension payments, the balance of Rp13.5 trillion to be met by the Government’s general budget and by drawing down the Taspen fund. Under the present split with Government covering 75% and Taspen covering 25% of pension payments, Taspen assets will be depleted by 2003. In view of low government salaries, benefit levels may not be adequate if not properly indexed to inflation. However, salary increases for government employees will further reduce the financial sustainability of pension schemes if the scheme design is not amended to compensate for this. As an example, possible 20% salary increases for the next 5 years for government employees would impose significant additional liabilities of Rp135 trillion and Rp17 trillion for Taspen and Asabri, respectively. The projected pension payments for Taspen2 are estimated as follows:

1 In August 2000, a Committee for the Improvement of National Social Security was formed. Coordinated by the

Vice President’s Secretariat, this Committee is exploring options for introducing a minimum pension scheme and legislation.

2 ADB. 1998. Technical Assistance to the Republic of Indonesia for Reform of Pension and Provident Funds. Manila.

Appendix 1

27

Table A1.1: Total Projected Pension Payments for Taspen, 2000–2004 (Rp trillion)

Year Current Arrangements

Assuming 20% Salary Increases for 5 Years

2000 14.1 14.1 2001 15.9 16.9 2002 17.5 19.8 2003 19.1 23.5 2004 20.8 27.8

4. The proportion of Taspen’s pension payment to be met by the Government will on present indications increase to over 96% in 2004 and will remain at that level. In real terms, the annual contribution from the general budget to Taspen is expected to exceed Rp20 trillion around 2010 and Rp30 trillion around 2070 under current arrangements. Under the increased salary scenario, that contribution would exceed Rp20 trillion in 2004, Rp30 trillion around 2010, and Rp40 trillion around 2020. 5. For Jamsostek, a defined contribution plan, the primary concern is that the plan as presently designed will not provide sufficient retirement income, potentially burdening the Government in the years ahead. Some critical concerns for Jamsostek include: low wage replacement ratio (small retirement income provisions) due to low contribution rate and poor investment performance; lack of annuitization requirement; low coverage, underreporting of wages and lack of enforcement; lack of a common national identification number; and monopoly status of the program, precluding the development of potentially more effective schemes. Institutional and governance issues include: lack of transparency and disclosure; weak internal corporate governance structures; directed investments under political pressure and poor returns; high administrative and operational costs; cross-subsidization between pension and non-pension programs; payment of dividends and taxes to the Government due to corporate status; a general perception among participants that there is no independent audit; and inadequate management information systems, raising the possibility of underreporting or misallocation of contributions 6. General lack of confidence in Jamsostek, low returns, and inadequate benefits contribute to the low 45% compliance rate for the program. Many issues for Jamsostek are those broadly facing the pension sector. Improvements in supervision, regulation, and governance are required throughout, and industry practices and operations need to be brought in line with international standards. Encouraging competition and eliminating state monopolies will be important factors in facilitating reform measures. Gradual elimination of the option for one-off lump-sum benefits at retirement with no subsequent lifetime income is also important. Taking lump-sum benefits, a preferred practice in Indonesia, leaves room for myopic spending by retirees with the potential to significantly reduce or eliminate retirement savings. Additionally, the severance and service benefits mandated for employees under separate legislation are not required to be separately funded, and do not provide protection for employees against employer insolvency, which has been a frequent occurrence. 7. Investment allocation by pension fund managers continues to be heavily skewed toward time deposits. Such investments have accounted for 70% of the portfolios of private pension fund managers. Investments in Bank Indonesia Certificates also account for a significant portion of pension fund portfolios. These investment patterns reflect the combination of low risk and relatively attractive interest rates offered by these instruments as well as a lack of investor

Appendix 1 28

interest in the stock market due to the weak business environment and market governance issues. In part due to aggressive marketing by private pension companies, there appears to be an increasing awareness of the importance of pensions for providing income continuity into retirement. The number of participants in financial institution pension funds increased by 29.2% from 260,277 in 1999 to 336,213 in 2000, and estimated participants in 2001 were 400,000. B. Insurance Sector

Table A1.2: Selected Insurance Sector Data in Indonesia (Rp trillion)

1996 1997 1998 1999 2000 2001 Life Insurance Number of Companies 56 62 62 62 62 61 Total Premiums 2.9 3.6 4.9 5.5 7.3 9.2 Total Investments 5.7 7.9 9.0 12.6 14.2 17.3 Total Assets 7.3 12.7 13.7 16.8 18.7 22.4 Total Technical Reserves 5.1 9.8 10.4 10.5 14.9 17.9 Nonlife Insurance Number of Companies 102 110 113 114 111 109 Total Net Premiums 1.2 2.2 3.6 2.8 3.5 Total Investments 3.7 5.1 6.2 7.2 8.2 9.4 Total Assets 5.4 8.0 10.4 11.3 12.6 14.8 Total Technical Reserves 1.4 1.8 2.9 2.1 2.7 3.3 “Social Insurance”

Number of Companies (all state monopolies) 5 5 5 5 5 5

Total Premiums 2.1 2.7 3.1 1.9 2.1 Total Investments 8.6 10.4 12.7 9.4 9.7 Total Assets 9.3 11.5 14.6 10.0 10.2 11.4 Total Technical Reserves 7.7 9.9 12.7 6.9 7.9 = not available Source: Insurance Directorate, Ministry of Finance. 8. The Government announced in August 2002 its plans to close nine insurance companies, and more firms, particularly in the life sector, are in danger of insolvency. It is generally agreed that a number of life insurance companies in Indonesia were already fundamentally unsound before the Asian financial crisis. A life insurance company can continue to operate in a deficit situation, vulnerable to a financial shock, for many years if the deficit is not apparent and policyholders continue to pay premiums so that there is enough cash to meet claims. Issues causing or allowing financial weakness to persist in the life insurance industry in Indonesia include:

• small capital base of companies limiting ability to cope with fluctuations; • overoptimistic product pricing locking companies into payments not supportable by

investment income, further eroding capital; • asset-liability mismatches exposing the companies to rollover risk; • high acquisition and maintenance expenses; • lack of management expertise and technical skills; • lack of transparency due to unreliable accounting and financial reporting; • lax enforcement of solvency requirements; • lack of autonomy of the insurance regulator; • weak internal governance; • controlling shareholders with objectives not consistent with policyholder interests;

Appendix 1

29

• apparent corruption in claims settlement practices and use of intermediaries for diversion of funds; and

• lack of consumer protection provisions and procedures. 9. General areas of weakness identified for the life sector are similar for the nonlife sector in terms of a reform agenda. However, the nonlife sector is less vulnerable to collapse by comparison. Its liabilities are short term and can be more easily managed, and the failure of a single company is less likely to be as devastating. Some concerns for the nonlife sector include captive companies established primarily to service parent groups and related organizations (rather than to underwrite insurance on a commercial basis); lack of proper controls for engaging in surety insurance (loans, performance bonds, promissory notes); excessive reliance on reinsurance cover; and writing international reinsurance with limited capacity and expertise. 10. Additional key issues in the insurance sector include a weak competitive position for the opening of Association of Southeast Asian Nations (ASEAN) markets in 2003, underdevelopment of the private sector, elimination of state monopolies, government exposure in SOEs, enhancement of the legal and regulatory system, development of tax-based incentives for socially desirable forms of insurance, and development of institutions and legislation to improve consumer protection. C. Capital Markets Sector 11. Capital markets in Indonesia are small and underdeveloped in comparison to the banking sector. By the end of 2001, there were 189 securities companies licensed to act as broker-dealers, 116 licensed to act as underwriters, and 47 licensed to act as investment managers. In terms of institutional investors, there were 108 mutual funds, 60 venture capital funds, 62 life insurance companies, 109 nonlife insurance companies, 5 social insurance companies, 327 private pension funds, and 3 public pension schemes. 12. The ability of firms to raise funds from Indonesia's capital markets is limited by the small size and low liquidity of these markets—with market capitalization of the Jakarta Stock Exchange at only 16% of gross domestic product (GDP) in 2001 (among the lowest in the region).3 Apart from setbacks due to political and macroeconomic instability, growth and development of capital markets in Indonesia have been hindered by:

• highly concentrated share ownership patterns among listed firms that contribute to

low market liquidity as well as weak corporate governance;4 • weak governance at the regulator, financial institution, and firm levels, which

increases the scope for market manipulation and undermines public confidence; • a small institutional investor sector: combined assets of the domestic pensions and

insurance sectors amounted to Rp51.2 trillion in 2001 or approximately 3.4% of GDP;

• company groups that include banks as well as industrial firms, where capital needs are typically met through intra-group lending;

• investor bias toward bank deposits: this is particularly pronounced among institutional investors, whose portfolios are dominated by bank instruments. State-

3 By way of comparison, stock market capitalization as a percentage of GDP in the Philippines was 77.6% in 2000. 4 Most listed companies are majority owned by the founding shareholders with the general public holding 20–30% of

the total shares.

Appendix 1 30

owned pension programs have over 90% of their assets invested in bank deposits while the corresponding figure for private pension funds is around 70%;

• a mutual ownership structure for domestic exchanges that weakens governance and limits their ability to raise capital for investment and expansion;

• the lack, until very recently, of a government bond market to provide suitable benchmarks for corporate bonds and private issues of securities;5

• shortage of qualified market professionals; and • globalization: competition from larger, more efficient, and more transparent

markets has reduced the prospects of small markets everywhere, including Indonesia's. Multinationals as well as large domestic firms have the option to raise money offshore where costs are lower, while increasing correlation between markets due to globalization has reduced the incentive for industrial country investors to diversify into emerging markets.6

Selected capital market indicators are given in Table 3 in the main text. D. Consolidated Regulatory and Supervisory Authorities 13. The emergence of integration of regulatory and supervisory powers over different types of financial institutions within a single agency first gained recognition in the 1980s as Norway and Denmark and then Sweden adopted an integrated approach to regulation. The banking crises in these countries impacted the decision to adopt this structure, and subsequently increasing interest and adoption of this approach in other regions, including Asia, have been seen. The institutional innovation and experience with implementation, in most countries that have adopted this approach, are still at an early stage. 14. The specifics of institutional responsibilities and powers have varied somewhat across the group of innovators, and motivations underlying the move toward regulatory integration have included:

• the need for greater consistency in the application of policy across different industries (i.e., regulatory neutrality);

• the ability to make more efficient use of scarce regulatory resources; • economies of scale; • incapacity of small nonbank financial sectors to sustain separate and effective

regulatory agencies; • more effective supervision of financial conglomerates; and • the opportunity to improve the quality of supervision of specific sectors.

15. Efficient use of regulatory resources, regulatory neutrality, and the opportunity to improve the quality of supervision of specific sectors are motivations that remain consistent

5 Until the crisis, Indonesia had a balanced budget policy that did not allow for treasury bills and government bonds.

The first bond issue to finance recapitalization was in May 1999. 6 The changing composition of investors in Indonesia's equity markets reflects this growing difficulty in remaining

attractive to foreign investors. In 1996, investor composition was roughly equally split between local and foreign investors, while by 2001 foreign participation had dropped to about 10%.

Appendix 1

31

across countries. Tables A1.3 and A1.4 below summarize the differences in regulatory responsibilities and powers among nine integrated regulators.7

Table A1.3: Regulatory Responsibilities

Responsibility Australia Canada Denmark Japan Korea, Rep. of Norway Singapore Sweden

United Kingdom

Prudential Policy Y Y Y Y * P Y Y Y Prudential Implementation

Y Y Y P Y Y Y Y Y

Market Conduct (General)

N P P Y Y N P P Y

Market Conduct (Fund Raising)

N N P Y Y P P Y Y

Disclosure N P P Y Y P Y Y Y Competition Policy N N N N N N N N N

Table A1.4: Regulatory Powers

Responsibility Australia Canada Denmark Japan Korea, Rep. of Norway Singapore Sweden

United Kingdom

Licensing Y N Y N N P Y Y Y Fit and Proper Rules N Y Y Y Y Y Y Y Y Inspection Y Y Y Y Y Y Y Y Y Request Information Y Y Y Y Y Y Y Y Y Give Directions Y Y Y Y Y Y Y Y Y Standards for Individual Institutions

Y Y N N Y Y P Y N

Remove Directors/Auditors N Y Y Y Y P Y N Y Suspend Operations N Y P Y N P Y N Y Appoint Administrator Y Y Y Y Y Y Y N Y Transfer Engagements Y N Y Y N Y Y N Y

7 Source: Carmichael Consulting Pty Ltd. Data as reported in 1999. Provided for workshop under TA 3620. The

terms "regulation" and "supervision" are used interchangeably. “Y” indicates full responsibility, “N” indicates no responsibility, and “P” indicates partial responsibility (e.g., shared with another agency or government).

Appendix 2 32

POLICY LETTER AND POLICY MATRIX

I. Policy Letter from the Government

Appendix 2

33

Appendix 2 34

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

I. CONSOLIDATED REGULATORY AND SUPERVISORY AUTHORITY – OTORITAS JASA KEUANGAN (OJK) (Steering Committee: Ministry of Finance (Directorate General of Financial Institutions, Bapepam); Ministry of Justice and Human Rights; Bank Indonesia (BI))

A1. Prepare draft OJK Law for approval by Ministry of Justice and Human Rights (MOJHR) Draft OJK law to include:

(a) provisions to ensure independence and accountability of OJK (see Attachment 1 for specific provisions to be maintained in OJK Law); (b) provisions to ensure entities related to existing and future mandatory social insurance or social security programs will be under the jurisdiction of OJK and be subject to OJK’s regulatory and supervisory authority in respect to OJK’s prudential and consumer protection mandate; and (c) provisions requiring OJK’s written approval for filing petition of winding-up/ bankruptcy cases initiated against entities under OJK’s jurisdiction.

AA1. Submit draft OJK Law approved by Ministry of Justice and Human Rights (MOJHR) to State Secretary Office with the OJK package of laws.1 Draft OJK law to include provisions as specified in first tranche.

B1. Draft OJK law endorsed by President and submitted to Parliament with the OJK package of laws. Draft OJK law to include provisions as specified in first tranche.

C1. Establish OJK and issue implementing regulations for OJK Law. Enacted OJK law to include: (a) provisions to ensure independence and accountability of OJK (see Attachment 1 for specific provisions to be maintained in OJK Law); (b) provisions to ensure entities related to existing and future mandatory social insurance or social security programs will be under the jurisdiction of OJK and be subject to OJK’s regulatory and supervisory authority in respect to OJK’s prudential and consumer protection mandate; and (c) provisions requiring OJK’s written approval for filing petition of winding-up/ bankruptcy cases initiated against entities under OJK’s jurisdiction.

A2. Continue developing transitional arrangements for OJK including:

(a) initial assessment of operating and set up costs for OJK for 2003-2004 ; (b) initial assessment of capacity building needs for prudential regulation and supervision under

B2. Begin transitional arrangements for OJK and transfer of supervisory authority to OJK including: (a) preparation of detailed timebound implementation plans; (b) launch capacity building programs for prudential regulation and supervision for relevant institutions;4

C2. (a) President to appoint the Board of Commissioners to OJK. OJK to be operational in 2004. OJK to report regularly to the President and publish reports in full. OJK to adopt and implement good corporate governance principles.

1 Bank Indonesia (BI) Act, Capital Market Law, Pension Law No. 11, Insurance Law 1992 and other related legislation.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

OJK; and (c) begin2 assessment of potential retrenchment/ redeployment of employees in institutions3 to be consolidated in OJK.

(c) relevant institutions to complete assessment and plan for phased retrenchment/ redeployment of employees to be approved by Government. (d) Prepare draft budget for transitional 2003 costs.

(b) Mechanism for consumer protection established. (c) Continue training and capacity building and complete retrenchment / redeployment of employees.

II. ANTI-MONEY LAUNDERING REGIME (Working Group on Money Laundering: Ministry of Justice and Human Rights; Bank Indonesia; Ministry of Finance; Ministry of Home Affairs, Attorney General’s Office; Police; Bedan Pengawas Keuangan dan Pembangunan [Finance and Development Supervisory Board] (BPKP); Bapepam; PPATK A3.

(a) Anti-Money Laundering (AML) Law signed by President.5 Prepare plan to address deficiencies identified by Financial Action Task Force on Money Laundering (FATF). (b) Arrangements confirmed by CMEA for adequate budget for the financial intelligence unit (PPATK) for 2003 for setup and operational costs.

B3. Begin implementation of plan to address deficiencies in AML regime. Provide funding for PPATK in 2003 and prepare budget allocation for 2004 for operational costs of the financial intelligence unit (PPATK).

C3. Complete implementation of plan, including necessary revisions, to address deficiencies in AML regime.

A4. (a) Bank Indonesia (BI) Regulation for the Transparency of Bank Financial Conditions6 issued. (b) Key PPATK officials to be appointed by President. BI to begin assuming financial intelligence unit (FIU) functions for the banking sector until PPATK is operational.

AA2. (a) BI to provide an interim report on monitoring of suspicious transactions. (b) Additional staff to be seconded to ensure PPATK operational capacity.

B4. (a) BI to continue financial intelligence unit (FIU) functions for the banking sector until PPATK is operational. (b) Issue Presidential Decree on the organizational structure and operations of the PPATK.

C4. PPATK to be fully operational and to issue semi-annual reports to President, Parliament and related agencies.

2 ADB. 2001. Technical Assistance to the Republic of Indonesia for the Development of a Financial Services Supervisory Institution. Manila. 3 Bank Indonesia (BI), Bapepam (Capital Markets Supervisory Authority), and Directorate General of Financial Institutions (DGFI). 4 ADB. 2002. Technical Assistance to the Republic of Indonesia for the Establishment of a Financial Services Authority. Manila. 5 Anti-money Laundering Law established in April 2002. 6 BI Regulation No. 3/22/PBI/2001 issued in December 2001.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

AA3. (a) Prepare amendments to the AML Law to address deficiencies identified by FATF. (b) Begin preparation of implementing regulations for the AML Law.

B5. (a) Promulgate implementing regulations for the AML Law including -Regulation on the protection of reporting parties -Regulation of PPATK's reporting systems. (b) Develop guidance notes to institutions subject to the AML Law for procedures and requirements for reporting suspicious transactions.

C5. Undertake training and capacity building for PPATK and related institutions as necessary. 7

A5. BI rules for Know Your Customer Rules for banks issued. Bapepam to prepare Know Your Client Rules for securities market.

B6. Bapepam to issue Know Your Client Rules for securities market

C6. Bapepam to enforce sanctions for noncompliance.

B7. (a) PPATK to undertake all necessary measures to enter into operational memorandum of understandings with other Government agencies and Institutions; (b) PPATK to begin dialogue to enter into information sharing and cooperation arrangements for anti-money laundering efforts with regulatory institutions in the Asia and Pacific Region.

C7. Enter information sharing and cooperation arrangements for anti-money laundering efforts with regulatory institutions in the Asia and Pacific Region and join the Egmont Group of FIUs.

III. ADVANCEMENT OF SECTOR REFORMS IN TRANSITION TO OJK A. BAPEPAM (Capital Market Supervisory Agency) A6. Prepare draft amendments to the Capital Market Law including provisions for:

AA4. Submit draft amendments to the Capital Market Law to State Secretary Office with OJK Law including provisions as specified in

B8. President to endorse draft amendments to the Capital Market Law and submit to Parliament with OJK Law. The draft amendments to include provisions as

C8. Issue implementing regulations for the amendments to the Capital Market Law.

7 To be supported by ADB TA Development of an Anti-Money Laundering Regime. 8 Including provision to eliminate the requirement that stock exchanges be in the mutual form (Joint Bapepam and SRO Report on Demutualization and options

issued January 2002) and prepare regulation to require public companies and issuers to have independent commissioners and audit committee.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

(a) Establishment of a legal framework for broadening ownership of stock exchange. (b) Establishment of the legal status of collateral funds administered by the Clearing Guarantee Institution. (c) Establishment of a legal framework for scripless trading. (d) Establishment of liability of directors for violation of the Capital Market Law. (e) Establishment of the responsibility of lawyers involved in the preparation of legal audit for reporting violations of the Capital Market Law. (f) require public companies and issuers to have independent commissioners and audit committee8 (g) Sanctions with clearly defined criminal content stipulations to facilitate enforcement.

first tranche. specified in the first tranche.

A7. Issue rule on Independence of Accountants Providing Audit Services in the Capital Market.

B9. Enforce sanctions for noncompliance of rule.

A8. Issue rule to require publication of (i) audited financial reports of listed companies within 90 days and (ii) unaudited interim reports within 30 days of financial year-end.

B10. Monitor compliance with reporting requirements and enforce sanctions.

C9. Monitor compliance with reporting requirements, enforce sanctions, and enhance enforcement procedures where necessary.

A9. Bapepam to ensure that listed company shares are converted for scripless trading and settlement in line with JSX rules.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

A10. Member firms of Securities Clearing House, and firms that extend margins or keep custody of securities to maintain Rp5 billion net-adjusted working capital and report daily.9 Revoke licenses of broker dealer companies not in compliance with risk-based capital and reporting requirements.10

B11. Monitor compliance of securities companies with risk-based capital requirements and enforce sanctions for noncompliance, and enhance enforcement procedures where necessary.

C10. Monitor compliance of securities companies with risk-based capital requirements and enforce sanctions for noncompliance, and enhance enforcement procedures where necessary.

A11. Require securities companies and brokers and dealers to provide information on beneficial ownership of securities.

AA5. Prepare a rule to ensure that securities companies, brokers and dealers' securities sub-accounts identify the beneficial ownership of securities held in the sub-accounts.

B12. Issue a rule to ensure that securities companies, brokers and dealers' securities sub-accounts identify the beneficial ownership of securities held in the sub-accounts

A12. Begin review of potential measures/options for an early warning system of financial exposure.

B13. Adopt measures for an early warning system of financial exposures for securities brokers and dealers and issue any necessary rules.

C11. Adopt plan and policy for winding up insolvent securities companies including provisions to safeguard company assets and protect customers’ funds and securities.

A13. Expand application of, and continue conducting, investor education program. (Bapepam and Self Regulatory Organizations).

B14. Continue conducting investor education program.

C12. Continue conducting investor education program.

B. DIRECTORATE GENERAL OF FINANCIAL INSTITUTIONS - INSURANCE DIRECTORATE A14. Prepare draft amendments to the Insurance Law to State Secretary Office with OJK Law. The draft amendments to include provisions for:

(a) Life insurance companies to manage employer-sponsored pension plans. (b) Written approval of Minister of

AA6. Submit draft amendments to the Insurance Law to State Secretary Office with OJK Law. The draft amendments to include provisions for: (a) Life insurance companies to manage employer-sponsored pension plans.

B15. President to endorse draft amendments to the Insurance Law and submit to Parliament with OJK Law. The draft amendments to include provisions for: (a) Life insurance companies to manage employer- sponsored pension plans; (b) Written approval of Minister of Finance prior to the filing of a petition of winding-up/

C13. Issue sanctions for noncompliance with disclosure requirements and monitor levels of compliance and sanctions imposed. (a) Life insurance companies to manage employer-sponsored pension plans; (b) Written approval of Minister of

9 Bapepam released rule number V.D.5. regarding Maintenance and Reporting of Net Adjusted Working Capital, last revision April 2000. 10 Companies that fail to meet net-adjusted working capital requirements for a continuous period of more than 30 days or more than 60 days in any 12-month

period.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

Finance prior to the filing of a petition of winding-up/ bankruptcy.

(b) Written approval of Minister of Finance prior to the filing of a petition of winding-up/ bankruptcy.

bankruptcy.

Finance prior to the filing of a petition of winding-up/bankruptcy (transferred to OJK when operational).

A15. Launch independent special audit of Jamsostek,11 with international and domestic auditors.

B16. Ensure satisfactory progress of special audit of Jamsostek.

C14. Evaluate potential measures to restructure Jamsostek and/or eliminate its monopoly status.

A16. Issue decree12 requiring publication of insurance companies’ financial position, solvency position, ownership and name of directors. Enforce sanctions against firms not in compliance with insurance regulations.

AA7. Enforce sanctions against firms not in compliance with insurance regulations.

B17. Enforce sanctions against firms not in compliance with insurance regulations.

C15. Enforce sanctions against firms not in compliance with insurance regulations.

A17. Launch independent assessment and evaluation of selected insurance company as agreed to provide options to improve financial condition and/or restructure company.

AA8. Launch independent assessment of financial condition of insurance industry to identify undercapitalized, illiquid or insolvent firms and provide options for restructuring.

B18. (a) Ensure satisfactory progress in the assessment of insurance sector including the financial condition of insurance companies, (b) develop a plan to strengthen insurance sector after reviewing the recommended options for restructuring, consolidation, or closure of firms and (c) assess the possibility for need for government assistance/guarantee fund.

C16. Actions to be determined upon outcomes under first loan program.

A18. Issue written notification to all firms not complying with risk-based capital requirements. Continue phased implementation of risk-based capital requirements for insurance companies to be phased in by 2004.

B19. Enforce sanctions against firms not in compliance with risk-based capital requirements. Continue phased implementation of risk-based capital requirements.

C17. Enforce sanctions against firms not in compliance with risk-based capital requirements. Continue phased implementation of risk-based capital requirements.

A19. Increase paid-up capital requirement for new entrants into insurance sector and issue decree.

B20. Enforce sanctions against insurance companies not in compliance with paid-up capital requirements.

C18. Enforce sanctions against insurance companies not in compliance with paid-up capital requirements.

11 Project to be conducted under ADB TA Loan 1620. 12 Directorate General of Financial Institutions Decree No: KEP-6098/LK/2001 on December 28, 2001.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

A20. Prepare decree strengthening qualification requirements for insurance experts in line with international standards.

B21. Issue decree strengthening qualification requirements for insurance experts in line with international standards.

C19. Enforce sanctions against insurance experts not in compliance with the qualification requirements.

A21. Conduct training for supervisors and examiners on international standards and practices.

B22. Conduct training for supervisors and examiners on international standards and practices.

C20. Conduct training for supervisors and examiners on international standards and practices.

A22. Prepare guidelines and decree for standard procedures for onsite examinations of insurance companies in line with international best practices.

B23. Issue decree for standard procedures for onsite examinations of insurance companies in line with international best practices.

B24. Develop plan for providing training and long-term development for actuaries.

C21. Provide training and long-term development for actuaries to increase skills capacity to implement international best practices and standards.

C. DIRECTORATE GENERAL OF FINANCIAL INSTITUTIONS - PENSIONS DIRECTORATE A23. Prepare draft amendments to Pensions Law to State Secretary Office with OJK Law. The draft amendments to include provisions for management of pension funds to be legally responsible for establishing anti-money laundering procedures.

AA9. Submit draft amendments to Pensions Law to State Secretary Office with OJK Law. The draft amendments to include provisions as specified in first tranche.

B25. President to endorse draft amendments to the Pensions Law and submit to Parliament with OJK Law. The draft amendments to include provisions as specified in first tranche.

C22. Issue implementing regulations for the amendments to the Pensions Law.

A24. Issue decree requiring pension funds to submit financial reports and other required data to Directorate in hard copy and electronically commencing 2003 financial year.

B26. Issue circular requiring Pensions Directorate to publish annual pension sector report within 120 days of the due date for submission of annual financial reports.

C23. Enforce sanctions against firms not in compliance with electronic filing requirements.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

A25. Issue decree to require submission of audited reports within 5 months of financial year-end commencing 2003, and unaudited 6 monthly reports within 2 months of the semester end beginning June 2003, with significant administrative sanctions for noncompliance.

B27. Enforce sanctions against firms not in compliance with reporting requirements.

C24. Review time requirements for reporting under decree. Continue rigorous enforcement of sanctions.

A26. Issue decree requiring all private pension fund managers to satisfy standards of competence through certification in line with international best practices.

B28. Pension fund managers to be licensed by 2004. Qualifications and ongoing education requirements to be specified in decree.

C25. Prepare amendments to legislation13 to establish personal liability of officers for misallocation of public and private pension funds.

A27. Prepare decree requiring financial institutions pension funds to publish and make public annual financial statements and portfolio assets valuations.

B29. Issue decree requiring financial institutions pension funds to publish and make public annual financial statements and portfolio assets valuations. Enforce sanctions against financial institutions for pension funds not in compliance with reporting requirements.

C26. Enforce sanctions against pension funds and schemes not in compliance with reporting requirements.

A28. Conduct training for supervisors and examiners on international standards and practices.

B30. Conduct training for supervisors and examiners on international standards and practices.

C27. Conduct training for supervisors and examiners on international standards and practices.

A29. Prepare proposal for amendment of regulation to allow for deferral of taxation on pension fund income for voluntary pensions for DGTax consideration.

B31. Pending outcome of dialogue with Pensions Directorate and DG Tax regulation to be prepared for deferral of taxation on pension fund income.

C28. Pending outcome of dialogue with Pensions Directorate and DG Tax, regulation to be issued for deferral of taxation on pension fund income. Continue to evaluate best practices for private and public pension funds.

IV. NATIONAL SOCIAL SECURITY (Ministry of Finance; Ministry of Manpower and Transmigration; Ministry of Home Affairs; Ministry of State Administration; BKN)

A30. CMEA to coordinate with Presidential Team14 for National Social Security Reforms and to commence preparation of a concept paper for national social security law including

B32. CMEA to coordinate with Presidential Team to prepare a draft national social security law for improvement and harmonization of social insurance and social security.

C29. Subject to enactment of the law, issue implementing regulations for the national social security law. CMEA to continue coordination with Presidential Team for measures for

13 Act No. 3 1992, Act No. 11 1969, Act No. 6 1966, and Act No. 11 1992 14 Established in April 2002 by Presidential Decree No. 20.

II. Policy Matrix

1st LOAN (PHASE 1: 2002-2003) 2nd LOAN (PHASE II: 2003-2005)

2nd Tranche ($100 million) 1ST Tranche ($100 million) Incentive Tranche ($50 million) (Target June 2003)

unified identification system for social security; modification of P T status of companies offering mandatory pension programs; adoption of trust principle; segregation of retirement funds and assets to eliminate cross-subsidization of programs; portability of benefits; protection of vested rights; improvement of existing programs and extension of coverage to informal sector.

improvement of national social security.

AA10. Taspen to complete valuation of unfunded pension liabilities and begin preparation of financing options for submission to MOF for reducing its liabilities.

B33. Taspen to submit options and recommendations for reducing its liabilities to MOF for consideration.

C30. Actions to be determined based upon proposed options and DG Budget considerations.

V. CORPORATE GOVERNANCE Ministry of Justice and Human Rights (MOJHR) and Directorate General of Financial Institutions (DGFI)

A.31. As an interim measure, pending the amendment of the Company Law to impose liability on commissioners and directors for board decisions and/or false or misleading public information, BAPEPAM to exercise its regulatory power by imposing sanctions as applicable to boards of commissioners and directors of listed companies.

AA11. MOJHR to submit draft amendments to the Company Law to State Secretary Office, including provisions imposing liability of commissioners and directors for false and misleading public information and board of commissioners’ decisions.

B34. President to endorse draft amended Company Law and submit to Parliament, including provisions imposing liability of commissioners and directors for false and misleading public information and board of commissioners’ decisions.

C31. Company Law including provisions imposing liability of commissioners and directors for false and misleading public information and board of commissioners’ decisions to be enacted.

A32. MOF to issue decree imposing liability on auditors for negligence. MOF to prepare draft Public Accountants Law including provisions imposing liability on auditors for negligence.

B35. Submit draft Public Accountants Law to State Secretary Office including provisions imposing liability on auditors for negligence.

C32. Public Accountants Law including provisions imposing liability on auditors for negligence to be enacted.

II. Policy Matrix

Attachment 1

PROVISIONS REQUIRED FOR INDEPENDENCE AND ACCOUNTABILITY OF OJK TO BE PROVIDED IN DRAFT OJK LAW

The draft OKJ Law should include the following provisions to ensure independence and accountability:

(a) the regulator should have the capacity to (i) develop regulatory policy, (ii) implement regulatory policy, and (iii) enforce regulatory policy, without inappropriate interference from Parliament, Government or from industry.

(b) regulatory officials should have immunity from civil prosecution and are protected from dismissal and financial loss for carrying out their legal responsibilities in good faith;

(c) regulatory officials should not hold any political appointment or office;

(d) President nominations for appointments should be subject to Parliamentary approval;

(e) President recommendations for removal of officials should be subject to Parliamentary approval;

(f) there should be well-defined, appropriate and transparent conditions circumscribing the circumstances under which the Government can direct the agency to act or not act in certain ways;

(g) the agency should control its own finances (within the terms set down by the Law) so that its finances cannot be withheld as a means of coercing it to make or not make certain decisions; and

(h) the regulator should publish its annual report of operations in full, including publication through the regulator’s website.

(The Elucidation should include a description of the matters to be reported including the financial statements, details of the use of the regulator’s discretion, number and extent of sanctions imposed, and the number of policies developed and implemented.

PROGRAM FRAMEWORK

Design Summary Performance Indicators

and Targets Monitoring Mechanisms Assumptions and Risks

A. Goal To strengthen financial sector governance and the social security system in order to facilitate broad-based economic growth and reduce vulnerability to crises

• Sustained growth of the economy • Increased monetary assets to

gross domestic product (GDP) ratio

• Increased market capitalization and trading volume

• Increased participation of foreign investors in capital markets

• Increased insurance and pension funds assets/GDP ratio

• Successful prosecution of money laundering cases

• Macroeconomic developments,

economic reports and financial sector statistics

• Financial sector growth and development

• Policy dialogue with Government • Assessments and evaluations by

Financial Action Task Force on Anti-Money Laundering (FATF) and the Asia/Pacific Group on Money Laundering

• Macroeconomic stability • Political stability • Continued presidential priority and

support for the President’s Team for Improvement of National Social Security

• Political commitment to anti-money laundering efforts

• Adequate Government budget for set up and operations of the financial intelligence unit, Pusat Pelaporan Analisis Transaki Keuangan (PPATK)

B. Purpose/Objectives Strengthen financial services regulation and supervision and efficiency through consolidation of authorities Reduce financial sector vulnerabilities through adoption of international best practices and standards for prudential regulation and supervision Develop an effective anti-money laundering regime

• Process legislation for the financial

services authority (OJK) and covered sectors

• Number of enforcement actions by the Ministry of Finance, Capital Market Supervisory Agency (Bapepam), Bank Indonesia (BI), and OJK

• Number of suspicious transactions

reported to BI (as interim financial intelligence unit) and PPATK, and number of transactions investigated and prosecuted.

• Progress toward removal of Indonesia from FATF list of Non-Cooperative Countries and Territories (NCCT)

• Regular OJK Reports to President

and published Annual Reports • Official copies of laws, decrees,

regulations and directives and notices of issuance in Indonesian Gazette

• Official statements from the State Secretary Office acknowledging receipt of draft laws and from the President’s Office reporting President’s endorsement and submission to Parliament

• Periodic progress reports from ministries and agencies

• Asian Development Bank (ADB) review missions

• Semi-annual reports of PPATK to President, Parliament, and related agencies

• ADB review missions

• Effective collaboration among

ministries and agencies • Parliamentary approval of OJK law • Strong leadership, independence,

accountability, and capacity of OJK and appointment of suitable board members and officials

• Continued Government

commitment to establish an effective anti-money laundering regime

PROGRAM FRAMEWORK

Design Summary Performance Indicators

and Targets Monitoring Mechanisms Assumptions and Risks

Strengthen investor confidence through improved governance, transparency and investor protection Strengthen insurance sector through enforcement of regulations and closure or merger of weak or insolvent firms Strengthen corporate governance by increasing accountability of auditors, directors, and commissioners Improve national social security by: (i) improving supervision and governance of mandatory pension and provident funds by bringing under OJK jurisdiction; (ii) developing plans to reduce unfunded pension liabilities of mandatory plans; (iii) supporting the development of a unified national identification system for social security; and (iv) improving programs to provide adequate retirement income and increased coverage of the population.

• Number of listed companies and number of new securities issues and amount of foreign investment

• Compliance with risk-based capital and reserve requirements and disclosures

• Consolidation of insurance firms through closure or merger

• Process legislation increasing

accountability of auditors, directors, and commissioners

• Extension of coverage into informal

sector • Percentage of population covered

by social insurance • Development of a unified

identification system for social security

• Taspen (mandatory pension for civil servants) submits plan to Government to reduce unfunded pension liabilities

• Bapepam annual reports; monthly and annual stock exchange statistics and reports; and private sector reports

• ADB review missions • Sector data • Policy dialogue with Government • ADB review missions • Official copies of laws, decrees,

regulations and directives and notices of issuance in Indonesian Gazette; official statements from the State Secretary Office acknowledging receipt of draft laws; and from the President’s Office reporting endorsement and submission to Parliament

• ADB review missions

• Policy dialogue with Government

• Foreign investors willing to invest in Indonesia’s capital markets

• Exchange rate stability • Sustained Government

commitment to carry out reforms • Adequate capacity and sustained

Government commitment to carry out social security reforms

• The President’s Team for Improvement of National Social Security maintains its timeframe for drafting and submission of a national social security law

• Parliamentary approval of a national social security law

C. Key Outputs Facilitate establishment of an independent consolidated regulatory and supervisory authority (OJK) for financial services firms

• OJK draft law submitted to State Secretary, endorsed by President, and submitted to Parliament. Implementing regulations issued for OJK

• Appointment of Government officials to OJK OJK operational

• Official copies of laws, decrees, regulations, and directives and notices of issuance in Indonesian Gazette; official statements from the State Secretary Office acknowledging receipt of draft laws and from the President’s Office

• Continued Government commitment for reforms and coordination among key institutions • Availability and recruitment of appropriate skilled staff for OJK and PPATK

PROGRAM FRAMEWORK

Design Summary Performance Indicators

and Targets Monitoring Mechanisms Assumptions and Risks

Capacity building for prudential regulation and supervision Facilitate establishment of a financial intelligence unit (PPATK) to support an effective anti-money laundering (AML) regime Provide capacity building for PPATK and relevant institutions for anti-money laundering Improve legislative frameworks to provide sufficient liability and sanctions for auditors and company commissioners to improve governance and accountability Support development of a national social security law and improve frameworks for social security governance

officials to OJK. OJK operational, reporting regularly to the President and publishing reports in full

• Training programs for Directorate General of Financial Institutions, Bapepam, and BI in transition to OJK and training for OJK officials

• Government appointment of

PPATK officials and staff and provision for budget allocation. Implementing regulations for anti-money laundering law issued and supporting decrees and regulations by relevant institutions

• Guidance notes developed for financial institutions in the reporting of suspicious transactions. Training materials prepared for law enforcement officers, prosecutors, and judiciary in the enforcement of AML law

• Ministry of Finance to issue decree on public accountants and prepare draft law on public accountants including adequate provisions for liability of auditors. MOJHR to prepare amendments draft Company law including provisions for commissioners and directors liability. President to endorse draft laws and submit to Parliament

• Preparation of draft national social security law, submission to State Secretary Office and endorsement by President for submission to Parliament

• Mandatory social insurance programs, Jamsostek, Taspen,

and from the President’s Office reporting endorsement and submission to Parliament

• Progress Reports from Government

• ADB review missions

• Assessments and evaluations by FATF and the Asia/Pacific Group on Money Laundering

• Copies of guidance notes and

training material • ADB review missions • Copies of decree and draft

legislation • Copy of draft law • Reports from Presidential Team for

National Social Security • Copy of OJK legislation

• • Continued Government

commitment to the establishment of an effective anti-money laundering regime

PROGRAM FRAMEWORK

Design Summary Performance Indicators

and Targets Monitoring Mechanisms Assumptions and Risks

and Asabri are included under the jurisdiction of OJK

• Progress toward establishment of a unified identification numbering system for social security

• Expanded coverage of social insurance to informal sector

• Satisfactory progress of Jamsostek audit and insurance sector and company review(s)

• Stakeholders workshops and participation in social security development

• Policy dialogue with Government • Policy dialogue with Government • Joint monitoring of audit and

company reviews with the International Monetary Fund on informal basis

• Auditors and accountants reports • Public reports from stakeholders

• Availability of access to data • Opposition from vested interest

groups

D. Key Inputs • $250 million program loan to the

Government of Indonesia to support Financial Governance and Social Security Reform Program

• $1 million technical assistance to assist with implementation of reforms

• $1.5 million TA 3849: Development of an Anti-Money Laundering Regime

• $1.5 million TA 3850: Establishment of a Financial Services Authority

• $1.5 million component under TA Loan 1620 for special audit of Jamsostek

• $1.0 million component under TA Loan 1620 for financial review and assessment of insolvent insurance firm

• Compliance with policy matrix • Advice to Government on social

security reform and other reforms related to policy matrix

• Technical advice and capacity building support to Government for establishment of an effective anti-money laundering regime

• Advice to Government on establishment of OJK

• Special audit of Jamsostek • Financial review and assessment

of insolvent insurance firm

• Regular progress reports,

statistics, and review missions • Monthly reports from Financial

Governance and Social Security Reform Program Project Implementation Unit (PIU)

• Continued Government support of

reforms • Adequate and timely provision of

skilled staff and facilities

Appendix 4

49

TECHNICAL ASSISTANCE

COST ESTIMATES AND FINANCING PLAN ($'000)

Foreign Local Total Item Exchange Currency Cost

A. Asian Development Bank Financinga 1. Consultants a. Remuneration and Per Diem i. International Consultants 550.0 550.0 ii. Domestic Consultants 155.0 155.0 b. Travel i. International 20.0 20.0 ii. Local c. Reports, Communications, Printing, and

Distribution of Materials for Public Education Campaign

50.0 50.0

2. Conference and Workshops 70.0 70.0 3. Equipment 15.0 15.0 4. Contingencies 70.0 70.0 140.0 Subtotal (A) 705.0 295.0 1,000.0 B. Government Financing b 1. Office, Secretarial, and Related Services 150.0 150.0 2. Local Counterpart Staff 100.0 100.0 Subtotal (B) 250.0 250.0 Total 705.0 545.0 1,250.0 a Grant funds from ADB’s technical assistance funding program. b In-kind provision and contribution.

Appendix 5 50

TECHNICAL ASSISTANCE TERMS OF REFERENCE FOR CONSULTANTS

A. International Consultants

1. Insurance Sector Expert/Senior Insurance Regulators (4 person-months)

1. An international insurance sector expert and/or senior insurance regulators with experience in insurance sector restructuring and familiarity with the insurance sector in Indonesia will work with the Government to assess the financial condition of the sector, and determine options for restructuring and consolidation, along with the level and type of government support needed to implement recommended options. The expert/senior regulator will also facilitate industry dialogue and input as necessary, and provide a realistic timebound plan for sector restructuring over the 2003-2005 period.

2. Social Security Expert (6 person-months)

2. The international social security expert will have extensive knowledge and experience in the design and reform of social security systems. The expert will:

(i) conduct a feasibility study for social security reform which will provide, among others: (a) options for restructuring existing public social insurance schemes to improve governance and programs; (b) recommendations for contribution rates and other factors to improve retirement income under existing and proposed schemes; and (c) proposals for a realistic scope of expansion of social security systems to the informal sector in the near and medium term, and potential sequencing of reforms given existing constraints;

(ii) conduct a series of stakeholder consultations through public workshops to

provide inputs from participants for formulation of a national social security; (iii) support socialization of the new draft national social security law through a range

of media and public workshops and seminars; (iv) provide training for key officials in core concepts of social security system

management and administration; (v) in collaboration with the public education expert, prepare an educational booklet

to support wider public understanding of the issues involved in social security reform. Among other things the booklet will outline: (a) the structure of the existing system and issues related to it, (b) the reasons reform might be desirable, (c) possible options for reform and the pros and cons of these; and

(vi) in collaboration with the public education expert, design and support

implementation of a public education campaign to widen public understanding of the issues involved in social security and social security reform.

Appendix 5 51

3. Senior Legal Expert (4 person-months)

3. The senior legal expert will have extensive experience in legal reform, the preparation and drafting of legislation, knowledge of social security reform issues and systems, and experience in developing countries. The expert will:

(i) review existing legislation and assist in the preparation of legislation and

regulations for the new law on national social security;

(ii) prepare a comparative study of social security legislation in selected developed and developing countries; and

(iii) assist in the preparation and development of legislation and regulations for the

new agency for national social security.

4. Public Education Expert (5 person-months) 4. The international public education expert will have experience in the design and implementation of public education campaigns. The expert will preferably have experience in conducting public education campaigns in Indonesia. The expert will:

(i) have primary responsibility for the design and implementation of a public education campaign aimed at widening public understanding of social security and the issues involved in social security reform. The expert should work with representatives of stakeholder groups and related civil society groups to test and refine a range of products and media to be used to inform the public on social security and reform issues;

(ii) advise the social security expert in the design of the educational booklet on

social security reform with a view to maximizing user friendliness and audience interest; and

(iii) have primary responsibility for the design and implementation of a campaign to

support socialization of the new draft law on national social security.

5. Social Security Identification System Design/Administration Expert (3 person-months)

5. The expert will have expertise in the design and administration of social security identification systems. The expert will:

(i) coordinate closely with the ongoing Deutsche Gesellschaft für Technische Zusammenarbeit (GTZ) Citizens' Administration System project with a view to using the identification system developed under that project as a possible basis for a unified social security identification system;

(ii) survey management of existing social security schemes to determine the issues

involved in switching over to a unified social security identification system; and (iii) recommend practical steps for moving toward a unified social security

identification system.

Appendix 5 52

B. Domestic Consultants

1. Social Security Expert (12 person-months) 6. The domestic social security expert will have a clear understanding of the features and constraints of the existing social security system as well as a practical appreciation of the issues involved in reform. The expert will provide support, as necessary, to the international social security expert.

2. Public Education Expert (5 person-months; individual consultant) 7. The domestic public education expert will have experience in the design and implementation of public education campaigns. The expert will provide support, as necessary, to the international public education expert.

3. Financial Governance and Social Security Reform Expert (12 person-months) 8. The expert will have substantial experience in facilitating the implementation of reforms related to financial sector governance and social security reform. The expert will have substantial experience in project management and in working with external funding organizations and government counterpart agencies. The consultant will report directly to the Coordinating Ministry for Economic Affairs (CMEA) program director and will have primary responsibility for:

(i) monitoring and documenting the progress of reforms under the Financial Governance and Social Security Reform Program (FGSSR) through ongoing data collection and policy dialogue with implementing agencies;

(ii) preparing and submitting monthly draft reports in Bahasa Indonesia and English

to the CMEA program director and the Asian Development Bank on the progress of reforms under the FGSSR, including identification of existing and potential obstacles and the provision of practical advice on how to effectively address these;

(iii) facilitating the organization of meetings, as necessary, to monitor progress of

reforms under the Program and address outstanding issues; and (iv) conducting research, as needed, to support the timely progress of reforms under

the FGSSR.

4. Actuarial Expert (2 person-months) 9. The expert will have actuarial qualifications and a sound understanding of the current state of the actuarial profession in Indonesia. The expert will be responsible for preparing a study and conducting a survey of actuaries, insurance firms, pension funds, government officials, and agencies that will:

Appendix 5 53

(i) provide an overview of the current state of the actuarial profession in Indonesia and its capacity to effectively support the insurance and pension sectors in the implementation of international best practices and standards;

(ii) outline issues constraining the growth of the profession; (iii) in consultation with relevant domestic and international industry associations,

identify areas for development in the actuarial education system in Indonesia to bring it in line with international standards; and

(iv) recommend practical options and incentives for increasing both the quantity and

quality of actuaries in Indonesia.

Appendix 6 54

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY AND POVERTY IMPACT ASSESSMENT

I. Summary Poverty Reduction And Social Strategy

A. Linkages to the Country Poverty Analysis Sector identified as a national Yes priority in country poverty analysis?

Sector identified as a national Yes priority in country poverty partnership agreement?

Contribution of the sector/subsector to reduce poverty in Indonesia: Significant weaknesses in financial governance lay at the heart of Indonesia's vulnerability to the recent crises and remaining weaknesses have slowed the pace of its recovery. Stronger financial governance will not only help reduce the likelihood and severity of future crises (and consequently help safeguard against corresponding marked increases in the incidence of poverty) but will also play a powerful, albeit indirect, role in poverty reduction through facilitating long-term economic growth. B. Poverty Analysis Proposed Classification: Growth Analysis: Financial sector development facilitates long-term economic growth by supporting productivity growth and stimulating savings and investment. Of these two channels, raising productivity is the chief way of promoting long-term economic growth. Financial sector development can raise productivity by (i) improving resource allocation, and (ii) strengthening the monitoring of resource usage. A key factor in supporting growth through this channel is the effectiveness of the legal, regulatory, and supervisory system in supporting financial sector efficiency. A well-governed financial sector can also stimulate growth and employment generation by increasing investor confidence and restoring the flow of much-needed investment capital to Indonesia. That growth is instrumental to poverty reduction is incontrovertible. Growth, however, is turbulent and not necessarily pro-poor. Growth entails change, which the poor may often not be well equipped to cope with. A well-governed financial sector that facilitates competition can help make growth user-friendlier by (i) improving access to savings, credit, and insurance instruments, which enable the poor to cushion shocks as well as take advantage of opportunities created by change, and (ii) allowing for better terms on those instruments. As noted above, a well-governed financial sector also reduces the likelihood and severity of financial crises. Balanced financial sector development can likewise promote financial system stability and strengthening by allowing risks to be more evenly spread among different types of financial institutions and spurring competition between them. In hindsight, one of the indications signaling Indonesia's vulnerability to the recent crises, may have been found in the heavily unbalanced structural composition of its financial sector—characterized by bank dominance and underdeveloped capital markets. Reducing the scope for regulatory arbitrage between different types of financial institutions can help promote balanced financial sector development and the establishment of a consolidated regulatory and supervisory authority can significantly facilitate this goal. Also, support for the development and strengthening of certain types of financial institutions (e.g., pension funds and insurance companies) can directly and markedly stimulate development of other types of financial institutions (e.g., capital markets) by generating demand for their products. The strengthening of social protection programs is also fundamentally interrelated with financial sector

development. The pension and insurance sectors play direct and key roles in provision of instruments for social protection. Their role, moreover, will assume increasing importance as reliance on family or indigenous systems of social security becomes less viable due to declining family size and increasing population mobility. Strengthening these sectors through improved regulation and supervision and where possible, through promoting competition, is fundamental if Indonesia is to develop an effective social safety net system.

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C. Participation Process Stakeholder analysis prepared Yes Participation strategy Yes D. Social Issues Subject

Significant, Nonsignificant, None

Strategy to Address Issues

Output Prepareda

Resettlementb None No negative impacts to be mitigated None Gender None No negative impacts to be mitigated None Affordability None No negative impacts to be mitigated None Labor Nonsignificant. There

may be some retrenchment/retraining associated with the establishment of a consolidated financial services regulatory and supervisory authority—the extent of this, however, is not anticipated to be major and will be further determined during the appraisal mission

Redundancy severance packages/ retraining programs as necessary

None

Indigenous People

None No negative impacts to be mitigated None

Other Risks/ Vulnerabilities

None No negative impacts to be mitigated None

a A plan will be required if any of the potential issues are found to be significant. b Significant involuntary resettlement requires a full resettlement plan; nonsignificant resettlement requires a short

resettlement plan.

II. Poverty Impact Assessment

A. Background

1. Poverty reduction relies on sustainable economic growth, good governance, and social development including social protection. This program loan promotes poverty reduction through all three channels. Sustainable economic growth is underpinned by a well-regulated and supervised financial system. This in turn requires good governance, a well-developed legal environment for regulation and institutional capacity for supervision, reduced opportunities for graft and corruption, and greater access to timely information by industry players. The Program supports reforms in the pension and insurance sector, and capital markets, enabling further potential contributions to growth. The Program supports the development of a national framework for delivering social protection and helps to improve the supervisory frameworks for pension and insurance firms that deliver services for the working population.

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2. About 35 million people or 37% of the labor force are in the formal sector. Of these, 15% are poor and another 15% are near poor.1 By 2001, 60% of the formal sector was covered by a mandatory state scheme, the main source of coverage for lower income classes and the working poor; however, compliance was less than 50%. 3. Private insurance supplements the state programs. In 2000, about 1.2 million employees were covered under employer pension funds, and financial institution pensions funds2 and insurance premiums had risen to Rp7.2 trillion. The demand for insurance for workers in the informal sector is growing. A number of insurance companies have programs targeting the lower end of the retail market such as pedicab drivers and sidewalk vendors. In general however, the lower end of the retail market is underdeveloped. Further expansion must be matched by adequate regulation, supervision, and enforcement to protect consumers against risk of insurance failure and mismanagement. B. Poverty Impact Assessment of the Program

4. Taken as a whole, the reforms to the financial sector proposed under this cluster loan are necessary steps toward strengthening the financial sector and developing a system of national social security. The measures to be undertaken under the first loan of the cluster are described in the four subsections below:

1. Consolidate Regulatory and Supervisory Authority

5. The program for strengthening existing financial sector regulation and consolidating financial sector supervision and regulation facilitates regulatory neutrality, reduces regulatory distortions, thereby promoting better allocation of resources to support growth. Including mandatory social insurance, programs under the authority will provide protection for the 25 million participants in core pension schemes and the more than 30 million participants in private sector insurance programs. Increased harmonization of standards in line with international best practices and greater efforts to increase compliance and enforcement with rules and regulations will lead to a more robust system and development of the financial sector, and reduce vulnerability to external shock. 6. The consolidation of regulatory and supervisory authority under a single roof under the second loan in the cluster is likely to require smaller staff numbers than under the current system. This will lead to either redeployment or retrenchment of staff emanating from Bank Indonesia and the Ministry of Finance, each with their own employment and separation rules. Part of the preparation for the establishment of the consolidated regulatory and supervisory authority for financial services (OJK), supported under TA 3850-INO: Establishment of a Financial Services Authority will include a further review of the potential labor impact and recommendations for an equitable process. The Government has represented that, although redeployment is expected, retrenchment is highly unlikely. It should also be noted that state employees engaged in regulation and supervision are not drawn from the lowest level of the civil service that comprises the vulnerable working poor, and past government reorganizations have resulted in redeployment rather than retrenchment.

1 Calculated based on the proportion of the workforce in the formal sector in the lowest and second lowest quintile

in 1999 (to be recalculated for 2000). 2 ADB. 2000. Indonesia Poverty Assessment. Manila.

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2. Establish an Effective Anti-Money Laundering Regime

7. Indonesia needs to continue to work to improve its anti-money laundering regime. Money laundering activities have their origins in graft, corruption, and other forms of criminal activity. These activities undermine the Government’s legitimacy as well as investor confidence. The development of an effective anti-money laundering regime will provide the Government with key tools in its fight against graft and corruption and is fundamental to strengthening market governance and investor confidence. Indonesia has been included in the Financial Action Task Force on Money Laundering’s (FATF) list of Non-Cooperative Countries and Territories (NCCT), and it needs to substantially comply with FATF recommendations to avoid countermeasures. The countermeasures would significantly impede the ability of financial institutions located in Indonesia and of Indonesian financial institutions located abroad to conduct international transactions. Imposition of countermeasures would have a disastrous impact on the country’s economic recovery. The loan will support the development of a legal framework and the building of institutional capacity necessary to implement an effective anti-money laundering regime.

3. Strengthen Financial and Corporate Governance

8. The Program will strengthen transparency and disclosure of market transactions and increase efficiencies. Corporate responsibility and accountability are promoted through requiring public companies to have independent commissioners and audit committees composed of a majority of independent commissioners, and imposing adequate liabilities on auditors and liability on commissioners for false or misleading public information and board decisions. Market stability is promoted through prudential safeguards such as increased capital requirements, enhanced rules of disclosure, and the adoption of an early warning system of financial exposure. These measures will increase public confidence and investor participation contributing to market liquidity and an expanded capital market to support growth.

4. Improve Pensions, Provident Funds, and Insurance, and Develop a National Social Security System

9. These reforms are intended to strengthen the supervisory framework and promote a sound system for social benefits, to improve the system for pensions and provident funds to provide adequate retirement income, and eventually to expand coverage to a wider segment of the population. Strengthening the capacity of institutional investors can deepen the capital markets and enable the expansion of the social protection system and the provision of basic public infrastructure. 10. The measures to be undertaken under this reform area include: (i) assessment and special audits of mandatory programs, (ii) strengthening regulatory and supervisory capacity, (iii) strategic restructuring of the pension and insurance sector, and (iv) development of a national social security law and policy framework for pension and insurance. 11. The Program supports assessment of unfunded liabilities of mandatory social insurance schemes, enabling preparation of financial options to reduce these liabilities and prevent unanticipated demands on the public budget. 12. Regulatory and supervisory capacities will be enhanced through measures to improve governance and timely disclosure of information regarding financial position, solvency, and ownership of insurance companies as well as establishment of minimum competencies and training for insurance and pension fund supervisors and examiners. Prudential safeguards and

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enforcement of capital-based requirements will also provide greater consumer protection by ensuring soundness of companies and their ability to meet obligations. 13. Development of a national social security law and policy framework for pension and insurance requires a comprehensive evaluation of existing laws and frameworks impacting pensions, insurance, and social protection. Such a law is required to ensure adequate system for social security in the future, but requires decisions with far-reaching implications regarding the role of the state and the private sector in providing social security and must be subject to discussion and debate. The Program supports a feasibility study addressing options for improving the current system and expanding access to the informal sector to support the drafting of a new law on social security. The Program further supports discussion of the draft law with a broad range of civil society. C. Poverty Impact Assessment Matrix

14. Taken as a whole, the Program is poor-neutral in its direct impact and indirectly pro-poor supporting the three pillars of ADB’s poverty reduction strategy, namely, pro-poor sustainable economic growth, good governance, and social development. A poverty impact matrix is shown for the overall Program as each component of the Program contributes to the same outcome.

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Table A6: Poverty Impact of the Program

Channel Indirect Impact on

the Poor—Medium Term Other Stakeholders Mitigation or Enhancement

Measures Labor Helps promote adequate retirement

income for the working poor through strengthening contractual saving schemes. Strengthens financial sector regulation and supervision, supporting economic growth and employment.

Increased corporate governance and improved monitoring reduce the possibility for market manipulation, fraud, and abuse. The cost of these financial crimes has a direct impact on business confidence, future investment, and consequently labor absorption.

Potential negative labor impacts resulting from consolidation of regulation and supervisory authority, if any, are likely to be small. These will be addressed under the technical assistance (TA) supporting preparation of establishment of the financial services authority (OJK).

Markets and Prices

Improved governance and financial soundness of mandatory social insurance schemes help reduce vulnerability to poverty for the working poor.

Greater investor confidence leads to greater capital formation increasing pool of funds for short-term and longer-term investment.

Expansion of social security system to informal sector will provide greater coverage for the working poor.

Harmonization of standards and strengthened governance can stimulate competition and lower prices for social insurance products making them more affordable to the poor.

Increased prudential standards and greater efforts to increase compliance and enforcement with rules and regulations leads to a more robust system thereby reducing vulnerability to external shock and price swings.

Access to Public Service

Strengthening regulation and supervision for contractual saving schemes can support sector development and increase the availability of long-term financing to support projects such as low-income housing and infrastructure development.

Net Impact Narrative

The direct impact of the Program is neutral with regard to the poor. The indirect impact is pro-poor. The actions taken under the Program will promote sustainable growth and enable a more robust and efficient financial sector where participants are better informed and protected. Improved governance in the capital market improves investor confidence and provides an alternative to the banking sector, thus reducing an over reliance on bank debt and the potential for external shock. Increased access to financial markets creates employment opportunities for skilled and unskilled labor, and increased opportunities for small businesses. Pension and insurance reforms enables workers (including the working poor) and their families to obtain contracted benefits and to provide greater protection in illness and old age, and in the event of the loss of a breadwinner. Increased transparency, stability, and supervision in financial markets increases the opportunities for local government, pension plans, and insurance schemes to raise funds and develop long-term investment and long-term savings instruments. This enables expansion of the provision of public services to the poor and improves the reliability of the social protection system.

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ENVIRONMENTAL IMPACT ASSESSMENT 1. The Program will not have any direct and immediate environmental impacts and it is expected that any indirect and long-term environmental impacts will be neutral.

Policy Actions Potential Environmental Impacts 1. Restructure and Consolidate Financial Sector Supervision and Regulation Strengthen existing regulation and supervision for the financial sector

Establish new consolidated supervisory and regulatory authority to harmonize supervision and regulation (Otoritas Jasa Keuangan or OJK)

Neutral

2. Strengthen Financial and Corporate Governance Establish a national corporate governance code and reform strategy Reform national company registration system under a decentralized framework Strengthen transparency and disclosure of market transactions and increase efficiencies through improved capital market infrastructure

Neutral

3. Improve Pensions and Insurance Sectors and Support Development of a Unified Social Security System Assess current financial condition and operations of mandatory programs Strengthen pension and insurance sectors through improved supervision and enforcement and strategic restructuring Develop a unified social security law and policy framework for pension and insurance

Neutral

4. Establish an Effective Anti-Money Laundering Regime

Neutral