Bank Indonesia, Financial Stability Review No 3, June 2004

This Financial Stability Review (FSR) is one the report Bank Indonesia provides

to public in order to achieve its mission ≈to achieve and maintain stability of the Indonesian

Rupiah through maintaining monetary stability and promotes on financial system stability for

safeguarding long-term and sustainable national development.∆

Published by:

Financial System Stability Bureau

Directorate of Banking Research and Regulation

Bank Indonesia

Jl. MT Thamrin No.2, Jakarta 10010

Indonesia

Information and Order:

This document was used data as of 30 June 2004, unless otherwise state.

This completed document is available at http//www.bi.go.id.

Any requests, comments and advises should be directed to :

Bank Indonesia

Directorate of Banking Research and Regulation

Financial System Stability Bureau

Jl. MT Thamrin No.2, Jakarta, Indonesia

Tel: (+62-21) 381 7990, 7353

Fax: (+62-21) 2311 672

Email: [email protected]

FSR issued biannually and has the following objectives:

- To foster public vision on financial system stability issues, both domestically and internationally;

- To analyze potential risks to financial system stability; and

- To recommend policies to relevant financial authorities for promoting a stable financial system

fsrFinancial Stability Review

No. 1, June 2004

iii

Foreword v

Executive Summary ix

Chapter 1 Overview 3

Chapter 2 Development of International & Domestic

Economies 7

1. Development of International Economy 7

2. Development of Domestic Economy 9

3. Development of the Real Sector 12

Box 2.1: Potential Pressures on Several Industries due to

Oil Price Hikes 16

Chapter 3 Indonesia»s Banking Industry 21

1. Structure of Banking Industry 21

2. General Picture of Banking Industry 21

3. Credit Risk 22

4. Liquidity Risk 29

5. Market Risk 34

6. Operational Risk 37

7. Profitability 39

8. Capital 41

9. Directon of Banking Policies 43

9.1. Indonesian Banking Architecture 43

9.2.Rural Bank (BPR) 44

9.3.Sharia Banking 45

Box 3.1: Financial Safety Net 46

Chapter 4 Non-Bank Financial Institutions 49

1. Condition of Insurance Industry 49

2. Development of Pension Fund Industry 50

Box 4.1: Cases of Bankruptcy Pronouncements of

Insurance Companies : PT. Prudential Indonesia

dan PT. Manulife Indonesia 51

Contents

Chapter 5 Capital and Money Markets 55

1. Stock Market 55

2. Development of Bond Market 57

2.1.Corporate Bonds 57

2.2.Surat Utang Negara 58

3. Development of Mutual Funds 59

4. Money Market 60

Box 5.1: Oversubscribed Foreign Currency Bonds:

Momentum of Rising Foreign Confidence 62

Chapter 6 Payment System 65

APPENDIX

1. Table 1. Balance of Payment 71

2. Table 2. Macroeconomic Indicators 71

3. Table 3. State Budget 72

ARTICLES

1. Analysis of Foreign Bank»s Role in Enhancing

Indonesia»s Real Sector Recover 75

2. The Model To Predict Bankruptcy for Commercial

Banks in Indonesia 95

3. An Analysis in respect of the Behavior of Investment

Managers in Facing Uncertainties 115

iv

List of Table and Chart

Table

2.1. GDP of Major Trading Partners

2.2. GDP of Some Asian Countries

2.3. Export Performance of Some Major Industrial Countries

2.4. Euro and Yen Exchange Rates Against USD S1-2004

2.5. Exchange Rates of Asian Currencies Against USD

Chart Box 2.1 Loan Classification of Airline Industry - July

2004

3.1. Earning Assets

3.2. Loans by Group

3.3. Loan to Deposit Ratio

3.4. NPL of Consumer Loan

3.5. New Disbursed Loan 2002, 2003, 2004

3.6. Undisbursed Loan by Sector

3.7. Undisbursed Loan by Usage

3.8. NPL Gross and Net

3.9. NPL to Capital

3.10. NPL of ASEAN Countries

3.11. Stress Test of NPL - June 2004

3.12. Loan by Sector

3.13. NPL by Sector - June 2004

3.14. NPL by Agriculture, Mining and Manufacture

3.15. Foreign Loan by Group - June 2004 (%)

3.16. Liquidity Ratio

3.17. Deposits Ownership

3.18. Interbank Offering Rates QII-2004

3.19. Composition of Deposits among Large Banks

3.20. Stress Testing of Exchange Rate

3.21. Interest Rate Stress Testing

3.22. Net Open Position to capital of Large Banks

3.23. Composition of Interest Income of Large Banks

3.24. Composition of Interest Income of All Banks (2003-

2004)

3.25. Net Interest Income Trends (Excl. Interest Income from

Securities)

3.26. Trend of ROA (Peer Group Comparison) - June 2004

3.27. Distribution of ROA - June 2004

3.28. Efficiency and Overhead Cost Ratios - June 2004

3.29. Fee Based to Total Operating Income Ratios

3.30. CAR - June 2004

3.31. Distribution of CAR

3.32. Tier 1 to Total Asset Ratio - June 2004

4.1. Government Bond Ownership

5.1. Equity Index and Market Capitalization

5.2. Volatility of Equity Index

5.3. Equity Index and Transaction of Foreign Investors

5.4. PER of World Stock Exchanges

5.5. Equity Index of Financial Corporations

5.6. NAV per Type of Mutual Funds

5.7. Composition of NAV per Type of Mutual Funds

5.8. Trend of Domestic Interest Rates

5.9. Spread of Interest Rates

6.1. Volume and Value of Real Time Gross Settlement

6.2. Volume and Value of Clearing Settlements

6.3. Real Time Gross Settlement System Transactions

2.1. Repayment Plan of Indonesian Offshore June -

December 2004

2.2. Simulation of Debt Equity Ratio of 3 Major Group of

Companies

2.3. Outstanding and Growth of Loans to Small Scale

Business

3.1. NPL by Nominal

3.2. NPL By Bank Group

3.3. 25»s Top Debtors (25 TD)

3.4. Loan Restructuring

3.5. Bank Funding & Placement Structure

3.6. Development of Deposits and Net Asset Value (NAV)

3.7. Deposits and Core Deposit Ratios

3.8. Interbank Money Market

3.9. Interbank Rates

3.10. Deposits Permaturity Bucket

3.11. Exchange Offer

3.12. Fraud Cases in Banks

Table Box 4.1 Fiancial Highlights of Prudential Life Assurance

(Indonesia)

5.1. Corporate Bonds

5.2. Auctions of Government Bonds

Table Box 5.1 Long-term Foreign Currency Bonds of the

Republic of Indonesia

Chart

v

One of the roles of Bank Indonesia is the maintainance and stability of the national currency. To meet the

objective, Bank Indonesia undertakes routine enhancement actions and continually monitors factors that influence

domestic financial stability. Results of our monitoring and assessment are presented in the bi-annual Financial

Stability Review.

During the first half of 2004, Indonesian financial system was stable and we expect continued stability

throughout 2004. Notwithstanding, potential internal and external challenges that could pose greater risks to

Indonesian financial system remain threatening. Several positive signs occurred during the first half of 2004,

rising international confidence as evidenced by oversubscriptions in Indonesian international bonds sales, Indonesia’s

improved ratings, and high foreign investors’ interest in buying Indonesian financial products. Within the country,

the legislative and presidential elections went smoothly helping maintain public confidence in the recovery of

the Indonesian economy.

There are still several national challenges, however, such as the real sector that has not fully revived, weak

enforcement of sound administrative practices and laws. Immediate measures have to be made to pull out Indonesia

from prolonged crisis and and therefore become a respected, prosperous country. Considering the broad scope of

efforts required to achieve financial system stability, the development and maintenance of financial stability requires

joint responsibility of the related authorities and stakeholders. This review is expected to provide useful information

to our various stakeholders in conducting their respective roles for more stable economy. We want to express our

highest appreciation to those whose contributions in completion of this review improved the quality of the review

along with sharper analyses.

In closing, we welcome any suggestions, comments or critiques from all stakeholders to enhance the quality

of this review in the coming periods.

Jakarta, June 2004

Maman H. Somantri

Deputy Governor

Foreword

vii

Executive Summary

ExecutiveSummary

viii

Executive Summary

ix

Executive Summary

During the first half of 2004, the Indonesian financial

system was reasonably stable. However, at the end of the

semester, there was potential for rising risk exposures

largely prompted by a slight depreciation of the rupiah

and a modest inflation increase. The success of general

election on 5 April 2004 helped contribute to the

improvements in public confidence and business activities

in Indonesia.

The economies of Indonesian trading partners, such

as the US, Japan, and ASEAN countries, were stable during

semester I/2004. This is expected to continue into the

next period. However, there is an uptrend of the Federal

Funds rates, which could change global market conditions.

Also, competition with exports from China needs to be

closely watched in the coming periods.

The changes of economic indicators did not create

serious consequences on the financial sector, particularly

the banking sector. Financial and operational performances

of banks as the most dominant player of Indonesian

financial was reasonably stable and adequate, despite a

slight drop in CAR, stemming from increases in number of

loans granted.

Programs for implementation of the Indonesian

Banking Architecture, preparation for implementation of

international standards (best practices), including Basel 2,

as well as Bank Indonesia»s strong commitments to

implement sound risk management principles within the

banking industry have contributed to maintaining public

confidence on the Indonesian banking industry.

Loans grew quite rapidly by Rp51.5 trillion (10.8%),

or 93.8% of banks» business plan for semester I/2004

accompanied by a modest rising of NPLs. NPLs actually

trended downward, however, this was more due to quite

large rise in loans. In the short-to-medium term, it is

predicted that credit risk would have a slight upward trend,

largely prompted by rising interest rates and the remaining

sluggish real economy.

In addition, market risk remained stable despite the

rupiah depreciation since April 2004. The measures of

Bank Indonesia to minimize the excess liquidity has

boosted the strength of the rupiah. In addition, results of

stress tests show that capital of the major banks stays

robust should the rupiah depreciates up to Rp2,500/USD.

As banks converted bonds and SBI, profitability of

banking industry started to rise in line with growth of loans.

Consequently, ROA and NII also improved from 2.5% and

Rp3.2 trillion in December 2003 to 2.7% and Rp5.4 trillion

as of June 2004. However, potentials for increases in

interest rates and credit risk must be carefully watched by

bank management in order to maintain and increase their

abilities to earn revenues and maintain adequate capitals.

Cases of fraud in the banking sector also need special

attention, considering that its frequency has relatively

increased, particularly in the period 2003/2004. As such,

there is a need for early detection approach and effective

law enforcement to prevent the recurrence of similar

incidents in the future.

Capital markets became relatively more sensitive as

reflected by the downward trend of the composite index

since April 2004 while it previously experienced a rise since

end-2003. This has boosted an upward shift in investment

to lower-risk portfolios such as mutual funds with

underlying government bonds and bank deposits that are

fully guaranteed by the government. This condition is

Executive Summary

x

Executive Summary

reflected by rising net asset value (NAV) of Rp16 trillion

(23.2%) to Rp85 trillion.

In addition, the payment system, operating both

through the BI-RTGS system as well as the clearing system,

stayed robust. During the first semester, daily average

transaction value of BI-RTGS system has dropped by

Rp49.7 trillion (- 35.9%), while that of the clearing system

has increased by Rp4.6 trillion (92.3%). Nevertheless, the

role of the clearing system is relatively smaller than that of

the BI-RTGS, at only 0.02% of BI-RTGS daily average value.

Supervision of the BI-RTGS system continuously

strengthen, particularly for ensuring the operational safety

of the system, both on the operators as well as the

participant side. Supervision of the BI-RTGS system safety

on the participant side is also aimed at minimizing the risk

of fraud.

Going forward, Bank Indonesia will intensify

supervision over card-issuing institutions with the objective

to ensure a safe and efficient payment system and to

examine consumer protection aspects.....

1

Overview

Chapter 1O v e r v i e w

2

Overview

3

Overview

Risks to Indonesia»s financial system stability, and that

of several of its major trade partner countries and other

ASEAN countries, are moderating in the short-term.

However,a rising interest rate environment at a time of

relatively high levels of bank credit and domestic

government debt would have the potential to increase

market and liquidity risks.

In general, Indonesia»s financial institutions and

markets, particularly banks, remain sound and growing.

Problems, risks, and mitigation of risks will be discussed in

more detail in this financial stability review.

International economies have improved in the first

half of 2004 as evidenced by rising GDPs of the US,

countries in the Euro region, and Japan. However, this

opportunity has not been optimally seized by Indonesia as

reflected by the low rise in Indonesia»s non-oil/gas

international trade volume.

In addition, the domestic condition is susceptibile to

an increasing state budget deficit and pressures on several

of Indonesia»s largest foreign currency contributing

commodities, such as textiles and textile products, footwear

products, wood-based products, paper products, etc.

However, economic growth is predicted to continue with

the support from the consumption sector and productions

from micro, small, and medium businesses.

Major risks to Indonesia»s banking industry, such as

credit, liquidity, and market risks were relatively under

control. However, in the coming few periods, it is predicted

that credit and market risks would rise again due to high

uncertainty stemming from less supportive domestic

economic condition and pressures coming from

international factors, namely rising global interest rates

and oil price hikes.

Meanwhile, banking operational risk is still quite high.

This is evidenced by the few incidents of fraud that have

occurred at several banks. This high level of risk results

from weak internal controls and loosely applied good

corporate governance. Bank Indonesia has taken follow-

up actions on violations in the banking sector through

cooperation with related authorities and the issuance of

enforcement orders dealing with bank risk management

practices, including operational risk management.

Improvements in the Banking sector is evidenced by

rising profitability resulting from credit expansion that

began in the beginning of 2004. ROA rose from 2.5% to

2.7%, while NII rose from Rp3.2 trillion to Rp5.4 trillion.

However, there were still many national banks with ROA

far below 1.2% (28 banks) due to relatively low efficiency

levels, particularly in state banks.

Meanwhile, the downward trend of interest rates

during semester I has lowered the profits of non-bank

financial institutions, particularly insurance companies and

pension funds. However, the potential rise in interest

rate in the post-semester I period and expanded business

opportunities resulting from new financial product

offerings provides for potential improvement in

profitability.

The capital market as an alternative source of

financing has shown quite encouraging performance.

However, it is predicted that a weak performance of world

bourse, the potential for rising interest rates and payment

failures (defaults) on the part of several large companies

in the Asia Pulp and Paper group (PT Tjiwi Kimia, PT Indah

Kiat, PT Lontar Papyrus and PT Pindo Deli) and Mulia group

(PT Muliakeramik Indahraya and PT Muliaglass) could

deteriorate investors» confidence. Meanwhile, the surat

Chapter 1O v e r v i e w

4

Overview

utang negara/SUN (government bond) market condition

is still growing positively and liquid, despite having

experienced sales cancellations for two consecutive months

and the existence of high potential for refinancing risk in

a state budget condition that is more burdened.

Efforts to support financial system stability,

particularly regarding the realization of a safe and reliable

payment system , are continuously undertaken. Control

over risks within the payment system, both settlement and

operational risk, is implemented in line with international

standards (best practices). In addition, institutions that issue

credit cards, debit cards, and ATM cards will be supervised

to ensure that the payment system remains safe and

efficient and the customer is protected

A bankruptcy prediction model for individual

commercial banks and banking groups operating in

Indonesia, based on their financial reports has been

developed. Results of statistical analyses show that this

model is effective in predicting bankruptcy three months

ahead of the occurrence.

In addition, research has been conducted on the

role of foreign banks in the recovery of intermediation,

particularly in credit channeling. Results of this research

confirm that currently foreign banks» activities are more

focused on activities that earn fee based income, credit

channeling to the consumption sector, and placement of

funds in marketable securities. Data also show that foreign

banks give priority to non-credit incomes (42.1%) and that

their ROA (0.29%) has a negative correlation with credit

growth.

In relation to the realization of financial stability on

the capital market side, a review has been made on

investment manager»s behaviors through the

implementation of progressive incentives in order to increase

the financial industry»s competitiveness. However, this needs

to be undertaken cautiously in order to prevent fraud.

5

Chapter 2 Development of International & Domestic Economies

Chapter 2Development of International& Domestic Economies

6


7


Opportunities that came with improving international

economy in the first half of 2004 have not been optimally

seized by Indonesia. This is evidenced by relatively low

increase in Indonesia»s international (non oil/gas) trade

volume, which stemmed from supply problem such as

structural problem and weak competitiveness of Indonesia»s

industry sectors that produced prime export products.

1. DEVELOPMENT OF INTERNATIONAL ECONOMY

During semester I/2004, world economy still

experienced quite high growth (Chart 2.1) although it was

overshadowed for a while by a worry over rising uncertainty

that has risen from several geopolitical problems such as

heightening political condition in the Middle East.

Economies of advanced countries such as the US and

Britain still showed quite high growth, largely supported

by rising domestic demand. Meanwhile, in the Euro region,

domestic economic performance was still moving slowly

and as such economic growth in that region was more

supported by external sector performance. In the particular

case of Japan, significant improvement in economic

performance occurred both on the external side as well as

on the domestic side.

Economic growth of advanced and Asian countries

has given positive influence on Indonesia»s exports as

evidenced by Indonesia»s export performance that was still

rising, particularly oil and gas exports. However, it has to

be realized also that Indonesia»s rising oil and gas export

performance was also much influenced by rising

international oil prices. Considering the volatile trend of

oil prices, Indonesia»s oil and gas industry sector should

increase efforts to raise production volume, which would

make institutions that finance this sector feel more secured

because their debtors» revenue source would be more

certain.

Chapter 2Development of International & Domestic Economies

Chart 2.1 GDP of Major Trading Partners

% y-o-y

Source : Bloomberg

USA

EU

Japan-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

2000 2001 2002

I II III IV I II III IV I II III IV I II III IV I II

20042003

Chart 2.2GDP of Some Asian Countries

% y-o-y

-10.0

-5.0

0.0

5.0

10.0

15.0

Source : Bloomberg

2000 2001 2002 20042003I II III IV I II III IV I II III IV I II III IV I II

MalaysiaKorea Singapore China Thailand

Indonesia»s major export destination countries in

semester I/2004 was still dominated by Japan with total

export value of USD3,796.9 million (15.82% of total non-

oil/gas exports), followed by the US with total value of

USD3,601.6 million (15.01%), Singapore with total value

of USD2,467.6 million (10.28%), and China with total

8


value of USD1,382.6 million (5.76%). On the other hand,

Indonesia»s largest non oil/gas imports came from Japan

with total value of USD2,504 million (16.22% of total non

oil/gas imports), followed by the US with total value of

USD1,510.9 million (9.78%), China with total value of

USD1,421.4 million (9.21%), and Singapore with total

value of USD1,094.1 million (7.09%).

In several Asian countries, the growth rates of their

trades with other countries were still rising, as reflected

by indicators of export-import activities in several

countries (Chart 2.3). Meanwhile, China»s policy package

to solve the overheating of its economy has started to

show influence, particularly in the decline of its

international (export-import) trade activities. For

Indonesia, China»s economic slowing policy has not

shown influence in semester I/2004. This is evidenced

by non oil/gas exports that still rose by 8.4% relative to

the same period in 2003, while non oil/gas imports rose

by 30.9%. However, adoption of above policy by China

would make it difficult for non oil/gas exports to that

country to expand, which currently have only reached

5.76% of Indonesia»s total non-oil/gas exports (compared

to Japan, the US, and Singapore each with a share of

15.82%, 15.01% and 10.28%). For certain industry

sectors that are looking for alternative export markets

other than the US, this situation poses a heavy challenge.

Financing institutions/banks also need to pay close

attention to this phenomenon.

Expanding global economic activities and rising oil

and gas and non-oil/gas commodity prices have prompted

expanding demand, which has accelerated the rise of

inflation in several countries. Inflation rate in advance

country group went up from 1.5% (yoy) in semester II/

2003 to 1.9% (yoy) in semester I/2004.

These expanding economic activities have been

followed by an uptrend of interest rates in the international

money market, which has been prompted by similar trend

in advanced countries (except Japan). Meanwhile, offered

interest rates in Asian countries were relatively stable. In

the international stock market, shares recovered after

experiencing a drop for a while as uncertainty regarding

US economy lessened and optimism regarding improved

profits for corporations in the US rose. In addition, in the

foreign currency market, the strengthening trend of the

US dollar exchange rate, which was related to expectation

over acceleration of US economic growth followed by

expectation over the rise of Fed Fund interest rate, was

only temporary. The US dollar weakened again because

market players considered that the US economy was still

in a big problem in the short-term, largely due to existing

twin deficits (US deficit in trade transactions and fiscal

deficit). In addition, crude oil price hikes also put pressure

on the US dollar exchange rate. Fundamentally, oil price

hikes occurred because the need for crude oil was larger

than its supply, which was quite disrupted by the crisis in

Iraq and problem in the world second largest oil company,

Yukos.

From the sentiment side, these oil price hikes were

related to speculative activities on oil amidst uncertainties

over the plan to reduce OPEC oil production quotas, oil

company labor strikes in Venezuela, political fighting in

Nigeria and Middle East, as well as information on low

Chart 2.3Export Performance of Some Major Industrial Countries

Source: Interntational Financial Statistics, (processed)

Jan2 0 0 2

% y-o-y

USA Japan

U K Germany-20.00

-10.00

0.00

10.00

20.00

30.00

40.00

Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May2 0 0 3 2 0 0 4

9


fuel reserves in several advanced countries, particularly the

US and Europe.

This condition has had negative influence for

Indonesia, which currently is a net oil importer. It would

raise fuel subsidy cost and as a result would increase

state spending in the state budget. In the end, it would

have the potential to expand Indonesia»s state budget

deficit. Meanwhile, financial institutions need to give

close attention to potential interest rate increases due

to quite large pressure on the rupiah as a result of this

condition. In addition, they also have to be cautious in

financing projects that are much influenced by oil prices.

Oil price hikes have the potential to raise production

cost, which in turn will have the potential to threaten

the sustainability of these projects. Financing of export-

oriented businesses with exports to countries that are

very much dependent on oil imports also need to be

closely watched. Oil price hikes could have an impact

in slowing down these countries» economic growth and

reducing their imports.

International capital flows to developing countries,

including Indonesia, experienced outflows for a while due

to the issue on Fed Fund interest rate rise. During the first

few weeks in semester I/2004, outflows that occurred in

developing countries reached USD124 million. However,

those capitals are predicted to have returned in line with

lessening expectation over US economic recovery in the

short-term.

2. DEVELOPMENT OF DOMESTIC ECONOMY

On the side of balance of payments, current

transactions in semester I/2004 recorded a surplus of

USD659 million, lower than USD3.6 billion in the same

semester in 2003 (Table Indonesia»s Balance of Payments,

Appendix 2.1). This drop in surplus was prompted by

import rise (14.2%) being larger than export rise (1.1%),

particularly oil and gas import rise.

During semester I/2004, the rupiah exchange rate

experienced depreciation compared to the previous period,

along with rising volatility. Up to end of June 2004, the

average rupiah exchange rate has reached Rp8,733/USD,

or slightly above the beginning estimated range of

Rp8,200/USD √ Rp8,700/USD.

Meanwhile, in June the rupiah exchange rate reached

its lowest of Rp9,486/USD for a while. This depreciation

in general was spurred by external and domestic factors.

The external factors were the spill over impact of US dollar

strengthening, which was related to expectation over Fed

Fund interest rate rise and acceleration of US economic

recovery, as well as regional sentiment over China»s

economic slowing, all of which were overreacted by

domestic market players. This attitude has dampened the

Chart 2. 4Euro and Yen Exchange Rates Against USD S1-2004

JPY/USD

JPY/USD (right axis)USD/EUR (left axis)

Source: Bloomberg

USD/EUR

1,1200

1,1400

1,1600

1,1800

1,2000

1,2200

1,2400

1,2600

1,2800

1,3000

1-Jan 21-Jan 10-Feb 1-Mar 19-Mar 8-Apr 28-Apr 18-May 7-Jun 25-Jun98

100

102

104

106

108

110

112

114

116

2 0 0 4

Chart 2. 5Exchange Rates of Asian Currencies Against USD

IDR,KRW/USD THB,PHP/USD

Source: Bloomberg

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

33

38

43

48

53

58

1-Jan 21-Jan 10-Feb 1-Mar 19-Mar 8-Apr 28-Apr 18-May 7-Jun 25-Jun

THB/USD PHP/USDIDR/USDKRW/USD

10


prompted the formation of public expectation over rising

inflation. If this inflationary pressure persists, it will have

an impact in raising interest rate. As a consequence,

interest rates of credits and domestic bank deposits would

rise. This would make credit channeling more difficult

and the real sector movement would become slower.

Weakening trend of rupiah exchange rate and rising

inflation expectation have prompted a slowing in the

acceleration of SBI interest rate decline, which made SBI

interest rates relatively stable in the last two months.

During semester I/2004, average interest rates of 1-month

and 3-month SBIs came to 7.57% and 7.49%, lower than

11.51% and 11.66% in semester I/2003. Fed Funds

interest rate increase of 25 bps in June 2004 does not

seem to have influenced domestic interest rate

development yet. However, it is predicted that in the

coming period it would influence domestic money market

condition, which would be reflected in the rise of interbank

money market interest rate. The prediction is even stronger

as US interest rate increase is predicted to continue in

several stages.

On the side of state budget realization in semester I/

2004, domestic currency decline against US dollar and

rising trend of crude oil prices in the international market

have influenced realization of state budget aggregates and

made several basic assumptions, used as references in the

calculation of state budget realization, become no longer

valid. This situation has the potential to raise state budget

deficit and as such revision on state budget cannot be

avoided.

State receipt in semester I/2004 came to Rp144,783.3

billion or 41.4% of state budget target. Meanwhile, tax

receipt for the same period reached Rp118,909.2 billion

or 43.7% of state budget target, with the main sources

being non oil/gas income tax and value-added tax.

On the side of state spending, in semester I/2004,

there has been a rise in government spending in relation

positive sentiment arising from improvement on Indonesia»s

foreign debt rating.

In May 2004, Standard and Poors has raised

Indonesia»s sovereign rating outlook from stable to positive

while Japan Credit Rating Agency (JCRA) has also raised

Indonesia»s ratings on long-term currency senior debt as

well as long-term local currency senior debt from B to B+.

Meanwhile, in June 2004, Japan»s rating institution Rating

& Investment raised Indonesia»s long-tem debt rating from

B- to B with stable outlook.

Domestic factor also contributed in putting pressure

on rupiah exchange rate through negative market

sentiment at the approach of the general election. In

addition, negative market sentiment was also influenced

by the bandwagon effect from the rupiah exchange rate

weakening, which was evidenced by rising foreign currency

demand by corporations for import financing, foreign

obligations, in addition to speculative motives.

In the framework of reducing pressures on the

rupiah, Bank Indonesia has issued an economic

stabilization policy package, which covers three aspects.

The first aspect covers controlling policy on the side of

rupiah liquidity by way of absorption of the banking

sector»s excess liquidity that has not been utilized by the

real sector. This is achieved through activation of 7-day

Bank Indonesia Deposit Facility and increase in minimum

reserve requirement for banks. The second aspect covers

enhancement of bank prudential requirement on foreign

currency net position. The third covers increased

monitoring on foreign currency demand.

During semester I-2004, CPI inflation reached 6.83%

(yoy), up from 6.62% (yoy) in the same period last year.

In general, the rise in inflation was prompted by the rise in

telephone tariffs, declining supplies of a number of

commodities that are classified as volatile food due to

seasonal factor, as well as influence of exchange rate

weakening. Combination of these three factors has

11


to government policy to give 13th month salaries to civil

servants, members of the Arm Forces/Police, retired civil

servants, and government officials, which were paid in

June 2004, foreign debt interest payments, and other

routine spending related to the cost of holding the general

election. In addition, realization of fuel subsidy reached

Rp8,773.2 billion or 60.4 % of its ceiling in the 2004 state

budget, which was primarily influenced by high realization

of crude oil prices. This realization of fuel subsidy in

semester I/2004 was much higher compared to semester

I/2003 when it reached Rp3,852.9 billion. Development

spending also experienced a slight rise, particularly due to

rupiah financing. Realization of total state spending in

this semester reached Rp163,337.3 billion or 43.6% of

2004 state budget target.

With above developments, semester I/2004 brought

a deficit of Rp18,553.9 billion (3.3% of GDP or 76.0% of

state budget target), which was primarily financed from

the balance of the government account at Bank Indonesia,

particularly investment fund account, yields from

government shares privatization, sales of assets under the

bank restructuring program, and net yields of issuance of

surat utang negara/SUN.

Meanwhile, decline in oil production and increase in

domestic fuel consumption along with rising international

oil prices have the potential to raise deficit. Of course,

rising state budget deficit would have negative influence

for Indonesia because it would lower investors» confidence

in Indonesian government capability to finance that deficit

rise. Further impact would be negative sentiment, which

would bring pressure on the rupiah exchange rate and in

the long-run could also lower Indonesia»s foreign debt

rating.

Indonesia»s foreign debt payments up to May 2004

have reached USD2,142 million, comprising payments on

principals and interests amounting to USD1,900 million

and USD241 million, respectively. Of the total, USD569

million was for government foreign debt payments and

USD1,572 million was for private foreign debt payments.

Of total private foreign debt payments, USD1,195 million

was for financial institutions» foreign debt payments (for

banks amounting to USD1,184 and for non-banks

amounting to USD11 million). The remaining balance of

USD377 million was for non-financial institution foreign

debt payments. These foreign debt payments influenced

the weakening of rupiah exchange rate for a while due to

quite large demand for dollars for the need of these

payments. However, weakening of rupiah exchange rate

was not such that it has endangered Indonesia»s banking

financial condition.

Planned 2004 payments on Indonesia»s foreign debts

(June up to December 2004) are projected to reach

USD16,523 million, comprising payments on principals and

interests in the amounts of USD13,102 million and

USD3,421 million, respectively. Of the total, payments on

government foreign debts are projected to reach USD6,005

million, comprising payments on principals and interests

in the amounts of USD3,969 million and USD2,036 million,

respectively. This payment plan needs to be scheduled

cautiously in order to avoid excessive demand for the dollar

at the same time, which would bring pressure on the rupiah

exchange rate.

Table 2.1Repayment Plan of Indonesian Offshore

June - December 2004

T y p e

*) Marketable securities own by non residentSource: Bank Indonesia

(USD million)

Principal Interest Total

A. Government Debt 3,969 2,036 6,005B. Private Debt 7,965 1,385 9,350

b.1. Financial Institution 1,699 93 1,792Bank 1,142 41 1,183Non Bank 557 52 609

b.2. Non Financial Institution 6,266 1,292 7,558

C. Securities *) 1,200 0 1,200

T o t a l T o t a l T o t a l T o t a l T o t a l 13,13413,13413,13413,13413,134 3,4213,4213,4213,4213,421 16,55516,55516,55516,55516,555

12


this oil price increase has the potential to raise state budget

deficit and companies» production cost, such as airline

companies (see box), with a possibility of threatening the

sustainability of these companies» businesses.

Meanwhile, import value in semester I/2004 rose by

27.2% compared to the same period in 2003. This rise

was brought about by the increases in oil and gas imports

by 36.47% and non-oil/gas imports by 24.5%. Import

growth, which was quite high and exceeded that of

exports, prompted the trade account to drop by 23.8% in

the months of January √ May 2004.

In addition, foreign currency reserve during the period

May √ June 2004 dropped by US$1.9 billion due to among

others payments on foreign debts and Bank Indonesia»s

foreign currency interventions. However, in the month of

June 2004, foreign currency reserve position was still quite

high, reaching US$34.9 billion or equivalent to around 6

months of imports and foreign debt payments. Such level

of foreign reserve was still considered to be safe by investors

as evidenced by the ability of Indonesia to obtain foreign

debts and the existence of foreign investment inflows to

Indonesia.

3.1 Impact of Changes in Exchange Rates On

Corporate Payment Capability

Results of a simulation of exchange rate changes on

debt to equity ratios (DERs) of three large groups show

that DERs of these groups have the potential to worsen

prompted by assumed exchange rate changes. The main

factor for this potential is the fact that each business group

debt structure is still dominated by foreign currency debts,

which are accompanied by relatively low export share in

total sales. Part of their foreign currency debts has been

obtained from national banks. The potential worsening

of these three group»s DERs indicates a potential danger

to the national banking industry and financial system

3. DEVELOPMENT OF THE REAL SECTOR

Indonesia»s economy in semester I/2004 grew 4.66%

(yoy). This growth was still dominated by consumption

activities, while investment and export activities had yet

to gain larger roles. This situation was brought about by

rising public purchasing power as well as availability of

various easy financing facilities. Meanwhile, rupiah

exchange rate weakening has not lowered consumer

expectation of the economy.

Easing in financing by financial institutions was

evidenced by quite active offers for consumer credit

products, which in the end bolstered rapid consumption

credit growth during the reporting period. During semester

I/2004, investment activities (formation of gross domestic

fixed capital), which had occurred since quarter III/2003,

have not shown optimal performance. In the last few

periods, the real sector seemed to start reviving as an

impact of improving economic stability and rising market

confidence over Indonesia»s better economic prospects in

the coming periods. This is reflected by rising approvals

for domestic capital investments by 34.1% from January

√ July 2004 compared to the same period the year before

while foreign capital investment dropped by 33.6%.

However, several investment activity indicators have not

shown satisfactory performances, as reflected in the decline

in capitalization value of the corporate bond market during

semester I/2004 by 38.8% compared to the same period

the year before.

Export performance in semester I/2004 recorded a

growth of 3.14% relative to the same period in 20031 .

This growth originated in the increases of oil and gas

exports by 6.29% and non-oil/gas exports by 2.21%. Oil

and gas export rise was prompted by the increases in crude

oil and natural gas exports, while, in contrast, oil product

exports dropped. In addition, although daily level of oil

production dropped, the rise in oil and gas exports was

influenced by the rise in international oil price. However, 1 Source: BPS-Statistic Indonesia

13


stability that might come from these groups» lessening

repayment capability.

Under the assumption that the rupiah exchange

rate against USD would become Rp11,000, results of

the simulation show that the Sinar Mas group would

face the largest potential DER decline, from 2.7x to 3.3x

or a drop of 21.2%. This is largely due to the fact that

59% of the groups» debt composition as of December

2003 is dominated by foreign currency debts. Basically,

this group has the potential to adapt to exchange rate

fluctuations, considering that their export sales give

58.94% contribution to total sales. However, the

existing foreign currency debt structure would bring

heavy pressure on this group in its efforts to immediately

raise its income in the short-term to be used for settling

its obligations.

Table 2.2 Simulation of Debt Equity Ratioof 3 Major Group of Companies

AstraAstraAstraAstraAstra 1.21.21.21.21.2 1.21.21.21.21.2 1.21.21.21.21.2 1.31.31.31.31.3 1.31.31.31.31.3 1.31.31.31.31.3

IndofoodIndofoodIndofoodIndofoodIndofood 2.62.62.62.62.6 2.62.62.62.62.6 2.72.72.72.72.7 2.82.82.82.82.8 2.82.82.82.82.8 3.03.03.03.03.0

Sinar MasSinar MasSinar MasSinar MasSinar Mas 2.72.72.72.72.7 2.82.82.82.82.8 2.92.92.92.92.9 3.03.03.03.03.0 3.13.13.13.13.1 3.33.33.33.33.3

8,465 9,000 9,500 10,000 10,500 11,000Assumptionof USD/IDR

Source : The related company»s publicized financial report (processed)

in their automotive products, which are the main engine

of the Astra group»s businesses.

The banking industry needs to well anticipate the

potential worsening of DERs as shown by results of this

simulation, which uses an assumption of weakening rupiah

exchange rate. Otherwise, this condition has the potential

to spur these groups» worsening repayment capability,

which in turn would raise banking industry»s non-

performing loans.

3.2 Textiles and Textile Products Industry

One of the industry subsectors that has experienced

quite serious problems is the textiles and textile products

(TTP) industry. Since 2003, credits extended to this industry

have been declining. There are banks that even have

classified the TTP industry into the negative list because

this industry is considered to be an industry that is going

down (sunset industry), with high risk (its debts are

susceptible to becoming non-performing) and not so good

prospects. There are several factors that have influenced

banks» evaluation. First, the TTP industry, which exports

have once been one of the largest foreign currency

contributors for Indonesia, is facing heavy threat because

it has to compete with cheaper TTP products from China

and it has to survive despite the revocation of export quotas

by the European Union, US, and Canada starting 1 January

2005 as part of WTO agreements. Second, the slow down

of the TTP industry also stems from unclear regulations

and labor problems. Third, banks consider the TTP industry

complicated and that it requires special skills to enter this

business due to its specific characteristics. In addition, its

competitiveness is diminishing against China or Vietnam,

who are more aggressive and able to produce cheaper

products.

The main factor that has made Indonesia»s TTP

industry loose in competition against neighboring

countries» products is the fact that the industry»s

The second potential DER decline would occur in the

Indofood group, from 2.6x to 3.0x or a decline of 15.4%.

However, this group would face heavier challenge because

its exports share of total sales is only reaching 17.46%. In

order to reach the ASEAN and International markets, this

group plans to build factories overseas (particularly ASEAN),

which will at the same time be the basis for competing in

overseas markets.

Meanwhile, results of simulation on the Astra group

show that the DER of this group would worsen, from 1.2x

to 1.3x or a drop of 12.4%. This would largely occur

because its foreign currency debt share to total debts

reaches 35%. Other heavy challenges that would face

this group would be among others yet high import-content

14


machineries are already out-of-date and almost reach

maximum utilization. Therefore, the most important step

that can be taken at this time is to revive the TTP industry

through revitalization. According to the Indonesian Textile

Association, there are 2 options in revitalization. Option

one involves replacement of machinery spare parts and

machineries. If replacement is done using own capital,

only machinery spare parts can be replaced. If bank credits

can be obtained, all machineries can be replaced. However,

in order to increase Indonesia»s TPT competitiveness against

other countries as well as raise production capacity, option

two has to be adopted. As is the case with other industry

sectors, development of several TPT industry sub sectors

still need to be supported. In addition to bringing in foreign

currency, the industry also absorbs high level of labors (it

provides jobs), which is currently a national problem. From

financial system stability side, there is a worry that a

collapsed TTP industry would raise banks» NPLs, both from

the industry sector itself as well as its laid-off workers.

3.3 Micro, Small, and Medium Scale Business

One of the business units that has quite large role in

moving the real sector is the micro, small, and medium

scale business (MSMB). Research has shown that MSMB

has proved to be able to withstand crises compared to

large businesses . In addition, MSMB has also proved to

be a source for economic growth and absorbs extremely

large number of workers. Therefore, various problems that

are facing the MSMB need to be immediately solved so

that MSMB can be developed into a strong part of the

Indonesian economic system and later on can also play a

role in maintaining financial system stability.

In semester I/2004, bank credits extended to MSMB

experienced a growth of Rp30.5 trillion or 14.3%

compared to its end-2003 position. This figure represents

84.7% of 13 large banks» plan for total credit channeling

to MSMB in 2004, which amounts to Rp36.02 trillion. This

growth reflected the banking industry»s commitment to

continue assistance in developing MSMB although it is

probably still far from optimal.

Several problems that face the banking industry in

channeling credits to MSMB are among others (i) limitation

on number of bank marketing staffs as well as bank outlets/

networks, which makes it difficult to reach remote areas

or centers of small business people, (ii) lack of information

on potential and bankable MSMB debtors, (iii) lack of

proper collaterals, while guarantees through PT Askrindo

and Perum Sarana Pengembangan Usaha will add costs

to potential MSMB debtors, (iv) higher overhead cost for

credit channeling to MSMB.

In order to solve all these various problems and to

raise credits channeled to MSMB in 2004, several efforts

have been made by banks, which cover among others : (i)

actively increase marketing efforts to MSMB centers, (ii)

increase human resource quality through various trainings,

(iii) increase linkage programs through partnership with

BPRs ad Small Business Credit Financing Institutions such

as state pawn company, (iv) develop credit scheme of core-

plasma partnership, and (v) undertake business mapping

of potential Rural Banks (BPRs).

Source: Bank Indonesia

Table 2. 3Outstanding and Growth of Loans to Small Scale Business

Total loans to Small Scale BusinessTotal loans to Small Scale BusinessTotal loans to Small Scale BusinessTotal loans to Small Scale BusinessTotal loans to Small Scale Business 75,047 75,047 75,047 75,047 75,047 87,199 87,199 87,199 87,199 87,199 16.2 16.2 16.2 16.2 16.2 119,749 119,749 119,749 119,749 119,749 37.3 37.3 37.3 37.3 37.3 161,814 161,814 161,814 161,814 161,814 35.1 35.1 35.1 35.1 35.1 213,291 213,291 213,291 213,291 213,291 31.831.831.831.831.8 243,791 243,791 243,791 243,791 243,791 14.30 14.30 14.30 14.30 14.30

ConsumerConsumerConsumerConsumerConsumer 23,307 36,215 55.4 54,869 51.5 76,122 38.7 100,965 32.6 118,033 16.90

InvestmentInvestmentInvestmentInvestmentInvestment 12,148 10,423 (14.2) 14,599 40.1 16,718 14.5 22,296 33.4 26,408 18.44

Working CapitalWorking CapitalWorking CapitalWorking CapitalWorking Capital 39,592 40,561 2.4 50,281 24.0 68,974 37.2 90,030 30.5 99,350 10.35

(Billion rupiah)

Uraian Dec-99 Dec-00 % ∆∆∆∆∆ Dec-01 % ∆∆∆∆∆ Dec-02 % ∆∆∆∆∆ Dec-03 % ∆∆∆∆∆ Jun-04 % ∆∆∆∆∆

15


Meanwhile, on the side of business people,

constraints coming from banks that face them in

developing their businesses are among others : (i) Banks

are considered to still be hesitant in extending credits to

MSMB. This is evidenced by difficult and lengthy credit

extension procedures, requirement for additional collaterals

along with legal proofs (certificates and licenses to build/

IMB), as well as high interest rates, (ii) The banking industry

does not yet have clear knowledge on MSMB condition,

(iii) Difficulty in communicating with banks» officers

because they are too rigid, (iv) Lack of information on

availability of cheap funds provided by state-owned

enterprises, that are managed by banks, and (v) There is

no sustainable supervision over MSMB debtors.

In the framework of increasing intermediary function

and in order to solve one of the constraints coming from

banks that are facing MSMB, the banking industry needs

to continue holding periodic meetings with business people

and the government. In addition, it is hoped that the

government and the banking sector can provide

information on funds coming from parts of state-owned

enterprises» profits that have been given to and are

managed by several banks for channeling to MSMB.

Micro credits have become segmentation target of

several commercial banks such as Bank Danamon, BNI,

and Bank Mega through the establishment of micro

business units so that this business segment can develop

rapidly in line with these banks» work plans. There is a

need for further monitoring and review, particularly as

regard the possibility of competition over the same target

market between commercial banks and BPRs.

This possible competition would create problems for

BPRs, although these will still be within the context of free

competition, considering that protection for common

people has become a sensitive issue, which if not handled

properly would trigger overall financial system instability.

16


Box 2.1 Potential Pressures on Several Industries due to Oil Price Hikes

World oil price development that has been

trending upward and reached US$47.86 per barrel

on 23 August 2004 warrants cautious attention. In

addition to its potential to bring pressures on the state

budget, world oil price hikes also have the potential

to put pressures on the real sector performance,

particularly the airline industry. Although credits

extended to this industry has only reached 0.09% of

total credits extended by the banking industry as of

end of June 2004, the industry»s NPLs have reached

6.8%. If this situation is not well anticipated, this

trend would bring pressures on financial system

stability.

World crude oil price hike that reaches US$50/

barrel would trigger transportation cost hike, which

in turn has the potential to put pressures on

performance of businesses, which raw materials are

based on imports. The textile and plastic industries

have the potential to come under pressure due to

soaring world oil prices because almost 90% of their

raw materials still depend on imports. Although direct

impacts of oil price hikes have not materialized yet,

several companies in the plastic industry have already

slowed down their factory performance and

undertaken efficiency efforts in several areas. In

addition, companies in the plastic industry plan to raise

their selling prices by 25%.

The airline industry will be the first to feel the

impact of world oil price hikes because these hikes

would trigger avtur price hikes, where avtur price

constitutes one of the components that determine

tariffs (35% up to 40% of the cost of an airline

company comes from avtur cost). This condition has

the potential to prompt operational cost to rise, while

on the other hand airline companies are facing price

war, which in the end would influence revenue.

There is a worry that this upward trend in world

crude oil prices that is predicted to continue until end-

2004, prompted by among others rising world demand

as several developing countries such as China and India

are advancing, upcoming summer season on the other

hemisphere, as well as sensitivity towards news of

violence in Iraq, would disrupt world oil supply.

Data as of end of July 2004 show that non-

performing loans of credits that have been extended

to the airline industry have reached Rp29,985 million

or 6,8% of total credits that have been extended to

this industry. Of these NPLs, 83% is owned by Bank

Danamon and 11% is owned by Bank Mandiri.

Although credits channeled to the airline industry have

only reached 0.09% of total credits channeled by the

banking industry as of end of June 2004, this industry»s

relatively high NPLs need to be closely watched,

Chart Box 2.1Loan Classification

of Airline Industry - July 2004

Source : Bank Indonesia,BPS

Current Special Mention Doubtful Loss

7 % 0 %23 %

70 %

17


price hikes such as the airline companies or related

companies. In addition, Bank Indonesia and the

government (fiscal authority) need to intensify

coordination, among others in maintaining

assumptions on inflation rate and SBI interest rates in

line with market needs.

considering that the uptrend of oil prices would

probably continue until end of 2004 and heavy tariff

war is still on going among airline companies.

In view of above development, banks are

expected to continuously increase their monitoring of

their debtors that are directly impacted by world oil

18


19

Chapter 3 Indonesia’s Banking Industry

Chapter 3Indonesia’s Banking Industry

20


21


1. STRUCTURE OF BANKING INDUSTRY

Indonesia»s financial system was yet dominated by

the banking industry (representing 90% of the financial

system»s total assets). The condition of the banking industry

itself was very much marked by the conditions of 15 large

banks (major banks), considering these banks dominated

the banking industry»s total assets (72.5%). Ten of these

large banks were recap banks.

Up to June 2004, number of banks was lower than

in previous report»s period. Due to the closure of two

small banks, it came to 137 banks with total assets

amounting to Rp1,185.7 trillion.

Indonesia»s banking industry still relied on credit

channeling and accumulation of public deposits and as

such the largest potential for instability would come from

these two sources. However, in terms of earning assets,

the share of credit itself was only 47.5% and the rest

comprised marketable securities (recap bonds and SBIs),

which had zero risk. Meanwhile, deposits were yet

dominated by short-term and corporate deposits, which

were extremely sensitive to interest rates.

Ten banks among the above-mentioned 15 large

banks were recap banks that were yet undergoing

consolidation. Therefore, the operational risks faced by

those banks were yet quite significant, considering that

there have been additions of new owners and

management, which could result in rising operational risks.

2. GENERAL PICTURE OF BANKING INDUSTRY

Stability of the financial system during semester I/

2004 was quite maintained with the support of the banks

as major players in controlling risks being faced, coming

both from internal as well as from external factors.

Chapter 3Indonesia’s Banking Industry

During the said period, the banking industry faced

heavier pressures relative to the previous year due to yet

inconducive economic condition, exchange rate

weakening, world oil price hikes, and the general election.

In addition, during the same period, two small banks have

been closed and incidents of fraud have occurred in several

banks.

These pressures did not disturb financial system

stability because the related institutions were able to handle

the situation well. Bank Indonesia consistently continued

its efforts in maintaining the banking industry»s stability

by issuance of new regulations to strengthen the banking

system, which included among others reformulation of

the minimum reserve requirement (MRR) and net foreign

currency position, as well as planned implementation of

the Indonesian Banking Architecture.

Credit risk was quite under control and there were

no risk fluctuations that could significantly affect the

financial system»s stability. This is reflected by improving

credit quality marked by decreasing NPL ratio. In addition,

at the end of semester one recorded a quite large jump in

new credits and a decline in the rise of undisbursed loan

relative to the previous month.

Banking sector»s excess liquidity that was quite large

was gradually reduced by a new formulation in the MRR,

which could reduce potential for speculations. In addition,

the plan for phasing out the blanket guarantee needs to

be approached carefully because of its potential in reducing

public confidence in the banking industry.

On the other hand, market risk was quite moderate

despite exchange rate weakening and interest rate rise

by The Fed. Banking industry»s profile, particularly that of

15 large banks, was not much differet that in the previous

22


report. It was yet at short position for the short-term

and as such was extremely susceptible to market risk as

well as liquidity risk. Meanwhile, opeational risk was yet

relatively high due to yet ineffective risk management

and good governance implementations, which have

allowed a few cases of fraud to occur. However, banking

industry profitability rose in line with rising credits. On

the other hand, capital declined due to a rise in risk-

weighted assets (RWA) resulting from rising credits.

However, this capital decline did not stir problems in the

banking sector because aggregate CAR was yet relatively

high, namely above 20%.

However, there were a few factors that needed close

attention, particularly credit risk and operational risk, which

had the potential for disturbing banking industry stability.

In the light of developments during the previous year

and economic prospects of semester II/2004, the banking

industry is projected to face heavier pressures. Stage 3 of

the general election is not expected to be a factor of

concern for businesses or the banking industry, considering

that stages 1 and 2 of the general election that has been

held during semester I/2004 has not caused fluctuations

in the banking sector. However, economic and banking

industry»s growths would be much influenced by

developments of world oil prices, rupiah stability, and

interest rates.

The rise in oil prices would raise production costs,

including transportation cost for businesses, which in the

end would raise prices. Should such a situation occurs in

a condition where there is no rise in public income,

business people would experience difficulty in paying off

their debts to banks, which in the end would rise banking

industry NPL.

3. CREDIT RISK

In the period of end December 2003 up to semester

I/2004, Indonesia»s bank credit risk was relatively under

control. This was marked by improving bank credit quality

as reflected by declining trend of NPL ratio. However,

starting semester II/2004 onwards, credit risk would again

rise due to high level of uncertainty coming from external

factor, namely yet inconducive domestic economic

condition, and pressures from international factor, namely

oil price hikes. In addition, the business and banking

sectors would be waiting for policy directions of the newly

elected government, which are expected to be announced

at the start of 2005.

In general, several main challenges, which would face

the banking industry in improving its credit quality in the

future, cover :

i. National economic condition that is not yet conducive

and rising world oil prices. In the long-run, these

would have an impact in raising production cost.

Currently, sea transportation tariffs for goods have

experienced a rise of 20%, both domestic as well as

international.

ii. Existence of a potential rising in credit interest rates

due to interest rate hikes by The Fed and several other

world central banks, which would indirectly influence

global economy, including Indonesia.

iii. Weakening of rupiah value, which would disturb the

performances of exports as well as domestic

businesses that use imported raw materials.

iv. Absorption capability of the real sector, particularly

the corporation sector, is still relatively low because

in general their restructuring process has not been

fully completed. Therefore, it is difficult to

significantly raise new credits. As an impact, new

credit channeling is dominated by small credits and

consumption credits, which cannot accelerate

growths of bank credit portfolio as well as the

economy.

v. There is a potential for a rise in NPLs in the future,

which would come from restructured credits.

23


0

10

20

30

40

50

60

70

80

90

0

5

10

15

20

25

Des Dec Dec Dec Dec Dec Dec Jun Dec Jun

1996 1997 1998 1999 2000 2001 2002 2003 2003 2004

Loan (left) Interbank (right) Securities (left) SBI (left)

Percentage PercentageIn the short-term, the impact of oil price hikes would

not yet be realized by the business sector. However, the

size and duration of oil price hikes cannot be predicted

yet, including by APEC, because they are very much related

to issues of wars/terrorism and political instability in several

countries that are world largest oil suppliers.

On one hand, new credit1 rise and undisbursed loan2

decline, which have occurred in the last months of semester

I/2004, are sufficient to prompt bank credit as well as

economic growths. On the other hand, these will also

raise credit risk, which could reduce capitals, if a prudential

approach is not adopted. It is hoped that this credit rise

will not be temporary but will continue.

However, improving economies of Indonesia»s major

trading partners, such as the US, on the one hand and

China»s overheating economy on the other hand give an

opportunity for Indonesia to expand its exports, which in

turn would raise demand for investment and working

capital credits.

3.1. Development of Credits

Bank credit growth was yet influenced by sectors

and types that did not prompt economic growth, which

in nominal terms did not dominate. New credit

withdrawals were smaller than in the pevious year although

the last two months showed quite encouraging

development, which has prompted the share of credit to

surpass that of marketable securities and caused bank LDR

to rise.

Indonesia»s bank post-crisis earning asset composition

is marked by quite large share of recap bonds that has

zero risk as a result of the recapitalization program in 1998.

As of June 2004, bank earning assets rose by Rp29.7 trillion

(2.7%) from December 2003 position, particularly credits

and SBIs, which rose by 11.6% and 9.1%, respectively.

As of above position, credit rise reached Rp50.9

trillion, which particularly came from public funds mobilized

by the banking sector amounting to Rp24.2 trillion, a

decline in recap bonds (Rp19.6 trillion) and interbank

placements (Rp12.0 trillion). This growth prompted a rise

in the share of credit in produtive assets from 42.5% to

46.1%. This share of credit is the largest compared to the

shares of other types of earning assets in the post-crisis

period, which two months previously was yet dominated

by marketable securities (government bonds and SBIs).

The rise in credits resulted from the banking sector»s

efforts to continuously promote its intermediary function,

which prompted banking LDR to also rose to 46.4%.

This is reflected by the credit growth (y-to-y) of foreign

bank group, which was recorded as being negative in the

Chart 3.1Earning Assets

1 New credits are credits withdrawn by debtors in the same months as the dates of thecredit agreements.

2 Credit facilities made available by banks but not yet utilized by debtors.

Chart 3.2Loans by Group

Trillion Rp

State-owned Bank

Private Bank

Foreign and Joint Venture Bank

Regional Development Bank

1996 1997 1998 1999 2000 2001 2002 2003 20040

50,000

100,000

150,000

200,000

250,000

300,000

24


Chart 3.5New Disbursed Loan 2002, 2003, 2004

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May

2000 2001 2002 2003 2004

Substandard Doubtful Loss

Trillion Rp.previous report but started to show positive growth in

this reporting period. However, bank credit growth during

this period was yet supported by the domestic bank group.

Therefore, it can still be stated that marketable

securities still provide a safe and quite large source of

income for the banking sector because their risk do not

weigh as much as that of credits.

3.1.1 Consumption Credits

Despite its small share (9.7%), the quality of

consumption credits need to get special attention,

considering the growth of this type of credit has been

recorded to be the highest with a trend of rising NPLs.

Since the start of 2002 up to May 2004, consumption

credit NPLs have been recorded as being on the rise

although it has started to experience a decline, where as

of June 2004 it came to 2.4% with similar nominal value

as its December 2003 position of Rp2.9 trillion.

This high consumption credit growth relative to public

income growth requires a close attention in a situation of

yet inconducive economic condition. Economic condition

very much influences the performance of this type of credit,

particularly in a situation where there are occurrences of

company closures and employee discharges, considering

that the payoff for this type of credit relies on individual

income.

3.1.2 New Credits and Undisbursed Loans

Withdrawals of new credits were lower relative to

the previous year, however, the last two months showed

quite a significant rise. In addition, undisbursed loans (Uls)

was quite large relative to the previous year. However,

the large number of new credit withdrawals have caused

a decline in the rise of Uls. It is hoped that this positive

development would continue in order to support economic

growth.

The rise in credit portfolio was prompted by a rise in

withdrawals of new credits that have been approved and

withdrawn during 2004, which up to June have reached

Rp31.9 trillion, smaller compared to the same position in

2003 of Rp41.8 trillion.

Chart 3.4NPL of Consumer Loan

Chart 3.3Loan to Deposit Ratio

Trillion Rp Percent

Loan (left axis) Deposits (left axis) LDR (right axis)0

10

20

30

40

50

60

70

80

90

100

1996 1997 1998 1999 2000 2001 2002 2003 20040

100,000

200,000

300,000

400,000

500,000

600,000

700,000

800,000

900,000

1,000,000

0

5,000

10,000

15,000

20,000

25,000

Jan Feb Mar Apr May Jun

2002

2003

2004

Billion Rp

25


Based on type of use, the largest extension of new

credits occurred in working capital credit (amounting

to 52.3%), while based on sector, it occurred in the

business services, trade, and industry sector. Meanwhile,

46.5% of new credits extended during 2004 was

channeled to small-to-medium size businesses.

However, the number of Uls for this type of credit and

this sector was also the highest. The percentage shares

of Uls by type of use and by sector are presented in the

following two Charts.

Most (91.6%) of bank Uls belonged to 25 banks

(13 large banks, including 3 state banks, 7 foreign banks,

4 foreign joint venture banks, and 1 other private bank).

3.3.1 Non Performing Loans

Improvement of non-performing loans (NPLs) has

reached a saturation point where bank NPLs declined with

a much lower magniture although credits continuously

rose. In addition, there is a concern that NPLs that has

reached a saturation point might reverse.

Credit quality is a reflection of bank credit risk. This

is indicated by developments of NPL ratios, both gross and

net. Position of bank NPLs at the reporting period was

quite high. This was due to economic condition that has

not fully recovered, which was tackled by the banking

sector through quite cautious implementation of its

intermediary function as well as through formation of quite

large reserve in anticipation of possible risk.

During the period of December 2003 up to June

2004, Indonesia»s bank credit quality improved as reflected

by a decline in gross and net NPL ratios. Gross NPL ratio

dropped from 8.21% to 7.54%, the smallest ratio since

the 1997/1998 banking crisis. Net NPL ratio also dropped

from 3.04% to 2.09% (Chart 3.8).

Chart III.7Undisbursed Loan by Usage

Chart 3.6Undisbursed Loan by Sector

Chart 3.8NPL Gross & Net

However, in nominal terms, NPLs also rose as the

result of yet inconducive economy. However, this rise was

relatively small compared to the rise in total credits. Bank

credits rose by 10.8%, while the rise of NPLs was only

1.8% (Table 3.1).

Agriculture Electricity Transportation Others

Mining Construction Business Services

Manufacture Trading Social Services

5%2%

1%4%24%

33%

3%

15%1%

12%

73.3%

14.7%

12.0%

Working Capital Loan Investment Loan Consumer Loan

Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun

1997 1998 1999 2000 2001 2002 2003 2004

0

10

20

30

40

50

60

NPLs Gross NPLs Net

Percent

26


In the short-term, it is estimated that bank CAR

would not be influenced by the rise in credit risk,

considering that in general banks have formed reserves

that exceed requirements. A more conservative ratios are

NPLs to Equity and NPLs to Core Equity. As of June 2004,

these ratios came to 24.1% and 30.5%, which dropped

from their positions at December 2003 of 26.6% and

35.8%, respectively.

The largest NPLs yet belonged to the state bank

group, foreign bank group, foreign joint venture bank

group with ratios above that of the industry, a condition

that did not much change from the previous condition.

NPLs of the foreign bank group and foreign joint

venture bank group experienced a slight improvement

relative to December 2003 positions, while NPLs of the

state bank group tended to continuously rise. Weakening

of state bank»s credit quality was particularly prompted by

Table 3.1NPL by Nominal

LoanClassifica-

tion Nom % Nom % Nom % Nom %

Current 333.4 80.8% 342.2 78.8% 389.0 81.5% 441.0 83.4%Special Mention 43.7 10.7% 57.2 13.2% 49.0 10.3% 47.7 9.0%Substandard 9.1 2.5% 11.2 2.6% 13.9 2.9% 12.5 2.4%Doubtful 7.9 1.9% 6.2 1.4% 5.1 1.1% 5.6 1.1%Loss 16.1 4.0% 17.3 4.0% 20.1 4.2% 21.7 4.1%

Total Loan 410.2 434.1 477.1 528.6Total NPL 33.1 8.1% 34.7 8.0% 39.1 8.2% 39.9 7.5%

December June December June

2002 2003 2004

quite large number of restructured credits and IBRA»s

credits, which quality had yet to improve. Meanwhile,

improvement on the credit quality of the foreign bank

group and foreign joint venture bank group was due to

their credit portfolios that have started to rise, where

previously they had negative growths

Chart 3.9NPL to Capital

Table 3.2NPL By Bank Group

Chart 3.10NPL of ASEAN Countries

NPLs in Other Countries

Indonesia»s bank NPLs were recorded to be relatively

better although the ratio has included a factor of credit

channeling. Malaysia, Thailand, and the Philippines each

had NPL ratios of 8.8%, 12.1% and 13.9% at May 2004

position. However, there has been an indication that

Indonesia»s bank NPLs were understated as proven by the

findings of bank auditors. In the future, this situation will

be corrected in order to have NPL values that are closer to

actual conditions.2002

15

20

25

30

35

40Percent

Dec Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

2 0 0 3 2 0 0 4

NPL to Total Capital NPL to Core Capital

60

50

40

30

20

10

0

Percent

Dec Aug Apr Dec Aug Apr Dec Aug Apr

1998 1999 2000 2000 2001 2002 2002 2003 2004

Thailand

Indonesia

Philippines

Malaysia

Banks

Gross Net Gross Net Gross Net Gross Net

State-owned Banks 6.83 1.47 9.04 3.11 9.77 5.27 10.02 3.13

Major Banks 6.80 1.56 7.05 0.55 8.53 3.31 8.09 1.97

Medium Size Banks 5.16 3.46 3.27 1.86 3.9 2.73 3.94 2.59

Small Banks 3.79 1.44 4.34 2.91 3.00 1.71 3.46 1.86

Joint Venture Banks 18.62 6.48 16.52 5.28 11.95 3.32 9.16 2.92

Foreign Banks 16.14 2.12 13.74 1.67 11.47 1.14 9.03 1.97

December June December June2002 2003 2004

27


3.1.4 Provision for Earning Assets Losses

The amount of provision for earning assets losses (PEAL)

was quite larger than required. On one hand this indicates

high credit risk being faced, while on the other hand in so

doing banks looses opportunities to maximize profits.

Value of the PEAL established by Indonesia»s banks

was in aggregate adequate and no bank has violated the

requirement. Compared to December 2003, PEAL ratio

established over required ratio experienced a decline, from

181.1% to 167.4%, however it still exceeded the

requirement. This condition differed between banks. It

was recorded that 23 banks (medium and small banks)

had ratios of 100%, while the rest had ratios of over 100%.

Meanwhile, special provision for credits established

by banks also rose, from Rp31.8 trillion to Rp36.2 trillion.

The rise in the value of PEAL influenced bank net NPL ratio,

which at June 2004 showed improvement.

Differences found between collectibility calculations

by banks and auditors as well as by banks and debtors

indicated that NPLs reported by banks were lower than

actual. This supported the reason why banks established

provisions that exceeded the required amounts. It showed

that banks were ready for worst probability.

3.1.5 NPL Stress Test

In order to assess the impacts of lower credit quality

on capital (CAR), stress test has been conducted on 15

large banks using a number of hypothetical scenarios (NPL

rise from 5% up to 50%) with June 2004 CAR position as

the base. Bank capital resilience was still adequate for

NPL rise up to 25%. Meanwhile at NPL rise of 30%, one

bank had its CAR come below 8%.

3.2. Credit Concentration

3.2.1 Large Debtors

Large credits had the potential to become problem

credits in several banks, considering NPLs at those large

debtors were above the banking industry»s NPLs.

Credits extended by 13 large banks to 25 largest

debtors on average has reached 22.5% of total credits

extended by those banks, where the largest NPL reached

28.9% of outstanding credits to that particular debtor.

Amongst those credits that concentrated on 25 large

debtors, the highest was extended by one private bank

with a value of around 43% of that bank»s total credits.

Meanwhile, the lowest credit was extended by a state bank

with a value of around 2.0% and NPLs amongst those

credits extended to 25 large debtors were in general high

as presented by the following table.

Chart 3.11Stress Test of NPL - June 2004

Table 3.325»s Top Debtors (25 TD)

BankPercent

to Total LoanNPL

Nominal Percent

25 TD toCapital

A 20.6% 1.885.4 11.7% 64.6% 171.7%B 27.7% - 0.0% 70.5% 78.4%C 13.4% 1.264.4 18.1% 57.6% 69.1%D 2.5% 79.6 27.4% 21.3% 30.9%E 10.6% 1.414.2 24.3% 54.9% 64.7%F 49.2% 418.0 17.1% 156.6% 307.7%G 30.9% 561.0 15.1% 112.0% 173.1%H 18.6% 418.8 18.7% 151.6% 166.0%I 40.9% 532.1 12.8% 112.1% 134.5%J 52.2% - 0.0% 727.3% 782.8%K 14.1% - 0.0% 49.8% 56.0%L 17.4% 353.3 12.5% 139.8% 184.4%M 25.1% 211.6 12.4% 151.4% 174.6%

20.4%20.4%20.4%20.4%20.4% 7.138.4 7.138.4 7.138.4 7.138.4 7.138.4 11.2%11.2%11.2%11.2%11.2% 81.7%81.7%81.7%81.7%81.7% 119.1%119.1%119.1%119.1%119.1%

In the short-term, debtor concentration with such

level of NPLs as presented in the above table would not

bring too much influence on those banks» capital nor on

NPL Incremental Scenario

CAR (%)

J N O 15 BB

0

5

10

15

20

25

10% 15% 20% 25% 30% 35% 40% 45% 50%

25 TD to Core Capital

28


the overall banking industry, considering that in general

those banks have set up PEAL in adequate amounts.

3.2.2 Credits By Economic Sector

The industry sector has wide inter-relations with other

sectors. Problems that occur in this sector would have a

wide impact, considering that this sector dominated bank

credits and contributed quite a large share to bank NPLs

and that it is extremely susceptible to economic condition.

Problems occurring in this sector would also very much

influenced credit demand, particularly for investment and

working capital credits.

sector, bank credits were yet dominated by the industry

sector (27.8%) and the trade sector (20.0%). Meanwhile,

the highest growths (y-to-y) in semester I/2004 were

dominated by the social services and mining sectors, which

were recorded at 63.0% and 60.4%, respectively. High

growth was also recorded by the construction and

transportation sectors. In the other hand, the industry and

agriculture sectors, which were the main pillars of the

economy, recorded the lowest growths of 18.0% and

12.4%, respectively.

By economic sector, the industry sector still posed

the highest credit risk potential, considering that quite large

percentage of NPLs came from this sector. In addition,

credits to this sector are very much susceptible to domestic

as well as international economic conditions.

Compared to December 2003, the industry sector»s

NPLs rose, from 10.59% to 10.62% as of June 2004, or

equivalent to 47.4% of total bank NPLs (Chart 3.14).

Therefore, the largest source for bank credit risks would

be credits extended to this sector.

During 2003 and 2004 (up to June), there has been

practically no significant change in the distribution of

credits by economic sector as well as by type of use. By

Chart 3.12Loan by Sector

Chart 3.13NPL by Sector - June 2004

Chart 3.14NPL by Agriculture, Mining and Manufacture

Amongst several economic sectors, credit quality of

the construction sector experienced a slight improvement,

from 6.04% to 4.92%. This was in line with quite large

rise in the portfolio of this type of credit, which was due

to vigorous growth of property credits during post-crisis

period.

Percent

Trading

Others

Manufacture

Transportation Agriculture

Construction

Business Services

Social ServicesMining Electricity

0

5

10

15

20

25

30

8.0% 1.3%

47.4%15.6%

9.8%1.3%7.8%

1.2%2.6%

4.8%


Mining Construction Services


1996 1997 1998 1999 2000 2001 2002 2003 2004

Agriculture

Mining

Manufacture

70

60

50

40

30

20

10

0

Percent

29


3.2.3 Credit Restructuring

In general, there has been quite meaningful

improvement in restructured credits at 15 large banks,

where 3 large banks that had previously owned quite large

portfolios of restructured credits, during the reporting

period recorded zero positions. However, restructured

credits, particularly at bank B, need close attention because

the amount of its restructured credits was quite large

(29.3% of its total credits), however these had better

development relative to the previous reporting period. Total

restructured credits at 15 large banks reached Rp 36.9

trillion, which included credits purchased from IBRA

amounting to Rp 12.8 trillion.

credits, considering that the share of this type of credits

was relatively small. By currency, credits were still

dominated by rupiah credits, reaching 76.5% of total

credits. However, this condition need to be closely watched

at the foreign and foreign joint venture bank groups

because the share of foreign currency credits was larger

than the share of rupiah credits, as reflected by the

following Chart.

3.2.4 Foreign Currency Credits

There has been no potential risks arising from foreign

currency credits, considering the share and growth of this

type of credits were relatively small. Development of this

type of credits at foreign and foreign joint venture bank

groups needs close attention, considering that this type

of credits dominated their portfolios.

Weakening of the rupiah against the US dollar that

has occurred in the last few months has not raised potential

risk to banks, which would originate from foreign currency

Banks have been asked to map their debtors that

have obtained foreign currency credits but had local

marketing targets. In addition, although foreign and

foreign joint venture banks were not classified into large

bank category, these banks were still reminded to monitor

developments of their debtors that have obtained foreign

currency credits.

4. LIQUIDITY RISK

The banking industry was in overliquid condition and

therefore faced relatively low liquidity risk and tended to

be stable during the first semester of 2004. This condition

was evident by relatively high ratios of liquid assets to short-

term liabilities and to total assets as well as relatively low

bank funds channelled in the form of credits. National

banking industry still had excess liquidity in large amount,

which in general was placed in SBIs and interbank

placements.

Table 3.4Loan Restructuring

Bank Share to Industry

Total NPL

A 9,355.3 1,579.8 17.9% 16.9%B 21,697.1 2,340.1 27.9% 10.8%C 912.5 266.0 7.6% 29.2%D 146.0 36.7 2.6% 25.1%E 63.2 43.6 0.9% 69.0%F 153.0 - 1.1% 0.0%G 10.1 8.9 0.2% 88.1%H 806.5 36.0 8.0% 4.5%I 1,534.0 547.9 12.7% 35.7%J 866.5 225.7 17.4% 26.0%K 773.8 492.2 3.4% 63.6%L 3,455.9 1,318.7 6.3% 38.2%M 18.1 - 0.1% 0.0%N 239.2 89.1 2.1% 37.2%O - - 0.0% 0.0%

TotalTotalTotalTotalTotal 40,031.2 40,031.2 40,031.2 40,031.2 40,031.2 6,984.7 6,984.7 6,984.7 6,984.7 6,984.7 11.7%11.7%11.7%11.7%11.7% 17.4%17.4%17.4%17.4%17.4%

Share to Industry : 8.1%

% NPLto Total LoanRestructuring

Chart 3.15Foreign Loan by Group - June 2004 (%)

Rupiah Foreign Exchange

120

100

80

60

40

20

0State-owned

BankPrivateBank

RegionalDevelopment Bank

Joint VentureBank

ForeignBank

30


Meanwhile, ratios of bank liquid assets4 to short-

term liabilities and to total assets were yet adequate,

although in the middle of the semester for a while the

ratios experienced quite large drop due to lower SBIs.

However, the amount of SBIs rose again at the end of

the semester. SBIs together with FASBIs were used by

several large banks to fulfill the new MRR in July 2004.

With the occurrence of this conversion, fulfilment of the

new MRR is predicted to not put pressure on bank

liquidity.

With relatively stable liquidity condition, the closure

of two banks at beginning of April 2004 did not put

pressures on bank liquidity. Likewise with Bank Indonesia»s

plan to raise the rupiah MRR effective July 2004. It is

estimated to not disturb banking liquidity, considering that

the additional need for reserve requirement can be supplied

by SBIs/FASBIs and recap bonds.

Several matters that potentially can put pressures on

banking liquidity and need to always be anticipated by

banks are :

(i) Third-party funds was still dominated short-term (less

than 3 months) deposits. During the first semester

of 2004, the average ratio of short-term deposits to

total third-party funds reached around 93%.

(ii) Although deposits owned by corporations and

institutions only reached around 14% of total

deposits, funds withdrawals by these depositors at

relatively the same time are estimated to have the

potential to influence the liquidity condition of large

banks.

(iii) The plan to phase-out the coverage of the blanket

guarantee is estimated to have the potential to lower

public confidence in the banking sector as indicated

by results of the confidence towards the banking

sector index survey3 .

4.1 Structure of Bank Funding and Placement

Bank overliquid condition was reflected by yet

relatively low amount of funds, which came from third-

party funds mobilized by the banking industry, channeled

in the form of credits. During semester one of 2004, on

average, the comparison of bank credits against third-

party funds reached around 55% with a rising trend each

month relative to the condition at end of 2003. Most of

that excess liquidity was placed by banks in SBIs and

3 Results of the 2003 confidence towards the banking sector index survey. Results of thesame survey for 2004 are still in process.

Table 3. 5Bank Funding & Placement Structure

Chart 3.16Liquidity Ratio

interbank placements. Although this overliquid condition

tended to support bank liquidity resilience, a close watch

needs to be placed over its impact on bank profit

sustainability, considering the existence of a trend of

declining interest rates.

Liquid Asset/Short-term Liabilities

Liquid Asset/Total Asset

Percent

Dec Jan Feb Mar Apr May Jun

2003 2004

30

25

20

15

10

5

0

Dec Jan Feb Mar Apr May Jun

FUNDINGFUNDINGFUNDINGFUNDINGFUNDING

Third Party Fund 888.6 888.6 877.1 875.1 872.9 895.1 912.8

Borrowed Fund 7.5 7.5 9.7 9.1 8.6 10.3 9.8

Interbank Borrowings 68.6 65.1 65.3 68.0 66.1 69.2 65.6

Securities 10.8 10.8 11.4 11.5 11.7 12.3 12.7

PLACEMENTPLACEMENTPLACEMENTPLACEMENTPLACEMENT

Credit 477.2 475.0 477.3 485.9 496.1 513.4 528.7

Equity Investment 5.9 6.0 6.0 6.1 6.8 6.90 7.1

SBI 101.4 130.4 136.8 133.2 120.3 106.7 110.6

Securities and other investment 68.7 67.2 71.3 71.6 71.8 70.5 77.1

Intarbank Lending 112.2 103.2 102.8 100.2 91.8 108.7 100.2

loan/TPF (%) 53.7 53.6 54.4 55.5 58.8 57.4 57.9

Loan/Source of Funds (%) 48.9 49.0 49.5 50.4 51.7 52.0 52.8

Rp. Trillion

2 0 0 3 2 0 0 4

31


Mutual funds NAV growth that was relatively large

during December 2003 √ June 2004 (24.8%) reflected a

condition where mutual funds as an investment alternative

tended to get more public interest. The availability of more

varied investment alternatives would enable investors to

undertake more optimal diversifications in order to

minimize risks. On the other hand, mutual funds growth

would prompt banks to increase competitiveness through

product development, innovation, and service.

Meanwhile, with the assumption that core deposits

reached 70% of total third-party funds, its ratio to total

Although there has been a rise in the MRR, banks

yet had excess liquidity that could be placed again,

particularly in SBIs/FASBIs, as well as in other forms of short-

term placements. This is in consideration that the amount

of excess liquidity that could be absorbed (locked-up) was

relatively small based on a simulation of Rp18.4 trillion5 .

With such condition, imposition of the new MRR will not

have influence on the banking system liquidity, unless BI

implements extremely tight monetary policy (tight-biased

policy). This condition is predicted to not influence banks»

capability to channel credits (recovery of bank

intermediation), as reflected by the credit rise that occurred

during semester one.

Development of third-party funds, particularly

deposits, during semester one of 2004 was relatively in

line with the trend of development of deposit interest rates.

Bank third-party funds trended to rise with a growth of

2.7% (December 2003 to June 2004), although it dropped

for a while during the first quarter of 2004. The largest

rise occured in current accounts, particularly those owned

by state-owned companies and private corporations,

followed by saving accounts while deposits trended to

decline. The relatively low deposit interest rates during

this period have caused the public to choose more

attractive instruments, among others mutual funds and

capital market instruments. This was reflected by the rising

trend of net asset value (NAV) of mutual funds during the

first semester of 2004. Meanwhile, current accounts and

savings accounts yet had stable growths, considering they

were mostly used for transactional needs (transactional

motives).

This rise in third-party funds, particularly in May 2004,

is estimated to be the impact of the policy on realignment

of guarantee interest rates.

4 Liquid assets comprise cash, current accounts at BI, and SBIs.5 Results of a simulation undertaken by the Directorate for Economic and Monetary Policy

Researches

Table 3. 6Development of Deposits and Net Asset Value (NAV)

Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04

NAV 69.5 72.2 76.1 72.9 83.9 86.2 86.77

Deposits 888.6 886.5 877.1 875.1 872.9 895.1 912.8

- Current Account 219.1 216.1 223.9 226.1 216.9 235.6 243.9

- Saving Account 240.7 243.9 244.0 247.3 251.5 254.8 260.8

- Time Deposits 428.8 426.4 409.2 401.7 404.5 404.7 408.0

Core Deposits* 622.0 620.5 614.0 612.6 611.0 626.0 639.0

Rp. Trillion

Sources : BI and Capital Market Supervisory Body* Core Deposits : assumption 70% of Deposits

Table 3.7 Deposits and Core Deposit Ratios

Des-03 Jan-04 Feb-04 Mar-04 Apr-04 Mei-04 Jun-04

- Demand to Total Deposits 24.7% 24.4% 25.5% 24.7% 24.7% 24.7% 24.7%

- Saving to Total Deposits 27.1% 27.5% 27.8% 28.3% 28.8% 28.5% 28.6%

- Time Deposits to

Total Deposits 48.3% 48.1% 46.7% 45.9% 46.3% 45.2% 44.7%

Core Deposit to Total Assets 52.0% 53.6% 53.3% 53.3% 53.4% 53.1% 53.9%

Chart 3.17Deposits Ownership

May Jun Jul Aug Sep Oct

State-owned enterprise (1) Private insurance company (2)

Pension Fund (3)

% to Deposits

2 0 0 3

12

10

8

6

4

2

0

32


Borrowing interest rates during semester I/2004

relatively did not experience significant fluctuations, where

borrowing interest rates in the foreign currency interbank

money market even stayed relatively the same during the

first 6 months of 2004. Borrowing interest rates in the

rupiah interbank money market in total, as well as in the

morning and afternoon interbank money markets tended

to decline. Meanwhile, interest rates of the overseas

foreign currency interbank money markets relatively

fluctuated each month.

assets during semester one of 2004 on average reached

53.4% and tended to be stable.

4.2 Interbank Money Market Transactions

During semester one of 2004, the largest players in

the interbank money market were dominated by large

banks (state banks and national private banks) as well as

foreign banks.

In the rupiah interbank money market, the foreign

and foreign joint venture bank groups always became net

borrowers, where several foreign banks even dominated

as 5 largest net borrowers. Meanwhile, the state bank

group and Regional Government Banks (BPD) group took

the role of net lenders with net transaction volumes that

tended to rise at end semester, where several state banks

dominated as 5 largest net lenders. In the case of national

private bank group, from beginning to mid semester it

came as net lender while at end semester it»s role switched

to a net borrower with a relatively small change.

In domestic foreign currency interbank money

market, most bank groups played as net borrowers,

dominated by the foreign and state bank groups.

Meanwhile, in the case of the foreign joint venture bank

group, at the beginning of the semester it played as a net

lender for a while, and then in March its role switched to

a net borrower with transaction volumes that continously

rose until end semester. Meanwhile, the group that played

continous net lender role was the national private bank

group, particularly the large banks that dominated as 5

largest lenders.

In overseas foreign currency interbank money

markets, all bank groups played as net lenders with

relatively similar transaction volume fluctuations, namely

it tended to rise in March, declined in April, and then rose

again at end semester. The group with relatively large

transaction volume rise compared to other bank groups

was the foreign bank group. These foreign banks

Table 3.8Interbank Money Market

Interbank MM(IDR)

State-owned Banks 38,920,300 Private National Banks 3,369,237 Foreign Banks 43,444,335

Private National Banks 4,495,430 Regional Govt» Banks 19,400 State-owned Banks 27,267,8477

Regional Govt» Banks 4,482,000 State-owned Banks (1,621,383) Private National Banks 17,228,268

Foreign Banks (39,016,250) Joint Venture Banks (1,308,204) Joint Venture Banks 3,725,615

Joint Venture Banks (7,847,600) Foreign Banks (985,650)

Interbank Money Market Peer Group

Chart 3.18Interbank Offering Rates QII-2004

dominated as 5 largest net lenders in these markets. The

overall interbank money market positions of each bank

group in semester I/2004 are presented in the following

table.

Several banks that obtained funds from borrowings

in the interbank money markets with interest rates that

exceeded those of the industry are presented in the

following table. In relation to the closure of 2 banks at

Percent8

6

4

2

0April May June

Interbank IDR Interbank IDR (am) Interbank IDR (pm)

Interbank Foreign Exchange Currency (on shore) Interbank Foreign Exchange Currency (off shore)

2 0 0 4

Rp(Million)

On shore interbankMM (Forex Currency)

USD(Thousand)

Off shore interbankMM (Forex Currency)

USD(Thousand)

33


beginning April 2004, the structure of the interbank money

markets relatively did not experience any changes. Several

banks that tended to be net borrowers were suspected to

experience structural liquidity problems.

4.3 Third-Party Funds Diversification

Despite relatively high liquidity, bank third-party

funds structure was yet not adequate, considering most

were short-term funds. The share of short-term funds (1

√ 3 months), particularly deposits, on average was around

85% of total deposits each month. If the components of

savings and current accounts were included, the share

exceeded that percentage (monthly average at 93.3%

of total third-party funds), causing the banking sector

yet to be susceptible to rising liquidity risk. In this situation,

liquidity risk exposure could rise should bank customers

do not roll-over their deposits after falling due or should

they even convert to other investment instruments. The

large share of short-term deposits also reflected yet high

Table 3.9Interbank Rates

Rate

Industry Average 6% - 1% - 2% -

Banks offering more than 7% 3 Joint Bank 2% 1 B.`non-SIBs 3% 2 Foreign Bank

industry average 1 Foreign Bank 4% 1 Joint Bank 1 Joint Bank

17 B. non-SIBs 4% 1 Foreign Bank

8% 4 B. non-SIBs 1 Joint Bank

9% 1 B. non-SIBs 6% 1 Joint Bank

IDR FX Currency on Shore FX Currency off Shore

Interbank Rates Q II-2004

Numberof Banks

Table 3. 10Deposits Permaturity Bucket

Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04

Deposits Permaturity Bucket (Rp Trillion)

1-3 month 359.7 358.1 345.3 341.4 347.3 351.8 356.7

3-6 month 25.9 25.3 25.1 24.9 23.8 21.8 21.8

6-12 month 32.45 33.6 31.0 29.6 28.8 26.7 22.2

> 12 month 10.7 9.3 7.7 5.6 4.6 4.3 7.1

Ratio to Total Deposits (Percent)Ratio to Total Deposits (Percent)Ratio to Total Deposits (Percent)Ratio to Total Deposits (Percent)Ratio to Total Deposits (Percent)

1-3 month 83.9 84.0 84.4 85.0 85.9 86.9 87.4

3-6 month 6.0 5.9 6.1 6.2 5.9 5.4 5.4

6-12 month 7.6 7.9 7.6 7.4 7.1 6.6 5.4

> 12 month 2.5 2.2 1.9 1.4 1.1 1.1 1.8

precautionary motive of bank customers. Domination of

short-term funds in the national banking funding structure

reflected yet low public confidence in the national banking

industry.

Imbalance funding structure can bring the following

implications to the national banking industry :

(i) The financial system will be susceptible to systemic

liquidity problems, where problems occurring in a

bank that has a systemic influence would arouse

contagion effect and as a result severe liquidity crisis

could quickly occur;

(ii) Due to public dependence on the government

guarantee program (blanket guarantee), funds

migration to other banks or to overseas banks could

occur should the program be discontinued.

Immediate follow-up actions need to be taken in

anticipation of these potential problems, which cover

among others the enforcement of the Financial Sector

Safety Net Law.

On the other hand, the banking industry»s

concentration on large deposits (> Rp100 million) was also

relatively high. Bank total large deposits at end semester

one of 2004 (June) reached Rp329.6 trillion, or around

80.8% of total deposits with number of accounts totalling

23.7% of bank total number of deposit accounts. This

amount dropped from that at end 2003 (December) of

Rp335.8 trillion (78.3% of total deposits). Likewise,

dependency of 15 large banks on large deposits was also

relatively high, on aggregate reaching 76.6% in June 2004.

Factors that have influenced high concentration on

large deposits in 15 large banks were:

(i) Customer profile that relatively concentrated on

customers that were corporations, state-own

companies, foundations, pension funds, and

insurance companies, which owned large deposits.

(ii) Widespread networks of bank branch offices.

(iii) Deposit minimum values imposed by large banks.

RateNumberof Banks Rate

Numberof Banks

34


(iv) Interest rates and services that were relatively better

compared to banks of medium and small scales.

Anticipative actions need to be taken to tackle this

condition, particularly in relation to the phasing out plan

of the government guarantee program and

implementation of a new guarantee scheme that plans

for a maximum of Rp100 million per customer per bank.

With the imposition of the new guarantee program, there

is a possibility that large depositors would break their funds.

And as such, there is a potential of fund migrations from

one bank to other banks or fund migrations outside the

banking sector.

swap transactions, buys and borrowings in the interbank

money markets. The next payment obligations will fall

due at end 2004.

Table 3.11Exchange Offer

NO PEER June December June

Projection 2004

Exchange Offer Repayment Plan

(in Million USD)

1. Freezed/Bank

under liquidation 153.35 4.9 1.97 97.08 1.97

2. Taken-over Bank 67.92 1.38 0.08 4 0.08

3. State-owned Bank 623.94 19.6 7.7 378.92 7.7

4. Others 46.99 1.24 0.34 16.95 0.34

TotalTotalTotalTotalTotal 892.2892.2892.2892.2892.2 27.1227.1227.1227.1227.12 10.0910.0910.0910.0910.09 496.95496.95496.95496.95496.95 10.0910.0910.0910.0910.09

Projection 2005

GROUP Pokok Bunga Bunga Pokok Bunga

6 At moderate scenario of rupiah depreciation against the US dollar by 2,500 points (forexample USD/IDR = Rp9,000 to Rp11,500).

Chart 3.19Composition of Deposits among Large Banks

5. MARKET RISK

During the first semester of 2004, Indonesia»s bank

market risk was relatively low however at a rising trend in

semester two 2004 in line with potential rise of global

interest rates. This relatively low market risk was prompted

by stable macroeconomic condition, reducing rupiah

exchange rate volatility, stable domestic interest rates, as

well as low net foreign currency position. Results of the

stress test6 showed that bank capital stayed stable at above

8% against exchange rate depreciation and interest rate

change. On regulatory side, implementation of the new

requirement for net foreign currency position is considered

as being able to increase banks» capability to manage

exchange rate risk.

Along the same line, implementation of the new

capital requirement in order to accommodate market risk

will not have a negative impact on bank capital. Despite

all these, there are several factors that could influence the

rise of market risk exposure, which are among others

pressures on the payment account due to world oil price

hikes and global interest rate increases, which are spurred

by US interest rate rise. In addition, bank maturity profile

Meanwhile, from ownership type, the shares of third-

party funds owned by state-owned companies, insurance

companies and pension funds trended downward during

semester one 2004, particularly those of state-owned

companies and pension funds. Most (>50%) funds owned

by state-owned companies and pension funds were placed

at 15 large banks. Deposit ownership of these three

depositors reached 14.4% of bank total deposits while

their ownership at 15 large banks reached 15.8% (June

2004 position).

As regards bank exchange offer obligations that

would fall due in 2004, banks have made pay-offs up to

end May or beginning June 2004, among others through

120

100

80

60

40

20

0

> 100 Million < 100 Million

A B

C

D

E

F

G HI

JK

L

M NO

15 Large Banks

Industry

GH

I

JK

L

M NO

15 Large Banks

Industry

A B

C

D

E

F

Percent

35


applied on a sample of 13 large banks, bank CARs remain

stable towards rupiah exchange rate depreciation against

USD. After rupiah depreciation, CAR drops by insignifican

percentage, 3 bps, or average CAR drops from 20.37% to

20.34%. Results of the stress test show that these banks»

CARs remain stable at above 10%. The main factor that

supports stability of bank capital is bank relatively low net

foreign exchage position, which raises bank capability to

accommodate unexpected losses attributable to rupiah

exchange rate depreciation.

is in general short for the short-term. This position is very

sensitive to interest rate rise.

5.1 Exposures

Indonesia»s banks, particularly those having the form

of local legal entities (locally incorporated), in general do

not have relatively high market risk exposures, considering

that the their portfolios and transactions that are exposed

to market risk are limited. Banks in Indonesia in general

only have interest rate risk and foreign exchange risk.

Considering the regulatory factor and the relatively

less complex bank transactions compared to other banks

abroad, other market risk components have not covered

equity position risk, commodity risk, and risk from option

price changes (option risk). The trading book position in

bank portfolio is in general still relatively small. Trading

book means all bank-owned trading positions (proprietary

positions) on financial instruments at on and off-balance

sheet positions, which are meant for resale in the short-

term and owned for the purpose of obtaining short-term

profits.

5.2 Stress Testing

Stress test is a tool used to measure bank capital

sensitivity to changes in exchange rates and interest rates.

In this relation, stress test is always conducted regularly

each month with a sample of large banks that have

relatively larger market risk exposure compared to bank

groups that are considered to be medium and small.

Results of stress tests undertook during semester I/2004

show that on average bank capital was adequate for

tackling changes in exchange rates and interest rates.

5.2.1 Exchange Rate Stress Test

Under a scenario of rupiah depreciation of Rp2,500

per USD (from USD1 = Rp9,268 to USD1 = Rp11,7687 )

Chart 3.20Stress Testing of Exchange Rate

5.2.2 Interest Rate Stress Test

During semester I/2004, bank capital in general was

adequate for covering increases as well as decreases of

interest rates. With an assumption of 1% drop in 1-month

SBI interest rate, results of stress test applied on a sample

of 13 large banks show that these banks» CARs drop on

average 68 bps (from 20.37% to 19.69%). In the case

where 1-month SBI interest rate rises by 1%, these banks»

CARs rise by 82 bps (from 20.7% to 21.20%). These

results show that banks are yet dependent on placements

in SBIs.

In this case, factors that have supported stability of

bank capital are as follows :

a. Spread between the interest rates of credits and third-

party funds was yet wide.7 Exchange rate as of 25 August 2004, CAR as of 30 June 2004

CAR Current (%) 18.61 17.69 25.29 14.98 30.62 29.94 10.74 11.65 18.18 21.74 16.24 21.62 27.47 20.3669

CAR after Stress Test (%) 18.56 17.64 25.23 14.83 30.61 29.93 10.74 11.64 18.17 21.85 16.23 21.61 27.43 20.3438

A B C D E F G H I J K L M Ave-rage

0

5

10

15

20

25

30

35

36


Chart 3.22Net Open Position to capital of Large Banks

Up to end semester I/2004, credit interest rate was

yet relatively high. The weighted average spread

between the interest rates of working capital credit

and 1-month term deposit, for example, reached

7.67%8 . As such, there was yet room for banks to

eliminate negative impacts attributable to rising cost

of funds.

b.b.b.b.b. High fund placements in SBIs and SUNs.High fund placements in SBIs and SUNs.High fund placements in SBIs and SUNs.High fund placements in SBIs and SUNs.High fund placements in SBIs and SUNs.

Bank earning asset structure at this time influenced

results of the stress test, where the share of fund

placements in SBIs and SUNs was quite large, 22.79%

of total earning assets9 . Considering banks» high

dependence on marketable securities that had low

risk and sovereign, declines in interest rates would

lower CAR and vice versa.

5.3 Net Foreign Currency Position

Banks» net foreign currency positions were in general

relatively low, which reflected banks» prudent approach in

taking open positions in foreign currency. The average

net foreign currency positions of 13 large banks, for

example, showed a downward trend since January 2004.

Those banks»s net foreign currency positions were in the

range of 1%-8%, except one state bank with an average

Chart 3.21Interest Rate Stress Testing

net foreign currency position above 6% due to an

exchange offer obligation that would fall due in June 2004.

Considering that all these banks had long USD positions,

a depreciating trend of rupiah against USD would not have

much influence on their profitability and capitals.

However, Bank Indonesia realizes that low net foreign

currency positions would give sufficiently large room to

these banks to undertake speculations, should monitoring

and regulating be inadequate. In this respect, effective 1

July 2004, a new regulation on net foreign currency

position is enforced whereby net foreign currency position

that should be maintained by a bank should be at

maximum 20% of its capital for balance sheet position,

admistrative accounts, and overall. This new regulation

would increase a bank»s capability to eliminate negative

impacts of exchange rate volatility so as not to disrupt it»s

capital. The new regulation has a very positive impact on

financial system stability.

5.4 Impact of Requirement on Market Risk

Adjusted Capital Adequacy On Bank Capital

Bank Indonesia has imposed an obligation on banks

to provide adequate capital for accommodating market

risk, effective January 2005. Implementation of this new

requirement would not have negative impacts on financial

system stability, considering that banks» CARs would yet8 As of 30 June 20049 As of 30 June 2004

CAR-Current (%) 18.61 17.69 25.29 14.98 30.62 29.94 10.74 11.65 18.18 21.74 16.24 21.62 27.47 20.367CAR-SBI rate decreases 1% 18.01 17.44 25.05 14.14 29.96 29.29 9.67 11.12 17.53 21.13 15.64 20.88 26.08 19.688CAR-SBI rate increases 1% 19.21 17.94 25.53 15.82 31.28 30.59 11.81 12.18 20.83 22.34 16.84 22.23 28.86 21.189

A B C D E F G H I J K L M Ave-rage

0

5

10

15

20

25

30

35

Note : CAR as of June 30, 2004

0

0.005

0.01

0.015

0.02

0.025

0.03

January Quarter-I Quarter-II (current)

2 0 0 4

37


remain above 8%. Based on a simulation on June 2004

positions of 39 banks that would have to meet this market

risk requirement, there was a drop in CARs in the range of

10 √ 212 bps, except CAR of one foreign bank that

dropped by 812 bps (outlier) due to the large amount of

marketable securities in its trading book portfolio.

However, overall, these banks would yet have CARs at

above 8.0%.

5.5 Market Risk Outlook

Despite that fact that banks» capital would yet be

stable, market risk is estimated to have a slight rising trend

in semester II/2004, taking into consideration the following

factors :

- Indonesia»s balance of payment is predicted yet toIndonesia»s balance of payment is predicted yet toIndonesia»s balance of payment is predicted yet toIndonesia»s balance of payment is predicted yet toIndonesia»s balance of payment is predicted yet to

experience relatively heavy pressures due to oil priceexperience relatively heavy pressures due to oil priceexperience relatively heavy pressures due to oil priceexperience relatively heavy pressures due to oil priceexperience relatively heavy pressures due to oil price

hikes and overseas debt payments in semsester twohikes and overseas debt payments in semsester twohikes and overseas debt payments in semsester twohikes and overseas debt payments in semsester twohikes and overseas debt payments in semsester two

of 2004of 2004of 2004of 2004of 2004. Continous oil price rise could put pressures

on rupiah exchange rate against USD, considering

that Indonesia»s position can be classified as net

importer. World oil price hikes would raise demand

for USD, which would not be met by equal supply.

- Gradual rise of US interest rate.Gradual rise of US interest rate.Gradual rise of US interest rate.Gradual rise of US interest rate.Gradual rise of US interest rate. Increases of Fed Funds

Rate (FFR) could be followed by increases of domestic

and international interest rates. Empirically,

Indonesia»s interest rate level has always been

influenced by US interest rate. As such, increases of

FFR could have impacts on banks» capability to

manage market risk exposures, considering the

following :

a. Overshooting of rupiah exchange rate would

continue in the short-term. With the increases

of FFR, investors would assess that investments

in Indonesia»s money and capital markets

become less attractive because its country risk is

yet high while its credit rating is not yet

∆investment grade∆;

b. Increasing volatility of the rupiah due to capital

outflows undertaken by foreign investors, who

enters and exits Indonesia»s money market within

a short time. Indonesia»s characteristic is quite

unique whereby hedge funds and foreign

investors dominate domestic capital market.

During semester I/2004, large banks» maturity profiles

in general showed short position for the short-term (less

than 3 months). This position is relatively sensitive to

interest rate changes, especially if Bank Indonesia

accommodates increases in US interest rates by raising SBI

interest rates, which influence domestic interest rate rise.

Although banks» capitals would be relatively stable at above

8% as shown by stress test results, interest rate increases

could lower performance of banks with maturity profile

at short position and as such these banks are predicted to

raise interest rates in order to maintain their profitability.

6. OPERATIONAL RISK

Indonesia»s bank operational risk was quite high. This

was particularly evidenced by the occurrence of a few cases

of fraud at several banks. This quite high risk was due to

weak internal cotrol and weak implementation of good

corporate governance. Bank Indonesia has taken follow-

up actions on cases of violations in the banking sector

through cooperations with related authorities as well as

issuance of regulations on risk management, which also

cover principles of operational risk management.

Operational risk arises from human errors, defaults

in systems and procedures, as well as fraud. Amongst

cases that have created operational risks at Indonesia»s

banks, fraud remained to be the largest source of risk. In

2003, there were two banks that have experienced fraud

and consequently suffered losses amounting to Rp1.70

trillion (18.45% of capital) and Rp294 billion (4.25% of

capital). During semester I/2004, one case of fraud

occurred in one bank with a nominal value of Rp35 billion.

38


Operational risks stemming from defaults in systems and

procedures as well as unintentional mistakes made by bank

staffs (human errors) were in general relatively small yet

and banks have handled these cases well.

The impact of operational risks on banks» capital in

Indonesia cannot yet be quantified. This is due to the fact

that data recorded by banks in Indonesia on losses resulting

from fraud, human errors, or weak systems is not yet

available. However, based on a simulation of 25 banks in

2003, operational risks faced by banks in Indonesia are

yet relatively high. Calculations based on the basic indicator

method and extreme scenario with __(beta) 18%, the

capital charge for opeational risks that these banks would

have to provide is extremely high. The impact would

drastically lower these banks» CARs to a range of 1.14%

to 14.26%.

In terms of number of banks, in 1999 61 banks have

been lodged. This number was getting smaller until it

became 22 banks in 2003. The quite high number of

banks lodged in 1999 stemmed from the fact that most

banks, which were liquidated and had their businesses

freezed, had undertaken violations with fraudulent motive.

Factors that have led to incidents of fraud at banks

in Indonesia are among others :

- Weakness in bank internal controlWeakness in bank internal controlWeakness in bank internal controlWeakness in bank internal controlWeakness in bank internal control

Although in general banks already have good internal

control systems, there are yet weaknesses in the

systems that makes their implementation weak.

Investigations of several cases of fraud , whether by

BI or bank internal audit work unit, revealed that the

main reasons that have led to the occurrence of fraud

were yet weak implementation of internal control,

lack of competency and independence in bank

internal audit work unit, as well as weak monitoring

of corrective actions undertaken.

- Collusion and yet low bank staffs» integrityCollusion and yet low bank staffs» integrityCollusion and yet low bank staffs» integrityCollusion and yet low bank staffs» integrityCollusion and yet low bank staffs» integrity

Based on investigation results, in general, various

cases of bank fraud involved insiders, who undertook

the fraudulent acts alone or under collusions with

external parties. Involvement of bank staffs showed

that at several banks there were yet staffs with low

integrity. Involvement of bank staffs confirmed the

statement that no matter how strong the internal

control system is, it will not be useful when people

that execute bank operations undertake a collusion.

- Weak law enforcementWeak law enforcementWeak law enforcementWeak law enforcementWeak law enforcement

Although Bank Indonesia has found and taken follow-

up actions on cases of fraud, law enforcement on

banking criminals in Indonesia is yet weak. Imposition

of penalties and sanctions on doers of fraud is felt to

be inadequate.

High operational risk could impact financial system

stability. If the situation is not well anticipated, it might

Table 3.12Fraud Cases in Banks

Bank 1Bank 1Bank 1Bank 1Bank 1 20032003200320032003 17001700170017001700 12001200120012001200 18.45%18.45%18.45%18.45%18.45% 941941941941941 78.4278.4278.4278.4278.42

Bank 2Bank 2Bank 2Bank 2Bank 2 20032003200320032003 294294294294294 294294294294294 4.25%4.25%4.25%4.25%4.25% 294294294294294 100.00100.00100.00100.00100.00

Bank 3Bank 3Bank 3Bank 3Bank 3 20042004200420042004 3535353535 3535353535 1.06%1.06%1.06%1.06%1.06% n.a.n.a.n.a.n.a.n.a. n.a.n.a.n.a.n.a.n.a.

Year

Total

Loss

(Rp Billion)

Value

(Rp Billion)

Fraud Value

to Capital

Write off

Provision

(Rp Billion)

%

10 Data source : UKIP 2003. Banks» data comprises those of commercial banks and bankperkreditan rakyat

Cases of violations in the banking sector in Indonesia

were yet many, however the occurrence was declining.

Cummulatively, violations in the banking sector that have

been reported to Bank Indonesia from 1999 up to 2003

comprise 376 cases10 . However, not all cases have criminal

elements (fraud). In addition to fraud, these cases

concerned abuse of authority, fictitious reporting, and

violations of banking regulations. Cases with element of

fraud were only 40% where all of these have been handed

over by UKIP (Special Unit for Bank Investigations) to the

law enforcement authority.

39


impact on lower banks» reputation, which in the end might

create distrust towards the banking sector. Taking this into

consideration, Bank Indonesia has taken follow-up actions,

both from the supervision side as well as regulatory side.

From the supervision side, Bank Indonesia has implemented

a risk-based approach to bank supervision. From the

regulatory side, Bank Indonesia has imposed the obligation

to implement risk management as incorporated in Bank

Indonesia regulation number 5/8/PBI/2003 dated 19 May

2003. In addition, banks are also put under the obligation

to implement effective bank internal control function.

7. PROFITABILITY

The banking industry»s profitability has shown

improvement in line with rising credits, which has started

since beginning 2004. ROA rose from 2.5% to 2.7% while

NII rose from Rp3.2 trillion to Rp5.4 trillion. However, there

were yet many national banks with ROA far below 1.2%

(28 banks). One of the reasons for this condition was yet

relatively low efficiency level, particularly at state banks.

During the next short-term, it is estimated that bank

profitability will be under pressure, mainly due to rising

trend of domestic and international interest rates. If this

risk is not well anticipated, it could have a negative impact

on profitability stemming from banks» maturity gap, which

tend to have more obligations that are sensitive to changes

in interest rates.

7.1 General Condition

The banking industry»s profitability has started to

improve, particularly prompted by the rise in credits.

In line with rising bank credits since beginning 2004,

the share of interest income from credits has slowly exceed

those from interbank placements and marketable

securities. The share of interest income from credits has

increased from 46.6% in December 2003 to 56.4% in

June 2004, while interest income from interbank

placements and marketable securities dropped from

15.3% and 30.8% to 9.5% and 26.3%, respectively.

The rise in the share of credit interest income has

prompted the rise of net interest income (NII) from Rp3.2

trillion in December 2003 to Rp5.4 trillion in June 2004.

As such, cummulatively bank interest income has risen from

Rp41.5 trillion (from July 2003 up to December 2003) to

Rp75.8 trillion (up to June 2004).

However, if interest income from marketable

securities are excluded from calculation of NII, up to

December 2003, the 15 large bank group, which mostly

comprise of recap banks, still experienced negative spread.

One of the largest state banks even only reached positive

spread at end of June 2004. This shows that although

credit exposure during 2004 has been quite large,

Chart 3.23Composition of Interest Income of Large Banks

Chart 3.24 Composition of Interest Incomeof All Banks (2003-2004)

Percent

May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

Securities Loan Placement at BI Others

55

50

45

40

35

30

18

16

14

12

10

8

6

4

2

0

Percent

Percent

Securities Loan Placement at BI Others

Percent17

15

5

13

11

9

7

60

55

50

45

40

35

30

25May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

40


Chart 3.26Trend of ROA (Peer Group Comparison) - June 2004

Indonesia»s banking industry has yet been very much

dependent on interest income from government bonds.

7.2 Return on Asset and Efficiency Level

National banks» profitability was far below that of

foreign bank group, stemming particularly from state

banks» being less efficient.

The banking industry»s Return on Asset (ROA) also

rose from 2.5% (December 2003) to 2.7% (June 2004).

This rise in ROA showed that the rise in banks» total assets

during semester I/2004 was particularly prompted by the

rise in earning assets and as such could raise profitability.

However, although in aggregate banks» ROA was

quite good, there were yet many banks with ROA at below

1.2%11 . The highest ROA belonged in the foreign bank

group, namely 4.25%, while the smallest ROA belonged

in the state bank group, namely 2.38%.

In addition to having stemmed from stable profit

growth and good efficiency level, this high ROA of the

foreign bank group stemmed from relatively small growth

of its assets. The low ROA of the state bank group

stemmped from among others : (i) yet relatively high

number of SBIs and government bonds (portfolios that

are sensitive fo interest rate declines) owned by those

banks; as well as (ii) this bank group»s operational

inefficiency as evidenced by its high ratio of operational

expense to operational income (OEOI).

Low level of efficiency seems to be a basic problem

at national banks, particularly state banks. For industry

average, yet adequate efficiency ratio (OEOI) would be

Chart 3.25 Net Interest Income Trends(Excl. Interest Income from Securities)

Chart 3.27Distribution of ROA - June 2004

<0 0.01 - 1.19 1.2 - 1.99 2.01 - 3.99 > 4

1216

22

45

36

Percent

Chart 3.28Efficiency and Overhead Cost Ratios - June 2004

11 Limit of sound ROA from level of sound

Industry State-owned Bank Private bank

Joint Bank Foreign Bank

6.0

4.0

2.0

1.0

5.0

3.0

Dec Apr Jun Aug Oct Dec Feb Apr Jun

2 0 0 2 2 0 0 3 2 0 0 4

100

6,0

60

40

20

10

120 35

30

25

20

15

10

5

0

Efficiency Ratio (left axis) OHC (right axis)

A B C D E F G H I J K L M N O

Sta

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dB

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15 L

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Ban

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Indu

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Fore

ign

Ban

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Percent Percent

8.0

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

15.0

10.0

5.0

0.0

-5.0

-10.0

-15.0

-20.0

-25.0

Foreign Banks Joint Venture Banks

Medium Banks Small Banks 15 Large Banks

15 Large Banks (right axis)

Dec Dec Dec Mar Jun

2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4

41


90.24% or classified as Sound. Meanwhile, the state bank

group and the 15 large banks group each had OEOI ratio

of 102.86 and 97.11% (Both groups are classified as

Unsound). The best efficiency levels were achieved by the

foreign and foreign joint venture bank groups with ratios

of 79.8% (Sound) and 84.5% (Sound), respectively.

7.3 Fee-Based Income7.3 Fee-Based Income7.3 Fee-Based Income7.3 Fee-Based Income7.3 Fee-Based Income1212121212

The foreign bank group was extremely dependent

on fee-based income.

The foreign bank group earned the highest fee-based

income compared to other bank groups. Relatively better

quality human resources and relatively better support of

experience, network, and information system technology

have prompted the share of fee-based income of the

foreign bank group reached 75% of its total operational

income. The next bank group that had high share of fee-

based income, namely 345, was the foreign joint venture

bank group. Meanwhile, the shares of the state bank

group and foreign currency bank group were only 19%

and 18%, respectively, far below the banking industry»s

average of 27%.

liabilities owned are larger than sensitive assets owned13 .

This condition will cause the interest expense side of the

banks to experience faster repricing compared to their

interest income side.

7.5 Future Risk and Prospect

In general, several matters that will threathen banks»

profitability are among others : (i) yet low level of efficiency

in national banks, particularly the state bank group and

15 large bank group, (ii) potential rise of interest rate that

in the short-term will influence banks» NII, as well as (iii)

yet relatively high banks» NPL ratio that is even suspected

to worsen, which is estimated to also pressurize banks»

profitability.

However, in the short-term, national banking

profitability is estimated to remain sufficiently stable

supported by yet rising credit channeling. Results of

simulation on the planned new minimum reserve

requirement effective July 2004 also show insignificant

impact in banks» profitability decline.

8. CAPITAL

The banking industry»s capital ratio during 2004 has

been quite adequate, on average above 20%, however

with a downward trend attributable to rapid credit growth.

However, up to end semester I/2004, there were two banks

with CARs below 8% and 7 banks with CARs between

8% - 10%.

In addition, several risk factors that have the potential

to put the banking industry»s capital under pressure are

among others : (i) Banks» tendency to undertake less tight

assessment of NPLs and as such banks» credit quality might

be worse than reported, (ii) There have been several cases

of violation of maximum limit for credit extensions, (iii) yet

12 Dividends, commissions on credit extensions and derivative transactions, fees on man-aged credits, and others

13 Sensitivity to interest rates is evidenced by the larger amount of short-term liabilitiesowned by a bank over the amount of its short-term assets

Chart 3.29Fee Based to Total Operating Income Ratios

7.4 Impact of Possible Interest Rate Rise on Bank NII

Indonesia»s bank portfolio maturity pattern in general

has a gap that is called liability sensitive, where sensitive

Dec Jun Sep Dec Mar Jun

Industry State-owned Bank Private Bank Joint Bank Foreign Bank

2 0 0 1 2 0 0 3 2 0 0 4

42


relatively low national banks» recapitalization capability,

and (iv) RWA rise due to credit rise.

However, this decline in capital ratio is estimated to

not have serious impact yet on financial system stability

and the banking industry in particular because the banking

industry»s capital is yet quite adequate.

Rapid growth of credits during 2004 was still ably

covered by adequate capital. The banking industry»s CAR

during 2004 averaged above 20% although with a

downward trend due to RWA growth resulting from rising

credits. As such, at June 2004 position the banking

industry»s CAR slipped a bit to 20.9%, its lowest in 2004. up to the end of the report period. Meanwhile, there

were 17 banks with CARs above 50%, which in general

were the foreign joint venture banks. This condition

reflected the intermediary function that has not yet fully

functioned in the related banks.

8.2 Capital Ratio By Bank Group

Using a more conservative approach, the tier 1 to

total asset ratio of the banking industry was 8.95%, while

those for the state bank group and 15 large bank groups

were less smaller, namely 7.92% and 8.0%, respectively.

The highest ratio belonged to the foreign bank group at

9.14%.

This condition showed that the foreign bank group»s

equity and capitalization capability were better than other

8.1 Composition of Banks» Capital

Although banks» capital ratio was yet relatively high,

there were 10 banks with CARs of 8% - 10%, which were

quite susceptible to declines in earning asset quality and

or rising risks. This condition has relatively not changed

since December 2003, which reflected these banks» lack

of capability to undertake improvement.

Meanwhile, there were 2 small banks with CARs of

<8%. These two banks have actually fulfilled the

commitment for additional capitals, which have been

placed in escrow accounts in May 2004. However, these

fund deposits could not be calculated as capital deposits

because they were still undergoing formal legal process

Chart 3.31Distribution of CAR

Chart 3.30CAR - June 2004

Chart 3.32Tier 1 to Total Asset Ratio - June 2004

Percent

DecDec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun10

15

20

25

30

35

40

45

50

55

00 01 2002 2003 2004

State-owned Bank

Industry

Private Bank

Joint Bank

Foreign Bank

< 8% (right axis)

Number of Banks90

80

70

60

50

40Sep Feb Jul Dec May Oct Mar Aug Jan Jun

2 0 0 0 2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4

> 20% 8 – 20% < 8%

30

25

20

15

10

5

0

15

12

9

6

3

-

40

35

30

25

20

15

10

5

0

CAR (right) T1 : TA (left)

A B C D E F G H I J K L M N O

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43


bank groups». The banking industry»s CAR is estimated to

be overstated because of banks still applied too loose

assessment on credit collectibility (overstated). This was

an evidence of differences in collectibility assessment

between bank auditors and the banks.

8.3 Future Prospects

Although the banking industry»s capital was relatively

quite adequate, there are several aspects that put pressures

on bank capital, specifically on banks that have CARs

between 8% - 10%, namely : (i) A potential of decline in

earning asset quality and or rise in losses, (ii) a tendency

of banks to apply less tight assessment on NPLs, (iii) the

findings of several cases of violation of maximum limit for

credit extensions, and (iv) yet relatively low national banks

recapitalization capability compared to the foreign bank

group.

However, this decline in capital ratio is estimated to

not yet have serious impact on financial system stability,

nor on the banking industry in particular, due to banks»

capital ratio being yet quite adequate.

9. DIRECTIONS OF BANKING POLICIES

9.1 Indonesian Banking Architecture

Indonesian Banking Architecture (IBA) activity

program implemented from January up to June 2004 went

well. This is evidenced by implementation of several IBA

programs from several pillars, namely :

9.1.1 Program for Strengthening National Banking

Structure (Pillar I)

Strengthening of Bank Capital

As already determined, the structure of the

national banking industry will comprise International-

quality banks (international champions), national banks

(national champions), banks that are focused players,

banks with limited business activities, and Rural Banks

(BPR). Programs concerning the strengthening of bank

capital comprise :

1. Program to increase minimum capital requirement for

commercial banks (including Regional Government

Banks) to Rp100 billion up to 2010; and

2. Program to retain capital requiremet of Rp3 trillion

for newly established banks up to 1 January 2011.

In order to realize these two programs, currently

formulation of scope concepts for each bank category is

undergoing in accordance with the categories determined

in IBA»s visions. More intensive studies and discussions

have been undertaken specifically for banks with limited

business activities category, which is commercial bank

group that will be downgraded to banks with limited

business activities, if their capitals come to below Rp100

billion in 2011.

9.1.2 Program for Enhancing Bank Regulatory

Quality

Expert Panel

Establishment of an expert panel , which is one

of the activities of the initiative for ∆formalization of

the syndication process in formulation of banking

policies∆, is for creating a forum for experts, both from

within the country and abroad, to give strategic inputs

on banking.

9.1.3 Program for Consolidation of Supervisory

Function (Pillar III)

For the five programs under Pillar III, namely program

for enhancement of bank auditor/supervisor competency,

program for development of risk-based supervision system,

program for enhancing coordination between supervisory

institutions, and program for enhancing enforcement

effectiveness, currently compilation of and review over

inputs are undergoing for inprovement of the preliminary

concept that has been developed.

44


9.1.4 Program for Minimum Standards of Good

Corporate Governance (Pillar IV)

Determination of minimum standards of good corporate

governance

Determination of minimum standards of good

corporate governance is one of the activities of the initiative

for ∆ enhancing bank good corporate governance∆. The

coverage of this activity is quite wide, and therefore its

discussions are undertaken in stages. At this stage,

discussion was focussed on bank directors and board of

commissioners. Internal discussions within BI that have

been conducted several times will be complemented with

discussions with representatives of the banking players.

Discussions with these external parties will be conducted

through a forum that will be established in the near future

through cooperation with the National Committee For

Good Governance Policies.

Requirement on Risk Manager Certification

Requirement on risk manager certification comprises

one of the activities of the initiative for ∆enhancing bank

risk management quality∆ (Pillar IV). Discussions under this

activity that have been undertaken with representatives of

the banks, namely the Indonesian Risk Professional

Association (IRPA), have reached an advance stage. In

cooperation with IRPA, blueprint for the risk management

certification program has been developed and formalized

in a kick-off meeting on 7 July 2004. The official formalization

was made by Bank Indonesia»s Governor and attended by

representatives of the banks and banking associations.

9.1.5 Program for Enhancement of Customer

Protection (Pillar VI)

Of the four programs under enhancement of

customer protection, namely development of mechanism

for customer complaints, establishment of independent

mediation institution, product information transparancy,

and customer education, two programs (development of

mechanism for customer complaints and product

information transparancy) have been completed and will

soon be enforced through Bank Indonesia new regulations

on Mechanism for Customer Complaints and Product

Information Transparancy. At the moment, specifically on

product information transparancy, there is a constraint that

is being solved that concerns implementation of standard

clauses in the banking industry.

As regards the two other programs, namely

establishment of independent mediation institution and

customer education, intensive discussions are made with

related parties, including banking law experts, and

recommendations have been put forward to raise the

status of the mediation institution to a banking arbitrage

body. Meanwhile, for the customer education program,

codification of materials and formulation of education

strategy for the short-term and long-term are also in

progress.

9.2 Rural Bank (BPR)

Rural Bank (BPR) have proven that their role is

becoming more important in promoting the growth of

small businesses. Although several BPRs have been closed,

there have been many more BPRs opened in order to

promote development of regional economy. In general,

performance and risk of BPRs have been relatively small

as evidenced by the rise of number of BPRs categorized

as being sound and adequately sound.

In the framework of creating sound BPR industry,

Bank Indonesia continues the implementation of

government guarantee program in order to maintain public

confidence as well as undertakes the policy to restructure

the BPR industry by making efforts in rehabilitation steps

through acquisitions, additions to paid-in capital, mergers

45


of problem BPRs that can still be salvaged, as well as

encourage the entry of new investors tht have capability

to strengthen BPR capital and management. When a BPR

cannot be salvaged, its business activity is freezed or its

business license revoked.

Enhancement of regulatory and supervisory system

that take into consideration BPR characteristics and

international best practices is implemented through

enhancement of several regulations concerning BPR

institution, utilization of BPR database as a facility for early

detection system, enhancement of law enforcement

effectiveness, selection of BPR new management

candidates through compliance and capability tests, and

enhancement of BPR prudential principles, including the

CAMEL requirement, BPR soundness level that include

CAMEL percentage, ratio of minimum capital, ratio of

earning assets, ratio of provision for earning assets losses,

maximum limit on credit extensions, changes in clasification

of credit collecibility, provision for earning assets losses, as

well as credit restructuring.

In addition, in order to strengthen BPR operations

and support real time supervision, there is a need to

develop adequate information technology in BPR

operations. Constraints faced in efforts to implement

information technology in BPR industry is the fact that

many BPRs still do not have computers (personal

computers), which causes delays in provision of information

on BPR nationally.

Bank Indonesia also promotes linkage program

between commercial banks and BPRs in relation to credit

channeling to small and micro businesses. This linkage

program is a development on the success of the Micro

Credit Project. This strategy is a form of mutual benefit

cooperation between commercial banks and BPRs as well

as with micro finance institutions in order to widen the

scope for channeling micro credits.

9.3 Sharia Banking

The sharia banking indusry was in relatively stable

condition with a potential to rise as evidenced by quite

rapid asset growth, growths of business volume and

soundness level, which are bolstered by widening sharia

banking service provisions through the opening of several

branch offices in several provinces.

In line with Bank Indonesia»s efforts to control excess

liquidity in the banking sector, enhancement of the

minimum reserve requirement (MRR) for commercial banks

is also followed by imposition of MRR on sharia banks.

The new MRR is basically a monetary policy instrument,

which imposition will involve all banking institutions as

institutions that have the capability to transmit every

monetary policy to the economic system. One of the

reasons for the decision to raise MRR is to support rupiah

exchange rate stability through absorption of banking

institutions» excess liquidity while still paying attention to

undergoing economic recovery process.

Sharia banks are banking institutions, where each

of their operational activities is an integral part of the

economic system itself. Therefore, results of

macroeconomic analyses will also include the sharia

banking institutions as agents that also can transmit every

adopted monetary policy. However, sharia banking has a

different operational concept than that of conventional

banking, where every transaction made has to be ensured

to have followed the sharia principles.

It can be understood that the rise in MRR, which

gives an insentive (current account fee) of 5% for every

increase from the previous level of MRR, is one of the efforts

to improve money market structural liquidity condition.

Imposition of MRR with an insentive package on sharia

banks will be made after a review has been conducted on

types of transactions that are acceptable by the sharia

principles.

46


Box 3.1 Financial Safety Net

Financial system stability is built on five pillars, namely

: (i) stable macroeconomic condition; (ii) sound regulating

and supervision of financial institutions; (iii) sound and

efficient money markets and institutions; (iv) safe and reliable

financial infrastructures; and (v) effective financial safety

net. In general, there are two major instruments that can

be used in relation to financial safety net, namely lender of

last resort (LLR) and deposit insurance.

Financial Safety NetFinancial Safety NetFinancial Safety NetFinancial Safety NetFinancial Safety Net

In the framework of increasing financial system

stability, Ministry of Finance and Bank Indonesia have

developed the frame for Indonesia»s Financial Safety Net/

IFSN. The IFSN frame has been developed together by the

IFSN team comprising officials from Ministry of Finance and

Bank Indonesia.

IFSN is a policy frame that explicitly contains the tasks

and responsiblities of each related institution, namely

Ministry of Finance (MoF), Bank Indonesia (BI), and the

deposit insurance institution (DII), as the players in the

financial safety net. In principle, MoF is responsible for

developing legislations for the financial sector and provide

funds for tackling crises. BI, as the central bank, is

responsible for maintaining monetary stability and banking

industry»s soundness, as well as safety and smoothness of

the payment system. DII is responsible for guaranteeing

bank customers» deposits as well as resolutions of problem

banks. The IFSN frame will be incorporated in the IFSN law,

which is planned to be completed at end 2004. This

upcoming IFSN law will function as a strong foundation for

policies and regulations that will be determined by related

authorities in the framework of maintaining financial system

stability.

Contingency Financing FacilityContingency Financing FacilityContingency Financing FacilityContingency Financing FacilityContingency Financing Facility

A good lender of last resort (LLR) policy has proven

to be one of the effective tools in preventing and handling

crises. In this regards, BI has formulated more clearly the

policy on LLR, both for normal and crisis conditions, by

making reference to best practices. In priciple, in a normal

condition, LLR facility is only given to an illiquid but solvent

bank with liquid collateral of high value. Meanwhile, in a

crisis condition, the main considerant is the potential for

systemic impact. However, requirements on solvency and

collaterals, with several exceptions, are still applicable.

In handling liquidity problems that have systemic

impact, BI as lender of last resort can give emergency

financing facility (EFF) to commecial banks, where the

government then bears their funding. This is based on

Law 23 of 1999 regarding Bank Indonesia as amended by

Law 3 of 2004, which has been approved by the People»s

Representative on 15 January 2004. On 17 March 2004, a

Minute of Agreement between the Minister of Finance and

BI»s Governor has been signed regarding stipulations and

procedures on decision making in handling bank financial

problems that have systemic impact, awarding of the

emergency financing facility, and financing source from the

state budget. For implementing guidelines, MoF and BI

have completed the development of draft regulation

concerning EFF for commercial banks that will be

incorporated in Minister of Finance Decree and BI

regulation.

Deposit Insurance InstitutionDeposit Insurance InstitutionDeposit Insurance InstitutionDeposit Insurance InstitutionDeposit Insurance Institution

Experience shows that deposit insurance institution

(DII) is one of the important elements for maintaining

financial system stability. The government blanket

guarantee program, which came into effect because of the

crisis that started in 1998, has indeed been successful in

recovering public confidence in the banking sector.

However, research shows that the blanket guarantee has

spurred moral hazard that has the potential to create crises

in the long-run.

In this regards, the government and BI have been

successful in developing draft law on DII. This draft law is

currently undergoing discussions with the People»s

Representative together with the government and BI as

source persons. In this draft law, DII will have two main

responsibilities, namely : (i) to guarantee bank customer

deposits; and (ii) to handle (find resolutions) problem banks.

In order to prevent negative impact on financial stability,

the implementation of the DII scheme will be made in stages.

Up to March 2005, the whole liabilities of banks will still be

guaranteed by DII. After that time, starting March 2007,

guarantee on bank customer deposits will be limited up to

Rp 100 million per account.

47

Chapter IV Non-Bank Financial Institutions

Chapter 4Non-BankFinancial Institutions

48


49


1. CONDITION OF INSURANCE INDUSTRY

The insurance industry still has a potential for

expanding in Indonesia. However, national insurance

companies face heavy challenges, especially if there are

no coordinated efforts to revive its image that has

deteriorated due to unprofessional management and

weak regulation enforcement. If these problems are not

addressed then the insurance companies» credibility will

continue to suffer, resulting in a negative influence on

financial system stability.

Gloomy prospects for the insurance industry

business are influenced by several factors. First, the

macroeconomic condition such as low interest rates and

fluctuating exchange rate have lowered investment yields.

This is due to the insurance industry»s investment portfolio

which, is mostly in deposits (29.06%) and corporate

stocks/bonds (25.48%). Although shifts in portfolio to

bonds and stocks have risen, their investment yields do

not automatically rise, considering bond interest rates

follow those of SBIs.

The second factor concerns legal uncertainty and

unsupportive business environment. For example, the

Central Jakarta Commercial Court decision to pronounce

bankruptcy on PT. Prudential Life Assurance. Although in

2003 this company»s capital reached Rp202.6 billion with

a ratio of capital adequacy to risk born reached 225%, far

above the Ministry of Finance»s requirement of 100%, and

its income from premiums rose to 114%, the court

approved PT Prudential bankruptcy. Such an incident

negatively affects the insurance industry by lowering public

confidence and interest in placing their funds in insurance

products. A similar incident also happened to PT. AJMI,

Chapter 4Non-Bank Financial Institutions

which is a business unit of Manulife Financial Corp.

(Canada). On 13 June 2002, AJMI was pronounced

bankrupt by the commercial court because it was judged

to be incapable of paying dividends for accounting year

1999 along with related interests to PT Dharmala Sakti

Sejahtera Tbk (DSS) in the amount of Rp32.7 billion.

These two incidents may have a negative impact

on the investment climate in Indonesia. Foreign investors

may become unwilling to make investments in solvent

companies are pronounced bankrupt by the Commercial

Court.

After a protest from parent companies, the court

decision was changed. This gave the impression that

judiciary institutions in Indonesia can be improperly

influenced , which lowers the credibility of the Indonesian

state and government.

The third factor, which also impacted insurance

industry development, is the unbalanced structure of

insurance companies, whereby small insurance companies

have to compete with large insurance companies with the

same market risks. This condition poses heavier challenges

for small companies due to the active cooperation between

large insurance companies and banks through the

mechanism of bancassurance. Consequently, large

companies become larger and small companies are pushed

back further. Data from Infobank Research Bureau reveals

that 75.83% of the premium market is dominated by 10

large life insurance companies, while the remaining share

is spread between 32 companies. Meanwhile, in the

general insurance market, the 10 largest companies

dominate 59.85% of the share, while the remaining share

is spread between 80 companies.

50


The fourth factor is low capability to raise capital,

which makes it difficult for companies to grow. Difficulty

in obtaining additional capital for expansion is

experienced by both state as well as private insurance

companies. In deciding to place additional capital,

investors do not only assess the insurance company

condition but also the industry climate. For state

insurance companies, additional capital through

additional paid-in capital by shareholders is difficult,

considering government inability to finance capital.

Meanwhile, privatization is also difficult, considering

investors» interest in the insurance industry is small. One

possible alternative might be increasing capital from

profits by reducing payment of dividends to the

government. Currently, based on the agreement between

the government and state insurance companies, 50% of

company profit is paid to the government. Judging the

current insurance industry»s condition, it is recommended

that government share should not be the same in all state

insurance companies but instead based on each

company»s condition. If the capital of a state insurance

company is not adequate, the government»s share of

the dividends should be reduced and profits be added

to capital. This recommendation has been put forward

by officers of state insurance companies in a hearing with

Commission V of the People»s Representative on

Wednesday, 9 June 2004.

Based on the above mentioned conditions, the

insurance industry needs to realign its capital and

reformulate its core business in addition to improving its

management and operations. Insurance practices that are

not sound will eventually harm insurance industry. The

addition of a number of insurance companies to the list

of companies with frozen business is suspected to have

occurred because these companies are not managed with

the principles of good corporate governance and have

weak capitals.

2. DEVELOPMENT OF PENSION FUND INDUSTRY

Performance of pension funds during semester I

declined. However, it is predicted to rebound in line with

rising deposit interest rate, investment shift to SUN and

mutual funds that give higher yields. Pension fund

investment in SUN has risen rapidly by 255.3%. Therefore,

it is predicted that condition of pension funds would be

relatively stable.

Current condition shows that although allowable

alternative pension fund placements are quite wide,

placements are still predominantly in deposits and bonds,

with average shares of 60% and 10%, respectively.

Therefore, with the occurrence of routine sales of SUN in

large amounts, there has been quite a sizable shift in

pension fund portfolio investment pattern to this

instrument. By placing in SUN, pension fund portfolio

face lower risk due to government guarantee of SUN

although it receives lower yield.

As of September 2003 position, managed funds were

recorded at Rp41.2 trillion or up 18% compared to 2002.

During semester I/2004, managed funds placed in SUN

rose rapidly by Rp10 trillion or 255.3% to Rp13.5 trillion

(Chart on Government Bond Ownership). However, the

share of pension funds ownership in SUN is still relatively

small at 3.42%. Nonetheless, pension funds» role in

supporting routine sales of SUN is becoming more

important because of their ability to absorb 10% of sales.

Chart 4.1Government Bond Ownership

Insurers

Banks

Pension Funds

0

5,000

10,000

15,000

20,000

25,000

30,000

Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr2 0 0 2 2 0 0 3 2 0 0 4

Billion Rp

51


utilization of this wider opportunity also demands that

pension funds managers apply tighter prudential principles

in the framework of risk management. Furthermore, growth

of managed funds is predicted to make pension funds role

become more strategic as a driving force for the capital

market and in the maintenance of financial stability.

Box 4.1 Cases of Bankruptcy Pronouncements of Insurance Companies :PT. Prudential Indonesia dan PT. Manulife Indonesia

Bankruptcy pronouncements on several insurance

companies, including PT Prudential Indonesia and PT

Manulife Indonesia, have been caused more by factor

of legal weakness than problems with the companies»

financial conditions. If event of such bankruptcy

pronouncements continues, it is predicted that such

situation could trigger reputation risk due to

deteriorating public confidence in the insurance

industry. Therefore, in the future, there is a need for

efforts in enhance the law on bankruptcy or insurance,

which is based on prudential principles in the insurance

business and justice.

PT. Prudential Life Assurance is a business unit of

Prudential Plc., an international financial services

company incorporated in 1848 in England with total

managed funds reaching US$300 billion all over the

world. In Indonesia, Prudential started to operate in

1995. The shareholders are The Prudential Assurance

Company LTD (94.6%) and PT Sasana Dwi Paramitra

(5.4%). Currently, Prudential has 230 employees and

more than 8,000 professional marketing staffs.

The financial performance of Prudential itself has

been quite good. In 2003, its capital reached Rp202.6

billion with a ratio of capital adequacy to risk born

reaching 225%, far above Ministry of Finance»s

Table Box 4.1 Fiancial Highlightsof Prudential Life Assurance (Indonesia)

Source: Bisnis Indonesia

(Billion Rp)

2002 2003

Total assets 756.6 1,567.7

Capital 125.2 202.6

Liabilities 631.4 1,365.1

Premium Income 476.8 1,018.8

Profits 18.6 78.1

Liquidity Ratio 109% 110%

RBC 141% 255%

requirement of 100%. Meanwhile, its premium income

rose to 114% compared to the year before to Rp1.0

trillion in 2003. Prudential»s office network in Indonesia

is also quite wide, with six marketing offices in : Jakarta,

Medan, Surabaya, Bandung, Denpasar, and Semarang,

61 agency offices, and 14 financial consultation centers.

Based on decision number 13/PAILIT/2004/

PN.NIAGA.JKT.PST dated 23 April 2004, the Central

Jakarta Commercial Court pronounced bankruptcy on

PT. Prudential Life Assurance. The bankruptcy suit was

lodged by Lee Boon Siong (a malaysian citizen), an ex

insurance agent consultant of Prudential. The plaintiff

considered Prudential (the accused) as having an

obligation under the Pioneering Agency Bonus

Agreement. The Central Jakarta Commercial Court

then pronounced bankruptcy on this insurance

In the framework of developing pension funds

business activities, in the near future, the supervisory

authority will issue a regulation that will widen the choice

of alternatives for pension fund portfolio placements in

various investment products. It is expected that pension

funds capability to earn profits would increase. However,

52


company because it was considered to have defaulted

on the payment of its obligation, which amounted to

Rp1.43 billion.

In taking the decision to pronounce bankruptcy,

the council of judges at the commercial court

considered the decision has fulfilled the stipulation of

Law 4 of 1998 on Bankruptcy. Paragraph 1, item (1) of

the law states that when a debtor that has two or more

creditors do not pay at least one matured debt can be

pronounced bankrupt by court decision. In other words,

without the need to consider the accused company»s

solvency, if the company has indeed legitimate debts

(meaning, the number of debts that have fallen due

matches the stipulation of the law) and the company

does not make payment, the commercial court could

pronounce bankruptcy on the company.

This law is considered to be the weak point of

the insurance industry. Pronouncement of bankruptcy

on insurance companies becomes quite easy. When

a debtor does not pay its debt (whether because it is

not able to, disputes the debt or because of another

reason), it can be pronounced bankrupt. Although

insurance companies are also financial service

companies, they are not like banks for example, where

pronouncements of bankruptcy must have Bank

Indonesia»s approval.

A similar case also occurred previously to PT. AJMI,

which is a business unit of Manulife Financial Corp.

(Canada). On 13 June 2002, AJMI was pronounced

bankrupt by the commercial court because it was

judged to have not paid dividends for accounting year

1999 along with related interests to PT Dharmala Sakti

Sejahtera Tbk (DSS) in the amount of Rp32.7 billion.

At that time, Manulife was in a sound condition with

total assets of Rp1.8 trillion, total obligations of Rp1.6

trillion, and ratio of capital adequacy to risk born of

167.3%. This pronouncement was then protest by the

Canadian government and International Finance Corp.

Afterwards, AJMI itself lodged an appeal at the supreme

court and the supreme court then agreed to the appeal

and annulled the commercial court decision.

These two incidents could have brought negative

impact on the investment climate in Indonesia. Foreign

investors could have become unwilling to place their

funds due to the ease at which companies are

pronounced bankrupt. Meanwhile, after a protest by

the parent companies, diplomatic inquires and others,

the court decision was subsequently changed. This gave

the impression that Indonesia can be influenced, which

could lower the credibility of the Indonesian state and

government.

In the settlement process of these cases, it is

predicted that these two insurance companies would

be able to fulfill their obligations, including through

the support from their parent companies. The problem

then would be the reputation of the insurance

companies. These incidents could make potential

customers hesitant in placing their funds in the

insurance, which could hamper development of the

national insurance industry that has just started to grow.

53

Chapter 5 Capital and Money Markets

Chapter 5Capital and Money Markets

54


55


Development of the capital market in semester I/2004

was quite encouraging, marked by rising bond and

composite indexes.They achieved their highest levels in

Indonesian capital market history during April 2004 before

trending downwardthrough theend of the semester. Index

weakening at end of semester I/2004 was largely related

to the weakened world bourse performance and the

heightened domestic political climate due to the general

election. It is predicted that a potential increase in interest

rates could lower the performance of the capital market ,

which has started to develop as an institution for public

fund provision (alternative financing) and investments.

1. STOCK MARKET

Rising activities in Indonesia»s stock markets

particularly during the first four months of 2004, marked

the attainment of the highest index of 783 in April.

Improved economic fundamentals and the smooth

election of members of the legislative body contributed to

this positive result. However, subsequent revelations related

to problems with the ballot counting process and protests

Chapter 5Capital and Money Markets

submitted by several election candidates have impacted

the political climate and given worry to investors.

Weakening in the global bourse resulting from oil price

hikes and Fed Funds interest rate hikes have also brought

pressures on regional and domestic bourse development.

These negative impacts have contributed to a downward

trend in the composite index during May and June 2004.

During semester I/2004, there have been 21

additional issuers that registered stocks with a total value

of Rp3.3 trillion (1.32%). In addition, market liquidity

rebounded to its pre-crisis level of average 0.30%, albeit

at far larger volume. Liquidity from transaction frequency

rose to an average of around 15,000 transactions per

month. This condition reflects a developing market, which

could become an alternative source for corporate financing

and investment and as such can be expected to contribute

in acceleration of the real sector recovery.

From risk indicator that is reflected by stock price

volatility, development of the stock market volatility was

relatively small and did not give a signal of significant

pressures of upcoming crisis. Currently, average volatility

during 6 months was recorded at 0.49 compared to 5.32

in the period approaching the crisis. This condition implies

that if there are no large crisis pressures, the stock market

is still safe and profitable.

However, the stock market is extremely sensitive to

market sentiment. In addition, potential interest rate rise

could again put pressures on the index and transaction

frequency. This is due to the fact that most investors still

make use of the stock market as a facility for undertaking

short-term investments and quick profits, particularly large

investors that could influence market movements.

Chart 5.1Equity Index and Market Capitalization

Market Capitalization

Index

Sourve: Bloomberg

Billion Rp

0

100

200

300

400

500

600

700

800

900

Jan-00 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-040

50

10

15

20

25

30

35

40

45

56


in the history of the capital market, although afterwards it

dropped quite drastically in May 2004.

In such condition, fluctuations in the stock market

cannot really be avoided. The important thing to do is to

maintain economic fundamentals and domestic stability

in order to keep the situation under control. Actually, the

Indonesian stock market still has room for expansion. This

is particularly due to the fact that stock prices in Indonesia

are still considered cheap compared to those in the regional

bourse. This is reflected by the relatively low price earning

ratio (PER) of stocks in Indonesia, which as of end of June

2004 was 12.06%, compared to several other Asian

countries, which PERs are above 13%.

The condition of the stock market could be adversely

impacted by the activities of foreign investors who are the

main players in the Indonesian stock market. These foreign

investors could easily spur fluctuations in the market due

to their ability to enter and exit the market with a

significant amount of funds and within short time.The

composite index movements during 2004, evidence how

index movements have been greatly influenced by

transactions undertaken by foreign parties. A rise in buying

transactions undertaken by foreign investors would be

followed by a rise in the composite index. On the other

hand, if foreign investors undertake selling actions, the

composite index would decline. Therefore, there is

probably a need to think about applying monitoring over

short-term capital flows, particularly those driven by foreign

speculators, as is adopted by several advanced countries.

During each of the first four months of 2004, foreign

investors recorded net buy transactions in relatively large

amounts that averaged Rp2.0 trillion. Only in May there

were net selling transactions undertaken by foreign

investors amounting to Rp0.3 trillion. Meanwhile, June

2004 again experienced net buying position, however at

a relatively small amount of Rp0.1 trillion. All these

transactions are reflected in the composite index

movements, which in April 2004 reached its highest point

Source: Bloomberg

HANG SENG

IHSG

STI

SET

PCOMP

KLCI

30

28

26

24

22

20

18

16

14

12

101/2 1/12 1/22 2/1 2/11 2/21 3/2 3/12 3/22 4/1 4/11 4/21 5/1 5/11 5/21 5/31 6/10 6/20 6/30

IHSG STI SET KLCI PCOMP HANG SENG2 0 0 4

Chart 5.4PER of World Stock Exchanges

Chart 5.2Volatility of Equity Index

y = 509.23e - 0.0013x))Source: CEIC, processed

0

5

10

15

20

25

30

35

40

0

100

200

300

400

500

600

700

800

900VJSX (LHS) JCI (RHS) Expon. (JCI (RHS))

97 98 99 00 01 02 03 04

Chart 5.3Equity Index and Transaction of Foreign Investors

Foreign Investors Net JCI

Foreign Investors, Net (Million Rp) JCI

Source : Bloomberg, CEIC

1/2 1/8 1/14 1/20 1/25 2/1 2/7 2/13 2/19 2/25 3/2 3/8 3/143/20 3/26 4/1 4/7 4/13 4/19 4/25 5/1 5/7 5/13 5/19 5/25 5/31 6/6 6/12 6/18 6/24 6/30600

680

700

720

740

760

780

800

8202,000,000

1,500,000

1,000,000

500,000

0

-500,000

57


The financial sector»s stock price index showed an

increase of 10.8 points to 89.6, while market capitalization

also rose by Rp426 million to Rp6.8 billion. These increases

were largely boosted by the stocks of banks such as Bank

Mandiri and BRI, which were still considered to be

undervalued but sufficiently profitable due to satisfying

profits.

The closure of Bank Asiatic and Bank Dagang Bali

did not bring large negative impact on banking sector»s

index performance. After these closures, the index

dropped by 1.02% but afterwards rose again in line with

the issuance of banks» financial reports and plans for

dividend distributions.

Chart 5.5Equity Index of Financial Corporations

Market Capitalization

Index

Source: Bloomberg

0

20

40

60

80

100

120

140

0

2

4

6

8

10

12

14

16

Jan-00 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04

Billion Rp

2. DEVELOPMENT OF BOND MARKET

2.1 Corporate Bonds

The corporate bond market displayed fluctuating

performance during semester I/2004. Its high spread of

around 4-5% above SBIs could still attract investors,

particularly pension funds and insurance companies.

However, the corporate bond market was not as active as

the SUN (government bond) market due to the relatively

small volume of outstanding corporate bonds and the high

risk potential for defaults. Several corporations such as

the Asia Pulp and Paper group (PT Tjiwi Kimia, PT Indah

Kiat, PT Lontar Papyrus and PT Pindo Deli) and the Mulia

group (PT Muliakeramik Indahraya and PT Muliaglass),

have issued bonds in large amounts that have been

restructured and areagain experiencing payment difficulty.

This situation has lowered investors» confidence in

corporate bond performance.

Total trading transactions of corporate bonds during

semester I/2004 amounted to Rp7.4 trillion, relatively did

not change compared to total transactions during semester

II/2003. Although number of transactions remained

relatively the same, the value of bond capitalization,

especially in rupiah, experienced quite significant increase,

from Rp45.4 trillion at end-semester II/2003 to Rp50.5

trillion this semester. Meanwhile, the highest monthly total

transaction value occurred in April 2004 in the amount of

Rp1.88 trillion, the highest during 2004. The same positive

conditions that boosted the stock market in early 2004s

also had a positive impact on the bond market, particularly

in relation to the downtrend of SBI interest rates. In line

with the stock market development, in the months of May

and June 2004, corporate bonds experienced declining

activities due to uncertain political condition and Fed Funds

interest rate hikes. This condition then forced issuers to

offer higher interest rates for bonds that were going to be

issued. The interest rates on Bonds III of PT Indofood Sukses

Makmur, originally offered at 12%, had to be raised to

12.5% in order to meet investors» request.

Table 5.1Corporate Bonds

Source: Surabaya Stock Exchange

Semester I Semester II Semester I

2003 2003 2004

Registered BondsRupiah 132 180 207USD 0 2 2

Registered Bond IssuersRupiah 61 90 98USD 0 2 2

Trading Volume (Rp Billion) 6.071 7.440 7.449Daily Average (Rp Billion) 50 62 62Capitalization

Rupiah (Rp Billion) 28.434 45.390 50.487USD ($ Billion) 0 105 105

58


The successful development of the corporate bond

market requires that investors have explicit legal

protections relative to issuer defaults and other situations,

such as buy backs that are not openly undertaken, that

are disadvantageous to the investor. In addition, issuers

are expected to provide interest incentive of around 1,5%

√ 2% above SUN interest rates and expand number of

issues in order to attract wider investors» interests.

2.2 Surat Utang Negara (Government Bonds)

Surat Utang Negara (SUN) market has developed

with positive potential. Despite cancellation of auction

for two consecutive months, it is predicted that future

auction will remain oversubscribed and rise significantly.

This result is expected due to the market liquidity and

the higher safety of the instrument and investor interest

in the varied maturity periods of government bonds.

Year-to-date June 2004, the government has issued

domestic and international bonds amounting to Rp16.3

trillion of the total planned SUN issues amounting to

Rp32.5 during 2004. As such, the remaining balance

to be issued to cover 2004 state budget»s needs, is still

quite large.

Meanwhile, SUN prices were still fluctuating. The

price of FR0002 series, which was the most saleable, had

a peak range in April of 114.0-115.0 before experiencing

a downward trend. The SUN price decline was prompted

by the announcement of a higher than estimated y-o-y

inflation rate in April of 5.92%, and the weakening of

rupiah exchange rate against the USD. This decline

continued in line with the expectation of rising the Fed

Funds target during the FOMC meeting in June, which is

expected to prompt a rising SBI discounted rate, and a

continued weakening of rupiah exchange rate.

Cancellations of the announcement of auction and

redemption of SUN VR005 series in the amount of Rp8.38

trillion have raised excess liquidity in the market, which

raised speculations that could trigger market risk, default

risk, and refinancing risk. The maturity positions of SUN

are actually relatively equal and balanced. However, the

values of bonds that would mature in the years 2008 √

2010 are quite large at an average of Rp34 trillion. The

large outstanding SUN that will mature in those periods

have the potential to trigger refinancing risk should SUN

sales be cancelled due to undersubscription, auction

announcement cancelled by the government, or market

condition and the economy worsen. Therefore, consistent

efforts are needed to increase market efficiency and

liquidity.

To mitigate the potential refinancing risk it is

recommended that new issuance be designed to maintain

balanced maturities by issuing SUN with longer longer

maturities either by adding 6 months to the maturity dates

of other SUN (for example 7 years and 6 months) or by

choosing a longer maturity period, for example more than

10 years. SUN of longer maturity periods can be used as

a benchmark and as investment alternative more suitable

for pension funds and insurance companies.

A good plan can guarantee smooth financing

through SUN and reduce financing cost, which would

lessen the burden of taxpayers in Indonesia.

Implementation of the buy back program is also very much

supportive of the creation of debt management efficiency

so that refinancing risk can be reduced and debt crises

Table 5.2Auctions of Government Bonds

Series

FR21 20-Dec-02 15-Dec-10 2.0 14.70 14.50 1.0 20

FR22 8-Apr-03 15-Sep-11 2.7 12.21 12.00 3.0 -3

FR23 11-Sep-03 15-Dec-12 3.3 11.60 11.00 1.4 15

FR24 6-Nov-03 15-oct-10 2.5 12.92 12.00 2.2 133

FR24 18-Dec-03 15-oct-10 3.2 13.05 12.00 2.0 85

FR23 24-Feb-04 15-Dec-12 2.5 11.86 11.00 2.2 -112

FR23 16-Mar-04 15-Dec-12 2.0 11.57 11.00 2.8 -34

FR25 27-Apr-04 15-Oct-11 3.0 10.72 10.00 3.3 -68

FR25* 25-May-04 15-Oct-11 3.1 11.74 10.00 - 15

Auction

Date

Maturity

Date

Volume(IDR

Trillion)

YieldAverage

(%)

Coupon

(%)Bid

Spread

FRO2 (bp)

* Canceled

59


that have happened in Latin American countries can be

avoided.

Based on development of SUN market and market

trend discussed above, good cooperation between the

monetary and fiscal authorities needs to be maintained

and enhanced in order to maintain financial stability in a

financial market that is becoming more integrated.

Similarly, market efficiency and monitoring of market

players» liquidity, particularly that of non-banks, needs to

be enhanced so that more clear information on market

conditions can be obtained and effective and credible

policies can be implemented.

3. DEVELOPMENT OF MUTUAL FUNDS

After having experienced a contraction in the second

half of semester II/2003, since January 2004, mutual funds

gradually improved. In May 2004, mutual fund net asset

value (NAV) recorded a new high. Although the capital

market experienced fluctuations in the months of May and

June 2004, mutual funds seem to still experience positive

growth. As of June 2004, mutual funds NAV reached

Rp87.7 trillion, up significantly (11.7%) from its March

2004 position of Rp78.5 trillion. The capital market

fluctuations did not seem to have any significant influence

on the development of mutual funds, except for an

indication of funds transfer from fixed-income mutual

funds to money market mutual funds. The availability of

various types of mutual funds would enable investors to

adjust their mutual funds portfolios in order to get

optimum results.

The rise in maximum guaranteed interest rates on

third-party deposits, followed by the rise in bank deposit

interest rate, apparently was not followed by a decline in

mutual funds NAV. The availability of four types of mutual

funds, namely fixed-income mutual funds, stock mutual

funds, money market mutual funds, and mixed mutual

funds, has made mutual funds quite a flexible product.

Chart 5.6NAV per Type of Mutual Funds

Decrease in bond price and increase in interest rate did

not automatically lessen investors» interests in investing in

mutual funds because they can switch from one type to

another type of mutual funds.

Redemption of SUN VR0005 series, that matured

on 25 May 2004, has resulted in an extremely large

amount of idle funds in mutual funds because most of

this SUN series was owned by mutual funds, particularly

fixed-income mutual funds. Meanwhile, alternative fund

placement again in SUN, which was planned through the

purchase of SUN FR0025 series, did not materialize

because the government has cancelled that auction. This

situation has made it difficult for investment managers

to seek bonds that will be used as the underlying of the

fixed-income mutual funds. Alternatively, they had to

buy from the secondary market at higher price. This

condition prompted over liquid positions at investment

managers.

Due to various factors such as interest rate hikes by

The Fed, deposit interest rate hike following the rise in the

blanket guarantee interest rate, as well as anticipation over

possible rise in SBI interest rate, mutual funds investors

have started shifting their funds to the money market.

The shift from fixed-income mutual funds to other types

of mutual funds are reflected among others by the decline

in fixed-income mutual funds NAV in June 2004 amounting

0

12

24

36

48

60

72

84

Source : Capital Market Supervisory Body

Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun0

2

4

6

8

10

12

2001 2002 2003 2004

Trillion Rp Trillion Rp

Money Market(right axis)

Stock (right axis)

Mixed (right axis)

Fixed Income (left axis)

60


portfolio. This revision is very much expected considering

the importance of determination of fair market values of

stocks that would be underlying mutual funds in order to

determine its NAV. The use of various values by an

investment manager for stocks that form the underlying

of the mutual funds could bring losses for the investors.

This condition would hamper development of mutual funds

as has occurred at the end of 2003. With the availability

of price references, it is hoped that development of mutual

funds would be stable and sustainable in the future. This

is related to increasing investors» interest in line with clearer

information on the development of their investment values.

4. MONEY MARKET

Money market conditions during semester I/2004

were relatively stable despite the fact that SBI and deposit

interest rates in real terms have been relatively low and

even negative during the last few months. The largest risk

to the capital market would be withdrawals of funds on a

large scale, which would create systemic risk. Because

deposits are currently guaranteed by the government a

potential increase in deposit interest rates rise would not

be expected to create fluctuations in the money markets.

In general, the money market was relatively liquid as

evidenced by the downward trend of interest rate in the

money market in line with changes in SBI interest rates.

Deposit interest rate that in the period of January up to

April dropped by 41 basis points to 5.86% have risen

again to 6.23% in June 2004. This excess liquidity condition

was also evidenced in the banking sector and low level of

its credit channeling. Therefore, funds mobilization in the

banking sector and payments on SUN interest coupons

are estimated to have increased liquidity supply in the

money market.

The rupiah money market fluctuated with a

downward trend during semester I and had an average

spread of JIBOR and SBI of 0.26. However, in February

Chart. 5.7Composition of NAV per Type of Mutual Funds

to Rp0.34 trillion, while NAV of money market mutual

funds experienced an increase of Rp1.78 trillion.

However, this condition is predicted to only be

temporary. After the capital market condition returns to

normal, mutual funds will also make adjustment. Fixed-

income mutual funds are still believed to be one that is

most attractive for investors, considering that they are

relatively safe and give adequate return.

In anticipation of mutual funds development and to

increase prudential principles in mutual funds transactions,

Bapepam (capital market supervisory board) as the

supervisory authority for mutual funds have and will issue

various regulations that will assist the development of

mutual funds in Indonesia. At end of May 2004, Bapepam

has issued regulation number IX.C.6 on Guidelines for

Prospectus Format and Contents for Initial Public Offering

of Mutual Funds. One of the items regulated in it concerns

the investment manager»s obligation to state the

calculation method for fair market values of stocks in

mutual funds portfolio. By this disclosure, it is hoped that

investors would clearly know the characteristics of mutual

funds that they buy, transparency would increase, and

investors would gain knowledge on portfolio valuation

made by the investment manager.

In the near future, Bapepam will also issue revised

regulation on fair market values of stock in mutual funds

0

20

40

60

80

100

Dec Dec Sep Oct Nov Dec Jan Feb Mar Apr May Jun2001 2002 2003 2004

Percent

Equity Mixed Portfolio Money Market Fixed Income

2.22.4

7.93.9 4.0 5.3 5.3 5.4 5.3 5.0

27.7

15.4 8.1 9.4 11.0 11.3 11.5 11.6 11.2 11.0

58.2

80.187.5 84.8 83.2 82.7 82.6 82.8 85.8 86.2 86.3 84.4

6.1 0.6 0.3 0.5 0.5 0.6 0.6 0.7 0.6 0.6 0.7 0.82.2 2.2

10.8 12.6

Source : Capital Market Supervisory Body (BAPEPAM)

61


depreciative trend of the rupiah/USD exchange rate.

During semester I, foreign currency supply was relatively

stable except for a slight pressure at June position due to

high foreign currency demand for payments of interests

and debts that have fallen due.

In line with the rising trend of SBI and Fed Funds

interest rates, it is predicted that Indonesian money markets

would become tighter and as such there is a need for

monitoring market condition, market players» behaviors,

and money market liquidity trend, particularly the foreign

currency money market that has the potential to raise

market risk in the financial system.

Chart 5.8Trend of Domestic Interest Rates

2004, the JIBOR and SBI spread rose to 0.83. Market

liquidity increase resulting from government account

expansion and the return of currency in circulation. This

situation has prompted the 1-month SBI interest rate to

drop quite sizably by 38 basis points. However, it is

predicted that in the coming few periods, the money

market would remain stable and liquid, due to relatively

small demand for transactional needs from the foreign

joint venture bank group and small bank group.

Meanwhile, the spread between interest rates of the

foreign currency interbank money market and Federal

Funds showed relatively stable condition despite

Chart 5.9Spread of Interest Rates

Jan May Sep Jan May Sep Jan May

SBI 1 month Saving

Time Deposit 1 month Blanket Guarantee Scheme-

2

4

6

8

10

12

14

16

18

20Percent

2 0 0 2 2 0 0 3 2 0 0 4

Percentage

JIBOR and SBI

Foreign Currency Denominated Interbank and Fed Fund

Source: CEIC, Bank Indonesia processed

(0.80)

(0.60)

(0.40)

(0.20)

-

0.20

0.40

0.60

0.80

1.00

Dec Mar Jun Sep Dec Mar Jun

2 0 0 2 2 0 0 3 2 0 0 4

62


Box 5.1 Oversubscribed Foreign Currency Bonds: Momentum of RisingForeign Confidence

Investors» high enthusiasm over foreign currency

bonds issued by the government of Indonesia as

evidenced by cases of oversubscriptions by several folds

(total subscription reached US$4.16 billion) has

prompted the government to raise the amount of

foreign currency bonds issues from original plan of

US$400 million to US$1 billion. 10-year tenor bonds

that will mature on 10 March 2014 based on results

of book building finally offers coupon interest of

6.75% and yield of 6.85%. With this yield, Indonesia

obtains a spread of 277 basis points over the yield of

US treasury bond, which currently is 4.08%.

Indonesia»s yield is lower compared to bonds issued

by several other countries for the same tenor but better

rating. For example, the Philippines, with BB/BB/Baa/

BB ratings its yield comes to 8.81%. Meanwhile, Turki,

with B+/B1/B+ ratings its yield comes to 7.20%

(Bloomberg data, 3 March 2004, 17.00 hours).

terms of current economic performance/condition as

well as its future prospects. Economic indicators during

2003 have improved significantly compared to the time

of crisis, evidenced by low and stable inflation rate,

relatively stable exchange rate, strengthening foreign

currency reserve, improving economic growth, as well

as political stability and security that are becoming

more conducive. Performance of the banking sector,

which was the economy»s driving force, also

experienced improvement as evidenced by various

banking sector»s indicators such as CAR, NPLs, ROA,

etc. In addition, rising international confidence in

Indonesia is also supported by Indonesia»s rating

upgrading by 3 international rating institutions during

2003.

Improving economic, monetary, fiscal, and

banking industry»s indicators as well as rising

international confidence provide a momentum for

acceleration of the real sector»s development. Concrete

foreign investment inflows would boost the real sector,

which is expected to create jobs that are currently a

national problem, as well as bolster economic growth.

The government needs to continuously make efforts

to provide conducive business climate through

economic stability and security, legal certainty for doing

business, as well as law enforcement. If these efforts

are successful, it is hoped that unemployment would

be solved, the real sector»s activities would rise, credit

rating would improve, and in turn all these would boost

economic growth.

Although Indonesia»s rating is still four levels

below the investment grade (BBB), relatively low

interest spread and the occurrence of ovesubscriptions

show rising foreign confidence in Indonesia, both in

Table Box 5.1Long-term Foreign Currency Bonds

of the Republic of Indonesia

InternationalRating Agency Date Rating Date Rating

Standard & Poor»s 5 May 2003 B- 8 Oct 2003 B Upgraded

Moody»s 20 March 1998 B3 30 Sept 2003 B2 Upgraded

Fitch Ratings 1 Aug 2002 B 20 Nov 2003 B+ Upgraded

Previous Rating Current RatingNote

63

Chapter 6 Payment System

Chapter 6Payment System

64


65


Efforts to support financial system stability through

continued implementation of Bank Indonesia»s supervision

functions ensure a safe and reliable payment system.

Control over risks within the payment system, both

settlement as well as operational risks, was applied through

Bank Indonesia»s supervision of operator of the payment

system, regulatory authority of the payment system,

oversight of the payment system, as well as facilitator in

the development of the payment system.

Control over settlement risk, which among others is

undertaken through implementation of the Bank

Indonesia Real Time Gross Settlement (BI-RTGS) system

since November 2000, has significantly minimized

settlement risk in the payment system. Based on data for

the period from January up to June 2004, the daily average

total transaction value processed through the BI-RTGS

system amounted to Rp108.75 trillion, while that of the

clearing system amounted to Rp5.87 trillion (94.87%

versus 5.13 %).

Although current value of transactions settled

through the clearing system is very small, around 5% of

total value of transactions booked, Bank Indonesia is

making efforts to implement a mechanism for Failure to

Settle (FTS) in the clearing system due to the possibility of

payment failures on the part of participating banks. This

FTS mechanism, which is designed to prevent and address

clearing participants inability to settle obligations, is

expected to be implemented in stages starting July 2005.

This mechanism is the result of agreement between

participating banks, which was formulated through

intensive discussions between representatives from all bank

associations with Bank Indonesia.

Chapter 6Payment System

In terms of the overall payment system, the shift in

the use of settlement system from the clearing system to

the BI-RTGS system is meant to reduce payment system

risk, particularly liquidity and credit risks. Efforts to

systematically minimize the rising of risk in payment system

operations also support the financial system stability. A

well managed payment system available to all banks, is

part of the infrastructure required to support the realization

of a stable financial system.

Chart 6.1 Volume and Valueof Real Time Gross Settlement

Currently, the BI-RTGS system is safe and efficient

and this condition has to be maintained. Daily activities

of the BI-RTGS system, between January to June 2004,

transactions settled through this system came to an

average value of Rp108.75 trillion and an average

volume of 19.842 transactions per day. Hence, there

have been increases from an average daily value of

Rp86.12 trillion and an average daily volume of 17,125

in 2003. By value, most transactions concerned are for

the settlements of marketable securities transactions

Value - Daily Averagel (Rp Million)Volume - Daily Average

Nominal RTGSVolume RTGS

25,000

20,000

15,000

10,000

5,000

-I II III IV V VI VII VIII IX X XI XII Total I II III IV V VI

160,000,000

140,000,000

120,000,000

100,000,000

80,000,000

60,000,000

40,000,000

20,000,000

-

2002 2003 2004

66


a. Confirmation of the term ≈real time∆, which

stipulates on the time limits for participants sending

transfer instructions and for forwarding of funds by

receiving banks to customers, as well as

compensations for customers in cases of delays on

funds forwarded by banks.

b. Confirmation on the responsibilities of sending

participants and receiving participants, in order to

avoid disputes between banks on the event of transfer

delays or errors.

c. Implementation of supervision over participants of

BI-RTGS system by Bank Indonesia»s Payment System

Supervisory Unit.

d. Announcements on status changes of participants to

all other participants (for example, when a participant

is suspended).

Chart 6.2Volume and Value of Clearing Settlements

VolumeNominal (Rp. Juta)

Volume Value (Rp Million)

10,000,000

9,000,000

8,000,000

7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

-

500,000

450,000

400,000

350,000

300,000

250,000

200,000

150,000

100,000

50,000

-I II III IV V VI VIIVIII IX X XI XII I II III IV V VI VIIVIII IX X XI XII I II III IV V VI

2002 2003 2004

administered by Bank Indonesia (SBIs and government

bonds). By volume, most transactions were bank

customers» transactions (74.6%).

From January to June 2004, banking liquidity in

relation to settlement of payment transactions was

adequate. This is illustrated by the share of nominal values

of transactions successfully settled, 99,993%. Meanwhile,

the share of nominal values of transactions cancelled at

end of day due to insufficient balance in banks» current

accounts was only 0,007 % or Rp7.61 billion per day. As

for the monitoring of financial system stability, smooth

processing of transactions by the BI-RTGS system is an

important factor that is expected to reduce liquidity risk

and systemic risk, minimizing bank liquidity problems that

could disrupt the overall banking system.

In the framework of BI-RTGS system implementation,

in order to ensure legal certainty for participants and users

of the BI-RTGS system, where its implementation has been

based on Bank Indonesia regulation number 2/24/PBI/2000

concerning Current Account Relation Between Bank

Indonesia and External Parties, on 11 March 2004, Bank

Indonesia regulation number 6/8/PBI/2004 concerning

Bank Indonesia Real Time Gross Settlement System was

issued. Basic changes in the management of the BI-RTGS

system as a result of BI regulation 6/8/PBI/2004 are as

follows :

Chart 6.3 UnsettledReal Time Gross Settlement System Transactions

CodeCodeCodeCodeCode Description Description Description Description Description

ACPT Transaction cancelled - due to incomplete

transmission

HCNL Transaction cancelled by Host

PSED Settlement pending √ waiting for data

QCNL Queue Cancelled - transactions in queue

cancelled by sender (bank) due to business

consideration (prioritization)

RJTD Transmission rejected by supervisor

By Total Value of Transaction

Percent

ACPT (T.Settle)

PSED (T.Settle)

RJTD(T.Settle)

HCNL (T.Settle)

QCNL (T.Settle)

Unsettled RTGS Transactions

Percent100.00

90.00

80.00

70.00

60.00

50.00

40.00

30.00

20.00

10.00

- Jan Feb Mar Apr May Jun Jul Aug OctSep Nov Dec Jan Feb Mar Apr May Jun

TRFC ACPT HCNL PSED QCNL RJTD

2003 2004

1.40

1.20

1.00

0.80

0.60

0.40

0.20

-Jan Feb Mar Apr May Jun Jul Aug OctSep Nov Dec Jan Feb Mar Apr May Jun

2 0 0 3 2 0 0 4

67


e. Imposition of sanctions in stages, starting with written

reprimand up to the highest sanction, namely

suspension (participants can only receive transactions

but cannot send transactions through the BI-RTGS

system).

To ensure financial stability, implementation of

transaction settlements of significant values through a

payment system dependent upon information technology,

assurances have to be made that the BI-RTGS system is in

a safe, reliable and its operations are sustainable. In this

regard, Bank Indonesia as the operator of the BI-RTGS

system is equipped with policies, procedures, and backup

facility to ensure the system»s reliable operations. The

components of the BI-RTGS system, namely hardware,

software, as well as communication network, have

adequate backups. In addition, off-site back up center

(Disaster Recovery Center/DRC) has been built since the

early stage of implementation. This enables operations of

the BI-RTGS system at the DRC in the event of disruptions

at the production site (at on-site facility). In order to ensure

sustainable operations, periodically tests are conducted on

the DRC facility.

Supervision of the payment system is continuous ,

both on the large-value payment system (BI-RTGS), and

on the retail payment system (the clearing system).

Supervision on the BI-RTGS system is required to ensure

safe operations of the system for both the operators as

well as the participants. Security of the BI-RTGS system

for participants is an important issue in required to

minimize operational disruptions that might disadvantage

the participants. In addition, supervision on the security

of the BI-RTGS system on the participants» side also

minimizes the risk of fraud.

Moving forward, Bank Indonesia will also increase

supervision on institutions that have roles in payment

instruments using cards, such as credit cards, debit cards,

and ATM cards. This will ensure the realization of safe

and efficient payment system as well as protection of

consumers. Implementation of supervision on payment

systems that use cards is planned to start in 2005.

Appendix

70

Appendix

71

Appendix

Table 2Macroeconomic Indicators

Inflation (%)Inflation (%)Inflation (%)Inflation (%)Inflation (%)Quarter (q-to-q) 0.77 0.46 1.24 2.51 0.91 2.35Annual (y-o-y) 7.12 6.62 6.2 5.06 5.11 6.83

GDP (% . annual)GDP (% . annual)GDP (% . annual)GDP (% . annual)GDP (% . annual)Demand Side: 4.45 3.65 3.97 4.35 4.46 4.32

Total Consumption 4.12 4.64 4.75 5.01 6.43Total Investment 4.26 -5.39 -1.15 -6.71 4.24 9.25

Production Side:Agriculture 5.54 1.18 3.06 -0.17 1.53 1.67Mining -1.05 0.96 -1.27 3.19 -2.72 -7.22Manufacturing 3.1 3.45 3.57 3.87 5.46 5.98

External Sector:External Sector:External Sector:External Sector:External Sector:Export-non oil and gas (fob. % annualized growth) 19.6 0.88 -4.82 2.36 1.48 3.8Import-non oil and gas (c&f. % annualized growth) 41.99 2.91 -10.69 8.55 -0.71 7.5Current Account (Million USD) 1,286 2,325 2,363 1,659 -667 1,325Foreign Debt (Million USD) 129,466 130,585 131,952 135,402 136,679 134,067

Interest Rate (%)Interest Rate (%)Interest Rate (%)Interest Rate (%)Interest Rate (%)SBI -1 month 11.4 9.53 8.66 8.31 7.42 7.34Interbank (o/n) 12.7 8.95 4.89 4.65 5.87 4.39Time Deposits-1 month 11.9 10.31 7.67 6.62 5.86 6.23Working capital Loans 18.08 17.41 16.07 15.07 14.61 14.1Investment Loans 17.85 17.43 16.53 15.68 15.12 14.64

Exchange Rate (Rp/USD),Exchange Rate (Rp/USD),Exchange Rate (Rp/USD),Exchange Rate (Rp/USD),Exchange Rate (Rp/USD), 8,6938,6938,6938,6938,693 8,2758,2758,2758,2758,275 8,3958,3958,3958,3958,395 8,4208,4208,4208,4208,420 8,5648,5648,5648,5648,564 9,4019,4019,4019,4019,401AverageAverageAverageAverageAverage 8,9028,9028,9028,9028,902 8,4888,4888,4888,4888,488 8,4318,4318,4318,4318,431 8,4688,4688,4688,4688,468 8,5808,5808,5808,5808,580 9,3929,3929,3929,3929,392

2 0 0 3 2 0 0 4

* May 2003Source : Bank Indonesia

Leading IndicatorsQ. I Q. II Q. III Q. IV Q. I Q. II

Appendix

1 (-) Surplus, (+) defisitSource : Bank Indonesia

Table 1Balance of Payment

CURRENT ACCOUNTCURRENT ACCOUNTCURRENT ACCOUNTCURRENT ACCOUNTCURRENT ACCOUNT 1.2861.2861.2861.2861.286 2.3252.3252.3252.3252.325 2.3632.3632.3632.3632.363 1.4671.4671.4671.4671.467 -666-666-666-666-666 1.3251.3251.3251.3251.325Export 16.075 15.484 16.298 15.397 15.047 16.843

Oil and Gas 4.074 3.402 3.951 3.807 3.957 4.307Non Oil and Gas 12.001 12.082 12.347 11.590 11.090 12.536

Import -10.570 -9.244 -9.737 -9.993 -11.781 -10.840Oil and Gas -1.922 -1.710 -2.164 -2.020 2.409 -2.619Non Oil and Gas -8.648 -7.534 -7.573 -7.973 -9.372 -8.221

Services -4.219 -3.916 -4.198 -3.937 -3.932 -4.678Oil and Gas -1.328 -1.280 -1.382 -1.180 -1.222 -1.018Non Oil and Gas -2.891 -2.635 -2.816 -2.757 -2.710 -3.660

CAPITAL ACCOUNTCAPITAL ACCOUNTCAPITAL ACCOUNTCAPITAL ACCOUNTCAPITAL ACCOUNT -946-946-946-946-946 -203-203-203-203-203 -630-630-630-630-630 188188188188188 1.3941.3941.3941.3941.394 -2.466-2.466-2.466-2.466-2.466Goverment (Net) -122 -401 -379 294 344 -368Private (Net) -825 198 -251 -106 1.050 -2.098

TOTALTOTALTOTALTOTALTOTAL 340340340340340 2.1222.1222.1222.1222.122 1.7331.7331.7331.7331.733 1.6551.6551.6551.6551.655 1.0731.0731.0731.0731.073 6262626262Monetary Movement 1) -539 -1.479 -11 -2.228 -1.123 2.568Memorandum ItemsReserves 32.578 34.057 34.068 36.296 37.419 34.851(In months of imports & Official debt Repayment) 6,3 6,6 6,6 7 6,5 6

2 0 0 3 2 0 0 4Description

Q. I Q. II Q. III Q. IV Q. I Q. II

72

Appendix

Table 3State Budget

A.A.A.A.A. Revenues and GrantRevenues and GrantRevenues and GrantRevenues and GrantRevenues and Grant 349,933.9349,933.9349,933.9349,933.9349,933.9 144,783.3144,783.3144,783.3144,783.3144,783.3 41.441.441.441.441.4I. Domestic 349,299.7 144,734.4 41.4

1. Taxation Revenues 272,175.1 118,909.2 43.7a. Domestic Taxation 260,223.9 113,200.8 43.5

i. Income Tax 133,967.6 60,033.1 44.81. Oil and gas 13,132.6 9,997.2 76.12. Non Oil and gas 120,835.0 50,035.9 41.4

ii. Value Added Tax 86,272.7 34,644.9 40.2iii. Land and Property Taxes 8,030.7 3,151.8 39.2iv. Land and Property Usage Duties 2,667.9 1,384.1 51.9v. Duties 27,671.0 13,107.8 47.4vi. Other Taxes 1,614.0 879.1 54.5

b. International Trade taxation 11,951.2 5,708.4 47.8i. Custom Duties 11,636.0 5,561.7 47.8ii. Export Taxes 315.2 146.7 46.5

2. Non Taxation 77,124.6 25,825.2 33.5a. Natural Resources 47,240.6 16,729.2 35.4

i. O i l 28,247.9 10,103.2 35.8ii. G a s 15,754.4 5,322.7 33.8iii. Mining 1,628.3 555.6 34.1iv. Forestry 1,010.0 591.7 58.6v. Fishery 600.0 156.0 26.0

b. Dividen from SOEs 11,454.2 1,450.3 12.7c. Others 18,429.8 7,645.7 41.5

II. Grant 634.2 48.9 7.7B.B.B.B.B. ExpenditureExpenditureExpenditureExpenditureExpenditure 374,351.3374,351.3374,351.3374,351.3374,351.3 163,337.3163,337.3163,337.3163,337.3163,337.3 43.643.643.643.643.6

I. Central Government 255,309.0 101,331.5 39.71. Routines 184,437.8 84,899.7 46.0

a. Renumeration and Benefits 56,738.0 30,804.5 54.3b. Goods Services 17,279.8 4,911.5 28.4c. Debt Repayment 65,651.0 30,084.5 45.8

i. Domestic 41,275.9 18,851.3 45.7ii. International 24,375.1 11,233.2 46.1

d. Subsidies 26,362.1 10,649.8 40.4i. Fuel 14,527.1 8,773.2 60.4ii. Non Fuel 10,995.0 1,813.0 16.5iii. PSO and Governmental Assistance 840.0 63.6 7.6

e. Other Routines 18,406.9 8,449.4 45.92. Development Expenditure 70,871.2 16,431.8 23.2

a. Development Projects 50,500.0 9,776.6 19.4b. Project Financing 20,371.2 6,655.2 32.7

II. Regional Expenditure 119,042.3 62,005.8 52.11. Balancing Funds 112,186.9 57,059.7 50.9

a. Profit Sharing Funds 26,927.9 8,873.8 33.0b. General Allocation Funds 82,130.9 47,775.9 58.2c. Special Allocation Funds 3,128.1 410.0 13.1

2. Special Autonomy and Adjustment Fund 6,855.4 4,946.1 72.1C.C.C.C.C. Primary BalancePrimary BalancePrimary BalancePrimary BalancePrimary Balance 41,233.541,233.541,233.541,233.541,233.5 11,530.611,530.611,530.611,530.611,530.6 28.028.028.028.028.0D.D.D.D.D. Surplus/DeficitsSurplus/DeficitsSurplus/DeficitsSurplus/DeficitsSurplus/Deficits -24,417.4-24,417.4-24,417.4-24,417.4-24,417.4 -18,554.0-18,554.0-18,554.0-18,554.0-18,554.0 76.076.076.076.076.0E.E.E.E.E. FinancingFinancingFinancingFinancingFinancing 24,417.624,417.624,417.624,417.624,417.6 6,423.26,423.26,423.26,423.26,423.2 26.326.326.326.326.3

I. Domestic Bank 19,198.6 8,000.0 41.7II. Privatization 5,000.0 3,489.0 69.8III. Asset Disposal-Banking Restructurisation 5,000.0 10,400.7 208.0IV.Government Bond (net) 11,357.7 -91.1 -0.8

1. Issues 32,500.0 16,301.1 50.22. Principal Repayment andRepos -21,142.3 -16,392.2 77.5

V. International Financing (net) -16,138.7 -15,375.4 95.31. Debt withdrawal 28,237.0 6,627.8 23.5

a. Program Debt 8,500.0 0.0 0.0b. Project Debt 19,737.0 6,627.8 33.6

2. Principal Installment -44,375.7 -22,003.2 49.6

(billion rupiah)

Description State Budget Semester I % to State Budget

Source: Ministry of Finance

73

Article I

A r t i c l e s

74

Article I

75

Article I

Article I

Analysis of Foreign Bank’s Rolein Enhancing Indonesia’s Real Sector Recover

Muliaman D. Hadad,1) Wimboh Santoso,

2)

Dwityapoetra S. Besar, Wini Purwanti, Ricky Satria dan Ita Rulina3)

Loan growth is an essential indicator of banking sector’s contribution to the real economy of a country.

Hence, this paper focuses on the role of foreign-incorporated banks in reviving the real economy of Indonesia

via loan growth. Estimation model used in this paper is Montgomery model (2003) postulating that return on

asset, cost-to-income and problem loan ratios are the best indicators for assessing the comparative performance

of the foreign-incorporated over local banks. To support the framework of analysis, this paper also makes use of

the method developed by Berger and Young (1997) using NPLs, efficiency ratio, capital (with return proxy over

the equity or asset), and risk-weighted asset as primary indicators.

The model is employed to search for factors driving foreign banks to grant loans and to observe their

behavior in expanding loan portfolios. On the basis of previously released research, this paper will apply five

variables turning out to be primary rationales for banks in granting loans: return on asset, efficiency ratio, non

performing loans, spread between US and domestic rates, and industry production index. To some extent,

however, estimation data for this paper is limited. Therefore, cautious interpretation over estimation result must

be exercised.

The outcome of this paper suggests that foreign-incorporated banks have long been shifting their roles

toward more fee-based income earners. Consequently, their roles in boosting the country’s economy growth

through loan making and trade financing have been dwindling. Although their focus on efficiency and asset

quality is similar to those of the other group of banks in Indonesia, foreign banks are leaning toward fee-based

items as their preferential sources of income and therefore their loans have proportionally lessening. The

estimation results presented in this paper confirm this phenomenon.

A b s t r a c t

1. Head of Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : [email protected]. Executive Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : [email protected]. Bank Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : [email protected] ; [email protected];

[email protected]; [email protected].

76

Article I

Classification JEL : G28

Keyword : Bank

This empirical study also suggests that foreign banks are in general less sensitive to the signal of domestic

economy changes than their domestic peers. Their highly dependence on inter-branches and headquarter funds

have driven those banks to be less susceptible to the adverse changes of Indonesian macroeconomy. Besides,

their loan portfolios have high degree of volatility and tendencies to be more contractive post crisis.

To ensure accuracy of capital measurement, this paper recommends that treatment over inter-branches

and headquarter fund placements in branches of foreign-incorporated banks in Indonesia be immediately

improved. The current regulatory capital for foreign banks in Indonesia does not ensure the function of capital

as cushion for absorbing unexpected losses and therefore less effective as a tool for monitoring their asset

growth.

77

Article I

1. OVERVIEW

1.1 Background

In Indonesia, banks with foreign ownership are classified into three groups, namely (i) those operating as branch

offices (called foreign banks); (ii) those operating as subsidiaries, whether through joint venture with domestic banks

(called foreign joint venture banks) or through mergers with and acquisitions of domestic banks, which occurred in the

post-1997 crisis period (divestment program); and (iii) those operating as representative offices. Through June 2004, the

number of foreign banks in Indonesia came to 11 banks, after only one addition with the reopening of Bank of China in

April 2003. Meanwhile, the number of foreign joint venture banks came to 20 banks, down from the number in pre-

crisis period (excluding banks with foreign ownership acquired through the divestment program). In general, as foreign

banks, their strategies on operational activity implementation and adopted policies tend to focus very much on the

interests of their foreign headquarters. Each future plan or operation will depend much on the decisions of their head

offices or regional offices.

The main difference between foreign banks and foreign joint venture banks lies in their legal entity forms. Foreign

banks» legal entities follow those of their foreign headquarters» and they constitute important parts of their headquarters»

organizations (in accordance with US Department of Commerce √ H. Montgomery). Consequently, all foreign banks»

financial policies very much depend on their headquarters, and in general credits are channeled to large corporations

(Pigott (1986)-H.Montgomery), such as have happened also with foreign banks in Indonesia where their credits tend to

be channeled to multinational companies that also receive financing from their headquarters. Meanwhile, foreign joint

venture banks have local legal entity form, which in Indonesia is Perseroan Terbatas/PT or limited company form, and

legally are separate entities from their headquarters.

Basically, Bank Indonesia»s policies and regulations are equally implemented on foreign banks and foreign joint

venture banks. All regulations, including those related to prudential principles, are uniformly imposed on all banks

operating in Indonesia, whether domestic, foreign joint venture or foreign banks. The difference between foreign banks

and foreign joint venture banks lies in capital regulations. Banks operating as Indonesian legal entities follow the PT law

where business capitals are recorded on banks» balance sheets as paid-in capitals. Meanwhile, as regard foreign banks

operating in the same legal entity forms as their headquarters, their business capitals are recorded on their balance sheet

in intercompany account as business funds. Limitation imposed on foreign banks concerns geographic location of their

offices where they can only have offices at provincial cities.

The backdrop for opportunity given to foreign banks and foreign joint venture banks to operate in Indonesia is the

need for foreign capitals. In addition, these banks» operations in Indonesia are expected to boost development of

national banking industry and economy. In general, benefits obtained from foreign banks» operations, including foreign

joint venture banks, are among others capital inflows for domestic economy, rising competitions between banks, and

introduction of more varied products. However, a negative side that has to be anticipated relates to the fact that

particularly during a crisis these banks can become the receivers of funds when capital flight occurs. In addition, foreign

funds are here temporarily and only seek profits for a time (capital inflow during good times and capital outflow during

bad times). Meanwhile, the complexity of products and technology brought in by foreign banks from advanced countries

cannot always be recognized and controlled by the supervisory authority of the host country, and as such instead of

78

Article I

enhancing bank supervision regulating and processing, it makes them worse.1

From several studies on foreign banks, it is revealed that although they are more responsive towards domestic

economic fluctuations, credit channeling by banks with foreign ownership in the form of subsidiaries is relatively

more stable compared to credit channeling by foreign banks that are in the form of branch offices (H.Montgomery).

Meanwhile, stability of credits channeled by foreign banks (both in the forms of branch offices and subsidiaries)

during the banking crisis period depended on their forms (mode of entry), whether as branch office or subsidiary.

Studies reveal that foreign banks in the form of subsidiaries can provide wider financial business activities and more

stable credit channeling in a host country compared to foreign banks» branch offices (Clarke and Sanches (2001)),

Miller and Parkhe ((1998)-H.Montgomery). In broad outline, it can be concluded that the entry of foreign financial

institutions tends to bring benefits for the host country. However, in order to get full benefit, policy makers must

receive these institutions in the forms of fully owned subsidiary and joint ventures, and turn away from offshore

institution and branch office models.

1.2 Problems

The 1997 Asian crisis period has left several remaining problems in the banking industry in Indonesia. Up to the

present time, development of bank credit channeling is still relatively stagnant or its growth is slower than that in the pre-

crisis period. This problem becomes heavier with continuously fluctuating rupiah exchange rate against world hard

currencies, such as the US dollar, which has influenced Indonesia»s economic development. Recent continuous drop of

rupiah exchange rate is suspected to be the result of several foreign banks in Indonesia having undertaken speculative

transactions.

Foreign banks have several advantages, such as more varied products and credit lines with overseas banks, which

enable these foreign banks to undertake transactions more freely with overseas markets. Due to bank credit channeling

that is still relatively hampered, including in the case of foreign banks, while on the other hand these foreign banks have

excess liquidity, as commercial banks that tend to be profit-oriented, these foreign banks would undertake activities or

transactions in order to maintain or raise their profitability.

With the prediction that problems in bank intermediation would remain and foreign banks would continue to

undertake speculative activities that could influence domestic economic development, a study needs to be undertaken

regarding the role of foreign banks in Indonesia»s economic development. This study would discuss and compare the

performances of foreign banks, foreign joint venture banks, and domestic banks until a picture emerges of the role of

each bank group in the national economy. Recommendations would depend on results of the study : whether it is still

necessary to retain the form of foreign banks as branch office with certain limitations or to change it; or to change the

form of branch office to subsidiary for existing foreign bank branch offices and to use the form of subsidiary for subsequent

new foreign bank offices.

This paragraph describes the structure of the study. Chapter 2 will cover analysis of the development of performances

of foreign banks, foreign joint venture banks, and domestic banks for pre-crisis, crisis, and post-crisis periods as well as

comparison of the performances of these three bank groups. Chapter 3 will discuss the experience and performance of

1 Claessens, Demirguc-Kunt, and Huizinga, 2001 and Demigurc-Kunt, Levin and Min, 1998

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Article I

foreign banks in other countries while making comparison with Indonesian situation. Both chapter 2 and 3 will also

include descriptions of existing regulations in each country. Chapter 4 will discuss qualitative and quantitative analyses on

the roles of foreign banks, foreign joint venture banks, and domestic banks. Quantitative analysis will be undertaken

using simple econometric technique. The last chapter, Chapter 5, will cover conclusions on the analyses and discussions

covered by the previous chapters as well as resulting recommendations.

2. REGULATIONS ON AND PERFORMANCE DEVELOPMENT OF FOREIGN BANKS

2.1 Regulations on Foreign Banks

As described in the previous chapter, a foreign bank»s participation in Indonesia»s banking sector can be done

through the opening of a foreign bank branch office (called foreign bank), a joint venture of foreign bank and domestic

bank (called foreign joint venture bank), or a representative office. In addition, in the post-1997 crisis period, government»s

divestment program of domestic banks has widened the entry opportunity for foreign participation in the national banking

sector through mergers or acquisitions.

Foreign participation in the national banking was reactivated around 1968 in order to boost the national banking

system. Foreign participation in the form of newly opened foreign bank branch offices at that time still exist until this

present time. There was one additional foreign bank branch office opened in April 2003 with the reactivation of Bank of

China. The opening of foreign bank offices is regulated by Bank Indonesia» Director Decree number 32/37/KEP/DIR dated

12 May 1999 regarding Requirements and Procedures for The Opening of Branch Office, Sub Branch Office, and

Representative Office of Banks That Domicile Abroad.

In post-1988 Pact at the time of banking liberalization, foreign participation increased with the entry of foreign

banks through joint ventures with domestic banks and often called foreign joint venture banks. In accordance with

prevailing regulation, the ownerships of foreign banks in foreign joint venture banks are at maximum 99%, up from

previous 85%. The opening of foreign joint venture banks is regulated by Bank Indonesia»s regulation number 2/27/PBI/

2000 dated 15 December 2000 regarding Commercial Banks, which is also applicable on domestic banks.

Basically, the prevailing regulation regarding Commercial Banks does not differentiate between foreign joint venture

banks and domestic banks. Neither does it differentiate between these two bank groups and foreign bank branch

offices. The prudential principles and related regulations are imposed uniformly on all commercial banks, which include

domestic banks, foreign joint venture banks, as well as foreign bank branch offices. Limitations or obligations previously

imposed on foreign bank branch offices, such as export credit channeling and number of foreign bank offices, are no

longer in effect. The main differences between domestic banks and foreign joint venture banks with foreign bank branch

offices only concern capital and legal entity form.

Domestic banks and foreign joint venture banks have Indonesian legal entity form under the prevailing PT form and

their business capitals are recorded as paid-in capital on their balance sheets. Meanwhile, foreign bank branch offices

have their headquarters» legal entity forms and their business capitals are recorded as Business Fund in the intercompany

account on their balance sheets.

Based on prevailing regulation, the definition of foreign bank branch office»s Business Fund is ≈net fund at the bank

branch office from the bank»s headquarter after deduction of bank branch office»s placements at bank offices abroad,

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Article I

Percent80

60

40

20

0

-20

-40

-60

-802000 2001 2002 2003 2004

Domestic Bank Foreign Bank Joint Venture Bank

1995 1996 1997 1998 1999 2000 2001 2002 2003 May-04

Domestic Bank Foreign Bank Joint Venture Bank

100

90

80

70

60

50

40

30

20

10

0

Percent

which is treated as the branch office»s capital component that must always be recorded for as long as the branch office is

in operation∆. This business fund can be in rupiah or foreign currencies in rupiah equivalence.

With regards business fund that is in foreign currencies, the size of bank capital will be influenced by rupiah

exchange rate fluctuations. Aside from that, with the existence of the stipulation on declared business fund (declared

NIOF), where a bank is obliged to maintain at minimum 90% of its total declared business fund, the bank can utilize the

difference between declared and realized business funds for transacting purposes in order to optimize its income.

Meanwhile, the intercompany fund method applied in the calculation of business fund can also be utilized by the bank

for transacting purposes in order to optimize profits.

2.2 Development of Foreign Bank Market Share (in terms of assets)

Through end-2002, there were only 10 foreign banks operating in Indonesia. By May 2004, with the reactivation of

Bank of China, the number of foreign banks came to 11 banks with total assets of Rp103 trillion or 8.77% of banks» total

assets. Foreign banks» total assets experienced quite significant development compared to one year prior to crisis, from

Rp14.37 trillion in 1996 (2.85% of banks» total assets) or up Rp88.63 trillion (617%). This quite significant change was

brought about by sharp exchange rate change, from Rp2,383 in 1996 to Rp9,210 per 1 dollar in May 2004. This

condition has made foreign banks» total assets, of which foreign currency portfolio was quite large, rose significantly.

If the foreign joint venture banks are included as part of the foreign bank group, the share of the foreign bank

group»s total assets to banks» total assets reached 12.75% in May 2004, from 7.74% in 1996. This is mainly due to quite

significant development of foreign joint venture banks to banks» total assets.

(in terms of credits)

Compared to credit growth of different bank groups, the foreign bank group experienced the smallest negative

credit growth in 1999. Further on, this group also experienced the lowest credit growth acceleration in the period of

2002 up to 2004.

Meanwhile, from the side of undisbursed loans (ULs), the foreign bank group, which comprises of relatively small

number of banks, has quite large Uls. In fact, it contributes 25.0% to banks» total Uls during 2004 of Rp21.0 trillion (up

Chart 1Development of Shares in Total Assets (%)

Chart 2Credit Growth (y-to-y)

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Foreign Bank Joint Venture BankIndustry

0

5

10

15

20

25

30

35

40

2000 2002 2 0 0 3 2 0 0 4

Percent

1999 2000 2001 2002 2003 2004 May

State-owned Bank Private Bank Regional Government Bank

Joint Venture Bank Foreign Bank

Percent80

70

60

50

40

30

20

10

0


Mining Construction Business Services


0.2%

12.2% 3.4% 4.0%1.0% 0.7%

48.0%

1.4%1.5%27.7%

71.9%

27.7%

0.4%

Investment LoanWorking Capital Loan Consumer Loan

to April 2004). In the foreign bank group, these Uls comprise

largely of working capital credits and are primarily for the

industry sector. Particularly in regard the industry sector, the

percentage share of Uls of foreign bank group is larger than

banks» percentage. This means that not only foreign banks

in Indonesia do not focus on credit channeling, but also the

real sector that has been given credit allocation is not able

to well absorb funds made available by this bank group.

2.3 Development of Foreign Banks» Performance

Due to past crisis, quality of earning assets, particularly

credits, of the foreign bank group is worse that the banking

industry»s total asset. This is reflected in this bank group»s

gross NPLs that are considered quite high although with a

downward trend compared to other banks» or even the

banking industry»s. The foreign bank group»s gross NPLs (April

2004) and net NPLs are recorded at 11.5% and 1.1%2

Nonetheless, this bank group»s operational and non-

operational incomes are relatively high compared to other

bank groups, both during 2003 as well as during the first

three months in 2004. The main source of income is not

credits but foreign currency/derivative transactions. With quite good profitability, this bank group»s CAR is quite high

compared to other bank groups» and as such these foreign banks have large room to raise their credit channeling. This is

suspected to be the result of the overall foreign bank group»s better risk and operational management.

2 For information, as of that position, the share of foreign currency credits in foreign bank group»s total credits was 46.3% (banks» share was 24.0%)

Chart 3Foreign Banks» Undisbursed Loans √ By Type of Use

Chart 5Gross NPLs

Chart 4Foreign Banks» Undisbursed Loans √ By Sector

Chart 6Chart 6 CAR (%)

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Chart 8 Foreign Banks» Total Creditsand Third-Party Funds in Malaysia

0.00

20000.00

40000.00

60000.00

80000.00

100000.00

120000.00

16

16

17

17

18

18

19

19

20

20RM mn Percent

Share of Foreign Banks Loans to TotalLoan

Deposits

1999 2000 2001 2002 2003

Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec

Source: CEIC

Thailand Korea Malaysia

Source: CEIC

-30.0

-25.0

-20.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar

Percent

1998 1999 2000 2001 2002 2003 2004

Chart 7 Foreign Banks» Credit Growth in Thailand,Korea, and Malaysia

REGULATIONS ON AND PERFORMANCE DEVELOPMENT OF FOREIGN BANKS IN OTHER COUNTRIES

The 1997 crisis in Asia and the need to undertake recapitalization of the banking sector have brought changes in

regulations concerning foreign bank establishment (entry) in countries that have experienced crisis such as Korea, Thailand,

and Indonesia. Despite changes in regulations, foreign banks» penetration in Asia has remained low but it is predicted to

raise competition, efficiency, and stability in the financial sector.

In the crisis period, namely around 1996 √ 1998, foreign banks» credit growth in Asian countries was relatively

higher compared to that of domestic banks. Where as in

Thailand it trended upward, in Malaysia and Korea credit

channeling trended downward. Foreign banks» credit growth

in Malaysia reached 38%, while that of its domestic banks

reached 38.2%. During the same period in Thailand, foreign

banks» credit growth reached 20.6%, while that of its

domestic banks reached √8.5% (negative). In Korea, foreign

banks» credit growth reached 13.6%, while that of its

domestic banks reached 2.9%.

To give an overall picture, the following will describe

changes in regulations on foreign banks made by the bank

supervisory authorities in Malaysia, Thailand, and Korea.

3.1 Malaysia

Regulations

Compared to other Asian countries, foreign banks» role in Malaysia is relatively larger. However, in the beginning,

the banking authority in Malaysia was quite cautious in the opening of the banking sector. One of the facilities given to

foreign banks was that they could extend credits through cooperation with local banks and joint venture banks. After

1983, there have been no more foreign banks established in Malaysia.

With the effectiveness of the Banking and Financial

Institution Act of 1989 (BAFIA), foreign banks having business

activities in Malaysia are obliged to have public company

form with licenses issued by the Minister of Finance on BNW

recommendations. Therefore, all foreign banks that wanted

to operate in Malaysia were also obliged to convert their

legal entities into subsidiaries (locally incorporated banks) at

the latest 1 October 1994 and foreign banks are allowed to

have 100% ownership.

Since 31 December 2001, all foreign banks are obliged

to raise minimum capital to MR300 million, after taking into

account their losses, while domestic banks are obliged to

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raise minimum capital to MR2 billion. However there are no separate policies or guidelines that limit the activities of

foreign banks.

Banks» Development

Although Malaysia adopts the foreign currency control regime, quite stable economic prospects have prompted

increased activities of foreign banks in that country. In the period of 1999 √ 2003, third-party funds mobilized by foreign

banks rose by 41.5% to MR103,396 million and their credits rose by 34% to MR92,693 million.

3.2 Thailand

Regulations

Establishment of foreign bank branch offices in Thailand has started since the start of commercial bank activities in

1888. In the beginning, foreign banks were the most active banks, however, the government then puts a limitation on

foreign banks» activities, including on issuance of licenses to new foreign banks. As it progressed, that limitation was

subsequently eased by allowing foreign banks to open one branch office in Bangkok and foreign banks could open banks

with domestic legal entity form by giving majority ownership to Thai»s citizens. As such, there were no foreign joint

venture banks or subsidiary banks wholly owned by foreign parties.

This situation changed in the post-1997 crisis period due to the need for foreign capitals in order to save problem

banks. In this regard, the Thai government changed the regulation on foreign ownership limitation by giving an opportunity

to foreign parties to wholly own shares in financial institutions in Thailand for a period of ten years. Because of this policy,

at the end of 2001, there were four foreign joint venture banks operating in Thailand and several foreign banks have

entered the banking sector by opening branch offices. However, none of these banks have become public companies

and sold their shares in the capital market.

Currently, there are two categories of foreign banks, namely banks operating as branch offices and regular banks.

In accordance with the Commercial Banking Act, foreign ownership in banks are limited to 25% with the exception that

by the Minister of Finance»s approval foreign parties can have 100% ownership for a period of 10 years (hybrid bank).

Bank supervision is performed based on the same regulations. In addition, the following apply on foreign banks :

1. Ownership Structure : There is no requirement on ownership structure, unlike parent banks that depend on the

assessment of the supervisory authorities in the foreign banks» countries of origin.

2. CAR for foreign bank branch offices is determined at 7.5% while commercial banks and hybrid banks are obliged to

maintain CAR of 8.5%.

The Bank of Thailand is currently undertaking enhancement of banking policies into what is called One Presence

Policy in the framework of Financial Master Plan as follows :

1. Foreign bank branch office or hybrid banks can become full branch offices under prevailing regulation (Commercial

Banking Act).

2. Foreign bank branch offices can become hybrid banks, with the exception of 10 foreign banks on which a grandfather

clause on foreign ownership is imposed.

3. Foreign bank branch offices or hybrid offices can become subsidiaries when foreign ownership has reached 95%

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Article I

Chart 10 Foreign Banks» Total Creditsand Third-Party Funds in South Korea

1997

0.00

1000.00

2000.00

3000.00

4000.00

5000.00

6000.00

7000.00

8000.00

9000.00

10000.00

0.00

0.50

1.00

1.50

2.00

2.50Won bn Percent

Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec

1998 1999 2000 2001 2002 2003Source: CEIC

Share of Foreign Banks Loans to Total

Loan Deposits

Chart 9 Foreign Banks» Total Creditsand Third-Party Funds in Thailand

0.0

5.0

10.0

15.0

20.0

25.0

Source: CEIC

-

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

Baht mn Percent

1997 1998 1999 20042003200220012000

Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Mar

Share of Foreign Banks Loans to TotalLoan Deposits

and there is no grandfather clause imposed on foreign

ownership. After its establishment, the number of additional

branch offices a subsidiary can open is limited to only four.

Banks» Development

Foreign banks» performance seems to be declining as

evidenced by a decline in credits by Baht 786,266 million or

64.2% to Baht 439,170 million. Post-crisis economic

recovery process is also followed by a decline in credit

channeling (credit rationing), both by domestic as well as

foreign banks. Foreign banks» share in credit channeling

after the establishment of the Thai Asset Management

Company (TAMC) in 2001 also dropped by Baht 147,374 (25.1%).

In line with the bank restructuring program in Thailand and implementation of Thailand Financial Master Plan, Bank

of Thailand has reviewed the existence of foreign banks. It is expected that the conversion of foreign bank branch offices

into foreign joint venture banks or local banks can boost the revival of bank intermediation through the role of foreign

banks.

3.3 Korea

Regulations

In the beginning, foreign banks in Korea faced restriction in operational activities. However, since the beginning of

1990, Korea has moved towards the direction of national treatment policy on foreign banks and eased the restriction by

revocation of limitation on number of branch offices that can be opened and allowing foreign ownership through the

establishment of foreign joint venture banks and subsidiaries that are wholly owned by foreign parties.

In post-1997 crisis period, the government of Korea sought funds in order to save two banks, namely Korea First

Bank and Seoul Bank, by inviting foreign investors. The

process took two years before there was agreement on sales

of shares. Although there has been quite large purchase of

shares by Newbridge Capital at Korea First Bank in 1999

and a possibility to establish foreign joint venture banks, most

foreign parties that have entered the banking sector are still

in the form of branch offices.

Banks» Development

In post-1997 crisis period, mobilization of third-party

funds by foreign banks has experienced rapid expansion. In

the period 1997 √ 2003, third-party funds rose by Won 7,644

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Article I

billion (or 737%). This was largely due to quite high public confidence in foreign banks and quite competitive interest

rate level.

Although in post-crisis period credit channeling has increased, foreign banks» credit channeling has relatively fluctuated

as reflected by a decline in outstanding credits in quarter III (September) 2001 by Won 768.93 billion (10.9%) from the

previous quarter due to bank restructuring program, which has prompted foreign banks to restrain from credit channeling.

3.3 Regulations on Foreign Banks in Several Other Countries

China

One of the websites provides information that in the beginning China allowed foreign banks to provide renminbi

for foreign companies and individuals, including citizens of Hong Kong and Macao. However, the more open banking

industry in China shows China»s commitment to fulfill the WTO agreement and widens foreign participation in its banking

industry»s reformation. This activity becomes China»s milestone in giving opportunity to foreign parties to be involved in

domestic business activities, both in foreign currencies as well as in local currency. CBRC (China Banking Regulatory

Commission) has boosted foreign role by easing regulations on foreign parties, which are strategically qualified in

participating in financial reformation by raising foreign individual investor»s equity share from 15% to 20%. CBRC also

amended the requirement on operating capital for foreign-financed financial institutions by reducing the minimum

requirement from US$72 million (600 million yuan) to US$60 million (500 million yuan) for the highest level, and from

500 million yuan to 400 million yuan for second highest level.

Canada

Foreign banks play quite a significant role in Canada»s financial sector. Currently, almost 42 foreign bank subsidiaries

operate with total assets reaching 10% of Canada»s domestic banks» assets. Several foreign banks also operate through

non-bank financial institutions such as insurance companies, securities, and leasing companies.

To optimize competition, foreign banks are allowed to operate as branches as well as subsidiaries. However, OSFI

still imposes several limitations on foreign banks operating as branches in Canada, which among others include :

1. Foreign bank branch offices are not allowed to receive retail deposits. The definition of a retail deposit is a deposit

at a value of below US$150,000. Foreign banks in the form of branches are allowed to receive deposits each with

a value of below US$150,000 as long as the total value of such deposits is still lower than 1% of total deposits

owned by the related branch.

2. In addition, in a condition that can endanger the financial system, the supervisory authority has the right to request

a foreign bank branch to maintain its assets in domestic currency for a certain amount.

3. Foreign banks in the form of branch offices can have indirect access through direct participation in the Canadian

Clearing and Settlement System. If a foreign branch office wants to have direct access to the Canadian Clearing and

Settlement System, the Canadian authority will undertake assessment of the insolvency laws of the origin country in

order to avoid conflicting regulations that might endanger the Canadian Clearing and Settlement System when the

foreign bank defaults.

4. When a foreign bank experiences an insolvent condition, the foreign bank»s branch in Canada will be liquidated, as

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is the case regarding Canada»s legal treatment of its legal entities. Assets owned by that foreign bank, whether

owned by the branch office or its subsidiaries would be used for settling claims on the defaulted foreign bank. At

the same time, the right of depositors of the subsidiary branch office will be protected.

4. THE ROLE OF FOREIGN BANKS IN BOOSTING CREDIT CHANNELING

4.1 Model

In most Asian countries» economies, foreign bank penetration is still a new phenomenon and as such empirical

studies on performances of foreign and domestic banks are still very limited. Mathieson and Roldos (2001) show that in

developing countries in Eastern Europe and Latin America, foreign banks in general have higher return on equity and

lower cost-to-income ratio, as well as lower NPLs compared to domestic banks.

Montgomery (2003) shows that return on assets, cost-to-income ratio, and problem loan ratio are important indicators

in assessing performance of foreign banks against that of domestic banks, particularly in post-crisis period. Therefore, in

this paper, analysis of foreign banks» performance in Indonesia will use these three indicators, which have been widely

used by economists in assessing foreign banks» performances in certain countries.

These indicators have also been used many times in previous studies, among others in a study on bank efficiency by

Berger and De Young (1997), which used NPLs, efficiency, capital (with the proxy of return on equity or assets) and ATMR

as indicators.

This paper will analyze in particular the influence of these indicators on foreign banks» performance in credit channeling.

Credit channeling is considered as an important indicator of bank role in boosting economic activities in developing

countries. Return on Assets (ROA) is an indicator, which when rises shows that bank assets have been optimally utilized

in earning income for the bank, and as such it is estimated that ROA and credit growth have a positive correlation. In

relation to bank business activities that boost the economy, a high ROA ratio shows that the bank has channeled credits

and earned interest income.

Another ratio, namely the operational expense to operational income (OEOI) ratio, shows bank efficiency level in

undertaking operational activities. Therefore, in this analysis, high OEOI ratio reflects a bank»s inefficient condition, where

as a consequence when the bank continues to channel credits it will experience a negative interest rate spread. This

condition will prompt a bank to reduce credit channeling in order to avoid larger losses and the bank would tend to

transfer its investments into marketable securities or fee-based income.

Non-performing Loans (NPLs) are calculated based on the share of a bank»s problem credits (collectability statuses of

3, 4, and 5) in total credits. If a bank»s NPLs are high the bank tends to reduce or stop extending credits (credit rationing),

which influences the bank management»s decision-making behavior in credit channeling. In an economic condition that

is considered less conducive, for example where the real sector has not fully recovered, a bank would tend not to channel

credits in order to avoid credit risk that is still high.

In addition, interest rate variable is also utilized by using the difference in monthly interest between federal funds

interest rate (monthly) set by the Federal Open Market Committee (The Fed) and SBI interest rate set by Bank Indonesia.

A rising difference will boost the banking sector, including foreign banks, to transfer their funds from credits to financial

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products in foreign currencies, particularly US dollar. Therefore, interest rate difference will be a market signal on bank

behavioral sensitivity to credit channeling and they have a negative correlation.

Industrial Production Index (IPI) also constitutes a market signal used for measuring production output. Rising IPI

reflects a positive signal on improving (booming) industry condition and will boost the banking sector to provide funds

(credits) for business makers.

In a mathematical format, the correlation between each variable can be illustrated as follows :

In order to give a clearer illustration, the five dependent variables, namely Income (Return on Assets/ROA), Efficiency

(Operational Expense over Operational Income/BOPO), Problem Credits (Non-Performing Loans/NPL), Difference between

Indonesia»s and US interest rates (Interest Rate Differential/INT) and Industry Growth (Industrial Production Index/IPI),

starting from the month of January 1999 through May 2004 can be formulated as follows :

t = January 1999,..., May 2004 and i = 1,..,5

The main purposes of this estimation is to obtain a complete model of several variables and its influence on overall

credit growth as well as to compare the condition of a certain bank group relative to the conditions of other bank groups.

For this consideration, this analysis will focus on relative values

of the estimation results on the constants 1β , 2β and 3β . In

principle, this parameter will give information on level of credit

growth. Bank group that has the larger value of β shows a

potential for undertaking larger credit channeling, while one

with smaller value of β shows a limitation in undertaking

credit channeling. The following table shows problems that

will be further reviewed.

4.2 Estimation Results

Estimation is performed using the regression model on overall as well as partial bases based on bank group, namely

foreign bank group, foreign joint venture bank group, and domestic bank group. This method is adopted in order to

obtain sharper analysis results by comparing a bank group with its peers and as such more realistic regression results will

be obtained.

a) Analysis on overall bank groups using the OLS method produces estimation that on average bank groups, including

foreign bank groups, have shifted from credit channeling to activities that earn fees (fee-based income) and foreign

bank group has relatively similar behavior as domestic bank group.

itit IPIINTNPLBOPOROAconstL εβββββ ++−−−+= 54321

Li,t = α + βi,k+εi,t

i=lΣ ΣΣ ΣΣ ΣΣ ΣΣ Σ

k=l

l k

Table 1Table 1Table 1Table 1Table 1Hypothesis and InterpretationHypothesis and InterpretationHypothesis and InterpretationHypothesis and InterpretationHypothesis and Interpretation

No.No.No.No.No. CasesCasesCasesCasesCases InterpretationInterpretationInterpretationInterpretationInterpretation

1

2

β1 = β2 = β3 = β4 = β5 = 0

β1 = β2 = β3 = β4 = β5 ? 0

It is proven that foreign banks only play asmall role in boosting economic growththrough credit channeling.

It is proven that foreign banks only play asmall role in boosting economic growththrough credit channeling.

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Credit channeling is declining as efforts to step up efficiency are more directed at efforts to reduce credit channeling,

which incurs relatively additional costs for administration and compensation for credit risk that is still considered

high.

NPLs also become an important consideration for banks in channeling credits. Based on estimation, it is proved that

in general rising NPLs have prompted all banks to reduce credit channeling. In a condition where the real sector has

not fully recovered, banks consider additional credit extensions have the potential to create risk, which could disrupt

banks» performance in the future.

In addition, income target that is measured by return on assets ratio constitutes the most influential factor on bank

credit channeling. In the case of domestic banks, particularly recapitalization (recap) banks, ROA or ROE targets

prompt bank management to put priority on high income by undertaking placements in marketable securities and

reducing credit channeling that has the potential to raise bank administrative costs. Meanwhile, in the case of

foreign banks, rising ROA is particularly achieved through a step up in fee-based income earning activities, such as

trade finance, credit cards, etc.

Foreign bank branch offices show similar behavior as domestic banks in viewing ROA, OEOI, and NPLs as points of

consideration in undertaking credit expansion. An increase in ROA of 1% will lower credit growth by 42.1%; an

increase in OEOI by 1% will also lower credit growth by 0.9%; and based on the last indicator, NPLs, an increase in

NPLs by 1% will have an impact in credit contraction by 5.2%.

With its NPL condition as the highest among the bank groups, foreign banks tend to contract credit channeling and

put more focus on fee-earning activities as well as activities related to consumption credit channeling, which credit

ceilings are not too high while the tenors are short such as credit cards.

In the case of foreign joint venture banks, changes of 1% in each of the indicators do not bring quite so large

influence on bank credit channeling activities. Compared with other bank groups, the change in credit growth

of the foreign joint venture banks is relatively small as reflected by 38.2% change - in response to the change

in ROA, 3.9% change - in response to the change in OEOI, and 1.5% change - in response to the change in

NPLs.

Credit channeling performance of the foreign joint venture banks proves to be not so sensitive as the foreign

banks», which is very much influenced by a small change in each indicator as well as in market signals, namely

interest rate and industry index. This proves that although foreign joint venture banks are still influenced by

funding contributions from bank owners, the banks still give sufficient contribution to credit channeling in

Indonesia»s economy.

This phenomenon of course can be taken up as a consideration in policy determination concerning a step up in

foreign banks» role in credit channeling by changing the requirement for their legal entity form to that of foreign

joint venture banks or banks with Indonesian legal entities. The benefits for Indonesia are that not only would it

strengthen the commitment of bank owners and management, it could also reduce systemic risk at a time when

foreign funds are needed to strengthen bank capital.

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Estimation results show signals in line with expectations that are based on assumptions of economic and financial

theories. However, there are several interesting phenomena. One phenomenon concerns foreign banks» ROA

coefficient of -0.29 that is different than preliminary expectation. This explains why a rise of 1% in ROA has

prompted credits to drop on average by 29%. This condition is not too shocking because based on data it has been

shown that foreign banks» credit growth is relatively low because their focus is on fee earning activities and credits

for the consumption sector.

Another phenomenon concerns the existence of a conflicting signal for NPLs at foreign joint venture banks, where a

rise of 1% in NPLs prompts a rise of 2% in credits. This condition stems from the fact that foreign joint venture

banks keep extending credits given by parent companies to their subsidiary companies in Indonesia. In addition,

most credits extended are in foreign currencies that are relatively not volatile against rupiah fluctuations.

Domestic banks also have an interesting phenomenon, where a rise in OEOI is followed by a rise in credits. A rise in

OEOI by 1% prompts a rise in credit channeling by 5%. This stems from the fact that funds deposited by customers

are still high and there is a rise in other income coming from government bonds and a rise in consumption credits,

particularly home ownership credits and vehicle ownership credits.

Estimation also shows that foreign joint venture banks and domestic banks are more sensitive to changes in market

signals compared to foreign banks. This stems from the fact that foreign banks» funds come from their headquarters

and as such they are not sensitive to changes in Indonesia»s macroeconomic condition. Nonetheless, foreign banks

show high level of volatility in credit channeling and tend to be contractive in post-crisis period.

Table 2Regresion Output by Ordinary Least Square

Bank GroupBank GroupBank GroupBank GroupBank Group ConstantConstantConstantConstantConstant ROAROAROAROAROA OEOIOEOIOEOIOEOIOEOI NPLNPLNPLNPLNPL INTINTINTINTINT IPIIPIIPIIPIIPI

Foreign Banks 1.51 -0.29-0.29-0.29-0.29-0.29 -0.08 -0.02 -0.37 0.01

# of observations = 320 (0.04) (0.65) (0.33) (0.77) (0.00) (0.91)

Joint Venture Banks 0.68 0.42 -0.05 0.020.020.020.020.02 -0.48-0.48-0.48-0.48-0.48 0.00

# of observations = 320 (0.47) (0.62) (0.53) (0.75) (0.00) (0.96)

Domestic Banks 0.72 0.38 0.050.050.050.050.05 -0.17 -0.44 0.050.050.050.050.05

# of observations = 320 (0.02) (0.09) (0.14) (0.02) (0.00) (0.36)

Source : Bank Indonesia and CEIC, processed.

b) Based on analysis using the OLS method, the following estimate results are obtained :

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Table 3Regresion Output by Ordinary Least Square

CoefficientCoefficientCoefficientCoefficientCoefficient

C -1,673962 0,914654 -1,830158 0,0742LN_ATMR 0,842146 0,106874 7,879832 0,0000LN_NPL(-1) 0,072976 0,033022 2,209926 0,0325LN_LOAN_DITA 0,097721 0,022747 4,295912 0,0001

R-squared 0,675745 Mean dependent var 6,859306Adjusted R-squared 0,653122 S.D. dependent var 0,101765S.E. of regression 0,059936 Akaike info criterion -2,709816Sum squared resid 0,154470 Schwarz criterion -2,552356Log likelihood 67,68067 F-statistic 29,87052Durbin-Watson stat 1,218106 Prob(F-statistic) 0,000000

Std. ErrorStd. ErrorStd. ErrorStd. ErrorStd. Error t-statistict-statistict-statistict-statistict-statistic Prob.Prob.Prob.Prob.Prob.VariableVariableVariableVariableVariable

Dependent Variable: LN_MODALMethod: Least SquaresDate: 09/16/04 Time: 19:24Sample(adjusted): 2000:09 2004:07Included observations: 47 after adjusting endpoints

The result will be used to estimate the required additional bank»s capital in the future for providing additional loan

to the economy. By using July 2004 data, inasmuch bank required to supply 1% loan increase or Rp 391,4 billion, the

bank needs additional capital approximately Rp 59,2 billion. Since, the aggregated CAR of foreign bank is quite high

(15,3%), the additional capital needed due to the increased of loan growth may not be necessary. The impact of increasing

1% of loan only reduce capital by 0,1% which is relatively low and it will not have negative impact to the banks» CAR

individually. By assuming CAR of foreign bank is adjusted to 12%, the economy will receive additional Rp 15,9 trillion

from the foreign banks

4.4 Analysis of Business Fund In The Calculation of Foreign Bank»s Capital

The entry of banks that domicile abroad into Indonesia through the opening of branch offices is the consequence of

the open economic system adopted by Indonesia. Naturally, their presence is expected to increase banking sector»s role

in advancing Indonesia»s economy. In order for that expected role to be realized, foreign bank branch offices operating in

Indonesia are not exempted from having to implement sound banking practices. One of the main quantitative indicators

for determining whether foreign banks are implementing sound practices is fulfillment of the minimum reserve requirement

ratio or what is commonly known as Capital Adequacy Ratio (CAR).

As such, it is obvious that a bank»s capital is an important component in the calculation of the minimum reserve

requirement. The operation of a bank, which domiciles abroad, in Indonesia basically does not constitute a permanent

business entity but is only a branch office. Naturally, in a branch office there is no capital component. The concept of

capital in a branch office is the capital of its headquarter.

4.3 Empirical analysis of Capital and Loan of Foreign Bank

The estimation of capital and loan of foreign bank using Least Square Method is presented as follows:

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Article I

In view of this condition and in consideration of the importance of capital in the calculation of the minimum reserve

requirement, Bank Indonesia has issued several regulations on foreign bank branch office capital. The latest regulation is

Director»s Decree number 32/37/KEP/DIR dated 14 May 1999. The existence of a regulation, which requires that a foreign

bank branch office must have its own capital, does not mean that the problem with foreign bank branch office capital is

totally solved.

This stipulation still raises a deep question of whether this concept of capital that consists of several components

can accurately define capital and as such when used in the calculation of the minimum reserve requirement will give a

reliable figure for minimum reserve requirement. From evaluation results there are several weaknesses in this concept for

calculating foreign bank branch office capital.

The May Package states that the capital for a branch office of a bank that domiciles abroad consists of net funds of

the headquarter and branch offices outside Indonesia (net head office funds), which among others comprise reserve from

after-tax profit of the Indonesian branch office, provision for earning assets losses (PEAL), reserve for fixed asset revaluation,

retained earnings, last year profit, current year profit, and net interoffice fund (NIOF).

The foreign bank branch office capital regulation under the May Package was amended by Director»s Decree number

32/37/KEP/DIR dated 14 May 1999. This latest decree requires that a foreign bank branch office uses the concept of

business fund to replace NIOF. Other components of capital are not changed by this latest decree and therefore remain

valid. Business fund is fund received from the foreign bank branch office»s headquarter abroad, which is expected to be

recorded on the foreign bank branch office» balance sheet for as long as it is in operation. If the foreign bank branch

office subsequently places back this fund at its headquarter or other branch offices abroad, the part that is placed back

reduces the bank»s business fund. This concept of business fund does not regulate declared business fund.

Based on the evaluation of foreign branch office capital components, there are several issues that cause the estimation

does not reflect the true value of bank capital. These weaknesses are as follows :

Total business fund might not reflect the real situation because of possibility of window dressing

With reference to the definition of business fund, there is a possibility for a foreign bank to window-dress its branch

office»s business fund so that the foreign bank branch office»s CAR looks good. Window dressing can be applied as

follows :

- On report dates, bank headquarter transfers fund to its branch office in Indonesia to improve its business fund.

- Bank only makes record but the fund itself is never transferred. This is possible because bank headquarter and its

branch office have one accounting book or they can be called as one accounting entity. This situation gets worse

because the branch office is not required to declare business fund, which is influenced by this transfer, to Bank

Indonesia»s Foreign Directorate and as such bank supervisors cannot monitor the existence of such transfer.

The amount of business fund does not reflect actual situation because of high frequency of transfers between a

foreign bank branch office and other branch offices as well as its headquarter

The possibility exists for a foreign bank»s headquarter window dresses its business fund in order to ensure that its

CAR fulfills requirement. However, there is one possible extreme situation where a foreign bank does not care about the

performance of its CAR and as such places back fund at headquarter or other branches. In this situation, this placement

has to be calculated as a reduction to business fund, which in the end would worsen its CAR. This situation is possible

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because most foreign banks that have branch offices in Indonesia are multi-national corporations that consider all sides of

the world as places where they can seek profits. Another possible extreme situation is when all branches of a foreign

bank race to transfer funds into Indonesia through headquarter and then through the branch office in Indonesia because

they consider there is a big opportunity for them to seek profits in Indonesia. These two possible extreme situations give

a picture of how fluctuant business fund can be, which makes it difficult for business fund to be one of capital components

in Indonesian foreign bank branch office capital.

5. CONCLUSIONS

Based on results of an analysis on all bank groups using the OLS method, estimation is obtained that on average

bank groups, including foreign bank groups, have shifted role from banks that extend credits to banks that undertake

activities that earn fees (fee-based income).

Results of estimation on overall bank groups confirm a phenomenon that exists amongst foreign banks where

although in efficiency and problem credit aspects foreign banks have similar behavior with domestic or foreign joint

venture banks, but from the point of view of income, foreign banks put more focus on income coming from non-credit

sources (42.1%).

In addition, based on an empirical study of each bank group, foreign banks are less sensitive to changes in domestic

condition signals compared to foreign joint venture and domestic banks. This stems from the fact that foreign banks»

funds relatively depend on funds coming from their headquarters and as such they are less sensitive to changes in

Indonesia»s macroeconomic condition. In addition, foreign banks also show high level of volatility in credit channeling

and tend to be contractive in post-crisis period.

In relation to weaknesses in the presentation of business fund in foreign bank branch office capital, the following

can be concluded :

√ The concept of capital regulated under BI Director»s Decree number 32/37/KEP/DIR dated 14 May 1999 should be

improved in calculating capital. This stems from the fact that one of the components of capital, namely business

fund, has weaknesses in its presentation.

√ The inaccuracy of this capital concept could make the result of calculation of the minimum reserve requirement not

as it should be.

√ The inaccuracy of this capital concept could make it not possible for the capital to be used as a buffer in anticipating

potential losses at the foreign bank branch office and cannot be used as a tool for controlling the foreign bank

branch office»s asset development.

The above condition of course can be taken up as a consideration in policy determination concerning a step up in

foreign banks» role in credit channeling so that foreign banks can play a greater role in domestic economic development

and be the motivator for foreign investors to reinvest in Indonesia.

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References

Berger and Robert DeYoungBerger and Robert DeYoungBerger and Robert DeYoungBerger and Robert DeYoungBerger and Robert DeYoung (1997): ≈Problem Loans and Cost efficiency in Commercial Banks∆ Journal of Banking

and Finance, Vol. 21.....

Cho, Y.J.Cho, Y.J.Cho, Y.J.Cho, Y.J.Cho, Y.J. (2002), ≈Towards Stronger Banking Sector: Lessons from Bank Restructuring in Korea after the Crisis∆,

mimeo., Asian Development Bank Institute

Clarke, G., R, Cull, M.S.M. Peria, and S. M.SanchezClarke, G., R, Cull, M.S.M. Peria, and S. M.SanchezClarke, G., R, Cull, M.S.M. Peria, and S. M.SanchezClarke, G., R, Cull, M.S.M. Peria, and S. M.SanchezClarke, G., R, Cull, M.S.M. Peria, and S. M.Sanchez: (2001) ∆Foreign Bank Entry: Experience, Implications for

Developing Countries, and Agenda for Further Research,∆ mimeo. World Bank, 2001.

Crystal, J.S., B.G. Dages and L. GoldbergCrystal, J.S., B.G. Dages and L. GoldbergCrystal, J.S., B.G. Dages and L. GoldbergCrystal, J.S., B.G. Dages and L. GoldbergCrystal, J.S., B.G. Dages and L. Goldberg (2001), ≈Does Foreign Ownership Contribute to Sounder Banks in Emerging

Markets?: The Latin American Experience,∆ in R.E. Litan. P. Mason, and M. Pomerleano (eds)., Open Doors: Foreign

Participation in Financial Systems in Developing Countries. Washington, D.C., Brookings Institution Press.

Goldberg, L. B.G. Dages and D. KinneyGoldberg, L. B.G. Dages and D. KinneyGoldberg, L. B.G. Dages and D. KinneyGoldberg, L. B.G. Dages and D. KinneyGoldberg, L. B.G. Dages and D. Kinney (2000),∆Foreign and Domestic Bank Participation in Emerging Markets:

Lessons from Mexico and Argentina,∆ NBER Working Paper 7714.

Mathieson, D.J.., and J. RoldosMathieson, D.J.., and J. RoldosMathieson, D.J.., and J. RoldosMathieson, D.J.., and J. RoldosMathieson, D.J.., and J. Roldos: (2001) ≈The Role of Foreign Banks in Emerging Markets, ≈ in R.E. Litan, P. Masson,

and M.Pomerleano (eds), Open Doors: Foreign Participation in Financial Systems in Developing Countries. Washington,

D.C.: Brookings Institution Press, 2001.

Miller S. and A. ParkheMiller S. and A. ParkheMiller S. and A. ParkheMiller S. and A. ParkheMiller S. and A. Parkhe(1998)∆ Patterns in the Expansion of U.S. Banks» Foreign Operations,∆ Journal of International

Business Studies, 29(2), 359-390, 1998.

Montgomery, HMontgomery, HMontgomery, HMontgomery, HMontgomery, H. (2003)≈ Do Foreign Banks Provide More Stable Credit?∆, Journal of Asian Development Bank

Institute, Dec. 2003

___________________________________________________________________________.(2003) ≈The Role of Foreign Banks in Post Crisis Asia: The Importance of Method of Entry∆, Asian

Development Bank Institute Research Paper No. 51, January 2003.

Peek, J.E. Rosengren, and F. KasiryePeek, J.E. Rosengren, and F. KasiryePeek, J.E. Rosengren, and F. KasiryePeek, J.E. Rosengren, and F. KasiryePeek, J.E. Rosengren, and F. Kasirye (1998): ≈The Poor Performance of Foreign Bank Subsidiaries: were the Problems

Acquired or Created,∆ Federal Reserve Bank of Boston Working Paper 98.

Reynoso, A.Reynoso, A.Reynoso, A.Reynoso, A.Reynoso, A., (2002) ≈Can Subsidiaries of Foreign Banks Contribute to the Stability of the Forex Market in Emerging

Economies? A Look at Some Evidence from the Mexican Financial System≈National Bureau of Economic Research Working

Paper No. 8864, April 2002.

Santiprabhob,V.Santiprabhob,V.Santiprabhob,V.Santiprabhob,V.Santiprabhob,V. (2002):∆Lessons Learned from Thailand»s Experience with Financial Sector Restructuring,∆ mimeo.

Asian Development Bank Institute.

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Article II

1. Head of Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : [email protected]. Executive Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : [email protected]. Lecturers, Department of Economics, State University of Jember

The objective of this research is to establish a model for the prediction of bankruptcy for commercial

banks both overall as well as for each group of commercial banks in Indonesia based on the financial statement.

The analysis used is the Factor Analysis and Logistic Regression. As independent variables are the capital

ratios’ factors, the financial risks and the dummy variable of time variation, while as dependent variables is the

bank bankruptcy. The result of the research shows that from the three prediction models, which succeeded in

being established, it turned out that only MP3 was adequately to be used as the prediction model for bankruptcy

for commercial banks in Indonesia. At the level of modeling, MP3 possesses a classification accuracy of

94,9% (default cut-off = 0,5) or 94,2% (specification cut-off = 0,939) while at the level of model validation it

owns a classification accuracy of 82,6% (default cut-off = 0,5) or 89,8% (specification cut-off = 0,939). The

prediction model for bankruptcy for each group of banks was also established with the MP3 Formula through

dummy substitution of the bank’s group.

The Model To Predict Bankruptcyfor Commercial Banks in Indonesia

A b s t r a c t

Classification JEL: G.21

Keywords : Bankruptcies, logistic regression, factor analysis, financial risk.

Muliaman D. Hadad,1) Wimboh Santoso,

2)

Sarwedi, Hari Sukarno, Moh. Adenan 3)

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1. INTRODUCTION

1.1 Background of the Problems

At present the business world is in a fast moving competitive environment. According to the Basel Committee on

Banking Supervision (1999), recently the world financial system has shown the presence of an economic turbulence. A

turbulence in a financial system may create explicitly several threats, which may weaken the competitive power of a bank.

It may probably even be eliminated from the banking industry. In order to maintain the life expectancy in a turbulent

financial system, a bank must be able to compete with competitor banks and their other financial intermediary units,

which also render financial services» service. A bank management, which is creative and innovative shall always endeavor

to create several profitable prospective bank services» products without neglecting the principle of asset liability management

(ALMA), i.e. adjusting itself between profitability and risk.

The economic crisis knocking down Indonesia since the middle of 1997 for example, has brought a less profitable

change almost to all aspects of the nation»s life. According to data from BPS for the years 1995 and 1996 in a row: the real

GDP growth was 8,21% and 7,82%; the GDP per capita was US$1, 023 and US$1,128; the inflation rate was 8,6% and

6,47%. In line with the occurrence of the economic crisis, all said achievements drastically decreased. Still according to

data from BPS, the real GDP growth was minus 13,7%; the GDP per capita was US$ 487; and the inflation rate soared to

become 77,6%. These facts gave the Indonesian a profuse feeling of optimism. These facts gave the Indonesian a profuse feeling of optimism. These facts gave the Indonesian a profuse feeling of optimism. These facts gave the Indonesian a profuse feeling of optimism. These facts gave the Indonesian a profuse feeling of optimism. In addition, it also showed that all former

achievements turned out not to be supported by a strong infrastructure, such as an irrational debt to service ratio

(DSR>30%) and the fragile banking sector, such as an inclination of the lowering of profit and the increasingly business

risk faced by the banks.

In order to anticipate the appearance of financial problems at banks, a system needed to be compiled, which could

give early warnings of a financial problematic threatening the bank»s operations. The capital factor and the financial risk

had an important role in explaining a bank»s bankruptcy phenomena. By detecting very early the banking condition, it

would be very probable for bank to take anticipative steps in order to avoid, such that the financial crisis could immediately

be taken care of. Referring to the explanation above, the problem forwarded through this research is whether bankruptcy

in commercial banks in Indonesia may be predicted through their financial reports? Specifically the problem to be thoroughly

investigated may be formulated whether bankruptcy of each bank group in Indonesia can be predicted?

1.2 The objective of the Research

Several objectives which intended to be achieved through this research was to establish a model to predict bankruptcy

in commercial banks as well as in each bank group in Indonesia based on the financial report of the respective bank.

2. BIBLIOGRAPHY REVIEW

2.1 Agency Theory and the Bank»s Failure

The Agency Theory, explains the contractual relationship between principals and agents. The party of the principals

is the party giving mandate to another party, i.e. the agent, to carry out all activities on behalf of the principal in his

capacity as decision maker (Sinkey, 1992:78; Jensen & Smith, 1984:7).

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According to Sinkey (1992:79), one of the most important relationships of principals-agents in the financial sector

and the financial services» industry is depositor-borrower (i.e. the bank).

Each party has a very potential rational importance to emerge problems. There are two types of problems in said

relationship of principals - agents (Arrow, 1985 in Sinkey, 1992:78), that is an unknown action (hidden action) and

unknown information (hidden information).

The findings of Pantalone & Platt (1987) and other researchers show that the main reason for a bank»s failure is poor

management of the bank, the result of being too daring to take risks, and the scarce supervision towards fraud acts and

embezzlement of funds. Sinkey (1992:196) said that the acts of such bankers such as fraud, authority misuse and banking

crime actions constitute examples of a hidden action, while evaluation of errors towards the on-and off balance-sheet

constitute examples from hidden information. At the moment the signal of bankruptcy arises, the depositor party (principal)

shall have the right to withdraw his savings from the bank (agent). Consequently the Agency Theory can be explained

relationally the depositor-borrower (e.g. bank) as well as the emergence of the phenomena of the bank»s failure.

2.2 The Analysis Profile and the Analysis Distress Prediction

Historically the study on business bankruptcy cannot be separated from the existence of the profile analysis and

prediction distress analysis study. The pioneer of the study on profile analysis is Fitz Patrick, 1932; Winakor & Smith, 1935:

and Merwin, 1942 (Beaver, 1966), while the pioneer of the prediction distress analysis is Beaver for the univariate model

and Altman (1968) for the multivariate model. At the profile analysis it is shown that there is a clear difference between

financial ratios of bankrupt companies and solvent ones. The Prediction distress analysis stresses more on the information

of prediction capacity of the financial report regarding one important matter, for example the business bankruptcy. The

result of the overall study is based on the value and average financial ratios of a company (for profile analysis) and in how

far its dispersion (for prediction distress analysis) for some time prior to bankruptcy.

2.3 The Empiric study on Bankruptcy prediction

The pioneer of the study on bankruptcy is Beaver (1966), and Altman (1968). Both used accountancy data from the

balance sheet and the profit-loss reports from manufacturing companies in the form of financial ratios as discriminator

variables and bankruptcy predictors.

BeaverBeaverBeaverBeaverBeaver (1966), used the single variable with the period 1954-1964. The sample proportion of bankrupt and non

bankrupt manufacturing and non-manufacturing was 79:79 (1 year prior to bankruptcy), 76:77 (2 years prior to bankruptcy),

75:75 (3 years prior to bankruptcy), 62:66 (4 years prior to bankruptcy), 54:63 (5 years prior to bankruptcy). As many as

30 financial ratios were classified in the group cash flow ratios, net income ratios, debt to total asset ratios, liquid asset to

total asset ratios, liquid asset to current debt ratios, and turnover ratios. 6 ratios were chosen as variables to be analyzed.

Its result was, all the six financial ratio variables in an univariate way could classify between bankrupt and non-bankrupt

companies for 1 up to 5 years prior to bankruptcy. The closer to the time of bankruptcy the lower the level of classification

errors.

The prediction for bankruptcy with the multivariate model was pioneered by AltmanAltmanAltmanAltmanAltman (1968). During the period

1946 √ 1966 samples of 33 bankrupt manufacturing companies were used in the USA and from 33 companies, which

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were not bankrupt. Through the multiple discriminant analysis and 5 of the most significant financial ratios measured the

profitability, liquidity and solvability, the popular Altman Formula called Z-score is :

Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5

in which : X1 : Working Capital /Total Assets; X2 : Retained Earning/Total Assets; X3 : Earning before Interest and

Taxes/Total Assets; X4 : Market Value Equity/Book Value of Total Debt; X5 : Sales/Total Assets and Z : Overall Index

The closer to the time of bankruptcy the higher level of prediction accuracy.

Several researchers abroad have developed the bankruptcy prediction model for banks. Among others : Meyer &

Pifer (1970); Stuhr & Wicklen (1974); Sinkey (1975); Korobow, Stuhr & Martin (1977); Santomero & Vinso (1977); Martin

(1977); Shick & Sherman (1980); Pettway & Sinkey (1980); Peterson & Scott (1985); Short, O»Driscoll & Berger (1985);

Bovezi & Nejezchleb (1985); Sinkey, Terza & Dince (1987); Pantalone & Platt (1987); Whalen & Thompson (1988); Randal

(1989); Young (1999); Hermosillo (1999); and Estrella & Peristiani (2000).

Research in respect of bankruptcy in commercial banks in Indonesia has ever been conducted by Wimboh Santoso

(1996), Indira & Dadang Mulyawan (1998), Abdul Mongid (2000), Titik Aryati & Hekinus Manao (2000), Etty M Nasser &

Titik Aryati (2000), Tengku N. Qurriyani (2000) Wilopo (2001), and Sri Haryati (2001).

2.4 The Validation Model Experiment

According to Beaver, Kennelly & Voss (1968), if the objective of a research were to predict an event, then logically

speaking an empirical comparison should be conducted. Its relation with the study on bankruptcy prediction, the estimate

of the probability of failure constitutes a signal in classifying firm i to one of the bankrupt and non-bankrupt groups.

(Ohlson, 1980). Rencher (1995; 334) states that in order to evaluate the ability of the classification procedure in predicting

membership of a group, the misclassification probability was used, called error rate. The errors may be known through

the validation experiment, comprising comparison with their actual data so that error type I and II may be known. At

another part, Ohlson (1980) said that a good prediction model is a model possessing a minimum sum of percentage

errors.

According to Hair, et. al (1998 √ 194), the empirical validation approach is the most suitable to experiment the

regression model based on a new sample lowered from the population. The researchers divide the research sample to

become 2 groups: the design sub sample to make the regression model and the holdout/validation sub sample to be used

for experiment of the regression model. According to Sumarno (1994;50) generally for the model experiment in the

research of the failure prediction is making use of the classification accuracy method both at the design as well as at

validation samples.

The size sample ratio for n-design samples is larger than n-validation samples. Hair et. al (1998;254) said, there is

no certain reference in dividing samples to become analysis groups and validation groups. Researchers like the division

of 60-40 or 75-25. Besides, the sample size for each dichotomy characteristic (failed √ non-failed) of the dependent

variable is not always the same (in pairs) so that both the design samples as well as the validation samples may be pair

or non-pair samples.

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3. METHODOLOGY

3.1 The Research Planning

This research is included in predicting organizational outcomes. Therefore, this first phase research established a

dependent variable prediction model and at the same time conducting its validation experiment. Later, it continued to

experiment the model validation based on new data (holdout samples).

3.2 The object and Research Population

This research object was ≈Commercial Banks∆ in Indonesia. The argumentation of choosing said object was that (a)

all commercial banks activities influence the national economic system, and (b) at present they have become the target of

the banking recapitalization program, carried out by the Indonesian Government. The group Bank Perkreditan Rakyat

(BPR) was intentionally not included as its role was felt less significant compared to the group Commercial banks.

The population in this research was ≈ all commercial banks∆ in Indonesia. The scope ≈commercial banks∆, which

was investigated comprised the state-owned, private, regional government , joint venture, and foreign banks. The

time period of investigated population were the monthly data from the period January 1995 up to December 2003,

while the establishment phase of the prediction model and its validation was separated between population for modeling

and population for validation. According to Sumarno (1994:23), a model should actually be evaluated by testing its

prediction accuracy based on design and validation sample. As long as the data used for validation accuracy are

different from the data used to establish the classification function (or prediction), the error rate obtained was unbiased

(Rencher, 1995:337).

3.3 The Variable operations and Research Data

The variables used comprised dependent and independent variables. Capital ratios, financial risks and time variations

(XT) constitute independent variables, while the condition of the bank to be predicted, i.e. the status of the bank»s

bankruptcy constituted a dependent variable (Y).

Capital Ratios

The measurement showing the level of the existence of a certain capital amount to protect depositors, to cover

losses and to protect the going concern bank, to buy fixed assets for the smoothness of the bank»s services service, and

in order to comply with the provision of the regulator»s party for protecting incorrect asset expansion (BC. Leavitt, in

Hempel et al., 1994:266). The ratios were : X2 ≈ (CAP1): capital to deposits; X3 ≈ (CAP2): equity to deposit; X4 ≈ (CAP3):

loans to equity; X5 ≈ (CAP4): loans to capital; X6 ≈ (CAP5): fixed assets to equity; X7 ≈ (CAP6) : fixed assets to capital; X8

≈ (CAP7): equity capital to total assets; X9 ≈ (CAP8): net open position to capital: X10 ≈ (CAP9): return on equity; X11 ≈

(CAP10): return on capital.

Financial Risk Ratios

The measurement showing the relative level on the consequence of the management decision taking in several

financial dimensions in order to achieve the expected return. A high return was usually only possible by also taking high

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risks, and the other way around (Short et al., 1985; Fraser & Fraser, 1990;30 and Hempel et al., 1994:68 and 272). Said

ratios were: X12 ≈ (Risk1): Liquidity Risk = (liquid assets-Short term borrowing) to total deposits; X13 ≈ (Risk2): Capital Risk =

equity to risk assets (= assets √ cash √ clearing BI √ Government Negotiable Papers); X14 ≈ (Risk3): Credit Risk = productive

assets classified (APYD) to productive assets (AP); X15 ≈ (Risk4): Deposit Risk = equity to total deposit; X16 ≈ (Risk5): Off -

Balanced Sheet Risk = loan commitment to fee income; X17 ≈ (Risk6): SOB1 Risk = Loans to assets; X18 ≈ (Risk7): SOB2 Risk

= Treasury Securities to assets; X19 ≈ (Risk8): SOB3 Risk = Other Securities to assets; X20 ≈ (Risk9): SOB4 Risk = Capital to

assets; X21 ≈ (Risk10): SOB5 Risk = core deposits to total liabilities; X22 ≈ (Risk11): NPL Ratio = Non Performing Loans to Total

Loans.

The use of the capital ratio indicators and financial risks was because : (1) wishing to be more realistic representing

the quality of the bank»s management, (ii) at the previous empirical study, the capital ratios constituted indicators which

almost always became the reason for the failure of a bank, and (iii) every bank»s management decision could raise risks

combinations, which might have the role of deciding a bank»s failure. Consequently, said ratios were meant as a proxy

towards the quality of the bank»s management in managing capital and its risk portfolio.

The condition of a bank predicted was expressed by the status of a bank, bankrupt or not. A bank having the status

of being bankrupt was a bank in the situation of legal bankruptcy, where a company was legally declared bankrupt

based on the bankruptcy law (Altman: 1992, in Brigham & Gapenski, 1997; 1034-5).A bankrupt bank in this study

comprised a bank of the status of a liquidated bank (BDL), a bank which stopped its operations (BSO), a bank take over

(BTO), a bank which business operations were suspended (BBKU) and a bank merger.

The argumentation of the use of some definitions of said bankrupt banks, was that the phenomena of a bank»s

bankruptcy legally only started in Indonesia, since the Government liquidated 16 BUSN on 1 November 1997, followed

by the policy of bank suspension (4 April and 21 August 1998); i.e. the policies on BTO, BBO, BBKU and the Recapitalization

Program, while said happenings almost never happened in the previous years. In the period prior to the 1st of November

1997, such banks maintained to be operating as a depository institution. Theoretically, a liquidation condition, suspension

of operations and a bank merger cannot happen, but were always preceded by said bank to experience financial

problems. Therefore, prior to the implementation of said policies there were several banks, which experienced financial

problems.

The time variation of the independent variable (XT) and the variable on the bank»s bankruptcy status have the

character of dichotomy. If XT=0, stating a time prior to the crisis (prior July 1997), and, XT=1 stated the time prior to the

crisis (after July 1997). Then if Y=1, stated that a bank was bankrupt and Y=0, stated that a bank was not bankrupt.

Consequently, the variable (XT) and Y constituted dummy variables and possessed the measurement of nominal scale.nominal scale.nominal scale.nominal scale.nominal scale.

Other independent variables possessed the measurement of ratio scaleratio scaleratio scaleratio scaleratio scale, i.e. the capital ratios» variables and the bank»s

financial risks obtained from the data arithmetic process in the balance sheet and the bank»s profit-loss report.

The type of data used was secondary data, in the form of a monthly Bank»s Financial Report compiled periodically

from January 1995 up to December 2003. According to Sumarno (1994:23), a model should actually be evaluated by its

prediction accuracy based on design and validation sample. As long as the data used to validation accuracy differed from

the data used to establish the classification function (or prediction) the error rate obtained is unbiased. (Rencher, 1995:337).

Data from the months of January 1995 up to December 2000 were used as population for a design model while the data

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in which: Pit : opportunity of the first bank bankrupt(Y=1); 0≤Pi ≤1

Xij : predictor variable j for the first bank

Zi : linier function from predictor variable; -∞ ≤ Zi ≤ +∞

t : time when the bank is bankrupt

k : period (month) prior to the bank being bankrupt

e : natural logaritm; e = 2,71828

‘ : regression coefficient

Value Y depends on the coefficient ‘j and explanatory variables Xj (j = 1, 2, º, J). Because this research used the

panel data, the assumption stated that the parameter coefficient is all the time the same and for all units (bank) cross

sectional, will cause all estimators in said panel data to become inefficient. Therefore, it needs to be reviewed whether the

effect at every unit (bank) cross sectional (_) and the length of time of the time series(l) constitute fixed effects or random

effects. In the event said effects are fixed effects, then the problem of an estimator who is not efficient can be overcome

by using dummy variables for the estimator and it seems that its regression equation coefficient slope is not connected.

On the other hand, if said effects were random effects, then the problem of the estimator who is inefficient can be

overcome by Error Component Models for Intercept (Mundlak, 1978 in Wimboh, 1996).

To determine fixed or random effects at a model to be used depends on whether there is a correlation between

each unit (bank) cross sectional (_i) and independent variable (Xi). In the random effects a most efficient estimator will be

produced when there is a correlation between (_i) and (Xi) with a certain/known distribution assumption (_i) known.

Judge (1985, in Wimboh, 1996) states that said random effects may produce an inefficient estimator when the (_i)

distribution, which actually turned out to be different with the distribution _i assumed known. Judge also suggested that

whatever the existence of the correlation between _i and Xi the dummy variable estimator constitutes a sufficient

adequate estimator for a small N. Referring to the opinion of said Judge, the dummy variable estimator to be used in this

of the months January 2001 up to December 2003 were used as population for a validation model. Said data was

obtained from Bank Indonesia (KBI).

3.4 Analysis Method

The prediction model was established based on the logistic regression model, with the formulation expressed by

following equation:

).

1

0(

1

11 .

ktijXi

J

je

XYEP ktiit

−

=

+− +

=== −

ββ

itZit eP −+=11

or ; and Zit = √ 0 + =

J

j 1

Σ √ j Xij.t-k

j = 1,2, J dan k = 3,6, 12

Σ

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research is proven to be valid, as he only used 6 groups of cross sectional banks (N=6, i.e. : Government Bank group,

Foreign Exchange BUSN, Non-Foreign Exchange BUSN, BPD, Mixed Banks, Foreign Banks) and distribution _i was not

exactly known. In other words, the logistic regression model by involving 6 bank groups used in this research means that

it has already taken into consideration the random effects.

Then, if the logistic regression model used has taken into consideration the fixed effects, its assumption is that

intercept and its coefficients» slope is not the same among the bank groups. However, individually at each bank group the

extent of the intercept and said coefficient slope are the same as long as the time series. Consequently, a treatment will

be conducted towards equation (1) by using independent variables XT (time variation) having the character of ≈biner∆ as

proxy, the importance to consider the time variation. If XT = 0, stating the time/month prior to the crisis (prior to July

1997), and XT =1, stating the time/month starting the crisis (July 1997) and further. As such, the logistic regression model

used in this research should have (with XT) considered the existence of fixed effects.

Then, prior to achieving the objective of the research, first of all a Factor Analysis should be conducted towards the

independent variable of the measurement ratio scale, (variable X2, º, X22) as predictor factors. According to Rencher

(1995:445); the goal of factor analysis is to characterize the redundancy among the variables by means of smaller

number of factors. The Factor Analysis process will result in a new variable (factor grouping is formed), which remains to

bring important information from the former variable (TN. Qurriyani, 2000). Every original variable constitutes a linier

combination at random a number of variables, called factor variables, i.e. common factor and unique factor.

1)(12)2(11)1(11 .......... efvfvfvX mm ++++=

2)(22)2(21)1(22 ......... efvfvfvX mm ++++=

pmmpppp efvfvfvX ++++= )(2)2(1)1( ..........

Zitite

P−+

=1

1∑=

m

j 1

(2)

in which: there is a number of m (m < p) common factor with notation f, and p original variable (notation X). vj,I is the

weight factor i (i = 1, 2, º.,p) related to variable j (j = 1, 2, º.., m). and ej (j = 1, 2, º.,p) is the unique factor.

After the original variable, comprising independent variables of the measurement ratio scale are grouped to become

the m factor, hence equation (1) is adjusted to become:

; and Zit = √ 0 + √ q fi(j)

q= 1, 2, 3, ,r

(3)

in which:

fi(j) : factor i to-j

m : the number of factors

Further in order to overcome the impact of the influence of the random and fixed effects, equation (3) needs to be

adjusted with the existence of dummy variables in the bank group and to enter variable XT (time variation).

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Article II

information:

f : factor, as independent variabel

D = XT : dummy variable time variation

k : the number of bank groups, for k = 1, 2, º, n

p : the number of factors in a group, for p = 1, 2,º,m

b : regression coefficient

In order to achieve objective no. 1, the prediction model is established by using the equation logistic regression

model formulation (4). Later, as a verification step a goodness of fit test and a significant Wald statistic test need to be

conducted towards equation (4)

a. Goodness of fit test. In this research to use Chi-square Hosmer and Lemeshow. The test Chi-square Hosmer and

Lemeshow measures the difference between the observation result value and the dependent variable prediction

value. The smaller the difference between the two, the better/adequate model obtained (Hair et.al, 1998:318-319).

b. The Wald Statistic Significance. Wald Statistic tests the significance of the logistic regression coefficient of each

predictor, with the statistic hypothesis formulation as follows. As this research is conducted towards the population

data, therefore the logistic regression coefficient significance does not need the Wald Statistic test as conducted

towards the sample data.

Later to be continued with the test power of regressions to predict, the bank»s opportunity experiencing bankruptcy

or not. Said prediction model will result in a score between 0 (zero) and 1 (one) interpreted as the probability figure. With

a certain cut-off point said prediction model will result in 3 estimation categories, i.e. : a exact estimation, an error

estimation Type 1 and the error estimation Type II (Wimboh, 1996:15). A cut-off-point constitutes a value to determine

whether a bank is estimated as a bankrupt bank or not. As stated by Wimboh, this approach has been often used by

previous researchers in estimating the opportunity of a failure of a bank/company. For example with a 0,4 cut-off-point,

the prediction model will identify a bank with a probability more than 0,4 as a bankrupt bank. On the other hand, a bank

with a probability of less than 0,4 is estimated as a non bankrupt bank. The prediction model will result in an accurate

estimate, while a bankrupt bank shall be accurately estimated as a bankrupt bank. The error Type I may occur when the

prediction model estimates a bank not to be bankrupt as a bankrupt bank, or the model results in a probability of a bank

not bankrupt more than 0,4. And, the error Type II may occur when the prediction model results in a probability of a

bankrupt bank less than 0,4. The lower the cut-off-point used the more banks that are predicted as bankrupt banks and

only some banks are predicted not to be bankrupt.

= =

−++++=

n

k

m

ppkmpifDZ

1 1)1(110

βββ Σ Σ

By involving said bank group»s dummy variable and dummy variable time variation (XT), hence equation (3) becomes:

Zitite

P−+

=1

1(4)

while:

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Article II

Therefore, the choice of cut-off-point plays an important role in the calculation of the level of errors. Hence a fair

cut-off-point decision is very much needed. According to Wimboh (1996), a sample proportion of a bankrupt bank and

a not bankrupt bank is convinced to constitute the best criteria to determine said cut-off-point. If a sample of a bankrupt

bank amounting to 50% for example, and a sample of a not bankrupt bank amounting to 50%, then a cut-off-point

amounting to 0,5 shall be chosen. And if a sample of a bankrupt bank amounts to 60%, while a not bankrupt bank

amounts to 40%, then a fair cut-off-point would be 0,4. The choice of a cut-off-point in this research uses a proportion

of a bankrupt and not bankrupt bank as stated by said Wimboh (1966).

Then, after the prediction model is established, then in order to achieve the second (two) objective a substitution

needs to be conducted towards equation (4) based on the bank»s group.

4. THE RESULT OF THE RESEARCH

The prediction model conditionally established towards capital ratios» indicators and financial risks of a bank for a

period of 3 moths, 6 moths and 12 months prior to a bank being declared bankrupt. The relative time period has been

chosen based on the uniqueness of the banking industry business character, which proposes confidence. If a bank looses

its confidence from the community, said bank will be left by its clients. Depositors will withdraw their deposits, creditors

will decrease/stop their loans, and investors will conduct divestment, so that the bank will be threatened to become

bankrupt. Said phenomena may happen anytime. It is possible, that on this day said bank would be sound, however due

to a rush triggered off by a negative sentiment, causing the loss of confidence of the market, the bank shall experience a

bankruptcy at the following day. Consequently tools are required, which may give early warning signals of the condition

of said bank leading towards bankruptcy. The result of the empirical study shows, that the nearer the time of bankruptcy

the lower the level of classification errors of bankrupt √ not bankrupt banks. The concerned empirical study was

conducted by: Beaver (1966), Altman (1968), Meyer & Pifer (1970), Pettwy & Sinkey (1980), Pantalone & Platt (1987),

Indira & Dadang (1998), Mongid (2000), and Wilopo (2000).

Therefore, a prediction model to be established is 1) The prediction model 3 months prior to bankruptcy, abbreviated

MP3; 2) the prediction model prior to 6 months, abbreviated MP6; 3) the prediction model 12 months prior to bankruptcy,

abbreviated MP12.

The modelling of each said prediction model through the following phases: a) Factor analysis, b) Establishment of

the bankruptcy prediction model, c) the test of Goodness of Fit, d) Specification of cut-off-point, e) Model Validation.

4.1 The model for bankruptcy prediction of commercial banks (K1-K6)

In order to achieve the first objective, data are needed of each bank group, having published before financial reports

of 3 moths, 6 months and 12 months. Then it is continued with the Factor Analysis towards capital ratios» variables and

financial risks.

From the result of the logistic regression computation of equation (4) and the measurement of the design population

9.166 bank data, MP3 possesses Chi-square 17,027 with a significance probability of 0,030 (attachment 1). Based on the

goodness of fit test of Hosmer & Lemeshow, it turns out that said value of 0,030 is larger than a (=1%), such that H0 is

accepted. The meaning is, that there is no differece between the classification of the observation result and the bank»s

105

Article II

prediction of bankruptcy √ non bankruptcy. In other words, said Chi-square value of 17,027 does not differ from 0 (zero).

Its implication is, as mentioned in Table 2 that MP3 statistically is adequate to be used as prediction model for bankruptcy

for commercial banks in Indonesia for a period of 3 months prior to bankruptcy at the level of significance less than 3%.

With the same procedure, MP6 possesses a Chi-square of 25,672 with a significance probability of 0,001 (attachment

2) and MP12 possesses a Chi-square of 21,924 with a significance probability of 0,005 (Attachment 3). Based on the

goodness of fit test of Hosmer & Lemeshow, it turned out that both values of said Chi-square were smaller than a

(=1%), such that H0 was rejected. The meaning is, that there was a difference between the classification of the observation

result and the bank»s prediction of bankruptcy √ non-bankruptcy. In other words, both said Chi-square values differed

from 0 (zero). Its implication was, that both MP6 as well as MP12 statistically were inadequately (Table 2) used as prediction

model for bankruptcy of commercial banks at the level of significance 1%.

Therefore, from the three prediction models that which suceeded being established (MP3, MP6, and MP12), it

turned out that only MP3 possessed a satisfactory result of the test goodness of fit. MP3 was declared adequately to be

used as prediction model for bankruptcy of commercial banks in Indonesia at the level of significance less than 3%.

Further, at the modelling level, at one part based on the correct estimates, it was proven that the three prediction

models showed a high classification accuracy (Table 2). MP3 was more accurate than MP6 and MP12, because MP3

possessed higher correct estimates (94,9%) than the two other prediction models (94,5% and 93,5%). Besides, MP3 also

possessed a level of errors (error I and error II), which were relatively lower than the level of errors possessed by MP6 and

MP12.

The level of model validation based on the validation population (January 2001 up to December 2003) showed that

MP3 was not better than MP6 and MP12, because MP3 possessed a lower level of classification accuracy (=82,6%) than

the level of classification accuracy MP6 (=86,5%) as well as MP12 (=91,32%) However, the classification accuracy of MP3

could be declared as being sufficient good as its value was still relatively high, i.e. amounting to 82,6%. The same result

was also obtained if their error-type was compared, where the error type at MP3 turned out to be higher than that at MP6

and MP12.

On the basis of said level, although MP3 possessed a lower classification accuracy based on validation population

than MP6 and MP12, but because MP3 was more adequate than the two other models, MP3 was declared as a better

InformationInformationInformationInformationInformation MP3MP3MP3MP3MP3 MP6MP6MP6MP6MP6 MP12MP12MP12MP12MP12

Table 2:Table 2:Table 2:Table 2:Table 2:The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (Cut-Off PointCut-Off PointCut-Off PointCut-Off PointCut-Off Point = 0,5) = 0,5) = 0,5) = 0,5) = 0,5)

Source: Monthly Processed Financial Reports of Commercial Banks.

Design Population (bank data) 9,166 8,456 7,828Goodness of fit (a = 1%) Adequate Inadequate InadequateCorrect Estimates (%) 94.9 94.5 93.5Error I Type (%) 0.7 0.6 0.7Error II Type (%) 74.7 79.1 83.2

Validation Population (bank data) 4,129 3,640 2,730Correct Estimates (%) 82.6 86.5 91.32Error I Type (%) 15.7 11.7 7.97Error II Type (%) 91.1 95.0 43.64

Modeling :Modeling :Modeling :Modeling :Modeling :

Validation Test:Validation Test:Validation Test:Validation Test:Validation Test:

106

Article II

At the modelling level (Table 3), the three prediction models based on the cut-off-point specification, each produced

a high correct estimates value. That is 94,2% for MP3, 94,9% for MP6 and 93,2% for MP12. These results indicated that

the prediction model established was able to correctly classify 94,2% (MP3), or 94,6 (MP6), or 93,2% (MP12) the design

population member. Although the classification accuracy of MP3 was somewhat lower than MP6, however it was still

more accurate than MP12, which possessed high correct estimates, so that it could be stated that MP3 could adequately

be used as a prediction model for bankruptcy of a bank.

Further, as a prediction test, obviously the three prediction models at the level of model validation (Table 3) possessed

also a high correct estimates value. That is 89,8% for MP3, 92,0% for MP6 and 94,62% for MP12. The meaning is, that

the prediction models established were able correctly to classify 89,8% (MP3), or 92,0% (MP5), or 94,62% (MP12) the

validation population member.

From said elucidation and remaining to refer to the result stated in Table 2, it seemed that MP3 was still declared

adequate as a prediction model for bankruptcy in commercial banks in Indonesia, considering that MP3 also possessed

high correct estimates both at the level of modeling and at the level of model validation based on default of cut-off point

0,5 as well as based on the cut-off point specification 0,939.

4.3 An analysis on the Prediction Model of Banks» Bankruptcy

If we were only referring to the rule of thumb, the prediction power of MP3 was indeed sufficiently good, as it

possessed a high classification accuracy (because > 50%). However, if paying close and accurate attention, there was one

prediction model than MP6 and MP12, so that MP3 was adequately used as the prediction model for bankruptcy in

commercial banks in Indonesia.

4.2 Cut-off point specification

The choice of the cut-off value in this research used the proxy of the bankrupt and not bankrupt bank proportion as

stated by Wimboh (1996). Based on the population data survey the Cut-off point obtained for MP3 was 0,939; for MP6

was 0,9366; and for MP12 was 0,9295.The extent of said three Cut-off points were relatively almost the same.

InformationInformationInformationInformationInformation MP3MP3MP3MP3MP3 MP6MP6MP6MP6MP6 MP12MP12MP12MP12MP12

Table 3:The empirical result on the Cut-off point specification.

Source: Monthly Processed Financial Report on Commercial Banks.

Specification cut-off point 0.9390.9390.9390.9390.939 0.93660.93660.93660.93660.9366 0.92950.92950.92950.92950.9295

Modeling:Modeling:Modeling:Modeling:Modeling:

Design Population (data bank) 9,166 8,456 7,828

Correct Estimates (%) 94.2 94.9 93.2

Error I Type (%) 0.03 0.1 0.1

Error II Type (%) 96.2 95.0 95.3

Validation Test: Validation Test: Validation Test: Validation Test: Validation Test:

Validation Population (data bank) 4,129 3,640 2,730

Correct Estimates (%) 89.8 92.0 94.62

Error I Type (%) 8.3 6.0 4.6

Error II Type (%) 95.6 97.5 43.64

107

Article II

matter which needed to be paid attention to in said modeling, especially MP3. It turned out that said MP3 prediction

strength was still less accurate (<90%), considering that this research constituted a survey research (population data).

Although the sum of correct rate exceeded the rule of thumb of 50%, it was less accurate (<90%) said prediction ability

was caused by; a) population used in the survey population, not the target survey so that there were still objects (bank

data) not involved in the statistic calculation because said bank»s monthly publication of financial report was not available,

b) there were predictors other than capital ratios and financial risks, determining the opportunity of a bank»s bankruptcy,

and c) financial report data publications which were used not revealing the aspect of a management moral violation, such

as fraud, embezzlement and cheating (Wimboh, 1996; Pantalone & Platt, 1987).

Some studies in respect of banks» bankruptcies in Indonesia had the basis of logistic methods, conducted by Wimboh

Santoso (1996), Abdul Mongid (2000), Tengku Nuzulul Qurriyani (2000), and Sri Haryati (2001). From the aspect of

classification accuracy (Table 4), empirically this research had the superiority of relative classification accuracy on prior

studies of banks» bankruptcies. At the level of modeling, this research classification accuracy reached 94,9% for cut-off

amounting to 0,5 and 94,2% for cut-off amounting to 0,939 while the classification accuracy at previous researches

stretched between 63,60% up to 92,55%.

At the level of model validation, the classification accuracy was somewhat different. A large part of former empirical

studies on bankruptcy of banks on the other hand did not conduct measurement of model performance as requirement

for validation of prediction model. The model performance test was only conducted by Wilopo (2001) and this research.

The classification accuracy value at validation population for this research was of a slightly higher value (82,6% and

89,8%) compared to the research of Wilopo (2001), i.e. 81,4%. Overall, both with the estimate data as well as with the

validation data, the results of said research proved to support the statement of Pantalone & Platt (1987) and Ou &

Penman (1989). That is, that failure of a bank may be predicted accurately although information publications as basis of

limited prediction, and financial ratios may be used to predict the future happenings by connecting financial ratios with

economic phenomena.

ResearchResearchResearchResearchResearch

Table 4Comparison of Classification Accuracy of a Prediction Model of Bankruptcy of Banks outside Indonesia

Source: Various Articles

Martin (1977) estimate 91.3 -.-

Estrella & Peristiani (2000):

• Bankruptcy 1993 estimate 85.5 -.-




This Research (2004)

default cut-off = 0.5 prediction 94.90 82.60

specification cut-off = 0.939 94.20 89.80

Classification Accuracy (%)Classification Accuracy (%)Classification Accuracy (%)Classification Accuracy (%)Classification Accuracy (%)

Estimate DataEstimate DataEstimate DataEstimate DataEstimate Data Validation DataValidation DataValidation DataValidation DataValidation DataModelModelModelModelModel Characteristic Characteristic Characteristic Characteristic Characteristic

Outside Indonesia, the study on bankruptcy of banks on the basis of logistic methods had also been conducted by

Martin (1977) and Estrella & Peristiani (2000). According to Table 5, the percentage of the classification accuracy of the

result of this research at the level of model estimate was also better than the two prior researches, i.e. 94,9% and 88,4%

108

Article II

- 88,8% for Estrella & Peristiani (2000) and 91,3% for Martin (1977). The difference was that other than producing the

bankruptcy prediction model, this research also assessed the performance of the prediction model established, while that

matter was not conducted in the research of Martin (1977) and Estrella & Peristiani (2000). While, the performance

assessment of the prediction model constituted a pre-requirement if the objective of the research were to predict an

event, i.e. by making empirical comparisons (Beaver, Kennelly and Voss, 1968).

Up to here, it may be stated that the prediction model established possessed a surplus, among others : (1) said

model constituted a prediction model not only for estimate (comparison with empirical study), (2) possessed a level of

relative high accuracy, i.e. 94,9% (cut-off=0,5) or 94,2% (cut-off=0,939) at the level of modeling and 82,6% (cut-off

=5%) or 89,8 (cut-off = 0,939) at the validation phase, and (3) did not use a conventional predictor (CAMEL based), but

used a capital factor predictor and a financial ratio factor.

Then, in order to achieve the second (2) research objective, the establishment for the prediction model for each

bank group was only implemented to predict the bank»s bankruptcy 3 (three) moths prior to bankruptcy.

4.4 The Prediction Model for Bankruptcy of each Bank group.

Bank Group 1 (K1)

The prediction model for bankruptcy established was MP3 for K1. By substituting the existence of a dummy bank

group, MP3 for K1 was established based on equation (4a) while its regression coefficient is served at Table 5.

Ziti te

PMP−+

==1

13

VariableVariableVariableVariableVariable βββββ WaldWaldWaldWaldWald SignificanceSignificanceSignificanceSignificanceSignificance

Table 5:Logistic Regression Coefficient MP3 for K1.

XT 3.068 139.537 0.000

F1X3K1 0.000413 0.03 0.956

F5X4K1 -0.637 0.236 0.627

F4X7K1 -80.241 0.590 0.442

F6X11K1 -0.914 0.043 0.837

F2X8K1 0.503 0.130 0.719

F3X17K1 2.663 0.545 0.460

F7X18K1 -1.059 0.012 0.911

Constant -7.148 441.107 0.000

Source: Processed Attachment 1.

VariableVariableVariableVariableVariable βββββ WaldWaldWaldWaldWald SignificanceSignificanceSignificanceSignificanceSignificance

Table 6: Logistic Regression Coefficientfor MP3 for K2.

XT 3.068 139.537 0.000

F1X3K2 0.108 3.508 0.061

F5X4K2 0.157 71.260 0.000

F4X7K2 -4.610 18.157 0.000

F6X11K2 5.355 134.499 0.000

F2X8K2 0.963 23.130 0.000

F3X17K2 1.654 24.126 0.000

F7X18K2 3.668 19.903 0.000

Constant -7.148 441.107 0.000


in which

(5)

=

++++=m

ppmpi fDZ

1110 βββ Σ

109

Article II

Bank Group 3 (K3)

The bankruptcy prediction model established was MP3 for K3. By substituting the existence of a dummy bank

group, MP3 for K3 was established based on equation (4c), while its regression coefficient value is served at Table 8.

Ziti te

PMP−+

==1

13

=

++++=m

ppmpi fDZ

12110 βββ Σ

Bank Group 2 (K2)

The prediction model on bankruptcy established was MP3 for K2. By substituting the existence of a dummy bank

group, MP3 for K2 was established based on equation (4b), while its regression coefficient value is printed at Table 6.

(6)

in which

Ziti te

PMP−+

==1

13

=

++++=m

ppmpi fDZ

12110 βββ Σ

VariableVariableVariableVariableVariable βββββ WaldWaldWaldWaldWald Significance Significance Significance Significance Significance

Table 7: The Logistic Regression Coefficientfor MP3 for K3.

XT 3.068 139.537 0.000

F1X3K3 -0.056 0.469 0.493

F5X4K3 -0.406 3.712 0.054

F4X7K3 -6.541 4.961 0.026

F6X11K3 5.178 32.487 0.000

F2X8K3 -0.060 0.042 0.838

F3X17K3 2.246 11.020 0.001

F7X18K3 2.417 1.228 0.268

Constant -7.148 441.107 0.000


(7)

in which

Bank Group 4 (K4)


group, MP3 for K4 was established based on the equation (4d), while its regression coefficient value may be seen on

Table 8.

in which

VariableVariableVariableVariableVariable βββββ WaldWaldWaldWaldWald Significance Significance Significance Significance Significance

Table 8: The Logistic Regression Coefficientfor MP3 for K5.

XT 3.068 139.537 0.000

F1X3K4 0.001 0.059 0.808

F5X4K4 -0.104 4.832 0.028

F4X7K4 1.420 0.065 0.799

F6X11K4 0.046 0.002 0.960

F2X8K4 0.501 2.164 0.141

F3X17K4 0.771 5.673 0.017

F7X18K4 24.136 27.162 0.000

Constant -7.148 441.107 0.000


Ziti te

PMP−+

==1

13

=

++++=

m

ppmpifDZ

14110

βββ Σ

(8)

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Article II

Bank Group 6 (K6)

The bankruptcy prediction Model established was MP3 for K6. By substituting the existence of a dummy bank

group MP3 for K6 was established based on the equation (4f) while its regression coefficient value is served at Table 10.

(10)

in which

VariabelVariabelVariabelVariabelVariabel βββββ WaldWaldWaldWaldWald SignifikanSignifikanSignifikanSignifikanSignifikan

Table 9: The logistic Regression Coefficientfor MP3 for K5.

XT 3.068 139.537 0.000

F1X3K5 0.0027908 0.000 0.993

F5X4K5 -0.626 0.001 0.981

F4X7K5 -119.778 0.002 0.966

F6X11K5 -15.887 0.003 0.956

F2X8K5 -3.421 0.004 0.952

F3X17K5 -5.361 0.002 0.964

F7X18K5 -19.906 0.000 0.996

Constant -7.148 441.107 0.000

Source: Processed Tables 4.12.

VariabelVariabelVariabelVariabelVariabel βββββ WaldWaldWaldWaldWald SignifikanSignifikanSignifikanSignifikanSignifikan

Table 10: The logistic Regression Coefficientfor MP3 for K6.

XT 3.068 139.537 0.000

F1X3K6 3.567 16.956 0.000

F5X4K6 0.346 19.301 0.000

F4X7K6 2.487 8.235 0.004

F6X11K6 -4.971 13.503 0.000

F2X8K6 -6.257 8.018 0.005

F3X17K6 3.228 17.853 0.000

F7X18K6 -414.625 29.790 0.000

Constant -7.148 441.107 0.000


Bank Group 5 (K5)


group, MP3 for K5 was established based on the equation (4e), while its regression coefficient value may be seen on

Table 9.

Zitite

PMP −+==1

13

=

+++=m

pppi fDZ

1110 βββ Σ

(9)

in which

Ziti te

PMP−+

==1

13

=

++++=m

ppmpi fDZ

15110 βββ Σ

111

Article II

5. CONCLUSION

a. To establish a prediction model for bankruptcy in commercial banks in Indonesia (K1 up to K6) based on the relevant

bank»s financial report. An adequate prediction model is a model predicted 3 months prior to bankruptcy (MP3). The

result of the complete establishment of the prediction model is served at Attachment 1 (for MP3).

b. To establish a prediction model for bankruptcy of each bank group based on the bank»s financial report. The prediction

model referred to is MP3 for every bank group. The result of the complete prediction model for every bank group can

be seen at sub chapter THE RESULT OF THE RESEARCH.

112

Article II

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114

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Article III

The application scheme of progressive incentive statistically has the potential to increase the performance

of investment managers in increasing return.

The concept of progressive incentive on the other hand has been widely applied in banking management

as one of the endeavors to upgrade the competitiveness in the financial industry which more and more is facing

a very sharp level of business competitiveness. Nevertheless, the application of progressive incentives must be

conducted prudentially taking into consideration that the application of said scheme may have the potential to

increase the level of aggressiveness of the agent and may decrease the attitude of prudence in carrying out a

transaction. Macro-wise this is not in line with the industrial expectation in achieving a more stable financial

stability system. The application of progressive incentives must always be followed by an increasing accurate

and effective supervisory system to suppress the probability of the occurrence of fraud as the result of the

increase of aggressiveness occurred of the investment behavior.

Classification JEL: C51, C53

Key Words: Risk, Risk Preference

Article III

An Analysis in Respect of the Behaviorof Investment Managers in Facing Uncertainties

Dadang Muljawan 1)

A b s t r a c t

1 Bank Researcher at Directorate of Sharia Banking , Bank Indonesia ; email address : [email protected].

116

Article III

1. INTRODUCTION

The stability of a financial system constitutes one of the pre-requirements of achieving a sustainable economic

growth. The experience of the crisis, which occurred in several countries has shown how large the damage can be when

to an economic system as a result of instability in a financial system. In many countries, especially in industrialized countries,

the attention given in order to achieve stability in a financial system is significant . Even in those countries a special

institution was established bridging prudential issues both at micro as well as in macro level. In the macro level, attention

had been given in the form of implementation of financial and monetary policies, the strengthening of their supporting

institutions and the consistency in policy implementation taken from time to time in the endeavor to achieve a high level

of industrial efficiency. In the micro level, attention had been given in the form of a financial structure analysis and market

discipline, which may support the creation of efficient and prudential financial activities for the users of financial services.

In a condition, in which the banking system still has a dominant character, attention naturally must be given in order that

the banking system may operate efficiently without resulting in a potential of the occurrence of financial problems being

the result of less prudential operational activities.

One of the sufficient important aspects for discussion is the analysis on the behavior of banking agents in facing

risks/uncertainties. In a condition of an increasingly liquid and sophisticated financial system, investment activities involving

financial instruments in large volumes are very easy to be handled. Moving funds from one instrument to another form of

instrument may be rapidly implemented through a very simple form of procedure. The benefit from the development,

achieved in this sophisticated financial system may succeed if and only if the supporting system is ready to anticipate each

potential of an arising problem; if not, a financial crisis √ difficult to be avoided √ resulting in very large economic costs,

which naturally will become the burden of the community.

The second part of this article provides the analysis background, which shows the importance of risk behavior from

the market agents. The third part discusses the model to be used in order to conduct simulation on the potential of the

agent»s behavior in facing uncertainty. The fourth part discussed the result of the analysis obtained and the fifth part

contains the conclusion.

2. THE BACKGROUND OF THE ANALYSIS

The technological application in the financial industry nowadays constitutes a challenges, which can no longer be

avoided. For the future it may be said that the industrial/banking industry has become an industry possessing a solid

technological basis. Technological development and innovation in creating financial instruments, as have been discussed

in the introduction, have significantly increased the efficiency in investment activities and the company»s liquidity

management. Nonetheless, at the same time, said matter has also increased the risk in investment activities. Financial

transactions at present are conducted in a wider market scope and in an increasingly narrower transaction time interval.

In facing an increasingly sharp level of competition, the financial/banking institutions have employed investment managers

in order to be able to benefit from the increasingly liquid market condition with the expectation that they produce a high

return. To increase the performance of their investment managers, a large percentage of banking institutions have

applied incentives for every Rupiah profit obtained from the transaction activities.

117

Article III

However, although at one part the application of incentives may spur the performance of the transaction experts to

obtain return for the banks, this may have the potential to increase the aggressiveness of the transaction experts in

choosing their investment portfolios.1 The experience of the fall of Barrings has shown that a too aggressive behavior

from a dealer, possessing the authority of placing sufficient large funds without supplemented by sufficient adequate

internal control has a very large potential in arising sufficient deep financial problems. Barrings was considered to be a

sound banking institution prior to the occurrence of said internal financial crisis.2 Barrings proves that weak internal

controls can crush a sound institution in a relatively short time.

At the level of an institution, Dewatripont and Tirole (1994, 1996) discussed the optimal stopping time in the

endeavor to take over the bank operations if the performance shown is low. The principal idea from this matter is the

concept of separating the supervisory right between shareholder and depositor. Takeover authority shall be done if the

management of the bank produces the potential of losses, which may threaten the sustainability of its operations,

although the evaluated losses have not yet occurred.

In its reality, problems in the banking activities are very much related to prudential policies taken both in the micro

as well as in macro level. Macro policies , comprise fiscal, monetary aspects as well as de-regulation policies, which will

determine a feasible set, which may be used as basis for choosing investment portfolio»s. Micro-wise, prudential provisions

will influence the behavior of the bank risks in taking every investment decision. Both types of policies will very much

influence the occurrence of problems in the banking industry in future. A good understanding in respect of the potential

of the behavior of investment managers certainly will very much be beneficial for the application of every provision in the

banking industry (drawn in Exhibit 1).Exhibit 1).Exhibit 1).Exhibit 1).Exhibit 1).

RiskBehaviour

Probability of havingbanking problem

Micro - prudentialbanking regulation

Macro-prudentialeconomic policy

InvestmentFeasible Set

PortfolioSelection

1 A typical condition of adverse selection in which a bank will not possess complete information in respect of the behavior of the agent. First investigations in respect of the adverse selectionproblem and the risk concept may be seen in detail in Akerlof (1970) and Arrow (1970)

2 A complete discussion on the Barrings» case and its problems can be seen in Hall (19954a,b and c) and Hall (1996a,b)

Exhibit 1Macro and Micro Prudential and Risk Behavior

118

Article III

This article tries to model analytically the behavior of an investment manager in facing uncertainties by making use

of the income assumption of a stochastic nature. This article is expected to be able to provide a better level of understanding

both regarding the potential of behavior from investment managers in facing uncertainties so that said matter may be

useful both for supervisory authorities as well as banking institutions themselves in order to always increase a better

supervisory quality. Consequently, we can expect that the financial crisis potential of a banking institution, resulted by the

application of improper set of incentives, may encourage minimize the less prudential banking activities.

3. THE MODELING PROCESS

3.1. Assumption

An investment manager will obtain a reward in the form of a salary E[pV] on placing activities conducted. Funds

placed at various investment instruments possess certain financial characteristics (_, _). Pursuant to placing of funds at the

chosen types of instruments, a bank will obtain cash inflow as follows:

(1)

Detail-wise, the placing mechanism and reward are shown in Exhibit 2.Exhibit 2.Exhibit 2.Exhibit 2.Exhibit 2.

With the freedom to choose investments, a transaction expert is

assumed to have two types of investment preferences in facing two

different conditions, which are shown with two different variances for

each condition, in which ],[, 21 σσσσ . Generally, the present value

of a continuous cash flow is shown as follows:

∫ −+=t

t

rt dteswtwPV0

][),( π (2)

In which PV, w and s_ represent the present value from the reward

to be obtained, the constant salary component and the performance salary

at a certain time between t0 up to t. It is assumed that a manager possesses

two types of future cash inflow based on performance in placing his funds:

limited contract, if the performance shown by the manager is under the

expectation of the bank, so that the process of severing the work relationship may happen at any time; unlimited contract,

at the time the performance of the manager is above the expectation of the bank, it is assumed to establish a contract for

a long time. The present value for the manager, which may expect a contract for a long time with the Bank may be

expressed as follows:

(3)

dzdtd σµπ +=

rsw

dteswwPV rt ππ

+=+=∞ ∫

∞−

0

][]),0[,(

(?,?)

E[rV]

Bank

Manager

PortfolioInvestments

d? ? ? dt ? ? dz

Exhibit 2Monetary reward and punishment

119

Article III

−+=

01

'1πππα sw

r

On the other hand, the present value for a manager who works in a condition in which the termination process of

the work relationship may happen at any time can be formulated as follows:

(4)

Exhibit 3Exhibit 3Exhibit 3Exhibit 3Exhibit 3 shows an income stream which will be obtained by each manager and bank and the present value from

investment activities by a manager. Exhibit 3 (a)Exhibit 3 (a)Exhibit 3 (a)Exhibit 3 (a)Exhibit 3 (a) shows the wage scheme from a manager towards his investment

performance. If the return yielded is above the minimum return threshold p0, the salary received amounting to w added

with _s as performance fee. If the return level produced is below the minimum expectation, it is assumed that a

manager will experience severance of the work relationship, as cost to be spent in order to maintain the existence of said

manager is higher compared to the level of return, which he may produce (Exhibit 3 (b)).(Exhibit 3 (b)).(Exhibit 3 (b)).(Exhibit 3 (b)).(Exhibit 3 (b)).

r

sw π+

Suddentermination

region

W

s

Incomeflow formanagers

(a)

(b)

(c)

Infiniteemploymentregion

Incomeflow forthe bank

PVfor the

managers

π0

π0

π1

π1

π1π0

−+

=01

'1πππ

αsw

r

0][]),0[,(0

0

=+=∞ ∫+

− dteswwPV rtπ

While, Exhibit 3 (c)Exhibit 3 (c)Exhibit 3 (c)Exhibit 3 (c)Exhibit 3 (c) shows the present value from the reward accumulation obtained by a manager from a bank. In

order to simplify the problem, it is assumed that the probability of the occurrence of contract relationship severance with

the manager is linear distributed. The slope established from a pessimistic scenario to an optimistic scenario is shown as

follows:

Exhibit 3Graphical Interpretation on the Income Stream

Through a mathematic manipulation from similarity (1) and (5) a second order differential similarity is obtained for

two different conditions.

(5)

120

Article III

3.2 Simulation

The aggressive incentive scheme

In the model two incentive mechanisms are simulated with two different incentives» proportions. The dotted line

shows a lower prudential pattern at the time the performance is nearing the lowest point. Said matter shows that the

aggressiveness of an investment manager will increase. Said matter will certainly increase the potential of the occurrence of

the gamble condition for resurrection, which certainly have the potential to endanger the sustainable operations of a bank.

The incentive scheme with a lower ratio poisson.

In the model also two incentive conditions are simulated

with the probability of detecting a loss as a result of a transaction

by the bank management for further action. A broken line shows

a model with a lower poisson value, resulting in a lower value of

prudence.

4. EMPIRICAL4. EMPIRICAL4. EMPIRICAL4. EMPIRICAL4. EMPIRICAL RESEARCHRESEARCHRESEARCHRESEARCHRESEARCH

Based on a theoretical analysis executed at the prior part, a

empirical research is conducted to see the general pattern which

may occur at a Mutual Fund company from the performance

aspect and the relationship between risk and return.3

Vqr )( + [ ]MMM VVMax 2

],[ 21

21

σασσσ

+ 0ππ <

rV [ ]MMM VVMax 2

],[ 21

21

σασσσ

+ 0ππ ?

πµπµπ 21)( BeAeV +=

−×=π ×−×− += 210 µµ eBeA

0=π BABA +=+=0

0=π BABA 21210 µµµµ +=+=

*ππ = sBeAeVM =+= *2

*1

21*)( πµπµ µµπ*ππ = 0*)( *2

2*2

121 =+= πµπµ µµπ BeAeVMM

3 Data Source is obtained from the column Stock Exchange and Finance; the financial performance of the mutual fund institution issued by the daily ≈Bisnis Indonesia∆ with a observationduration during one month (15 December 2003 up to 15 January 2004). The observation activities of 109 active mutual fund companies in transaction and registered in the capital market.

-0.5 -0.3 -0.1 0.1 0.3 0.5 0.7 0.9

Cummulated Profit

Absolute risk aversion (Vxx/Vx)10

9

8

7

6

5

4

3

2

1

0

-1

In which the homogenous solution for both similarities above in general may be expressed as follows:

with boundary conditions to comply with the requirement smoothing conditions as follows:

Exhibit 4 Absolute risk aversion levelwith different incentive schemes

121

Article III

The difference in performance between a foreign

mutual fund company and a local one.

Generally, a mixed mutual fund company has a level of

performance and an average higher increase deviation of the

Net Asset Value (NAV) compared to a local mutual fund company.

A mixed mutual fund company has an average NAV growth

amounting to 0,7279% per month with a deviation amounting

to 0,4166%, while a local mutual fund company has a average

NAV growth amounting to 0,6194% per month with a deviation

amounting to 0,3339%. Nevertheless, individually, the financial

performance produced cannot make the determining factor in

the difference between a local mutual fund company and a mixed

company significantly. This is shown by the low level significance

at the logistic regression implemented.

The behaviour on risk and return from the manager of the mutual fund company.

In one general concept , an investment decision taken by an investor very much depends on the budget constraint

of an investor and the investment feasible set faced. The investment optimum Point occurs at the time the budget

constraint is established is touching the feasible set with a positive point of contact gradient (Investing on more profitable

investments would bear higher level of risk). Said matter obviously did not happen at mutual fund companies. The

empirical investigation result proves that the level of NAV growth (assumed as gains for investors) owns a negative

relationship with risk (represented by the variation level of NAV produced by each institution) (See attachment 1). Said

matter shows that the Investment Manager (MI), which has the task to manage investment activities not having the same

preferences with that which actually should be owed by an investor. A MI in processing a mutual fund company acts as an

agent, having full freedom to determine the effort level (including in it is the profit level target and determining the risk

level in investment). An MI, in this case, owns two types of values, i.e. the value of an deterministic character and

stochastic, originating from an uncertainty. It is assumed that in the mutual fund industry in Indonesia, each MI owns an

equal relative value, so that ;

),(: StokDetMI VVfV

Stok

Stok

MIDet

Det

MIMI dV

V

VdV

V

VdV

ƒ

ƒ+

ƒ

ƒ=

0=MIdV Γ=ƒ

ƒ

Det

MI

V

VΩ=

ƒ

ƒ

Stok

MI

V

VStokDet dVdV Ω−=Γ

-0,5 -0,3 -0,1 0,1 0,3 0,5 0,7 0,9

Cummulated Profit

Absolute risk aversion (Vxx/Vx)10

8

6

4

2

0

-2

Exhibit 5 Absolute risk aversion levelwith different Poisson ratio

if and, then

122

Article III

As previously discussed, the stochastic value of a MI will be comparable to the extent of the return variations

occurred and said matter will be maximize by the MI as a compensating factor or a lower deterministic gain.

5 MATTERS BENEFICIAL FROM THE GAIN OBTAINED.

Analyses conducted in order to reveal the preference dynamics of a investment manager in facing uncertain conditions

offer several benefits at least in 3 areas, among others:

a.a.a.a.a. To understand the nature of the types of incentives - To understand the nature of the types of incentives - To understand the nature of the types of incentives - To understand the nature of the types of incentives - To understand the nature of the types of incentives - Each financial/banking institution may possess a different

incentive scheme in its endeavour to increase the work performance, which at the end is expected to increase

income (profit) for the company. One of the forms of the incentives, which may be implemented is providing income

components to managers based on the achievement of profit, being the result of their transactions. Nonetheless,

the application of said incentives have the potential to raise problems taking into consideration that incentive

components may cause an investment manager to have a more aggressive attitude, which naturally directly may

threaten the sustainability of operations of a banking institution and provide a bad influence towards the overall

financial system.

b.b.b.b.b. Anticipatory actionAnticipatory actionAnticipatory actionAnticipatory actionAnticipatory action - If a banking institution intends to apply incentives to an investment manager, there are several

matters, which must become the attention in the endeavour to handle the lowering of the absolute risk aversion

level of said manager to become in a nothing to loose condition. In the endeavour to lower the probability of

occurring disruptions towards the financial system, a necessary regulator in order to understand the establishment

of the risk behaviour, especially established because of the application of a certain incentive.

6. CLOSING

The application of progressive incentives have become the trend in reward mechanism for the banking agents.

Many parties are convinced that the application of said incentives will be able to increase the performance of front-liners

in said industry in obtaining a higher level of return. Nevertheless, the application of progressive incentives must be

prudentially implemented, considering that said matter will have the potential to increase the level of aggressiveness of

an agent and will lower the absolute risk aversion in conducting transactions. This certainly is less in line with the macro

expectation to obtain a more stable level of stability in the financial system. In addition, the application of progressive

incentives must be followed by a increasingly accurate and effective supervision concept in order to press the probability

of the occurrence of fraud as a result of the formation of a level of aggressiveness.

123

Article III

References

AKERLOF, G. (1970). The market for lemons, qualitative uncertainty and market mechanism. Quarterly Journal of

Economics, 89: 488-500.

ARROW, K. J. (1970). Essay in the Theory of Risk Bearing. Amsterdam: North-Holland.

DEWATRIPONT, M. and J. TIROLE (1994). A Theory of Debt and Equity: Diversity of Securities and Manager-

Shareholder Congruence. The Quarterly Journal of Economics, V: 1027-1054.

DEWATRIPONT, M. and J. TIROLE (1994). The Prudential Regulation of Banks. The MIT Press, Massachusetts.

DIXIT, A.K. and PINDYCK, R.S. (1994) Investment Under Uncertainty, Princeton University Press, New Jersey.

HALL, M.J.B. (1995a). A review of the Board of Banking Supervision»s Inquiry into the Collapse of Barings: Part1.

Butterworths Journal of International Banking and Financial Law, Vol.10. No.9, pp.421-425, October.

HALL, M.J.B. (1995b). A review of the Board of Banking Supervision»s Inquiry into the Collapse of Barings: Part2.

Butterworths Journal of International Banking and Financial Law, Vol.10. No.10, pp.470-474, November.

HALL, M.J.B. (1995c). A Review of the Singapore Inspectors» Report on Baring Futures (Singapore) Pte Ltd.,

Butterworths Journal of International Banking and Financial Law, Vol.10. No.11, pp.525-529, December

HALL, M.J.B. (1996a). Barings: The Bank of England»s First Report to the Board of Banking Supervision. Butterworths

Journal of International Banking and Financial Law, Vol.11. No.3, pp.128-130, March.

HALL, M.J.B. (1996b). The Collapse of Barings: The Lessons to be Learnt. Journal of Financial Regulation and

Compliance, Vol.4, No.3, pp.255-277.

MILNE, A and D. ROBERTSON (1995). Firm behaviour under the threat of liquidation. Journal of Economics Dynamics

and Control, 20: 1427-1449.

MILNE, A. and WHALLEY, A.E. (2001). Bank Capital Regulation and Incentive for Risk Taking. Mimeo. City University,

Business School, London. Available from <http://www.staff.city.ac.uk./~amilne>

MILNE, A. and WHALLEY, A.E (1999). Bank capital and risk taking. Bank of England, Working paper series No.90,

available in Bank of England website.

CoordinatorNELSON TAMPUBOLON AND MULIAMAN D. HADAD

Editors in ChiefWIMBOH SANTOSO, SATRIO WIBOWO, AND DODU BLASYUS

Analyst/ContributorsBSSKFG Banking : S. Batunanggar Ricky Satria Wini Purwanti

Endang Kurnia Saputra Fernando R.Butarbutar

FG International & Domestic Finance: Indradjaja Yulianti Kusumastuti

Ita Rulina

FG Non Bank Financial Institutions and Markets: Dwityapoetra S. Besar Noviati

Ferial Ahmad Dipa Pertiwi

FG Indonesia Banking Architecture: Boyke W. Suadi

Directorate of Banking Supervision 1Directorate of Banking Supervision 1Directorate of Banking Supervision 1Directorate of Banking Supervision 1Directorate of Banking Supervision 1 : Tindomora Siregar PriyantinaDirectorate of Banking Supervision 2Directorate of Banking Supervision 2Directorate of Banking Supervision 2Directorate of Banking Supervision 2Directorate of Banking Supervision 2 : Yusra Riza A. Ibrahim

Irwan Lubis Irisa NavyariniDirectorate of Banking Examination 1Directorate of Banking Examination 1Directorate of Banking Examination 1Directorate of Banking Examination 1Directorate of Banking Examination 1 : Agus PriyantoDirectorate of Banking Examination 2Directorate of Banking Examination 2Directorate of Banking Examination 2Directorate of Banking Examination 2Directorate of Banking Examination 2 : Julius Liston T.Directorate of Sharia BankDirectorate of Sharia BankDirectorate of Sharia BankDirectorate of Sharia BankDirectorate of Sharia Bank : Dadang MuljawanDirectorate of Rural BankDirectorate of Rural BankDirectorate of Rural BankDirectorate of Rural BankDirectorate of Rural Bank : AyahandayaniDirectorate of Accounting and Payment SystemDirectorate of Accounting and Payment SystemDirectorate of Accounting and Payment SystemDirectorate of Accounting and Payment SystemDirectorate of Accounting and Payment System : Farida Perangin-angin Pipih Dewipurusitawati

Compilator, Layouter and ProductionDwityapoetra S. Besar, Fernando R.Butarbutar, and Ricky Satria

PartnersDirectorate of Economic Research and Monetary PolicyDirectorate of International AffairsDirectorate of Monetary ManagementDirectorate of Economic and Monetary StatisticsDirectorate of Foreign Exchange ManagementBureau of CreditDirectorate of Banking Licency and Information

Data AnalystFernando R.Butarbutar Ricky Satria Suharso I Made Yogi

Supporting TeamHolil Hasanuddin Adek Achiriyadi Merlinda Pelawi

Financial Stability ReviewNo. 1, June 2004

Bank Indonesia, Financial Stability Review No 3, June 2004

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