Bank Indonesia, Financial Stability Review No.8 March 2007

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

Published by:

Bank Indonesia

Jl. MH Thamrin No.2, Jakarta

Indonesia

This edition was launched in March 2007 and is based on data and inormation available by the end of 2006, except stated

otherwise. With the exception of those stated in graphs and tables, all data sources are from Bank Indonesia.

The pdf format is downloadable : 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 7353, 381 8336

Fax : (+62-21) 2311672

Email : [email protected]

FSR is published biannually with the objectives:

to analyze potential risks confronting domestic financial system;

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

To foster market discipline and public knowlege on domestic and global financial system

stability issues.

Financial Stability ReviewII - 2006

( No. 8, March 2007 )

ii

iii

Foreword vi

Overview 3

Chapter 1 Macroeconomic Condition 9

Global Economy 9

Domestic Economic Performance 11

Chapter 2 Financial Sector 19

Banking Industry 19

Indonesian Financial Sector Structure 19

Liquidity Risk and Funding 20

Credit Performance and Risk 22

Market Risk 31

Profitability and Capital 33

Non bank Financial Institutions and Capital Markets 36

Finance Companies 36

Capital Markets 37

Box 2.1.Limited Deposit Insurance Scheme and

Potential Impacts 22

Box 2.2.Impact of BI Rate On Bank Lending Rates 29

Box 2.3.Short term Capital Inflows through

the Financial Market 42

Table of Contents

Chapter 3 Financial System Prospects 45

Economy Prospects and Risk Perception 45

Banking Industry Risk Profile: Level and Direction 46

Prospects of the Financial System 46

Potential Vulnerability Needs to be Anticipated 47

Banking Industry Prospects 47

Chapter 4 Financial Infrastructure and Risk

Mitigation 51

Payment System 51

Financial Sector Safety Nets (FSSN) 53

Risk Management and Basel II Implementation 54

Box 4.1.Basel II and Financial System Stability 56

Articles

Article 1 Financial Safety Nets: Review of Literature

and Its Practices in Indonesia 61

Article 2 Macroeconomic Model to Measure

Financial Stability Index: The Case of

Indonesia 79

Box A1.1. Key Considerations of Emergency Lending 65

Glossary 91

iv

List of Graph and Table

Tables

1.1 World Economic Indicator (Volume) 9

1.2 GDP Growth (y-o-y) Based on Constant Price 12

2.1 Interest Rate and Exchange Rate 31

2.2 Risk Sensitive Assets and Liabilities -

Interest Rate 33

2.3 Banking Profitability Monthly Average 35

3.1 Concencus Forecast of Selected Economic

Indicators 45

3.2 Indonesian Risk Perception 45

Table Box :

2.2.1 Increasing of SBI and BI Rate 30

2 2.2 Decreasing of SBI and BI Rate 30

2.2.3 Increasing of SBI and BI Rate 30

2.2.4 Decreasing of SBI and BI Rate 30

4.1.1 Basel II Implementation Plan 57

1.1 World Trade 9

1.2 World Commodity Prices 10

1.3 Interest Rate Performance 10

1.4 JPY & EUR Exchange Rate against USD 10

1.5 Exchange Rate of Selected Currencies

in the Asian Region 10

1.6 Private Capital Flows to Developing Countries 11

1.7 Composite Index 11

1.8 Inflation, BI Rate and SBI 12

1.9 Rupiah Exchange Rate against USD 12

1.10 Non Oil and Gas Exports 13

1.11 Non Oil and Gas Imports 13

1.12 Credit and NPL of Consumption Credit 13

1.13 Interest Rate and Inflation 13

1.14 Customer Confidence Index 13

1.15 Unemployment Rate 14

1.16 ROA and ROE 14

1.17 Business Financial Indicators 14

1.18 Corporate Loss Ratio 14

1.19 DER and Debt/TA 15

1.20 Liabilities 15

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 Liquid Asset Ratio of 15 Largest Banks 20

2.5 IBMM Interest Rate Performance 21

2.6 Deposits Structure 21

2.7 Deposits and Credit Growth (y-t-d) 23

2.8 Earning Assets 23

2.9 Loan to Deposit Ratio 23

2.10 Interest Rate 23

2.11 Credit Growth by Economic Sector (y-t-d) 24

2.12 Credit Growth by Type (y-t-d) 24

2.13 MSM Credit 24

Graphs

v

2.14 Non Performing Loans 25

2.15 NPL Performance in 2006 25

2.16 Gross NPL Ratio per Bank Group 25

2.17 NPL Trends by Economic Sector 25

2.18 NPL Share by Economic Sector 26

2.19 Gross NPL Ratio by Economic Sector 26

2.20 NPL Growth of Investment Credit 26

2.21 NPL Growth of Working Capital Credit 26

2.22 NPL of Consumption Credit 27

2.23 Growth in NPL Value 27

2.24 Gross MSM and Corporate Sector NPL 27

2.25 Foreign Exchange Rate and NPL 27

2.26 Gross NPL Performance of Foreign Exchange 27

2.27 Credit, NPL and APLL 28

2.28 Interest Rate and Exchange Rate Performance 31

2.29 Lending Rate by Bank Group 31

2.30 Rupiah Maturity Profile 31

2.31 Foreign Exchange Maturity Profile 31

2.32 NOP Performance (Overall) 32

2.33 NOP Performance (Balance Sheet) 32

2.34 Government Bonds in Bank Portfolio 32

2.35 NII Growth 33

2.36 Rupiah Spread (Weighted Average) 33

2.37 Structure of Bank Interest Income 34

2.38 Structure of Interest Income of

the 15 Largest Banks 34

2.39 R O A 34

2.40 Efficiency Ratio 34

2.41 Capital Adequacy Ratio 35

2.42 Tier 1 Capital 35

2.43 CAR by Bank Group (December 2006) 35

2.44 CAR Distribution (December 2006) 35

2.45 Operational Activities of Finance Companies 36

2.46 Net Cash Flow of Finance Companies 36

2.47 ROA, ROE and Ratio of Financing to Equity 37

2.48 Global Index Performance 37

2.49 Regional Index Performance 37

2.50 SET Volatility 37

2.51 JCI Volatility 38

2.52 Asset Performance 38

2.53 Stock Ownership 38

2.54 Sectoral Index Performance 38

2.55 Share of Sectoral Index Capitalization

(December 2006) 38

2.56 Price Performance of several Government

Bonds Series 39

2.57 Yield of 10-year Government Bonds of

Selected Countries 39

2.58 Liquidity Distribution of Government Bonds 39

2.59 Government Bond Price Volatility in

Selected Asian Countries 40

2.60 Value and Volume of Corporate Bonds (2006) 40

2.61 Mutual Funds by Type (2006) 40

2.62 Time Deposits and NAV 41

3.1 Yield Curve 46

3.2 Risk Profile of Banking Industry and

Its Direction 46

4.1 BI - RTGS Settlement Performance 52

4.2 BI - RTGS Settlement Performance (by Agent) 52

Graph Box :

2.1.1 Deposit Growth 22

2.2.1 Interest Rate Performance 29

2.2.2 Lending Rate and NPL 29

2.3.1 Foreign Net Transactions: Stocks, Government

Bonds and the Exchange Rate 42

2.3.2 Net of Foreign Shares Transaction - JCI 42

Diagram 1 Basel II Structure 57

vi

Since its inception in 2003, the format of the Financial System Stability Review (FSR) has

evolved despite maintaining an identical target, namely to present an analysis of financial

system development and resilience. We continually strive to make the FSR more focused and

future oriented. The material used in this edition is further emphasized by the evaluation of

significant risks on the financial system - be it externally or internally - and measures to mitigate

them.

Externalities are yet to relent, particularly due to global instability and sluggish global

economic growth, especially in the United States of America, and the potential of short-term

capital reversals. However, significant pressures on the domestic economy are yet to materialize.

Meanwhile, the domestic economy remains relatively stable despite lackluster growth and

such conditions support a sound banking industry.

Two fundamental challenges confronting banks are slow credit growth and high credit

risk. However, in general, banking risk remains moderate and controllable with support from

sufficient profitability and capital, as well as better risk management and corporate governance.

The performance of non-bank financial institutions as well as the capital and bond markets is

also relatively sound without significant risk exposure. In terms of infrastructure, the rise in

settlement value and volume, particularly through the BI-Real Time Gross Settlement (BI-RTGS)

system, is mitigated by the development of the settlement system coupled with effective

supervision. To this end, the reliability and security of the payment system can be maintained.

To further strengthening financial system resilience, the government and Bank Indonesia

continue to improve the Financial Sector Safety Net (FSSN). Banking supervision, on the one

hand, is more effective as a result of numerous post-crisis initiatives including Indonesian Banking

Architecture. On the other hand, the effectiveness of risk management and corporate

governance in the banking industry continues to improve in line with preparations for Basel II

implementation. Furthermore, the role of the Indonesian Deposit Insurance Corporation (IDIC)

Foreword

vii

as an insurer and administrator of failed banks will become more strategic in the more dynamic

banking business environment, especially with the full implementation of a limited deposit

insurance scheme in March 2007. In addition, coordination between Bank Indonesia, IDIC

and the Ministry of Finance to prevent and overcome financial crises is more effective with the

function of the Financial System Stability Forum.

The stability and prospects of the financial system over the next six months will improve

due to monetary stability and economic growth. This is attributable to endeavours taken by

the government to meliorate the business climate and nurture corporate governance. Tighter

collaboration between the government and Bank Indonesia, including introducing the Financial

Sector Policy Package, will stimulate real sector development.

The current FSR provides a clearer picture to all parties regarding the performance, risks

and prospects of the financial system. Therefore, stakeholders can proactively perform their

roles in maintaining financial system stability.

Finally, on behalf of the Board of Governors, I extend our gratitude and appreciation to

the writers and all parties who have contributed to the latest FSR. May God guide the way

and bless us all so that we perform our tasks and responsibilities to the best of our abilities.

DEPUTY GOVERNOR

BANK INDONESIA

MULIAMAN D. HADADMULIAMAN D. HADADMULIAMAN D. HADADMULIAMAN D. HADADMULIAMAN D. HADAD

This page is intentionally blank

1

Overview

Overview

2

Overview


3

Overview

The resilience of the financial system was maintained in semester II 2006

with improving prospects. This was supported by monetary stability and the

buoyant domestic economy, as well as the release of pressures stemming

from the global economy coupled with a decline in interest rates and a rise in

asset value.

Stable conditions nurtured financial sector performance, particularly banks,

despite slower than expected growth for credit. Bank profitability rose and

capital remained adequate to cushion mounting risks. With improved

efficiency as well as better risk management and corporate governance, it is

projected that banks will accelerate the pace of credit growth to stimulate

the economy.

Notwithstanding, there remain sources of instability that must be well

mitigated to avoid disruptions to financial system stability.

Overview

1. SOURCES OF VULNERABILITY

Nearly ten years on since the financial crisis, the

financial system - banks in particular - is becoming

healthier and more stable yet remains beset by multi-

faceted challenges. Analysis of Indonesian financial

system resilience focus on banks, especially the major

ones, the markets and financial infrastructure since

these sectors tend to have systemic effects.

Risk exposure generally stems from externalities

in the form of volatile short-term capital inflows.

Internally, risk emanates from the on going

restructuring of major debtors as well as inadequate

risk management and weak corporate governance.

The External Environment

The external environment remained

unfavourable primarily due to global imbalances and

sluggish global economic growth, especially in the

United States. However, pressures emanating from

the external sector were relatively low and did not

significantly affect the domestic economy.

Meanwhile, the domestic economy remained

relatively steady supported by monetary stability.

Unfortunately, such conditions were not fully utilised

to foster economic growth, primarily because of

inefficiency as well as an unfavourable business

climate and restricted real sector growth.

4

Overview

Banking

The banking system remained relatively sound

with moderate risks. However, the slow pace of bank

credit requires attention, as do mounting credit risk

and operational risk that could threaten financial

system stability.

Slow credit growth

Bank credit continued to grow, however, at a

slower pace attributable to high credit risk and an

under-performing real sector, in particular

corporations, primarily due to the inauspicious

business climate. This encouraged banks to prefer

investing in SBI, ergo undermining financial

intermediation.

Unresolved credit restructuring

The restructuring of unhealthy corporations by

major banks remained unresolved, which could

exacerbate credit risk and erode bank profitability.

Challenges facing the limited deposit insur-

ance scheme

Implementation of the transitional limited

guarantee scheme - with a maximum of Rp100

million per customer per bank beginning March 2007

- has not triggered flight to safety. However, the high

concentration of bank deposits of over Rp100 million

could trigger liquidity risk for some banks. This needs

to be anticipated to avoid systemic effects.

Financial Market and Capital Market

Increasing short-term capital volatility

Macroeconomic improvements attracted short-

term foreign investment in the capital market. High

fluctuations in the exchange rate or interest rate could

impinge upon the domestic financial markets. Non-

transparent pricing and the shallow market made

the government bonds (SUN) market more attractive

for short-term investment, which is more volatile.

Increased financial market performance underpinned

primarily by sentiment rather than fundamentals lead

to a price bubble.

2. RISK MITIGATION

To minimize the risks outlined, a series of

measures were required for both the financial sector

and related authorities as follows:

Financial Sector Policy Package (FSPP)

The government and Bank Indonesia continued

financial sector reform to bolster the role of financial

institutions and markets in financing the economy.

The FSPP strives to buttress the structure of the

financial sector, enhance market and institutional

infrastructure as well as broaden the access of

business players to financing. Hence, macroeconomic

stability and financial system stability will foster real

sector development.

Strengthening the Risk Management of Banks

Basel II will be implemented in 2008 along with

advancements in the practice and methodology of

risk management and international standards,

commencing with the simplest approach to calculate

capital adequacy. The implementation of Basel II will

not only boost the quality of banking risk

management, therefore, leading to healthier

operations but will also bolster financial system

stability, especially in the banking sector.

5

Overview

Reinforcing Financial Infrastructure

Payment system

Bank Indonesia continuously develops a reliable

and secure payment system. Risk management - in

the Systemically Important Payment System (SIPS) and

Systemically Wide Important Payment System (SWIPS)

- has been conducted from the outset including the

system design phase, operational procedures and

participants» rules. In addition, oversight continues

to be strengthened. Other policies instituted include

the management of money remittances.

Furthermore, operational risk is mitigated by a

contingency plan and business continuity

management.

Strengthening the Financial Sector Safety Net

(FSSN) including Crisis Management

Through four key elements the government

and Bank Indonesia continue efforts to develop

FSSN, namely: (i) effective bank regulation and

supervision; (ii) lender of last resort for normal

conditions and systemic crises; (iii) a limited and

explicit deposit insurance scheme; and (iv) clear crisis

resolution policy. These key elements were

encompassed in the draft FSSN Act, which clearly

defines the tasks and responsibilities as well as a

coordination mechanism between related

authorities to prevent and cope with crises. This,

among others, is instituted through the Financial

System Stability Forum comprising of board

members, senior executives and officials from the

Ministry of Finance, Bank Indonesia and IDIC as

members.

Enhancing the Effectiveness of Financial

System Surveillance

The effectiveness of financial system surveillance

in terms of performance and vulnerability is

continuously improved through the development and

implementation of numerous methodologies

including stress tests. This is a crucial front guard

action to identify and anticipate potential instability.

3. FINANCIAL SYSTEM RESILLIENCE AND

PROSPECTS

Overall, risks in the financial system in semester

II 2006 was less pronounced and steadier in line with

monetary stability and the betterment of economic

conditions.

External factors had the potential to affect

Indonesian financial system resilience, including a

slight dip in the global oil price, sluggish global

economic growth and short-term capital inflows.

Internally, expanding credit allocation and

reducing persistent credit risk, which are highly

correlated, represent two primary challenges

confronting banks. Another challenge is to improve

the effectiveness of internal controls and corporate

governance as well as formulate a contingency plan

to curb operational risk.

Measuring financial system stability represents

a particularly challenging task and requires improved

methodologies and tools. However, a simple stress

test conducted to measure credit risk, liquidity risk

and market risk, demonstrated that banks have

adequate resilience to absorb shocks as a result of

changes in macroeconomic variables.

6

Overview


7

Chapter 1 Macroeconomic Condition

Chapter 1Macroeconomic Condition

8



9


1.1 GLOBAL ECONOMY

External sector pressures stemming from

burgeoning capital inflows attributable to

globalization are projected to intensify.

The global economy remains confronted by the

downside risk of global imbalance issue emanating

from the large current account deficit in the US to

other countries, particularly Asian and oil exporting

countries. Global economic imbalances have

benefited some countries, particularly oil exporters,

as reflected by high savings and current account

surpluses. Such countries have become the primary

contributors of excess global liquidity and propagate

the low long-term interest rate.

Against this backdrop, global economic growth,

particularly in developing countries can prosper.

Furthermore, global economic expansion befalls

some regions in a more balanced manner, allowing

Volatility in the external sector, due to surging globalization, did not

significantly affect economic stability. The shock from external sector may

emerge from global oil price hikes, continuing investor concerns regarding

the propagation of the foreign exchange control taken by Thailand and other

Asian countries, and outbreaks of avian influenza.

In addition, domestic economic conditions remained steady despite the

absence of sound economic growth. However, rigidity in the economy

brought inefficiency, which impinged upon real sector growth.

Macroeconomic ConditionsChapter 1

Table 1.1World Economic Indicator (Volume)

Category 2004 2005

World Output 5.3 4.9 5.1 4.9Advanced Economies 3.2 2.6 3.1 2.7Emerging & Developing Countries 7.7 7.4 7.3 7.2

Consumer PriceAdvanced Economies 2.0 2.3 2.6 2.3Emerging & Developing Countries 5.6 5.3 5.2 5.0

LIBORUS Dollar Deposit 1.8 3.8 5.4 5.5Euro Deposit 2.1 2.2 3.1 3.7Yen Deposit 0.1 0.1 0.5 1.1

Oil Price ($) - Average 30.7 41.3 29.7 9.1

%%%%%Projection

2006 2007

Source: World Economic Outlook - September 2006

Graph 1.1World Trade

%

-4

-2

0

2

4

6

8

10

12

14

World Trade VolumeTrend 1970-2005

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Source: IMF

10


THB/$, PHP/$ SGD/$

30

35

40

45

50

55

60

1.4

1.45

1.5

1.55

1.6

1.65

1.7

1.75

THB/$ PHP/$ SGD/$ (right axis)

2003 2004 2005 2006

JPY/$ $/EUR

1.05

1.1

1.15

1.2

1.25

1.3

1.35

1.4

90

95

100

105

110

115

120

125

JPY/$ $/EUR (right axis)

2003 2004 2005 2006

property investment in the US. To restore US

economic growth amidst the looming threat of high

inflation rates, the Fed did not raise its interest rate

during semester II 2006. A level of 5.75% was

maintained to the end of 2006, which is expected to

drop in semester I 2007.

High capital inflows were prevalent to emerging

countries, particularly in Asia, including Indonesia.

These flows were attributable to a US dollar slump

coupled with a more flexible exchange rate system

in Asia together with the adoption of monetary policy

anchored to inflation targets and the high investment

yield in some emerging markets.

In semester II 2006, financial markets in the

Southeast Asian region experienced a steep bullish

rally compared to the previous semester. Surpluses

in some countries encouraged the further

Graph 1.2World Commodity Prices

$

0

50

100

150

200

250

300

350

400

450

500OilAluminumCopperTinGold

2001 2002 2003 2004 2005 20062000

US economic growth is projected to decelerate

to 2.9% in 2007 from 3.4%, in 2006 following

tendencies of falling property asset value. This

precipitates a decline in household consumption and

Graph 1.4JPY & EUR Exchange Rate against USD

Graph 1.3Interest Rate Performance

%

-

1

2

3

4

5

6

7

2001 2002 2003 2004 2005 2006

LIBOR Fed Fund RateSIBOR

2000

Graph 1.5Exchange Rate of Selected Currencies in the Asian Region

them to exceed initial projections. In addition, global

trade volume has also surpassed its long-term

average.

Entering semester II 2006, the global economy

was adjusting to the imbalances, aiming for a soft-

landing scenario, including improvements in Asian

exchange rate flexibility, boosting expenditure from

oil-producing countries, structural reform in the Euro

zone and Japan as well as fiscal consolidation in the

US. Adjustments to global imbalances were

accompanied by a drop in the global oil price, which

fostered economic growth in developing countries,

while the US economy tended to cool off.

11


development of hedge fund activities with greater

volume.

Such investment is generally short term,

sparking high volatility in financial markets.

The capital control policy in Thailand in mid

December 2006, despite affecting the performance

of financial markets in other Asian countries, did not

trigger persistent bearish conditions. The JSX

Composite continued to climb and approached 1800

from the middle of 2006 but tumbled by 2.9% to

1737 on 19th December; coinciding with Thailands

Capital Control Policy. However, relatively steady

Indonesian macroeconomic conditions enabled

continuing capital flows into Indonesia.

Consequently, the Jakarta Composite Index (JCI)

regained momentum and reached its new highest

level of 1805 at the end of 2006.

Market risk pressures are projected to intensify

due to resurgent short-term capital inflows. These

flows are driven by expectations of improving

economic growth in emerging markets.

Therefore, caution and domestic economic

resilience are necessary to avoid a sudden capital

reversal. The shock may stem from global oil price

hikes, continuing investor concerns regarding the

propagation of the foreign exchange control taken

by Thailand and other Asian countries, outbreaks of

avian influenza and potential politic instability

domestically and regionally.

1.2. DOMESTIC ECONOMIC PERFORMANCE

Amidst ongoing adjustments to global

imbalances, economic activities, which slumped at

the beginning of 2006 due to weaker public

purchasing power post the fuel price hikes in October

2005, gradually regained momentum. Government

consistency not to push for another hike in fuel prices

and the basic electricity tariff in 2006 was responded

to positively, reflected by a drop in inflation to 6.6%

in December 2006. The dip in inflation provided

sufficient manoeuvrability for steady BI Rate cuts,

which restored the expectations of investors

concerning economic prospects. Consequently, this

fostered a surge in capital inflows to Indonesia, which

contributed to rupiah appreciation. Nevertheless,

caution is still necessary considering that the majority

of the inflows are short term.

Through semester II 2006 the rupiah exchange

rate strengthened with low volatility (0.24%)

compared to the previous semester (0.46%) driven

by domestic macroeconomic improvements.

Furthermore, rupiah appreciation was also

attributable to strong Asian exchange rates and

Graph 1.6Private Capital Flows to Developing Countries

Source: World Bank

Billions of $

Estimation

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

550

500

450

400

350

300

250

200

150

100

50

0

Graph 1.7Composite Index

1,736.67

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Jul Aug Sep Oct Nov Dec2006

Jun

12


not significantly improved with the exception of

construction projects that have tended to

increase.

Externally, the balance of payments is

projected to maintain its surplus due to the rise in

exports and a surge in capital inflows. Against this

backdrop, Indonesian forex reserves are adequate

at a level of USD42.4 billion as of year end 2006.

Consequently, Indonesia succeeded in servicing its

external debt to the International Monetary Fund

(IMF). Notwithstanding, the rise in exports was not

Graph 1.8Inflation, BI Rate and SBI

%

-

2

4

6

8

10

12

14

16

18

20

2003 2004 2005 2006

Inflation SBI BI Rate

2002

Graph 1.9Rupiah Exchange Rate against USD

Rp/$

- Katrina Hurricane in New Orleans (Aug 29, 2005- World Oil Price $69.81/barrel

(Aug 30, 2005)The implementation ofNew Fuel Price &2nd Bali Bomb (Oct 1, 2005)

FFR 5% (May 10, 2006)BI Rate 12.50% (May 9, 2006)

7,000

7,500

8,000

8,500

9,000

9,500

10,000

10,500

11,000

11,500

12,000Feb Apr Jun Jul Sep Nov Dec Feb Apr Jun Jul Sep Nov DecJan Feb Apr Jun Jul Sep Nov Dec Feb Apr Jun Jul Sep Nov Dec

2003 2004 2005 2006

Table 1.2GDP Growth (y-o-y) Based on Constant Price (Billions of Rp)

2005** 2006**

1.1.1.1.1. Consumption ( 2 + 3 )Consumption ( 2 + 3 )Consumption ( 2 + 3 )Consumption ( 2 + 3 )Consumption ( 2 + 3 ) 2.032.032.032.032.03 2.632.632.632.632.63 5.525.525.525.525.52 6.716.716.716.716.71 4.254.254.254.254.25 3.753.753.753.753.75 5.575.575.575.575.57 2.842.842.842.842.84 3.533.533.533.533.53 3.913.913.913.913.912. Household 3.42 3.78 4.42 4.18 3.95 2.94 2.99 2.99 3.76 3.173. Government -9.60 -6.67 14.69 24.91 6.64 11.51 28.77 1.72 2.18 9.614.4.4.4.4. Investment ( 5 + 6 )Investment ( 5 + 6 )Investment ( 5 + 6 )Investment ( 5 + 6 )Investment ( 5 + 6 ) 18.4018.4018.4018.4018.40 18.4418.4418.4418.4418.44 11.2211.2211.2211.2211.22 -11.52-11.52-11.52-11.52-11.52 8.398.398.398.398.39 -3.24-3.24-3.24-3.24-3.24 -2.94-2.94-2.94-2.94-2.94 -0.55-0.55-0.55-0.55-0.55 14.1514.1514.1514.1514.15 1.431.431.431.431.435. Formation of Fixed Gross Domestic Capital 14.88 16.71 10.30 2.46 10.80 1.14 1.09 1.29 8.18 2.916. Stock Changes 108.88 39.46 24.89 -165.61 -25.69 -65.17 -43.74 -24.60 88.57 -29.79

Statistic Discrepancy1) -16.76 30.18 11.90 -30.19 -50.67 -25.76 -10.06 3.246.19 31.52 456.41Domestic Demand ( 1 + 4 )Domestic Demand ( 1 + 4 )Domestic Demand ( 1 + 4 )Domestic Demand ( 1 + 4 )Domestic Demand ( 1 + 4 ) 5.895.895.895.895.89 6.546.546.546.546.54 7.007.007.007.007.00 1.931.931.931.931.93 5.295.295.295.295.29 1.911.911.911.911.91 3.233.233.233.233.23 1.921.921.921.921.92 5.955.955.955.955.95 3.273.273.273.273.27Net Export ( 7 - 8 )Net Export ( 7 - 8 )Net Export ( 7 - 8 )Net Export ( 7 - 8 )Net Export ( 7 - 8 ) 21.7321.7321.7321.7321.73 -6.28-6.28-6.28-6.28-6.28 -5.06-5.06-5.06-5.06-5.06 47.0547.0547.0547.0547.05 13.5613.5613.5613.5613.56 54.6554.6554.6554.6554.65 30.9930.9930.9930.9930.99 0.090.090.090.090.09 -4.56-4.56-4.56-4.56-4.56 15.6015.6015.6015.6015.60

7. Goods and Services Export 21.97 17.44 11.97 15.16 16.36 11.56 11.30 8.17 6.08 9.168. Substracted by Goods and Services Import 22.02 23.52 17.04 7.23 17.07 2.76 7.47 10.12 9.70 7.579. GROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCT 6.066.066.066.066.06 5.875.875.875.875.87 5.815.815.815.815.81 5.005.005.005.005.00 5.685.685.685.685.68 4.984.984.984.984.98 4.964.964.964.964.96 5.875.875.875.875.87 6.116.116.116.116.11 5.485.485.485.485.4810. Net Income to Foreign Production Factor 4.97 -48.84 -41.17 -46.84 -33.45 -23.64 -9.72 0.49 -3.51 -7.5211. GROSS NATIONAL PRODUCTGROSS NATIONAL PRODUCTGROSS NATIONAL PRODUCTGROSS NATIONAL PRODUCTGROSS NATIONAL PRODUCT 6.626.626.626.626.62 3.763.763.763.763.76 4.004.004.004.004.00 2.772.772.772.772.77 4.274.274.274.274.27 4.154.154.154.154.15 4.624.624.624.624.62 6.316.316.316.316.31 6.306.306.306.306.30 5.355.355.355.355.3512. Substracted by Indirect Tax 10.10 -110.96 -62.16 230.15 -24.89 3.49 1,360.45 107.51 -127.71 60.2713. Substracted by Amortization 6.06 5.87 5.81 5.00 5.68 4.98 4.96 5.87 6.11 5.4814. NATIONAL INCOMENATIONAL INCOMENATIONAL INCOMENATIONAL INCOMENATIONAL INCOME 6.436.436.436.436.43 8.688.688.688.688.68 6.546.546.546.546.54 -0.78-0.78-0.78-0.78-0.78 5.115.115.115.115.11 4.144.144.144.144.14 -1.45-1.45-1.45-1.45-1.45 4.904.904.904.904.90 8.908.908.908.908.90 4.094.094.094.094.09

Q I Q II Q III Q IV Total BI»s Projection

Q IV*Q I Q II Q III BI»s Projection

Total*

Source: BPS-Statistics Indonesia (calculated)1) Gap between GDP based on sectoral and GDP based on usage

bullish capital markets in Asia following investor

pessimism surrounding the US economy.

Along with the fall in inflation and rupiah

appreciation, the economy in semester II 2006 also

grew positively, primarily underpinned by the surplus

balance of payments supported by rising exports.

Notwithstanding, macroeconomic performance in

2006 was below expectations due to a persistently

low growth.

Internally, demand remains reliant on

consumption. Meanwhile, private investment has

13


0

10

20

30

40

50

60

70

80

90

2000 2001 2002 2003 2004 2005 2006

Millions of $

ManufacturingMining and QuarryingAgriculture, Hunting, & FishingTotal

0

10

20

30

40

50

60

70

80

90

2000 2001 2002 2003 2004 2005 2006

Millions of $

ManufacturingMining and QuarryingAgriculture, Hunting, & FishingTotal

Graph 1.10Non Oil and Gas Exports

Graph 1.11Non Oil and Gas Imports

private investment. This was attributable to weak

purchasing power and the second-round effects of

fuel price hikes at the end of 2005; exacerbated by a

tirade of natural disasters throughout 2006. Such a

phenomenon was clearly evidenced by the tendency

of rising non performing loans (NPL) for consumption

credit.

Trillions of Rp %

0

50

100

150

200

250

2003 2004 2005 2006

0

1

2

3

4

5

6

7

8

Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec

NPL (right axis)Nominal

Graph 1.12Credit and NPL of Consumption Credit

triggered by improvements in efficiency or product

competitiveness, but more substantially by strong

global demand and price hikes on some

commodities. Conversely, imports grew at a slower

pace than exports tainted by controversy

surrounding smuggled goods.

Weak product competitiveness and an

unfavourable business climate triggered capital

inflows from exports to short-term investment in the

capital market. If this continues, it could adversely

affect exchange rate stability and, coupled with

negative sentiment, trigger a capital reversal. Also,

more liquidity in the market, not followed by a rise

in production, could aggravate inflation.

Relatively slow real sector growth was evidenced

by low household consumption and uninspiring

Graph 1.13Interest Rate and Inflation

%

0

5

10

15

20

25

2003 2004 2005 2006

1 Month Time DepositsInterest Rate of Investment LoanBI Rate1 Month SBI

Interest Rate of Working Capital LoanInterest Rate of Consumer LoanInflation

2002

Graph 1.14Customer Confidence Index

0

20

40

60

80

100

120

140

160

2003 2004 2005 2006

Recent Economy ConditionConsumer ExpectationConsumer Confidence Index

Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec

14


expected. In addition, the BI Rate cut of 300 basis

points (12.75%) in 2006 to 9.75% has had, until

recently, only limited influence on banks reducing

their lending rates.

Therefore, despite an increase in producer

optimism regarding economic prospects, pervasive

rigidity in the economy created inefficiency that

triggered reluctance among business players to

expand. If this persists, it has the potential to raise

redundancies and consequently push up

unemployment, which in turn would impinge upon

economic growth and disrupt financial system

stability.

An apathetic real sector was reflected by the

poor financial performance of public listed companies

until the third quarter of 2006. This was further

Graph 1.15Unemployment Rate

%

2001 2002 2003 2004 2005 Feb-06 Aug-060

2

4

6

8

10

12

Graph 1.17Business Financial Indicators

Base Year 2001 = 100

Q3:2005Q3:2006

Current Ratio

ROA

ROE

Inventory Turn Over Ratio

Collection Period

DER

-50

50

150

250

350

450

Graph 1.16ROA and ROE

% %

-100

0

100

200

300

400

500

600

700

-100

-50

0

50

100

150

200

250

300

350

2003 2004 2005 2006

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q1 Q2 Q3

ROE (right axis)

ROA

Graph 1.18Corporate Loss Ratio

Mining Infrastructure Basic Industry TradingProperty Consumption Agriculture Misc. Industry

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q1 Q2 Q3

2004 2005 2006

Various sweeteners offered through an

investment and infrastructure policy package at the

beginning of 2006, a financial sector policy package

at the beginning of semester II 2006 as well as

improved macroeconomic conditions, including a

drop in the inflation and interest rates, were unable

to stimulate real sector growth. This is primarily due

to unresolved real sector issues, particularly labour

issues, inadequate infrastructure and the high cost

economy. Amendments to the Labour Act designed

to improve the labour sector were postponed due

to massive labour rallies. Furthermore, the

infrastructure policy package, which requires tight

coordination among institutions, has not progressed

adequately. Meanwhile, government commitment

to support investment has not been realized as

15


Graph 1.19DER and Debt/TA

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2003 2004 2005 2006

DERDebt/Total Assets

Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q1 Q2 Q3

Graph 1.20Liabilities

Trillions of RpBillions of Rp

0

500

1,000

1,500

2,000

2,500

3,000

2003 2004 2005 2006Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q 1 Q 2 Q 3 Q 4 Q1 Q2 Q3

-

100

200

300

400

500

600

Total of Corporate Liabilities

Total of Working Capital + Investment Loan (Industry) (right axis)

Corporate leverage reflected by the debt-to-

equity ratio (DER) tended to remain steady despite

an ongoing downturn since early 2004.

To restore purchasing power and foster

economic growth, collaboration between related

authorities must focus on resolving prevailing

constraints to improve real sector performance in

order to maintain macroeconomic stability.

evidenced by the drop in business profitability in terms

of ROA and ROE.

The performance shortfall primarily occurred in

other sectors including the textile industry and textile

products, shoes and the automotive industry, which

witnessed more defaults than any other sectors. This

was marked by a high number of redundancies in

these industries throughout the reporting period. On

the other hand, the mining and agricultural sectors

grew positively.


17

Chapter 2 Financial Sector

Chapter 2Financial Sector

18



19


2.1. BANKING INDUSTRY

2.1.1. Indonesian Financial Sector Structure

The Indonesian financial sector is dominated by

banks, especially large banks.

The Indonesian financial sector comprises of

commercial banks, rural banks and non bank financial

institutions, namely insurance, superannuation,

finance companies, securities and pawn shops. The

market share of the banking sector represents about

80% of the total assets of the financial system. Thus,

banking sector vulnerability, particularly in the major

banks with a market share of 69.6% of banking

assets, highly affects financial system stability.

Since 2001, non bank financial institution

activity has escalated, particularly insurance, finance

companies and securities companies, eroding the

market share of banks slightly, however, bank total

assets continue to accrue.

Total funds managed by the financial sector

have reached Rp1,824.2 trillion or approximately

65.50% of GDP1 . Total assets of the financial

Financial SectorChapter 2

Graph 2.1Assets of Financial Institutions

Sources: BI and Others

0

20

40

60

80

100

Share of Total Asset of Financial Institution

87.9%80.6%

2001 2005

SecuritiesCompany

LeasingCompany

Pension Fund

Insurance

Rural Bank

Commercial Bank

Pawn Shop

Financial sector resilience was maintained. The financial sector, which

remained dominated by banks, continued to improve amidst slow credit

growth. Bank liquidity was adequate but concentrated on short-term deposits.

Despite lower NPL, high credit risk remained a salient feature of the banking

industry. To mitigate the credit risk, banks maintained adequate capital and

reserves. On the other hand, market risk stayed relatively controllable in line

with the drop in the interest rate.

Meanwhile, bullish sentiment triggered by improving macroeconomic

conditions fostered rapid growth in the financial market and bonds market.

Nevertheless, this required caution considering the lack of fundamentals,

which could trigger high price volatility.

20


sector have grown on average by 10% annually

since 2001. In addition, the past year of 2006

witnessed 16.6% growth, which exceeds annual

GDP growth at 5% compared to the previous three

years.

2.1.2. Liquidity Risk and Funding

Deposits remain the largest source of funds.Deposits remain the largest source of funds.Deposits remain the largest source of funds.Deposits remain the largest source of funds.Deposits remain the largest source of funds.

Deposit growth remained steady amidst a diminishing

savings rate. Deposits still dominate bank funds with

share of 89%, most of which is short term. This

reflects inadequacy of banks to narrow the gap in

the maturity profile through, among others,

subordinate loans with longer terms.

147.3% at the end of semester II. This was triggered

by an increase in the number of liquid assets

(29.73%), which surpassed the increase in short-term

liabilities (10.39%).

The liquid asset ratio of the 15 largest banks

was relatively lower than other banks. At the end of

semester II, the liquid asset ratio of the 15 largest

banks had only reached 118.8%, whereas other

banks had reached 199.4%. The difference is due to

slower deposit growth of other banks compared to

the 15 largest banks.

Graph 2.2Structure of Funding and Bank Placements

EquityParticipation

Inter Bank

Securities

Placement toBankIndonesia

Credit

0

25

50

75

100

Funding Placement

SecuritiesInter Bank

Borrowing

Deposits

53.5

13.1

22.9

10.10.4

90.4

0.97.7

1.0

%

1 Nominal GDP of current price2 To the end of November 20063 Liquid asset ratio is a comparison between the number of liquid assets owned by banks

and the amount of non-core deposits (NCD)4 A liquid asset comprises of cash and placements at BI (BI checking account, SBI, and

FASBI)

Graph 2.3Bank Liquid Asset Ratio

0

80

160

240

320

Dec Dec Dec80

100

120

140

2002 2005 2006

NCD Liquid Asset/NCD (right axis)Liquid Asset

%Trillions of Rp

Jun

Graph 2.4Liquid Asset Ratio of 15 Largest Banks

0

50

100

150

200

250

60

75

90

105

120Liquid Asset NCD Liquid Asset/NCD (right axis)

Dec Dec Dec

2002 2005 2006

%Trillions of Rp

Jun

Liquidity Adequacy

Bank liquidity remained sufficient while liquidity

risk relatively moderate through semester II 20062 .

This is evidenced by the ratio of liquid assets above

100% at the end of the reporting period3 . In addition

to liquid assets4 , the inter-bank money market also

performed steadily.

The liquid asset ratio of banks continued to

improve; from 129.0% at the end of semester I toInter-Bank Money Market (IBMM)

Generally, rupiah IBMM performance through

semester II 2006 remained steady and liquid with an

average interest rate of 5% - 7%. The IBMM

transaction interest rate touched its highest level of

21


Unbalanced Deposits Structure

At the end of semester II 2006, deposits

totalled Rp1,287 trillion or 76.0% of total banking

assets. Furthermore, the structure of deposits

remained highly concentrated on short-term (up

to 3 months) deposits (91.9%) and a deposit value

of over Rp100 million (75.0%). Deposits of Rp100

million represented just 2.3% of total customer

accounts. The deposit structure, which is mostly

short term and of large value, is susceptible to

sudden withdrawals, particularly by the larger

customers.

A bank strategy to overcome the gap in maturity

profile was by adding liquid assets, particularly SBI/

Fasbi that increased by Rp46.6 trillion (63.8%) over

semester II 2006. With the overnight period for Fasbi

and 1 to 3 months for SBI, placements in SBI/Fasbi

were more profitable, due to far lower risk, and more

liquid.

Implementation of the Limited Deposit

Insurance Scheme

In line with the phased schedule, the deposit

insurance scheme will be limited to a maximum of

Rp100 million per customer per bank as of 22nd March

2007. Although the majority of customer accounts

total less than Rp100 million, deposits are still

concentrated on accounts of over Rp100 million. This

has the potential to intensify bank liquidity risk if one

or a combination of three aspects occurs: (i) flight to

safety; (ii) a breakdown of customer deposits into

smaller amounts; and (iii) switching of deposits to

other investment forms.

To mitigate liquidity risk Bank Indonesia, the

Deposit Insurance Corporation (IDIC) and banks

continued socialization programs through mass

media and more directly through customer service

officers and bank statements sent to customers. In

addition, Bank Indonesia also mandated banks to

prepare a contingency plan. In addition, some banks

maintained their liquidity through liquid placements,

such as SBI/Fasbi.

Graph 2.6Deposits Structure

Individual(57.7%)

< 3 month(91.9%)

> 100 million(75.0%)

others(42.3%)

> 3 month(8.1%)

< 100 million(25.0%)

Ownership

Maturity

Nominal

Graph 2.5IBMM Interest Rate Performance

2006

%

0

3

6

9

12

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

Morning

Afternoon

FX-Onshore

FX-Offshore

30% as a result of huge liquidity requirements to

settle Indonesian Retail Bonds (IRB) and to satisfy the

large public demand for currency for a long weekend

holiday. To provide additional liquidity, some banks

sold SBI Repo.

22


2.1.3. Credit Performance and Risk

Credit growth in semester II 2006 remained

below expectations despite recording higher

growth than the previous semester. This was

primarily attributable to real sector issues and

an inauspicious investment climate

compounded by weak purchasing power.

Furthermore, bank credit risk was deemed

moderate, marked by persistently high NPL.

Credit Performance

Credit growth reported poor performance

unparalleled in the last four years. Credit growth5 in

2006 was 14.1%, well below the target contained

in the bank business plan of 18%. This affected

investment structure and bank income. Bank

investment shifted from credit disbursement to SBI,

although credit remained dominant with a share of

Limited Deposit Insurance Scheme and Potential ImpactsBox 2.1

As scheduled, the limited insurance deposit

scheme will be limited to a maximum of Rp100 million

per customer per bank from 22nd March 2007. This

replaces the government blanket guarantee scheme

adopted since 1998 to minimize moral hazard and

boost public confidence in banking industry after the

Asian financial crisis.

Since the reduction in the value of deposits

insured no serious impacts on bank liquidity and

financial system stability have been evident. This has

been corroborated by at least three specific conditions.

First, there has been no flight to safety. Second,

deposits have not been broken down into a number

of smaller accounts, evidenced by the lack of a surge

in the number of customer accounts, which actually

even declined. Third, no symptoms of significant

deposit switching to other investments were apparent.

Furthermore deposits grew steadily from September

2005 to the end of 2006.

Bank Indonesia coordinated with IDIC to

anticipate the potential effects of a limited deposit

insurance scheme, primarily by intensifying the

socialization program to the public through banks and

the mass media. As bank supervisor, Bank Indonesia

mandated that banks assess and mitigate their risks,

including a contingency plan. To this end, several banks

increased their liquid assets.

Customer comprehension of the limited deposit

insurance scheme and financial system stability,

particularly the soundness of the banking system, is

crucial to maintain public confidence in banking. In

addition, efforts to uphold the reputation of banks

and foster customer loyalty represent the first line of

defense against risk pressures.

Graph 2.1.1Deposits Growth

Trillions of Rp

34.3

91.2

16.1

33.4

35.9

92.0

125.5129.1

85.3

92.1

96.4

89.7

34.3

15.617.4

480.4

20.0

84.9

444.6

431.4

71.8

396.9

72.8

388.4

426.8

78.2

411.6

447.2

Mar '06

Dec '05 Sep '06

Dec '06

State-owned Banks

Regional Dev. Banks

Foreign Banks

Joint Venture Banks

Small Private Banks

Middle Private Banks

Big Private Banks

5 Including channeling

23


53.5%. Bank income from placements at BI increased

significantly despite the falling BI Rate (300 bps in

2006). Nevertheless, the share of income from credit

remained relatively constant.

LDR changed little due to relatively low credit

growth, namely 64.7%. The narrow gap between

the BI/SBI rate and lending rate affected the

investment behavior of banks.

Credit extension is affected by developments

in the BI/SBI rate and the magnitude of the gap

between the BI/SBI rate and the lending rate. One of

the reasons for an increase in bank placements in

SBI was the relatively narrow gap between the BI/SBI

rate and the lending rate, thus not covering the risk

premium. Furthermore, deposit rate adjustments to

the cuts in the BI Rate outpaced lending rate

adjustments. Therefore, the falling trend of the BI

Rate is projected to widen the gap between the BI

Rate and lending rates, which will further improve

credit extension. This phenomenon is presented in

Box 2.2.

Graph 2.9Loan to Deposit Ratio

Trillions of Rp%

LDR (left axis)

Deposits (right axis)

Credit (right axis)

-

10

20

30

40

50

60

70

80

2003 2004 2005 2006-

200

400

600

800

1,000

1,200

1,400

2002

Graph 2.7Deposits and Credit Growth (y-t-d)

% %

0

5

10

15

20

25

30

0

5

10

15

20

25

30

2003 2004 2005 2006

Deposits

Credit

6.328.38

17.11

14.10

16.31

22.7024.70

14.07

Graph 2.8Earning Assets

0

25

50

75

100

2005 2006

54.0 53.5

7.9 13.1

25.922.9

11.8 10.1

0.5 0.4

Equity Participation

Inter-Bank

Securities

Placement on BI

Credit

%

Working capital credit experienced the highest

growth, whereas consumption credit is already

considered optimal. High working capital credit

growth (16.97%) in 2006 was in line with various

improvements made to encourage credit growth;

however, it remained below the previous year

(22.40%). Conversely, consumption credit recorded

the most impressive expansion during the preceding

year (36.81%). This reflects improvements in

economic growth.

Investment credit growth was slow (12.51%)

primarily due to various constraints in infrastructure,

Graph 2.10Interest Rate

BI Rate

1 Month Time Deposits

Consumer

Working Capital

Investment

5

8

10

13

15

18

20

Jun

2005 2006

5

8

10

13

15

18

20% %

DecDec

24


legal wrangling, an unfavorable investment climate

and high costs. However, the outlook for investment

credit is still bright because of falling interest rates

for investment credit. However, undisbursed loans

(UL)6 for investment credit remained high at 28.0%

through 2006.

Micro, Small and Medium (MSM) credit

remained prominent. The share of MSM credit was

approximately 52% of total credit at the end of 2006.

However, its growth plunged from 25.60% (2005)

to 12.4% (2006). Notwithstanding, the portion of

commercial MSM credit represented just 26% of total

credit.

Credit Risk

In addition to uninspiring credit growth, credit

risk re-emerged as a central issue of the banking

industry. Bank NPL tailed off at the end of the

reporting period subsequent to a significant

surge in the third quarter of 2006. Meanwhile,

stress tests on the 15 largest banks evidenced

their resilience in tackling credit risk assuming

a 20%-rise-in-NPL scenario.

Credit growth was surpassed by growth of

investment in SBI. Albeit slow, credit grew steadily

and reached 53.5% of total earning assets. Bank

placements in SBI also witnessed strong growth

(41.5%), which pushed its share in total banking

earning assets up to 14.0%.

Banks perceived risk to remain high, reflected

by the tendency of banks to invest in risk-free liquid

assets rather than in credit. Banks with a better fund

management strategy and excess liquidity actively

invested in SBI and government bonds. The same

applies to mid-sized banks, particularly regional

government banks, as a result of abundant project

funds from the central government. This

phenomenon, on one side, slightly eased credit risk

pressures but, on the other hand, impinged on both

credit and economic growth.

The quality of bank credit improved along with

more conducive economic conditions in semester II6 Indicates credit approval yet to be withdrawn

Graph 2.12Credit Growth by Type (y-t-d)

%- 5 10 15 20 25 30 35 40

22.40

16.97

13.22

12.51

36.81

9.49

2006June»062005

Working Capital

Investment

Consumer

Graph 2.13MSM Credit

0

20

40

60

80

100

2005 2006

49.0 48.0

25.3 26.0

25.8 26.0

Non-productive

Productive

Non-MSME

%

Graph 2.11Credit Growth by Economic Sector (y-t-d)

24.7

9.3

7.4

36.4

22.6

21.5

8.0

20.273.4

34.5

2006Jun 062005

-20 -10 0 10 20 30 40 50 60 70 80 %

Trading

Others

Manufacturing

Transportation

Construction

Agribusiness

Business Services

Services

Mining

Electricity

25


2006. Brighter economic prospects supported credit

restructuring, which is clear from the drop in NPL

(12.4% or Rp8.2 trillion) compared to the previous

period (9.0% or Rp5.7 trillion). As a result NPL fell

to Rp58.1 trillion. Although credit extension was

unimpressive, growth was reasonably buoyant

compared to the previous period. Consequently, the

ratio of gross NPL in the banking industry tumbled

from 8.7% to 7.0%.

However, banks have sufficient provisions and

adequate capital to absorb risks and, therefore, avoid

instability. The decline in NPL mentioned largely

depended on the success of the restructuring

program.

that gross NPL of this group decreased from 10.6%

to 8.4%. Gross NPL of other banks was in the range

of 3% - 4% on average. The fall in NPL of the largest

banks was supported by the restructuring process of

two state-owned banks, which positively impacted

profitability and capital to buffer risk exposure. Hence,

the lower risk emanating from large banks helped

reduce instability.

Graph 2.14Non Performing Loans

% Trillions of Rp

0

10

20

30

40

50

60

70

80

2002 2003 2004 2005 2006

NPL Gross

NPL NetNPL Nominal (right axis)

-12

3

4

56

7

8

910

11

12

Graph 2.15NPL Performance in 2006

Jan Feb Mar Apr Jun Jul Aug Sep Oct Nov2005 2006

Sub-standardDoubtfulLoss

0

5

10

15

20

25

30

35

40

45

50

The decline in NPL from large banks also

contributed to relieve credit risk pressure. The NPL

of the 15 largest banks dropped by Rp7.7 trillion so

Graph 2.16Gross NPL Ratio per Bank Group

0

2

4

6

8

10

12

14

2004 2005 2006

Large Bank

Foreign

Joint Venture

Middle

Small

2003

Loan restructuring of corporate debtors in the

industrial sector was relatively successful, which

precipitated a decline in the gross NPL ratio from

15.3% to 10.5% in the manufacturing sub-sector.

As a result, the NPL of this sector contracted from

43.8% to 40.3% of total NPL; however, any

downturn in this sector could potentially raise

vulnerabilities.

Graph 2.17NPL Trends by Economic Sector

-8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0

Semester ISemester II

Trillions of Rp

Agribusiness

Mining

Manufacturing

Electricity

Construction

Trading

Transportation

Business Service

Services

26


The quality of trade sector credit improved

indicated by the slight decline in gross NPL from 7.5%

to 6.2% mainly due to credit growth. However, the

value of non-performing loans in this sector rose by

37.2% compared to year end 2005.

The risks in trade sector credit were more

controllable compared to the industrial sector due

to a relatively small outstanding credit and negligible

corporate debtors which diluted the risks.

The quality of household sector credit

deteriorated as a result of the decline in purchasing

power; however, stability was unaffected due to its

relatively small share.

High lending rates in 2006 coupled with weaker

purchasing power due to higher inflation severely

affected the household sector. This was reflected by

a rise in the value of consumption credit NPL - of

which nearly all debtors are households - by 42.8%

in semester I 2006. However, improving economic

conditions in semester II 2006 encouraged a slight

decline in gross consumption credit NPL (3.4%).

Therefore, the gross NPL ratio for consumption credit

contracted from 3.2% in the previous report to 2.9%.

The plan to raise the salary of civil servants and the

minimum regional wage in 2007 is expected to boost

the repayment capacity of households, which will

consequently improve the quality of consumption

credit.

The quality improvement of corporate credit

contributed significantly to the amelioration of bank

credit quality. The decline in corporate NPL by 25.9%

triggered a drop in the gross NPL ratio from 12.2%

-

5

10

15

20

25% Trillions of Rp

0

5

10

15

20

25

30

35

40

45

2001 2002 2003 2004 2005 2006

NPL (right axis) Interest Rate

2000

Graph 2.18NPL Share by Economic Sector

Other Manuacturings = Mining, Electricity, Service, Construction, Transportation

0

20

40

60

80

100

2000 2001 2002 2003 2004 2005 2006 Dec

Business Service

Agribusiness

Manufacturing

Trading

Other Sectors

%

Graph 2.19Gross NPL Ratio by Economic Sector

Agribusiness

Mining

Manufacturing

Electricity

Construction

Trading

Transportation

Business Service

Services

0.0 5.0 10.0 15.0 20.0

Semester ISemester II

Graph 2.20NPL Growth of Investment Credit

-

2

4

6

8

10

12

14

16

18

20% Trillions of Rp

2001 2002 2003 2004 2005 2006-

5

10

15

20

25

Interest Rate

NPL (rigth axis)

2000

Graph 2.21NPL Growth of Working Capital Credit

27


to 8.1%. This is primarily the result of loan

restructuring in the major banks. Meanwhile,

vulnerabilities stemming from foreign exchange credit

risk remained relatively low due to a steady exchange

rate.

The value of non performing foreign exchange

loans dropped quite substantially (34.0%) mainly due

to the restructuring program. Consequently, the gross

NPL ratio of foreign exchange credit contracted

significantly; from 18.0% to 9.9%. In addition, this

type of credit also showed robust growth (19.4%)7 .

Conversely, the drop in NPL of credit denominated

in rupiah was only 10.0%.

Credit Risk Mitigation

To mitigate credit risk several steps are required,

including raising the effectiveness of credit risk

management, improving infrastructure and human

resources, restructuring credit, allocating sufficient

provisions and adequate capital.

Improving credit risk management functionImproving credit risk management functionImproving credit risk management functionImproving credit risk management functionImproving credit risk management function.

Since the introduction of risk management for

banks in 2000 and its subsequent ratification in

2003, significant progress has been achieved in

Graph 2.22NPL of Consumption Credit

-

5

10

15

20

25

0

1

2

3

4

5

6

7

8

% Trillions of Rp

2001 2002 2003 2004 2005 2006

Interest RateNPL (right axis)

2000

Graph 2.23Growth in NPL Value

-

10

20

30

40

50

2003 2004 `2005 2006

Corporation

MSME

Trillions of Rp

2002

Graph 2.24Gross MSM and Corporate Sector NPL

-

2.0

4.0

6.0

8.0

10.0

12.0

14.0

-

1.0

2.0

3.0

4.0

5.0

6.0

2003 2004` 2005 2006

Corporation

MSME (right axis)

2002

Graph 2.25Foreign Exchange Rate and NPL

2001 2002 2003 2004 2005 2006

Rp/$ Trillions of Rp

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

-

5

10

15

20

25

30

35

40

45

50NPL of Foreign Exchange

Exchange Rate (left axis)

2000

Graph 2.26Gross NPL Performance of Foreign Exchange

0

5

10

15

20

25

30

35

40

45

2000 2002 2003 2004 2005 2006

NPL ofForeign Exchange

Total of NPL

NPL of Rp

%

1999

7 Without channeling

28


risk management. The major banks generally

have their own risk management unit and

implement four eyes principles to improve the

quality of credit extension. Furthermore, the

management of banks has to adhere to and

complete risk management certification to

embed risk management practices in daily

operations.

Utilization of credit information to reduceUtilization of credit information to reduceUtilization of credit information to reduceUtilization of credit information to reduceUtilization of credit information to reduce

asymmetric information and mitigate credit riskasymmetric information and mitigate credit riskasymmetric information and mitigate credit riskasymmetric information and mitigate credit riskasymmetric information and mitigate credit risk.

To support banking infrastructure, Bank

Indonesia established the Credit Information

Bureau (CIB) on 29th June 2006. CIB collates,

stores and disseminates credit data from all

financial institutions such as commercial banks,

rural banks and finance companies, including

non-bank credit card providers. Such credit

information is valuable in supporting decision-

making for consumption credit and reducing

credit risk.

Improving proficiency and infrastructure toImproving proficiency and infrastructure toImproving proficiency and infrastructure toImproving proficiency and infrastructure toImproving proficiency and infrastructure to

support MSM credit expansionsupport MSM credit expansionsupport MSM credit expansionsupport MSM credit expansionsupport MSM credit expansion. Large banks

continue to strive to augment the capabilities of

their personnel, including through the

recruitment of experts from rural banks and

establishing an MSM special unit to assess the

quality of MSM credit. The efficiency of the credit

approval process has also been streamlined

through a computerized credit scoring system.

Restructuring and write offs to stall the onslaughtRestructuring and write offs to stall the onslaughtRestructuring and write offs to stall the onslaughtRestructuring and write offs to stall the onslaughtRestructuring and write offs to stall the onslaught

of non performing loansof non performing loansof non performing loansof non performing loansof non performing loans. The restructuring

process will be continued into the next reporting

period, mainly in two state-owned banks, which

is in line with the development of large debtors.

The government also renewed Government

Regulation No 14/2005 regarding procedures of

write off state receivables with Government

Regulation No 33/2006 to harmonize the

restructuring process in state - owned and private

banks.

Allocating Provisions for Loan LossesAllocating Provisions for Loan LossesAllocating Provisions for Loan LossesAllocating Provisions for Loan LossesAllocating Provisions for Loan Losses (PLL).

Throughout semester II 2006, banks established

PLL of Rp0.6 trillion representing an increase of

1.6%. However, several banks are yet to allocate

sufficient PLL as was indicated by a NPL ratio of

over 5%.

Maintain adequate capitalMaintain adequate capitalMaintain adequate capitalMaintain adequate capitalMaintain adequate capital. In addition to

allocating adequate PLL, banks must also

maintain sufficient capital to mitigate risk. In

2006 the capital adequacy ratio (CAR) increased

slightly from 19.5% to 20.5%, whereas for large

banks it reached 19.4%.

Graph 2.27Credit, NPL and APLL

0

10

20

30

40

50

60

70

80

90

100

1999 2000 2001 2002 2003 2004 2005 Dec0

100

200

300

400

500

600

700

800

900

NPL

Provision

Credit (right axis)

Trillions of Rp

29


Impact of BI Rate on Bank Lending RatesBox 2.2

The BI Rate tended to decline subsequent to

significant hikes in 2005. In response, banks were

expected to cut their lending rates.

A preliminary survey was conducted incorporating

the 15 largest banks, which represent 69.6% of total

banking assets, to identify bank response to BI Rate

changes by adjusting their lending rates.

Generally, the survey results showed that the BI

Rate strongly influences bank lending rates, as does

the deposit insurance interest rate cap; lending rates

of other banks; deposit rates and economic factors such

as economic growth, inflation and the exchange rate.

If the BI Rate is cut, banks immediately adjust their

deposit rate; no later than 1 month. However, response

through lending rates is slower, as banks enjoy

temporary profit taking considering that customers are

still able to repay their liabilities at prevailing lending

rates.

The results of a further survey of 56 banks

returned similar results. Adjustments to deposit rates

occurred as follows: for time deposits the lag was 6.24

days, for savings 14.05 days and checking accounts

38 days. On the other hand, lending rates were

adjusted as follows: working capital credit 31.7 days,

investment credit 38.46 days and consumption credit

48.26 days.

A rise in SBI and the BI Rate significantly affects

adjustments to the basic lending rate over a shorter

period than the rise in the cost of loanable funds

(COLF). This demonstrates that the lending rate is more

responsive than COLF to rises in the BI Rate but,

oppositely, COLF is more responsive than the lending

rate when the BI Rate is cut.

A rise in the BI Rate would trigger a surge in NPL

within a 3 month period. This is possibly due to weaker

debtor ability to make repayments because of the

soaring oil price. A rise in NPL generally tends to be

followed by higher interest rates, primarily to cover

losses. The data presented below shows lending rate

performance, in particular following COLF.

Graph 2.2.1Interest Rate Performance

-5

0

5

10

15

20

Base Lending Rate Credit Growth

SBI and BI Rate

2000 2001 2002 2003 2004 2005 2006Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun

Cost of Loanable Funds

Graph 2.2.2Lending Rate and NPL

0

5

10

15

20

25

30

NPL GrossInterest Rate of Loan

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

2000 2001 2002 2003 2004 2005 2006

30


Table 2.2.1Increasing of SBI and BI Rate

0.94 Month 0.92 Month 1.2 Month 1.04 Month 0.98 Month 0.89 Month


Table 2.2.2Decreasing of SBI and BI Rate



Table 2.2.3Increasing of SBI and BI Rate

0.087 0.055 0.084 0.065 0.044 0.061

0.028 0.026 0.014 0.038 0.018 0.027

Table 2.2.4Decreasing of SBI and BI Rate

-0.022 -0.026 0.034 0.055 0.004 0.044

-0.014 -0.015 0.008 0.0023 -0.024 0.009

PeriodState-owned

BanksPrivate Banks Foreign Banks Joint Venture

BanksRegional Dev.

Banks15 Big Banks

Increasing of Cost of Loanable Funds

Increasing of Base Lending Rate

September 2000 to

June 2006

PeriodState-owned


BanksRegional Dev.

Banks15 Big Banks

Decreasing of Cost of Loanable Funds

Decreasing of Base Lending Rate

September 2000 to

June 2006

PeriodState-owned


BanksRegional Dev.

Banks15 Big Banks

Elasticity of Cost of Loanable Funds

Elasticity of Base Lending Rate

September 2000 to

June 2006

PeriodState-owned


BanksRegional Dev.

Banks15 Big Banks

Elasticity of Cost of Loanable Funds

Elasticity of Base Lending Rate

September 2000 to

June 2006

31


2.1.4 Market Risk

Bank exposure to market risk was relatively smallBank exposure to market risk was relatively smallBank exposure to market risk was relatively smallBank exposure to market risk was relatively smallBank exposure to market risk was relatively small

and nevertheless bank capital was adequate to coverand nevertheless bank capital was adequate to coverand nevertheless bank capital was adequate to coverand nevertheless bank capital was adequate to coverand nevertheless bank capital was adequate to cover

such risks. Bank market risk was manageable owingsuch risks. Bank market risk was manageable owingsuch risks. Bank market risk was manageable owingsuch risks. Bank market risk was manageable owingsuch risks. Bank market risk was manageable owing

to more favorable economic conditions and a fallingto more favorable economic conditions and a fallingto more favorable economic conditions and a fallingto more favorable economic conditions and a fallingto more favorable economic conditions and a falling

interest rateinterest rateinterest rateinterest rateinterest rate. Semester II 2006 was marked by a drop

in interest rates triggered by a decline in the BI Rate.

As of December 2006, the BI Rate had plummeted

275 bps on the previous semester. This was also

followed by a cut in bank interest rates for both time

deposits and credit. Although such a decline was

considered relatively low, the interest rate of all credit

types declined compared to the previous semester.

With a short maturity profile comprised

principally of short term funds, banks enjoy profits

when interest rates decrease. Risks emerge if the

interest rate rebounds, which could potentially lessen

bank capital. Based on simulation results, a 1% rise

in interest rates would lead to an average CAR

decrease of 54 bps.

The prevailing interest rate slump has triggered

public expectations of a continuation of the interest

rate trend. The banking maturity profile, particularly

Graph 2.28Interest Rate and Exchange Rate Performance

% Rp/$

2002 2003 2004 2005 20067500

8500

9500

10500

11500

1 Month Time Deposits

Working CapitalLoan

Consumer Loan

Exchange Rate (right axis)

Investment Loan

4

7

10

13

16

19

22

Graph 2.29Lending Rate by Bank Group

%

0

10

20

30

40Dec 05

Nov 06Dec 06

WC I C WC I C WC I C WC I C WC I C

State-OwnedBanks

Regional Dev.Banks

Private Banks Foreign &Joint Venture

Total

WC = WorkingCapital

I = InvestmentC = consumer

Table 2.1Interest Rate and Exchange Rate

Jun Dec

BI Rate 12.75 12.50 9.75 -0.25 -2.75Exchange Rate 9830 9300 9020 -530 -2801-month Time Deposit 11.98 11.55 8.96 -0.43 -2.59

Loan:Working Capital 16.23 16.15 15.07 -0.08 -1.08Investment 15.66 15.94 15.10 0.28 -0.84Consumer 16.83 17.82 17.58 0.99 -0.24

Growth

Semester I Semester II

Dec2005

2006

Graph 2.30Rupiah Maturity Profile

Trillions of Rp

0

-450

-300

-150

150

300

450

up to 1 month 1 - 3 months 3 - 6 months 6 - 12 months > 12 months

Nov»06 Dec»06

Dec»05 Jun»06Sep»06 Oct»06

Trillions of Rp

-10

-5

0

5

10

up to 1 month 1 - 3 months 3 - 6 months 6 - 12 months > 12 months

Dec»05 Jun»06Sep»06 Oct»06Nov»06 Dec»06

Graph 2.31Foreign Exchange Maturity Profile

32


Graph 2.34Government Bonds in Bank Portfolio

Trading

% Government Bond to Total Assets (right axis) Investment

% Government Bond - Trading to Total Assets (right axis)

0

50

100

150

200

250

300

2005 2006Dec Feb Apr Jun Aug Oct Dec

7

9

11

13

15

17

19

21

Trillions of Rp %

rupiah, has shifted slightly since October 2006 from

short term liabilities (under 1 month) to a longer

tenure (1 to 3 months). As for foreign exchange,

banks only have a short position for periods under 1

month. Periods of more than 1 month are dominated

by foreign exchange assets rather than liabilities.

The rupiah exchange rate remained relatively

stable (appreciating just Rp280/USD, on average,

compared to the end of semester I), which will not

heap pressure on bank market risk. This is in line

with banks» ability to better mitigate exchange rate

risk and maintain an overall average net open position

of only 5%. Therefore, the ability of banks to mitigate

exchange rate risks is relatively strong. This was

reflected by bank CAR remaining above 8% under

stressed rupiah depreciation conditions.

Government bonds in the trading portfolio of

seven previously recapitalized banks reached 47.1%.

The expanding share of government bonds in the

trading portfolio, which has been prominent since

August 2006, coupled with the declining BI Rate

intensified market risk. Simulation results

demonstrate that bank CAR would drop below 8%

only if the government bonds price fell by 10% or

more.

Graph 2.32NOP Performance (Overall)

0

4

8

12

16

20

24

18.919.8

16.9 17.115.6

14.7

Dec Jun Sep Oct Nov Dec

2005 2006

%

Foreign Bank

Domestic Private Banks

Joint Venture Bank

All Banks

Regional Banks

Thehighest of NOP

State-Owned Banks

Graph 2.33NOP Performance (Balance Sheet)

0

4

8

12

16

20

2005 2006Dec Jun Sep Oct Nov Dec

Private BanksJoint Venture Banks

Regional Dev. Banks

State-Owned BanksForeign Banks

All Banks

%

Bank market risk was manageable, supported

by maintaining their maturity profile and NOP,

relatively high bank capital and improved economic

conditions compounded by the falling interest rate.

However, banks have had to anticipate a rise in the

interest rate which would spark interest rate risks.

In addition, the potential of a short-term

capital reversal could intensify market risk, especially

if the rupiah depreciates significantly while banks

have significant foreign exchange liabilities.

Therefore, a bank»s ability to manage its assets and

liabilities by maintaining NOP below 20% will help

mitigate risk.

33


2.1.5. Profitability and Capital

Bank profitability is improving primarilyBank profitability is improving primarilyBank profitability is improving primarilyBank profitability is improving primarilyBank profitability is improving primarily

supported by credit growth and the declining SBIsupported by credit growth and the declining SBIsupported by credit growth and the declining SBIsupported by credit growth and the declining SBIsupported by credit growth and the declining SBI

interest rateinterest rateinterest rateinterest rateinterest rate. However, bank efficiency has

deteriorated due to large provisions following the

rise in NPL. Meanwhile, the bank CAR remained

steady mainly due to sufficient capitalization,

despite significant credit growth through semester

II 20068 .

Profitability

The decline in the BI Rate precipitated a rise in

income because the decline in the lending rate was

less pronounced than the drop in the deposit rate.

Consequently, bank net interest income (NII)

increased slightly from Rp7.6 trillion to Rp7.7 trillion.

The small rise in NII stemmed from credit growth

three-fold that of the previous semester and the

falling SBI rate since early 2006.

The interest rate spread is widening attributable

to the declining BI Rate and SBI rate, which are used

as a reference to determine deposit and lending rates.

The spread (weighted average) for banks grew from

9.76% in semester I 2006 to 10.17% at the end of

December 2006.

Graph 2.35NII Growth

3.0

4.0

5.0

6.0

7.0

8.0

Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec

2001 2002 2003 2004 2005 2006

Trillions of Rp

Graph 2.36Rupiah Spread (Weighted Average)

Dec Jun Dec Jun Dec Jun Dec

2003 2004 2005 2006

%

Deposits Credit Spread0

2

4

6

8

10

12

14

16

18

The dip in the interest rate drove the NII rise

because the bank balance generally has a negative

net gap where total sensitive liabilities outweigh total

sensitive assets.

*) Government Bond - variable rate**) Assumption: 20% of credit

Table 2.2Risk Sensitive Assets and Liabilities - Interest Rate

I t e m Dec'05 Jun'06 Dec'06

SBI/FASBI 106.898 153.768 217.589

Securities *) 203.793 182.057 99.053

Credit **) 113.123 117.264 127.685

Interbank Placement 44.780 45.669 64.205

Total 468.594 498.758 508.531

Assets (Billions of Rp)Assets (Billions of Rp)Assets (Billions of Rp)Assets (Billions of Rp)Assets (Billions of Rp)

Liabilities (Billions of Rp)Liabilities (Billions of Rp)Liabilities (Billions of Rp)Liabilities (Billions of Rp)Liabilities (Billions of Rp)

1 month Time Deposit 324.464 322.001 317.362

Saving 281.266 279.062 333.864

Interbank Borrowing 50.370 53.092 70.386

Total 656.100 654.154 721.613

G a p (Billions of Rp)G a p (Billions of Rp)G a p (Billions of Rp)G a p (Billions of Rp)G a p (Billions of Rp)

Nominal (187.506) (155.396) (213.081)

% (40) (31) (42)

Income sourced from interest on credit, which

still dominates bank interest income, increased in line

with credit growth. In addition, income from interest

on SBI also accrued mainly due to asset switching

from securities to SBI.8 Comparison between June 2006 - December 2006, unless stated otherwise

34


Big Banks Other Banks Industry

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5%

Dec Dec Dec Dec Jun Dec

2002 2003 2004 2005 2006

Graph 2.39R O A

50.0

60.0

70.0

80.0

90.0

100.0

%


2002 2003 2004 2005 2006


Graph 2.40Efficiency Ratio

Graph 2.37Structure of Bank Interest Income

0

25

50

75

100

OtherCreditSecuritiesBI

10.8 8.3 6.0 8.7 10.4

32.525.1

22.0 22.9 21.4

49.859.7 63.1 59.2 60.1

7.0 6.9 8.9 9.2 8.2

2003 2004 2006Dec Dec Jun Dec

%

2005

Graph 2.38Structure of Interest Income of the 15 Largest Banks

OtherCreditSecuritiesBI

0

25

50

75

100

9.4 6.8 4.3 6.2 7.8

40.131.4

27.8 29.0 27.3

45.856.8

61.5 58.4 58.4

4.7 5.0 6.4 6.5 6.5

Dec Dec Jun Dec

2003 2004 2005 2006

%

The switching of securities to SBI was triggered

by a securities price hike, which was perceived as

optimal and consequently sold. Additionally, it was

also driven by the need to maintain liquidity. In order

to mitigate the knock on effects of the limited

deposits insurance scheme.

In line with the rise in net interest income ROA

increased slightly from 2.5% to 2.6%.

Efficiency deteriorated evidenced by the rise in

the efficiency ratio9 from 83.2% to 86.4%. The 15

largest banks recorded the highest efficiency ratio,

9 The ratio of operational costs to operational income

Capital

Capital remained adequate and stable at 20.5%

despite a rise in risk weighted assets, in particular

those sourced from credit. However, this was

followed by an accruement of capital, principally

originating from profit accumulation.

Banks were able to absorb risk due to their

capital adequacy, which alleviated instability. Capital

adequacy also provided maneuverability for banks

to expand credit.

namely 89%, whereas other banks recorded 81.3%.

The weakening efficiency ratio was attributable to a

rise in provisions along with the increase in NPL.

35


Table 2.3Banking Profitability Monthly Average

Profit and Loss Items Semester I 2005 Semester II 2005 Semester I 2006 Semester II 2006

I Operational Income 13.0 16.6 17.5 21.5 3.9Interest Income 10.2 12.1 14.6 17.4 2.9Other Income 2.8 4.5 3.0 4.0 1.0

II Operational Expense 11.3 14.8 15.6 18.3 2.7Interest Expense 4.4 6.0 7.8 8.9 1.1Other Expense 2.8 5.3 3.1 3.8 0.7Provision 2.4 1.5 2.6 2.8 0.3

III Operational Profit/Loss 1.7 1.8 2.0 3.2 1.2IV Non Operational Profit/Loss 1.0 1.2 1.2 1.2 (0.0)V Profit/Loss after Tax 2.0 2.1 2.3 2.9 0.6

Graph 2.41Capital Adequacy Ratio

-

100

200

300

400

500

600

700

800

900

1,000

1,100

10

12

14

16

18

20

22

24CAR (right axis)Risk Weighted AssetCapital

Dec Dec Dec Dec Jun Dec Jun Dec Jun Dec

2000 2001 2002 2003 2004 2005 2006

%

Graph 2.42Tier 1 Capital


15

16

17

18

19

20

21

22

%


2002 2003 2004 2005 2006

Gap (Semester I -Semester II)

However, several medium and small banks

persisted with a relatively small CAR ranging from

9% to 12%, leaving them susceptible to more risk.

Banks will be obliged to maintain minimum

capital of Rp100 billion by the end of 2010 in line

with the institution of Indonesian Banking

Architecture to strengthen the structure of the

banking industry. Implementation is phased,

therefore, by the end of 2007 the level will be Rp80

billion.

Graph 2.43CAR by Bank Group (December 2006)

%

0.0

5.0

10.0

15.0

20.0

25.0

30.0

A

15 Bi

g Ban

ks

Fore

ign Ba

nks

Joint

Vent

ure B

anks

Othe

rs

All B

anks

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

CAR

Tier 1 to Risk Weighted Assets

B a n k

Graph 2.44CAR Distribution (December 2006)

15 Big Banks Others

0 5 10 15 20 25 30 35 40

%

<8

8 - 12.9

13 - 18.9

19-25.9

> 26

36


Graph 2.46Net Cash Flow of Finance Companies

Billions of Rp

-4,000

-2,000

0

2,000

4,000

6,000

2006Mar Jun Sep Oct

Net cash flow of operation activities

Net cash flow of Investment activitiesNet cash flow of funding activities

Graph 2.45Operational Activities of Finance Companies

Trillions of Rp

0

20

40

60

80

100

120

Assets Financing Source of Funds Capital

2003

2004

2005

Oct 06

2.2. NON BANK FINANCIAL INSTITUTIONS AND

CAPITAL MARKETS

2.2.1. Finance Companies

Persistently high lending rates aggravated thePersistently high lending rates aggravated thePersistently high lending rates aggravated thePersistently high lending rates aggravated thePersistently high lending rates aggravated the

performance of finance companiesperformance of finance companiesperformance of finance companiesperformance of finance companiesperformance of finance companies. The high

dependency on funds sourced from banks intensified

risks for finance companies. The knock on effects of

this also spurred risks for banks that extend credit to

finance companies.

Risks emerging from the operational activities

of finance companies remained high in 2006.

However, high bank lending rates undermined the

funding of finance companies, primarily sourced from

banks. In addition, finance companies had difficulty

in raising alternative sources of funding as the yield

of corporate bonds remained high.

a result of aggressive automotive financing,

especially by joint financing companies.

Tight competition in terms of business expansion

led finance companies to become less cautious

when extending loans. For example, loans were

distributed without a down payment.

High dependency on short-term loans from

banks, consequently the quality of loans

deteriorated, which had the potential to intensify

bank credit risk.

Previous expansive financing by finance

companies began to adversely affect the performance

of the 10 largest finance companies. In addition to

poorer credit quality, this was compounded by

inadequate capital. Finance companies with a ratio

of financing to equity greater than 5 tended to have

a lower ROA and ROE compared to those with a ratio

below 5. Finance companies tended to suffer losses

if the ratio of financing to equity reached 10.

Joint venture finance companies additionally

seek financing from overseas loans rather than solely

domestic. Rupiah financing sourced from overseas

loans has higher exchange rate risk. Such conditions

are susceptible to high fluctuations in the exchange

rate, which will also encroach on the servicing of

their overseas loans.

Soaring interest rates hampered the ability of

debtors to service their loans, while finance

companies also struggled with their liabilities to

banks. To this end, finance companies issued bonds,

however, this was insufficient to offset the deficit to

finance their operations.

Several factors propagated business risk for

finance companies as follows:

Operational activities concentrated on customer

financing (63%), primarily to finance vehicles as

37


Graph 2.47ROA, ROE and Ratio of Financing to Equity

0

2

4

6

8

10

12

ROA

Financing/Equity (right axis)

ROE

-1.5

-1

-0.5

0

0.5

1

Jan Feb Mar Apr Mei Jun Jul Aug Sep Oct Jan Feb Mar Apr Mei Jun Jul Aug Sep Oct

Non Joint Venture Finance Company Joint Venture Finance Company

%

2 0 0 6 2 0 0 6

2.2.2. Capital Markets

Stock Market

The buoyant stock market, which was to a largeThe buoyant stock market, which was to a largeThe buoyant stock market, which was to a largeThe buoyant stock market, which was to a largeThe buoyant stock market, which was to a large

extent supported by bullish sentiment, sparked a priceextent supported by bullish sentiment, sparked a priceextent supported by bullish sentiment, sparked a priceextent supported by bullish sentiment, sparked a priceextent supported by bullish sentiment, sparked a price

bubblebubblebubblebubblebubble. Weak fundamentals left the stock market

prone to corrections and high volatility, therefore,

the market only appealed to speculative investors.

In 2006, foreign capital inflows to emerging

markets were the primary catalyst to development

of the stock market. Nearly all global stock exchanges

experienced immense growth. Consequently,

sentiment that influences the performance of global

stock exchanges mainly stemmed from the global

interest rate, particularly the Fed Fund Rate,

fluctuations in the global oil price and other

commodities as well as from domestic political and

security concerns. The Jakarta Stock Exchange (JSX)

experienced vast growth and recorded its highest ever

level of 1805.52; becoming the highest performing

stock exchange after China.

The bullish JSX brought with it high volatility,

exceeding the Thai and Philippine stock exchanges,

which were under pressure numerous times in 2006

due to the political and security concerns in the

countries themselves. Weak economic and corporate

fundamentals led to non-transparent pricing that

impinged on any potential rebound.

Vast interest from foreign investors in the JSX

was clear from the growing asset share of foreign

investors in 2006; reaching 52.62%. However,

investor strategy was more attributable to bullish

short-term market sentiment, which had the potential

to spark a sudden capital flow reversal should any

Graph 2.48Global Index Performance

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40


DJIAJCIKOSPI

Hang Seng

SHCOMP Index

Nikkei

SZCOMP Index

FTSE

SENSEX Index

2006

Graph 2.49Regional Index Performance

Graph 2.50SET Volatility

Source : Bloomberg

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

500

550

600

650

700

750

800

850

(y = 509,23e-0,0013x))

2004 2005 2006

VSET (LHS)SET(RHS)Expon. (SET(RHS))

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60


JCI SET STI PCOMP KLCI

2006

38


Graph 2.55Share of Sectoral Index Capitalization (December 2006)

Graph 2.54Sectoral Index Performance


Source : Bloomberg

Q II

Q III

Q IV

250

450

650

850

1,050

1,250

40

100

160

220

280

340

400

2006

Agribusiness(left axis)

Property(right axis)

Infrastructure

Q IMiscellaneous

(right axis)

Mining(left axis)

Basic Industry6.06%

Miscellaneous6.38%

Trading & Services5.60%

Financial26.63%

Infrastructure27.12%

Consumer14.27%

Mining7.88%

Agriculture2.74%

Property3.34%

Graph 2.53Stock Ownership

-

100,000

200,000

300,000

400,000

500,000

600,000


2 0 0 6

Domestic Foreign

Billions of Rp

Graph 2.51JCI Volatility

Source : Bloomberg

(y = 509,23e-0,0013x))

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

2004 2005 2006400

600

800

1000

1200

1400

1600

1800

2000VJSX (LHS) JCI (RHS) Expon. (JCI (RHS))

Graph 2.52Asset Performance

0

100

200

300

400

500

600


Domestic Foreign

Billions of Rp

2 0 0 6

bearish sentiment arise. This eventually transpired in

Indonesia in May-June 2006.

Several indices that demonstrated dogged

growth include the agricultural sector, property,

infrastructure as well as the mining and financial

sectors. Sentiment surrounding the domestic interest

rate decline, soaring mining commodity prices and

high demand for alternative energy sources strongly

affected fluctuations in the sectoral indices.

Brighter prospects for the domestic economy

in 2007 and projections of a steady global interest

rate will positively shape the performance of the JSX.

However, more conducive market fundamentals

will still only leave the JSX attractive to speculative

foreign investors. Movements in the Fed Fund Rate

as well as the global oil price and other commodity

price fluctuations will continue to drive the market.

Stocks in the banking sector will become more

attractive to investors. Divestment issues and the

performance of the NPL settlement process strongly

affect banking stock price fluctuations. Stocks

sensitive to commodity prices are expected to have

the potential to strengthen with more limited

fluctuations. Furthermore, stocks of prominent state-

39


Graph 2.56Price Performance of several Government Bonds Series

60

70

80

90

100

110

120

130

2006

FR0002FR0010FR0017FR0020

FR0026FR0031FR0034

Jan Feb Apr May Jun Jul Aug Sep Oct Nov Dec

owned banks that dominate stock market

capitalization could still potentially strengthen as the

issuing companies generally service the needs of the

public.

Bonds Market

The decline in the domestic interest rate acted The decline in the domestic interest rate acted The decline in the domestic interest rate acted The decline in the domestic interest rate acted The decline in the domestic interest rate acted

as a catalyst to rapid growth in the government bondsas a catalyst to rapid growth in the government bondsas a catalyst to rapid growth in the government bondsas a catalyst to rapid growth in the government bondsas a catalyst to rapid growth in the government bonds

market. Non transparent pricing and the shallowmarket. Non transparent pricing and the shallowmarket. Non transparent pricing and the shallowmarket. Non transparent pricing and the shallowmarket. Non transparent pricing and the shallow

market led to the government bonds marketmarket led to the government bonds marketmarket led to the government bonds marketmarket led to the government bonds marketmarket led to the government bonds market

becoming more attractive for short-term investment,becoming more attractive for short-term investment,becoming more attractive for short-term investment,becoming more attractive for short-term investment,becoming more attractive for short-term investment,

which intensified price volatilitywhich intensified price volatilitywhich intensified price volatilitywhich intensified price volatilitywhich intensified price volatility. Generally, foreign

investors were financial institutions interested in

short-term government bonds to optimize income

from the hedge funds they managed.

will continue primarily due to the following two

factors:

- The domination of government bonds in the

bank trading portfolio coupled with a Primary

Dealers System.

- Low liquidity due to a lack of supply, leading to

non-transparent pricing, coupled with a shallow

market makes short term investment more

profitable.

The government bonds market suffered from

persistent high volatility preventing it from acting as

the reference for the corporate bonds market. For

example, a drop in government bonds yield would

not trigger a subsequent decline in the yield of

corporate bonds. However, the soaring yield of

The fall in yield did not discourage foreign

investors, reflected by government bonds in the

portfolio of foreign investors jumping from Rp31

trillion to Rp54.5 trillion. Attractive government

bonds were primarily due to higher yields compared

to other Asian countries.

In 2007 the government bonds market will

remain active primarily due to the persistent interest

rate decline. Investor interest in government bonds

Graph 2.57Yield of 10-year Government Bonds of

Selected Countries

0

2

4

6

8

10

12%

2006

15 17 19 21 23 25 27 29 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Indonesia Philippines USAThailandIndia

Nov Dec

Graph 2.58Liquidity Distribution of Government Bonds

0

5

10

15

20

25

30

35

40

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Trillions of Rp

Fixed Rate Variable Rate

40


Graph 2.61Mutual Funds by Type (2006)

Graph 2.59Government Bond Price Volatility in

Selected Asian Countries

0,0 1,5 3,0 4,5 6,0 7,5 9,0 10,5 12 13,5 15

10

30

50

100

%

IndonesiaIndiaPhilippinesThailand

corporate bonds discouraged issuing companies from

issuing bonds. Consequently, only 3 new issuing

companies emerged in 2006 and the volume and

value of stock issued rose by just Rp2.11 million and

Rp11.5 trillion respectively.

recovery in the mutual funds market. However,recovery in the mutual funds market. However,recovery in the mutual funds market. However,recovery in the mutual funds market. However,recovery in the mutual funds market. However,

mutual funds remained high risk, particularly becausemutual funds remained high risk, particularly becausemutual funds remained high risk, particularly becausemutual funds remained high risk, particularly becausemutual funds remained high risk, particularly because

mutual funds are concentrated on fixed incomemutual funds are concentrated on fixed incomemutual funds are concentrated on fixed incomemutual funds are concentrated on fixed incomemutual funds are concentrated on fixed income

securities that are sensitive to interest rate fluctuationssecurities that are sensitive to interest rate fluctuationssecurities that are sensitive to interest rate fluctuationssecurities that are sensitive to interest rate fluctuationssecurities that are sensitive to interest rate fluctuations

and non-transparent pricing. Such conditions canand non-transparent pricing. Such conditions canand non-transparent pricing. Such conditions canand non-transparent pricing. Such conditions canand non-transparent pricing. Such conditions can

potentially trigger reputation risk for banks involvedpotentially trigger reputation risk for banks involvedpotentially trigger reputation risk for banks involvedpotentially trigger reputation risk for banks involvedpotentially trigger reputation risk for banks involved

in selling mutual fundsin selling mutual fundsin selling mutual fundsin selling mutual fundsin selling mutual funds. The impressive growth

witnessed in the stock market and government bonds

market facilitated recovery in the mutual funds

market as evidenced by the burgeoning NAV of

mutual funds in 2006, approximately 76%.

Noteworthy NAV growth was not only the result of

higher underlying asset prices but also due to the

reemergence of investors in mutual funds. This was

indicated by the rise in participation units by about

70%.

Risks associated with mutual funds remained

high, especially due to the concentration of fixed

income securities with a market share of about 39%.

Furthermore, protected mutual funds, which grew

rapidly in 2006, achieved a market share of 22%

mainly based on underlying government bonds. High

risk principally stemmed from interest rate

fluctuations to underlying assets.

The prospects of a falling interest rate in 2007,

which will perpetuate the bullishness of the stock

If the decline in lending rates tapers off it will

undermine the issuance of corporate bonds in the

domestic market. The lower interest rate in the global

market will encourage corporate investors to issue

global bonds as a source of funds for business

expansion.

Graph 2.60Value and Volume of Corporate Bonds (2006)

Mutual Funds

Vast growth in the stock market andVast growth in the stock market andVast growth in the stock market andVast growth in the stock market andVast growth in the stock market and

government bondsgovernment bondsgovernment bondsgovernment bondsgovernment bonds market successfully underpinnedmarket successfully underpinnedmarket successfully underpinnedmarket successfully underpinnedmarket successfully underpinned

59

60

61

62

63

64

65

66

67

68

69

12.5

13

13.5

14

14.5

15

15.5

16Value Volume (right axis)

Trillions of Rp Millions of Rp

Dec Mar Jun Sep Dec

20062005

0

5

10

15

20

25

2005 2006

Trillions of Rp

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

ProtectedMoney MarketMixedStocksFixed Income

41


market and government bonds market, will raise the

net asset value of mutual funds. Investor interest in

mutual funds will also heat up amidst tighter

competition from offshore products that use

underlying assets in the form of domestic capital

market instruments, especially government bonds.

The high risk nature of mutual funds could lead

to mounting reputation risk for banks acting as selling

agents. Higher risk mutual funds instruments are

mainly due to:

The lack of understanding by investors of mutual

funds characteristics triggered higher risks while

investors switched their deposits to mutual funds

due to low expected inflation. Furthermore, if

market corrections are levied on financial asset

prices leading to a drop in NAV, ill-informed

investors would panic triggering mass

redemptions. That actually occurred in Indonesia

in 2004.

Investor switching from fixed-income mutual

funds and protected mutual funds to mutual

0

100

200

300

400

500

600

700

Oct0

2

4

6

8

10

12

14

Trillions of Rp %

2003 2004 2005 2006

NAV Mutual Funds

Interest Rate of 3 months Time Dep. (right axis)Time Deposits

Graph 2.62Time Deposits and NAV

funds based stock, such as indexed mutual funds

and Exchange Traded Funds (ETF), will disrupt

fixed-income mutual funds and increase risk due

to a highly volatile stock market.

Non-transparent investment valuation for

investors is reflected by the absence of mark to

market valuation by investment managers.

To mitigate such risk, Bank Indonesia instituted

regulations to ensure that banks implement and

monitor risk in their subsidiary companies on a

consolidated basis.

42


-5

0

5

2005 2006

Trillions of Rp

-15.00

-10.00

-5.00

0.00

5.00

10.00

15.00

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

%

Net Foreign Growth of JCI

Short-term Capital Inflows through the Financial MarketBox 2.3

The Indonesian financial market has attracted

the interest of foreign investors. However, the lack

of fundamentals caused more investment in short

term instruments. As a result, the risks in the

financial market remain high; therefore, the

market cannot function as a long term source of

funds.

The increasing trend of the global interest

rate in 2005 triggered short term capital inflows

to emerging markets in Asia. The interest of

foreign investors will remain high even if interest

rates in developing countries subside due to the

high investment yields possible in such countries,

including Indonesia.

taking. This was demonstrated by the

strength of foreign investor stock

transactions, which tended to affect

fluctuations in the JCI.

Investment in government bonds by foreign

investors (primarily financial institutions), to

optimize profit from hedge funds, triggered

high price volatility.

Upbeat economic prospects in 2007 will

further push the interest rate down. However,

high short-term capital inflows will persist as the

result of two factors. First, speculative capital

inflows will emerge from previous investments

in other emerging markets, particularly Thailand.

Second, bullish sentiment regarding the global

bond market and the falling interest rate, will

encourage foreign investors to invest more

actively. This will mitigate the effects of changes

in interest rate spread on the income generated

from hedge funds.

Graph 2.3.1Foreign Net Transactions: Stocks, Government Bonds

and the Exchange RateTrillions of Rp

2006

Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec8200

8400

8600

8800

9000

9200

9400

9600

9800

10000

Rp/$

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00Stocks Government Bond Exchange Rate

Graph 2.3.2Net of Foreign Shares Transaction - JCI

Factors affecting foreign short-term

investments are as follows:

Stock market development lacking

fundamentals and non transparent pricing

provides a lucrative opportunity for investors

to influence pricing for short term profit

43

Chapter 3 Financial System Prospects

Chapter 3Financial System Prospects

44



45


Financial System ProspectsChapter 3

3.1. ECONOMIC PROSPECTS AND RISK

PERCEPTION

Prospects for economic growth remain highProspects for economic growth remain highProspects for economic growth remain highProspects for economic growth remain highProspects for economic growth remain high

with lower riskwith lower riskwith lower riskwith lower riskwith lower risk. Market consensus remains positive

in terms of the economic outlook. Accelerated

economic growth will be supported by stable inflation

and increasing trade transactions. Such conditions

are expected to favorably reduce risks, especially

market risk. Improved macroeconomic conditions

have attracted foreign investment in the capital

market. However, such investment is primarily short

term and has lead to high price volatility and

vulnerability to shocks.

The perception of risk in Indonesia is improving

as was evidenced by the narrowing spread of global

bonds issued by the Indonesian Government against

the US Treasury.

The improvement in bond spread - which also

serves as a benchmark for the issuance of bonds and

credit - will reduce domestic business costs by seeking

alternative sources of funding overseas. In addition,

market players will remain optimistic concerning

economic outlook and the financial sector prospects,

which is reflected by the improving yield curve as

well as higher expectations of economic growth.

Table 3.2Indonesian Risk Perception

Bonds Rating

Indo 14 BB- 5.93 140 89

Indo 35 BB- 6.61 216 137

Indo 17 BB- 5.99 162 90

Source: Bloomberg

Spread (bp)

June December

The Indonesian financial system was relatively stable in Semester II 2006.

Large banks maintained moderate profit and adequate capital. Furthermore,

favorable macroeconomic indicators and positive risk perception will help

preserve financial stability over the forthcoming six months. However, certain

risks could still intensify, including credit risk, market risk and operational

risk in the financial system, especially banks, which need to be well managed

to avoid instability.

Yield toMaturity (%)

Table 3.1Concencus Forecast of Selected Economic Indicators

2006

GDP 4.8 5.1 5.5 6.1 5.9 5.7 5.9 5.7 5.9 5.9

Inflation 16.9 15.5 14.9 6.1 5.5 6.1 6.2 6.1 5.8 5.8

Balance of Trade 8.7 8.7 6.9 7.7 8.5 8.2 7.1 9 8.7 8.5

Source: Asia Pacific Concensus Forecast

2007 2008

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

46


Graph 3.1Yield Curve

Years

%

Source: Bloomberg

0

20

40

60

80

100

120

140

0.5 3 4 5 6 7 8 9 10 15 20

Jun 2006

Feb 2007

Log. (Feb 2007)

Log. (Jun 2006)

Strong Acceptable Weak

Outlook

Semester II 2006

Market Risk

HighM

oderateLow

Inherent Risk

Credit Risk Operational Risk

Outlook

Semester II 2006

Strong Acceptable Weak Strong Acceptable Weak

Outlook

Semester II 2006

Risk Control Risk Control Risk Control

3.2. BANKING INDUSTRY RISK PROFILE: LEVEL

AND DIRECTION

Banking resilience was relatively well

maintained. Despite low credit growth and excess

liquidity, profits remained high, particularly those

stemming from interest payments on government

bonds (SUN) and SBI. Against this backdrop, banks

maintained capital at a solid level of 20.5%,

supported by profit accumulation and fewer high-

risk bank assets. Nonetheless, credit risk and

operational risk require special attention to prevent

disruptions to financial stability.

Market risk was reasonably low supported by

modest market risk exposure as well as stability in

the macro-economy and the markets. Nevertheless,

its direction improved slightly predominantly

attributable to a potential short-term capital inflow

reversal.

Credit risk remained moderate amidst an

inauspicious business climate and sub-optimal

financial intermediation. However, credit risk is

expected to improve if the restructuring process for

major debtors can be concluded and real sector

conditions recover in line with support from the

government to realize infrastructure projects, which

will drive performance in related sub-sectors.

Additionally, relatively high operational risks persist

that require attention. A high number of banking

crimes are committed due to ineffective internal

control and weak corporate governance. The

promulgation of effective regulations, law

enforcement, risk-management improvement and

technological infrastructure development, all

adhering to international best practices, will allow

banks to operate in a sound and efficient manner,

hence dissipating operational risks.

3.3. PROSPECTS OF THE FINANCIAL SYSTEM

Stress tests on banking demonstrated bankingStress tests on banking demonstrated bankingStress tests on banking demonstrated bankingStress tests on banking demonstrated bankingStress tests on banking demonstrated banking

resilience against fluctuations in the exchange rateresilience against fluctuations in the exchange rateresilience against fluctuations in the exchange rateresilience against fluctuations in the exchange rateresilience against fluctuations in the exchange rate

Graph 3.2Risk Profile of Banking Industry and Its Direction

47


and interest rateand interest rateand interest rateand interest rateand interest rate. The banking industry is relatively

resilient to changes in macroeconomic variables;

especially the exchange rate and interest rate based

on assessments for the upcoming six months using

stress testing.

Capital adequacy, as the primary indicator of

resilience, remained steady despite slight depreciation

of the rupiah against USD in the range of Rp500-

2500 as well as interest rate hikes of up to 5%. With

projected GDP growth and stable inflation in 2007,

banking conditions, non-bank financial institutions

and the financial markets are expected to be sound.

Banking industry soundness will also improve in

concurrence with better risk management.

3.4. POTENTIAL VULNERABILITY NEEDS TO BE

ANTICIPATED

Risk taking behavior in the future is not certainRisk taking behavior in the future is not certainRisk taking behavior in the future is not certainRisk taking behavior in the future is not certainRisk taking behavior in the future is not certain.

Indonesian financial system stability is strongly

influenced by the behavior of financial institutions

and investors. Price hikes (JCI) and lagged volatility

in the financial markets has increased the concern

of market players for potential mounting risk. Such

conditions could easily be compounded by natural

disasters - for example floods and earthquakes that

have struck several regions - and adverse effects of

globalization. This will therefore require

sophisticated assessments of risks. However, the

necessary tools for market players are unavailable

but optimism surrounding conditions in 2007

remains upbeat.

A combination of various volatility levels can beA combination of various volatility levels can beA combination of various volatility levels can beA combination of various volatility levels can beA combination of various volatility levels can be

significantsignificantsignificantsignificantsignificant. In assessing the future financial system

resilience it is crucial to consider extreme scenarios

despite their small probability of occurrence.

However, an amalgamation of various pressures can

affect financial system stability. Based on data from

the previous six months, two scenarios with dominant

effects on stability emerged as follows: (i) a resurgent

global oil price due to mounting geopolitical pressures

in the Middle East could affect business activities and

purchasing power; and (ii) soaring financial asset

prices, including shares, would bring price

adjustments and could lead to a foreign capital

reversal.

Numerous measures have been taken to bolster

the future stability of the financial system including

the development of bio-energy to reduce

dependency on oil supply and ease pressure on the

domestic oil price to avoid disruptions in production.

Also, an array of efforts has been taken, including

the improvement of risk management by market

participants and diversifying instruments in the capital

market. This is expected to dissipate potential risks

stemming from severe asset price adjustments and

portfolio switching by foreign investors.

3.5. BANKING INDUSRTY PROSPECTS

The scale of business has the potential to expandThe scale of business has the potential to expandThe scale of business has the potential to expandThe scale of business has the potential to expandThe scale of business has the potential to expand

in 2007in 2007in 2007in 2007in 2007. Business prospects will improve primarily

supported by the low interest rate, stable exchange

rate as well as growing domestic and global demand.

Meanwhile, several sectors are projected to achieve

higher growth including the construction sector

(9.4%), transportation and communications (8.9%),

utilities (electricity, gas and water) (7.6%), as well as

manufacturing (7.1%).

Banking credit is projected to expand to an

average of 20%, supported by growth in deposits

by an average of 10%. Sources of additional funds

48


for large banks will originate from interest payments

on government bonds (SUN). Credit growth will

originate predominantly from business expansion,

particularly for working capital in the trade (75%)

and industrial (20%) sectors. The growth is expected

to precipitate development in other sectors, which

will support financial sector stability.

To this end, amendments and refinements are

required to the legal framework, particularly business

and investment. Furthermore, law enforcement and

good corporate governance are required to ensure

market participants act optimally and responsibly.

Such conditions are prerequisite to financial

intermediation and a stable financial system.

49

Chapter 4 Financial Infrastructure and Risk Mitigation

Chapter 4Financial Infrastructureand Risk Mitigation

50



51


4.1. PAYMENT SYSTEM

The Indonesian payment system remainedThe Indonesian payment system remainedThe Indonesian payment system remainedThe Indonesian payment system remainedThe Indonesian payment system remained

sound with negligible risks that could disrupt financialsound with negligible risks that could disrupt financialsound with negligible risks that could disrupt financialsound with negligible risks that could disrupt financialsound with negligible risks that could disrupt financial

system stabilitysystem stabilitysystem stabilitysystem stabilitysystem stability. The BI-RTGS (Real Time Gross

Settlement) system was also robust and effective in

settling transactions, which totaled Rp131 trillion per

day in 2006. To mitigate payment system risks, Bank

Indonesia instituted a full array of policies. The failure-

to-settle mechanism (FtS) was implemented, which

requires a pre-fund from participants of the Bank

Indonesia National Clearing System (BI-NCS). FtS will

reduce settlement risk and credit risk stemming from

debit clearing. In addition, new regulations were

enacted regarding the administration of a nationally

integrated Black List of bad cheque and postal order

users to preserve confidence. Bank Indonesia also

reinforced oversight of the payment system and

regulated money remittances.

Settlement Development

Through semester II 2006, settlement value andThrough semester II 2006, settlement value andThrough semester II 2006, settlement value andThrough semester II 2006, settlement value andThrough semester II 2006, settlement value and

volume continued to risevolume continued to risevolume continued to risevolume continued to risevolume continued to rise. Settlements through BI-

RTGS increased with an average daily transaction

value in semester II 2006 of Rp131 trillion; up 21.4%

(y-o-y). Notwithstanding, transaction settlements

through the clearing system totaled Rp5.14 trillion,

on average, daily in semester II 2006, representing

an increase of 11.35% (y-o-y). Despite the impressive

rise in transactions processed, no significant

operational risk emerged in BI-RTGS or clearing that

could disrupt the payment system. As much as 96%

of settlements in the payment system are now

performed through BI-RTGS. This evidences the

importance of BI-RTGS in the payment system.

Furthermore, BI-RTGS is essentially aimed at reducing

settlement risk in order to maintain financial system

stability.

The panoply of initiatives including significant improvements in the payment

system, the introduction of a financial safety net, risk management practices

and corporate governance have ensured adequate financial infrastructure to

mitigate risk. Bank risk management improved reflected by the adequacy of

risk control systems and better corporate governance. Furthermore, the

financial safety net has been bolstered by the adoption of lender of last

resort for systemic risk and limited deposit insurance scheme. The payment

system was safe and robust due to well mitigated settlement risk and

operational risk.

Financial Infrastructure and Risk MitigationChapter 4

52


The use of payment cards grew rapidly. The

use of card based payments was prolific, dominated

by ATM cards (59.4%) followed by debit cards

(31.26%) and credit cards (9.34%). Based on value,

debit cards represented the largest transaction share

of 61.42%, followed by ATM cards (34.39%) and

credit cards (4.19%). The extensive use of payment

cards indicated a shift in the use of payment

instruments such as currency towards non-cash

means instead, therefore leading to a less-cash

society. To limit the risk exposure of credit cards to

banks, Bank Indonesia imposed a minimum payment

of 10% of the monthly invoice.

Mitigating Payment System Risks

Risks in the payment system, both theRisks in the payment system, both theRisks in the payment system, both theRisks in the payment system, both theRisks in the payment system, both the

Systemically Important Payment System (SIPS) andSystemically Important Payment System (SIPS) andSystemically Important Payment System (SIPS) andSystemically Important Payment System (SIPS) andSystemically Important Payment System (SIPS) and

Systemically Wide Important Payment SystemSystemically Wide Important Payment SystemSystemically Wide Important Payment SystemSystemically Wide Important Payment SystemSystemically Wide Important Payment System

(SWIPS), were well managed(SWIPS), were well managed(SWIPS), were well managed(SWIPS), were well managed(SWIPS), were well managed. As the regulator,

overseer and administrator of the payment system,

Bank Indonesia is mandated to ensure that the

payment system runs safely, smoothly and efficiently.

To this end, Bank Indonesia manages risks in SIPS

and SWIPS. Risk management was conducted

comprehensively including system design,

operations as well as rules for SIPS and SWIPS

participants. Furthermore, risk control in SIPS,

particularly for BI-RTGS, took into account various

aspects that influence its smooth operation and

performance. As a result, the reliability of BI-RTGS

was evidenced by the availability of the system,

which reached 99.9%. Risk control in SWIPS was

performed through expanding BI-NCS and FtS to

mitigate settlement risk stemming from the clearing

system.

Operational risk was mitigated by a thoroughOperational risk was mitigated by a thoroughOperational risk was mitigated by a thoroughOperational risk was mitigated by a thoroughOperational risk was mitigated by a thorough

contingency plancontingency plancontingency plancontingency plancontingency plan. To maintain operational reliability,

Bank Indonesia routinely tests the readiness of the

Disaster Recovery System (DRC). The test results have

shown that the reliability of the back-up system as

well as operational procedures executed by the

administrator (BI) and participants (banks) are

adequate. Bank Indonesia also consistently advocates

and develops Business Continuity Management

(BCM). BCM is a comprehensive risk-management

process that involves identifying potential emergency

conditions that could disrupt the payment system.

It includes details regarding organizations,

responsibilities and procedures to prevent disruptions

and also restore the payment system when

disruptions, both internal and external, occur. BCM

development is part of the efforts to support financial

system stability.

Graph 4.1BI - RTGS Settlement Performance

Thousands of Transactions

-

5

10

15

20

25

30

35

2000 2001 2002 2003 2004 2005 2006

-

20

40

60

80

100

120

140

160

180Trillions of Rp Transactions

Daily Volume Average

Daily Nominal Average (Trillions of Rp)

Poly. (Daily Volume Average)

Poly. (Daily Nominal Average (Trillions of Rp))

11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11

Graph 4.2BI - RTGS Settlement Performance (by Agent)

0

5

10

15

20

25

30

35

40

45

50

15.21

20.01

47.26

0,03

3.52

44.17

12.51

4.56

9.49 9.40

0.21

24.46

3.525.65

Foreign BanksJoint Venture

Banks State-OwnedBanks

CentralBank Regional Dev.

Banks

Private BanksNon Bank

Fin. Institutions

Nominal ShareVolume Share

53


System development is necessary to improve theSystem development is necessary to improve theSystem development is necessary to improve theSystem development is necessary to improve theSystem development is necessary to improve the

reliability of the payment system.reliability of the payment system.reliability of the payment system.reliability of the payment system.reliability of the payment system. Realizing the

importance of the payment system as vital financial

infrastructure, Bank Indonesia continuously strives to

improve payment system reliability through various

endeavors as follows:

Improving the quality of payment system

application by enhancing Bank Indonesia

National Clearing System (BI-NCS) in December

2006. BI-NCS is equipped with new, simpler

features that help smooth clearing operations

in participating banks. Thus, the public can enjoy

the services of the payment system through fast,

efficient and secure clearing.

Improving the integrity of the payment system

by enacting BI Regulation No 8/29/PBI/2006, 20th

December 2006. With this policy the

administration of blacklisted cheques and postal

orders will be performed nationally (National

Blacklist). Customers who bounce cheques or

postal orders three times or more within 6

months on the same account can be blacklisted.

This regulation is expected to encourage the user

accountability.

Improving the security and transparency of

remittances. Bank Indonesia issued BI

Regulation No 8/28/PBI/2006 regarding money

transfers on 5th December 2006 regarding

remittances by non bank administrators. The

new regulation is expected to foster

transparent fund transfers through non-banks,

maintaining the integrity of the payment

system. This regulation is also designed to

safeguard security, transparency as well as

legal and customer protection. Thus, criminal

money transfers such as for money laundering,

terrorist financing and other illegal activities

can be minimized and easier to detect.

4.2. FINANCIAL SECTOR SAFETY NET (FSSN)

EnhancingEnhancingEnhancingEnhancingEnhancing FSSNFSSNFSSNFSSNFSSN to buttress financial systemto buttress financial systemto buttress financial systemto buttress financial systemto buttress financial system

stabilitystabilitystabilitystabilitystability. FSSN strengthening was continued to

improve financial system stability. Under the FSSN

framework the roles, responsibil it ies and

mechanisms of coordination between Bank

Indonesia, the Ministry of Finance and the

Indonesian Deposit Insurance Corporation (IDIC)

are clearly outlined to prevent and overcome

financial crises.

The framework was formulated in draft acts

that will become the clear legal foundation for

Bank Indonesia, the Ministry of Finance and IDIC

in performing their roles and collaborating to

maintain financial system stability. In the draft acts

four primary elements of FSSN are stipulated: (a)

effective bank regulation and supervision; (b)

lender of last resort; (c) a limited and explicit deposit

insurance scheme; and (d) effective crisis resolution

policy. To ensure effective coordination, the

Coordination Committee was established,

comprising of the Minister of Finance, the Governor

of Bank Indonesia and the Chief of IDIC Board of

Commissioners.

As part of the efforts to reinforce FSSN, IDIC

was established on 22nd September 2005 mandated

by Law No 24, 2004. IDIC has two roles, namely to

insure customer deposits at banks and administrate

failing banks. In March 2007, the limited deposit

insurance scheme was fully implemented to a

maximum of Rp100 million per customer per bank.

The scheme replaced the government blanket

guarantee program, which has been phased out

54


periodically since 22nd September 2005 to minimize

moral hazard.

Effective coordination among authoritiesEffective coordination among authoritiesEffective coordination among authoritiesEffective coordination among authoritiesEffective coordination among authorities

through the establishment of the Financial Systemthrough the establishment of the Financial Systemthrough the establishment of the Financial Systemthrough the establishment of the Financial Systemthrough the establishment of the Financial System

Stability Forum (FSSF).Stability Forum (FSSF).Stability Forum (FSSF).Stability Forum (FSSF).Stability Forum (FSSF). On 30th December 2005, a

Joint Decree between the Minister of Finance,

Governor of Bank Indonesia, and Chief of IDIC Board

of Commissioners was signed regarding the

establishment of the Financial System Stability Forum

(FSSF). FSSF has four primary functions:

1. To support the Coordination Committee in

making decisions regarding problematic banks

considered systemic. The Coordination

Committee comprises of the Minister of Finance,

the Governor of Bank Indonesia, and the Chief

of IDIC Board of Commissioners and is regulated

by the Deposit Insurance Corporation (IDIC).

Meanwhile, the decision to provide liquidity

assistance to banks with systemic risk is made

by the Minister of Finance and the Governor of

Bank Indonesia.

2. To coordinate and exchange information in order

to harmonize laws and regulations in the

banking sector, non bank financial institutions

and the capital market;

3. To discuss problems in the financial system with

systemic effects based on information from the

relevant supervisory authority.

4. To coordinate the implementation and

preparation of certain initiatives, including the

development of Indonesian Financial Sector

Architecture and the preparation of the Financial

Sector Assessment Program (FSAP);

FSSF will enhance effective coordination

between related authorities to maintain financial

system stability. This is prerequisite to confront

systemic risk and necessitates collective actions as

well as timely and accurate decision making.

4.3. RISK MANAGEMENT AND BASEL II

IMPLEMENTATION

Banks» improving ability to implement riskBanks» improving ability to implement riskBanks» improving ability to implement riskBanks» improving ability to implement riskBanks» improving ability to implement risk

management helped bolster financial systemmanagement helped bolster financial systemmanagement helped bolster financial systemmanagement helped bolster financial systemmanagement helped bolster financial system

stabilitystabilitystabilitystabilitystability. Financial system stability, particularly in the

banking sector, was supported by better bank risk

management. Since the implementation of Bank

Indonesia Regulation No. 5/8/PBI/2003 regarding the

implementation of risk management, banks have

established risk-management units and committees.

In essence, banks are becoming more competent in

identifying and mitigating various risks, especially

credit risk, liquidity risk and market risk. Banks also

have in place risk management information systems

tailored to the complexity of the bank risk profile.

In addition, the risk-management certification

program was instituted to raise the competence of

bank managers. To the end of December 2006, more

than 8,289 bankers had passed the certification

program.

More effective risk management is reflected by

improvements in the risk profile and the adoption of

risk control systems. In general, banks and especially

large banks use their own risk control systems. The

risk-management systems include internal controls,

management information systems (MIS) and

corporate governance. The challenges confronting

banks in developing effective risk management

include limited data and basic measurement

methods.

Improving risk management effectiveness is

congruent to the implementation of Basel II. As

planned, Basel II will be implemented in 2008 with

55


the simplest approach. The Basel II framework

provides incentives for banks to ameliorate their

risk-management quality. The better the risk

management, the more accurate the capital

calculation in anticipation of unexpected losses.

Adequate bank capital will cushion against any

shocks that may arise. Bank Indonesia regularly

reviews bank capital adequacy to ensure that risks

are well mitigated and supported by sufficient

capital. In addition, market discipline will be

fostered by bank transparency on one side and

public awareness of bank conditions as well as

responsible bank customers on the other. Synergy

between capital adequacy, effective bank

supervision and market discipline will further

reinforce the resilience of the financial system.

56


Basel II and Financial System StabilityBox 4.1

Banks, for the most part, are the dominant

financial system component in the economy. Banks have

numerous risks inherent with the business, and thus

need to be regulated, supervised and managed soundly.

Bank failure - especially with systemic risk - can

endanger financial system stability and the economy.

Therefore, banks must maintain adequate capital to

cover the risks that may arise. To this end, augmenting

the quality of risk management is crucial to mitigate

fluctuations in the financial market and real sector. As

a refinement of the Basel Accord 1988, Basel II provides

incentives for banks to improve the quality of their risk

management.

In addition, Basel II will strengthen financial system

stability by maintaining the capital adequacy of banks

with systemic effects (Kupiec, 2006)1 . An adequate

solvency level of a bank has been proven to be a

precondition to a stable financial sector (Haldane et al,

2005)2 . Parity between regulatory capital and economic

capital would enable banks to overcome risks and

therefore become more resilient to instability.

The comprehensive Basel II framework, in

essence, stipulates three pillars that mutually reinforce

one another, namely: (i) minimum capital requirement;

(ii) supervisory review process; and (iii) market

discipline.

Pillar I: Minimum capital requirementPillar I: Minimum capital requirementPillar I: Minimum capital requirementPillar I: Minimum capital requirementPillar I: Minimum capital requirement details the

framework for calculating minimum bank capital

to cover credit risk, market risk and operational risk.

Pillar I provides several approaches to each risk type

in line with the complexity and quality of risk

management. The higher the bank»s quality of risk

management a more advanced and accurate

approach can be taken. Therefore, banks have the

opportunity to gain incentives as the minimum

regulatory capital nears the economic capital3 of

a bank. Pillar 1 also expands the acknowledgement

of risk mitigation techniques, including collateral,

guarantees, netting agreements and credit

derivatives.

Pillar II: Supervisory review processPillar II: Supervisory review processPillar II: Supervisory review processPillar II: Supervisory review processPillar II: Supervisory review process emphasizes the

importance of the supervisory authority»s role in

continually assessing capital adequacy where:

1. Banks have to comprehensively assess capital

adequacy according to their risk profile,

including a strategy to maintain capital

adequacy;

2. Supervisors have to review and observe: (i)

strategy and capital adequacy calculations

performed by banks internally; and (ii) a bank»s

ability to monitor and comply with the

regulatory capital adequacy ratio;

3. Supervisors can request banks to operate above

the capital adequacy ratio and provide capital

greater than the minimum standard; and

4. Supervisors can intervene preemptively to

prevent a bank»s capital adequacy falling below

the minimum level and ensure that the bank

has conducted its contingency plan to maintain

or recover capital to its initial level.

Pillar III: Market disciplinePillar III: Market disciplinePillar III: Market disciplinePillar III: Market disciplinePillar III: Market discipline. Pillar I and pillar II are

more effective if market discipline is successfully

nurtured. Basel II set the minimum information limit

that must be published by banks, such as prevailing

risks, capital, risk exposure, risk measurement and

capital adequacy. Basel II minimizes the problem

of asymmetric information by encouraging

transparency that empowers the public to assess

risk profiles and a bank»s condition.

1 Kupiec, Paul H. (2006), ≈Financial Stability and Basel IIΔ2 Haldane et al, (2005), ≈Financial Stability and Bank SolvencyΔ3 Economic capital is real capital required by a bank to maintain its business.

57


Synergy between the three pillars will foster

financial system stability. First, banks are continuously

impelled to improve their risk management quality.

Second, less variance between capital and risks will

bolster bank resilience against potential crises. Third,

transparency will encourage banks to run their

businesses in a healthier way and also advocate the

responsibility of bank customers.

To this end, Bank Indonesia will initiate

implementation of Basel II for Indonesian banks in 2008

to be completed in 2010. Capital calculations will begin

using the simplest approach, namely a standard

approach for credit risk and market risk, and a basic

indicator approach for operational risk. However, banks

will have the opportunity to use more advance

approaches upon satisfaction of relevant criteria and

approval from the supervisor. Bank Indonesia has

published consultative papers regarding capital

calculations whilst banks themselves are also preparing

for Basel II implementation.

Table 4.1.1Basel II Implementation Plan

Implementation ofRisks Assesment

ApproachIssue of BIRegulation

P I L L A R 1 P I L L A R 2 PILLAR 3

Market RiskMarket RiskMarket RiskMarket RiskMarket Risk

Standardized Q3 2007 Q1 2008 - Q4 2008 Q1 2009 Q4 2008 Q1 2009

Internal Model Q3 2007 Started in Q3 2007 Q2 2008 Q2 2008 Q1 2009

Credit RiskCredit RiskCredit RiskCredit RiskCredit Risk

Standardized Q3 2007 Q1 2008 - Q1 2009 Q1 2009 Q4 2008 Q1 2009

IRBA Q4 2009 Started in Q1 2010 Q4 2010 Q4 2010 Q2 2011

Operational RiskOperational RiskOperational RiskOperational RiskOperational Risk

Basic Indicator Q3 2007 Q1 2008 - Q1 2009 Q1 2009 Q4 2008 Q1 2009

Standardized Q4 2009 Started in Q1 2010 Q4 2010 Q4 2010 Q2 2011

AMA Q4 2009 Started in Q2 2010 Q2 2011 Q4 2010 Q2 2011

Parallel Run(Standardized)

orValidation Process(Internal Model)

EffectiveCAR

Calculation

CompletingMonthly

Accounting Report

Other Risks Transparency

On line SystemIssue of BIRegulation

Effective CARCalculation

Issue of BIRegulation

Q 3

2

0 0

7

Q 1

2

0 0

9

58



Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

59

Ar t ic les


60



61

Financial Safety Nets:Review of Literature and Its Practices in Indonesia

Sukarela Batunanggar1

1. INTRODUCTION

Financial Safety Nets (FSN) is a key building block

of financial system stability. It prevents bank run,

limits probability of financial instability, as well as

minimizes frequency and adverse impact of economy

In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essential

to foster financial system stability, predominantly in banking sector. Financial system stability and monetary

stability are mutually dependent and, therefore, must be preserved for sustainable economic growth. To

safeguard financial stability - particularly banking system - a financial safety nets is key pilar in addition to

effective supervisory and regulatory frameworks. As a chief conduit to sustainable economy growth, financial

system and monetary stability - both intertwined - must be well-preserved. A well-designed and comprehensive

financial safety nets mitigates risks to financial system and as a tool of crisis management to eliminate adverse

impacts of crisis when they occur. Albeit its scheme varies, FSN fundamentally consists of four elements : (i)

independent as well as effective regulation and supervision; (ii) effective lender of last resort; (iii) explicit

deposit insurance scheme; and (iv) clear crisis management. The Government and Bank Indonesia have drafted

a comprehensive framework for a Financial Safety Nets (FSN). The FSN framework clearly defines objectives

and elements of FSN, roles and responsibilities of relevant authorities, and coordination mechanism among

the authorities involved in the FSN: Ministry of Finance, Bank Indonesia, and the Deposit Insurance Corporation.

Equipped with a lucid legal framework for FSN and integrated implementation, effective preventive measures

and crisis resolution are possible.

contraction. Crises showed us that deposit insurance

scheme, discount facilities, emergency liquidity

assistance of central banks offer security and liquidity

to banks. Notwithstanding, FSN has negative

consequences unless it is well-designed. It may trigger

distortion in price signal used for resource allocation,

provoke risk taking and moral hazard that ultimately

call for for effective supervision and regulation.

1 Executive Bank Researcher at Bank Indonesia. The views expressed in this paper arethose of the author and do not necessarily reflect the views of Bank Indonesia. E-mailaddress: [email protected]

Abstract


62

Stable and SoundFinancial System

Solid legal framework, clear division of roles and responsibilitiesand effective coordination mechanism

Regulationand

SupervisionSystem

Central Bank(as Bank

Supervisor)

Lender ofLast Resort

Policy

(as LoLR)

DepositInsuranceSystem

D I C

CrisisManagement

Policy

MoF,Central Bank,

and DIC

Central Bank

Graph 1:Financial Safety Nets

Until recently, there is no universal definition of

FSN. In general, FSN is public policy provided by

government to foster economy growth and financial

stability. Albeit its scheme varies, FSN fundamentally

consists of four elements : (i) independent as well as

effective regulation and supervision; (ii) effective

lender of last resort; (iii) explicit deposit insurance

scheme; and (iv) effective bank resolution and crisis

management. Typically, FSN has been succinctly

associated with lender of last resort and deposit

insurance. In this paper, on the other hand, the term

FSN refers to a broader definition.

2. REGULATION AND SUPERVISION

The ultimate objective of regulation and

supervision is to foster security and soundness of

financial institutions via evaluation and continous

surveillance. These include assessment on quality of

risk management, financial conditions, and

compliance with laws and regulations. Effective

regulation and supervision is the first safety nets

aiming at creating and promoting sound financial,

predominantly banking system.

Lack of supervisory capability is often cited as

one of the reasons for financial system weaknesses

(Mayes, Halme dan Liuksila, 2001). As Mishkin (2001)

argued, asymmetric information leads to adverse

selection and moral hazard problems that have an

important impact on financial systems and justifies

the need for prudential supervision.

The main focus of determining condition of a

bank pre-crisis is to rapidly help supervisor

differentiate banks having probability to survive from

those having probability to fail in a crisis. The main

characteristic of systemic crisis is that financial

condition of a bank will rapidly deteriorate as a result

of adverse economy and or widespread bank run.

Along with the rapid advancement, increasing

complexity, and greater risks confronting finance

industry, some multilateral agencies have developed

internationally accepted standards and supervisory

principles. The reference of standards and regulation

for banking industry is The 25 Basel Core Principle

for Effective Banking Supervision which is published

by the Basel Committee of Banking Supevision

(BCBS). For insurance industry, the standard refers

to The Principles of Insurance Supervision.

Some scholars including Goodhart (1998) and

Llewellyn (1999) have set up guiding principles of

banking regulation. Aside from the Basel Core

Principles, they set up principles of the importance

of incentives for bank management, effective

financial safety net which fosters prudential behavior

of bank management and stakeholders, market

discipline, and good corporate governance.

Financial system stability will exist should there

is power balance among various stakeholders,

shareholders, depositors, debtors, creditors, and

supervisors. Therefore, good corporate governance

is the key element in a supervisory framework (Mayes

et al., 2001). With respect to good corporate


63

governance, it is important to adopt regulatory

regime that is more market-based. Within this

context, transparency improvement through

enhanced disclosure must be the top agenda. New

Zealand is the country more adopting market-based

regime.

Drawbacks in governance and supervision have

been cited by experts as one of factors exacerbating

the Asian financial crises in 1997-1998, particularly

in Indonesia (Halim (2000), Nasution (2000),

Batunanggar (2002)). Hence, Bank Indonesia has

been strongly committed to enhance effectiveness

bank supervision comprehensively along with the

post-crisis bank restructuring program. Despite the

progress that has been made, challenges remain to

be seriously dealt with. From the supervision side, it

is essential to continuously enhance quality and

quantity of bank supervisors as well as enhance

quality of supervision information system in

proportion to the increasing complexity of business

and risks banks are confronting. From the banking

industry side, it is essential that banks exercise good

corporate governance, robust risk management, as

well as consistent and effective internal control.

Beside, to bolster the structure of banking industry,

banking consolidation initiative via merger is

indispensable.

The other important issue us the plan to unite

supervisory function of central bank and various

authorities into an independent mega regulator as

in the case of the United Kingdom, Australia, Japan,

and Korea in the last decade. In general, two

rationales for unification are to enhance supervision

efficiency and to effectively supervise financial

conglomerates. However, no empirical evidence has

been found concerning benefits of the unification

particularly from both micro-prudential and financial

system stability. In fact, Abram and Taylor (2000) and

Goodhart (2001) provide excellent discussions on the

issues in the unification of financial sector supervision.

Goodhart argues that banking supervision in less

developed countries is better to be kept within the

central bank because it will be better funded, more

independent and more expert and reliable. Hence, it

is important to rigorously consider the unification to

prevent potential problems from occurring, which

may deteriorate financial stability.

3. LENDER OF THE LAST RESORT (LLR)

LLR is discretionary provision of liquidity to a

financial institution (or the market as a whole) by

the central bank in reaction to an adverse shock

which causes an abnormal increase in demand for

liquidity which cannot be met from an alternative

source (Freixas et al., 1999).

The LLR concept was born in the19th century

by Henry Thornton (1802) who explicated the

fundamental elements of good central banking

practice in the light of emergency lending. Then,

Walter Bagehot (1873), more widely known as the

founding father of modern LLR, developed the

concept of Thornton (even though he did not

mention his name). Bagehot stated three principles

of LLR: (i) provide the lending against sufficient

collaterals (for solvent bank only); (ii) provide the

lending with penalty rate (for liquid banks only); (iii)

announce commitment to lend witout limit (to ensure

credibility).

Historical experience suggests that successful

lender of last resort actions have prevented panics

on numerous occasions (Bordo, 2002). Similarly,

Mishkin (2201) argues that central bank can


64

encourage the recovery of financial crisis by providing

loan in as lender of the last resort. Although there

may well be good reasons to maintain ambiguity over

the criteria for providing liquidity assistance, He

(2000) argues that properly designed lending

procedures, clearly laid-out authority and

accountability, as well as disclosures rules, will

promote financial stability, reduce moral hazard, and

protect the lender of last resort from undue political

pressure. There are important advantages for

developing and transitional economies to follow a

rule-based approach by setting out ex ante the

necessary conditions for support, while maintaining

such conditions is not sufficient for receiving support.

In the same vein, Nakaso (2001) suggests that Japan»s

LLR approach has shifted from ≈constructive

ambiguityΔ towards increasing policy transparency

and accountability.

As argued by Sinclair (2000) and Goodhart

(2002), within the time scale allowed, it is often

difficult, if not impossible, for central banks to

distinguish between a solvency and a liquidity

problem. Similarly, Enoch (2001) argued that there

should be restrictions against protracted use of such

lending, since this is likely to be an indicator of

solvency difficulties.

LLR activities by a central bank in a emerging

market countries with substantial foreign-

denominated debt, may not be as successful as in

an industrialised countries. Therefore, the use of the

LLR by a central bank in countries with a large amount

of foreign-denominated debt is trickier because

central bank lending is now a two edged sword

(Mishkin, 2001).

While individual frameworks differ from country

to country, there is a broad consensus on the key

considerations for emergency lending during normal

and crisis periods (see Box A1.1).

Lender of Last Resort in Normal Times

In normal times, LLR assistance should be

based on clearly defined rules. Transparent LLR

policies and rules can reduce the probability of self-

fulfilling crises, and provide incentives for fostering

market discipline. It may also reduce political

intervention and prevent any bias towards

forbearance. LLR in normal times should only be

provided for solvent institutions with sufficient

acceptable collateral, while for insolvent banks

stricter resolution measures should be applied such

as closure. Therefore, there should be a clear and

consistent adoption of a bank exit policy. Once a

deposit insurance scheme has been established, the

central bank role in LLR in normal time can be

reduced to a minimum since the deposit insurance

company will provide bridging finance in the case

where there is a delay in closure process of a failed

institution2 .

LLR in Exceptional Circumstances

In systemic crises, LLR should be an integral part

of a well-designed crisis management strategy. There

should be a systemic risk exception in providing LLR

to the banking system. Repayment terms may be

relaxed to support the implementation of a systemic

bank restructuring programme. In systemic crises the

disclosure of the operation of LLR may become an

important tool of crisis management. The criteria of

a systemic crisis will depend on the particular

circumstances, thus, it is difficult to clearly state this

2 See Nakaso (2001) for a discussion on the Japanese LLR model.


65

Key Considerations of Emergency LendingBox A1.1

1. Have in place clearly laid out lending procedures,

authority, and accountability.

2. Maintain close cooperation and exchange of

information between the central bank, the

supervisory authority (if it is separate from the

central bank), the deposit insurance fund (if exist),

and the ministry of finance.

3. Decision to lend to systemically important

institutions at the risk of insolvency or without

sufficient, acceptable collateral should be made

jointly by monetary, supervisory, and the fiscal

authority.

4. Lending to non-systemically institutions, if any,

should be only to those institutions that are deemed

to be solvent and with sufficient acceptable

collateral.

5. Lend speedily.

6. Lend in domestic currency.

7. Lend at the above average market rates.

8. Maintain monetary control by engaging effective

sterilization.

9. Subject borrowing banks to enhanced supervisory

surveillance and restrictions on activities.

10.Lend only for short-term, preferably not exceeding

three to six months.

11.Have a clear exit strategy.

Additional Requirements for Systemic Crisis

12.Decision to lend should be an integral part of crisis

management strategy and should be made jointly

by monetary, supervisory, and the fiscal authority.

13.Emergency support operations should be disclosed

when such disclosure will not be disruptive to

financial stability.

14.Repayment terms may be relaxed to accommodate

the implementation of a systemic bank

restructuring strategy.

15.Emergency support operation should be disclosed

when such disclosure will not be disruptive to

financial stability.

Source: Dong He (2000), «Emergency Liquidity Support Facilities», IMF Working PaperNo. 00/79.

beforehand in a law. However, the regulations on

the LLR facility should clearly set the guiding principles

and specific criteria of a systemic crisis and or a

potential bank failure leading to systemic crisis. To

ensure an effective decision making process and

accountability, there should be a clear institutional

framework and LLR procedures. Bank Indonesia

should be responsible for analysing the systemic

threats to financial stability while the final decision

on systemic crises resolution should be made jointly

by Bank Indonesia and the Ministry of Finance. To

ensure accountability, an appropriate documentation

audit trail should be maintained.

Criticism on LLR

Experts criticized the classic doctrine of LLR.

Goodhart (1999) argued the impossibility to make a

clear distinction between the illiquid and insolvent

banks. Given the modern inter-bank money markets

are generally available, the solvent banks will be able

to obtain money market borrowings. Solow (1982),

stated that a central bank is also responsible for

financial system stability. In the light with financial

stability maintenance, he added, in most cases a

central bank must rescue insolvent banks to prevent

a financial system from systemic crisis. In addition,

Kauffman (1991), criticized LLR practice in which the


66

3 The Act of the Republic of Indonesia number 23 1999 concerning Bank Indonesia asamended by The Act of Republic of Indonesia number 3 2004

government intervention will lead to a potential

political pressure and deteriorate regulation. Discount

window is obscurely granted to rescue insolvent

banks. Goodhart and Huang (1999) also argued a

dilemma between systemic risk avoidance and moral

hazard by bank management predominatly in the

rescue of large insolvent banks (too big to fail).

The other means to prevent moral hazard as

recommended by Bagehot more than a century ago

is via penalty rates. Yet, according to Freixas et al.

(1999) this may: (i) aggravate problem confronting

banks; (ii) indicate erroneous signal to market that

exacerbate bank run; and (iii) provide incorrect

incentives to bank managers to adopt higher risk-

reward strategy to pay higher interst rates. Hence,

to prevent the moral hazard from occurring, Freixas

et al. (1999) recommended that intervention be made

conditionally on the lending that is not fully

collateralized. The constructive ambiguity is expected

to thwart moral hazard, providing that it is furnished

by strong law enforcement on managers and

management of banks which are lacking of

prudential attitude when operating bank.

LLR Policy in Indonesia

As stipulated in the Law3 , Bank Indonesia may

provide LLR facility both for normal conditions and

for preventing systemic crisis. According to article 11

verse 1 and 2 of the Law, in a normal condition, Bank

Indonesia may provide LLR to a bank for resolving

short term liquidity problem in the form of

conventional lending or Syariah based principle

financing for maximum of 90 days. These facilities

are guaranteed by high quality and liquid collaterals,

at least of the similar value against the received

facilities.

Furthermore, according to the above mentioned

article, stipulated ≈in case of a bank confronts

financial difficulties deemed to be systemic and may

trigger a crisis threatening financial system, Bank

Indonesia may provide emergency liquidity lending

whose source of funds will come from the

governmentΔ. Regulations of decision making to

determine whether a crisis systemic, provision of

Emergency Liquidity Assistance (ELA), and source of

funds from the state budget are stipulated in a

separate law.

Prior to the enactment of the ELA regulations,

temporarily the ELA provision was stipulated in the

Memorandum of Understanding between the

Minister of Finance and the Governor of Bank

Indonesia dated March 17, 2005. As stipulated in

the MoU, Bank Indonesia is responsible for analysing

systemic risk that will threat financial system stability,

whereas decision to provide the ELA will be made

by both the Governor of Bank Indonesia and

Minister of Finance. The procedure of ELA provision

will be technically stipulated in the Regulation of

Bank Indonesia and Regulation of the Minister of

Finance.

Learning from the case of Bank Indonesia

Liquidity Support, at least two basic issues need to

be clearly made in a regulation to ensure

accountability in providing the ELA. First, collateral

issue, it is essential to determine whether the ELA is

secured or unsecured lending. Refer to best practices,

in general ELA is seen as unsecured lending from a

central bank and, therefore, some exceptions may

be applied. Second, the decision making needs to

be anticipated and clearly defined in the law should


67

4 However, this was done primarily for domestic rather than foreign banks.5 The plan for establishing a deposit insurance scheme has been discussed quite intensively

since the early 1990s. However, the authorities declined the proposal because theyconsidered that it would create moral hazard.

disagreement between the Minister of Finance and

the Governor of Bank Indonesia occurs.

4. DEPOSIT INSURANCE

In general, deposit insurance have three

interlinked objectives: (i) to guarantee less

sophisticated depositors; (ii) to preserve public

confidence on the financial system, particularly

banking system; and (iii) to safeguard financial

stability. Fundamentally, deposit insurance system is

aimed at preventing bank runs. Refer to the model

of Diamond-Dybvig (1983), bank runs has a feature

≈self-fulfilling prophecyΔ, in which the erosion of

depositors may trigger banking crisis. This is due to

two factors: (I) information assimetry between

depositors and bank management; and (ii) in general,

depositors are lacking capacity to assess financial

soundness of a bank. Besides, banks are also

susceptible to liquidity risk as their liquid assets are

far less than their liquid assets.

In more detail, Thompson (2004) explained five

arguments to implement deposit insurance: (i) to

foster banking system stability that is susceptible to

bank runs during a crisis that would pose contagion

effect to sound and solvent banks (Diamond and

Dybvig, 1983); (ii) protected deposits provide

options to small depositors and, consequently, help

raise savings for investment purpose; (iii) if a

supervisory authority is under political pressure to

bail-out depositors (when an implicit deposit

insurance scheme exists), explicit deposit insurance

will be able to limit guranteed liabilities by

determining ex-ante what is or what is not

guaranteed; (iv) a deposit insurance scheme

empowers small banks to compete against large

banks; (v) explicit deposit insurance help supervisory

authority to exercise more rigorous supervision on

banks.

Before the 1997 crisis, none of the East Asian

crisis countries except the Philippines, which was least

affected by the crisis, had an explicit deposit insurance

scheme. Bank Indonesia provided both liquidity and

capital support to problem banks on an ad-hoc basis

and in non transparent ways4. The support was also

not based on any pre-existing formal guarantee

mechanism but rather on a belief that some of the

banks that needed support were too big to fail or

the failure of a bank could cause contagion.

A limited deposit guarantee in Indonesia was

first applied when the authorities closed down Bank

Summa at the beginning of the 1990s which was

considered unsuccessful5 . After then, there were no

bank closures until the authorities closed down 16

banks in November 1997 and introduced a limited

guarantee. However, this failed to prevent systemic

bank runs.

To restore domestic and international

confidence in the economy and the financial system,

the government signed the second agreement with

the IMF on 15 January 1998. However, market

perceptions and reactions to the government

commitment and capacity to resolve the crisis were

still negative. There was a huge amount of capital

flight of around $600 million to $700 million per

day. On 22 January, the rupiah plummeted to a record

low of Rp16.500.

To prevent a further slide and to maintain public

confidence in the banking system on 27 January, the

government issued a blanket guarantee. It covered


68

6 Initially it was to be retained for a minimum of two years, with a provision for an automaticsix months extension in the absence of an announcement of termination of the scheme.

7 BI retains the role of administering the guarantee scheme to trade finance, inter-bankdebt exchange and rural banks.

all commercial banks liabilities (rupiah and foreign

currency), including both depositors and creditors. It

was an interim measure pending the establishment

of the Deposit Insurance Agency6 . Initially, the

administration of the blanket guarantee was a joint

task between Bank Indonesia and IBRA. From June

2000 it has been the responsibility of IBRA alone7 .

The Indonesian case suggests that a very limited

deposit insurance scheme was not effective in

preventing bank runs during the 1997 crisis. Deposits

denominated of more than Rp20 millions - the

uninsured component - accounted for about 80%

of total deposits. Therefore, if a blanket guarantee

had been introduced earlier at the outset of the crisis,

the systemic runs might have been reduced.

There was a controversy over the adoption of a

blanket guarantee. Some commentators such as

Furman and Stiglitz (1998), Stiglitz (1999,2002),

Radelet and Sachs (1998) argue that the if the blanket

guarantee had been introduced earlier, before some

banks had been liquidated, the damage and costs of

the crisis would have been much less.

In contrast, others criticised the blanket

guarantee for being too broad. Goldstein (2000)

argued that had all bad (insolvent) banks been closed

at the beginning of the crisis then even with the

limited deposit guarantee scheme in place there

would not have been widespread deposit

withdrawals because the remaining banks would

have been «good» ones. He believed that with a

blanket guarantee, the government ended-up

providing ex-post deposit insurance at a higher fiscal

cost and with adverse moral hazard effects increasing

the likelihood of future banking crises. Therefore, he

suggested that Indonesian should develop an

incentive-compatible deposit insurance system -

along the lines of FDICIA in the United States - which

should be a permanent part of the financial

infrastructure.

However, systemic bank runs in Indonesia at the

outset of the 1997 crisis cannot be attributed solely

to the absence of a blanket guarantee. The

inconsistent and non transparent bank liquidation

policies applied by the authorities and some political

uncertainties during the end of Suharto»s regime also

played their part, as Lindgren et al. (1999) and Scott

(2002) document. The introduction of the blanket

guarantee programme at the outset of the crisis

might be necessary in order to prevent larger potential

economic and social costs of the systemic crisis

(Lindgren et al. 1999). However, the scheme should

be replaced as soon as possible with one that is more

appropriate to normal conditions and does not create

moral hazard.

Best Practices

Garcia (1999, 2000), based on surveys in 68

countries, identified the best practices of explicit

systems of deposit insurance principally should have

good infrastructure, avoid moral hazard, avoid

adverse selection, reduce agency problems and

ensure financial integrity and credibility. Based on a

study of deposit insurance systems in Asian countries,

Choi (2001) argues that it is reasonable in Asia to

establish and maintain an explicit and limited deposit

insurance system in order to prevent further possible

financial crisis. Pangestu and Habir (2002) suggest

that Indonesia»s deposit insurance scheme should be

designed on two key aspects. First, it should provide


69

incentive to better performing banks by linking the

annual premium payment to their risk profile. Second,

it should be self-funded in order to foster market

discipline and reduce the fiscal burden.

In order to avoid a disruption to the banking

system, Garcia (2000) suggests that a partial

guarantee should not be introduced ideally until: (1)

the domestic and international crisis has passed; (2)

the economy has begun to recover; (3) the macro-

economic environment is supportive of bank

soundness; (4) the banking system has been

restructured successfully; (5) the authorities possess,

and are ready to use, strong remedial and exit policies

for bank that in the future are perceived by the public

to be unsound; (6) appropriate accounting,

disclosure, and legal systems are in place; (7) a strong

prudential regulatory framework is in operation; and

(8) public confidence has been restored. It seems that

currently Indonesia does not meet all these

requirements.

Demirguc-Kunt and Kane (2001) suggest that

countries should first assess and remedy the

weaknesses of their international and supervisory

environments before adopting an explicit deposit

insurance system. In line with this, Wesaratchakit

(2002) reported that Thailand decided to adopt a

gradual transition from a blanket guarantee to a

limited explicit deposit insurance scheme. It was

considered that there are some preconditions that

should be met - particularly the stability of banking

system and the economy as a whole, effectiveness

of regulation and supervision as well as public

understanding - before shifting to an explicit limited

deposit insurance system.

There is an issue of how depositors will react to

the introduction of the limited scheme. In January

2001, Korea replaced its blanket guarantee with a

limited deposit insurance system with an insurance

limit of 50 million won per depositor per institution.

There was a noticeable migration of funds from lower

rated to sounder banks. Also, large depositors actively

split their deposits to several accounts in banks and

non-bank financial institutions. But there has been

no bank run on the Korean financial system as a

whole.

It is important to prepare a contingency plan

before removing the blanket guarantee in order to

anticipate the worst-case scenarios such as a loss of

public confidence. If such conditions occur, the central

bank may have to extend liquidity support to illiquid

but solvent banks. In addition, there should be a clear

legal framework for the deposit insurance scheme.

To reduce moral hazard and to induce market

discipline, the authorities should set a tough sanctions

to the financial institutions and players which are

violate the rules and cause problems into banks and

ensure that law enforcement are in place.

Criticism on Deposit Insurance

Arguments in favor of explicit deposit insurance

scheme for financial deepening and financial stability

has been widely accepted by policy makers, even IMF

has recommended it to many countries (Folkerts-

Landau and Lindgren, 1997; Garcia, 1999).

Notwithstanding, some experts remain skeptical. Cull

(1998) is unconvinced about the argument that

deposit insurance fosters financial deepening by its

ability to expand deposit base as well as it lay solid

ground for more advanced banking system. Cull et

al. (2000) also argued that explicit deposit insurance

does not have strong effect on sectoral concentration

- that is likely to promote keener competition. Kane


70

(2000) concluded that based on study in 40 countries

in deposit insurance scheme, the weaker information

condition, ethics, and governance of a country, the

more detrimental effect of explicit deposit insurance

scheme on banking system stability. Corresponding

to the study, in a more comprehensive study, Kane

and Demirguc-Kunt (2001) concluded that whenever

law enforcement is feeble and creditors» rights are

not well-protected,explicit deposit insurance will likely

to spur financial instability.

Honohan and Klingebiel (2000), based on

sample of 40 developed and emerging market crises,

found that unlimited deposit guarantees, open-

ended liquidity support, repeated recapitalisation,

debtors bail-out and regulatory forbearance

significantly and sizeably increase the resolution costs.

Moreover, based on evidence from 61 countries in

1980-97, Demirguc-Kunt and Detragiache (1999),

find that that explicit deposit insurance tends to be

detrimental to bank stability, the more so where bank

interest rates are deregulated and the institutional

environment is weak. Similarly, Cull et al. (1999)

based on a sample of 58 countries also find that

generous deposit insurance leads to financial

instability in the presence of a weak regulatory

environment.

Greenspan (2002) explained two contradictory

implications of deposit insurance. On one side,

deposit insurance prevents bank runs disturbing

short-term financial structure. On the other hand, it

may erode market discipline and incite moral hazard

that is most likely trigger future systemic risks. A

deposit insurance scheme helps banks raise fund

more efficiently and take greater risks without

worrying of losing customers. In other words,

deposit insurance foster resources misallocation by

cutting correlation of risk and reward in particular

markets. Hence, it is imperative to have effective

supervision to protect tax payers and avoid cost of

crisis resolution.

Deposit Insurance Practice in Indonesia

To restore public confidence on banking sector

following the financial meltdown in 1997, the

Indonesian government was compelled to issue

blanket guarantee program. Under this program, all

deposits at banks are insured. The program

successfully restore public confidence on domestic

banking industry. Nonetheless, the all-inclusive

created burden on the state budget and triggered

moral hazard by management and bank customers.

Bankers were lacking of incentives to conduct

business prudently, whereas customers overlooked

financial conditions of bank when making

transaction. Beside, in general, blanket guarantee is

a temporary measure to restore public confidence

during a crisis.

Finally, Indonesia has a Deposit Insurance

Instition (Lembaga Penjamin Simpanan or LPS)

following a long and painstaking debates in the

Parliament. The Parliament enacted Deposit Insurance

Law number 24 year 2004 on September 22, 2004.

As stipulated by the law, the Deposit Insurance

Institution has two core functions: (1) provide

guarantee on customer deposits and (2) implement

resolution over failing bank. The law also stipulates

legal status, governance, asset and liabilities

management, reporting system and accountability

of the Deposit Insurance Institution as well as lay legal

basis for cooperation with other authorities. This is

important to ensure that the Deposit Insurance

Institutions is independent, transparent, and


71

accountable in performing its roles and

responsibilities.

The Deposit Insurance Institution carries out a

limited and explicit deposit insurance scheme. The

rationales behind the selection of this scheme are to

purge the burden of crisis resolution on the state

budget and to prevent moral hazard. This scheme is

mandatory for all banks operating in Indonesia, both

commercial and rural banks. The insured items are

saving accounts, demand deposits, certificate of

deposits, time deposits, and other similar type of

deposits.

For effective implementation, a two year

transition period was introduced prior to a full fledge

deposit guarantee scheme:

September, 22 2005 - March, 21 2006 : all

deposits

March 22, 2006 - September 21, 2006 : all

deposits up to Rp 5 billion

September, 22 2006 - March 21, 2007 : all

deposits up to Rp 1 billion

March 22, 2007 - onwards : all deposits up to

Rp 100 million

Some challenges remain. First, coordination

system between the Deposit Insurance Institution and

other authorities, in particular Bank Indonesia needs

to be clearly defined. The foremost challenging effort

is to foster coordination in handling and

implementing resolution on a failing bank. The

procedure of coordination can be set up by referring

to the best practices in other countries, including

using a Memorandum of Understanding.

Nonetheless, the practice is not so simple, as gaining

agreement between the respective authorities is

frequently a lengthy process. Notwihstanding,

interlocking structure of the Board of Commisioner

involving ex-officio member from Bank Indonesia and

the Ministry of Finance should help resolve the

coordination issue. Also, to cultivate more effective

coordination in the operational layer, some staff

members of the Deposit Insurance Institution are

seconded from central bank and ministry of finance.

This option is adopted by the Indonesian Deposit

Insurance Institution. Second, capital adequancy of

the Deposit Insurance Institution must be well-

mainted to ensure public confidence. Considering

the capital base of the Deposit Insurance Institution

is reasonably modest, it is essential to anticipate the

probability of bank failure demanding a substantial

amount of resolution cost in the short-term that will

substantially erode the capacity of the Deposit

Insurance Institution to perform effective resolution.

Third, it is essential to anticipate the probability of

flight to quality from the perceived less sound banks

to the perceived sounder banks. This is a sensitive

issue considering the concentrated structure of

banking deposits, in which around 50% of bank

depositors are those having balance exceeding Rp100

million. Hence, it is recommended that the flight to

quality issue be empirically studied or surveyed to

formulate accurate policy response. Fourth,

considering the lack of public awareness, the Deposit

Insurance Institution and Bank Indonesia need to

intensively make public the Deposit Insurance

Institution and its scheme.

5. CRISIS MANAGEMENT

In the last decade, the vast majority of countries

hit by systemic banking crises demanded expensive

and unavoidable cost of crisis to restore their banking

system. Shareholders of the shut down banks were

indeed reluctant to bear the crisis cost and, therefore,


72

how to solve the problem? In many countries, all

costs were borne by taxpayers. For instance, fiscal

cost of Indonesian banking resolution in 1997 and

1998 was Rp654 trillion or about 51% of GDP, the

highest in Asia. Indonesia ranked second after

Argentina which booked cost or 55.1% of GDP when

a crisis hit the country in 1980-1982.

Empirical study by Honohan and Klingebiel

(2000, 2002) revealed findings that unlimited deposit

insurance, open-ended liquidity support, repetitive

bank recapitalization, bail out, and regulatory

forbearance, augment fiscal cost of crisis substantially.

The case of Indonesia revealed five factors behind

high cost of crisis: (i) long delay of crisis resolution,

particularly bank closure and recapitalization

program; (ii) lack of understanding about the root

and the magnitude of crisis resulting in incorrect

strategy of crisis resolution (for instance partial

approach in bank closure); (iii) sub-effective

coordination and lack of consensus among

authorities with regard to crisis management; (iv) lack

of commitment to make prompt decision to solve

the crisis, for instance to close down insolvent banks

in the eve of the crisis and to avoid political

intervention; and (v) sub-optimal law enforcement

and drawbacks in legal and supervisory frameworks,

which in turn, incite moral hazard. Indonesia would

have been better should prompt corrective actions

were taken; however, it was extremely difficult as

due to rampant political intervention.

Along with the increasingly integrated global

financial system, responsive supervision and crisis

management policies are vital. The ultimate objective

of supervision is obvious; yet, challenges in crisis

management differ significantly. For instance,

resolution for globally operating large banks needs

a clear crisis management policy, cost sharing, as well

as effective inter government coordination (Gulde

and Wolf, 2005).

Considering the substantial cost of crisis and its

serious magnitude, robust crisis management is vital.

Crisis management should be supported by legal

framework and clear crisis resolution policies that

clearly define roles and responsibilities as well as

effective coordination of respective authorities. Also,

it is critical to have effective organization and

leadership and, hence, strategies and corrective

measures can be promptly made.

To bolster financial system stability, the

Government and Bank Indonesia have prepared a

comprehensive framework of Financial Safety Net

(FSN). The FSN framework clearly defines objectives

and elements of FSN, roles and responsibilities of

relevant authorities, and coordination mechanism

among the authorities. The FSN has four elements:

effective supervision and regulation; (ii) lender of last

resort; (iii) deposit insurance; and (iv) effective crisis

management. Currently, a task force composed of

staff members of Ministry of Finance, Bank Indonesia,

and Deposit Insurance Corporation, is drafting the

FSN Law. The law will be a solid legal basis for

respective authorities to preserve financial stability,

particularly for crisis management.

6. CONCLUSION

To enhance the Indonesian financial safet net,

two principal policies are recommended. First,

gradually replace blanket guarantee with a limited

explicit deposit insurance scheme. Second, formulate

and implement a transparent lender of last resort

policy both for normal and crisis times. Nevertheless,

both policies must be implemented comprehensively


73

and linked with banking prudential supervision and

market discipline to prevent a banking crisis.

For effective coordination, Coordination

Committee consisting of Minister of Finance, Bank

Indonesia and the Deposit Insurance Corporation was

established. In addition, Financial System Stability

Forum (FSSF) as a venue of coordination and

information sharing to discuss financial stability issues

among fiancial safety nets player was created.

Learning from the 1997 crisis, some crisis

management issues remain challenging. First, it is

imperative to: (i) lay a clear legal basis clearly defining

effective coordination means; (ii) clearly define

responsibilities of respective authorities, and (iii) foster

trust and cooperative culture among respective

authorities. This needs strong leadership and political

support from the parliament. Third, it is vital to

enhance operational capacity of resources from

respective authorities. Crisis management should be

promptly and accurately made. In some countries,

authorities set up «crisis management team» which

regularly meet to discuss financial stability issues and

exercise crisis management simulation as a part of

efforts to enhance organizational capacity.

Crisis episodes in some countries in the last two

centuries remind us two important lessons: first,

financial crisis repeatedly occurs; and two, a financial

crisis is difficult to predict and, therefore, difficult to

avoid. Hence, it is easier to prevent than to cure.

Referring to the principles, it is imperative to enhance

financial system stability via implemention of effective

supervision and regulation, robust risk management,

effective internal control - the first line of defense in

banking industry.


74

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78


79

Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Macroeconomic Model to Measure Financial Stability Index:The Case of Indonesia

Muliaman D. Hadad1, Wimboh Santoso2, Sugiharso Safuan3,

Dwityapoetra S. Besar4, and Ita Rulina5

1. INTRODUCTION

The tendency of growing instability in

industrialized and emerging countries, particularly

since the banking crisis in 1997, has encouraged

several countries to pay greater attention to the

soundness of their banking sector and in financial

system policy.

The 1997 economic crisis that undermined economies in the region taught valuable lessons on the

importance of clear crisis management and monitoring potential crises. Therefore, this paper aims to build a

model to formulate the financial stability index based on three business activity blocks, namely the equity

market, bonds market and banking that influence financial stability. Based on various statistical tests such as

data trends of forecast results against actual data and measurements of model accuracy, the mean absolute

percentage error (MAPE) is expected to be relatively low indicating a fair and accurate prediction model. This

will enable the calculation of the financial stability index (Financial Soundness Indicator/FSI), which can be used

to explain phenomena in the banking and financial sectors. The simulation results for 2007 used to simulate

financial system stability show that in mid 2005 FSI was relatively higher than during other study periods. With

economic growth targeted at 6%, the decline in FSI up to the end of 2007 reflects improved stability.

High instability can trigger many crises including

economic crises. When a crisis occurs, a country often

not only suffers great financial loss but also struggles

to recover economic conditions.

The Indonesian banking industry still dominates

(80%) the share of total assets in the financial sector;

therefore, to stimulate economic activity requires a

Abstract

1 Director, Directorate of Banking Research and Regulation, Bank Indonesia,[email protected]

2 Head of Financial System Stability Bureau, Directorate of Banking Research and Regulation,Bank Indonesia, [email protected]

3 Lecturer Department of Economic, University of Indonesia, [email protected]

4 Senior Researcher, Financial System Stability Bureau, Directorate of Banking Researchand Regulation, Bank Indonesia, [email protected]

5 Researcher, Financial System Stability Bureau, Directorate of Banking Research andRegulation, Bank Indonesia, [email protected]

80


robust banking sector that functions well. The stability

and health of the banking sector as part of financial

sector stability is closely tied with economic

performance (Andrew Crocket, 1997). This

relationship is reflected by the intermediary function

of the banking system. Disruptions in the

intermediation function will constrain bank fund

allocation for investment in productive sectors of the

economy.

Looking at the strategic role of the financial

system in an economy, various instruments need to

be reviewed to supervise and assess financial sector

stability. One of the instruments is the financial

stability index, an indicator to monitor developments

and identify influential factors on financial stability.

In this study, financial sector sources will be discussed,

as well as the factors chosen to calculate the financial

stability index. In addition, this paper will discuss

the results of econometric simulation modeling to

assess the effect of microeconomic and

macroeconomic factors on financial sector stability.

2. LITERATURE STUDY

Some experts define financial instability as

something that can disrupt the implementation of

financial system functions. More precisely, financial

instability is the inability of a bank to function well,

particularly in extending credit and performing its

intermediation function (Mishkin, 2000; Bergman

and Hansen, 2002; Hawkesby, 2000). In this context,

financial stability can be defined as a situation where

the possibility of banking crisis is absent or negligible.

However, looking from a broader viewpoint,

financial risk also depends on financial system

structure. The financial system is highly integrated,

which means the disruptions to stability that may

arise from one component will immediately affect

other parts of the system. Therefore, the term

financial instability may also represent several aspects

that can agitate the financial markets including falling

asset prices, non-bank financial institution defaults,

for example in the bonds market, company

bankruptcies of non-financial institutions, or a

combination of the above.

The current paper defines financial instability

as various levels of financial pressure. The degree of

financial instability is estimated between 0 and 1.

Banking Sector: NPL and Financial Instability

One of the proxies that can be used to illustrate

banking sector stability is the amount of non-

performing loans (NPL) at a given time. The higher

the number of NPL, the greater the possibility for banks

to perform optimally as financial intermediaries, thus

the higher their instability becomes.

Equity Market: Stock Prices and Financial

Instability

Equity market fluctuations have an enormous

effect on the economy, which can be seen from four

sides (Mishkin, 2001). First, the effects of the equity

market on investment. Second, the effect of company

balance sheets. Third, the effect of household wealth.

And fourth, the effect of household liquidity.

Bonds Market: Corporate Bond Spread and

Financial Instability

The variable normally used to illustrate financial

instability in the bonds market is corporate bond

spread, which is a combination of credit risk, market

risk and liquidity risk (Duca, 1999). Credit risk is a

function of expected losses, whereas market risk and

81


liquidity risk are functions of risk and uncertainty.

Therefore, a rise in risk premiums is an indication of

growing pressure on the company»s financial

conditions, which eventually impinge upon financial

stability. Sources of credit risk include default risk, credit

migration risk, uncertainty risk and recovery risk.

3. METHODOLOGY

This study adopted model developed by

Sterken (1991). The models constructed from

simultaneous equation comprising of 4 blocks:

banking sector, equity market, bonds market and the

real sector. Each block is represented by a set of

structural and behavioral equations, whereas

relationships between blocks are illustrated by an

identity equation.

Banking Sector: Credit Risk

NPL is defined as the following function:

NPL = f(REER, Y, M, BCRPB)

The banking sector block involves the following

structural equations:

BCRCOR = f(SHCOR-1, ML-1, LTD-1, BCRCOR-1,

LIQCOR-1, RSH, DV)

BCRHOU = f(BCRHOU-1, YD-1, RBCR, P)

ΔRCB = f(RCB-RSUSA-1, ((KUS/KEUS)-1))

ΔKUS = f(ΔKEUS, KUS-1, KEUS-1)

Meanwhile, the identity equation in the banking

sector block is defined as

BCRDNB = BCRCOR + BCRHOU - BCRPB

Equity Markets

IHSG = f(SHCOR, P, RBCR)

There are two structural equations in the equity

market block:

SHFOR = f(SHFOR-1, BONFOR-1, ERLFOR)

SHHOU = f(SHHOU-1, BONHOU-1, ERNFA)

The equity market block also uses the following

three identity equations:

ERLFOR = RLUSA + 0.2 ((KEUS / KUS) - 1)

ERNFA = RSUSA + 0.2 ((KEUS / KUS) - 1)

SHCOR = SHHOU + SHFOR

Real Sectors

The consumption function the real sector block

is formulated as:

KONS = f(SHHOU-1, BONHOU-1, BCRHOU-1,

KONS-1, YD, RCB)

Meanwhile, the investment function (I) in this

block is formulated as:

I = f(BONCOR-1, LIQCOR-1, RBON, DV, RCB)

The estimation process begins with the

identification of variables in all equations. The

specification process include determining the

specification of the model and the estimation

technique employed. Based on specification test we

found that the equation system over-identifies so

two stage leas squared method (TSLS) was applied.

Econometric tests on the classic assumptions are

performed to produce Best Linier Unbiased Estimation

(BLUE). Model testing prior to the estimation process

is performed to exclude specification errors in the

model and set the error variant at normal distribution.

The tests predominantly used include the Jarque Bera

(JB) test for normality and Ramsey»s Regression

Specification Error Test (RESET). The econometric tests

conducted include multicolinearity tests,

heteroscedastisity and autocorrelation. Significance

testing is undertaken to investigate the degree of

significance between endogenous and exogenous

variables. The significance tests used are the t test

and Goodness of Fit test (F test and adjusted R2).

82


Among all variables in the NPL equation, two

variables are statistically significant in the regression:

real effective exchange rate (REER) and money supply

(M). The coefficient of determination (adjusted-R2)

shows that the variations of independent variables

in this equation are able to explain 92.5% of

variations in the NPL. As the parameter of REER is

negative, it can be concluded that real exchange rate

depreciation will reduce NPL. Meanwhile, the money

supply parameter (M), which was negative, shows

that the contraction of money supply will reduce

the NPL.

Equity Market

This block is specified by the Jakarta Composite

Index (IHSG), which is a function of stock supply by

corporations (SHCOR); inflation rate (P) and interest

rate on short-term bank credit (RBCR).

Estimation results using the TSLS method on

the stock market block are as follows:

Sensitivity tests are conducted to reveal changes in

the model due to shocks from exogenous variables

which produce significant models. Tests conducted

include: Root of Mean Square Error (RMSE); Mean

Absolute Error (MAE); Mean Absolute Percent Error

(MAPE); and Theil Inequality Coefficient (TIC) including

its decomposition. The weighting techniques used to

combine variables into an index are: factor analysis,

credit aggregate weights and variance equal weights

(illing and Liu, 2003) and (Bordo et al. 2000).

4. ESTIMATION RESULTS


The banking sector block is specified by the non-

performing loan (NPL) variable, which is a function

of the real effective exchange rate (REER); gross

domestic product (Y); M2 money supply (M); and

the supply of short-term bank credit by private banks

(BCRPB). Estimation results using the TSLS method

for the banking sector block (credit risk) are as follows:

NPL NPL NPL NPL NPL = 42.937 - 0.172 REER + 2.57e-05 Y √ 2.88e-05 M √ 9.14e-06 BCRPB

(t-stat) (2.953) (-9.723) (0.944) (-2.275) (-0.412)

Adj.R2 = 0.925 Durbin Watson = 0.627

BCRCOR BCRCOR BCRCOR BCRCOR BCRCOR = - 10355.19 √ 0.109741 SHCOR(-1) + 1.062 ML(-1) + 0.026 LTD(-1)

(t-stat) (-0.412) (-0.598) (2.548) (0.615)

+ 0.812 BCRCOR(-1) - 15.859 LIQCOR(-1) √ 152.94 RSH - 0.12 DV

(8.944) (-1.18) (-0.809) (-1.16)

Adj.R2 = 0.991Ω; Durbin Watson = 2.37

BCRHOUBCRHOUBCRHOUBCRHOUBCRHOU = -14315304 + 0.997 BCRHOU(-1) + 48.994 YD - 81398.89 RBCR

(t-stat) (-1.16) (42.25) (1.565) (-0.299)

+ 111883.6 P

(0.636)

Adj.R2 = 0.998Ω; Durbin Watson = 2.18

D(RCB)D(RCB)D(RCB)D(RCB)D(RCB) = 0.27 √ 1.417 D(RSUSA) √ 0.06 (RCB - RSUSA) - 4.85 ((KUS/KEUS)-1)

(t-stat) (0.64) (-1.89) (-1.155) (-0.812)

Adj.R2 = 0.006; Durbin Watson = 2.66

D(KUS)D(KUS)D(KUS)D(KUS)D(KUS) = 0.928 D(KEUS) - 0.367 (KUS(-1) - KEUS(-1))

(t-stat) (7.14) (-2.51)


The coefficient of determination value for the

IHSG equation is high (0.948). From the three

explanatory variables, only one variable is not

significant, namely the inflation rate (P) variable.

Meanwhile, SHCOR and RBCR variables are

statistically significant.

IHSG = 1474.12 + 0.02 SHCOR - 22.267 P √ 63.848 RBCR

(t-stat) (16.39) (10.166) (-1.636) (-13.93)


SHFOR = 1327.58 + 0.79 SHFOR(-1) - 0.106 BONFOR(-1) - 90.55 ERLFOR

(t-stat) (1.869) (9.127) (-1.154) (-0.54)


SHHOU = 3271.253 + 0.47 SHHOU(-1) - 0.027 BONHOU(-1) - 66.285 ERNFA

(t-stat) (3.084) (3.688) (1.875) (-0.4904)

Adj.R2 = 0.344 ; Durbin Watson = 2.20

83


BONPB-1 has a statistically significant relation. The

structural equation BONHOU has a coefficient of

determination of 0.99. From the six independent

variables in the equation, two are statistically

significant: BONHOU-1 and YD (disposable income).

Both parameters of those two variables have positive

signs.

Meanwhile, coefficient of determination in the

structural equation BONFOR is 0.605. Interestingly,

there is only one variable that is statistically significant

in the equation, namely BONFOR-1.

Real Sector

The real sector block comprises of the

consumption function and the investment function.

The consumption function is further specified as a

function of stock demand by households (SHHOU),

bonds demand by households (BONHOU) in the

previous period, short-term bank credit demand by

households (BCRHOU) in the following period,

consumption in the previous period (KONS-1),

disposable income (YD), and an official discount rate

(RCB).

Results of the estimation using TSLS for the real

sector block are as follows:

Bonds Market

The bonds market block is specified by the

interest rate (RBON), as a function of the official

discount rate (RCB); M2 money supply (M), and

supply of bonds by corporations in the previous

period (BONCOR).

Estimation results using the TSLS method on

the bonds market block are as follows:

Regression of the RBON equation in the

simultaneous model produces a high coefficient of

determination (0.93). However, in this regression,

there is only one variable significant at 10 percent

significance level, i.e. the BONCOR-1.

Furthermore, regression of the BONPB equation

in the model also shows good results. The coefficient

of determination is high (0.92) and in this equation,

BONHOU = - 62437.47 + 0.859 BONHOU(-1) + 0.092 ML(-1) + 0.232 LIQHOU(-1)

(t-stat) (-0.027) (6.03) (0.224) (0.331)

+ 0.1706 YD + 58.786 RBON + 8.698 ERNFA + [AR(1) = 0.240]

(2.155) (0.086) (0.068) (1.27)


BONFOR = 1356.201 + 0.772 BONFOR(-1) √ 41.861 RBON √ 153.03 ERLFOR

(t-stat) (1.913) (8.676) (-0.374) (-0.902)


BONCOR = 1338.037 + 0.113 SHCOR(-1) + 0.1907 BONCOR(-1) + 0.013 BCRCOR(-1)

(t-stat) (0.823) (3.203) (1.435) (1.164)

- 3.386 LIQCOR(-1) - 93.162 RBON - 131.337 RLIQ

(-2.07) (-0.753) (-2.328)


BONCG = 1.02 BONCG(-1) + 1.128 BD

(t-stat) (102.92) (1.92)


RBON = - 6.0648 √ 0.135 RCB + 4.47E-06 M + 0.000173 BONCOR(-1) + [AR(1) = 0.786]

(t-stat) (-1.402) (-1.604) (1.083) (1.858) (9.306)


BONPB = 33720.66 - 0.0007 CASH(-1) + 1.96e-05 NFA(-1) + 0.94 BONPB(-1) - 0.034 W

(t-stat) (0.708) (-1.532) (1.002) (11.21) (-0.354)

- 117.93 ERNFA + [AR(1) = 0.12]

(-0.684) (0.85)


KONS = -11673.25 - 0.001 SHHOU(-1) + 0.0079 BONHOU(-1) √ 2.62E-05 BCRHOU(-1)

(t-stat) (-0.768) (-0.037) (0.37) (-0.946)

+ 1.012 KONS (-1) + 0.03 YD + 12.44 RCB

(16.18) (2.14) (0.176)


I = 65706.73 √ 0.625 BONCOR(-1) + 27.885 LIQCOR(-1) - 104.04 RBON √ 0.354 DV - 379.83 RCB

(16.669) (-0.91) (8.868) (-0.21) (-2.58) (-1.44)


The consumption equation in the real sector

block has a high coefficient of determination

(adjusted R2), 0.99. Variables that are statistically

84


significant in the equation are consumption in past

period (KONS-1) and disposable income (YD). The two

variables have positive relationships with

consumption.

The investment equation in the real sector block

has 0.836 as its value of adjusted R2. In the equation,

two independent variables are statistically significant,

more specifically liquidity demand by corporations

(LIQCOR-1) and change in GDP (DV).

Model Prediction: in the sample period

The simultaneous equation model in this study

is used as a projection tool for various indicators.

This section presents projections of the main variables

in each block involved in the simultaneous equation.

The performance of a model can be evaluated in two

ways: by measuring the accuracy of the prediction

and through graphical methods. The accuracy

measurement is used to verify the power of prediction

and the validity of prediction results. Furthermore,

accuracy measurement is evaluated from several

aspects: Root Mean Squared Error (RMSE), Mean

Absolute Error (MAE), Mean Absolute Percentage

Error (MAPE), and the Theil Inequality Coefficient.

Table A2.1 presents the accuracy measurements

of the model used in this paper.

For prediction purposes, the performance of this

model is considered «fair». For instance, the MAPE of

the model (as one measurement of accuracy) has a

high average error value. There are several reasons

for the «fair» evaluation of this model. First, the design

of the simultaneous equation model does not fully

reflect general equilibrium for each sector within the

economy. Second, is related to the lack of available

data. Finally, is the behavior of several economic

agents in each sector block that is not compatible

with ≈normalΔ behavior extolled in economic theory.

Nonetheless, inaccuracy in the estimations is often

found in empirical studies, especially among those

involving simultaneous equation models.

In the next stage of the evaluation the following

variables obtained from the projections will be used

to formulate the financial stability index (FSI):

1. Banking sector (credit risk), using predictions

from the non-performing loan variable (NPL).

2. Equity market, using predictions from the JCI

variable (IHSG).

3. Bonds market, using predictions from the interest

rate on bonds variable (RBON).


In the following graph it can be seen that during

the research period projected NPL and actual NPL

followed a similar trend. This graphically

demonstrates the goodness of fit of the model.

Table A2.1Accuracy of the Simultaneous Model

NPL 0,962 0,803 8,558 0,044

BCRCOR 4585,164 3740,251 3,255 0,017

BCRHOU 2251698 1864571 2,014 0,011

D(RCB) 2,226 1,763 19,868 0,087

D(KUS) 257,708 160,732 1,705 0,014

Structural Equation RMSE MAE MAPE Theil

Banking Banking Banking Banking Banking (Credit Risk)(Credit Risk)(Credit Risk)(Credit Risk)(Credit Risk)

Stock MarketStock MarketStock MarketStock MarketStock Market

IHSG 52,426 42,103 7,626 0,041

SHFOR 2031,948 1779,489 1191,246 0,327

SHHOU 3585,084 2614,779 38,572 0,199

Bond MarketBond MarketBond MarketBond MarketBond Market

RBON 0,588 0,483 15,307 0,073

BONPB 7487,752 6180,553 1,698 0,01

BONHOU 5444,276 4564,28 17,686 0,044

BONFOR 2103,221 1601,784 28,08 0,18

BONCOR 601,786 405,277 50,96 0,25

BONCG 6,868 5,578 3,353 0,021

Real SectorReal SectorReal SectorReal SectorReal Sector

KONS 1655,005 1492,961 0,637 0,003

I 7689,442 7014,681 8,751 0,048

85


Equity Market

Throughout the research period, projected IHSG

performance follows a similar trend to actual IHSG.

This also graphically demonstrates the strengths of

the model used.

Financial Stability Index (FSI)

The financial stability index (FSI) formulated in

this study is a composite index based on the behavior

of the three markets. The composite index is based

on the study of Bordo, et.al. (2000). It is assumed

that the median is used as stability points throughout

the observation period. Here, the selection of the

observation period is crucial.

Graph A2.1Projected NPL against Actual NPL

4

6

8

10

12

14

16

18

20

2002 2003 2004

NPL ForecastNPL Actual

Graph A2.4 illustrates FSI performance during

2001 - 2005. At the initial point, FSI values during

2003 are assumed as the «stability points» for financial

stability. Extreme departure from the values of FSI in

2003 is considered a symptom of financial system

instability. The movement of FSI, as depicted in Graph

A2.4, marks symptoms of instability.

Model Simulation

This section presents simulation results of the

simultaneous equations model. The period is

extended up to the end of 2007. The Indonesian

economy is assumed to grow by 6% in 2007.

Graph A2.5 shows the influence of economic

growth on the banking sector block through the NPL

ratio. Simulation results indicate a rise in NPL in line

with economic growth.

Graph A2.2Projected JCI against Actual JCI

300

400

500

600

700

800

900

1000

1100

1200

2001 2002 2003 2004

JCI Actual JCI Forecast

Graph A2.3Projected RBON against Actual RBON

-9

-8

-7

-6

-5

-4

-3

-2

-1

2002 2003 2004

RBON ForecastRBON Actual

Bonds Market

Graph A2.3 illustrates that during the research

period, projected RBON and actual RBON followed a

similar trend. Again this graphically proves the

goodness of fit of the model used.

Graph A2.4FSI Performance based on the Change in Standard

Deviation and Median

FSI

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2001 2002 2003 2004 2005Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May

86


Graph A2.6Projected IHSG against Baseline IHSG

300

400

500

600

700

800

900

1000

1100

1200

2001 2002 2003 2004 2005 2006 2007

JCI JCI (Baseline)

Graph A2.5NPL Simulation Results against Baseline NPL

4

6

8

10

12

14

16

18

20

2002 2003 2004 2005 2006 2007

NPL (Baseline)NPL

Graph A2.7Projected RBON against Baseline RBON

-9

-8

-7

-6

-5

-4

-3

-2

-1

2002 2003 2004 2005 2006 2007

RBON RBON (Baseline)

yield (RBON) until early 2002. Simulation results show

that in 2006 the average rate of risk in the bonds

market is -1.87, while in 2007 it is -1.92.

Analysis of Financial Stability Index Simulation

The results of simulations up to the end of 2007

are used further to estimate the stability of the

financial system. Graph A2.8 shows that FSI in mid

2005 is relatively higher compared to other periods.

Using the assumption of 6% economic growth, FSI

is expected to decline up to the end of 2007.

Through the results of the simulations, it is

expected that with the assumption of 6% economic

growth financial system stability can be maintained.

In terms of the equity market, the simulation

returns under-predicted results in 2004, with IHSG

predicted to reach 1,000 by the end of 2004. The

simulation shows that IHSG will grow gradually with

the assumption of 6% economic growth. Furthermore,

the simulation projects that IHSG drops to 937 in 2006

but rebounds to around 944.52 in 2007.

In terms of the bonds market, Graph A2.7

demonstrates that the simulation over-predicts bond

Graph A2.8Projected FSI Performance based on Fluctuating Standard

Deviation According to Position x from the Median

0

0.5

1

1.5

2

2.5

3

3.5

4FSI Simulation

2001 2002 2003 2004 2005 2006 2007Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep

5. CONCLUSION

Regression of the simultaneous equation model

in this study produced good results. Furthermore, the

F-test is statistically significant. The adjusted

coefficient of determination (adjusted R2) for each

structural equation with direct impact on the

composition of FSI is large (above 90%). However,

structural equations with indirect impact on the

composition of FSI produced poor results. In this case,

several parameters were insignificant, while the

coefficient of determination (R2) was small. Generally,

poor parameter performance can undermine the

87


ability of a model to explain the phenomenon under

analysis and, therefore, cannot provide an accurate

forecast.

However, the in-sample-period prediction of this

model produced good results. In brief, the strength

of the simultaneous equation model used in this study

can be used to formulate a financial stability index

for Indonesia.

Although the results of the model used generally

returned satisfying results, several weaknesses were

found. One of the primary weaknesses was the

unavailability of data. Furthermore, in Indonesia some

sectors remain underdeveloped, such as the bonds

market. Notwithstanding, there are sectors that have

developed but unfortunately the data is as yet

unavailable.

Another constraint was found in the activities

(market) block of the structural equation, which was

unable to fully illustrate Indonesian economic activity.

To illustrate an economic system using simultaneous

equations, the study employed three market blocks

namely the credit market, equity market and bonds

market. The use of only three market blocks limited

the analysis scope.

To improve the study in the future, it is essential

to refine the model»s structure to make it more

suitable to Indonesia»s characteristics as a developing

country. In addition, more complete data is required.

Also, short-term corrections to the long-term balance

through an error correction mechanism (ECM) should

be included. Through such improvements it is

expected that a future Macroeconomic Model FSI can

be formulated to project a number of periods into

the future. The model will also be a reliable

forecasting tool, as part of efforts to support

policymaking in the banking and financial sectors.

88


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90


Appendix

Notations, Indicators, Units, and Data Sources

1 BCRCOR demand of short-term bank credit by corporation Billion BI

(value of working capital loans and investment loans)

2 BCRHOU demand of short-term bank credit by household Billion BI

(value of consumer loans)

3 BCRDNB supply of short term bank credit by central bank Billion BI

4 BCRPB demand of short-term bank credit by private banks Billion BI

5 BD central government budget deficit Percent APBN

6 BONCG supply of bonds by the central government Billion BI

7 BONCOR supply of bonds by corporations Billion BI

8 BONFOR net demand for bonds by foreigners Billion BI

9 BONHOU demand for bonds by households Billion BI

10 BONPB demand for bonds by private banks Billion BI

11 CASH net demand for interbank money by private banks or J02

(total cash) Billion BI

12 DV GDP change (DV = Y - Y-1) Billion BPS, with further calculation

13 ERLFOR expected interest rate on short-term net foreign assets Billion Bloomberg

14 ERNFA expected foreign long-term interest rate Billion Bloomberg

15 I investment, gross fixed capital formation Billion BPS

16 IHSG stock market composite price index Rupiah Bloomberg

17 KEUS expected exchange rate (Rp per USD) Rupiah Bloomberg

18 KONS household consumption (constant price, 2000) Billion BPS

19 KUS nominal exchange rate (Rp per USD) Rupiah IFS

20 LIQCOR demand for liquidity by corporations Billion BI

21 LIQHOU demand for liquidity by households Billion BI

22 LTD long-term time and savings deposits (DPK) Billion BI

23 M money supply (M2) Billion BI

24 ML mortgage loan (KPR+KPA) Billion BI

25 NFA net foreign assets or V21 (foreign currency assets) Billion BI

26 NPL non performing loan Percent BI

27 P inflation rate Percent BI

28 RBCR interest rate on short term bank credit Percent BI

29 RBON interest rate on bonds Percent Bloomberg

30 RCB official discount rate Percent BI

31 REER real effective exchange rate Percent Bloomberg

32 RLIQ interest on liquidity Percent BI

33 RLUSA interest rate on US capital market Percent Bloomberg

34 RSH yield on domestic shares Percent Bloomberg

35 RSUSA interest rate on US money market Percent Bloomberg

36 SHCOR supply of shares by corporations Billion Bloomberg

37 SHFOR net demand shares by foreigners Billion BAPEPAM

(stock purchases-BAPEPAM)

38 SHHOU demand for shares by households Billion CEIC

39 W financial wealth Billion CEIC

40 Y gross domestic product (constant price, 2000) Billion BPS

41 YD disposable income Billion BI

No. Variable Indicator Unit Source

91

Glossary

Glossary

92

Glossary


93

Glossary

Cost of loanable funds:Cost of loanable funds:Cost of loanable funds:Cost of loanable funds:Cost of loanable funds: includes interest on funds,

overhead costs, the deposit insurance premium and

minimum reserve requirement.

Bank Indonesia Real Time Gross Settlement (BI-RTGS):Bank Indonesia Real Time Gross Settlement (BI-RTGS):Bank Indonesia Real Time Gross Settlement (BI-RTGS):Bank Indonesia Real Time Gross Settlement (BI-RTGS):Bank Indonesia Real Time Gross Settlement (BI-RTGS):

Electronic transaction settlement in real time where

accounts are debited and credited multiple times per day.

Business continuity management:Business continuity management:Business continuity management:Business continuity management:Business continuity management: Risk management to

ensure critical functions during disruptions as well as having

an effective recovery process.

Downside Risk:Downside Risk:Downside Risk:Downside Risk:Downside Risk: The likelihood that a security or other

investment will decline in price, or the amount of loss that

could result from that potential decline.

Failure to settle: Failure to settle: Failure to settle: Failure to settle: Failure to settle: a mechanism which obliges participants

of the clearing system to provide a pre-fund to anticipate

liabilities emerging at the end of the day.

Discount Window: Discount Window: Discount Window: Discount Window: Discount Window: credit extended to banks by the central

bank to overcome liquidity problems caused by a temporary

mismatch in liquidity management.

Financial Sector Assessment Program: Financial Sector Assessment Program: Financial Sector Assessment Program: Financial Sector Assessment Program: Financial Sector Assessment Program: a joint program by

the IMF and World Bank to assess the resilience of a

country»s financial system and its adherence to international

standards.

Flight to safety: Flight to safety: Flight to safety: Flight to safety: Flight to safety: switching funds from banks considered

less safe to safer banks.

Four-eyes principle: Four-eyes principle: Four-eyes principle: Four-eyes principle: Four-eyes principle: credit approval considering business

prospects and risk management.

Financial Safety Net: Financial Safety Net: Financial Safety Net: Financial Safety Net: Financial Safety Net: framework to strengthen financial

system stability through four key elements: i) bank

regulation and supervision; ii) lender of last resort; iii)

deposit insurance; and iv) crisis management.

Capital Adequacy Ratio (CAR): Capital Adequacy Ratio (CAR): Capital Adequacy Ratio (CAR): Capital Adequacy Ratio (CAR): Capital Adequacy Ratio (CAR): The ratio of a bank»s total

regulatory capital to its risk-weighted assets.

Glossary

Non-performing loans (NPL): Non-performing loans (NPL): Non-performing loans (NPL): Non-performing loans (NPL): Non-performing loans (NPL): a loan that is in default or

close to being in default categorised as sub-standard (SS),

doubtful (D) and loss (L)

Lender of last resort: Lender of last resort: Lender of last resort: Lender of last resort: Lender of last resort: the function of a central bank in

extending credit to banks to overcome liquidity problems

caused by a mismatch in funds and to prevent systemic

crisis.

Crisis management: Crisis management: Crisis management: Crisis management: Crisis management: a comprehensive framework to

identify, mitigate and resolve crises.

Mark to market: Mark to market: Mark to market: Mark to market: Mark to market: Evaluating the price or value of a security,

portfolio, or account on a daily basis, to calculate profits

and losses or to confirm that margin requirements are being

met.

Risk mitigation: Risk mitigation: Risk mitigation: Risk mitigation: Risk mitigation: efforts to reduce the possibility and effects

of risk.

Economic capital:Economic capital:Economic capital:Economic capital:Economic capital: is the amount of real capital required

to cover accumulative excess or unexpected losses over a

fixed time period with a set confidence level.

Moral Hazard: Moral Hazard: Moral Hazard: Moral Hazard: Moral Hazard: behaviour of business players (bank owners,

managers and customers) that triggers financial losses for

the bank.

Crisis prevention: Crisis prevention: Crisis prevention: Crisis prevention: Crisis prevention: efforts to prevent crises through policies

for micro prudential regulation and supervision of financial

institutions and financial markets as well as macro

prudential surveillance of the financial system.

Crisis resolution: Crisis resolution: Crisis resolution: Crisis resolution: Crisis resolution: efforts to overcome crises including

restructuring and recapitalising banks with systemic effects.

Profit taking: Profit taking: Profit taking: Profit taking: Profit taking: the selling of assets or securities by investors

at a high price to receive profit.

Regulatory capital: Regulatory capital: Regulatory capital: Regulatory capital: Regulatory capital: the minimum capital required applied

to banks set by the regulator.

94

Glossary

Restructuring: Restructuring: Restructuring: Restructuring: Restructuring: the act of improving loan conditions by

applying several options: i) adjusting the covenants to

provide additional financing; ii) converting all or partial

interest as new loans; iii) converting all or part of the loan

as equity for the bank in the company with or without

rescheduling or reconditioning.

Credit risk: Credit risk: Credit risk: Credit risk: Credit risk: the risk of loss due to a debtor»s possibility of

default, or non-payment of a loan.

Liquidity Risk:Liquidity Risk:Liquidity Risk:Liquidity Risk:Liquidity Risk: risk that an institution will not be able to

execute a transaction at the prevailing market price because

there is, temporarily, no appetite for the deal on the other

side of the market.

Operational risk: Operational risk: Operational risk: Operational risk: Operational risk: the risk of loss resulting from inadequate

or failed internal processes, people and systems, or from

external events.

Market risk: Market risk: Market risk: Market risk: Market risk: the risk that the value of an investment will

decrease due to the movements in market factors.

Systemic risk:Systemic risk:Systemic risk:Systemic risk:Systemic risk: describes the likelihood of the collapse of a

financial system, such as a general stock market crash or a

joint breakdown of the banking system.

Risk-free assets: Risk-free assets: Risk-free assets: Risk-free assets: Risk-free assets: an asset whose future return is known

with certainty. However, such assets remain subject to

inflation risk.

Systemically Important Payment Systems: Systemically Important Payment Systems: Systemically Important Payment Systems: Systemically Important Payment Systems: Systemically Important Payment Systems: are those that,

in terms of the size or nature of the payments processed

via them, represent a channel in which shocks could

threaten the stability of the entire financial system.

Risk-control system: Risk-control system: Risk-control system: Risk-control system: Risk-control system: is a system to control risk implemented

through bank policy and procedure in line with sound risk

management principles.

Credit scoring systems: Credit scoring systems: Credit scoring systems: Credit scoring systems: Credit scoring systems: provide a consistent, mathematical

system to evaluate potential debtors. A credit scorecredit scorecredit scorecredit scorecredit score is a

numerical expression based on a statistical analysis of a

potential debtor»s credit files, to assess the creditworthiness

of that debtor, which is the likelihood the debtor will pay

his or her debts.

Financial system stability: Financial system stability: Financial system stability: Financial system stability: Financial system stability: refers to a state in which a

financial system, consisting of financial institutions and

markets, functions properly. In addition, the participants,

such as firms and individuals, have confidence in the

system.Ω

Stress testing: Stress testing: Stress testing: Stress testing: Stress testing: is a simulation technique used on asset

and liability portfolios to determine their sensitivities to

different financial situations. Stress-testing is a useful

method of determining how a portfolio will fare during a

period of financial crisis.

Undisbursed Loans: Undisbursed Loans: Undisbursed Loans: Undisbursed Loans: Undisbursed Loans: are loans that have been agreed but

are yet to be withdrawn.

Unexpected losses: Unexpected losses: Unexpected losses: Unexpected losses: Unexpected losses: are defined as the difference between

expected loss and worst case loss. Expected losses are

≈smallΔ losses, unexpected losses are ≈low probability high

impactΔ losses and worst case losses are losses of such

magnitude that they would render most institutions

bankrupt.

Volatility: Volatility: Volatility: Volatility: Volatility: is the relative rate at which the price of a security

moves up and down. Volatility is found by calculating the

annualized standard deviation of daily change in price. If

the prices of securities move up and down rapidly over

short time periods, it has high volatility. If the price almost

never changes, it has low volatility.

Yield:Yield:Yield:Yield:Yield: The rate of income generated from a stock in the

form of dividends, or the effective rate of interest paid on

a bond, calculated by the coupon rate divided by the bond»s

market price. Furthermore, for any investment, yield is the

annual rate of return expressed as a percentage.

DIRECTOR

Muliaman D. Hadad SWD. Murniastuti Wimboh Santoso

COORDINATOR & EDITOR

Sukarela Batunanggar

WRITER

Satrio Wibowo, Tirta Segara, Linda Maulidina, Herawanto, Ronald L. Toruan,

Dwityapoetra S. Besar, Pungki P. Wibowo, 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.

COMPILATOR, LAYOUT & PRODUCTION

Ita Rulina Ricky Satria Primitiva Febriarti

CONTRIBUTOR

Directorate of Bank Licensing and Banking Information

Directorate of Bank Supervision 1



Directorate of Economic Reserach and Monetary Policy

Directorate of Monetary Management

Directorate of Accounting and Payment System

DATA SUPPORT

Suharso I Made Yogi

Financial Stability ReviewNo. 8, March 2007

Documents

Bank Indonesia, Financial Stability Review No.8 March 2007