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Published by:

Bank Indonesia
Jl. MH Thamrin No.2, Jakarta
Indonesia

The Financial Stability Review (FSR) is one of the avenues through which
Bank Indonesia achieves its mission ≈to safeguard the stability of the Indonesian Rupiah by
maintaining monetary and financial system stability for sustainable national economic
developmentΔ.

FSR is published biannually with the objectives:


To foster public awareness regarding domestic and global financial system stability issues;
To analyze potential risks confronting the domestic financial system;
To evaluate progress and issues related to financial system stability; and
To recommend policies to relevant authorities for promoting a stable financial system.

This edition was launched in September 2007 and is based on data and information available as of June 2007, except where
stated otherwise.

The complete Financial Stability Review is available for download in PDF format from Bank Indonesia»s website : http://www.bi.go.id

Any inquiries, comments and feedback please contact:

Bank Indonesia
Directorate of Banking Research and Regulation
Financial System Stability Bureau
Jl.MH Thamrin No.2, Jakarta, Indonesia
Phone : (+62-21) 381 8902, 381 8336
Fax : (+62-21) 351 8629
Email : BSSK@bi.go.id
Financial Stability Review
I - 2007 2007 )
( No. 9, September
ii
Table of Contents

Foreword vi Chapter 3 Prospects of the Indonesian Financial


System 45
Overview 3 Economic Prospects and Risk Perception 45
Bank Risk Profile: Level and Direction 46
Chapter 1 Macroeconomic Conditions and Prospects of the Indonesian Financial System 47
the Real Sector 9 Potential Vulnerabilities 48
Macroeconomic Conditions 9 Box 3.1. Financial Stability Index and Probability
Conditions in the Real Sector 12 of Default 50
Box 1.1. Potential Impacts of the US Subprime
Mortgage Crisis on the Domestic Financial Chapter 4 Financial Infrastructure and Risk
Market 15 Mitigation 55
Payment System 55
Chapter 2 The Financial Sector 19 Payment System Policy and Risk Mitigation 57
Financial Sector Structure 19 Financial Sector Safety Net (FSSN) 58
Banks 20 Financial System Stability Forum (FSSF) 59
Funding and Liquidity Risk 20
Credit Growth and Credit Risk 22 Articles
Market Risk 27 Article 1 The Dynamics of Banking Industrial Structure,
Profitability and Capital 29 Strategic Risk, and Their Implications on
Non-bank Financial Institutions and Financial Systems Stability 63
the Capital Market 31 Article 2 Credit Risk Modelling:
Finance Companies 31 Rating Transition Matrices 77
Capital Markets 33
Box 2.1. Financial Deepening In Indonesia 38
Box 2.2. Capital Inflows and Sudden Reversal:
Are We Ready to Face a Crisis? 40

iii
List of Tables and Figures

Table Graph
1.1 World Economic Indicator (Volume) 9 1.1 Interest Rate Performance 9
1.2 GDP Performance 10
2.1 Selected Regional Price Index Performance 33 1.3 Non Oil and Gas Exports 10
2.2 Sectoral Price Index Performance 34 1.4 Non Oil and Gas Imports 10
2.3 Performance of Stocks Market Efficiency 35 1.5 Composite Index 10
1.6 Indonesia and US Real Interest Rate 10
3.1 Concencus Forecast of Selected Economic 1.7 Exchange Rate of Selected World Currencies 11
Indicators 45 1.8 Rupiah Exchange Rate against USD 11
3.2 Indonesian Risk Perception 45 1.9 World Oil Price 11
3.3 Impacts of Exchange Rate to Conglomeration 1.10 World Commodities Price 12
Equity 48 1.11 Interest Rate and Inflation 12
1.12 Consumer Loans 12
4.1 BI-RTGS Settlement Performance (in Value and 1.13 Consumer Expectation 12
Volume) 55 1.14 Financial Performance of Non Financial Public
4.2 Card Based Payment Transaction 56 Listed Companies 13
4.3 Structure and Membership of Financial System 1.15 NPL of Working Capital and Investment Loans 13
Stability Forum (FSSF) 59 1.16 Corporates Financing and Expansion 13
1.17 Unemployment Rate 14
Table Box: 1.18 Output Gap Estimation 14
2.1.1 Indonesia Financial Deepening Performance 38 1.19 DER and Debt/TA Performance 14
2.1.2 Indonesia Financial Deepening Performance 38 1.20 Net Foreign Transaction: Stocks and Government
2.1.3 Indonesia Real Rates of Return 39 Bonds 14

2.1 Assets of Financial Institutions 19


2.2 Structure of Funding and Bank Placements 20
2.3 Bank Liquid Asset Ratio 20
2.4 Average Interbank Money Market Interest Rate 20
2.5 Deposits Performance 21
2.6 Deposits Performance Based on Exchange Rate 21
2.7 Foreign Exchange Deposits Performance 21
2.8 Time Deposits Growth 21
2.9 Deposits Structure 22
2.10 Deposits Performance (Related to Guarantee) 22
2.11 Loans Growth 22
2.12 Share of Earning Assets 23

iv
2.13 Loans Growth by Type 23 2.45 Capital Inflows in Government Bonds, SBI
2.14 Share of Loans by Type 23 and Stocks 33
2.15 Share of Loans by Economic Sector 24 2.46 Regional Index Performance 34
2.16 Non Performing Loans (NPL) 24 2.47 Sectoral Index Performance 34
2.17 NPL Value Performance 24 2.48 Stocks Transaction of Domestic and Foreign
2.18 Gross NPL Performance by Bank Group 24 Investor 34
2.19 Gross NPL by Economic Sector 25 2.49 Value of Capitalization and IPO 35
2.20 Share of NPL by Economic Sector 25 2.50 Performance of Selected Government Bonds
2.21 Share of NPL by Loans Type 25 Price 35
2.22 Performance of Consumer Loans NPL 26 2.51 Distribution of Government Bonds by Maturity 36
2.23 NPL Gross Performance 26 2.52 Ownership of Government Bonds 36
2.24 NPL Value of Corporate and MSME 26 2.53 Yield of 20-year Government Bonds of Selected
2.25 NPL Gross of Corporate and MSME Loans 26 Countries 36
2.26 Foreign Exchange Rate and Foreign Exchange 2.54 Comparison of Financial Asset Price Volatility 36
NPL 27 2.55 IPO and Position of Corporate Bonds 55
2.27 Performance of Foreign Exchange Gross NPL 27 2.56 Mutual Funds by Type 55
2.28 Loans, NPL and APLL 27
2.29 Interest Rate and Exchange Rate Performance 28 3.1 Yield Curve 45
2.30 Loans Interest Rate by Bank Group 28 3.2 Risk Profile of Banking Industry and Its Direction 46
2.31 Rupiah Maturity Profile 28 3.3 Financial Stability Index 47
2.32 Foreign Exchange Maturity Profile 28 3.4 Non Financial Public Listed Companies Probability
2.33 NOP Performance (Overall) 29 of Default 48
2.34 Government Bonds in Bank Portfolio 29
2.35 NII Performance 30 4.1 Activities of Payment System Transaction
2.36 Profit and Assets Performance 30 Semester I 2007 55
2.37 Structure of Bank Interest Income 30
2.38 Risk Weighted Assets, Capital, and CAR 31
2.39 Tier 1 Capital to Risk Weighted Assets Ratio Graph Box :
and CAR 31 1.1.1 Residential Price Index of Selected Countries 15
2.40 Operational Activities of Finance Companies 31 1.1.2 Delinquency Rate of SPM 15
2.41 Finance Companies 32 1.1.3 Foreclosure Rate of SPM 16
2.42 Source of Fund of Domestic Private Finance
Companies 32 2.2.1. Pre and Post Crisis of NPL & CAR 41
2.43 Source of Fund of Joint Venture Finance 2.2.2. Foreign Exchange Loans Performance 41

Companies 32
2.44 Net Cash Flow of Finance Companies 32 3.1.1. Probability of Default - Barrier Option Methods 51
3.1.2. Probability of Default - Common Option
Methods 51

v
Foreword

By expressing thanks and praise to God Almighty, we are pleased to publish the Financial Stability Review (FSR)
No. 9, September 2007. This review is deemed timely and pertinent considering the recent dynamism of global financial
markets experiencing high volatility and uncertainty, suggesting that the subsequent effects on domestic financial
stability need to be well understood. This review will help reinforce the importance of preserving financial stability
amidst closer correlation between the global market and the domestic financial market.
As with previous reviews, this edition will detail Indonesian financial system stability, sources of volatility and the
risks faced, steps to mitigate the risks, as well as an outlook for the financial system. In addition, this review will draw
focus on numerous recent developments such as the subprime mortgage crisis and the possibility of a sudden reversal,
which could trigger a crisis similar to that which took place exactly 10 years ago. In the context of maintaining financial
system stability, this review will also outline the importance of prioritizing financial deepening in Indonesia.
By elaborating on the above issues, this review is expected to become an invaluable input to business players in
the financial market, government officials, academics and economic analysts. This review is also expected to attract the
attention of all related parties to proactively collaborate in preserving financial system stability. Without a stable and
well maintained financial system, it would be difficult to bolster economic growth, reduce unemployment and alleviate
poverty.
Finally, on behalf of the Board of Governors, I would like to extend my gratitude and appreciation to all parties
who have directly and indirectly contributed to this review. May the fruits of this hard work prove useful in maintaining
sustainable financial system stability.

DEPUTY GOVERNOR
BANK INDONESIA

Muliaman D. Hadad

vi
Overview

Overview

1
Overview

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2
Overview

Overview

Indonesian financial system stability in the first semester of 2007 was well
maintained and future prospects remain positive. A possible sudden reversal
of short term capital flows, contagion stemming from the subprime
mortgage crisis that recently affected several other countries and a potential
surge in capital outflows did not undermine Indonesian financial system
resilience. Monetary stability and an improving domestic economy, as well
as well-controlled pressures originating from the international economy,
all served to maintain financial system stability. Taken holistically, such
conditions proved favorable for improvements in financial sector
performance. Banks continued to dominate the financial sector and
remained liquid with maintained productive asset quality, rising profitability
and strong capital. However, continuous anticipative measures as well as
comprehensive risk mitigation are imperative due to the prevailing sources
of instability.

1. SOURCES OF INSTABILITY 1.2. High dependence on banks


1.1. Fluctuations in the external environment Banks continue to dominate Indonesia»s financial
Greater integration between the domestic and global sector, which resulted in high dependency on banks as
economies has left Indonesia prone to fluctuations in the the funding source for development and the economy.
external environment; both economic and non economic. Such high reliance on banks can trigger volatility because
The fluctuations stemmed from the presence of global fluctuations can quickly spread and subsequently disrupt
imbalances, the soaring global oil price and excess global financial system stability. Consequently, all types of risk
liquidity, which encouraged short term capital flows. that can jeopardize banks must be accurately mitigated to
Fluctuations also arose from the contagion effects of prevent any escalation and therefore become a source of
specific problems in a particular business sector, namely instability. One source of instability that requires close
the subprime mortgage crisis affecting several countries monitoring is the possibility of higher credit risk due to
recently. partially unresolved credit restructuring, the as yet sub-

3
Overview

optimal implementation of credit risk management and The ongoing risk management certification program and
some weaknesses in the bank credit management the implementation of Basel II commencing in 2008 are
information system. expected to improve the quality of bank risk management.
Additionally, the bank credit management information
1.3. Constraints in the real sector system is continuously upgraded to improve risk
The real sector remains beset by several constraints, management effectiveness. From a supervisory side, the
namely workforce issues and infrastructure limitations. In risk based supervision approach continues to be developed
addition, the costs borne by the business community also and implemented. This is supported by advances in
remains high undermining further expansion. If such supervisor capacity and skill level through the bank
conditions persist, many companies may decide to supervisory certification program.
discontinue conducting business in Indonesia and relocate
abroad. As a result, banks would continue to experience 2.2 Bolster Financial Infrastructure
excess liquidity in line with the limited demand for credit Financial infrastructure can be strengthened in two
from the business sector, resulting in the ineffective ways. First is through the development of a secure and
intermediary function of banks. Therefore, overcoming reliable payment system by Bank Indonesia. Second is
constraints in the real sector is a crucial step in establishing through a sound financial sector safety net (FSSN) coupled
financial system stability. with crisis management based on joint efforts between
Bank Indonesia and the Government. Risk of instability in
1.4. Credit concentration on consumer financing the financial sector can be minimized through a robust
Another important source of instability is the financial infrastructure.
concentration of bank credit on consumer financing.
Among others, this is indicated by the rise in loans for 2.3. Improving the Effectiveness of Financial
credit cards, motor vehicles and housing. Credit risk may System Surveillance
arise should household income be insufficient to repay Risk mitigation in the financial sector is only effective
outstanding liabilities to the banks. if financial system performance is continuously monitored.
Improvements in surveillance effectiveness are ongoing and
2. RISK MITIGATION utilize various methodologies and stress testing to gauge
To minimize instability and mitigate the high risk the risks and improve resilience in the financial system.
faced by the Indonesian financial sector, the following Discussions with market players, academicians and
measures have been taken: observers are held regularly to further sharpen financial
sector analysis and oversight.
2.1. Strengthen Bank Risk Management
Bank risk management is continually strengthened 2.4. Financial Deepening
due to the more complex and dynamic nature of business Financial deepening has become a dominant issue
activity in line with advancements in information in order to reduce, among others, dependence on the
technology and a more competitive business environment. banking sector. Financial deepening can spur growth in

4
Overview

non bank financial business activities, provide more capital outflows. Vigilance is also necessary because banks,
options for financial instruments as well as improve the which dominate the financial sector, will shortly face
accessibility of financial products and services to the numerous challenges, among others, the resolution credit
underprivileged. restructuring, improving bank risk management and credit
management information system, as well as
3. OUTLOOK FOR FINANCIAL SYSTEM STABILITY synchronization between efforts to improve intermediation
In general, financial system risk in the first semester and reduce credit risk. In addition, banks will continue to
of 2007 remained relatively steady and under control in develop contingency plans to decrease operational risk,
line with monetary stability and improving economic improve internal control effectiveness and corporate
conditions. A possible sudden reversal of short term capital governance, as well as meet the minimum core capital
flows, contagion stemming from the subprime mortgage requirement of Rp80 billion by the end of 2007 and Rp100
crisis that recently affected several other countries and a billion by the end of 2010.
potential surge in capital outflows did not undermine Meanwhile, stress testing to measure credit risk,
Indonesian financial system resilience. Looking ahead, liquidity risk and market risk has indicated that banks are
sluggish global economic growth, the soaring global oil adequately resilient to numerous shocks stemming from
price and short term capital inflows may weaken fluctuations in macroeconomic variables. The results of
Indonesian financial system resilience. Subsequent stress tests on a sample of conglomerates/large
measures taken by the relevant monetary authorities and corporations that borrowed foreign currency demonstrate
banks within the affected countries to resolve the subprime resilience towards fluctuations in exchange rate risk.
mortgage crisis may also influence Indonesian financial Despite the estimation results indicating that the probability
system stability. of default (PD) for a sample of non financial public listed
Internally, self awareness is essential regarding the companies with a PD of 0.5 will increase slightly, however,
possible effects of the upcoming general election on given the existing provisions and strong bank capital, this
business activities and risk in the financial sector. In is not expected to trigger instability. Overall, financial sector
particular, unfavorable security conditions could trigger prospects remain steady and controllable.

5
Overview

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6
Chapter 1 Macroeconomic Conditions and the Real Sector

Chapter 1
Macroeconomic Conditions
and the Real Sector

7
Chapter 1 Macroeconomic Conditions and the Real Sector

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8
Chapter 1 Macroeconomic Conditions and the Real Sector

Macroeconomic Conditions
Chapter 1
and the Real Sector

Economic expansion continued with maintained macroeconomic stability


throughout the first semester of 2007. External vulnerabilities had no
significant effects on domestic economic stability. Meanwhile, the lower
domestic interest rate began to gradually catalyze activity in the real sector.
However, various business constraints and financing issues restricted real
sector growth.

Table 1.1
1.1. MACROECONOMIC CONDITIONS
World Economic Indicator (Volume)
The global economy was beset by pressures %
Projection
stemming from a slowdown in economic growth and a Category 2005 2006
2007 2008
subprime mortgage crisis in the property sector throughout World Output 4.9 5.5 5.2 5.2
Advanced Economies 2.6 3.1 2.6 2.8
the first semester of 2007. In order to recover economic
United States 3.2 3.3 2.0 2.8
growth in the United States (US), and in particular to Emerging & Developing Countries 7.5 8.1 8.0 7.6

alleviate concerns of high inflation, the Fed decided to Consumer Price


Advanced Economies 2.3 2.3 2.0 2.1
postpone plans to raise the Fed Fund rate; maintaining it Emerging & Developing Countries 5.4 5.3 5.7 5.0
LIBOR
at a level of 5.25%1Ω. This severely affected growth in the
US Dollar Deposit 3.8 5.3 5.4 5.3
global financial market since the Fed Fund rate was Euro Deposit 2.2 3.1 3.8 3.7
Yen Deposit 0.1 0.4 0.8 1.2
previously expected to fall.
Oil Price (USD) - average 41.3 20.5 (0.8) 7.8
In line with US economic recovery, the global Source: World Economic Outlook - IMF July 2007

economy has shown signs of the adjustments to global


imbalances leading to a soft landing scenario. This is Graph 1.1
Interest Rate Performance
partially due to an increase in Asian exchange rate flexibility, %
7.0
greater expenditure by oil producing countries as well as SIBOR LIBOR
6.0 ECB FFR
structural reform in Europe and Japan. Efforts undertaken
5.0

to correct the global imbalances have encouraged 4.0

economic expansion in emerging countries, including 3.0

2.0
Indonesia.
1.0

1 In the latest development, on 18th September 2007 the Fed cut its Fed Fund rate by 0
Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun
50 bps to 4.75%.
2001 2002 2003 2004 2005 2006 2007

9
Chapter 1 Macroeconomic Conditions and the Real Sector

Throughout semester I 2007, the Indonesian public purchasing power and high global demand
economy continued to grow aided by a managed inflation supported economic growth through quarter II 2007. The
rate. In the first quarter of 2007, economic growth current account is estimated to run a surplus of USD1.2
reached 6.0% (y-o-y), rising to 6.1% (y-o-y) in quarter II. billion, which will bolster the Indonesian balance of
This surpassed growth in the same quarter of the previous payments (BoP) with a surplus totaling USD3.7 billion.
year, which reached just 5.0% (y-o-y). Increases in private With such favorable developments, Indonesia»s foreign
consumption and exports, particularly exports from the exchange reserves reached USD50.9 billion at the end of
manufacturing sector, coupled with improvements in June 2007.
Meanwhile, unstable US economic conditions and
Graph 1.2
GDP Performance the decision to postpone plans to raise the Fed Fund rate
%
8.00
have diverted investment towards emerging markets where
6.30
6.00
economic growth has improved offering higher returns.
5.87
5.22 4.96 Hikes in the price indices of domestic, regional and
4.00 4.39
4.12 international capital markets indicated rapid foreign capital

2.00 inflows. In semester I 2007, the regional South East Asian


financial market was more bullish than the previous
-
Q-I Q-II Q-III Q-IV Q-I Q-II Q-III Q-IVQ-I Q-II Q-III Q-IV Q-I Q-II Q-III Q-IVQ-I Q-II Q-III Q-IV Q-I Q-II
2002 2003 2004 2005 2006 2007
semester.

Graph 1.3 Graph 1.5


Non Oil and Gas Exports Composite Index
Millions of USD
9,000
2,500
8,000
7,000 2,000
6,000
5,000 1,500
4,000
3,000 1,000

2,000
500
1,000
0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
0
2006 2007 Jun Dec Jun Dec Jun Dec Jun Dec Jun
Agriculture, Hunting and Fishing Mining and Quarrying 2003 2004 2005 2006 2007
Manufacturing Total

Graph 1.6
Graph 1.4
Indonesia and US Real Interest Rate
Non Oil and Gas Imports
Millions of USD %
8,000 6.00
Agriculture, Hunting and Fishing Mining and Quarrying
7,000 Manufacturing Total 4.00
6,000
2.00
5,000
-
4,000
(2.00)
3,000
(4.00)
2,000

1,000 (6.00)
Indonesia US
0 (8.00)
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jun Dec Jun Dec Jun Dec Jun Dec Jun
2006 2007 2003 2004 2005 2006 2007

10
Chapter 1 Macroeconomic Conditions and the Real Sector

developments in the global and regional financial markets


Graph 1.7
Exchange Rate of Selected World Currencies that precipitated a drop in the domestic financial market
110
SGD THB
spurred slight rupiah depreciation. The slump in subprime
PHP KRW
108 EUR JPY
mortgages in the US that stemmed from subprime loans
IDR
106
triggered negative sentiment and provoked foreign
104

102
investors to reduce their high risk financial instrument
100 portfolio in emerging markets like Indonesia and switch
98 to dollar denominated assets (see Box 1.1). Such behavior
96
Jan Feb Mar Apr May Jun sparked subsequent capital outflows that contributed to
rupiah depreciation against the US dollar. The rising global

A surplus of funds in several countries has oil price further weakened the rupiah exchange rate.

encouraged growth in hedge fund activities of greater Nevertheless, an expanding BoP surplus, burgeoning

volume. Meanwhile, the low interest rate in Japan triggered foreign exchange reserves, maintained risk exposure from

carry trades by global market players utilizing low-yielding the exchange rate and strong resilience from the fiscal

fund sources in Japan to invest in other high-yielding side have indicated robust economic fundamentals.

currencies in search of profit spread. Carry trades are Furthermore, in semester I 2007, an improvement in

generally short term and, therefore, price volatility Indonesia»s debt rating outlook, from steady to positive,

remained high in global and regional financial markets, awarded by the international ratings agencies (Fitch Ratings

including Indonesia. The rise in capital inflows positively and Moody»s) together with a decline in premi swap and

affected the exchange rates of emerging market countries, the stable yield spread showed effective management of

including Indonesia. On the contrary, carry trades the domestic risk factors. Taken as a whole, this drove

weakened the Japanese yen. In May 2007, the rupiah was positive sentiment towards Indonesia shielding the

strong against the US dollar, reaching Rp8,670.-. domestic economy and financial sector from pressures

Since the end of July 2007, however, the exchange emanating from escalating global financial market volatility.

rates of several Asian currencies have tended to fluctuate Upcoming market risk pressure is expected to be

and weaken, despite remaining manageable. Unfavorable significant, particularly that stemming from global and

Graph 1.8 Graph 1.9


Rupiah Exchange Rate against USD World Oil Price
Rp/USD
USD/barrel
12,000
80.00
11,500 - Katrina Hurricane in New Orleans (Aug 29, 2005)
WTI Spot Price
- World oil price USD69.81/barrel (Aug 30, 2005)
11,000 70.00 3-month Future
6-month Future
10,500
The implementation of 60.00
10,000 new fuel price &
nd
2 Bali bomb (Oct 1, 2005)
9,500
50.00
9,000
8,500 40.00
FFR 5% ( May 10, 2006)
8,000 BI-Rate 12.50% ( May 9, 2006)
30.00
7,500
7,000
Jan Apr Jul Oct Feb May Aug Dec Mar Jun
20.00
Jun Dec Jun Dec Jun Dec Jun Dec Jun
2005 2006 2007 2003 2004 2005 2006 2007

11
Chapter 1 Macroeconomic Conditions and the Real Sector

Graph 1.10 Graph 1.11


World Commodities Price Interest Rate and Inflation
USD %
300 25
Plywood 1-month Time Deposits BI-Rate
Interest Rate of Investment Loans 1-month SBI
250 Crude Palm Oil
Rice
20

200
15
150
10
100

50 5
Interest Rate of Working Capital Loans
Interest Rate of Consumer Loans Inflation
0 0
Jun Dec Jun Dec Jun Dec Jun Dec Jun
Jun Dec Jun Dec Jun Dec Jun Dec Jun
2003 2004 2005 2006 2007 2003 2004 2005 2006 2007

Graph 1.12
regional financial market volatility. The potential for further Consumer Loans
% %
global oil price hikes and inflationary pressures due to 52 9.00
47 8.00
soaring global commodity prices remains. Vigilance is
42 7.00
therefore required to avoid pressures on financial system 37 6.00
32 5.00
stability.
27 4.00
22 3.00
17 2.00
1.2. CONDITIONS IN THE REAL SECTOR Growth of Consumer Loans
12 1.00
NPL (right axis)
Improving macroeconomic indicators have instilled 7
Jun Dec Jun Dec Jun Dec May
0.00

2004 2005 2006 2007


confidence in the achievement of future inflation targets
Graph 1.13
and enabled Bank Indonesia to reduce the BI-Rate to a
Consumer Expectation
level of 8.25% at the end of semester I 2007. The reduction
180

in the BI-Rate met the expectations of market players and, 160


140
therefore, encouraged positive sentiment regarding the 120

rupiah. Amidst a steady and gradually improving rupiah 100


80
exchange rate, the lower BI-Rate was subsequently 60
40
followed by other domestic interest rates, in particular the Income
Economy
20
Employment Rate
1-month term deposit interest rate, which at the end of 0
Jun Dec Jun Dec Jun Dec Jun Dec May
2003 2004 2005 2006 2007
June 2007 was at 7.46%; representing a decline of 150
bps compared to its position at the end of December 2006.
Meanwhile, during the same period, the interest rates for and improving macroeconomic indicators drove customer
working capital, investment and consumption loans fell, demand and restored optimism concerning supply.
albeit with slightly less momentum, namely 119 bps, 111 From the demand side, although limited, private
bps and 67 bps respectively, to 13.88%, 13.99% and consumption followed an increasing trend and continues
16.91%. in the expansion phase. As a result of the reduction in
Despite the limited transmission of the BI-Rate decline interest rates, stronger public purchasing power has
to lending rates, the prevailing trend of lower interest rates boosted private consumption. This is apparent from the

12
Chapter 1 Macroeconomic Conditions and the Real Sector

acceleration in consumption credit growth in the wake of Graph 1.15


NPL of Working Capital and Investment Loans
sustaining heavy pressures in October 2005 due to the
%
hikes in fuel prices. In addition, several economic indicators 18
16
also point to an increase in private consumption along 14
12
with higher expectations for income, the economy and
10
job availability. 8
6
From the supply side, in line with favorable
4 Working Capital Loans
macroeconomic conditions the improving financial 2
Investment Loans
0
performance of non financial public listed companies, Jun Dec Jun Dec Jun Dec Jun Dec Jun
2003 2004 2005 2006 2007
which began in December 2006, is expected to continue.
This is, amongst others, marked by increasing business working capital credit and investment credit drop in

profitability (ROE) and maintained leverage. semester I 2007.

Better corporate performance imbued positive However, robust corporate sector performance failed

impacts on the financial sector as it strengthened credit to spur adequate business expansion. In general, the

repayment ability. Therefore, it was not surprising that the corporate sector remains beset by numerous constraints

value and percentage of non-performing loans (NPL) for to business expansion, such as labor issues and poor
infrastructure. Meanwhile, persistently high business costs
forced companies to utilize internal fund sources rather
Graph 1.14
Financial Performance of than credit from banks to finance business expansion. This
Non Financial Public Listed Companies also explains why bank credit expansion stayed below
expectations.
Current Ratio
20.0 The tendency of utilizing internal fund sources was
15.0
also evident from the relatively high capital to total assets
DER 10.0 ROA
ratio for public listed companies. On one hand such a
5.0
tendency illustrates an improvement in corporate financial
-

conditions since the company no longer depends on debt

Sales to ROE financing. However, on the other hand such an inclination


Total Assets
2005
2006 Graph 1.16
ITO
Note:
Corporates Financing and Expansion
Nearer to the centre, the lower the risk

2.0 0.6
% Growth of Go Public Corporation Assets
Sales Growth
Self Financing (right axis) 0.5
2005 2006 1.5

0.4
Current Ratio 1.27 1.21 1.0
ROA (Return on Assets) 0.06 0.06 0.3
ROE (Return on Equity) 0.15 0.17 0.5
0.2
ITO (Inventory Turn Over) 0.18 0.16
Sales to Total Assets 0.87 0.78 0.0 0.1

DER (Debt Equity Ratio) 1.53 1.52 -0.5 0.0


1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

13
Chapter 1 Macroeconomic Conditions and the Real Sector

potentially restricts a company from fully expanding due particularly the corporate sector. Furthermore, the debt-
to limited internal funds. Consequently, new job creation to-equity ratio of non financial public listed companies has
can be limited, thus undermining prevailing efforts to tended to slide, despite the strong capital inflows. This is
reduce unemployment. evidence that capital inflows have not been absorbed by
the corporate sector, especially those that have listed in
Graph 1.17
Unemployment Rate the capital market. The capital inflows are short term in
% nature and are predominantly in the form of financial
12

10
instruments such as shares, government bonds (SUN) and

8
Bank Indonesia»s Certificates (SBI).

6
Graph 1.19
4 DER and Debt/TA Performance
%
2 90 9
Total Liabilities/Total Assets
80 8
0 Debt to Equity Ratio (right axis)
Feb Aug Feb 70 7
2001 2002 2003 2004 2005 2006 2007
60 6
Source : BPS-Statistic Indonesia
50 5
40 4
In addition, despite the lower interest rate, bank 30 3
20 2
credit is yet to be fully utilized by business players.
10 1
Indications remain that business players await the 0 -
2003 2004 2005 2006

investment climate improvement package, through


Graph 1.20
ratification of the Draft Capital Investment Act (RUU-PM), Net Foreign Transaction: Stocks and Government Bonds
and the acceleration of infrastructure development. This Trillions of Rp Rp/USD
10.00 10,000
suggests that Indonesia»s resurgent economy is actually 9,800
8.00
9,600
growing below potential. 6.00
9,400
4.00 9,200
Graph 1.18 2.00 9,000
Output Gap Estimation 8,800
0.00
8,600
0.1 -2.00
Output gap acceleration 8,400
to zero Stocks Government Bonds Exchange Rate
0.05 became slower down
-4.00 8,200
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
0
2005 2006
-0.05

-0.1 In the future, support from various relevant parties


Output gap periode is
-0.10 closer to zero
to overcome the constraints in the real sector is required
-0.5

-0.01 Output Gap to enable more dynamic economic growth. As a result,


Accelerated Output Gap
-0.0
Q-II Q-IV Q-II Q-IV Q-II Q-IVQ-II Q-IV Q-II Q-IV Q-II Q-IV Q-II Q-IV Q-II Q-IV Q-II Q-IV Q-II Q-IVQ-II Q-IV Q-II Q-IV Q-II Q-IV improving macroeconomic indicators would truly reflect
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
developments in the real sector. This will boost the resilience
Strong capital inflows to Indonesia in semester I 2007 of the economy and domestic financial sector against
are yet to significantly impact real sector funding, external vulnerabilities.

14
Chapter 1 Macroeconomic Conditions and the Real Sector

Potential Impacts of the US Subprime Mortgage Crisis on the


Box 1.1
Domestic Financial Market

Subprime mortgage loans (SPM) is the practice Graph Box 1.1.1


of extending credits to borrowers who do not meet Residential Price Index of Selected Countries
acceptable standards for granting loans because of their %
40.0
deficient credit history; or are considered high risk.
30.0
Applicable schemes include Fixed Rate Mortgages (FRM) 20.0
and Adjustable Rate Mortgages (ARM). However, the 10.0

majority of SPM are adjustable rate, namely mortgage 0.0

loans with an adjustable interest rate after a given -10.0

-20.0
period according to the level of risk in the market.
-30.0
SPM have boomed in the United States since US UK Australia South Korea Hongkong Thailand
-40.0
2003. The demand for subprime mortgages soared in Q-IV Q-III Q-II Q-I Q-IV Q-III Q-II Q-I Q-IV Q-III Q-II Q-I Q-IV Q-III Q-II Q-I Q-IV Q-III Q-II Q-I
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
line with the rapid development of the US real estate
sector at the time. Financial institutions utilized this
business opportunity and developed securitization for Conversely, the lackluster property market swung
SPM. Rapid securitization supported development of SPM creditor expectations of risk. To mitigate the
the SPM secondary market, both in developed countries higher risk, creditors adjusted the interest rate of SPM
and in emerging countries such as Latin America, and set a far higher margin. This subsequently
Eastern Europe, and Asia (excluding Indonesia). In exacerbated the repayment ability of debtors pushing
addition, numerous SPM-based derivative instruments the ARM delinquency rate from 14.5% (December
also became popular among investors. Rapid growth 2006) to 16% (March 2007), despite the FRM
in the SPM secondary market drove demand for SPM delinquency rate remained relatively steady at 10%.
from property investors in order to purchase property A rise in the foreclosure rate for both SPM owed
for resale to get high returns from the property boom. for up to 90 days (starting delinquency) and SPM owed
Furthermore, the ongoing property boom in the US at for more than 90 days (serious delinquency) also
the time obscured creditor perception of SPM credit indicated a decline in SPM performance. The
risk. Consequently, creditors tended to perceive SPM
credit risk as relatively low due to strong expectations Graph Box 1.1.2
of uninterrupted soaring property prices, which would Delinquency Rate of SPM
%
cover the loans. 18
ARM
However, in mid 2006 the US property market 16
Total Sub-prime FRM

peaked, followed by a drop in property prices. 14


12
Circumstances then became less desirable as pressures 10
stemming from US economic downturn weakened the 8

repayment ability of SPM debtors, in turn, triggering 6


4
non-performing loans. In addition, other countries that
2
also adopted the SPM business model experienced 0
Q-I Q - III Q-I Q - III Q-I Q - III Q-I Q - III Q-I Q - III Q-I
similar problems. 2002 2003 2004 2005 2006 2007

15
Chapter 1 Macroeconomic Conditions and the Real Sector

Graph Box 1.1.3 requirement for liquidity in the global market due to
Foreclosure Rate of SPM pressures emanating from the SPM crisis has
%
14 undermined financial market performance in emerging
Total Sub-prime Serious Delinquency Starting Delinquency
12 markets that are predominantly supported by capital
10 inflows.
8 Global market liquidity pressures have triggered
6 capital outflows in the Indonesian financial market,
4 as reflected by a drop in the number of foreign
2 investors, particularly in SUN and SBI. The already high
0 yields received from SUN and SBI investment coupled
Q-I Q - III Q-I Q - III Q-I Q - III Q-I Q - III Q-I Q - III Q-I
2002 2003 2004 2005 2006 2007 with the declining profit potential of SUN investment
has encouraged foreign investors to realize the profits
foreclosure rate for starting delinquency and serious and divest to the global market, especially dollar-
delinquency rose respectively from 2.0% and 7.8% denominated assets. Such conditions have recently
(December 2006) to 2.4% and 8.3% (March 2007). weakened the rupiah against the US dollar.
Declining SPM credit quality had widespread Meanwhile, available data show that Indonesian
impacts, with the biggest losses reported primarily banks do not directly invest in SPM, hence, the direct
by investors in the secondary market for SPM-based impacts of the SPM crisis has been avoided. This is
securities and their derivatives. Massive and specifically attributable to prevailing bank regulations
simultaneous redemptions were the result of negative that mandate banks to categorize investment in non-
sentiment attributable to the rising delinquency rate investment grade securities as non-performing.
and soaring SPM foreclosure rate. Accordingly, a However, losses could arise from the sale of SUN by
number of hedge funds were liquidated, triggering foreign investors, leading to a drop in the SUN price.
a rise in the requirement for liquidity in the global Nevertheless, any subsequent losses affecting banks
market. with a SUN portfolio will be minor because the
Losses are predicted to be relatively smaller and expected drop in SUN price stemming from the SPM
insignificant in emerging market countries due to crisis is small (around 2% throughout July-August
the comparatively low exposure to financial 2007). In addition, based on the results of stress
institutions that have SPM-based instruments. The testing, a fall of 20% or more in the SUN price would
relatively robust capital position of financial be necessary to affect bank capital (CAR). As such,
institutions in several emerging market countries also the SPM crisis did not disrupt financial system stability
alleviated prevailing concerns. However, the larger in Indonesia.

16
Chapter 2 The Financial Sector

Chapter 2
The Financial Sector

17
Chapter 2 The Financial Sector

This page is intentionally blank

18
Chapter 2 The Financial Sector

Chapter 2 The Financial Sector

Financial system stability was maintained throughout semester I 2007.


Banks, which continued to dominate the financial sector, performed
favorably despite the need to extend more credit. Banks remained liquid
with maintained asset quality. Furthermore, market risk was anticipated
along with high profitability and strong capital. Meanwhile, regardless of
the numerous risks and challenges emanating from external vulnerabilities,
non-bank financial institutions and the capital market showed significant
progress.

2.1 FINANCIAL SECTOR STRUCTURE capacity should be applied by securities companies, as well
The Indonesian financial sector comprises of as more stringent oversight by the related supervisory
commercial banks and rural banks, as well as non-bank authority. Therefore, such positive developments would
financial institutions such as insurance, superannuations, benefit the economy rather than jeopardize financial system
finance companies, securities and pawnshops. With a stability.
market share of 80% of total assets of the financial system,
banks remain at the forefront of the financial sector. This Graph 2.1
Assets of Financial Institutions
reflects the high dependency on banks as a source of
Share of Total Assets of Financial Institution
funding for development and the economy. In addition, 100 1.0 3.7

the major banks continued to dominate the banking


80
Pawn Shops
industry, with a market share of about 69% of total bank Securities
Companies
60
Leasing
assets. As a result, financial system stability in Indonesia is Companies
40 80.6 Pension Funds 80.1
strongly affected by the risk behavior of the major banks. Insurance Companies
Rural Banks
Securities companies have witnessed a significant 20 Commercial Banks

surge in their market share of total financial system assets; 0


2005 2006
from 1.0% in 2005 to 3.7% in 2006. Such growth was Sources: BI and Others

balanced by a slight decline in market share for banks and


finance companies. On one hand, the rise can be viewed High dependence on banks is one indication that
as positive since it reduces the dependency on banks. the financial sector is facing problems with regards to
Conversely, this suggests that better risk-management financial deepening (see Box 2.1). Consequently, financial

19
Chapter 2 The Financial Sector

deepening needs to be prioritized to improve the role of Market (PUAB) remained relatively stable suggesting that
the financial market in supporting economic development banks can maintain sufficient liquidity resilience with low
in Indonesia. liquidity risk.

2.2. BANKS Graph 2.3


Bank Liquid Asset Ratio
2.2.1. Funding and Liquidity Risk Trillions of Rp %
400 180
Deposits remain the largest source of funds for banks
320
despite a downturn in growth in line with the downward
240
trend in the interest rate. Deposits, primarily short term,
120
accounted for 90% of bank funding. Prior experience has 160

shown that banks are able to manage liquidity. However, 80

banks should continue to effectively manage the mismatch 0 60


Dec Dec Jan Feb Mar Apr May Jun
in maturity profile to prevent negative effects on bank 2005 2006 2007

Liquid Assets NCD Liquid Assets/NCD


liquidity.

Graph 2.2
Structure of Funding and Bank Placements Inter-Bank Money Market (PUAB)
% The rupiah PUAB throughout semester I 2007 was
100 Equity 6.0 16.81
165.08 118.67 Securities
Participation
Inter Bank
13.98 Inter Bank controllable and the interest rate for overnight transactions
80 342.0
Securities
Borrowing (O/N) averaged between 4% and 10%. PUAB tightened
224.1
60 SBI/Fasbi
on several occasions, particularly when confronted by the
1353.75 Deposits
40 rather strong appetite for liquidity such as during the
Loans 904.0
20 annual tax payments around the end of March. As a result,

0 the O/N interest rate peaked at 29% on 22nd March 2007.


Placement of Funds Source of Funds
However, the banks» ability to manage liquidity through

Liquidity Adequacy SBI Repo and Fine Tune Expansion (FTE) ensured that PUAB

Bank liquidity was relatively well controlled through remained robust.

semester I 2007. This is evident from the ratio of liquid


Graph 2.4
assets2 to non-core deposits (NCD)3 , which remained Average Interbank Money Market Interest Rate
%
above 100%, although bank liquidity tended to decline
12

slightly as shown by the drop in the ratio to 138.9% at Afternoon

the end of June 2007. The decline was attributable to 9

the rise in short-term liabilities (6.6%) exceeding the rise Morning

in liquid assets (1.2%). Meanwhile, the Inter-Bank Money 6


FX-Onshore
FX-Offshore
2 Liquid assets comprise of cash and bank placements at BI (i.e. demand deposits at BI, SBI
and Fasbi). 3
3 For Non-Core Deposits (NCD), the assumption is 30% demand deposits and savings plus Jan Feb Mar Apr May Jun
10% of 3-month term deposits. 2007

20
Chapter 2 The Financial Sector

Structure of Deposits Graph 2.7


Foreign Exchange Deposits Performance
Bank deposits continued to grow throughout
Billions of Rp Trillions of Rp
semester I 2007, despite a slowdown, and reached 25 240

Rp1,353.7 trillion at the end of June; or 76.4% of total


24
in USD
bank assets. This represents an increase of Rp66.8 trillion 220
23
or 5.2% compared to the position at end of the previous
22 in Rupiah
semester. Meanwhile, growth of foreign currency (right axis) 200

21
denominated deposits surpassed rupiah denominated
deposits, leading to their market share of total bank 20 180
Dec Jan Feb Mar Apr May Jun
2006 2007
deposits increasing from 15.0% to 16.5%.

Graph 2.8
Graph 2.5 Time Deposits Growth
Deposits Performance
(m-t-m)
Trillions of Rp 10
380 630

Time Deposits (right axis)


5
625
360
0
620

340 Demand Deposits -5


Saving Deposits 615
Rupiah Foreign Exchange
-10
320 610 Jul-Jun Nov-Oct Mar-Feb Jul-Jun
Dec Jan Feb Mar Apr May Jun 2006 2007
2006 2007

by term deposits, whereas savings accounts reported the


Graph 2.6
Deposits Performance Based on Exchange Rate highest growth. Foreign currency deposits grew because

Trillions of Rp some depositors conjectured that placements in foreign


1,150 230
currency, especially term deposits, were more profitable.
220
1,125 In particular, the rise in savings in foreign currency was
210 indirectly precipitated by PBI No 9/4/2007 dated 26th March
Deposits of Rupiah
1,100
200 2007 that rescinded the ban on foreign currency savings.
1,075
Deposits of Foreign Exchange 190
Although bank deposits have grown, concerns
(right axis)
remain regarding a potential rise in liquidity risk, specifically
1,050 180
Des Jan Feb Mar Apr May Jun
2006 2007 stemming from the imbalance in deposit structure, namely
the concentration on short-term funds, the large depositors
During semester I 2007, deposits denominated in and ownership by several individuals. By the end of
foreign currency increased uniformly for all types of semester I 2007, short-term deposits (demand deposit
deposits (demand deposits, term deposits and savings) by accounts, savings and 3-month term deposits) reached
USD3.16 billion. In terms of value, demand deposit 93.2% of total deposits. The large depositors with account
accounts recorded the most significant increase followed values of over Rp100 million covered 78% of total deposits

21
Chapter 2 The Financial Sector

Graph 2.9 confidence in banks. Furthermore, the reduction of the


Deposits Structure deposit insurance scheme has not resulted in fund

> 100 million < 100 million migration or flight to safety.


Nominal (78.0%) (22.0%)
Meanwhile, the hypothesis that a decline in the

Maturity
< 3-month > 3-month deposit insurance scheme would encourage customers to
(93.2%) (6.8%)

split their account into smaller value accounts did not occur.

Ownership
Individual Others Since implementation, the number of customer accounts
(54.8%) (42.5%)

held at banks has even tended to decline. Moreover, the


percentage of accounts valued below Rp100 million has
despite constituting just 2.5% of total customer accounts. also not increased. Taken holistically, there is strong
In addition, deposits from several individuals still evidence that the reduction in the deposit insurance
dominated; accounting for 54.8% of total deposits. This scheme has not triggered any significant negative impacts
structure of deposits is vulnerable to sudden withdrawals, on banks, whilst public confidence in the Indonesian
especially by the large depositors and individuals. To reduce banking system has grown, which is important for financial
liquidity risk, banks have invested in low-risk liquid assets. system stability.
As a result, SBI ownership by banks increased by 12.9% in
semester I 2007. 2.2.2. Credit Growth and Credit Risk
Credit Growth
Impact of the Reduction in the Limited Deposit Despite a relatively low growth rate of 8.5%, the
Insurance Scheme nominal value of bank loans continued to grow in semester
Reducing the limited deposit insurance scheme up I 2007; up Rp71.1 trillion compared to the 2006 year-end
to a maximum of Rp100 million per customer per bank on position. Nevertheless, the low growth rate exceeded that
nd
22 March 2007 has, hitherto, not significantly affected in the same period of the previous year (3.7%). Credit
bank deposits. In fact, growth in all categories of bank growth (y-o-y) as of June 2007 recorded 19.4%, surpassing
deposits is evidence and reflects the public»s strong the previous year at 14%. With a relatively small deviation
of Rp0.3 trillion, however, the accomplishment of credit
Graph 2.10
Deposits Performance (Related to Guarantee)
Graph 2.11
Trillions of Rp Loans Growth
600
%
500 25

400 20 y-o-y

300 15

200 10 y-t-d

100 5

0 0
State-Owned Foreign Small Middle Big
Regional Dev. Joint Venture Private Private Private

March 22, 2007 468.8 124.9 99.5 39.4 20.3 84.311 449.840 -5
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul
June 26, 2007 479.7 138.2 103.8 46.9 20.9 86.518 457.632
2006 2007

22
Chapter 2 The Financial Sector

Graph 2.12 Graph 2.13


Share of Earning Assets Loans Growth by Type
Percent %
8
0.4 0.4 Working Capital Loans Investment Loans Consumer Loans
10.1 6
100 Equity
10.1
Participation
22.0 20.8 4
Inter Bank
75
14.0 13.7 2
Securities

50 SBI & Fasbi


0

53.5 Loans 55.1 -2


25
-4

0 -6
Dec Jun Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul
2006 2007 2006 2007

targets by the end of semester I 2007 remained below responded by granting more of such loans. The greatest
those stipulated in the bank business plan. Furthermore, drop recorded for any lending rate (229 bps) was for
bank loan to deposit ratio (LDR) rose from 64.7% in working capital loans; however, it did not spark an increase
December 2006 to 66.8% in June 2007 due to credit in their credit extension. Up to May 2007 working capital
growth eclipsing deposit growth. Meanwhile, excess loans followed a decelerating trend but had grown
liquidity at banks was generally invested in SBI/Fasbi and significantly by June 2007.
government bonds. Consumption loans continued to dominate credit
Banks» preference for placements in SBI/Fasbi tended growth. In terms of nominal value, working capital loans
to decline, demonstrated by a reduction in market share remained foremost, totaling Rp31.3 trillion (7.5% growth),
against total productive assets from 14.0% to 13.7%, however, consumption loans recorded the highest growth,
despite the tranche climbing by Rp6.5 trillion in nominal namely 10.2% (an increase of Rp23.1 trillion) y-t-d. Based
value. Meanwhile, bank ownership on corporate bonds on the economic sector, consumption loans sought by the
increased, albeit remaining relatively low, whereas others sector experienced the largest rise, more specifically
government bonds tended to subside. Consequently, this by Rp23.1 trillion. Credit for the mining sector experienced
led to a drop in the share of bonds from 22.0% to 20.8%. the most impressive growth at 44.9%.
A stronger rupiah in the second quarter of 2007
Graph 2.14
also affected credit growth, with a decline in credit Share of Loans by Type
extension in foreign currency but a hike in rupiah
denominated loans. However, foreign currency credit
33%
strengthened (9.1%) in June 2007 in line with a drop in
46%
the value of the rupiah.
The lower lending rate did not trigger a direct rise in
all types of bank loans. Over the last 13 months, the fall in
21%
interest rates of investment and consumption loans
Working Capital Loans Investment Loans Consumer Loans

reached 174 bps and 43 bps respectively, and banks have

23
Chapter 2 The Financial Sector

Graph 2.15 Graph 2.17


Share of Loans by Economic Sector NPL Value Performance

24.0 75.0
Trading 22.0 70.0
1% 2% 1% Others 20.0
11% 21% 65.0
Manufacturing 18.0
5% Sub-standard Total NPL (right axis) 60.0
Transportation 16.0
4% Construction 14.0 55.0
Agribusiness 12.0 50.0
Business Services 10.0
3% 45.0
Services 8.0
40.0
Mining 6.0 Loss (right axis)
22% 30% 35.0
4.0 Doubtful
Electricity
2.0 30.0
Mar Jun Sep Dec Mar Jun
2006 2007

The outlook for bank loans remains positive. Credit Notwithstanding, the improvement in NPL did not
will continue to grow, which is reflected by the increasing automatically mean better overall bank credit quality. This
amount of undisbursed loans, especially for working capital is because the improvement in loans quality primarily
purposes. Meanwhile, approval for investment loans since occurred in channeling credit, for which the risk does not
quarter II 2007 has risen. The steady ratio of undisbursed affect banks. In fact, the nominal value of non-performing
loans against total loans, at around 20%, indicates that loans for non-channeling credit rose by Rp1.7 trillion (3.6%).
the rise in undisbursed loans is relatively manageable. Although banks have made provisions for loan losses (PPAP)
to anticipate a surge in NPL, vigilance is still imperative to
Credit Risk prevent any early symptoms of credit risk developing and
Compared to the position at the end of semester II subsequently disrupting financial system stability.
2006, the nominal value of non-performing loans dropped Regarding banks, NPL growth tended to vary. Gross
by Rp0.6 trillion (1.0%) to Rp57.5 trillion by the end of NPL at the large banks dropped from 8.4% to 7.4%,
semester I 2007. Meanwhile, the amount of banks primarily attributable to improved channeling credit quality
extending loans surged compared to the previous semester. at state-owned banks. Meanwhile, foreign banks
As a result, the NPL ratio fell from 7.0% to 6.4% (gross) experienced the highest NPL growth in recent years at
or from 3.6% to 2.9% (net). 43.7% (Rp1.2 trillion) for the reporting period. A rise in

Graph 2.16 Graph 2.18


Non Performing Loans (NPL) Gross NPL Performance by Bank Group
% Trillions of Rp
12 75 13
12 Big Middle Small Joint Venture Foreign
11 70
10 11
65
9 NPL Gross 10
8 60
9
7 55 8
6 50 7
NPL Net
5 45 6
NPL Nominal (right axis)
4 5
40
3 4
2 35
3
1 30
2
- 25 June June June June
2002 2003 2004 2005 2006 2007 Jun 2004 2005 2006 2007

24
Chapter 2 The Financial Sector

NPL nominal value was also experienced by mid-sized Graph 2.20


banks, by Rp0.8 trillion or 30.3%. Share of NPL by Economic Sector
%
100
Credit quality in the industrial sector also improved Other Sectors

in line with more favorable macroeconomic conditions. 80 Business Services

This was reflected by a decline in gross NPL from 10.5% 60 Trading

to 10.0%. However, non-performing loans in the industrial 40


Manufacturing
sector require tight monitoring and effective resolution as
20
they dominate total bank NPL (37.2%) and are prone to Agribusiness
0
becoming a source of instability. 2000 2001 2002 2003 2004 2005 2006 2007 Jun
Other manufacturings = Mining, Electricity, Services, Construction, Transportation

On the other hand, propitious economic conditions


did not ameliorate credit quality in the others sector loans throughout 2007 failed to raise credit quality. In fact,

(generally consumption loans) or the trade sector. The consumption loans NPL increased significantly by Rp21.1

nominal value of NPL in the two sectors grew in semester trillion (31.7%) during semester I 2007, rising from 2.9%

I 2007 by Rp2.0 trillion (31.4%) and Rp0.9 trillion (0.9%) to 3.5% (gross).

respectively. However, credit risk in the trade sector and It should be noted that the quality of consumption

others sector was more manageable compared to the loans began to decline in 2000. Since then the market

industrial sector. This was due to: (i) credits in the trade share of consumption loans NPL against total NPL has

sector and others sector are generally working capital and persistently increased, peaking at 17.4% by the end of

consumption loans with relatively smaller outstanding semester I 2007; up from 13.7% at the end of the previous

credit; (ii) debtors are generally not corporations; and (iii) semester. The concentration of loan extension for

nearly all banks have credit portfolios for these sectors, consumption purposes must be closely monitored because

further diversifying the risk. if household income is insufficient to repay the bank loans
it will raise credit risk.

Graph 2.19
Gross NPL by Economic Sector Graph 2.21
Share of NPL by Loans Type
Services Jun-2007 %
Business Services Dec-2006 100
Consumer
Transportation
Trading
80 Investment

Construction
60
Electricity
Manufacturing
40 Working Capital
Mining
Agribusiness
20
0.0 2.0 4.0 6.0 8.0 10.0 12.0
%
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Although favorable macroeconomic conditions
persist, credit quality in the household sector, which is The quality of working capital and investment loans
reflected by the performance of consumption loans, only experienced slight improvements as reflected by a
continued to decline. A low interest rate for consumption drop in their gross NPL from 6.3% to 5.8% and 10.3% to

25
Chapter 2 The Financial Sector

Graph 2.22 Graph 2.24


Performance of Consumer Loans NPL NPL Value of Corporate and MSME
Trillions of Rp Trillions of Rp
10 275 50

9 255
235 40
8 Corporation
215
7 Loans (right axis)
195 30
6
175
5
155 20
4 NPL
135 MSME
3 115 10
2 95
1 75 -
2003 2004 2005 2006 2007 June 2001 2004 2005
` 2006 2007 June

9.1% respectively. Despite the immaterial nature of these in recent years. However, this is not expected to threaten
improvements, they are expected to reduce potential financial system stability in the short term, primarily due
instability due to their dominance in total bank NPL, namely to loan diversification with relatively little outstanding credit
52.1% (working capital loans) and 30.5% (investment and a relatively large number of debtors.
loans).

Graph 2.23 Graph 2.25


NPL Gross Performance NPL Gross of Corporate and MSME Loans
% % % %
4.0 13.0 5.5
22.0 Consumer (right axis) 12.0 MSME (right)
5.0
3.5 11.0
Investment 4.5
17.0 10.0
3.0 4.0
9.0

12.0 8.0 3.5


2.5
7.0
Corporation 3.0
7.0 6.0
Working Capital 2.0
2.5
5.0

2.0 1.5 4.0 2.0


2002 2003 2004 2005 2006 2007 Jun 2003 2004 2005 2006 2007 June

The quality of corporate loans tended to improve, as Occasional positive exchange rate performance
reflected by a drop in gross NPL from 8.1% to 7.2%. This during semester I 2007 increased foreign denominated
is projected to have positive impacts on financial system loans and dissipate credit risk. During the reporting period
stability considering the substantial share of corporate loans the rupiah strengthened against the USD by Rp191/USD.
(48.6%) in total bank credit. Furthermore, the share of Meanwhile, the majority of corporate debtors restructured
corporate loans NPL in total bank NPL is very large (60.8%). by state-owned banks were granted a foreign denominated
Credit restructuring by several state-owned banks improved loans facility. As a result, the NPL of foreign denominated
corporate loans quality. loans dropped significantly by Rp1.7 trillion or 11.0%.
A rise in gross NPL from 4.2% to 4.4% in the micro, Therefore, the gross NPL ratio of foreign denominated loans
small and medium enterprise (MSME) sector indicated a fell from 9.9% to 7.9%. Conversely, the quality of rupiah
drop in credit quality. In terms of nominal value, NPL in denominated loans decreased as reflected by the increase
the MSME sector rose by Rp2.4 trillion (14.3%), the highest in NPL by Rp3.4 trillion or 10.4%. The gross NPL ratio for

26
Chapter 2 The Financial Sector

Graph 2.26 Graph 2.28


Foreign Exchange Rate and Foreign Exchange NPL Loans, NPL and APLL
Rp/USD Trillions of Rupiah Trillions of Rupiah
12,000 50 100 1,000
NPL of Foreign Exchange (right axis) 900
11,500 45 90
Exchange Rate Loans (right)
11,000 40 800
80
10,500 35 700
70 NPL
10,000 30 600
60
9,500 25 500
50
9,000 20 400
Provision
8,500 15 40 300

8,000 10 30 200
2001 2002 2003 2004 2005 2006 2007 June 2000 2001 2002 2003 2004 2005 2006 2007June

Graph 2.27
Performance of Foreign Exchange Gross NPL Government Regulation No. 33/2006 on Procedures for
%
45 Writing Off State-Owned Receivables ( Tata Cara
40
35
Penghapusan Piutang Negara ), to facilitate credit
Foreign Exchange NPL
30 restructuring by state-owned banks. Through these various
25
20
efforts, banks are expected to surmount the prevailing
15 problem loans that can threaten financial system stability.
10 Total of NPL
5 Rupiah NPL In line with the development in bank businesses, in
0
2000 2002 2003 2004 2005 2006 2007 June
the future alternative credit risk mitigation measures need
to be developed. These include securitization and credit
rupiah denominated loans rose slightly from 5.1% to derivatives, which would assist banks in managing credit
5.3%. risk, ease liquidity problems and promote financial
deepening.
Credit Risk Mitigation
To mitigate credit risk, banks maintained adequate 2.2.3. Market Risk
loan loss provisions. In semester I 2007, banks established Favorable macroeconomic conditions, supported by
loan loss provisions of Rp4.2 trillion; representing an a relatively low inflation rate and the decreasing trend of
increase of 10.7% over the previous semester. With such the interest rate, helped maintain bank market risk
provisions, net NPL at banks dropped from 3.6% to 2.9%. exposure. The managed reduction of the interest rate,
Additional measures undertaken by banks to mitigate which began mid 2006, continued in semester I 2007.
credit risk include: (i) implementing appropriate risk- Reductions also occurred on the deposit interest rate (1-
management practices in loan extension; (ii) improving the month term deposits) and all types of lending rates
capabilities of bank loans officers in credit analysis; (iii) (working capital loans, investment loans and consumption
overcoming asymmetric information in granting loans by loans). Although the declines in the deposit interest rates
utilizing data and information provided by the Credit in semester I 2007 (150 bps) exceeded the declines in
Bureau; (iv) intensifying loan extension through syndication lending rates, they failed to reach the magnitude of the
and other risk sharing agreements: and (v) ratifying previous semester (238 bps). In contrast, the extent of the

27
Chapter 2 The Financial Sector

decline in lending rates during semester I 2007 surpassed exchange maturity profile. This reflects a transition in bank
those of the previous semester. As a whole, these factors portfolio composition from rupiah to foreign exchange, in
indicate that banks are now more willing to lower lending line with the persistently lower interest rate.
rates. Nevertheless, the interest rate for consumption loans Against this backdrop, risk would appear if there is
remains high, particularly for foreign banks and joint- a swing in the interest rate to trend upwards. This potential
venture banks, with an average rate of over 30%. vulnerability requires close monitoring because the hedging
and derivatives markets that can facilitate the mitigation
Graph 2.29 of interest rate risk remain under developed. A swing in
Interest Rate and Exchange Rate Performance
the interest rate could trigger losses that place pressures
% Rp
22 11,500
on banks» capital (CAR) if not well responded to by the
19 Consumer Loans
10,500
banks. Based on stress testing on interest rates, an average
16 Investment Loans
drop in CAR of 28 bps would occur for every rise in the
13 Working Capital Loans 9,500
interest rate by 100 bps.
10
8,500
7 Graph 2.31
Exchange Rate (right axis)
1-month Time Deposits Rupiah Maturity Profile
4 7,500
2002 2003 2004 2005 2006 2007 Trillions of Rp
450

Graph 2.30 300


Loans Interest Rate by Bank Group
150
%
40 0
Dec-05 Jun-06
(150)
30 Dec-06 Jun-07
Dec-05 Dec-06
WC = Working Capital (300)
I = Investment Jun-06 Jun-07
C = Consumer
20
(450)
< 1-month 1 √ 3-month 3 √ 6-month 6 √ 12-month > 12-month

10

0
Graph 2.32
WC I C WC I C WC I C WC I C WC I C Foreign Exchange Maturity Profile
State-Owned Regional Dev. Domestic Private Foreign & Joint All Banks
Banks Banks Banks Venture Banks Billions of USD
10

In general, banks managed interest rate risk by


5

maintaining portfolios with short positions for the short


0
term and long positions for the long term. Using short
profile maturity on short-term funds, banks realized profits (5)
Dec-05 Dec-06
with the lower interest rate. Short and long positions were Jun-06 Jun-07
(10)
used on both rupiah and foreign exchange portfolios. The < 1-month 1 √ 3-month 3 √ 6-month 6 √ 12-month > 12-month

rupiah maturity profile showed a downward trend for the


short position for short term and long position for long Meanwhile, to overcome exchange rate risk, banks
term. Oppositely, a growing trend was reported on the maintained a relatively low Net Open Position (NOP). On
short position for short term (up to 1 month) on the foreign average, bank NOP in semester I 2007 was between 3%

28
Chapter 2 The Financial Sector

Graph 2.34
Graph 2.33
Government Bonds in Bank Portfolio
NOP Performance (Overall)
% %
% 100 21
20

18.4 75 17
16
17.1 16.9 16.6 17.0
16.3
15.6 15.3
14.7
12
Domestic Private Banks Joint Venture Banks Regional Dev. Banks State-Owned Banks 50 13
Foreign Banks All Banks The highest of NOP
8
25 9
4

0 5
0 Dec Mar Jun Sept Dec Mar Jun
Oct Nov Des Jan Feb Mar Apr May Jun 2005 2006 2007
2006 2007 Trading % of Trading Government Bonds to Total Assets (right axis)
Investment % of Government Bonds to Total Assets (right axis)

and 5%. By maintaining NOP (overall) at a low level, banks Hedging and derivative markets are required to
were better able to manage exchange rate risk. Stress support the capability of bank management in controlling
testing on the impact of rupiah exchange rate fluctuations and mitigating market risk. Without hedging and derivative
against CAR showed that, in general, banks can maintain markets, the ability of bank managers to control market
CAR above 8%. Therefore, recent fluctuations in the rupiah risk is very limited. Well-developed hedging and derivative
should not trigger any instability. markets will assist in market risk-management
With the ability to maintain a reliable maturity profile, implementation and simultaneously bolster financial
the low NOP position, and a relatively strong capital deepening.
coupled with conducive economic conditions, banks are
expected to effectively manage market risk. However, 2.2.4. Profitability and Capital
vigilance is imperative over a rise in the interest rate or a Profitability
sudden reversal of short-term foreign capital inflows. As a The profitability of banks improved during semester
result, banks must continuously improve their risk I 2007 as reflected by the rise in net interest income (NII)
management as well as prepare an adequate contingency from Rp42.5 trillion to Rp46.4 trillion, and an increase in
plan. return on assets (ROA) from 2.6% to 2.8%. Meanwhile, a
SUN ownership by banks for trading purposes grew drop in the operating expense to operating income ratio
from 7.4% to 8.9% of total bank assets in semester I 2007. (BOPO) from 86.5% to 84.6% indicated an improvement
In addition, their proportion against total SUN also in operational efficiency.
increased; from 46.3% to 61.1%. This rise in trading Banks benefited from a decline in interest rates to
portfolio could intensify market risk. Stringent monitoring boost income. In general, banks widened their spread
is required because the global financial market fluctuates through larger and more rapid reductions in their deposit
highly that could trigger a drop in the value of financial interest rates compared to the drop in lending rates. As a
assets of domestic banks, including SUN. The drop in result, the interest rate spread for rupiah denominated
value of SUN could place pressures on bank capital. Based credit increased slightly from 10.17% to 10.28%, whereas
on stress tests, should the SUN price drop by 15% or more, the spread on the interest rate for foreign currency credit
the CAR of two large banks would fall below 10%. widened from 5.30% to 5.47%. In addition, the growth

29
Chapter 2 The Financial Sector

of earning assets, especially credits, surpassed the growth The increase in loans during semester I 2007 led to a
of the deposits. Therefore, the income generated from rise in income generated from loans. The share of interest
loan payments exceeded the additional interest expense income from loans in the previous semester was 60.1%
for deposits. As a whole, the factors outlined above raised of total bank interest income; rising to 63.5% in semester
NII in semester 1 2007. I 2007. The interest income from SBI/Fasbi investment also
increased, primarily due to greater bank placements in SBI/
Graph 2.35
NII Performance Fasbi, to Rp6.5 trillion. However, the share of interest
%
18.0 income from other securities dropped significantly, from
16.0
14.0 21.4% to 16.8%, mainly due to the decline in bank
12.0
investment in corporate bonds by Rp16.5 trillion.
10.0
8.0
6.0 Graph 2.37
4.0 Structure of Bank Interest Income
2.0
Interest Income Interest Expenses NII
- %
Feb Jun Oct Feb Jun Oct Feb Jun 100
7.0 7.8 6.9 7.3 8.9 9.2 8.2 7.9
2005 2006 2007

75
49.8
On average, the rise in NII as well as non-operational 56.4 59.7 63.3 63.1 59.2 60.1 63.5

50
income raised bank profits by a greater amount than the
increase in total assets. In semester I 2007, bank profits 25 32.5
26.3 25.1 22.9 21.4 16.8
22.2 22.0
increased by 14.1%, contrasted against a rise in total assets 10.8 9.5 8.3 8.7 10.4 11.8
7.2 6.0
0
Dec Jun Dec Jun Dec Jun Dec Jun
of only 7.7%. Consequently, bank ROA rose from 2.6% 2003 2004 2005 2006 2007
BI Securities Loans Others
to 2.8%. Based on bank group, ROA increased the most
for 15 large banks, namely from 2.4% to 2.6%.
Improved profitability was consistent with greater
Meanwhile, ROA climbed from 3.2% to 3.3% for the
business efficiency, which was reflected by a drop in the
others bank group. The relatively significant ROA increase
BOPO ratio. Despite the additional burden of a rise in
of large banks is a reflection of the crucial role these banks
provisions for loan losses (PPAP) from Rp2.6 trillion per
play in determining the financial performance of the
month to Rp3.0 trillion per month on average, robust
banking industry.
operational income originating from interest payments
Graph 2.36 triggered a drop in BOPO; from 86.5% to 84.6%. Higher
Profit and Assets Performance
Millions of Rp
profitability and better bank operating efficiency has
1,700,000 50,000
contributed to financial system stability.
1,600,000
45,000
1,500,000

1,400,000
40,000 Capital
1,300,000 High profitability in semester I 2007 enabled banks
35,000
1,200,000
30,000 to expand their capital internally. Meanwhile, the rise in
1,100,000 Average Assets
Profit (right axis) bank capital outstripped the rise in risk-weighted assets
1,000,000 25,000
Jun Dec Jun Dec Jun Dec Jun
2004 2005 2006 2007 and, therefore, CAR increased slightly from 20.5% to

30
Chapter 2 The Financial Sector

20.7%. The bank nominal capital increased by 8.8% to 2.3. NON-BANK FINANCIAL INSTITUTIONS AND
Rp198.5 trillion, whereas risk-weighted assets increased THE CAPITAL MARKET
by 7.2% to Rp958.9 trillion. The performance of finance companies and the
capital market as alternative sources of funding remained

Graph 2.38 healthy in semester I 2007. Robust performance was


Risk Weighted Assets, Capital, and CAR
primarily supported by conducive economic conditions that
Trillions of Rp %
1,100
Capital Risk Weighted Assets CAR (right axis)
22 enabled a decline in interest rates. In the capital market,
1,000
900 20 new issuances improved market liquidity slightly and
800
18
700 reduced volatility, thereby deflating the pressures
600
16
500 associated with investment risk. However, issuance growth
400 14
300 tended to be slow and, thus, unable to meet the rapid
200 12
100
surge in investor demand, especially from foreign investors.
- 10
Dec Jun Dec Jun Dec Jun Dec Jun As a result, a price bubble was unavoidable. Market
2003 2004 2005 2006 2007
growth, primarily supported by foreign investor demand,
On top of the high CAR ratio, banks also maintained was vulnerable to corrections, especially in the event of a
a high core capital against risk-weighted assets ratio of sudden reversal. Therefore, financial deepening remains
17.8%. With such robust capital, banks could absorb crucial to offer investment alternatives and, consequently,
several types of risk, further bolstering financial system diversify risk.
stability. The high capital ratio also provided adequate room
to improve the bank intermediation function. 2.3.1. Finance Companies
The decline in interest rates in semester I 2007 began
Graph 2.39
Tier 1 Capital to Risk Weighted Assets Ratio and CAR to impact the performance of finance companies, both

% national private finance companies and joint ventures. As


30.0
CAR such, increases in the financing to equity ratio and financing
25.0 Tier 1 to Risk Weighted Assets Ratio

20.0
to loan ratio were reported. Total assets of finance

15.0 companies grew by 4.2% in line with increased financing.


10.0
Joint Venture Banks

Graph 2.40
Foreign Banks
15 Big Banks

5.0
All Banks

Operational Activities of Finance Companies


Others

0.0
A B C D E F G H I J K L M N O
Banks Trillions of Rp
120
2005 Jan 07
100 2006 Mar 07
Although aggregate bank CAR is considered high, May 07
80
there remain a very limited number of banks with marginal
60
CAR. A low CAR ratio leads to vulnerability to risks. To
40
overcome this, bank compliance to the minimum core
20
capital requirement of Rp80 billion by the end of 2007
0
and Rp100 million by the end of 2010 is imperative. Assets Financing Funding Capital

31
Chapter 2 The Financial Sector

The business activity of finance companies remains Graph 2.43


Source of Fund of Joint Venture Finance Companies
concentrated on consumer financing (64%), especially to
Billions of Rp
finance motor vehicles. Notwithstanding, financing from 35,000
Domestic Borrowing Foreign Borrowing Securities
joint-venture companies exceeded the national private 30,000

25,000
companies. This is partly due to joint-venture companies
20,000
expanding their financing over the longer term, including
15,000
infrastructure and housing financing through leasing. 10,000

Bank loans remain the primary source of funds for 5,000

0
finance companies, with the share growing from 85% Dec May Dec Jan Feb Mar Apr May
2005 2006 2007
(May 2006) to 90% (May 2007). National private finance
companies rely heavily on domestic banks, whereas joint- particularly due to the expensive cost of funds. Conversely,
venture companies rely more on overseas bank loans. the joint ventures operated more efficiently due to the
Regardless, joint-venture finance companies have begun lower interest payments for overseas loans.
to diversify their fund sources by reducing overseas bank As previously mentioned, both the national privates
loans and raising the issuances of stocks and bonds. and the joint ventures relied heavily on bank loans for
Reliance on domestic bank loans undermined the funding but with the joint ventures using more overseas
national private finance companies» performance, bank loans. The lower interest rates offered by overseas
banks gives the upper hand to joint venture finance
Graph 2.41
Finance Companies companies in extending financing. Furthermore, joint
Billions of Rp
120,000
ventures also actively issue bonds abroad despite its
Total Finance Companies
100,000 Domestic Private Finance Companies relatively small nominal value, around USD6 million.
Joint Venture Finance Companies
80,000 Higher operational costs for the national privates are
60,000 mainly due to the increase in credit defaults, suggesting
40,000 the need for greater reserves. Subsequently, higher
20,000
operational costs lead to a growing deficit in operational
0
Dec May Dec May activity and therefore, higher liquidity risk.
2005 2006 2007

Graph 2.42 Graph 2.44


Source of Fund of Domestic Private Finance Companies Net Cash Flow of Finance Companies

Billions of Rp Billions of Rp
14,000 4,000
Domestic Borrowing Foreign Borrowing Securities
12,000
2,000
10,000

8,000
0
6,000

4,000
-2,000
2,000 Net Cash Flow of Operation Activities Net Cash Flow of Investment Activities
Net Cash Flow of Funding Activities
0 -4,000
Dec May Dec Jan Feb Mar Apr May Jan Feb Mar Apr May
2005 2006 2007 2007

32
Chapter 2 The Financial Sector

In addition to liquidity risk, national private finance The marked surge in capital inflows from foreign
companies also faced mounting credit risk due to the investors bolstered capital market performance. However,
tendency of aggressive and concentrated financing. the absence of a hedging market and the illiquid capital
Aggressive expansion has potential contagion effects, market lead to short-term foreign investment. Profit taking
particularly due to growing conglomeration among banks, by foreign investors in June 2007, which was triggered
finance companies, insurance agencies and automotive primarily by negative sentiment in the international market,
businesses. From another perspective, high reliance of spurred corrections in the domestic capital market. This
finance companies on bank loans could intensify risk weakened the exchange rate.
exposure in the banking industry. Against this backdrop, fears of a repeat of the
The tendency of joint-venture finance companies to financial crisis in 1998, which stemmed from a sudden
borrow money from overseas for expansion in rupiah could reversal of capital inflows, placed pressures on financial
mount pressure on financial system stability, in particular system stability (see Box 2.2). However, prevailing financial
if no hedging strategies are undertaken. Moreover, rupiah system resilience supported by more favorable economic
weakening would also hinder the servicing of overseas conditions and optimistic prospects are expected to negate
loans by finance companies. Collectively, such factors could the effects of any capital outflows.
strain financial system stability.
Equity Market
2.3.2. Capital Markets Equity markets in emerging countries remained
Positive sentiment that supported persistent capital bullish in semester I 2007, supported by strong demand
inflows stemmed primarily from well-managed inflation. from foreign investors. In early 2007, equity markets in
This provided ample room for declines in the BI-rate to emerging countries faced a correction triggered by negative
8.25% (June 2007) from 9.5% (early 2007). Capital inflows sentiment in Chinese capital markets. Also, market
emanating from foreign investment in SBI, SUN and corrections occurred due to negative sentiment stemming
domestic shares surged dramatically (over 100%) in from US inflationary pressures, especially towards the end
semester I 2007; reaching Rp58 trillion compared to Rp24.5
Table 2.1
trillion in the previous semester. Selected Regional Price Index Performance

Graph 2.45 Growth (%)


Jun 06 Dec 06 Jun 07
Capital Inflows in Government Bonds, SBI and Stocks Sem II 06 Sem I 07

Trillions of Rp
JCI 1,310.26 1,805.52 2,139.28 37.80 18.49
30 STI 2,435.39 2,985.83 3,548.20 22.60 18.83
KLCI 914.69 1,096.24 1,354.38 19.85 23.55
20
SET 678.13 679.84 776.79 0.25 14.26
10 PCOMM 3,020.13 3,940.47 5,148.42 30.47 30.65
HSCI 2,182.73 2,802.68 3,109.64 28.40 10.95
0 NIKKEI 309.54 336.39 356.40 8.67 5.95
NASDAQ 2,172.09 3,415.29 2,603.23 57.24 -23.78
-10
DJI 11,150.22 12,463.15 13,443.75 11.77 7.87
Stocks Securities Government Bonds
-20
SIASA 4,543.79 6,979.53 13,202.68 53.61 89.16
Jun Jul Sep Oct Nov Dec Jan Feb Mar Apr May Jun
KOSPI 1,295.15 1,434.46 1,743.60 10.76 21.55
2006 2007

33
Chapter 2 The Financial Sector

Table 2.2
Graph 2.46
Sectoral Price Index Performance
Regional Index Performance

6000 Growth (%)


JCI STI KLCI Jun 06 Dec 06 Jun 07
SET PCOMM HSCI Sem II-06 Sem I-07
5000
NIKKEI NASDAQ
Agribusiness 661.25 1,190.71 1,680.12 80.07 41.10
4000
Basic Industry 111.45 148.79 196.10 33.50 31.80
3000
Construction,
2000 Property, RE 77.43 120.82 211.72 56.03 75.24

1000
Consumer 299.32 390.19 437.01 30.36 12.00
Financial 142.39 204.39 223.14 43.54 9.17
0
29 12 26 9 23 9 23 6 20 4 18 1 15 29 Infrastructure 585.96 754.54 750.43 28.77 -0.54
Dec Jan Jan Feb Feb Mar Mar Apr Apr May May Jun Jun Jun

2006 2007 Mining 729.65 920.31 1,647.04 26.13 78.97


Miscellaneous 192.43 282.14 324.96 46.62 15.18
of semester I 2007. However, strong positive sentiment in Trade Service 212.68 274.28 387.38 28.96 41.24

the international market, primarily attributable to the rising


metal commodity price and the prospect of continuing US investor transactions also climbed; recording net buying
economic growth, strengthened equity markets in of Rp11 trillion in semester I 2007 compared to Rp7.5
emerging countries. In the domestic equity market, bullish trillion in semester II 2006.
sentiment stemming from the prospective future economy Strong price performance, which was only supported
drove market growth. The JSX Composite rallied 18% to by high transaction volume, led to market capitalization
reach 2,139.28 by the end of the semester. growth despite low market liquidity. Equity market liquidity
Despite rapid growth in semester II 2006, market was expected to improve in semester I 2007 with new
corrections triggered a slowdown in the indices of nearly issuances totaling Rp11.5 trillion. However, such issuances
all sectors. Improving economic prospects, which provided have, as yet, failed to stifle the strong demand of investors
space for regular interest rate reductions, have supported to invest in shares; resulting in a price bubble. The trend
rallies in the construction and real estate sectors; expanding of restricted new issuances is also due to several businesses
by 75% in semester I 2007 compared to 56% in semester opting for bond issuances, making use of strong market
II 2006. Impressive growth in the mining sector was growth momentum due to the interest rate cuts.
primarily supported by improving commodity price
performance. Index growth in the basic industrial sector Graph 2.47
Sectoral Index Performance
remained steady at around 30% supported by rising metal
2000
prices on the international market. Profit taking by foreign Agribusiness Basic Industry Construction, Property, Real Estate
1800 Consumer Financial Infrastructure
investors in the equity of the financial institutions triggered 1600 Mining Miscellaneous Trading Service

1400
a price correction. However, bullish sentiment attributable 1200
1000
to interest rate cuts strengthened share prices in the 800

financial sector. 600


400
Soaring share prices are primarily due to the high 200
0
amount of transactions. In semester I 2007, transactions 29
Dec
12
Jan
26
Jan
9
Feb
23
Feb
9
Mar
23
Mar
6
Apr
20
Apr
4
May
18
May
1
Jun
15
Jun
29
Jun
2006 2007
rose by Rp38 trillion to Rp87 trillion. In parallel, foreign

34
Chapter 2 The Financial Sector

Graph 2.48 distribution that reflects a significant drop in short-term


Stocks Transaction of Domestic and Foreign Investor
volatility in semester I 2007 with an increasing MEC value
Trillions of Rp
120 proportion of 0.75 - <1.4
Total Indonesia Foreign
100

80 Bonds Market
60 The bonds market experienced rapid growth in
40 semester I 2007, primarily supported by the lower interest
20 rate. Rapid price performance was not balanced by an
0 equivalent liquidity performance, resulting in an
Jun Sep Dec Jan Feb Mar Apr May Jun
2006 2007
excessively high price level. The position of SUN climbed
Graph 2.49
Value of Capitalization and IPO from Rp419 trillion to Rp451 trillion in semester I 2007.

Capitalization (Trillions of Rp) IPO (Trillions of Rp) The government also issued Treasury Bonds ( SPN ),
1,600 286

1,400
Capitalization Value (JSX)
Capitalization Value (SSX) 284
beginning in May 2007, totaling Rp3.9 trillion by the end
IPO Value
1,200 282 of the semester.
1,000 280

800 278
Graph 2.50
600 276 Performance of Selected Government Bonds Price
400 274
130
200 272
125
0 270
Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun 120
2006 2007 115

110
105
Although not fully able to support efficient prices, 100
95
new issuances have improved liquidity, consequently FR0040 FR0043 FR0042
90 FR0028 FR0034
FR0045 FR0044
unbundling and transferring risk in the equity market. This 85
2 16 30 13 27 13 27 10 24 8 22 5 19
Jan Jan Jan Feb Feb Mar Mar Apr Apr May May Jun Jun
is evidenced by the market efficiency coefficient (MEC)
2007

Table 2.3 The illiquid market, especially for long tenures,


Performance of Stocks Market Efficiency exacerbated by rumors surrounding a hike in the global
Semester II-2006 Semester I-2007 interest rate stemming from inflationary pressure in the
< 0,5 0,5 - <0,75 0,75 - <1 >1 < 0,5 0,5 - <0,75 0,75 - <1 >1 US, encouraged SUN primary investors, namely banking
JCI 0.80 0.20 0.00 0.00 0.15 0.43 0.43 0.00
and foreign investors, to adjust their portfolios by selling
Agribusiness 0.51 0.49 0.00 0.00 0.46 0.54 0.00 0.00
Basic Industry 0.31 0.69 0.00 0.00 0.35 0.27 0.39 0.00 overpriced SUN and buying lower priced SUN in the primary
Construction,
Property, RE 0.31 0.69 0.00 0.00 0.39 0.61 0.00 0.00 market. Furthermore, bank investors diversified
Consumer 0.33 0.67 0.00 0.00 0.37 0.27 0.35 0.00 investments in Treasury Bonds (SPN). Such behavior led to
Financial 0.47 0.53 0.00 0.00 0.36 0.64 0.00 0.00
Infrastructure 0.29 0.71 0.00 0.00 0.46 0.54 0.00 0.00 a minor correction in the SUN price.
Mining 0.34 0.66 0.00 0.00 0.39 0.45 0.16 0.00
Miscellaneous 0.42 0.58 0.00 0.00 0.34 0.66 0.00 0.00
4 Further information on the market efficiency coefficient (MEC) is available in FSR No 5,
Trade Service 0.31 0.69 0.00 0.00 0.39 0.34 0.27 0.00 September 2005.

35
Chapter 2 The Financial Sector

Graph 2.51 markets in emerging countries have been undermined by


Distribution of Government Bonds by Maturity
market corrections triggered by negative sentiment
Trillions of Rp
40
surrounding the rising global interest rate. Concerns
Fixed Rate Variable Rate
35

30
spurred a higher long-term investment yield in emerging
25 markets at the end of semester I 2007 due to the rise in
20
US dollar investment yield. Additionally, concerns have lead
15

10 to investment in financial instruments in emerging markets


5
to be short term in nature, which in turn leads to volatile
0
1 yr 3 yrs 5 yrs 7 yrs 9 yrs 11 yrs 13 yrs 15 yrs 17 yrs 19 yrs 30 yrs price performance.

Portfolio adjustments led to a decline in SUN Graph 2.53


Yield of 20-year Government Bonds of Selected Countries
ownership by banks from Rp269 trillion (early 2007) to
%
12
Rp258 trillion (end of semester I 2007). However, the
10
prospective bonds market helped maintain investor
8
demand for SUN. In semester I 2007, SUN ownership by
6
non-bank resident investors and foreign investors rose
4
from Rp87 trillion and Rp55 trillion (early 2007) to Rp97
2 Indonesia Philippines Thailand
trillion and Rp82 trillion (end of semester I 2007) Malaysia Singapore US
0
8 22 5 19 5 19 2 16 30 14 28 11 25
respectively. Jan Jan Feb Feb Mar Mar Apr Apr Apr May May Jun Jun
2007
Expectations of persistent domestic interest rate
reductions have provided positive prospects for the bonds The lower interest rate has begun to positively affect
market. High expectations were indicated by a drop in the the performance of the corporate bonds market in line
yield of long-tenure rupiah investments by 80 bps. Similar with the decline in bank lending rates. Corporate bonds
performance was witnessed on the yield of long-term issuers grew from 162 in December 2006 to 168 in June
investments in emerging Asian markets, such as Thailand 2007. The issuance value of the six new issuers reached
and Malaysia. However, the long-term prospects of bonds Rp3 trillion, whereas the issuance value of all issuers grew

Graph 2.52
Graph 2.54
Ownership of Government Bonds
Comparison of Financial Asset Price Volatility
Trillions of Rp
300
Banking Resident Foreign Malaysia
250
Thailand
200
Singapore
150
Philippines
100
Indonesia
50
US 30hr 100hr
0
Sep Oct Nov Dec Jan Feb Mar Apr May Jun 0 5 10 15 20 25
2006 2007 Percent

36
Chapter 2 The Financial Sector

Graph 2.55 Graph 2.56


IPO and Position of Corporate Bonds Mutual Funds by Type
Trillions of Rp
IPO & Position (Trillions of Rp) Issuer 80
140 170
Fixed Income Stocks Mixed Protected Index
IPO Position Issuer 70
120 168
Money Market NAV
60
100 166
50
80 164
40

60 162 30

40 160 20

20 158 10

-
0 156
Jun Sep Dec Jan Feb Mar Apr May Jun
Mar Jun Sep Dec Jan Feb Mar Apr May Jun
2006 2007
2006 2007
Source: Bapepam

by Rp18.5 trillion to Rp121.12 trillion at the end of supported a rise in equity types of funds. Meanwhile,
semester I 2007. along with the low interest rate trend, money market
Taking into account the corporate bonds that have mutual funds have suffered a decline.
matured, total issuances rose by Rp12.5 trillion. This In addition to mutual funds, investors are becoming
indicates the presence of several corporate bonds issuances more active through investment managers (IM). Funds
for refinancing purposes, primarily due to take benefits managed through IM increased 15% to Rp90.53 trillion
from the lower interest rate. in semester I 2007 (to April 2007), whereas the number
of IM rose from 90 to 94. The Rp90.53 trillion mentioned
consists of mutual funds, discretionary funds and others.
Mutual Funds The majority of the managed funds (96%) are owned by
Rapid growth in the equity and bonds markets, as domestic investors, in particular institutions.
a result of the lower interest rate, affected the The growing number of capital market instrument
performance of mutual funds. The reduced savings alternatives offered through funds management by IM has
interest rate also encouraged investors to diversify led to a less substantial decline in the interest rate of mutual
investment from term deposits to capital market funds compared to previous years. Furthermore, stricter
instruments that yield higher returns, especially mutual mutual funds regulations, specifically regarding the
funds. Net asset value (NAV) increased by 31.7% to implementation of mark-to-market and transparency
Rp67.01 trillion in semester I 2007. The rise in NAV, along aspects, have increased public knowledge of the risks
with an increase in the number of participating units, associated with mutual funds. With the prevailing
reflects additional investors. Mutual funds remain regulations, growth in mutual funds will continue to
concentrated on fixed income types with underlying become more sustainable and risk exposure to investors
assets, especially SUN . The bullish equity market further anticipated.

37
Chapter 2 The Financial Sector

Box 2.1 Financial Deepening in Indonesia

Financial deepening illustrates the development


Capital flight takes place.
of the financial sector (Lynch, 1996; Kiyotaki and Moore,
Recently, the Indonesian financial sector has
2005). It refers to the increased provision of financial
indicated signs of progress, demonstrated by rapidly
services with a wider choice of services geared to all
expanding activity in the equity market and bonds
levels of society. Financial deepening is paramount to:
market (especially SUN). In addition, foreign exchange
(i) enforce and improve financial system stability; (ii)
transactions have gradually increased to meet the
increase capital flows in the financial sector; (iii) improve
needs of market players. This is also associated with a
efficiency and the competitiveness of the financial
rapid rise in the participation of foreign investors in
sector; and (iv) broaden access to financial products
the domestic financial market.
and services, including access for the poor and
underprivileged.
To assess financial deepening, Shaw (1973) utilizes Table Box 2.1.1
Indonesia Financial Deepening Performance
the M2/GDP ratio, Claims on the Private Sector/GDP
ratio, and Fixed Capital Formation/GDP ratio. A higher M2/GDP Claims on Private Fixed Capital
Year
(%) Sectors /GDP (%) Formation/GDP (%)
ratio indicates greater financial deepening, broader use
1997 56.66 60.82 28.31
of money in the economy, or increased activity in the
1998 60.41 53.21 25.43
financial sector. The assessment can also be performed
1999 58.76 20.48 20.14
by comparing nominal finance and real finance, as well 2000 53.75 19.45 19.85
as by examining whether low or negative real rates of 2001 50.11 17.75 19.23
return are present. 2002 47.44 18.91 19.00
2003 46.93 20.95 19.29
The opposite of financial deepening is ≈shallow
2004 45.48 24.97 21.68
financeΔ (Shaw, 1973), with the following
2005 44.06 25.96 21.97
characteristics: 2006 41.40 23.86 23.97
The financial sector is dominated by banks and
Source: Bloomberg (processed).
capital flows from abroad in the form of aid/loans,
supplier credits or direct investments.
Table Box 2.1.2
Low or negative real rates of return. As a result, the Indonesia Financial Deepening Performance
owner of financial assets fails to effectuate a gain
Nominal Finance
from real growth in the portfolio; instead suffering Year Real Finance Index
Index
a loss. 2000 1.00 1.00
The economy relies heavily on the government»s 2001 1.13 0.97
budget and international capital accounts. 2002 1.18 0.96
2003 1.28 0.99
Demand for financial assets is constrained by a low
2004 1.38 1.01
real interest rate, whereas supply is restricted by 2005 1.61 1.03
credit rationing. 2006 1.85 1.02
Domestic money is over-valued in the foreign Source: The result is processed from Bank Indonesia data. Index is calculated by
using year of 2000 as a base year, following real GDP calculation which use year of
exchange spot market. This does not encourage 1000 constant price. Real finance is calculated by using Consumer Price Index (CPI)
from related year as deflator.
exports and savings but promotes imports and
consumption.

38
Chapter 2 The Financial Sector

Table Box 2.1.3


Indonesia Real Rates of Return

Time Deposits Yield SUN Yield SUN Real Rates of Returns Real Rates of Returns Real Rates of Returns
Year
Interest Rate (%) FR05 (%) FR21 (%) Time Deposits (%) SUN FR05 (%) SUN FR21 (%)
2000 12.17 n.a n.a 2.82 n.a n.a
2001 15.48 n.a n.a 2.93 n.a n.a
2002 15.28 14.79 n.a 5.25 4.76 n.a
2003 10.39 12.16 13.07 5.29 7.06 7.97
2004 7.07 8.66 10.27 0.67 2.26 3.87
2005 10.95 13.25 13.30 -6.15 -3.85 -3.80
2006 11.63 8.31 9.36 5.03 1.71 2.76
Sources: Bloomberg and Bank Indonesia (processed)

However, financial deepening in Indonesia In order to discuss measures to advance financial


remains unsatisfactory, as reflected by the M2/GDP deepening in Indonesia, an International Seminar was
ratio, Claims on the Private Sector/GDP ratio and the held in Bali on 22-24 August 2007 entitled ≈Financial
Fixed Capital Formation/GDP ratio that tend to keep Sector Deepening and Financial Stability: Benefits and
decreasing (Table 2.1.1). Other indicators include far ChallengesΔ. Learning from the experiences of other
lower real finance compared to nominal finance. For countries presented at the seminar, the importance
example, M2 growth value in 2006 was 85%, of financial deepening in Indonesia is obvious.
however, the real value was only 2% (Table 2.1.2). However, it should be undertaken while exercising
Furthermore, using data for the term deposit interest caution to avoid disrupting financial system stability.
rate level and yields of SUN series FR05 and FR21 as To this end, several research proposals are currently
an example, the real rates of return are lower and under discussion.
even negative in certain years (Table 2.1.3).
Other factors indicating Indonesia»s ongoing References:
problems in terms of financial deepening include: (i) Kiyotaki, N. and Moore, J. (2005), ≈Financial
an ineffective bank intermediation function; (ii) DeepeningΔ, Journal of the European Economic
relatively expensive cost of funds; (iii) unavailability of Association, 3(2-3): 701-713.
long-term funding sources; (iv) limited financial Lynch, D. (1996), ≈Measuring Financial Sector
instrument alternatives offered by financial institutions; Development: A Study of Selected Asia-Pacific
and (v) underdeveloped hedging and derivatives CountriesΔ, The Developing Economies, 34(1):3-
markets. Notwithstanding, access to financial products 33.
and services for the poor and underprivileged remains Shaw, E. S. (1973), Financial Deepening in Economic
limited. Development, Oxford University Press, London.

39
Chapter 2 The Financial Sector

Capital Inflows and Sudden Reversal: Are We Ready to


Box 2.2
Face a Crisis?

Resurgent capital inflows to Indonesia recently instigate a price drop in SUN, therefore, any banks
have spurred concerns regarding a repeat of the that own SUN would incur losses.
financial crisis that took place exactly 10 years ago. In terms of second round effects, a sudden
Though no one can accurately predict when a crisis reversal would spark a rise in foreign exchange NPL,
will hit, it is imperative to analyze the possibility of which would, in turn, trigger a subsequent rise in
its occurrence and our readiness to confront the rupiah NPL as debtors of foreign exchange loans
crisis. usually also have outstanding rupiah loans. Disruptions
The most troublesome factor of any rise in capital in liquidity would magnify as rupiah depositors would
inflows is a sudden reversal, which could trigger a probably also withdraw their money to speculate in
recurrent crisis. Such concerns are warranted since the foreign exchange. As a result, the rupiah would be
majority of short-term capital inflows are generally further weakened and a new crisis could be imminent.
invested in SBI, SUN and equity shares. With investment How ready is Indonesia to face a crisis? Learning
in short-term instruments, foreign investors can quickly from the 1997/1998 crisis experience, numerous
divert investment away from Indonesia. improvement measures have been taken to better
What factors could trigger a sudden reversal? prepare this country. Furthermore, resilience in the
Generally, there are two groups of triggers: economic financial system is currently much more robust
and non-economic factors. Economic factors include: compared to the pre-crisis period. Several of the salient
(i) a narrowing interest rate differential; (ii) low yield accomplishments made by the banking industry post-
that makes investing in Indonesia unattractive; and (iii) crisis include:
contagion from other countries. Examples of non- Bank capital over the past few years has been far
economic factors include political turmoil and higher compared to pre-crisis levels, which can act
homeland security. To avoid a repeat crisis, it is essential as a buffer against any ≈shocksΔ. Profitability is
to take measures to eliminate, or at least minimize, also better compared to pre-crisis levels.
the presence of such triggers. Credit quality continues to improve, as reflected
The effect of a sudden reversal can generally be by the declining NPL ratio, contrary to the pre-crisis
witnessed from at least two perspectives, namely (i) period when credit quality persistently deteriorated.
First Round Effects; that directly affect a bank»s financial Banks have implemented a better risk-
position or which are micro in nature; and (ii) Second management function in their daily operations.
Round Effects; or follow-through effects that are Risk management was not implemented pre-crisis.
indirect in nature to a bank»s individual financial position Banks have also implemented good corporate
and the banking industry (macro). governance principles; something that was
First round effects create losses for a bank due abandoned prior to the crisis.
to the repricing of foreign exchange assets/liabilities, The current level of bank Net Open Position (NOP)
and disrupting liquidity supply in the fulfillment of the is only 3% to 5%; very low compared to pre-crisis
foreign exchange need. In addition, first round effects levels. Furthermore, the use of derivative
can also trigger losses on a securities trading portfolio. transactions is less active than before the crisis.
For example, excessive selling by foreign investors could Now, they are generally only used for hedging and

40
Chapter 2 The Financial Sector

Graph Box 2.2.1. Graph Box 2.2.2.


Pre and Post Crisis of NPL & CAR Foreign Exchange Loans Performance
Trillions of Rp USD/Rp
%
700 12,000
55.0
Credit of Foreign Exchange
Pre Crisis Recovery 600
45.0 Credit of Rupiah 10,000
Exchange Rate (right)
35.0 500
8,000
25.0 400
15.0 6,000
Crisis 300
5.0 4,000
200
-5.0
100 2,000
-15.0
NPLs Gross CAR
-25.0 0 0
1996 1998 2000 2002 2004 2006 1995 1997 1999 2001 2003 2005 2007

matching positions, not for the purpose of trading Indonesian Deposit Insurance Corporation (LPS) to
as occurred prior to the crisis. protect customer deposits. Prior to the crisis,
Currently there is good compliance to the legal Indonesia did not have such a safety mechanism.
lending limit, whereas approaching the crisis there International foreign exchange reserves far exceed
were numerous legal lending limit violations pre-crisis levels and are following a growing trend.
(especially by related parties). Financial system resilience is more robust due to
Post crisis, bank risks have relatively been reduced greater foreign exchange reserves.
and diversified along with: (i) a shift in credit focus Post crisis, Indonesian Banking Architecture (API)
from long-term to short-term tenors, or from was compiled, comprising of programs such as
corporate loans to micro, small and medium bank consolidation, compulsory risk-management
enterprise (MSME) loans; (ii) a shift from industrial certification for banks, improvement in operational
sector credit to trade sector credit; (iii) credit quality and bank management, and best practices
denominated in foreign currency, which is sensitive for bank supervision.
to exchange rate fluctuations, has remained steady The progress outlined above offers strong
at around 20% - 23% of total loans; and (iv) the indications that the Indonesian financial sector,
rise in bank placements in SBI and SUN. especially the banking industry, is comparatively more
Additional factors accomplished post crisis and resilient. Therefore, this country is now better prepared
which further bolster financial system resilience include: to face numerous worst-case scenarios that could
The institution of a Financial Sector Safety Net disrupt financial system stability, including a sudden
(FSSN), including the establishment of the reversal that could trigger a crisis.

41
Chapter 2 The Financial Sector

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42
Chapter 3 Prospects of the Indonesian Financial System

Chapter 3
Prospects of the Indonesian
Financial System

43
Chapter 3 Prospects of the Indonesian Financial System

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44
Chapter 3 Prospects of the Indonesian Financial System

Chapter 3 Prospects of the Indonesian Financial System

Strong bank capital, favorable macroeconomic indicators and robust corporate


profitability underpinned relatively stable financial system performance in
Indonesia during semester I 2007. However, the surge in short-term capital
inflows to the capital market, various pressures stemming from the global
market with the potential to trigger a sudden reversal, and potential risks
emanating from domestic-bank-allocated credit require consistent and
constant vigilance.

3.1. ECONOMIC PROSPECTS AND RISK PERCEPTION Foreign investors still consider economic conditions
Economic prospects remain positive with the in Indonesia attractive and relatively stable. Therefore, both
potential to improve in the future. Consensus forecasts long and short term investment flows are forthcoming,
for the Asia/Pacific region also indicate prospective
Table 3.2
economic growth supported by the expansion of
Indonesian Risk Perception
international trade and a controlled inflation rate at about
Yield Spread (bp)
6%. Such conditions are expected to act as an impetus Bonds Rating Y-t-m (%)
June December
for real sector development and improve economic Indo 14 BB- 6.57 196.5 114.8
resilience against risks to financial system stability. Hedge Indo 17 BB- 6.74 203 124
Indo 35 BB- 7.34 245.6 177.4
fund investment has proliferated, due partly to macro
Source: Bloomberg
stability and attractive yields, which has compensated the
Graph 3.1
decline in global investment credit spread.
Yield Curve
%
12

Table 3.1 10
Concencus Forecast of Selected Economic Indicators
8

2007 2008
6
Q-I Q-II Q-III Q-IV Q-I Q-II Q-III Q-IV
4
3/30/2007
GDP (% y-o-y) 6.0 6.3 6.1 6.1 6.2 6.0 6.1 6.0
6/29/2007
2 Log. (6/29/2007)
Inflation (% y-o-y) 6.4 6.0 6.3 6.5 6.3 6.5 6.4 6.3
Log. (3/30/2007)
Balance of Trade (Billions of USD) 8.0 9.3 8.7 9.5 9.4 9.6 9.5 10.3 0
1 3 5 6 7 8 9 10 15 20
Source: Asia Pacific Concensus Forecast Years
Source: Bloomberg

45
Chapter 3 Prospects of the Indonesian Financial System

which in emerging market countries take the form of interest rate risks are more alleviated than market risks
bonds, leveraged lending and structured credit products. linked to the price of SUN. This is because the volatility in
However, vigilance remains critical as an interest rate hike the global market can directly influence the SUN price,
in other developing or even developed countries of 200 which is beyond the control of management.
bps could trigger fund migration, which would affect The concentration on short-term deposits, large
economic growth in Indonesia. depositors and individually owned deposits can trigger a
rise in liquidity risk. Banks have consequently opted for
3.2. BANK RISK PROFILE: LEVEL AND DIRECTION low-risk placements in securities to mitigate liquidity risk.
Banks remain stable although the bank Such measures have had significant results in minimizing
intermediation function is still sub optimal. Such conditions liquidity risk with the risk control system deemed as
have encouraged banks to strengthen their capital with acceptable and is expected to improve in the future.
CAR at 21.4% and ROA at 2.8%. However, the relaxation Credit risk remains moderate amidst restructuring
of regulations, undertaken to encourage banks to extend efforts and an expansion of credit allocation due to better
credit, requires caution to avoid an increase in non- credit access for infrastructure projects. However, the
performing loans. protracted restructuring process of major debtors may
Market risks (exchange rate risks) remain low. Future inflate restructuring costs, therefore, credit risk is expected
risks are expected to remain immaterial due to the banks» to intensify in the future. Credit risk may also emerge from
insignificant foreign exchange portfolio, as reflected by imperfect credit risk management that requires further
the low net open position. However, interest rate risks refinement, as well as weaknesses in the bank credit
are moderate due to the bank maturity profile being management information system.
sensitive to swings in the interest rate. In addition, financial In terms of operational risk, Indonesian banks remain
instruments used to hedge interest rate risks remain limited, beset with various challenges, such as the existence of
which can be attributed to the under-developed domestic some banking crime cases and issues related to information
hedging and derivatives markets. technology. In addition, natural disasters such as floods
Similar to interest rate risks, market risks associated and earthquakes, as well as various other disruptions have
with the SUN price also remain moderate. However, crashed the telecommunications system. However, such

Graph 3.2
Risk Profile of Banking Industry and Its Direction
Market Risk Liquidity Risk Credit Risk

Semester-I 2007 Semester-I 2007 Semester-I 2007


High

Outlook Outlook Outlook


Inherent Risk
Moderate

Interest
Rate Government Bonds
Price
Low

Exchange Rate

Strong Acceptable Weak Strong Acceptable Weak Strong Acceptable Weak


Risk Control Risk Control Risk Control

46
Chapter 3 Prospects of the Indonesian Financial System

disruptions have not yet incurred significant losses or Graph 3.3


Financial Stability Index
reduced public confidence in banks. Another challenge
faced by banks is measuring operational risk and 3.5
FSI FSI Average
3
formulating appropriate risk mitigation tools. This is
2.5
primarily due to data limitations and relatively low Estimation
2

competence in some banks. Basel II implementation is 1.5

expected to boost competence and capacity in measuring 1

0.5
and controlling operational risk.
0
M8 M10M12M2 M4 M6 M8 M10M12 M2 M4 M6 M8 M10M12M2 M4 M6 M8 M10M12 M2 M4 M6 M8 M10M12
2003 2004 2005 2006 2007
3.3. PROSPECTS OF THE INDONESIAN FINANCIAL
SYSTEM the US market cause problems in other countries. This
The financial system is expected to remain stable and was evidenced by the subprime mortgage crisis in the US,
outperformed conditions as per year end 2006. This is which spread to Australia, Germany as well as other
reflected by a decline in the financial stability index (FSI) countries.
from 1.37 to 1.21 (see Box 3.1). Stability is supported by Despite several stock exchanges returning to normal,
improving macroeconomic conditions, healthy banks, as the potential for upcoming shocks remains significant.
well as robust equity and bonds markets. Financial system Higher inflation in China, an increasing global interest rate
resilience in the upcoming quarter is expected to remain and the soaring international oil price, which peaked at
strong, reflected by FSI simulations that projected 1.25 USD70.68 per barrel in semester I 2007, are considered
(December 2007). the primary sources of potential shocks and must be
The greatest potential risk faced by Indonesia is the monitored and mitigated to avoid aggravating conditions
result of burgeoning short-term foreign capital inflows to in Indonesia. Contagion in the Jakarta Stock Exchange
the bubbling capital market. This is a phenomenon where could force investors to withdraw funds or migrate to
capital can migrate swiftly across state borders and is instruments in the global money market. However,
attributable to three key aspects: (i) growth in assets pressures are expected to be temporary in nature and, thus,
managed by investment managers; (ii) a change in continuous supervision and vigilance is required to
investment behavior away from ≈home-biasΔ; and (iii) anticipate and mitigate potential risks.
innovation and progress in banking and corporate risk As mentioned earlier, results of stress tests on market
management. Hedge fund growth is projected to reach risk in banks indicate relatively strong resilience.
US$1.4 trillion. Their focus of obtaining absolute income Meanwhile, a stress test conducted on a sample of 35
affects hedge fund investment decisions in emerging major conglomerates/large corporations in Indonesia with
markets. foreign exchange liabilities demonstrated that their capital
The rise in capital flows between financial markets is sufficient to absorb exchange rate risk with the rupiah
avails that the inter-state market is borderless. For example, depreciating to Rp11,500/USD. Should the rupiah devalue
the bonds and equity markets in Europe, Japan and the further, however, more than one conglomerate/large
US are closer now compared to a decade ago. Pressures in corporation would struggle with capital.

47
Chapter 3 Prospects of the Indonesian Financial System

Graph 3.4
Non Financial Public Listed Companies Probability of Default

70 70
December 2006 December 2007
60 60

50 50

40 40

30 30

20 20

10 10

0 0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Probability of Default Probability of Default

The results of probability of default (PD) estimations manufacturing (8.5%). Credit extension by banks is
for a sample of 219 non financial public listed companies planned to expand by 22% on average, supported by
indicated that the number of companies with a PD of more growth in deposits. Increased activity in the capital
than 0.5 will rise slightly; from 66 companies at the end of market, especially through corporate issued bonds, will
December 2006 to 69 at the end of December 2007 (see foster real sector performance.
Box 3.1). This indicates that credit risk in the future will
increase a little. The estimation results are consistent with 3.4. POTENTIAL VULNERABILITIES
previous analyses showing a small increase in upcoming Financial system resilience in Indonesia will remain
credit risk. However, existing provisions and strong bank robust in the future. Externally, however, volatility persists
capital is expected to absorb the projected rise in credit stemming from sluggish global economic growth, a soaring
risk. oil price and short-term capital inflows. The effectiveness
In the future, GDP growth and the low interest of measures to resolve the subprime mortgage crisis
rate are expected to boost the business activities of undertaken by relevant monetary authorities of affected
banks. The sectors projected to exceed average countries could also influence financial stability in
economic growth include construction (10.2%), Indonesia. Internally, volatility could arise from the
transportation and communications (9.7%), and upcoming election, which is expected to affect business
activities and risks in the financial sector. In particular,

Table 3.3 undesirable security conditions could trigger capital


Impacts of Exchange Rate to Conglomeration Equity outflows.
Number of Conglomeration Which Have Meanwhile, banks will face intricate challenges, such
Exchange Rate
Difficulties in Their Equity
as resolving the credit restructuring, refining risk
Until Rp.11,000/USD 0
Until Rp.11,500/USD 1
management, upgrading the credit management
Until Rp.12,000/USD 2 information system, as well as synchronizing efforts to
Until Rp.13,000/USD 7
Until Rp.15,000/USD 10
improve the bank intermediation function and reduce
Until Rp.17,000/USD 14 credit risk. Other challenges include the development of a
> Rp17,000/USD 35
contingency plan to ease operational risk as well as

48
Chapter 3 Prospects of the Indonesian Financial System

improving the effectiveness of internal controls and To reduce risk in the financial system close
corporate governance in order to reduce vulnerabilities in coordination between Bank Indonesia and the Government
the banking industry. Compliance to the minimum core is required. As discussed in the following chapter, one joint
capital requirement of Rp80 billion by the end of 2007 initiative is the establishment of the Financial System
and Rp100 billion by the end of 2010 will also be a Stability Forum (FSSF), which aims to act as a medium to
challenge for a few banks as it could affect their risk exchange information and resolve risks in the economy
management capacity. that could trigger a crisis.

49
Chapter 3 Prospects of the Indonesian Financial System

Box 3.1 Financial Stability Index and Probability of Default

Financial Stability Index Utilizing monthly data from the Monthly Report
The Financial Stability Index (FSI) is an indicator of Commercial Banks (LBU), Bloomberg and CEIC, each
used to assess financial stability performance in a equation is calculated using the Three Stage Least
country. FSI is established upon three primary blocks in Squares (3SLS) method. In this Review, the observation
the Indonesian financial sector: banks, the equity period is from January 2003 to June 2007. The validity
market and bonds market (see Hadad et al., 2007). of the estimation results on the endogenous variables
The three blocks correlate with one another and their are tested using root mean squared error, mean
interactions affect financial stability. Each block is absolute error, mean absolute percentage error, and
represented by a set of behavioral equations, whereas theil inequality coefficients. The results are then
inter-block relationships are explained using an identity weighted to form the FSI. Considering that banks
equation. The equations are written as follows: dominate the financial sector, greater weight is
allocated to banking indicators, i.e. NPL. Estimation
Behavioral Equations: results for this model can be used to predict FSI up to
Bank Block: Non-Performing Loans one year in advance.
npl = f[rlnd, log(income), (rlnd-sbi)]
Equity Market Block: Jakarta Composite Index (JCI) Probability of Default
Log(ihsg) = f[log(ihsg(-1)), log(income), rlnd, log(er)] Probability of default (PD) is used to predict the
Bonds Market Block: Government Yield Bonds (5 Years) probability of a default occurring (failure to meet
yield5yr = f[rdep1m, log(income), log(er)] company liabilities) in the future. In this Review, the
Barrier Option method is used to estimate a PD, which
Identity Equation: models company asset behavior towards its liabilities
Income = cons + inv based on balance sheet data. This method is preferable
since it can calculate individual company»s PD using
Explanation of Variables: only limited data, whereas other models require larger
quantities of data. This method is also suitable to
Variable Description measure a PD for an economic sector or for an industry
with specific characteristics.
(rlnd-sbi) Difference between lending rate and SBI
Log(er) Nominal exchange rate (Rp per USD)
The Barrier Option method is based on the
Log(ihsg) Jakarta Composite Index Merton (1974) approach where assets are assumed
Log(income) Aggregate income; consumption and to follow Brownian Motion, a stochastic process with
investment sectors
a continuous time frame limited by the Random Walk
Npl Non performing loans
Rdep1m 1-month deposit interest rate process. The Barrier Option method can determine the
Rlnd Lending rate probability of an asset»s value dropping to a specified
Sbi 1-month SBI rate threshold. The threshold in this regard is the company»s
Yield5yr Government yield bond, 5 years
Cons Consumption
liabilities. This approach is deemed superior to the usual
Inv Investment option approach as it can be used to calculate the

#) log : natural logarithm


likelihood of an asset»s value reaching its specified
##) ≈(-1)Δ : value of in the previous period threshold prior to the asset»s maturity date.

50
Chapter 3 Prospects of the Indonesian Financial System

In this Review, data for total assets and total public listed companies on the Jakarta Stock Exchange
liabilities is taken from a sample of 219 non financial at the end of December 2005 and 2006. Based on
total asset data, estimations are made based on
Graph Box 3.1.1. average asset growth and its corresponding volatility
Probability of Default - Barrier Option Methods values. The results are subsequently used to calculate
a PD up to 1 year ahead. To calculate a PD for the end
Asset
of 2006, company balance sheet data for the end of
Possible asset December 2005 is used. Likewise, to calculate a PD
value path
for the end of December 2007, data for December
2006 is used. Estimation results indicate that the
number of companies with a PD of greater than 0.5
at the end of 2007 is slightly higher than the position
Default at the end of 2006.
Point
t* T
Default Event References
Source: Reisz and Perlich (2007)

Crosbie, P. (2003), Modeling Default Risk; Modeling


Methodology, Moody»s KMV, 18 December 2003.
Graph Box 3.1.2.
Hadad, M.D., Safuan, S., Santoso, W., Besar, D.S., and
Probability of Default - Common Option Methods
Rulina, I. (2007), ≈Macroeconomic Model to
Distribution Measure Financial Stability Index: The Case of
Asset of asset value
Possible
asset value
at the horizon IndonesiaΔ, Financial Stability Review (FSR), II -
path
2006 No.8, March 2007.
Merton, R.C. (1974), ≈On the Pricing of Corporate
Vo
Debt: The Risk Structure of Interest RateΔ, Journal
of Finance, 29:449-470.
Default
Point
Reisz, A. S. and Perlich, C. (2007), ≈A Maket-Based
Probability of
Default Framework for Bankruptcy PredictionΔ, Journal of
0 H
Financial Stability, doi:10.1016/j.jfs.2007.02.001.
Source: Crosbie (2003)

51
Chapter 3 Prospects of the Indonesian Financial System

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52
Chapter 4 Financial Infrastructure and Risk Mitigation

Chapter 4
Financial Infrastructure
and Risk Mitigation

53
Chapter 4 Financial Infrastructure and Risk Mitigation

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54
Chapter 4 Financial Infrastructure and Risk Mitigation

Chapter 4 Financial Infrastructure and Risk Mitigation

Reliability of the payment system, which represents Indonesia»s prime financial


infrastructure, was maintained and, consequently, bolstered financial system
stability throughout semester I 2007. The payment system functioned well
despite a rise in transaction volume and value. Meanwhile, efforts to strengthen
the Financial System Safety Net (FSSN) were continued. Refinements were
made to the Financial System Stability Forum (FSSF), which began operation
in semester I 2007. In the future, FSSF will also be responsible for coordinating
the implementation of the Financial Sector Assessment Program (FSAP) as
well as Indonesian Financial System Architecture (IFSA).

4.1. PAYMENT SYSTEM million) are settled through BI-RTGS, the payment system
The payment system in Indonesia remained reliable is dominated by BI-RTGS. The BI-RTGS system accounted
with no demonstrable risks to disrupt financial system for 92.85% of settlements in semester I 2007, with the
stability. Furthermore, default risk in the payment system clearing system making up 3.50% and the balance settled
was greatly minimized. outside of Bank Indonesia. Transactions through BI-RTGS
during the reporting period increased in value and volume
Graph 4.1
Activities of Payment System Transaction compared to the previous semester. Transaction value in
Semester I 2007
semester I 2007 reached Rp22.09 thousand trillion; up
Credit Card Clearing Account Based Card (ATM, RTGS
ATM+debet & debet)
38.03% over the previous semester (Rp16.01 thousand
3.50%
0.18% trillion). The volume for the semester totaled 3.87 million
3.48%
transactions; up 6.48% compared to the previous semester
(3.63 million transactions).

Table 4.1
BI-RTGS Settlement Performance (in Value and Volume)
92.85%
Growth
Semester II-2006 Semester I-2007
q-t-q
A rise in settlement volume and market share Transaction Transaction Transaction Transaction Value Volume
indicated that Bank Indonesia»s real-time gross settlement Value Volume Value Volume
(thousand (thousand
system (BI-RTGS) played a more important role in the trillions) (millions) trillions) (millions)

payment system. Since all major transactions (>Rp100 Rp 16.01 3.63 Rp 22.09 3.87 38.03% 6.48%

55
Chapter 4 Financial Infrastructure and Risk Mitigation

The rise in settlement value and volume was primarily fund transfers could be performed rapidly at relatively
attributable to the hike in money market transaction value. low cost.
Money market activity still represents the largest share of Meanwhile, the use of payment card instruments
BI-RTGS. The value of transactions in the money market (APMK) is expanding, not only in volume and value, but
topped out at Rp9.16 thousand trillion in semester I 2007; also in the types and the number of cards available.
a rise of 58.45% over the previous semester. Although Currently, APMK cards include credit cards, ATM cards as
the volume of transactions in the money market represents well as ATM cards that also function as debit cards
a mere 1.19% of total RTGS transaction volume, the share (ATM+Debit). To the end of the reporting semester, the
of total transaction value in BI-RTGS is 41.46%. number of all three card types outstanding was 40.46
Growth in inter-bank transactions also continued million cards with a transaction volume of 809.22 million
apace. Inter-bank transaction value in semester I 2007 and transaction value of Rp1.103 thousand trillion. Of the
reached Rp9.72 thousand trillion; up 36.32% over the three card types, ATM+Debit cards represent the largest
previous semester. Considering total transactions in BI- market share in number, value and transaction volume.
RTGS this past semester, inter-bank transactions constitute The number of ATM+Debit cards in the market at the end
the largest share with 44.01% of total transaction value of semester I 2007 was 29.63 million cards or 73.23% of
and 86.66% of total transaction volume. Inter-bank total cards, with a volume and transaction value share of
transactions primarily consist of trading on securities; rising 61.95% and 66.07% respectively.
by Rp586.81 trillion, or 81.04%.
Settlements processed through clearing also ran Table 4.2
Card Based Payment Transaction
smoothly. Implementation of the Bank Indonesia National
Total Transaction Transaction
Clearing System (BI-NCS) began in 2005 and, up to Cards Type Cards Volume Value
(millions) (millions) (trillions)
semester I 2007, covered 36 Bank Indonesia branch office
Credit Card 8.44 62.01 33.05
areas and 28 non branch office areas. Clearing is grouped ATM Card 2.39 245.86 341.46
ATM + debet Card 29.63 501.29 729.39
into the following cycle: credit clearing I, credit clearing II
Total 809.22 1,103.89
and debit clearing (comprising of incoming and return
clearing). Credit clearing is performed centrally in Jakarta
whereas debit clearing is performed locally in each Bank Default risk in the payment system has been further
Indonesia branch office region; however, settlements are minimized. Currently, only 3.72% of transactions in the
still centralized. The value of credit clearing transactions Indonesian payment system are not covered, due to the
through BI-NCS in the reporting semester totaled use of «no money no game» principles in BI-RTGS and the
Rp170.26 trillion comprising of 18.01 million transactions, implementation of failure-to-settle (FtS) in BI-NCS. As
while the value of debit clearing transactions using regulator, Bank Indonesia has intensified risk mitigation
cheques and giro instruments amounted to Rp466.76 efforts in the payment system through the ratification of
trillion consisting of 19.85 million transactions. Full BI- appropriate regulations. Such regulations include
NCS implementation in all domestic regions would have prudential principles and customer protection, as well as
an immense stimulatory impact on economic activity as enhanced security to safeguard payment card activity.

56
Chapter 4 Financial Infrastructure and Risk Mitigation

4.2. PAYMENT SYSTEM POLICY AND RISK important payment system (SIPS). Thus, the BI-RTGS
MITIGATION system is a prime concern in terms of payment system
Bank Indonesia continued its risk mitigation efforts oversight. BI-RTGS system oversight is necessary to
throughout semester I 2007, and close attention was paid ensure that BI-RTGS system implementation is
to the intensification of payment system reliability. Efforts performed accurately, securely and in a reliable fashion
focus on four salient principles: risk minimization, efficiency in order to support financial system stability in
optimization, access equality and customer protection. compliance with customer protection principles.
Several payment system policies instituted and BI-RTGS system implementation involves two parties,
accomplishments made in semester I 2007 are outlined as namely Bank Indonesia as administrator, and the
follows: participants. BI-RTGS system oversight previously only
1. Intensification of BI-RTGS Adherence to Core focused on the participants; however, during the past
Principles for Systemically Important Payment Systems semester oversight has also focused on the
(CP SIPS) administrator. Oversight of the administrator
Core Principles for Systemically Important Payment concentrates on an overall assessment on BI-RTGS
Systems (CP SIPS) is an international standard issued system implementation based on security, efficiency,
by the Bank for International Settlements (BIS), customer protection, compliance to prevailing
through the Committee on Payment and Settlement regulations, agreed implementation standards and
Systems (CPSS). CP SIPS stipulates the principles current payment system policies.
necessary in designing and operating a payment 3. Business Continuity Plan (BCP) for BI-RTGS
system in each country. Based on the results of self- Bank Indonesia continues to build the capacity and
assessment of the BI-RTGS system, performed in competence of human resources (HRD) under
semester II 2006, several core principles (CP) are yet emergency conditions for BI-RTGS participants. This
to be met by BI-RTGS. To this end, Bank Indonesia is carried out through routine BCP tests. The continuity
has refined the application of BI-RTGS system as well of the BI-RTGS system for both the administrator and
as related regulations. In terms of application, security the participants requires not only infrastructure
features of BI-RTGS are in the process of being reliability (application, hardware and network), but
upgraded. In particular, improvements have been also on the availability of a competent human
made to BI-RTGS system reliability regarding system resources department (HRD) that fully comprehends
availability during operational hours; both the main all procedures involved in the contingency plan. To
system and backup. Regulations have been refined this end and in accordance with one of the
by explicitly defining Bank Indonesia»s role in running recommendations of the self-assessment, Bank
BI-RTGS, namely as regulator, administrator and Indonesia routinely tests the preparedness of all
supervisor of the BI-RTGS system. participants using BCP testing. In addition, to improve
2. Oversight of BI-RTGS the readiness of the backup system, Bank Indonesia
BI-RTGS oversight is intensified to ensure system facilitates periodic backup tests for the participants.
reliability. The BI-RTGS system is a systemically To improve infrastructure awareness from the

57
Chapter 4 Financial Infrastructure and Risk Mitigation

administrator»s side, Bank Indonesia regularly tests the participant. As administrator and participant, Bank
BI-RTGS system through the backup system at the Indonesia faces potential risks including financial,
Disaster Recovery Centre (DRC). reputation and legal risks emanating from operational
Regarding emergency procedures, Bank Indonesia will problems caused by system disruptions and human
refine regulations on alternatives to transaction error. To alleviate the possibility of human error, Bank
settlement through the BI-RTGS system in order to Indonesia regularly conducts risk assessments to
enable participants to maintain operations in case of identify factors that can trigger operational problems,
a system shutdown. This will reduce the potential risks and their impacts, and the anticipatory measures
systemic risk of one participant»s downtime on the required. These are performed using a number of
whole system. Improvements include additional methods, one being Control Self Assessment (CSA).
alternative transaction settlement mechanisms that 6. National Black List ((DHN
DHN
DHN))
can be used by the participants in emergency Through the implementation of customer protection
conditions. Previously only the Bank Indonesia Giro principles and to maintain public confidence in cheque
Account ( BGBI ) was available, however, Bank and giro accounts as payment instruments, Bank
Indonesia intends to provide a backup RT system at Indonesia introduced a new regulation on a National
Bank Indonesia head office to be used by participants Black List (DHN) of dishonored cheques and giro using
in an emergency. a different method compared to the previous
4. Security Upgrades for Payment Cards (APMK) regulation. An additional clause was attached to the
Bank Indonesia amended payment card regulations terms and conditions of checking accounts governing
governing APMK online reporting. As a result, indirect the use of cheques and giro as well as a bank»s
oversight of payment cards was simplified. In addition, obligations in terms of the DHN in order to improve
this has lead to improved customer protection. customer protection.
Furthermore, payment card information is now more Furthermore, Bank Indonesia also amended the way
up to date so that policy making is more akin to the the DHN is administrated. Under the previous
rapid nature of payment cards. Apart from indirect regulation, the black list was managed by Bank
oversight through APMK report analysis, Bank Indonesia whereas the new regulation stipulates that
Indonesia also conducts direct oversight on APMK each bank manage the black list. This method was
administrators to ensure the risks of APMK activities implemented because individual banks are generally
are not allowed to crystallize. Aware of the potential better at identifying their own customers»
risk of card fraud and misuse, Bank Indonesia will strive characteristics than Bank Indonesia. In addition, the
to mitigate risk by implementing chip technology for method also improves the banks» awareness of Know
ATM cards and debit cards in the future. Your Customer (KYC) principles.
5. Risk Assessment and Risk Management in the
Payment System 4.3 FINANCIAL SECTOR SAFETY NET (FSSN)
Bank Indonesia has two roles in the BI-RTGS system Implementation of the financial sector safety net
and clearing system, namely as administrator and (FSSN) continued in earnest during semester I 2007 in order

58
Chapter 4 Financial Infrastructure and Risk Mitigation

to increase financial sector resilience, particularly the coordination and information exchange between Bank
banking sector. The current structure of the safety net has Indonesia and LPS listing five key aspects regarding the
been included in a draft act that comprehensively includes: deposit insurance scheme, bank oversight and the handling
(i) regulations and supervision of institutions and financial of unhealthy banks, namely: (i) implementation of the
markets; (ii) lender of the last resort facility; (iii) deposit deposit insurance scheme; (ii) handling of problem banks;
insurance program; and (iv) crisis management. (iii) resolution and/or handling of failed banks, (iv) follow-
The deposit insurance scheme administered by the up on banks with revoked license; and (v) deciding an
Deposit Insurance Corporation (LPS) and the Emergency appropriate interest rate level for claims to be paid. With
Funding Facility (EFF) are two of the most important the signing of the MoU between Bank Indonesia and LPS,
components of FSSN. In terms of the deposit insurance Indonesia is approaching completion of its legal
scheme, LPS has resolved claims from the customers of infrastructure and a clear guide to prevent and overcome
nine rural banks that were closed in 2005 and 2006. financial crises.
Meanwhile, although EFF has been in effect since 2005,
to date no bank has made use of the facility. To some 4.4. FINANCIAL SYSTEM STABILITY FORUM (FSSF)
extent, this reflects sound bank conditions and the absence Coordination to maintain financial system stability
of systemic liquidity problems. can be achieved through the Financial System Stability
th
On 29 June 2007, the Governor of Bank Indonesia Forum (FSSF). FSSF was established on 30th December 2005
(BI) and the Chairman of LPS signed a Memorandum of through a Joint Decree between the Minister of Finance,
Understanding (MoU) as a part of the efforts to strengthen the Governor of Bank Indonesia and the Chairman of the
the Financial Sector Safety Net (FSSN). The MoU regulates Deposit Insurance Corporation (LPS). A recent reshuffle in

Table 4.3
Structure and Membership of Financial System Stability Forum (FSSF)

Forum Members

Directive Forum works to provide directions Ministry of Finance


for the Executive Forum - Director General of Financial Institutions
- Director General of The Treasury
- Head of the Economic Policy, Finance and International Cooperation Body.

Bank Indonesia
- Senior Deputy Governor
- Deputy Governor of Banking Research and Regulations
- Deputy Governor of Bank Supervision
Deposit Insurance Corporation
- Executive Director of the Deposit Insurance Corporation (LPS)

Executive Forum works to implement the Consisting of 18 members, namely six officers from the second echelon of the
functions of the FSS Forum in line with the Ministry of Finance, six directors from related departments of Bank Indonesia and two
direction provided by the Directive Forum. directors from the Deposit Insurance Corporation (LPS).

Working Group functions to support the The Working Group is made up of officials from the Ministry of Finance, Bank
work of the Directive Forum and the Indonesia and the Deposit Insurance Corporation (LPS) based on proposals from
Executive Forum. respective institutions and agreed by the Directive Forum. In addition, it is possible to
form a Task Force for specific projects, for example IFSA and FSAP.

59
Chapter 4 Financial Infrastructure and Risk Mitigation

the Ministry of Finance and reorganization in Bank financial system compliance to international standards
Indonesia affected FSSF membership, therefore, on 29th regarding prudential principles. FSSK working group will
June 2007 the following joint decrees were signed between also coordinate and harmonize IFSA, which directs the
the Minister of Finance, the Governor of Bank Indonesia Indonesian financial system over the mid and long term.
and the Chairman of LPS: No 299/KMK.010/2007, No 9/ In the latest developments, at the FSSF Executive
27/KEP.GBI/2007, and No 015/DK-LPS/VI/2007. In essence, Forum held on 13th August 2007 the establishment of two
the joint decrees solemnize new memberships and reiterate working groups was agreed upon to coordinate the Macro
the role of the Forum. FSSF has operated and met regularly Early Warning System (EWS) and Crisis Management
since 1 July 2007. The Directive Forum (Forum Pengarah)
st
Protocol (CMP). The Macro EWS working group is expected
meets quarterly and the Executive Forum (Forum Pelaksana) to review a potential global crisis; how long would the
meets monthly every second Monday. In addition, meetings crisis persist and what steps could be taken. Meanwhile,
are also held at the Working Group (Tim Kerja) level. the CMP working group will provide guidance to the
In the near future, FSSF will act as the coordination financial authority on handling a crisis. CMP will outline
centre for the implementation of the Financial Sector the crisis management mechanism for banks, non-bank
Assessment Program (FSAP) and Indonesian Financial financial institutions, the capital markets and financial
System Architecture (IFSA). An FSSF working group will markets. With CMP, the relevant authorities will provide
collaborate to prepare and implement FSAP, which will be an accurate and effective response to address the crisis,
conducted by the World Bank and IMF. The goal of FSAP therefore, minimizing any negative impacts to the financial
is to assess the resilience of the financial market and assess system.

60
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Articles

61
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

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62
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

The Dynamics of Banking Industrial Structure, Strategic


Risk, and Their Implications on Financial Systems Stability

Muliaman D. Hadad1 , Wimboh Santoso2 , Bambang Hermanto3


Dwityapoetra S. Besar4 , Ita Rulina W. S5

This paper aims to analyze the structure, dynamics, and performance of banking industry against industrial
stability and strategic risk by using concentration indices, among others: HHI, HTI, CR 15, and HHI-CR 15. In
addition, Markov probability transition matrix was employed to examine the dynamics and industrial risk. The
industrial stability and strategic risk were measured by entropy values of performance rank dynamics both on the
industry and individual levels, while industrial performance was determined with profitability and share ratio.
Using monthly banking financial reports, we includes the entire commercial banks in Indonesia for the periods of
September 2000 (156 banks) through May 2006 (131 banks). The research demonstrates that Indonesian banking
industry is still in a stable condition, as normal competition level has not yet occurred. In terms of asset measure
and performance, however, a tight competition is found to be discrete within the inter sub-industry. The tight
competition exists in the medium sub-banks. The research also shows that declining number of banks within the
industry has been followed by lowering concentration indices, particularly HHI and HTI, as well as decreasing
market share of 15 large banks. In the initial period, the 15 large banks had approximately 70% market shares
and subsequently fell to about 60% in the end of the period. Mathematically, the declining number of banks
within the industry shall be followed by rising concentration index, ceteris paribus. In contrast, the research
demonstrates reversing facts which indicate industrial consolidation process is formed.

1 Deputy Governor of Bank Indonesia. This article was written by Muliaman D. Hadad 1. INTRODUCTION
when he was the Director of the Directorate of Banking Research and Regulation, Bank
Indonesia; e-mail addressΩ: muliaman@bi.go.id
2 Head of Financial System Stability Bureau, Directorate of Banking Research and Regulation,
The purpose of this research is to measure one type
Bank Indonesia; e-mail address: wimboh@bi.go.id
3 Lecturer of Economics Faculty, University of Indonesia; e-mail address: of risks, namely strategic risk in Indonesian banking industry
bhermant@fe.ui.ac.id
4 Senior Researcher at Financial System Stability Bureau, Directorate of Banking Research regarding the stability in banking industry, by using
and Regulation, Bank Indonesia; e-mail address: dwityapoetra@bi.go.id
5 Researcher at Financial System Stability Bureau, Directorate of Banking Research and Industrial Organization approach. The Structure√Conduct√
Regulation, Bank Indonesia; e-mail address: rulina@bi.go.id

63
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Performance paradigm was operationally translated in the 2. METHODOLOGY


forms of measuring variables, namely: concentration index, This research used monthly population data of
time series measurement, and entropy. commercial banks as of March 2006 during periods
It is generally agreed that market concentration is between September 2000 and May 2006, covering
one of the significant determinants of competition level, variables, among others: Asset, Costs, Profit, Capital,
although highly concentrated market does not necessarily Credit, Third Party Fund, and Incomes.
reflect the scarcity of competitive behavior in the market An industrial organization approach, Structure√
(Nathan and Neavel, 1989). Both studies provide empirical Conduct√Performance paradigm was operationally
evidences which suggest that highly market concentration translated into measuring-variable forms, namely:
tends to reduce the degree of competition in the banking concentration index, time series movement, and entropy.
sector (see among others Gilbert, 1984 and Bhattacharya The work flow of the research is presented in Figure A1.1.
and Das, 2003). Following Rueffli (1990), this research
subsequently associated competition with risk, and thus Figure A1.1
Research Framework
industrial stability.
Descriptive Statistic
(industry and group)
Having no references of its kind, this research is the
first study so that it is more explorative with limited initial Static Concentration Size
(industry and group)

analysis. The research report is systematically presented in Dynamic Size,


Strategic Risk,
and System Risk
the followings.
Incident Matrices
Part 2 will outline methodology employed to review Relative Ranking Matrices

Frequence Transition Frequence Transition


industrial structure, industrial dynamics, and the Rank Matrices (total) Rank Matrices (every 4 periods)

measures of performance, risk, and stability in the Markov Probability Markov Probability
Transition Matrices (every 4 periods)
Transition Matrices (total)

banking industry.
Dynamic Entropy of Dynamic Entropy of
Part 3 will present the results of static concentration Performance Rank (system) Performance Rank (individual)

measures of assets, credits, and Third Party Deposits (TPD)


in terms of HHI, HTI, and Static Entropy of both industrial
and sub-industrial group market shares as industrial Industrial Concentration
structure indicator variables with their changes from Measures of Static Concentration
beginning to ending period of the research. It will also One of static concentration measures popularly used
present relative entropy of banking industry rank dynamics is the Herfindahl-Hirschman Index (HHI). For n firms in an
from various variables during the observation period to be industry with market-share of Si, and the HHI is:
used as the banking industry stability measurements;
individual entropy of fifteen large banks as strategic risk HHI =

measurements, and changing dynamics of individual large


banks in the sub-groups. The more similar size of the firm, the HHI will be
Section IV will recapitulate findings in the previous smaller. By definition, HHI will have values between 10,000/
parts by utilizing framework of industrial organization. n and 10,000 where n is the number of firms in an industry.

64
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Maximum concentration index is 10,000 when a firm is a industry (system) stability are also measured by using the
monopolist in an industry. Other measures of static entropy.
concentration extensively used in many industrial
organization studies are follows. System Risk Measure
The Hall-Tideman Index (HTI) The information needed to measure uncertainty for
HTI which is defined as: a system can be obtained from probability distributions
which describe system behavior. This research uses a
HTI = conditional relative entropy measure H(KIJ)rel to represent
the relative uncertainty of the system. H(KIJ) is an average
conditional absolute entropy of the system and is defined

This index provides weightings for a firm»s market- as:

share in relation to its relative ranks. The number of banks


H(KIJ) =
should be taken into account when calculating
concentration index to reflect existing dominant players.
H(KIJ) indicates the information value carried by
observations on the system if sequence of firm»s ranks at
Relative Entropy Measure
the moment is given, while H*(KIJ) = is maximum average
The concept of entropy derived from information
conditional entropy of the system and has the same value
theory aims at measuring the degree of information about
as()ln n . Thus, relative entropy of performance rank
ex-ante expectation of some distribution. It is formulated
dynamics H(KIJ)rel is:
as:

Entropy-Share = H(KIJ)rel =

As the entropy-based measurement has a more general H(KIJ)rel expresses relative uncertainty of a system
character and is relatively easier to apply, its use in the which constitutes the value of average information about
context of measuring market concentration is often a transition of a firm in the system between two conditions
recommended in numerous textbooks. This research would in two different periods of time, given initial condition of
also measure the entropy of market share in the banking each firms. H(KIJ)rel has the range values of 0 to 1. If the
sector in Indonesia. system is definitely certain, i.e. if the probability of all
conditioned-output is 0 or 1, then the entropy of the
Strategic Risk and Stability system, H(KIJ)rel, is 0; and if the entropy of the system is
The strategic risk concept is based on ordinal close to the possible maximum entropy, H*(KIJ), H(KIJ)rel
approach, following Collins and Rueffli (1992). This is close to 1. This means that when the probability of
strategic risk in this context is translated as the probability individual transition in the transitional matrix is close to
of a firm in experiencing a loss of relative competitive 1/n, then the entropy will be close to maximum entropy
position in its business sector. Strategic risk and banking (or the system is random).

65
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Individual Strategic Risk Measure a modified BCG matrix of industrial organization discipline
As noted earlier, assuming is the total numbers of is used. This is because the number of time-series data is
transitions experienced by firm i moving from rank j to too small to analyze econometrically. The modification is
rank k. Next, given that for all firms pk|j = N.jk/N.j., then made into Matrixes of Share-Performance, Share-Risk,
the expected-weighted value of information associated and Risk-Performance in two different periods of time
with conditional rank transition can be defined as: for comparison reasons; at the beginning and ending
h(k|j) = - [N.jk/N.j.]ln(pk|j) period
Furthermore, the expected value of total weighted-
information associated with the transitions in the system 3. BANKING INDUSTRY STRUCTURE, INDUSTRY
from rank j to rank k, which is assigned to an individual STABILITY, AND BANK STRATEGIC RISK
firm i, can be formulated by using individual entropy as Competition pattern in an industry is determined by
follows: industry structure which is measured by: number of players,
hi(k|j) = - [Nijk/N.j.]ln(pk|j) existence of dominant players and level of industry
The portion of total uncertainty contributed by firm i in concentration. Results of statistical computation for several
the system is determined by: banking industry concentration indices during the research
periods by various variables are presented in the followings:

HWi(K|J) =
Concentration Measurements: Assets, Credits
and Third Party Deposits
HWi(K|J)rel = HWi(K|J)/ HW*(K|J).
It can be seen from the table that the HHI-asset
average is 888, which means that Indonesian banking
For a purpose of movement dynamics analyses of
industry is relatively unconcentrated in which four big
individual bank associated with risk and performance,
players are unable to dominate the market or big players»

Figure A1.2 market power is small. This is consistent with CR-15


Dynamics Matrix of Risk-Performance√
average indicating that the fifteen banks with the biggest
Beginning/Ending Period of T
asset values, collectively, dominates sixty eight percents of
Dynamics Matrix Risk-Performance - at Period of T

0.2 banking assets on the average, with the standard deviation


2 1
Alert 0.1 Balance of two percents; and so are with the small value of HTI
0
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 index, the trends of time-series for both asset concentration
Risk

-0.1
3 4
-0.2 Superior
indexes, HHI, HHI-15 and HTI tend to keep declining, as
Laggart
-0.3 shown in Graph A1.1 below. The trend suggests that big
-0.4
Performance players» market power is getting smaller.
Source: processed
The interesting fact above is that the declining asset
Notes :
- Quadrant 1 : position of individual banks with risk and performance values of more than concentration indexes coincide with the lowering number
group average (Balance)
- Quadrant 2 : position of individual banks with performance value of less than but with of banks which reach 16%. At the beginning period, 156
risk value of more than group average (Alert)
- Quadrant 3 : position of individual banks with risk and performance values of less than
group average (Laggard)
banks were recorded in the research but it became only
- Quadrant 4 : position of individual banks with performance value of more than but risk
value of less than group average (Superior) 131 banks at the ending period. The declining number of

66
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Table A1.1.
Mean, Standard Deviation and Several Static Banking Industry Concentration Coefficient Covariation

RANGE ASSETS LOANS DEPOSITS

HHI AVG 10.000/n < HHI < 10.000 888.937 601.451 890.798
SD 151.718 31.995 113.625
CV 5.859 18.798 7.840
HHI - CR 15 AVG 10.000/n < HHI-15 < 10.000 870.096 568.062 717.506
SD 153.562 41.908 105.800
CV 5.666 13.555 6.782
ENTROPY - STATIC AVG 0 < ENTROPY-STA < 1 0.643 0.701 0.648
SD 0.023 0.010 0.025
CV 28.514 71.702 25.571
CR-15 AVG 0 < CR-15 < 1 0.681 0.588 0.549
SD 0.025 0.047 0.027
CV 26.918 12.390 20.038
HTI AVG 0 < HTI < 1 0.042 0.034 0.045
SD 0.003 0.002 0.002
CV 15.792 19.543 19.020
Source: processed

banks should theoretically be accompanied by the Graph A1.3 below, it shows that from early 2002 to early
increasing concentration indexes, or rising market power 2005, there is an increase on HHI Industry, HHI-CR 15,
in the banking industry. and CR-15, which coincides with the declining share
This result is consistent with Bikker and Haaf (2002) entropy. It also indicates that the player»s market power is
who have conducted similar study in numerous countries increasing during that period, but starting from mid-2002
and Bhattacharya and Das (2003) who have investigated to the first quarter of 2006 the HHI and HTI indices just
concentration dynamics of banking sector in India. return to a decrease while the entropy values are rising
Credit market concentration is measured by meaning that the market power is declining.
numerous static concentration measures. As shown in Absolute concentration index value of TPD is closer
Table A1.1, it indicates that average-level of player»s market to the asset index but it is different from that of credit
power is smaller than the asset concentration. Under index. Hence, the interpretation and understanding of the

Graph A1.1 Graph A1.2


Movements of HHI, HHI-15, CR-15, and Banks Number Movements of Entropy Share Based on Assets :
Based on Assets : 06/2000 √ 05/2006 06/2000-05/2006

1400 0.7

1200 0.68

0.66
1000
0.64
800
0.62
600
0.6
400 0.58
Total Bank HHI 15 Large HHI HTI 15 Large Share
200 0.56

0 0.54
SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay
2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006
Note: Market share of 15 large banks is multiplied by 1000 in purpose to adjust the graph scale.
Source : processed Source : processed

67
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Graph A1.3 Graph A1.5


Movements of HHI, HHI-15, CR-15, and Banks Number Movements of HHI, HHI-15, CR-15, and Banks Number
Based on Loans : 06/2000 √ 05/2006 Based on Deposits : 06/2000 √ 05/2006
700 1200

600 1000

500
800
400
600
300
Total Bank HHI 15 Large HHI HTI 15 Large Share 400
200

200 Total Bank HHI 15 Large HHI HTI 15 Large Share


100

0 0
SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay
2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006

Note: Market share of 15 large banks is multiplied by 1000 in purpose to adjust the graph scale. Note: Market share of 15 large banks is multiplied by 1000 in purpose to adjust the graph scale.
Source : processed Source : processed

Graph A1.4 Graph A1.6


Movements of Entropy Share Based on Loans : Movements of Entropy Share Based on Deposits :
09/2000-05/2006 09/2000-05/2006

0.73 0.70

0.68
0.72
0.66
0.71
0.64

0.7 0.62

0.60
0.69
0.58
0.68
0.56

0.67 0.54
SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay SepNov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMayJul Sep Nov JanMarMayJul Sep NovJanMarMayJul Sep NovJanMarMay
2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006
Source : processed Source : processed

results over the competition are in line with the asset index. from the competition in the inputs and outputs market,
Table A1.1 above also illustrates that, on average, market as indicated by Rank Dynamics of Relative Entropy (RDRE)
power of TPD is relatively low throughout the research performance of all banks in the industry. This industry
period. Similar to the asset, there is a trend in the declining stability is closely related to banks» strategic risk measured
power of dominance over the market for the large banks by individual Rank Dynamics of Absolute Entropy since
as could be inferred from the lowering trends of HHI and both are derived from the same Markov probability
HTI, while market entropy values are getting close to one transition matrix.
as shown in the following graph. From the competition Scatter diagram of transitional probability distribution
side, it is found that the competition in the credit market by assets and ROIs shown in Figure A1.3 and Figure A1.4
is more intense than in the TPD market. below indicates that values of transitional probability, both
ROI and asset ranks, scatter along the diagonal line
Industry Stability and Strategic Risk spreading across the matrix in a regular way. This suggests
Banking industrial stability is reflected from the that the increase or decrease of performance ranks occurs
random intensity of bank performance ranks, resulting within a time-range in a relatively less random way. But

68
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Figure A.1.3 are presentation and analyses on the computational results


Distribution Pattern of Banking Industry
of entropy in the banking industry.
ROI Rank Transition Probability

Entropy Performance of 15 Large Banks


Absolute entropy shows the pattern of individual
bank»s behavior dynamics over time where high dynamics
indicates the uncertainty of position, both in obtaining
market and achieving performance, and is used as the
strategic risk indicators/measures. Table A.1.2 contains a
computational results summary of quarterly absolute
entropy for fifteen large banks.
From the table, it can be seen that there is a decline
Figure A.1.4
in the average entropy from beginning to ending period
Distribution Pattern of Banking Industry
Assets Rank Transition Probability of research; four of five banks with the least entropy and
smaller than average entropy at beginning period maintain
their positions until the end of period. In contrast, five
entropies at the beginning period rank the highest with
four of them have experienced position-swapped amongst
the banks; and further, only two banks retain its high
entropy, namely IIHB dan IIHI. In other words, high entropy
does show higher dynamics level than the small entropy.
Entropy»s position of the bank coded with IIPI, although
on the average possesses the smallest entropy, turns out
to have always been above the average of the fifteen large
some pattern is visible: on both ends of diagonal ranges, banks» from beginning to ending period, which implies
these are relatively narrow; three to seven on ROI ranks that only in the middle of the period does the bank»s
and then it becomes wider around the center of the entropy fall far below the average. The entropy figures of
diagonal line, between ranks twenties to eighties with a time series movement of the fifteen large banks during
range of twenty to seventy ranks. Similar pattern is also the research period are attached as the Appendix.
found on the RDRE asset but with narrower range. This
pattern indicates that it is the banks in the medium rank, Strategic Risk Dynamics and Individual
rank twenties to eighties as the most dynamics groups, Performance of 15 Largest Banks
which have greater probability to trigger the industrial Empirically there has no reference which states a
instability than are the top and low rank groups. Markov pattern of relationship between strategic risk and
probability transition matrix serves as the basis to calculate performance of a bank. Matrices of Risk-Performance,
banking industry stability, rank dynamics of relative entropy, Share-Performance, and Share-Risk were used to plot the
and certain individual bank»s strategic risk. The followings relative positions of individual banks at the beginning and

69
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Table A.1.2
ROI Rank Dynamic Absolute Entropy - 15 Large Banks
Average Value During Research Period, Q-II 2001 and Q-I 2006

Average Average Average


No. Code of No. Code of No. Code of
Beginning Position End Position
15 Large Banks Individual Entropy 15 Large Banks 15 Large Banks
of Period of Period
1 Iipi 0.0105 1 Iisb 0.0157 1 Iipp 0.0033
2 Iihp 0.0154 2 Iihp 0.0157 2 Iipb 0.0123
3 Iiir 0.0173 3 Iipp 0.0214 3 Iihp 0.0157
4 Iipp 0.0187 4 Iiir 0.0214 4 Iiir 0.0157
5 Iipb 0.0203 5 Iaia 0.0214 5 Iaia 0.0214
6 Iisi 0.0226 6 Irsb 0.0270 6 Iiap 0.0214
7 Irsb 0.0232 7 Irrb 0.0270 7 Iiar 0.0214
8 Iiap 0.0240 8 Iisi 0.0270 8 Irrb 0.0214
9 Iiar 0.0242 9 Iipi 0.0270 9 Irsb 0.0270
10 Iihb 0.0243 10 Iipb 0.0270 10 Iibi 0.0270
11 Irrb 0.0246 11 Iiar 0.0270 11 Iihb 0.0270
12 Iaia 0.0248 12 Iihi 0.0270 12 Iihi 0.0270
13 Iisb 0.0251 13 Iihb 0.0270 13 Iipi 0.0270
14 Iibi 0.0255 14 Iibi 0.0270 14 Iisb 0.0270
15 Iihi 0.0260 15 iiap 0.0270 15 iisi 0.0270
Average 0.0218 Average 0.0244 Average 0.0215
Source: processed

ending period of the research as a means to classify and


Figure A.1.5
describe the dynamics and their implications on the Risk Dynamics Matrix-Absolut Entropy and ROI
Performance of 15 Large Banks - Beginning and Ending
banking industry stability. The plotting results by various of Sample Period
matrixes are presented in the following.

Absolute Entropy vs ROI Standard-Beginning of Sample Period

Absolute Entropy versus ROI of 15 Large Banks


0.2
From the matrix of risk-performance dynamics below,
Absolute Entropy

0.1
0
it can be seen that, firstly, distribution of each individual -7 -6 -5 -4 -3 -2 -1 0
-0.1
1 2 3 4 5 6 7 8 9 10 11 12 13 14

-0.2
banks in the respective quadrants from beginning to ending -0.3
-0.4
research period remains unchanged; secondly, there is no ROI

linear pattern of relationship between performance and


strategic risk. Four individual banks (IIHP, IIIR, IIPI, and IIPP)
are seen to have above-average performances, but only Absolute Entropy vs ROI Standard-Ending of Sample Period

one individual bank (IIPI) indicates above-average absolute


0.4
entropy value or to be in quadrant balance, while the other
Absolute Entropy

0.2
0
-3 -2 -1 0 1 2 3 4 5 6 7
11 banks are in the below-average performance quadrants. -0.2
-0.4
Table A.1.2 contains figures of variable values -0.6
-0.8
indicating the positions of 15 individual large banks in the ROI

matrix quadrant above, from beginning to ending period


of sampling. Source : processed

70
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Market share is often used as a performance measure the probability of linear-relations between market and
in obtaining market. In order to find out the behavior of financial performance, although they are accompanied by
individual banks over time, the relationship pattern heteroskedastic phenomenon or a non-linear change at
between market share and ROI is presented in the following the end of the period.
section. To provide detailed-information regarding the above
matrices, Figure A1.6 below contains the position of 15
Market Share versus ROI of 15 Large Banks large banks from beginning to ending period of sampling.
The dynamics matrix below shows the position of Bank intermediation function in putting the third party
15 large banks by their market shares and performances. deposit collection and credit distribution into equilibrium
Similar to the entropy-ROI matrix above, it can be seen has attracted public concerns most of which has centered
that there are four individual banks (IIP, IIIP, IIPI, and IIPP) around the low-optimum level of credit distribution
which have above-average market share and performance functions. This research also examined these realities in a
and remains steady from beginning to ending period of more comprehensive manner by examining behavior
sampling. The other 11 banks are assembled on quadrant pattern of TPD growth/credit growth and ROI of 15 large
III having below-average market share and performance banks.
which implies that both matrices below also demonstrates A measure of equilibrium for bank intermediation
function could be indicated by TPD growth-level in
Figure A.1.6
proportion to credit growth level. In the next section, a
Risk Dynamics Matrix-Market Share and ROI Performance
of 15 Large Banks - Beginning and Ending review on the relationship pattern of comparison between
of Sample Period
TPD and credit growth against performance (ROI) of 15
large banks would be presented.
Market Share vs ROI Standard-Beginning of Sample Period

0.25
TPD Growth / Credit Growth versus ROI of 15
0.2
Market Share

0.15
Large Banks
0.1
0.05
0
The ratio between TPD growth and credit growth
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
-0.05
-0.1
from two different points of time, in addition to the
ROI
previous matrix, may demonstrate strategy focus stability
and policy of bank resources allocation. As shown in the
matrix below, the resources allocation to credit market is
Market Share vs ROI Standard-Ending of Sample Period
relatively high for the majority of banks, as is with the four
0.14
0.12 best performance banks lined-up in quadrant IV or superior
Market Share

0.1
0.08
0.06 (i.e. IIHP, IIR, IIPI, and IIPP). There are only 2 banks (IIBI,
0.04
0.02
0 IIHB) which show the contrary, along the beginning to
-3 -2 -1 -0.02 0 1 2 3 4 5 6 7
-0.04
-0.06 ending period of sampling, where their positions are
ROI
replaced by IIAR and IIRB. And when the credit qualities of
both banks are becoming less or poor, this condition may
Source : processed

71
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

Figure A.1.7 positions of the 15 large banks from beginning to ending


Risk Dynamics Matrix-Deposits Growth/Loans Growth period of sampling
and ROI Performance of 15 Large Banks- Beginning and
Ending of Sample Period As shown in the presentation above, the change or
movement of 15 large banks is relatively small, only few
Deposit Growth/Loan Growth (gD/gL) vs ROI Standard-Beginning of Sample Period
individual banks demonstrate significant changes from low

7
to high positions in terms of their average values of this
6
5
4
group (absolute entropy, market share, gD/gK, ROI). Even
3
gD/gL

2
1 more, the individual banks are seen to have high market
0
-7 -6 -5 -4 -3 -2 -1-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
-2 share but their performance levels are relatively low which
-3
ROI indicate a mass product activity with low market gain and
margin orientation.
The three relationships above (Section 3.6.1-3.6.13)
Deposit Growth/Loan Growth (gD/gL) vs ROI Standard-Ending of Sample Period
demonstrate a dynamics map within the 15 large banks in
60
50
which four individual banks (IIHP, IIIR, IIPI, IIPP) tend to have
40
30 above-average performance levels, whereas the rest have
gD/gL

20
10
below-average levels. The movements of those 15 large
0
-3 -2 -1 -10 0 1 2 3 4 5 6 7
-20 banks are relatively stable over time, although several
ROI
individuals (IIBI, IIHB, IIHI, IISB, IIPI, IISI, and IRSB) show
Source : processed above-average absolute entropy values. What draws
attention is the competition dynamics among eleven
undermine future performance and in turn becomes the individual banks (other than the four high-performing
trigger for banking industry instability. Relative positions banks) which demonstrate changes and position swaps
of the remaining large banks in this matrix are stable from from beginning to ending period of sampling. The tight
beginning until the end of the period. competition among these eleven banks is probably due to
Individual banks dynamics for TPD growth/credit their relatively similar measures compared to the four high-
growth variables appear only two individual banks having performing banks.
above-average values, which imply two meanings:
whether the individual banks» TPD value is relatively great OEOI vs. ROI of 15 Large Banks
or else its credit distribution value is relatively small. From the dynamics matrix below, it is shown that
Examining the data, it indicates that both banks have too four individual banks with relatively above-average
much TPD collection whereas their credit distributions are performances demonstrate relatively high Operating
relatively small (e.g. IIBI has TPD share of 5% with 0.6% Expense to Operating Income (OEOI) values (IIHP, IIIIR, IIPI,
credit share). However, ROI performance of both individual IIPP). This indicates that those 4 banks possess relatively
banks is relatively below average which means that both high operational costs but their ROI performances are also
banks have been attempting to focus themselves on relatively high. In contrast, the other 11 banks show
market expansion (inputs or outputs) with relatively low relatively below-average OEOI values with relatively low
margins. Table 3.6 below presents individual banks performance within their group. In other words, the 15

72
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

large banks could be classified into 2 groups, namely those of OEOI and ROI of those 15 large banks. The apparent
in quadrant I with above-average OEOI values and changes in positions are still seen in the same quadrant
performance, and those in quadrant III with below-average from beginning to ending period. This OEOI and ROI
OEOI values and performance. This phenomenon is relationship also demonstrates the same result with the
consistent with that of the relationship between linear previous discussion in which the segregation in this group
market-ROI and heteroskedasticity. happens, namely four banks with relatively high ROI and
Relationship pattern between OEOI and ROI in the OEOI and the other eleven banks with relatively low ROI
two different points of time observation seems illogical, and OEOI.
counter intuitive. But, in fact, it occurs in other countries
too (see Neceur, 2003 and Bhattacharya, 2003), and thus 4. CONCLUSION
it could be concluded that the pattern constitutes unique The purpose of this explorative research is to find
to the banking industry. Figure A1.8 below demonstrates out the relationship between structure, dynamics, and
the positions of individual banks of the fifteen large banks performance in the banking industry, especially industrial
from beginning to ending period of sampling. stability and strategic risk of individual banks by using
The table below provides additional information to industrial organization approach. The findings and
the above figure showing that there is no significant limitations can be summarized as follows.
change or movement, by observing relationship pattern 1. Bank grouping is done on the basis of numerous
criteria of Central Bank (Bank Indonesia) supported
Figure A.1.8. by the existence of differences in statistical
Risk Dynamics Matrix-Kinerja OEOI and ROI Performance
of 15 Large Banks-Beginning and Ending distributions of various financial variables amongst
of Sample Period
the groups. Those groups could be considered as
banking industry sub-groups which are materially
OEOI vs ROI Standard-Beginning of Sample Period

discrete.
0.25 2. A gradual consolidation in the banking industry exists,
0.2
0.15
0.1
as the number of banks declines and the big players»
OEOI

0.05
0 market powers become less, whereas medium
-7 -6 -5 -4 -3 -2-0.05
-1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

-0.1 players» market power are on the increase. This implies


ROI
some possibilities. First, the liquidated banks»
customers do not move to the large banks. Second,
OEOI vs ROI Standard-Ending of Sample Period the medium banks succeed in attracting new
customers. Third, the medium banks manage to get
0.25
0.2 the large banks» old customers. Fourth, the
0.15
combination of the three above.
OEOI

0.1
0.05
0
-3 -2 -1 -0.05 0 1 2 3 4 5 6 7
3. Related to point 2, for some Indonesian bank
-0.1
ROI customers and to the extent of relationship to the
trade off between return and risk, the large banks»
Source : processed
services/products are the same as medium/small

73
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

banks». This will likely make asymmetric information 3. Because the identities of individual banks are hidden
problems, popularly known as Akerloff»s lemon in this research, the researcher has not recognized
market, more serious in Indonesian banking industry. them, validation of the results are made on the basis
4. On the whole, Indonesian banking industry is in a of group identification of consistent variable patterns.
stable condition, as normal competition level has not 4. Given the individual bank analysis done only on 15
happened. However, on the basis of asset measure large banks, the findings above do not represent the
and performance, a tight competition would be medium banks.
discrete within inter sub-industry. The tightest
competition exists in medium sub-banks. 6. POLICY IMPLICATIONS
5. The pattern of linear relationship between strategic The above conclusions and limitations provide some
risk with numerous performance variables and share implications for policy makings:
can not be derived from the data. This may be 1. In relation to banking industry restructuring, API
associated with non linearity risk phenomenon which (Arsitektur Perbankan Indonesia), understanding over
is dissimilar to clearer pattern of relationship between banking industry behavior by the sub-clusters of
share and numerous financial performances. What measures and dynamics within a cluster and inter-
unique to the banking industry is the existence of cluster will assist in developing future banking industry
positive relationship between profitability ratio and scenario. Thus, it is important to measure and publish
OEOI ratio. the statistics of concentration indicators,
competitions, and industrial and sub-industrial risks
5. LIMITATIONS as a means to monitor the industrial dynamics.
Some notes concerning limitations of this research 2. Referring to lemon market problem which is generally
are: attributable to financial industry, it is institutionally
1. Being the first explorative research in strategic risk necessary to establish an independent rating agency
(entropy) measurement, this research has not analyzed which prepares an assessment and rating on banks
and modeled the pattern of relationship of entropy and financial institutions under various performance
(risk) using widely-used systemic risk indicator measures, especially risk, to provide customers with
variables, for example Non Performing Loan. a balanced information in selecting banks and
2. From the perspective of time series investigation, financial services.
twenty points are considered so small to be used in a 3. Concerning with bank strategic risk control, the
research that long-term patterns could not be grouping of individual bank strategic behavior can
covered. be of great help, but further study focusing on
medium banks group is needed.

74
The Dynamics of Banking Industrial Structure, Strategic Risk, and Their Implications on Financial Systems Stability

References

Avi Fiegenbaum and Howard Thomas (2004),Δ Strategic Freddy Delbaen (2000), ≈Coherent Risk Measures on
risk and competitive advantage: an integrative General Probability SpacesΔ, ¨ossische Technische
perspectiveΔ, European Management Review (2004) Hochschule, Z¨urich ,March 10
1, 84√95 Jorion, Philippe. (2001). Value at Risk: The New Benchmark
Basel Committee on Banking Supervision. 1998. Risk for Managing Financial Risk, 2nd edition. New York:
Management for Electronic Banking and Electronic McGraw-Hill.
Money Activities. Kaushik Bhattacharya and Abhiman Das (2003),Δ Dynamics
Basel Committee on Banking Supervision. 2001. Working of Market Structure and Competitiveness of the
Paper on the Regulatory Treatment of Operational Banking Sector in India and its Impact on Output and
Risk. Prices of Banking ServicesΔ, Reserve Bank of India
Basel Committee on Banking Supervision. 2003. Risk Occasional Papers Vol. 24, No. 3, Winter.
Management Principles for Electronic Banking. Mehra Ajay (1996), Δ Resources and Market based
Basel Committee on Banking Supervision. 2003. Sound Determinants of Performance in the US Banking
Practices for the Management and Supervision of IndustryΔ, Journal of Strategic Management Vol 17
Operational Risk. No.4
Ben Naceur, Samy.October (2003).ΔThe Determinants of Peraturan Bank Indonesia No 5/8/PBI/2003 tanggal 19 Mei
The Tunisian Banking Industry Profitability: Panel 2003 tentang Penerapan Manajemen Risiko.
EvidenceΔ. Universite» Libre de Tunis. Department of Ruefli, Timothy W (1990),Δ Mean-Variance Approaches
Finance. to Risk-Return Relationships in Strategy: Paradox
Boss, Michael, Helmut Elsinger, Martin Summer, dan Stefan LostΔ,Management Science; Mar 1990; 36, 3; ABI/
turner (2004) ,ΔThe Network Topology of the INFORM Global pg. 368
Interbank MarketΔ, Working Paper. Ruefli, Timothy W.; Wilson, Chester L. (1987), ΔOrdinal
Boss, Michael, Helmut Elsinger, Martin Summer, dan Stefan Time Series Methodology for Industry and
turner (2003), ≈An Empirical Analysis of the Network Competitive AnalysisΔ, Management Science, May;
Structure of the Austrian Interbank MarketΔ, Financial 33, 5; ABI/INFORM Global pg. 640
Stability Report 7. The Financial Services Roundtable. (1999). Guiding
Collins, James M and Ruefli, Timothy W (1992), Δ Strategic Principals in Risk Management for U.S. Commercial
Risk : An Ordinal ApproachΔ, Management Science Banks: A Report of The Subcommittee and Working
Vol.38 No.12 Group on Risk Management Principles. Washington
Elsinger, Helmut, Alferd Lehar, dan Martin Summer D.C.
(2006),ΔUsing Market Information for Banking System Winfrey, Frank L. dan James L. Budd (1997),Δ Reframing
Risk AssessmentΔ, International Journal of Central Strategic Risk Δ, S.A.M. Advanced Management
Banking, Vol 2 No 1. Journal. Autumn; 62, 4; ABI/INFORM Global, hal. 13-
Elsinger, Helmut, Alferd Lehar, dan Martin Summer,≈A New 21.
Approach to Assessing the Risk of Interbank LoansΔ,
Financial Stability Report 3.

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76
Credit Risk Modelling : Rating Transition Matrices

Credit Risk Modelling:


Rating Transition Matrices

Muliaman D. Hadad1 , Wimboh Santoso2 , Bagus Santoso3


Dwityapoetra S. Besar4 , Ita Rulina W. S5

This paper aims to estimate a credit rating transition matrix, specifically used to identify: rating migration
at a certain period, the heterogeneity of rating migration and the volatility level of rating migration. By using
company ratings and debt specific ratings published by PT Pemeringkat Efek Indonesia (Pefindo) in February
2001 up to June 2006, we calculate the transition matrices, using both Cohort and Continuous methods. We
performed annually, bi-annually (2004-2005), every three years (2003-2005), every four years (2002-2005)
and five years (2001-2005) for both methods. The result shows us that continuous method provides more
efficient results than the Cohort method. Additionally, estimations using the continuous method are best for
corporate or bond ratings, producing transition matrices with a more spread probability distribution. In terms
of the rating migration trend, estimation results using Cohort and continuous methods provided relatively
consistent results. Rating migration tends to upgrade, which is consistent with the analysis conducted on
rating activity and rating drift.

1. INTRODUCTION adequacy to anticipate the risk (Basel Committee on


Credit risk remains the dominant problem Banking Supervision, 1999). Basel II confirmed that financial
confronting banks. Nevertheless, banks need to identify, institutions must have the ability to analyze credit models
monitor and control credit risk as well as ensure capital and internal ratings to ensure the model is calibrated to
measure credit risk consistently and meaningfully. Van
1 Deputy Governor of Bank Indonesia. This article was written by Muliaman D. Hadad Deventer and Imai (2003) specifically mentioned that credit
when he was the Director of the Directorate of Banking Research and Regulation, Bank
Indonesia; e-mail addressΩ: muliaman@bi.go.id
2 Head of Financial System Stability Bureau √ Directorate of Banking Research and
risk is the major reason for bank default.
Regulation, Bank IndonesiaΩ; email address: wimboh@bi.go.id
3 Researcher at University of Gadjah Mada, Yogyakarta; email address: There are several difficulties in determining credit
BagusSantoso@ugm.ac.id
4 Senior Bank Researcher at Financial System Stability Bureau √ Directorate of Banking risk solutions that cover a number of companies. First, credit
Research and Regulation, Bank Indonesia; email address: dwityapoetra@bi.go.id
5 Bank Researcher at Financial System Stability Bureau √ Directorate of Banking Research risk has different types and sizes. Second, the different
and Regulation, Bank Indonesia; email address: rulina@bi.go.id

77
Credit Risk Modelling : Rating Transition Matrices

types of credit risk are generally managed centrally and in grade. All transition matrices exhibit the same
are closely monitored. The source of credit risk also varies characteristic; they all have high probabilities in a diagonal
widely; from corporate or sovereign bonds, credit matrix: the obligor tends to maintain its current rating.
derivatives, over the counter derivatives (such as interest The second largest probability is around the diagonal.
rate swap), commercial lending, retail mortgages and credit Meanwhile, the farther from the diagonal, the lower the
cards. Third, banks tend to manage their credit risk rating transition (Violi, 2004). A study by Kryzanowski and
separately from market risk. Menard (2001) shows that the probability of a bond
In measuring credit risk, Kamakura Risk Information remaining at its initial rating reduces as the time horizon
Services-KRIS (2004) applied three quantitative approaches analyzed becomes longer.
to model default probabilities, namely: Jarrow Chava The discussion on credit modeling not only focuses
Model, Merton Structural Model and Jarrow Merton Hybrid on the probability of default, but also analyzes what is
Model. The three approaches incorporate information happening to credit that is close to default (McNulty and
regarding a company»s equity market prices and interest Levin, 2000). For that reason, researchers began to focus
rates, so that prevailing market expectations can be on the probability of credit rating transition from one
accommodated in the default probability estimates. Van level to another. One of the representative ways of
Deventer and Wang (2003) use this model by estimating presenting such information is through a transition
default probability explicitly using logistical regression with matrix.
a historic default database.
In addition to default probability estimates, credit 2. THE OBJECTIVE OF THE RESEARCH
risk analysis can also be performed using risk migration This research aims to estimate a credit rating
analysis (migration probability of the bond rating). The transition matrix, specifically used to identify:
bond rating is an important indicator to evaluate a - Rating migration at a certain period;
company»s credit quality, as well as their default probability. - The heterogeneity of rating migration; and
A change in a company»s rating reflects the credit quality - The volatility level of rating migration.
of that company, either improved (upgrade) or
deteriorating (downgrade). Analysis of the rating»s 3. LITERATURE STUDY
transition, including default, is useful in the credit risk Transition Matrix Rating
model to measure future credit loss. Thus, the matrix Credit migration, or a transition matrix, indicates
containing rating transition probability (transition matrix) changes in the quality of settled credit at a particular
plays an important role in credit risk modeling. company. Transition matrices are the main input in various
Theoretically, the transition matrix can be estimated applications of risk management. One example, in the New
for the desired transition horizon. However, the matrix Basel Accord (BIS, 2001), capital requirement is based on
commonly used is an annual or five-yearly transition matrix. the rating migration. In 1999, the Basel Committee on
Specifically, a transition matrix illustrates the default risk Banking Supervision (BCBS) confirmed the use of transition
and high migration volatility of a low quality portfolio. matrices and has since advocated their use as a basis to
The default likelihood increases exponentially with a decline fulfill the securitization framework.

78
Credit Risk Modelling : Rating Transition Matrices

Credit rating is a process where any credit rating the vector of column x where the i component, namely xi,
observation can form one of several state ratings. In this is the probability of State i at time t. The column vector
research, it is assumed that the credit rating process follows can be formulated as:
the Markov Chain process. This means that the probability
placed on one state can only be determined by knowing
the state from its previous observation. The assumption
of Markov Chain in the credit rating process implies that
the credit transition is more time invariant or time (3.3)
homogenous, where the transition probability remains the According to theorem by Anton and Rorres (1987),
same towards time and constant during the predetermined if P is the Markov Chain transition matrix and x(n) is the
horizon. state vector at observation n, it makes:
If one Markov Chain has State Space S = {1,2,º..k},
the probability of the credit rating process in state j for (3.4)
one observation after being in state i in a previous
observation, is noted by p ij. This pij is known as the From 3.4, it is known that:
transition probability from state i to state j. A matrix with (3.5)
a transition probability from State i to State j is known as
the transition matrix of Markov Chain (Anton and Roses, In other words, Equation 3.5 verifies that the previous
1987). Subsequently, the transition matrix is noted with P. state vector x(0) and transition matrix P reveal the value of
The general format of the one step transition probability state vector x(n).
matrix is as follows:
4. SPECIFICATION OF THE TRANSITION MATRICES
APPROACH USED
In this study, a transition matrix is constructed for
(3.1) both discrete and continuous timescales. Based on the
discrete approach, changes in the obligor rating (credit
At equilibrium (3.1) above, p ij verifies the score) are only monitored after a certain period of time
transition probability from state i at time t to state j at (fixed), such as six months, nine months, one year or other
time t+1. In addition, the Markov Chain transition matrix specific periods. Meanwhile, based on the continuous
above has the characteristic that all entries on one line approach, any change in rating can be monitored at any
equal 1. Mathematically, that characteristic can be written time, even minute by minute (Ahmed et al. (2004).
as follows: Building a transition matrix using the discrete
approach follows Jafry and Schuermann (2004).
(3.2) Meanwhile, the transition matrix based on the continuous
The state vector x(t) for one Markov Chain approach was adapted from Lando and Skodeberg
observation with State Space S = {1,2,º..k} is defined as (2002).

79
Credit Risk Modelling : Rating Transition Matrices

Transition Matrix, Discrete Timescale: Cohort λij ≥ 0, for i≠j


Method (Frequentist)
One method to calculate changes in probability from (3.7)
the data estimated using a discrete timescale is the Cohort
method. The Cohort method has been widely used as it This entry explains the probabilistic behavior of
applies simple calculations, although sometimes the results holding time in state i as it is exponentially distributed with
are less efficient. parameter λi, where λi = - λii, and the probability of
shifting from state i to j is λij /λi .
Transition Matrix, Continuous Timescale The transition probability for each time horizon is
Constructing a transition matrix using a continuous the function of the generator. Thus, we can obtain the
timescale approach has fascinated many modelers in recent maximum likelihood estimator from the transition
years. Ahmed at al. mentioned two key elements when probability matrix using the estimation from the generator.
applying this approach: This is subsequently applied to the exponential matrix for
1. To facilitate the transition probability estimation where the maximum likelihood estimation of that generator.
the transition to a certain rating rarely occurs, for Based on the assumption of time homogeneity, the
example an indirect default (default through a element from the matrix generator is calculated using the
sequential downgrade) maximum likelihood estimator as performed by Kuchler
2. To facilitate the construction of a transition matrix and Sorensen, 1997:
for all lengths of time (for example the 73-day
transition matrix) for i ≠ j (3.8)

Continuous Method with the Assumption of


Time Homogeneity Where:
Using this approach, we get a K-state Markov Nij (T) : number of transitions from state rating i to state
Chain where state 1 is the highest state and state K is rating j in the period.
default. The transition probabilities for a certain period Yij (s) : number of companies with state rating i
are calculated in matrices P(t) KxK where ij is the migration during s.
probability from state i to state j during period t. The In other words, the denominator from Equation 3.8
generator matrix with K x K dimension is λ with shows the number of «firm-years» of all companies included
nonnegative, off diagonal entries and the number of lines in the sample that were initially state i . Thus, the state of
equal to zero (Israel et al., 2001), where (Lando and each company for each period is also counted in the
Skodeberg, 2002): denominator.
P(t) = exp (λt), t ≥ 0 (3.6)
The Continuous Method with the assumption of
Matrix λt is matrix λ multiplied by t for each entry Time Non-Homogeneity:
and the exponential function denotes the exponential According to a study carried out by Lando and
matrix. The entry for matrix λ is: Skodeberg (2002), one of the means to calculate a

80
Credit Risk Modelling : Rating Transition Matrices

transition probability matrix from continuous data, The Discrete Hazard Model
assuming non homogeneity, is by applying the Aalen- A credit risk model used to analyze credit risk is
Johansen estimator. Based on Jafry and Schuerman (2003), known as the hazard rate model. The hazard rate model is
the Aalen-Johansen estimator, or non-parametric product a method to measure bankruptcy by including default
limit, obtained is consistent. The construction of transition intensity. The model is widely used in operational
matrices using this method follows the Cohort Method measurements. One of the applications of this model is
over a very brief period, such as on a daily basis for pricing, bankruptcy and estimating the probability of
(Landschoot, 2005). company default. There are two types of hazard models,
In estimating the transition matrix using a continuous discrete hazard rate and continuous hazard rate. The
timescale and assuming non-homogeneity, is the transition difference between the two models is in the survival
probability matrix for period [s,t]. Element ij from the matrix function applied. This research paper focuses on discrete
notes the Markov probability process, beginning with the hazard. The discrete hazard model is an appropriate model
transition from state i at time s to state j at time t. Then, if to analyze data consisting of binary observations, time-
several m transitions are identified during the period [s,t], series and cross-sectional data, like the one in cases of
can be estimated by applying the Aalen-Johansen estimator bankruptcy. The hazard rate is defined in economic studies
(Jafry and Schuerman, 2003). as the transitional risk of different states. In financial
literature, the hazard rate indicates credit default risk.
(3.9)
5. DATA SOURCES
The data used originates from PT Pemeringkat Efek
Evaluating Rating Quality Indonesia (Pefindo). Company ratings as well as debt
To intensify the analysis results, several indicators specific ratings published by Pefindo in February 2001 up
must be observed. One of the most important indicators to June 2006 were used to calculate the transition matrices,
in evaluating the quality trend of corporate ratings is rating using both with discrete and continuous methods.
activity. According to Carty and Fons (1993), rating activity However, several bond ratings published by Pefindo also
can be calculated from the sum of rating shifts, both the contained the bond rating given by other rating agencies,
upgrades and the downgrades, divided by several issuers such as KASNIC.
operating at the beginning of the year. Another important The rating agency data published during the period
indicator is rating drift. Rating drift is the dependency on consists of a semi-annual publication, published every
previous ratings and is identified as non Markovian February and August. The publication in February year i is
behavior (Lando Skodeberg, 2002). Rating drift is the rating agency data from 31st December year i-1,
calculated by the total number of upgrades subtracted by whereas the publication in August year i is the rating data
the number of downgrades and divided by the number of from 31st June year i. Meanwhile, bond rating data used
issuers operating at the beginning of the year. Based on in the estimation is for the period of 2001-2005, published
the sample given by Carty and Fons (1993), a rating change monthly by Pefindo, from July 2003 to June 2006; and a
from BBB to A represents one rating, whereas from BBB semi-annual publication from 2001 to 2002. The data from
to AA is a change of two ratings. Pefindo comprises of 115 company ratings and 412 bond

81
Credit Risk Modelling : Rating Transition Matrices

ratings from 119 companies. However, not all the data


Graph A2.2
could be included in the estimation due primarily to a lack Number of Upgraded and Downgraded Sample Bonds

of available data at the beginning of the estimation period. %


18
16.8
Downgrade Upgrade
16
14 13.5
6. ANALYSIS OF THE TRANSITION MATRIX
12

RESULTS 10
8.2
7.7 7.4
8 7.1
6.3
6.1 Evaluating Rating Quality 6 5.1

4
Graph A2.1 illustrates that the corporate rating 2.5
2 1.3

quality of the sample, in general, showed improvement. 0


2001 2002 2003 2004 2005
Source: Pefindo, processed
This is indicated by the decline in the percentage of
downgraded companies during 2001-2004 (from 25% to
3.23%). Nonetheless, in 2005, the percentage of companies issuing bonds. This was buttressed by the fall

downgraded companies increased to 4%. On the other in both downgraded companies and bonds; as well as the

hand, higher corporate rating quality was evidenced by a rise in the percentage of upgrades.

rise in the number of upgraded companies, from 10% in


2001 to 14.3% in 2003. However, the percentage declined Rating Activity and Rating Drift:

again in 2004 and 2005. Since 2003, the number of A positive (+) rating drift shows that the number of

upgraded companies has exceeded the number of upgrades has surpassed the downgrades, more specifically

downgraded companies. This is a preliminary indication indicating an improvement in rating quality. Conversely, a

of an improvement in the conditions of the sample negative (-) rating drift shows that the number of

companies. downgrades has surpassed the upgrades, ergo a decline

This is further emphasized in Graph A2.2 where the in credit quality. In brief, rating drift indicates whether a

number of downgraded bonds has shown a declining trend rating shows any improvement or decline over a certain

over the past five years. In 2001, the number of period of time.

downgraded sample bonds was 13.5%, while in 2005 it The rating activity and rating drift of sample

was only 1.3%. In brief, Graph A2.1 and A2.2 indicate companies during 2001-2005 is presented in Graph A2.3.

initial improvements in the creditworthiness of sample It can be seen that there was a regression in letter activity
rating of the sample companies from 2001-2004. However,
Graph A2.1
in 2005, rating activity increased to 15%.
Number of Upgraded and Downgraded
Sample Companies Even though the percentage of rating activity showed
%
30 a decline, conversely, the rating drift experienced an
Downgrade Upgrade
25.0
25 escalating trend. This indicates that despite an
20
unsatisfactory activity rating for the sample companies over
14.3
15
12.2 12.2 the past few years, the rating is beginning to show
10.0
10
7.1 7.5 7.0 improvement. In 2001 and 2002, the rating drift was
5 4.0
3.2
negative (-), which means that the number of downgrades
0
2001 2002 2003 2004 2005
exceeded the upgrades. However, the rating drift has
Source: Pefindo, processed

82
Credit Risk Modelling : Rating Transition Matrices

Graph A2.4
Graph A2.3 Letter Rating Activity and Rating Drift of Sample Bonds
Letter Rating Activity and Rating Drift
of a Sample Companies
%
% 80
120 110.0 65.4
100 60

80 40 36.7 36.4

60 55.1
20 21.0
10.8 8.7
40
26.8 4.2 6.1
20 15.0 0
12.5 10.8
4.3
0 -1.0 -20 -18.4
-10.2
-20
-40 -42.3
-40 Rating Activity Rating Drift
Rating Activity Rating Drift
-55.0 -60
-60 2001 2002 2003 2004 2005
2001 2002 2003 2004 2005
Source: Pefindo, processed
Source: Pefindo, processed

declined since 2004 but not as bad as during 2001 and continuous/discrete method. The continuous method was
2002. identified based on time homogenous and time non
Graph A2.4 shows the letter rating activity and rating homogenous assumptions. In this study, the transition
drift of sample bonds from 2001-2005. The percentage matrix is estimated using the Cohort Method and
of letter rating activity of sample bonds has declined; from Continuous Method assuming time homogeneity.
65.4% in 2001 to 8.7% in 2005. In constructing a transition matrix based on a discrete
Despite a decline in rating activity, rating drift timescale, the Cohort method was used derived from Jafry
improved, which is shown by its escalating trend. This and Schuerman (2004). Meanwhile, the transition matrix
means that even though the percentage of activity rating based on a continuous timescale approach was adapted
over the past few years experienced a decline, the rating from the study of Lando and Skodeberg (2002). In this
still showed improvement. paper, we only present Continuous Method.
In 2001 and 2002, the rating drift was negative,
which means the number of downgrades exceeded the The Corporate Rating Transition Matrice by
upgrades. However, the rating drift continued to increase; Using The Continuous Method Assuming Time
reaching 21% in 2003, which indicated that the number Homogeneity
of upgrades outperformed the downgrades, as Estimations were made using a continuous
experienced by the rating drift in sample companies. approach on an annual, bi-annual (2004-2005), three
More concisely, it can be concluded that the yearly (2003-2005), four yearly (2002-2005) and five
percentage of rating activity and sample bonds during yearly (2001-2005) timeframe. The most salient matrices
2001-2005 declined relatively. Nevertheless, rating activity are presented here.
showed improvements as indicated by the positive rating
drift. This is initial evidence of improved creditworthiness The Five-year Transition Matrix (2001-2005):
for sample bonds over the past few years. During 2001-2005, the total number of transitions
based on the continuous method assuming time
6.2 Analysis of the Transition Rating Matrix homogeneity was 38 with two not-rated transitions. The
There are two main approaches to estimate a probability distribution of the five-year default transition
transition matrix, namely the Cohort Method and the matrix was similar to the four-year pattern. Moreover, the

83
Credit Risk Modelling : Rating Transition Matrices

Table A2.1
Corporate Rating Transition Matrix Based on The Continuous Approach (%), 2001-2005.

Number of Companies
at Beginning AAA AA A BBB BB B CCC D NR
of Period

AAA 1 100 0 0 0 0 0 0 0 0
AA 5 0 94.31 5.42 0.06 0.04 0 0.05 0.06 0.02
A 20 0 4.51 86.72 2.02 1.31 0.23 1.37 2.19 0.70
BBB 7 0 0.38 14.61 82.87 0.13 0.24 0.13 0.17 1.39
BB 0 0 0.10 5.50 27.41 41.40 1.40 13.48 10.32 0.28
B 2 0 0.03 1.55 7.70 4.94 78.33 5.18 1.29 0.07
CCC 1 0 0.56 19.19 2.59 6.82 8.99 39.50 21.43 0.11
D 3 0 0 0 0 0 0 0 100 0
NR 1 0 0.61 21.89 1.29 0.94 20.61 0.97 0.41 52.31
TOTAL 40 Ω Ω Ω Ω Ω Ω Ω Ω Ω

distribution of transitional probability in 2001-2005 was In terms of rating stability, the five-year and four-
wider spread. year transition matrices show that the investment grade
In terms of a symmetrical relationship between rating category maintains fairly high stability. Meanwhile, the
stability and rating quality, the estimation results for 2001- speculative rating category also displayed relatively high
2005 illustrate a similar relationship for the transition matrix stability for companies rated B and C for the four-year
of two, three and four years. The rating stability level transition matrix and rated B for the five-year transition
declined in line with a drop in rating, reaching BB. matrix.
Furthermore, rating B has greater stability than BB.
Transitional probability generally declined in line with Corporate Rating Stability based on the Continu-
the wider gap in transitional distance, although several ous Method Assuming Time Homogeneity
ratings displayed a fairly high probability of migration. The distribution of rating stability for investment
After five years, the possibility of transition emerged grade companies is illustrated in Graph A2.5, whereas the
from speculative grade to the investment grade and vice non investment and speculative grade categories are
versa. However, the transition direction of upgraded ratings illustrated in Graph A2.6. From Graph A2.7, it can be seen
surpassed the downgraded ratings. This implies that the that the investment grade generally maintains a stability
sample companies, over the long term, improved in terms level above 65%.
of creditworthiness, although several companies also Graph A2.5
Corporate Rating Stability for The Investment Grade Group
experienced a decline in credit quality.
Based on The Time Homogeneous Continuous Method
Over the five years measured, companies also faced %
100
the probability of default or being downgraded to rating
90
D. Even companies rated AA and A faced the possibility of
80
default. The safest companies are the ones rated AAA.
70
This is similar to the results of the four-year transition
matrix. The probability of default increases with a decline 60
AAA A
AA BBB

in rating quality, except for BBB and B. 50


2001 2002 2003 2004 2005

84
Credit Risk Modelling : Rating Transition Matrices

Graph A2.6 Figure A2.8


Corporate Rating Stability for The Speculative Grade Group Corporate Rating Stability for The Speculative Grade Group
Based on The Time Homogeneous Continuous Method Based on The Time Homogeneous Continuous Method
Using Various Estimation Period
%
100 %
90 120
BB 2005 (2004-2005) (2003-2005) (2002-2005) (2001-2005)
80 B 100
70
CCC
60 80
50
40 60
30
40
20
10 20
0
2001 2002 2003 2004 2005 0
BB B CCC

Rating A experienced an escalating stability trend to greater stability. Graph A2.7 also implies that the rating
from year to year. Meanwhile, ratings AA and BBB stability will continue to decline as more periods are added.
experienced significant fluctuations. Slightly different from previous estimations, the BBB rating
Sample companies rated AAA maintained high shows fluctuations.
stability from year to year. This indicated that issuers rated Rating stability of the speculative or non-investment
AAA tend to maintain high stability and are somewhat grade category generally experienced a decline in stability
resistant to negative market influences. However, it is noted as the estimation period lengthened (Graph A2.8).
that the number of observations for this rating was very However, fluctuations were also visible, particularly for
limited and, therefore, not fully representative of market rating CCC.
conditions. On the other hand, the most unstable rating
among the investment grade is BBB with the smallest Corporate Rating Transition Matrices by Using
stability percentage. Continuous Method Assuming Time Homogeneity:
Graph A2.7 illustrates the rating stability of the The Five-year Transition Matrix (2001-2005)
investment grade category for each estimation period. For In the given period, the total number of bond rating
the five estimation periods, rating stability remains relatively transitions based on the continuous method was 29 with
high, always above 75%. In general, higher ratings lead two not rated. The estimation results for 2001-2005 are
presented in Table A2.2.
Figure A2.7
Corporate Rating Stability For The Investment Grade Group The stability of bond ratings during 2001-2005 was
Based on The Time Homogeneous Continuous Method
sufficiently high, at around 88-100%, except for the CCC
Using Various Estimation Period
% rating with only 50.58%. It is due to its junk bond or
100
2005 speculative grade status, implying a low quality bond with
(2004-2005)
95
(2003-2005)
(2002-2005)
a relatively high default probability. Since investment grade
90 (2001-2005)
bonds are stable, such bonds are not speculative but for
85 investment. On the other hand, speculative grade bonds
80 with high rating fluctuations are often used by speculators

75
to generate high returns.
AAA AA A BBB

85
Credit Risk Modelling : Rating Transition Matrices

Table A2.2
Transition Matrix of Bond Ratings Based on The Continuous Method (%), (2001-2005)

Number of Bonds
at Beginning AAA AA A BBB BB B CCC D NR
of Period

AAA 0 100 0 0 0 0 0 0 0 0
AA 1 0 100 0 0 0 0 0 0 0
A 27 0 7 .14 86 .76 0 .99 0 0 .01 0 5 .10 0
BBB 11 0 0 .18 4 .54 93 .58 0 .03 1 .47 0 .04 0 .16 0
BB 2 0 0 0 .14 5 .82 87 .96 0 .05 0 6 .03 0
B 8 0 0 0 .15 6 .13 3 .77 82 .29 4 .43 3 .23 0
CCC 3 0 0 0 .03 1 .72 23 .87 22 .48 50 .58 1 .32 0
D 0 0 0 0 0 0 0 0 100 0
NR 0 0 0 .04 1 .22 39 .66 6 .85 6 .95 26 .98 0 .30 18 .01
Total 52 Ω Ω Ω Ω Ω Ω Ω Ω Ω

Table A2.2 illustrates that a CCC rating has a around 70-100%. Furthermore, from Graph A2.10 one
transition probability to upgrade to a B rating of 22.48%, can determine that speculative grade bond stability is
to a BB rating of 23%, a BBB rating of 1.72% and an A around 20-100%. The graph showing investment grade
rating of 0.03%. However, the CCC rating has a default bonds was flatter compared to the speculative grade.
probability of 1.32%. Among investment grade bonds, AAA rated are the most
The transition matrix for 2001-2005 did not return stable, followed by AA, BBB and A. The highest quality
a symmetrical distribution. The farther from the diagonal, rating is AAA, which also represents the most stable. The
the magnitude of rating transition varied and the stability of BBB outperforms A, which is illustrated by the
probability did not always decline. Even from the stability flatter line compared to line A. However, the stability trend
side (diagonal side), there was no consistent distribution. of A from 2001 to 2005 increases. This is contrasted against
Lower bond quality leads to less stability. the BBB rating, which regresses.
Regarding the five-year transition matrix, only A- and The stability of bond ratings from 2001-2005
BB-rated bonds (investment grade category) displayed a fluctuated wildly, as shown by increasing and decreasing
small transitional probability towards the speculative grade. shifts on the graphs. In terms of the speculative grade,
In addition, all speculative grade bonds (BB, B and CCC),
show a positive transitional probability to become Figure A2.9
Stability of Investment Grade Bond Rating
investment grade. Based on The Continuous Method Using
Time Homogeneous Assumption
%
Bond Rating Stability using the Continuous 110

Homogenous Method
The stability of bond ratings from 2001-2005 can 90

be analyzed separately between investment grade and


70
speculative grade respectively. The stability of investment
grade bonds is higher than speculative grade bonds. Graph AAA A
AA BBB
50
A2.9 illustrates that investment grade bond stability is 2001 2002 2003 2004 2005

86
Credit Risk Modelling : Rating Transition Matrices

Graph A2.10 estimations of a rating in a sequential way.


Stability of Speculative Grade Bond Rating Additionally, the method facilitates the construction
Based on The Continuous Method Using
Time Homogeneous Assumption of transition matrices which can accommodate the
%
120
dynamic factors of rating activity throughout the

100
period, not only at the beginning or the end.

80 2. The Cohort Method produced a transition matrix with

60 an uneven probability distribution concentrated

40 around the diagonal. Meanwhile, estimations using


20
BB
B
the continuous method are best for corporate or bond
CCC
0 ratings, producing transition matrices with a more
2001 2002 2003 2004 2005
spread probability distribution. This spread facilitates
the probability of distant migration far from the
the BB rating is the most stable followed by B and CCC diagonal (extreme transition), even to default without
ratings. From Graph A2.10, it can be concluded that the direct transition to that rating, and is possible through
lower the bond rating quality, the lower the stability level indirect transition through other ratings. The type of
will be. probability distribution shown is primarily illustrated
by the estimation results for a longer-than-one-year
CONCLUSION OF ESTIMATION RESULTS AND period.
POLICY IMPLICATIONS 3. Estimations using the Cohort Method failed to show
Rating Activity and Rating Drift the relationship between stability and rating; indicated
1. The sample of bond issuers improved their by the rating stability level not declining in line with
creditworthiness over time. This was evidenced by a the drop in the rating level. This mainly occurred for
decline in the percentage of downgraded companies estimation results using a one-year period.
and bonds as well as a rise in upgrades. Meanwhile, several estimation results for periods of
2. The percentage of rating activity of the sample of longer than one year indicated a symmetrical
companies and bonds during 2001-2005 decreased relationship between rating stability and rating level,
relatively. However, the current trend of rating activity but only when investment grade ratings were used.
is improving, which is reflected by an increase in rating 4. Most estimations, for various time periods, indicated
drift. This implies that the creditworthiness of the consistent results; that there is a symmetrical
sample of companies and bonds has improved over relationship between rating stability and rating level.
the past few years. This distribution was mainly found at the investment
grade rating. The stability level of the rating varies,
Estimation Results of the Rating Transition but in general was above 65%.
Matrix 5. Ratings in the speculative grade fluctuated and did
1. Estimations using the continuous method provide not show a consistent distribution due to a limited
more efficient results than the Cohort Method. number of samples, both corporate and bonds. Thus,
Furthermore, the method also facilitates indirect a one-sample transition in the speculative grade

87
Credit Risk Modelling : Rating Transition Matrices

category had a significant impact on the migration improved in creditworthiness over time. This was
probability distribution. expressed by the rating migration trend, which leaned
6. In terms of the rating migration trend, estimation towards higher ratings.
results using Cohort and continuous methods However, the major constraints of this study were
provided relatively consistent results. Rating migration the limited number of periods and samples. This is also
tends to upgrade, which is consistent with the analysis true for rating activity variation, which is shown by the
conducted on rating activity and rating drift. limited number of rating transitions. Such a brief sample
7. It can be concluded that using the continuous period prevented any long term transition matrix
method, assuming time homogeneity, produced a estimations and, unfortunately, the timescale did not date
transition matrix, which is more efficient. The matrix back far enough to the Indonesian recession post Asian
indicated the possibility of rating migration where crisis. Consequently, the limited number of samples
historically it had rarely occurred. For example, to caused a one-rating transition to have a substantial impact
experience default through an indirect default on the probability distribution. This mainly affected
mechanism. In addition, the estimation results for samples in the speculative grade category. This prevented
both the Cohort method and the continuous method any creditworthiness analysis of bond issuers in this
indicated that the sample of companies and bonds category.

88
Credit Risk Modelling : Rating Transition Matrices

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Glossary

Glossary

91
Glossary

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92
Glossary

Glossary

Cost of loanable funds: includes interest on funds, regulation and supervision; ii) lender of last resort; iii)
overhead costs, the deposit insurance premium and deposit insurance; and iv) crisis management.
minimum reserve requirement.
Capital Adequacy Ratio (CAR): The ratio of a bank»s total
Bank Indonesia Real Time Gross Settlement (BI-RTGS): regulatory capital to its risk-weighted assets.
Electronic transaction settlement in real time where
Non-performing loans (NPL): a loan that is in default or
accounts are debited and credited multiple times per day.
close to being in default categorised as sub-standard (SS),
Business continuity management: Risk management to doubtful (D) and loss (L)
ensure critical functions during disruptions as well as having
Lender of last resort: the function of a central bank in
an effective recovery process.
extending credit to banks to overcome liquidity problems
Downside Risk: The likelihood that a security or other caused by a mismatch in funds and to prevent systemic
investment will decline in price, or the amount of loss that crisis.
could result from that potential decline.
Crisis management: a comprehensive framework to
Failure to settle: a mechanism which obliges participants identify, mitigate and resolve crises.
of the clearing system to provide a pre-fund to anticipate
Mark to market: Evaluating the price or value of a security,
liabilities emerging at the end of the day.
portfolio, or account on a daily basis, to calculate profits
Discount Window: credit extended to banks by the central and losses or to confirm that margin requirements are being
bank to overcome liquidity problems caused by a temporary met.
mismatch in liquidity management.
Risk mitigation: efforts to reduce the possibility and effects
Financial Deepening: the development of the financial of risk.
sector; the increased provision of financial services with a
Economic capital: is the amount of real capital required
wider choice of services geared to all levels of society.
to cover accumulative excess or unexpected losses over a
Financial Sector Assessment Program: a joint program by fixed time period with a set confidence level.
the IMF and World Bank to assess the resilience of a
Moral Hazard: behaviour of business players (bank owners,
country»s financial system and its adherence to international
managers and customers) that triggers financial losses for
standards.
the bank.
Flight to safety: switching funds from banks considered
Crisis prevention: efforts to prevent crises through policies
less safe to safer banks.
for micro prudential regulation and supervision of financial
Four-eyes principle: credit approval considering business institutions and financial markets as well as macro
prospects and risk management. prudential surveillance of the financial system.

Financial Safety Net: framework to strengthen financial Crisis resolution: efforts to overcome crises including
system stability through four key elements: i) bank restructuring and recapitalising banks with systemic effects.

93
Glossary

Profit taking: the selling of assets or securities by investors Credit scoring systems: provide a consistent, mathematical
at a high price to receive profit. system to evaluate potential debtors. A credit score is a
numerical expression based on a statistical analysis of a
Regulatory capital: the minimum capital required applied
potential debtor»s credit files, to assess the creditworthiness
to banks set by the regulator.
of that debtor, which is the likelihood the debtor will pay
Restructuring: the act of improving loan conditions by his or her debts.
applying several options: i) adjusting the covenants to
Financial system stability: refers to a state in which a
provide additional financing; ii) converting all or partial
financial system, consisting of financial institutions and
interest as new loans; iii) converting all or part of the loan
markets, functions properly. In addition, the participants,
as equity for the bank in the company with or without
such as firms and individuals, have confidence in the
rescheduling or reconditioning.
system.Ω
Credit risk: the risk of loss due to a debtor»s possibility of
Stress testing: is a simulation technique used on asset
default, or non-payment of a loan.
and liability portfolios to determine their sensitivities to
Liquidity Risk: risk that an institution will not be able to
different financial situations. Stress-testing is a useful
execute a transaction at the prevailing market price because method of determining how a portfolio will fare during a
there is, temporarily, no appetite for the deal on the other period of financial crisis.
side of the market.
Undisbursed Loans: are loans that have been agreed but
Operational risk: the risk of loss resulting from inadequate
are yet to be withdrawn.
or failed internal processes, people and systems, or from
Unexpected losses: are defined as the difference between
external events.
expected loss and worst case loss. Expected losses are
Market risk: the risk that the value of an investment will
≈smallΔ losses, unexpected losses are ≈low probability high
decrease due to the movements in market factors. impactΔ losses and worst case losses are losses of such
Systemic risk: describes the likelihood of the collapse of a magnitude that they would render most institutions
financial system, such as a general stock market crash or a bankrupt.
joint breakdown of the banking system. Volatility: is the relative rate at which the price of a security
Risk-free assets: an asset whose future return is known moves up and down. Volatility is found by calculating the
with certainty. However, such assets remain subject to annualized standard deviation of daily change in price. If
inflation risk. the prices of securities move up and down rapidly over
short time periods, it has high volatility. If the price almost
Systemically Important Payment Systems: are those that,
never changes, it has low volatility.
in terms of the size or nature of the payments processed
via them, represent a channel in which shocks could Yield: The rate of income generated from a stock in the
threaten the stability of the entire financial system. form of dividends, or the effective rate of interest paid on
a bond, calculated by the coupon rate divided by the bond»s
Risk-control system: is a system to control risk implemented
market price. Furthermore, for any investment, yield is the
through bank policy and procedure in line with sound risk
annual rate of return expressed as a percentage.
management principles.

94
Financial Stability Review
No. 9, September 2007

DIRECTOR

Halim Alamsyah Wimboh Santoso

COORDINATOR & EDITOR

Agusman

WRITER

Sukarela Batunanggar, Linda Maulidina, Herawanto, Ronald L. Toruan, Dwityapoetra S. Besar,


Pipih Dewi Purusitawati, Wini Purwanti, Endang Kurnia Saputra, Ferial Ahmad, Ita Rulina,
Ricky Satria, Fernando R. B, Noviati, Sagita Rachmanira, Reska Prasetya, Leanita Indah P.,
Elis Deriantino, Hero Wonida, Mestika Widantri, Heny S

COMPILATOR, LAYOUT & PRODUCTION

Ita Rulina Ricky Satria Primitiva Febriarti

CONTRIBUTOR

Directorate of Bank Supervision 1

Directorate of Bank Supervision 2

Directorate of Bank Supervision 3

Directorate of Rural Bank Supervision

Directorate of Sharia Banking

Directorate of Banking Investigation and Mediation

Directorate of Bank Licensing and Banking Information

Directorate of Accounting and Payment System

Credit Bureau

Directorate of Economic Research and Monetary Policy

Directorate of Monetary Management

Directorate of Reserve Management

DATA SUPPORT

Suharso I Made Yogi Tita Hapsari

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