Published:

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

This Financial Stability Review (FSR) is presented as part of Bank Indonesia»s

mission ≈to achieve and maintain rupiah value stability through maintenance of monetary stability
and development of financial system stability for the achievement of sustainable long-term national
development∆.

The FSR is published biannually with the following objectives:

• To foster public understanding of financial system stability, both domestically and
internationally;
• To analyze potential risks to financial system stability; and,
• To analyze developments and problems in the financial market and recommend policies to
boost and maintain a stable financial system.

Information and Order :

This FSR document is based on data and information as of September 2003, except when otherwise indicated.
This FSR document is also available in pdf format at Bank Indonesia»s web site at http://www.bi.go.id

Inquiries, comments, and recommendations may be addressed to :

Bank Indonesia
Directorate for Banking Research and Development
Financial System Stability Bureau
Jl. MH Thamrin No.2, Jakarta, Indonesia
Telephone : (+62-21) 381 7779, 7990
Fax : (+62-21) 2311672
Email : Tim SSK √ BSSK@bi.go.id
 fsr
Financial Stability Review

No. 2, December 2003

ii
TABLE OF CONTENTS

Foreword vii
Executive Summary xi

Chapter 1 Overview 3 Chapter 4 Non-bank Financial Institutions 58

4.1. The Insurance Industry 58
Chapter 2 Development of Domestic and Interna- 2.2. The Pension Funds Industry 64
tional Economies 7
Boks IV.1 Bancassurance - Advantageous
2.1. External Influences 7
for All Parties? 59
2.2. Domestic Economic Conditions 9
Boks IV.2 Implementation of the Regulation on Fit &
Boks II.1 Will Property Become a Nightmare Again? 13
Proper Tests in the Insurance Industry 63
Boks II.2 Rocketing China : Threat or Opportunity? 15

Chapter 5 Capital and Money Markets 69

Chapter 3 Development of Banking Industry 19 5.1. Development of Indonesia»s Capital Market 69
3.1. Commercial Banks 19 5.2. Development of Indonesia»s Money Markets 75
3.1.1. Credit Risk 19
Boks V.1 Mutual Fund 71
3.1.2. Liquidity Risk 31
Boks V.2 Prospects for Issuance of Government
3.1.3. Profitability 36
3.1.4. Capital 38 International Securities (SUN) (the Yankee Bond) 76
3.1.5. Market Risk 40 Boks V.3 Corporate Bond 78
3.1.6. Operational Risk 42
3.2. Development of Sharia Banking 44 Chapter 6 Payment System 81
3.3. Development of Bank 45
3.4. Law Enforcement 46 Articles 85
Boks III.1 Indonesian Banking Architecture, Blue Print I. Study on the Cost of Intermediation At Several

and Strategic Directions in the Future? 20 Large Banks in Indonesia:Are Commercial

Banks» Interest Rates on Credits Overpriced? 87
Boks III.2 Rigidity of Loan Interest Rates 22
II. Early Indicators of Banking Crises 97
Boks III.3 Undisbursed Loans 24
III. Company Failure Indicators in Indonesia : As An
Boks III.4 Capital»s Resilience To Credit Expansion 27 Additional Early Warning Tool On Financial System
Boks III.5 Stress Test of NPLs Impact on Capital 29 Stability 109

Boks III.6 Provisions for Earning Assets Losses (PEAL) 29

Boks III.7 Implications of Implementation of The New
Guarantee Scheme 35
Boks III.8 Impact of IBRA»s Dissolution 43

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 List Charts and Tables
Chart III.4 Outstanding Credit by Bank Group 23
Tables Chart III.5 Growth of Credits & Funds 23
Chart III.6 Credit Growth by Debtor Group 23
Table II.1 Indonesia»s Balance of Payments (Million of Chart III.7 Credit Growth by Certain Economic
USD) 9 Sectors (%) 23
Table II.2 Government Financial Statistics 10 Chart III.8 Credit Development by Economic Sector 25
Table II.3 Number of Workers in Indonesia»s Textiles Chart III.9 Loan Development of Credit by Usage 25
and Related Products Industry 12 Chart III.10 Loan Growth by Usage 25
Table III.1 NPLs by Bank Group 30 Chart III.11 NPLs of Consumer Loans 25
Table III.2 Loans Concentration on 25 Largest Debtors Chart III.12 New Loans by Economic Sector 26
(LD) 30 Chart III.13 2003 New Credits 26
Table III.3 Development of Third Party Funds and NAV Chart III.14 Development of Property Loan 26
32 Chart III.15 Growth (y to y) of Property Sector (%) 26
Table III.4 Rural Bank Major Indicators 46 Chart III.16 Non Performing Loans 28
Table III.5 STR Reported to Police Chart III.17 Growth of Loans Classification 28
Table V.1 Rating of Default Probability of Large Chart III.18 Development of Outstanding NPLs 28
Corporate Bonds 75 Chart III.19 2003 Ratio of NPLs to Capital 30
Chart III.20 Gross NPLs of Asian Countries 30
Charts Chart III.21 Ratio of 25 Largest Debtors» to
Capital √ August 2003 31
Chart I.1 Asset Composition of Financial Chart III.22 Banks» Funding Structure 32
Institutions 3 Chart III.23 Structure of Third Party Funds 32
Chart III.24 Composition of Time Deposits by Tenor 33
Chart II.1 Developments of International Interest Chart III.25 Ownership of Third Party Funds by Core
Rates 7 Depositors 33
Chart II.2 Developments of 5 Major Trading Partner Chart III.26 Third Party Funds Ownership at 15 Big Banks
Countries» Economies 7 33
Chart II.3 Development of Inflation In 5 Major Trading Chart III.27 Composition of Time Deposits by Amount 34
Partner Countries 8 Chart III.28 Liquid Asset Ratio 34
Chart II.4 Foreign Investments and Portfolio Invest- Chart III.29 Ratio of Funds Channelled Over to Funds
ments (Net) 8 Sources 34
Chart II.5 Developments of Composite Chart III.30 Ratio of Liquid Assets to Short-Term Liabilities
Stock Price Index and Rupiah Exchange at 15 Big Banks 36
Rate 9 Chart III.31 Non-Core Deposits to Liquid Assets 36
Chart II. 6 Inflation and Consumer Loan 10 Chart III.32 Development of Net Interest Income 37
Chart II.7 2002 Supply and Demand for Logs 11 Chart III.33 Composition of Interest Income at 15 Big
Chart II. 8 Developments of Average Leverage and Banks 37
ROE of Several Textile Companies 14 Chart III.34 Composition of Interest Income 37
Chart III.35 Efficiency Ratio 38
Chart III.1 Number of Banks and Total Assets 19 Chart III.36 CER Comparison 38
Chart III.2 Development of LDR 21 Chart III.37 Development of ROA in 5 Asian Countries 38
Chart III.3 Loan Growth by Bank Group 23 Chart III.38 Risk-weighted Asset and ROA 39

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Chart III.39 Development of Banks» Earning Assets 39
Chart III.40 Ratio Tier 1 To Total Assets 40
Chart III.41 CARs of Several Asian Countries 40
Chart III.42 Stress Test on Interest Rates 41
Chart III.43 Stress Test on Exchange Rates Chart IV. 6 ROI Value √ Life and General Insurance
at Bank ≈X∆ 41 Companies 61
Chart III.44 Total Assets 44 Chart IV. 7 Investment Composition of Insurance
Chart III.45 Capital 44 Industry √ 2002 61
Chart III.46 Deposits 44 Chart IV. 8 Investment Composition of Insurance
Chart III.47 Financing 44 Industry √ Quarter II/2003 61
Chart III.48 Non Performing Loans 45 Chart IV. 9 ROA & ROI Values - Pension Funds 65
Chart III.49 ROA & ROE 45
Chart III.50 Development of Banking Cases Received by Chart V.1 A Shift in The Role of Bank Loans Versus
UKIP (in number of banks) 47 Capitalization of Stock and Bond Markets
Chart III.51 Development of Banking Cases, Where 69
Investigations Have been Stopped (in Chart V.2 Ratings of Indonesia and Other Developing
number of banks) 47 Countries 70
Chart III.52 Development of Banking Cases Transferred Chart V.3 Composite Stock Price Index and Volatility
to Law Enforcement Body (in number of 72
banks) 47 Chart V. 4 Trend of Jakarta Financial Index (JFI) 73
Chart III.53 Completion of Banking Cases (cumulative) Chart V. 5 Price Earning Ratio»s of Listed Bank 73
47 Chart V.6 Yield Curve of Indonesia Goverment Bond
Chart III.54 Types of Banking Violation Cases Followed- 73
Up During 2003 (by number of cases) 48 Chart V.7 Maturity Profile of Goverment Bond 74
Grafik III.55 STR reported to Police by Numbers of Chart V.8 Market Liquidity of Corporate Bond 74
Reports 49 Chart V.9 Development of SBI, Deposit, Interbank
Money Market Interest Rates 75
Chart IV.1 Developments of Shares, Bonds, Mutual Chart V.10 Development of Interbank Money Market
Funds 57 Interest Rates and Transaction Volumes 77
Chart IV. 2 Asset Composition of Financial Institutions
58 Chart VI.1 Clearing Transaction 81
Chart IV. 3 Total Non-Bank Financial Institutions 2000 √ Chart VI.2 Unsetled RTGS Transaction 82
June 2003 58 Chart VI.3 Average Clearing Cycle 83
Chart IV. 4 ROA Value - Life and General Insurance
Companies 61
Chart IV. 5 ROE - Life and General Insurance Compa-
nies 61

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vi
 Foreword

This financial system stability review provides a picture of the current state of financial system stability in
Indonesia and its outlook as of end-2003.

As of the end of 2003, the condition of our financial system was stable with quite encouraging developments.
It is expected that this will continue in 2004. However, there are still several problems that need close attention to
prevent them from becoming constraints in the future.

Important developments during 2003 included rising international confidence as indicated by an upgrade in
Indonesia»s debt rating as well as high foreign investors» interest in the sales of corporate shares and bonds. These
were possible largely due to rupiah exchange rate stability, lower interest rates and inflation, as well as improving
banking conditions. However, in the same year, the banking sector was strained for a time by several cases of
fraud, which caused considerable losses for the banks concerned. This shows how implementation of good
corporate governance needs to be stepped up by all parties, particularly those involved in financial systems
management.

There were several other problems originating internally to the financial system, such as continuing high
NPLs of banks, slow recovery of bank intermediation, and rigidity of interest rates on credits. Problems from the
external side of the financial system, such as slow real sector recovery more competitive global markets, have also
put pressure on our financial system development.

The downward trend in interest rates has prompted the public to shift some funds to the capital market,
which has boosted the composite stock price index and the bond index in the capital market, up 63% and 66%,
respectively from the previous year. Such growth has also boosted the mutual funds industry, which is up 56%
from the year before. These are, of course, encouraging developments. However, there is a need to emphasize
that rapid capital market expansion also has the potential to create new problems if it is not followed by improvements
in infrastructure, such as better accounting systems, regulations and market discipline on market players.

This Financial Stability Review is the second issue written in two languages (the first was in June 2003). It
disseminates educational information to the public, who are key stakeholders in financial system stability. Although
this document is issued biannually, monitoring of financial system stability is conducted routinely by Bank Indonesia,
and results are contained in weekly internal reports.

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 Bank Indonesia»s determined efforts in building and maintaining stability of the financial system cannot be
done properly without the support of related parties and institutions. For this, we express our appreciation and
thanks to all contributors and participants in the hope that this document will assist the general public and related
supervisory institutions in building a sense of joint concern and responsibility.

In closing, we welcome any suggestions, comments, and even critiques to enhance the the quality of this
review in the future.

Jakarta, January 2004

Maman H.Somantri
Deputy Governor

viii
 Executive Summary

Executive
Summary

ix
 Executive Summary

x

Executive Summary
In general, stability was maintained in the banking and
financial systems during 2003, as indicated by continuous
improvements in several banking and financial system
performance indicators. This condition was supported by
macroeconomic stability and relatively conducive
monetary conditions during the year, as indicated, for
example, by economic growth that reached its target and
by improved macroeconomic indicators that strengthened
domestic and international public confidence in the
Indonesian economy.
However, banks» dependence on income from
recapitalization bonds, continuing weak governance, and
limited risk management, could pose a threat to the
banking industry and financial system in the future. Also,
the real sector has not fully recovered and several business
sectors are susceptible to tough competition from other
countries. Both have the potential to cause banks» NPLs
to rise. Meanwhile, short-term foreign capital inflows are
on the rise; these tend to be volatile and could have a
negative impact on financial system stability and the overall
economy.
1. MACROECONOMIC STABILITY
Stable macroeconomic conditions that tended to
improve during 2003 have supported financial system
stability. The balance of payments, rupiah exchange rate,
and inflation rate all performed better than expected at
the beginning of the year, while economic growth achieved
the figure originally projected.
Improved economic indicators were greatly assisted
by consistent implementation of monetary and fiscal
policies. Relatively loose monetary policy during 2003
Executive Summary
provided room for the real sector to recover without
reducing the purchasing power of the public. Meanwhile,
the implementation of a conservative and cautious fiscal
policy has helped to strengthen confidence in
macroeconomic stability which leaded to hold down
inflation, which in turn helped with the maintenance of
financial system stability.
On the external side, declining international interest
rates helped provide room for domestic interest rates to
fall without undermining the exchange rate. These
conditions contributed to strengthening economic players»
confidence, and no damaging shocks occurred. In the
future, if fiscal policy remains conservative and is adjusted
to the needs of economic growth, it would further benefit
financial system stability.
Nevertheless, economic and non-economic
fundamental conditions are worrisome. Economic growth
of around 4.55% during 2003 was within the range of
original projections, but it was not able to make any
progress on Indonesia»s unemployment problem. Open
unemployment is estimated at 10.1 million people or 9.8%
of the whole work force in 2003. Also, the growth to date
has not been able to lift per capita income back to its pre-
crisis level. In addition, the major factor behind economic
growth during 2003 was consumption growth of 5.1%.
In the long-term, high unemployment and economic
growth dependent upon consumption pose risks for the
economy.
Investment expanded by 1.6%. However, this
expansion was more for construction than machinery, and
consequently it did not have any meaningful impact on
production capacity. Manufacturing grew by only 2.4%,
xi
 Executive Summary
down from 4% in the previous year. However, this did not
push up prices due to smooth flows of imported goods
that suppressed inflation. On the downside, this could pose
difficulty for banks and other financial institutions in
determining interest rates on credits to be channeled to
the real sector. In the long-term, businesses that are not
able to compete with imported products have the potential
to go bankrupt, which could cause economic instability, if
it were to happen on a large scale.
For its part, the balance of payment»s structure was
less encouraging. Non-oil/gas exports were dependent
upon demand from several countries (mainly the US, Japan,
and Singapore), but remained dominated by five main
commodities (textiles, wood products, electrical appliances,
and footwear), which have many international competitors
(except for paper products). Nonetheless, repayment
capacity of exporting companies generally seemed not to
have been disrupted because free trade regulations have
not yet been fully enacted. On capital account, inflows
were dominated by short-term portfolio investment, which
is susceptible to reversals. Foreign direct investment, which
is more stable, was on the decline.
A policy of low interest rates, which was successfully
implemented during 2003, is expected to be continued
cautiously. The large gap in maturity profiles between
banking assets and liabilities would raise banking instability
if interest rates were changed suddenly and with violent
fluctuations. But, because exchange rate stability could
be maintained, exchange rate risk was relatively low, which
added to stability in the financial industry in 2003.
2. FINANCIAL SYSTEM STABILITY
Macroeconomic stability supported banking and
financial stability in 2003. The banking industry»s stability
was reflected in several performance indicators, which
continued to improve during the year, despite several
potential problems concerning banking credit, assets and
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capital. Meanwhile, Indonesia»s capital markets experienced
extraordinary development during 2003, with the stock
market»s performance ranking as the second best in the
world. The bond market also recorded rapid growth with
a tendency towards oversubscription at each new issuance.
For its part, the money market did not fluctuate in any
way that could have endangered financial stability, while
conditions at non-bank financial institutions were also
relatively stable. This was further supported by policy on
the non-cash payment system that has successfully reduced
systemic risk and increased the efficiency of payment
transactions. Nonetheless, in order to maintain financial
system stability, there are several matters that warrant close
attention such as bank intermediation that has not fully
recovered; weak corporate governance that leads to large
operational risk in the banking industry; the possibility of
rising NPLs; and a reduction in the coverage of the blanket
guarantee program.
2.1. Banking Industry
In general, stability of the banking industry during
2003 was bolstered by banks» control of credit risk. At the
same time, market risk was quite moderate, being
supported by adequate banking capital, a stable exchange
rate, lower interest rates, and a relatively small net foreign
currency position of banks (which, for example, averaged
4.70% of banking capital in quarter III-2003). During 2003,
banks still experienced excess liquidity, which was mostly
placed in SBIs and the interbank money market. The large
size of interbank borrowings could have a systemic risk.
However, no banks experienced a liquidity crisis during
2003. Nevertheless, the large size of maturity mismatches
at several recapitalization banks could have created
instability if interest rates were to fluctuate excessively.
Operational risk remained high as evidenced by various
cases of fraud at several banks due to weak
implementation of good corporate governance.

The banking industry»s stability was further bolstered
by growing public confidence in the Indonesian banking
sector as indicated by confidence index surveys.
Improved banking conditions were generally reflected
in a rising rate of return on assets (ROA) during 2003,
from 1.9% (Dec«02) to 2.3% (y-t-d, Oct»03). This mainly
stemmed from banks» success in preventing a drop in their
net interest margins (NIM) in the face of declining interest
rates. During 2003, banks» NIM narrowed only modestly,
from 4.2% (Dec»02) to 3.8% (y-t-d, Oct»03). Also, banks»
CAR remained above the 20% level, which turned out to
be more than adequate to absorb business risks, particularly
credit risk, during 2003.
Rural Banks also did well during 2003, with asset
growth of 38.8%, reaching Rp10.4 trillion (June 2003).
Another indicator of improved performance was a rise in
the percentage of Rural Banks categorized as «sound» from
61.9% (June 2002) to 63.9% (June 2003). Sharia banks
had a similar experience, with strong growth in assets
(60%), third party funds (60%), and financing (50%) with
Capital Adequacy Ratio (CAR) reached 17%. In addition,
the quality of earning assets in the sharia banking industry
were in a sound condition as indicated by the level of non-
current financing, which was below 5%. In general, the
sharia banking industry also had a good level of earnings,
although in 2003 it did record a sizable drop due to large
expansion, which incurred sizable infrastructure costs.
However, several matters that arose during 2003
warrant close review, particularly concerning bank loan
and capital. As regards development of bank loan, growth
in outstanding loan and new loan extensions during 2003
were down from the year before. Also, there was a rise in
undisbursed banking loans to Rp25.6 trillion (Jan - Oct
»03), up from the previous year»s Rp19.1 trillion (Jan-Oct
«02). The slowdown in credit channeling was partly related
to on-going rigidity in interest rates on credit, which did
serve to protect banks» profitability. Excess liquidity and
Executive Summary
limited lending have prompted banks to depend on SBIs
and bonds for interest income. Unfortunately, this does
not boost economic growth, which in the long run could
disrupt financial stability.
During 2003, credit channeling continued to be
dominated by consumer credit. In line with the downward
trend of interest rates, consumer credit channeling was
on a rising trend (33.8%, y-o-y), far larger than the rises
of working capital and investment credits of 16.9% and
7.4%, respectively. This rapid expansion of consumer
credits risks higher NPLs, if economic growth were to
decline.
Meanwhile, outstanding property credit reached
Rp43.9 trillion (Oct »03) or 10.3% of total banking credits,
up Rp35.0 trillion from its position at December 2002.
This rapid increase is also susceptible to rising NPLs if
unemployment were to rise due to layoffs.
The aggregate CAR during 2003 ranged between
20% - 26%, with 17 (out of 138 banks) having CARs
between 8% √ 10%; of these, one was a large bank. Six
banks had CARs at between 10% √ 15%. This figure was
quite susceptible to changes in the quality of earning assets
and in the method of calculation to includes risk
components in addition to credit risk.
2.2. Non-Bank Financial Institutions
The downward trend in interest rates prompted
several insurance and pension funds industries to shift their
fund placements from deposits to capital market products
in order to minimize income declines.
During 2003, the insurance industry experienced
some restructuring to enable it to face rising competition,
fulfillment of minimum risk-based capital, and new
regulations, such as fit and proper tests. Still, lower interest
rates impacted directly on the earnings of funds managed
by the insurance and pension funds industries. To tackle
this, these industries started to shift their earning assets
xiii
 Executive Summary
structures from placements in banking products (deposits)
to capital market products (shares, bonds, and mutual
funds). However, this shift has not prevented a decline in
returns (ROA, ROI, and ROE). This was due to high
operational costs resulting from competition on premiums
and commissions as well as still inefficient business
activities.
2.3. Capital and Money Markets
Rapid growth of the stock market has the potential
to cause an overpriced situation. This could spur instability
in the future if it is not followed by implementation of
good governance, among others in the form of adequate
transparency. The extraordinary development that occurred
in Indonesia»s stock market during 2003 resulted in this
market having the second best record in the world after
Thailand. Several developments that boosted the capital
market»s performance were the downward trend in global
interest rates, improvements in several macroeconomic
indicators, and stable political and security conditions.
Despite a sell-off for a time in the wake of the bomb
incident at the JW Marriot Hotel, positive developments
(such as continued declines in SBI rates and improvements
in the quality of issuers) soon prompted a recovery. The
composite stock price index was at a low of 379.351 on
11 March 2003, but recovered very well, closing the year
at 691.90, the highest level in 2003. This rise of 82% was
only exceeded by Thailand»s bourse, which soared by
115.6% (Jan-Dec 2003). The stock market in 2003 also
benefited from the successful initial public offerings of
three large state-owned companies (Bank Mandiri, BRI,
and Perusahaan Gas Negara), which received an
enthusiastic response from domestic and foreign investors.
Meanwhile, the bond market also experienced rapid
growth with a trend toward oversubscription with each
issuance. Investor interest was also apparent in secondary
market trading for both corporate and government bonds.
xiv
One of the factors encouraging bond issuance was
continuing high credit rates at banks and the rising demand
for mutual funds with bonds as assets. Rapid development
of the bond market was further indicated by bond
issuances, which reached Rp24.7 trillion in 2003 out of
total bonds traded at the Surabaya Stock Exchange of
Rp46.2 trillion (November 2003). The 2003 issuance was
the largest in the history of Indonesia»s capital market. In
the secondary market, bond trading during 2003 was
active with prices increasing to an average of 99.4% of
nominal values (November 2003), compared to 95.31%
at the beginning of 2003). These developments warrants
close attention because if the bond issuers use these funds
for high-risk business activities, it would heighten credit
risk, including risk of systemic default.
Rapid expansion in the mutual funds marketƒ
without implementation of adequate accounting
standardsƒrisk a loss of customer confidence. Mutual
funds» NAV rose by 482.4% to Rp46.6 trillion in 2002
followed by a further rise of 70% to Rp79.2 trillion during
2003 (Jan-Oct). One of the reasons for the rise in mutual
funds» NAV was vigorous tradings of corporate and
government bonds in the secondary market. Most mutual
funds (85.2% in October 2003) were of the fixed-income
type with bonds as their major asset. This rapid growth
ended in October 2003, when there were large-scale
redemptions due to rumors of a change (to marked-to-
market) in the method for calculating mutual funds» NAV.
Consequently, there was a drop in mutual funds» NAV from
Rp85.9 trillion (September 2003) to Rp79.2 trillion (October
2003) because investors withdrew their funds.
During 2003 in the interbank money market, interest
rates trended downward in line with declines in SBI interest
rates. Interest rates in the morning and afternoon money
market sessions dropped from 12.3% and 9.6% (January
2003) to 8.3% and 5.8% (December 2003), respectively.
This was related to overliquid banking conditions, because

funds could not be quickly channeled to credits.
Nonetheless, lower interest rates in the money market did
not boost bank intermediation.
Turning to the payment system, credit and settlement
risk have eased considerably with implementation of the
real time gross settlement (BI-RTGS) system, whose
coverage now reaches over all of Indonesia. But despite a
major shift in transactions to the BI-RTGS system, the older
clearing system still has an important role in executing
payment transactions.
3. 2004 OUTLOOK
Macroeconomic and financial system stability are
expected to be maintained in 2004. With a stable rupiah
exchange rate, low inflation, and a downward trend of
interest rates, economic growth is projected to rise, although
it would still not be able to absorb all additions to the work
force. The main factor boosting growth is expected to be
domestic demand, particularly consumption. Global
economic conditions are forecast to improve in 2004, and
this would give a boost to the financial system, particularly
as regards credit extensions. However, several constraints
would remain due to difficulties in improving economic and
non-economic fundamentals, which in turn would cause
risk to remain high.
Based on developments in 2003 and economic
prospects for 2004, commercial banks» are expected to
remain stable in 2004. However, several conditions warrant
close review due to their potential for hampering
improvement of NPLs and banking performance, which
could disrupt banking stability.
Banking credits are projected to expand in line with
improving economic performance. In particular, improved
prospects for international commodity prices (especially
primary non-oil/gas commodities) and manufacturing due
to rising demand in export markets would have a positive
impact on the domestic business climate, which would
Executive Summary
raise demand for bank credits. However, there would be
several factors that could pose problems on the supply
side, including: (i) weak implementation of risk
management by banks remaining high risk perceptions
from the banking system towards credit; and (ii) high credit
interest rates due to declining interest income from SBIs
and bonds, as well as banks» inefficient business operations.
Meanwhile, on the demand side, demand for credits would
be limited by more attractive alternative funding sources
outside banking credits such as the issuance of bonds and
shares.
Banks» NPLs are estimated to remain below the
indicative target of 5% because banks are expected to
provision against (gross) NPLs through adequate Provisions
for Earning Assets Losses (PEAL). Another factor would be
banks» very conservative behavior in extending credits due
to perceptions of high risk. Consequently, NPLs (gross)
would tend to rise in 2004. Several conditions would
prompt this rise, such as ex-IBRA and restructured credits.
Furthermore, structural problems such as legal uncertainty
related to regulations and their enforcement would pose
constraints on banks» attempts to improve their NPLs.
The composition of banks» income is estimated to
continue improving during 2004 in line with rising credit
volume and credit»s share in banks» earning assets.
However, this rise would not significantly boost banks»
profitability due to several remaining problems, such as (i)
relatively large components of banks» income whose
sustainablity is doubtful, i.e. non-interest income, which
mostly comes from fluctuanting trading activities as well
as write backs provisioning coming from credit
restructuring and sales of NPLs; and (ii) rising costs due to
deterioration in the quality of banks» credits that require
more provisioning (PEAL).
On the capital side, banks» overall CAR is estimated
to remain well above 8%. However, there could be
pressures due to several factors, namely: (i) a rise in Risk
xv
 Executive Summary
Weighted Assets due to higher credits, (ii) difficulty in
building up capital from profits because several banks tend
to distribute dividends despite low profitability, and (iii) a
potential rise in NPLs (gross).
However, on the bank liquidity side, growth of third
party funds is expected to come under pressure, due to
factors such as: (i) a downward trend in interest rates; (ii)
a decline in the guarantee interest rate, which limits banks»
flexibility in setting interest rates on deposits; as well as
(iii) competition from mutual funds and corporate bonds,
which offer more attractive returns for fund owners.
Based on current growth trends, the sharia banking
industry is estimated to reach asset values of Rp12 - 13
trillion by end-2004 compared to Rp7 trillion at present.
As such, the percentage of sharia banking operations could
exceed 1% of the national banking industry»s total
business. Even higher asset growth is possible because of
plans by one conventional bank to change to a sharia bank
and by several conventional banks to open sharia units.
However, if expansion continues this rapidly, challenges
sharia banking will face increasing challenges, particularly
on the sides of risk management and capital.
Continuing previous years» developments, the Rural
Bank industry is also expected to expand rapidly. This will
be assisted in part by its captive market comprising
customers from communities in urban suburbs and villages
that are not served by commercial banks. However, several
constraints could hamper growth, among others: (i) a
relatively low quality of Rural Bank human resources; (ii)
insufficient numbers of Rural Bank supervisors; and (iii)
relatively inefficient business activities as indicated by
extremely high credit rates charged by Rural Banks.
As was the case in 2003, the insurance and pension
funds industries would continue to face problems with
funds management due to a continuing downward trend
in interest rates. Tough competition in the insurance
industry will force insurance companies to enhance their
xvi
efficiency and capital in preparation for merger or
acquisition. Meanwhile, the pension funds industry, which
been extremely conservative to date in its investment
strategy (as indicated by a large share of bank deposits),
will need to implement adequate risk management in
support of its desire for higher-yielding, long-term
placements.
Many analysts expect that the capital market will not
grow as rapidly in 2004 as it did in 2003. Investors that
have aggressively placed funds during 2003 are pulling
back somewhat, adopting a wait- and-see attitude.
Similarly, several businesses that have used the opportunity
to raise funds in the capital market during 2003 will wait
for indications that the market will accept new issuances
of their debt at better prices. However, if the national
general election agenda proceeds smoothly, investors √
domestic and international√ might rush to invest in
Indonesia.
Meanwhile, the money market is not expected to
experience any meaningful change in line with continued
trends towards lower interest rates and excess liquidity.
Concerning implementation of the payment system,
it is necessary to step up monitoring and supervision of
the system in accordance with international standards
( Core Principles for Systemically Important Payment
Systems √ CP-SIPS set the BIS). In addition, it is necessary
to make efforts to further develop that system in terms of
capacity and to mitigate operational risk.
4. POLICY DIRECTIONS FOR THE FUTURE
In line with continued accommodative monetary
policy and closer coordination between monetary and fiscal
policy, rehabilitation and enhancement of the banking
system»s resilience needs to be continued. Within the
framework of this policy, and along with rising risks facing
the banks, there is need for banks to implement better
risk management and for the establishment of a credit

bureau. Meanwhile, in order to safeguard stability,
elimination of the blanket deposit guarantee needs to be
undertaken gradually and cautiously. In this regard, the
implementation of prudential banking principles in
accordance with international standards need to be
continued.
Implementation of good risk management by banks
is vital. Risk management that is incorporated into bank»s
operations will support the creation of good governance
and minimize criminal banking practices. This ranges from
making misrepresentation to the public, through window
dressing of balance sheets and incorrect reporting, up to
fraud, such as has occurred recently. If these problems are
not seriously addressed by the supervisory authority and
other players in the banking industry, such cases will recur.
This will further undermine public confidence, which has
still not recovered fully.
One of the ways to implement good risk
management is by banks knowing their customers well.
This can be achieved by information sharing between banks
through a credit bureau, which is one effective way to
prevent fraud. Several recent cases of fraud were
undertaken by the same people and companies with the
same modus operandi.
The government plan to phase out the deposit
guarantee program could have a wide impact on the
banking industry. If thorough preparations and calculations
are not made at an early stage, this could result in public
funds shifting from one bank to another (a flight-to-quality)
or to outside the banking industry, particularly on the part
of depositors.
Executive Summary
In order to minimize this risk, reduction of the
guarantee needs to be done gradually. In addition,
reduction of the guarantee program needs to executed in
parallel with elements of the financial safety net, especially
the lender of last resort (LOLR) facility from Bank Indonesia.
LOLR can function as a contingency plan in anticipating
the negative impact of a decline of public confidence in
the banking industry while the guarantee program is being
narrowed.
As was the case in 2003, Bank Indonesia plans to
enhance several regulations during 2004, particularly those
related to prudential principles. The plan is to issue
regulations concerning several matters, including the
quality of earning assets, provisions for earning assets
losses, credit restructuring, and a limit on credit extensions.
In addition, BI will issue new guidelines for bank soundness
(CAMELS), which is planned to be effective in December
2004. This is intended more as a supervisory tool for BI
and for determination of action plans in the framework of
problem identification and problem resolution of certain
aspects of banks» operations. Meanwhile, in order for
implementation of the guidelines to function well, a trial
run will be undertaken on the June 2004 position for all
banks. In line with enhancement of the regulation on
bank»s soundness level, BI plans to enhance regulations
concerning banks» business plans.
As regards the end of the tenure of the Indonesian
Banking Restructuring Agency»s (IBRA) in February 2004,
BI plans to adjust BI regulation number 3/25/PBI/2001
dated 26 December 2001 concerning «Determination of
Bank»s Status and Transfer to IBRA».
xvii
 Executive Summary

xviii
 Overview

Chapter 1:
Overview

1
 Overview

2

Chapter 1:
Overview
With the financial industry»s ownership, organization,
operations, and products becoming more integrated,
instability in one type of institution can have an impact on
other financial institutions, with increasing systemic risk.
Within the financial industry, banking is still very important
in determining financial system stability, as it accounts for
some 91% of total assets of the financial system. However,
this does not mean that other types of financial institutions
can be ignored in the maintenance of financial system
stability. Recently, non-bank product innovation and non-
bank financial institutions have developed rapidly, in line
with heightening competition and customers» increasing
understanding of financial products.
In general, macroeconomic conditions were stable
and tended to improve during 2003, which has raised
public and investor confidence in Indonesia»s economy.
These conditions made a positive contribution to financial
system stability. Improvements of economic development
indicators were largely supported by consistent
implementation of monetary and fiscal policies. However,
economic growth that is largely dependent upon
consumption is quite susceptible to rising banks» NPLs, if
economic activity were to deteriorate.
Banking
91%
Pawn Shop
0%
Securities Leasing Pension Fund
Company Company 3%
Insurance
Corporation
1% 2% 3%
Chart I.1
Asset Composition of Financial Institutions
Overview
On the external side, the downward trend in
international interest rates has helped in lowering domestic
interest rates without weakening the exchange rate. This
stability is expected to continue in 2004. However, rising
competition and protectionism by certain countries could
disrupt export performance. In the long-term, domestic
businesses that are not able to compete with imported
products will likely go bankrupt, which could generate
economic instability.
Macroeconomic stability in 2003 was bolstered by
the maintenance of banking and financial system stability.
Despite several potential problems, the banking industry»s
stability continued to improve during 2003, as evidenced
by several performance indicators. In addition, credit,
liquidity, and market risks were relatively controlled, while
implementation of operational risk needs to be closely
watched.
Meanwhile, Indonesia»s capital market experienced
relatively rapid development during 2003. Indeed, the stock
market»s performance was the second best in the world.
The bond market also experienced rapid growth with a
trend towards oversubscription with each new issuance.
The money market also did not show any fluctuations,
which could endanger financial stability, since banking
tended to be overliquid.
The downward trend in interest rates has forced the
insurance and pension funds industries to shift the
composition of their investment portfolios from deposits
to capital market products in order to minimize loss of
revenues. Nevertheless, performance of these two
industries did deteriorate in 2003.
The generally stable condition of the financial system
was assisted by the policy on the non-cash payment
3
 Overview
system, which has been successful in reducing systemic
risk and enhancing the efficiency of payment
transactions.
Looking ahead to 2004, in line with economic
growth and conducive macroeconomic conditions, the
capital market»s performance is expected to continue on
a strengthening trend. However, many parties see the
potential for a decline in market activity. This would be
4
due to market players adopting a wait-and-see attitude
because of the socio-political agenda for that year,
although this would not entail any meaningful fluctuations.
If the general election proceeds smoothly, investors, both
domestic and international, are expected to rush to invest
their funds in Indonesia. For their part, money market
conditions are not expected to experience any meaningful
change.
 Chapter 2 Development of Domestic and International Economies

Chapter 2
Development of Domestic
and International Economies

5
 Chapter 2 Development of Domestic and International Economies Development Of Domestic

6
 Chapter 2 Development of Domestic and International Economies

Chapter 2
Development of Domestic and International Economies

Generally speaking, macroeconomic conditions during 2.1 External Influences

2003 were stable and trended to improve, as indicated
by several improved macroeconomic indicators. This
situation had a positive impact on public and investors»
confidence in the Indonesian economy, which was
already on the mend. An improving national economy
was largely supported by consistent implementation of
monetary and fiscal policies. However, economic
growth, which is still largely dependent on consumption,
is susceptible to many potential shocks. The immediate
impact on the financial system, particularly the banking
sector, would be higher NPLs and a lower quality of
earning assets. On the external side, the downward
trend in global interest rates has helped to reduce
domestic interest rates without a negative impact on
the exchange rate (Chart II.1), and it is expected that
this stability will be maintained in 2004. However, rising
competition and the imposition of limits on imports by
certain countries could disrupt performance of the
domestic business sector, partly because Indonesia»s
products are uncompetitive in world markets.
World economic growth has not fully recovered due
to several large countries» economies that remain sluggish.
(Chart II.2). This was marked by continuing low GDP
growth in the US, Japan, and Singapore, which were
Indonesia»s major trading partners in 2003. Development
of the world economy in semester I/2003 tended to
weaken due to the Iraqi war involving the US, which is a
superpower with major economic influence. In addition,
the outbreak of severe acute respiratory syndrome (SARS)
in several Asian countries and Canada weakened the global
economy. In this regard, in April 2003, the IMF
downgraded its projection on global economic
performance by 0.5% (from its September 2002 projection)
to 3.2%. Still, this figure is slightly higher than 2002 real
growth of 3%.
In order to stimulate domestic economies and to
revive capital markets, several countries have lowered
interests rates (Chart II.2). On 3 June 2003, the European
Central Bank lowered its refinancing interest rate by 0.5%
to an historical low of 2%. On 25 June 2003, the US

Percentage Percentage
7 12
10
6
8
5 6
4
4
2
3
0

2 -2
-4
1 USA Japan
LIBOR (1 Month) SIBOR (1 Month) Fed Funds Rate -6
Singapore China South Korea
0 -8
1997 1998 1999 2000 2001 2002 Q.1/03 Q.2/03 Q.3/03 Q.4/03 1997 1998 1999 2000 2001 2002 Q.1/03 Q.2/03

Chart II.1 Chart II.2 Developments of 5 Major

Developments of International Interest Rates Trading Partner Countries» Economies

7
 Chapter 2 Development of Domestic and International Economies Development Of Domestic
Federal Reserve lowered the Fed Funds rate by 0.25% to
1%, its lowest since 1958. The Bank of England reduced
its cut-base rate by 0.25% to 3.75%, its lowest since 1955.
Low world inflation, particularly in several advanced
countries, and rupiah appreciation have helped to lower
Indonesia»s inflation rate (Chart II.3). During 2003, the non-
oil/gas commodity price index rose sharply in international
markets, from 2.6 as of December 2002 to 12.8 as of
December 2003 . This rise in non-oil/gas commodity prices,
which is partly a result of the USD depreciation, and a rise
in world oil prices have boosted Indonesia»s exports by an
estimated 4.4% in 2003, despite limited recovery in the
economies of Indonesia»s trading partner countries. Higher
exports would increase exporters» incomes, which would
improve the quality of earning assets in the financial system.
The downtrend in international interest rates during
2003 along with growing worries over the enormous US
current account deficit have spurred investors to shift their
capital to developing countries in Asia and Latin America,
which offered more attractive yields. This was supported
by improving Asian countries» ratings. For example,
Indonesia»s rating was upgraded one level by international
rating institutions (Moody»s, Standard & Poor, Fitch) to the
equivalent of BB with stable prospects (Moody»s). In Asia,
foreign investment mostly came into countries with
Percentage
5 2,000
4 0
3
2 -3,000
1
0 -6,000
-1
-2
1998 1999 2000 2001 2002 Q.1/03 Q.2/03 Q.3/03
South Korea USA
Japan China Singapore
Chart II.3 Development of Inflation
in 5 Major Trading Partner Countries
8
economies that were considered to be stronger, such as
China, Vietnam and Thailand. In Indonesia, the investment
climate remains troublesome, causing foreign capital
inflows to be dominated by portfolio investment (Chart
II.4), such as purchases of shares and bonds. During 2003,
inflows of portfolio investment totaled USD1.4 billion, up
from the previous year (USD1.2 billion). Although these
short-term capital inflows are supportive of the
development of Indonesia»s capital market, they have the
potential to put pressure on the financial system due to
their short-term nature and therefore, potential quick
reversals. Also, these short-term capital inflows do little
to help with the real sector»s recovery.
Improving macroeconomic indicators and the
government»s plan to remain conservative as regards fiscal
policy in 2004 are the main factors promoting financial
system stability. Supported by a stable rupiah exchange
rate, low inflation, and a downward trend in interest rates,
domestic demand, particularly consumption, is boosting
economic growth.
In addition, global economic conditions are expected
to improve in 2004, triggered by rising economic growth
in several advanced countries and within the Asian region.
The IMF has forecast (November 2003) that world
economic growth in 2004 would reach 4.3%. This growth
(Million of USD)
1,000
-1,000
-2,000
-4,000
-5,000
-7,000
-8,000
-9,000
2001 2002 2003
FDI (net) Portfolio Investment (net) Others (net) Total
Chart II.4
Foreign Investments and Portfolio Investments (Net)
 Chapter 2 Development of Domestic and International Economies

Table II.1
would largely stem from advanced countries, such as the
Indonesia»s Balance of Payments (Million of USD)
US, Japan, and those in the European region of 4.3%,
Component 2002 2003* 2004**
1.5% and 2.2%, respectively, higher than the previous
Curren Account 7,822 7,800 5,020
projection (September 2003) of 3.9%, 1.4% and 1.9%.
Export 59,165 62,891 62,630
This situation has the potential to lift export growth Import -35,653 -39,509 -40,945
Services -15,690 -15,582 -16,665
appreciably. If this opportunity is seized by Indonesian
Capital Account -1,102 -2,554 -6,413
exporters, it will make a sizable contribution to the
Goverment (Net) -190 -779 -1,641
maintenance of financial sector stability. Private (Net) -913 -1,774 -4,772

Total 6,720 5,246 -1,393

Monetary Movement -4,021 -4,209 2,328
2.2 Domestic Economic Conditions
During 2003, domestic macroeconomic conditions Memorandum Items
International Reserve 32,037 36,246 33,918
tended to improve and this has contributed significantly (Import month &
to financial system stability. Govt» Foreign Debt) 6.6 7.1 6.1

The balance of payments, particularly the current * Realization Estimate

account, strengthened in 2003 as evidenced by a rise in
foreign currency revenues from exports, which were up
from USD59,165 million in 2002 to USD62,891 million
in 2003 (Table II.1). Capital flows also bolstered the
financial system. This was marked by rising inflows of
portfolio investment, which boosted the composite stock
price index to the level of 691.90 at end of 2003, up
266.955 points compared to end of 2002 (Chart II.5).
The rise in capital flows also triggered vigorous bond
trading, as indicated by increased trading frequency
during 2003, from 308 units in 2002 to 1,023 units in
2003 (source: CCIC).
Index
800
700
600
** Estimate
Source : Bank Indonesia
The rupiah exchange rate was quite stable in 2003,
with a strengthening trend from Rp8,940 at end- 2002 to
Rp8,420 at the end of 2003. This was due to Indonesia»s
Improved balance of payments, declining domestic interest
rates and the USD depreciation against several world
currencies. This strengthening trend of the rupiah had
mixed benefits. On one side, it could reduce business
players» foreign currency risk exposure, but it could also
reduce exports, if not complemented by improved exporter
competitiveness. Lower exports have the potential to
reduce exporters» repayment capacity, which could impact
on the quality of bank credit.
IDR/USD
16000 The inflation rate dropped from 10.0% during 2002
14000
to 5.06% during 2003 (Chart II.6). The downward trend
12000

500 10000
in inflation along with lower interest rates on credits, have
JCI
(Left axis )
400 8000 boosted consumer credit, from Rp79.99 trillion as of end-
300 6000
Rupiah Exchange Rate (Rigth axis) 2002 to Rp101.60 trillion as of October 2003. This rise
200 4000

100 2000 needs to be watched closely, due its potential for putting
JCI USD/IDR
0 0
Jan May Sep Jan May Sep Jan May SepJan May Sep Jan May SepJan May Sep Jan May Sep Jan May Sep pressure on the quality of bank credit, if a decline in
1996 1997 1998 1999 2000 2001 2002 2003
Source : JCI, Bank Indonesia economic growth were to occur.
Chart II. 5 Developments of Composite In the future, improved international developments
Stock Price Index and Rupiah Exchange Rate
and relatively easy domestic monetary policy are expected

9
 Chapter 2 Development of Domestic and International Economies Development Of Domestic

development. In particular, manufacturing grew by only

Trillions of Rp Percentage
120 90
2.4%, down from 4% the year before. Nonetheless, this
80
100
70 did not disrupt the smooth flow of goods supply due to
60
80
50 imported goods, which dampened price increases.
60 40
However, in the long-term, business sectors whose
30
40
20 products cannot compete with imported products will have
10
20
0 difficulty surviving, which could create economic stagnation
Inflation rate (Rigth axis) Consumer loan (Left axis)
0 -10
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct or instability.
1998 1999 2000 2001 2002 2003
Sources : Bank Indonesia, BPS Meanwhile, implementation of a conservative and
Chart II. 6
Inflation and Consumer Loan cautious fiscal policy helped to lower inflation, which
greatly assisted with the maintenance of financial system
to bolster the recovery of business activity in Indonesia»s stability. In light of large payments of principal and interest
real sector. However, this needs to be followed by on the national debt, and to safeguard fiscal sustainability,
conducive investment climate such as improved the government targeted its fiscal deficit within the
infrastructure, secure security conditions, and elimination framework of accelerating the economic recovery. The
of unofficial charges. fiscal deficit in 2003 edged up compared to last year, from
The modest rise in investment activity (1.6%) in 2003 1.7% of GDP in 2002 to 1.9% in 2003 (Table II.2). To
had no meaningful impact on the economy»s production achieve a fiscal deficit 1.9% of GDP, the government took
capacity, because it was concentrated in property a series of conducive policies, such as postponement of

Table II.2
Government Financial Statistics
(Billion Rp)

2002 2003 2003

Budget 1) Actual 2) Budget 3) % Budget-R 4) Actual 2) Budget 3) %
2002 of GDP Semester I of GDP
1. Government Revenues and Grants 301,874 300,188 336,156 17,3 342,812 137,204 343,876 17.2
a. Domestic Revenues 301,874 299,887 336,156 17,3 342,472 136,964 343,242 17.1
- Tax Revenues 219,628 210,954 254,140 13,1 248,470 108,807 271,023 13.5
- Non Tax Revenues 82,247 88,933 82,016 4,2 94,001 28,157 72,219 3.6
b. Grants 0 301 0 340 240 634 0.0

2. Government Expenditures 344,009 327,865 370,592 19,1 377,248 139,703 368,800 18.4
a. Central Government Expenditures 246,040 229,343 253,714 13,1 257,934 85,203 253,943 12.7
- Current Expenditure 193,741 189,072 188,584 9,7 191,788 70,993 185,842 9.3
- Development Expenditure 52,299 40,271 65,130 3,4 66,146 14,210 68,101 3.4
b. Regional Government Expenditures 97,969 98,522 116,878 6,0 119,314 54,499 114,856 5.7
- Balanced Budget 94,532 94,763 107,491 5,5 109,927 49,966 108,243 5.4
- Special Autonomy 3,437 3,759 9,387 0,5 9,387 4,533 6,613 0.3

3. Surplus/Deficit ( 1 - 2 ) -42,135 -27,677 -34,436 (1,9) -34,436 -2,498 -24,923 (1.2)

4. Financing 42,135 27,677 34,436 1,9 34,436 -2,498 24,923 1.2

a. Domestic Financing 23,501 20,562 22,450 1,2 31,530 2,229 39,844 2.0
b. Foreign Financing 18,634 7,115 11,986 0,7 2,906 -4,727 -14,921 (0.7)

Notes:
1) Parliament approved budget. October 2001
Basic Assumptions : GDP growth = 3.5%, Inflation rate = 9.3%, exchange rate = Rp.9,600/US$, 3 month-SBI rate = 15%, oil price = US$24/barel
2) Preliminary figure
3) Budget approved by parliament
Basic Assumptions : GDP growth = 4%, Inflation rate = 9%, exchange rate = Rp.9,000/US$, 3 month-SBI rate = 13%, oil price = US$22/barel
4) 2003 revised budget approved by parliament, 24 September 2003
Basic Assumptions : GDP growth = 4%, Inflation rate = 6%, exchange rate = Rp.8,000/US$, 3 month-SBI rate = 10.1%, oil price = US$27.9/barel
Source: Ministry of Finance

10

fuel price hike increasing excise taxes. Looking ahead, it
will be very important to closely watch for pressures on
the state finances originating in the refinancing of domestic
indebtedness because maturing bonds will total Rp36.3
trillion in 2004. Also, repayments of foreign debt and
interest will rise by around 50% compared with 2003,
because the Paris Club rescheduling facility is no longer
available after the end of the IMF program. Financing of
the 2004 state budget deficit will rely upon domestic
sources, whereas heavy servicing of the foreign debt could
reduce Indonesia»s official foreign exchange reserves.
2.3 Development of the Real Sector
During 2003, the real sector did not recover much
despite various efforts, including a policy to reduce interest
rates. Indeed, there was a worrisome trend of business
relocations to other countries. This could boost the
unemployment rate and increase banks» NPLs, particularly
for consumer credits.
Several recent cases illustrate how investors will pull
back in the face of legal uncertainty. For example, the
divestment of Kaltim Prima Coal (KPC) and the Cemex
investment in Semen Gresik. In the KPC case, the
divestment of that mining company from the old foreign
investor (Rio Tinto and British Petroleum) to the domestic
investor was prolonged. This was caused by court decisions
as well as regional and central governments» reactions to
the ownership change, which was believed to conflict with
the original agreement.
Such cases cause investors to reconsider placing their
capital in Indonesia. During 2003, the amount of long-
term foreign investment √which is very important to
boosting economic recovery√ actually declined (as
mentioned, capital inflows were dominated by short-term
portfolio investment). This is one of the reasons why real
sector growth was limited, and unable to absorb additions
to the work force. Indeed, many workers were laid off as
Chapter 2 Development of Domestic and International Economies
companies cut back operations, closed, or relocated to
other countries. For example, at PT Dirgantara Indonesia
and Texmaco. In 2003, the unemployment rate rose to
9.8% of the overall work force. Such high unemployment
could disrupt economic stability, including in the financial
sector. Settlement of cases like those mentioned above
will be difficult without enhanced legal instruments.
Equally serious, it will be difficult to prevent similar cases
from occurring in the future. However, it will necessary to
continue making efforts in this direction in order to improve
Indonesia»s investment climate, as it continues to
deteriorate in investors» eyes.
Meanwhile, several business sectors experienced
disappointing growth and have uncertain prospects. These
sectors need to be closely monitored in order not to create
problems in the financial sector in the future. These sectors
include wood and wood products, property, textiles and
textile related industry.
Wood and forestry products are one of Indonesia»s
major exports. During 2003, a number of companies in
this industry experienced operational disruptions and many
closed down. The main reason for closure was limited raw
materials due to license tightening by the Ministry of
Forestry and increased illegal logging, much of which is
smuggled out of the country (Chart II.7). Also, many
charges imposed by governments (central and regional)
Thousands of mm3
100,000
80,000
60,000
40,000
20,000
0
2002
Supply Demand Gap
Source: Ministry of Forestry
Chart II. 7
2002 Supply and Demand for Logs
11
 Chapter 2 Development of Domestic and International Economies Development Of Domestic

burden the wood industry. In the banking sector, credit
exposure to the wood and forestry industry is currently far
less than in the pre-crisis period, because large amounts
of banking credits to this industry were transferred to IBRA
during the crisis. Nonetheless, the condition of the wood
and forestry industry still has an influence on financial
stability, because credit exposure is still quite large and
many companies in the forestry and related industry have
issued shares and bonds in domestic and foreign markets.
One example is the Asia Pulp & Paper (APP) group, which
issued bonds amounting to USD12 billion. These have been
categorized as «default», and APP has been undertaking a
long restructuring process with its creditors.
Prospects for industries that use raw materials from
forestry are deteriorating. For 2004, it is estimated that 1
million workers will be laid off because of wood companies»
shutdowns, which would add to the large number of
unemployment in this country. International pressure on
Indonesia concerning compliance with proper
environmental rules (such as comprehensive logging plans,
including regreening) will raise operational costs of
domestic wood manufacturing, which will make them less
competitive in international markets. Therefore, it is
important for banks and financial institutions to prudently
and thoroughly calculate credit risk when channeling funds
to this industry.
Meanwhile, the property industry has experienced
very rapid growth, with the potential to generate an
Table II.3 Number of Workers in Indonesia»s
Textiles and Related Products Industry
oversupply, particularly in the commercial property sector
(Box II.1 : Will Property Become a Nightmare Again?).
In the textile area, China»s exports of textiles and
related products are very competitive due to conducive
economic policies, which include a low value of the Yuan
pegged to the USD; textile industry restructuring that has
reduced production costs; low interest rates on credits
(5%); and cheap labor due to an excess supply of workers
(Box II.2 : Rocketing China : Threat or Opportunity?). By
contrast, Indonesia»s production costs are high due to,
among others, high loading and unloading costs at ports;
illegal charges; high interest rates on credits; and a rising
cost of labor that has not been offset by improved
productivity. These developments represent a significant
challenge for the textiles industry (Table II.3).
Competition from China, (including products that are
either imported legally or smuggled) threaten to shutdown
some 3,250 small-to-medium scale businesses in the textile
and related products industry.1 In the future, with the plan
to end textile quotas by the US, European Union, and
Canada in 2005 as part of WTO agreements, Indonesian
exporters of textiles (which have been indirectly protected
to date by the quotas) will be in direct competition with
low-cost competitors such as China and Vietnam.
Based on the outlook for business in several of the
sectors mentioned above, it is necessary to review the
potential for rising unemployment due to layoffs and the
impact on banking credit, particularly consumer credits to
workers in these sectors.
Data of the Central Statistics Agency (BPS) indicate

2001
that 4.13 million people were (openly)2 unemployed in
Comodity 1996 1997 1998 1999 2000
1996. By 2003, this number had more than doubled to
Fibers 24.415 25.524 26.076 26.762 29.324 29.682
Yarns 170.275 175.337 186.450 189.785 193.361 207.871 10.13 million people. The chairman of the Indonesian
Fabrics 317.191 329.377 337.971 341.400 349.392 355.566 Businessmen Association predicts mass layoffs in the
Garments 329.440 346.167 348.419 355.236 372.716 376.584
forestry and textile sectors in 2004, each involving around
Others 241.486 243.884 244.525 246.710 247.372 249.622
Total 1.082.807 1.120.289 1.143.441 1.159.893 1.192.165 1.219.325 1
Source : Ministry of Industry and Trade.
2
Source: Asosiasi Pertekstilan Indonesia (API) People that do not have jobs and are looking for jobs.

12
 Chapter 2 Development of Domestic and International Economies

BoX II. 1 Will Property Become a Nightmare Again?

During 2003, the property business grew by Revival of the property sector since 2000 and its
78%. This is an exceptionally high figure, especially rapid growth during 2003 are positive developments,
considering that after the 1997 crisis, the property considering that property is a very cyclical business.
sector seemed to stall for several years. Such high An interesting new development in the property area
growth needs to be closely watched because is a shift in the financing structure, from mostly bank
experience indicates that the property sector is risky loans to developers» equity and consumers» down
for the financial system. payment and installment payments. Banking credit
In developing countries, the property sector plays for the property sector in total has dropped, and now
an important role, particularly in developing state is dominated by housing-ownership credits (KPR) and
infrastructure. During the pre-crisis period, the apartment-ownership credits (KPA).
property sector in Indonesia contributed 7 √ 8% of High NPLs in the property sector when the crisis
GDP, boosted by both government and private sector struck has made banks more cautious in channeling
spending. However, after the crisis, its contribution credit to the property sector. Meanwhile, latest
dropped to 5 √ 6%. developments show that leverage of the property

450,000 12
sector has tended to rise. This is indicated by the high
400,000
11.5 proportion of property industry financing coming from
350,000
300,000
11 outside the companies, particularly from individuals
250,000 10.5
or non-bank institutions. However, borrowing more
200,000 10
150,000 funds from non-bank sources does not mean that risk
9.5
100,000
Total Loan Share of Property Loan to Total Loan
9
is significantly less for the financial system, because
50,000 Poly. (Share of Property Loan to Total Loan)
0 8.5 these funds are still suspected to end up in the financial
2001 2002 2003
sector. Bit it does show that there is quite large
Chart Box 2.1.1
Development of Property Loan in Total Credits potential for banking funds to be channeled to the
property industry. On the other hand, this potential
120,000 10 could be a risk for financial stability should an over-
9
100,000 supply or a price bubble develop in this sector.
8
7
80,000 Symptoms of oversupply are already apparent in
6
60,000 5 several office buildings, on which construction is
4
40,000
3 complete but the space looks empty and there is
2
20,000 intense competition for tenants. The same is the case
GDP Share of Property Sector to GDP 1
0 0 in industrial areas where several tenants might relocate
1996 1997 1998 1999 2000 2001 2002 2003
to other countries, following indications that the
Chart Box 2.1.2
Development of Property Sector»s Contribution business climate has not improved to the standard
to GDP

13
 Chapter 2 Development of Domestic and International Economies Development Of Domestic

being set by competitor countries. If oversupply in the bubble could develop, which could eventually trigger

property sector continues to rise next year, a price a rise in NPLs such as occurred during the 1997 crisis.

Leverage (DER)-% ROE (%)

M2 Percentage
60 1000 2,850,000 82
0 Supply (semi gross) Occupancy Level (%)
2,800,000 81
50
-1000 80
2,750,000
40 79
-2000 2,700,000
78
30 -3000 2,650,000 77
20 -4000 2,600,000 76
-5000 2,550,000 75
10 74
-6000 2,500,000
73
0
-7000 2,450,000 72
leverage ROE
-10 -8000 2,400,000 71
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 99 00 2001 2002 2003
Source : SIC

Chart Box 2.1.3 Chart Box 2.1.4

Developments of Average Leverage and ROE at Average Supply and Occupancy Levels in Office
Several Property Companies Buildings in Jakarta and Surrounding Areas

1 million workers. With the addition of 2.5 million new worsen the quality of banks» consumer credit. This point
members to the work force every year, unemployment will is particularly notable because banks have been increasing
almost certainly rise in 2004, possibly to 3 times its pre- the share of consumer credits in their lending portfolios.
crisis level. Those increased share of consumer credits were triggerd

The high level of open unemployment and its upward by banks continuing perceptions of high credit risk,

trend constitute one of Indonesia»s critical social problems, especially towards industries marked by relatively high

which could ultimately undermine stability of the financial average Debt-Equity Ratios and relatively low Rate of

system. When part of the upward trend of unemployment Return on Equity (Chart II.8).

rate comes from layoffs, it can be a signal of declines in The unemployment problem is not easily solved.

borrowers» repayment capacity, which would eventually One important effort is government cooperation with the
Malaysian government through a Memo of

Leverage (DER) (%) ROE (%) Understanding concerning recruitment of Indonesian

600 50

0
workers to Malaysia. Also, the government is expected
500
-50 to be able to continuously increase work opportunities
400
-100
through capital investments by investors and labor-
300 -150

-200 intensive projects to anticipate short-term needs for the

200
-250 2004 general election activities. In addition, tight
100
-300
leverage ROE
monitoring needs to be undertaken of the rise in
0 -350
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Source: Jakarta Composite Index (processed)
unemployment and its impact on the banking sector.
Also, banks should be urged to include unemployment
Chart II. 8
Developments of Average in their calculation of credit channeling targets in their
Leverage and ROE of Several Textile Companies
business plans.

14

Box II. 2 Rocketing China : Threat or Opportunity ?
During 2003, the world economy began to
improve as reflected in the GDP growth of Indonesia»s
5 major trading partner countries. This recovery is
expected to have a positive impact on Indonesia,
particularly exports. The prices of non-oil/gas
commodities in international markets rose sharply
during 2003. This was due to, among others, a slow
recovery in production; producers» attempts to improve
prices after their sharp plunge in the period 1998 √
2001; and the USD depreciation. However, the growth
of world trade volume fell a bit compared to 2002 due
to the Iraqi war, the outbreak of SARS, and rising
protectionism in several advanced countries.
However, improved international trade is
accompanied by tougher competition. Competing
countries that previously were not taken into
consideration, have now improved their
competitiveness. China is a particular case in point;
this country experienced a high growth (on average at
around 8%) since the 1997 when many Asia countries
were hot hard by crisis. That country»s expanding
exports have contributed so much to official foreign
currency reserves that they reached USD346.5 billion
at end of quarter II/2003, up USD60.1 billion compared
to end of 2002.
Rapid expansion of China»s economy √with
increasing export competitiveness√ has become a worry
for advanced countries and other competing countries.
The trade account deficits of advanced countries with
China are getting wider. The US, which has been
continuously experiencing a widening trade account
deficit with China, has threatened to increase tariffs
on products imported from China. In addition, believing
Chapter 2 Development of Domestic and International Economies
thousands of USD
3,500
3,000
2,500
2,000
1,500
1,000
500
Export Import (Export-Import)
0
1998 1999 2000 2001 2002 Jan-Aug '03
Chart Box 2.2.1
Indonesia»s Non-Oil/Gas Exports to China &
Indonesia»s Non-Oil/Gas Imports from China
that the Renminbi is undervalued, the US continues
to urge China to revalue its currency, which has been
pegged within a narrow range at RMB8.2774 per
USD1 since 1994.
Rising competitiveness of China»s products poses
a threat to other exporting countries, particularly in
the Asian region including Indonesia. China may
takeover export markets that were previously
dominated by other countries.
For Indonesia, the worst-case impact on
producers would be closing down their business. This
could trigger a rise in unemployment and undermine
businessmen»s ability to fulfill their financial obligations
to creditors and investors, which could upset financial
system stability. In addition, the poor investment
climate in Indonesia has diverted foreign investors to
China, thus hampering real sector recovery.
However, China is also an enormous potential
market. In addition to its amazing economic growth,
China accounts for more than 15% of world
population, far exceeding for instance, the European
Union (335 million). This potentially makes China a
15
 Chapter 2 Development of Domestic and International Economies Development Of Domestic

major new trading partner for Indonesia. Just when of quality and price. In this regard, the government of
the US and Japan economies are sluggish, China could Indonesia must be able to build the economic and
rescue Indonesia»s exporters. However, this requires legal infrastructure that will invigorate Indonesia»s
improvement in Indonesia»s competitiveness, in terms exports and attract foreign investors.

16
 Chapter 3 Development of The Banking Industry

Chapter 3
Development of
The Banking Industry

17
 Chapter 3 Development of The Banking Industry

18
 Chapter 3 Development of The Banking Industry

Chapter 3
Development of The Banking Industry

Stability of the banking industry during 2003 was

Trillions Unit
maintained largely due to the firm risks control faced by 1200 300

banks during the year. Credit risk was under control, while 1000 250

such problems that did occur had no significant impact 800 200

on financial system stability. Meanwhile, market risk was 600 150

100
quite moderate due to adequate capital, banks» relatively 400

50
small net foreign currency position, as well as stability of 200
Total Asset (left axis) Number of Bank (right axis)
0 0
the rupiah exchange rate and interest rates. The banking 1995 1996 1997 1998 1999 2000 2001 2002 Oct-03

industry still experienced excess liquidity, which was

Chart III.1
primarily invested in SBIs and the interbank money market, Number of Banks and Total Assets

resulted in optimum interest income. At the same time,

maturity mismatches at several recapitalization banks could
have created instability, if interest rates had fluctuated
excessively. In addition, operational risk was still considered
relatively high, due to quite weak implementation of risk
management and good governance within the banks,
which caused several incidents of fraud. In view of previous
year developments and the economic prospects for 2004,
banks» condition is expected to remain stable.
Nevertheless, several conditions warrant close review due
to their potential for hampering NPLs improvement.
Likewise, relatively high operational risk could disrupt
banking industry stability that is currently improving
through, among others, the Indonesian Banking
Architecture program √ IBA (Box III.1 : Indonesian Banking
Architecture, Blue Print and Strategic Directions in the
Future).
Since the crisis of 1997/98, the number of banks
has declined drastically. However, total assets of the
banking industry have expanded due to mergers between
several banks and the entry of one new foreign bank.
Within the Indonesian financial system, the banking
industry still dominates, with total assets amounting to
91% of the financial system»s total assets.
As of October 2003, the number of banks stood at
139 with total assets of Rp1,126.1 trillion. Of these banks,
15 banks accounted for 75.0% of total bank assets. Of
these total assets, 91.5% comprised earning assets that
were extremely sensitive to risks, particularly credit risk,
market risk, and liquidity risk. As the Indonesian banking
industry has not yet moved to universal banking, the largest
risk was still credit risk. The share of credits in earning
assets reached 41.5%; the shares of marketable securities,
placements in SBIs, placements in other banks, and
participations were 35.2%, 12.7%, 10.0%, and 0.6%,
respectively. Some 91.1% (Rp362.5 trillion) of total
marketable securities comprised recapitalization bonds.
3.1. COMMERCIAL BANKS
3.1.1. Credit Risk
In general, credit risk remained under control. Several
problems arose, but none had any meaningful impact on
banking system stability. However, credit risk is expected

19
 Chapter 3 Development of The Banking Industry

Box III. 1 Indonesian Banking Architecture, Blue Print and Strategic

Directions in the Future

The Indonesian Banking Architecture (IBA), which Capital

(Trillions Rp)
Bank Indonesia started to develop two years ago, is
finally completed. The development process has International
Bank
involved large resources and has taken into account
50
inputs and recommendations from various
stakeholders. On 9 January 2004, the BI Governor National Bank

announced that implementation will begin in 2004.

10
Banks with focuses on:

Sound, strong, and efficient banking system Regional Corporate Retail Others
to create financial system stability for
promotion of national economic growth

0.1
Effective and Bank with
Healthy
banking
independent Adequate Rural Banks limited scope of
supervisory infrastructure
structure activities
system

Effective Strong Robust

regulatory banking
system industry
Pillar 1 Pillar 2 Pillar 3 Pillar 4
The completion of IBA opens a new page in the
history of Indonesian banking. The IBA itself constitutes
policy directions as well as policy recommendations for
the national banking industry and is a follow-up to the
bank restructuring program that started in 1998. The
IBA has one very fundamental goal, which is to create
sound, strong, and efficient national banking industry
in support of financial system stability within the
framework of promoting national economic growth.
The IBA enables Indonesia to have a banking
industry that is strong in the short- and long-term, so
that the industry will be able to prevent or to absorb
internal and external shocks, such as the 1997/98
monetary crisis.
customer
protection The IBA is a blue print for future national banking
with six pillars that constitute important elements
Pillar 5 Pillar 6
related to banks» operational activities. These six pillars
are formulated into recommendations that can be
grouped into 19 initiatives or work programs that are
to be achieved.
The IBA itself has a clear vision as regards the
banking industry»s direction and structure within the
next ten to fifteen years. The national banking
structure in the long-term is expected to comprise
from 2 to 3 international-quality banks (international
champions), which have the capacity and ability to
operate regionally as well as internationally. In
addition, it is expected that within the next 10 √ 15
years there will be around 3 to 5 national banks
(national champions), which will have business
coverage all over Indonesia. Furthermore, in the long-
run it is also expected that there will be around 30-50

20
 Chapter 3 Development of The Banking Industry

banks that are focused players. They would have or regional banks). In addition to commercial banks,
narrow business activities, such as retail, corporate, described above, the national banking industry of the
or banks that are focused on fixed business segments future will be complemented by BPRs and banks with
(such as agriculture banks, banks for hajj pilgrimage, limited business activities.

to remain high in 2004 due to pressures on banks from
both internal and external sources.
On one hand, the Indonesian banking industry
seemed to be overly prudent in extending loans as reflected
in extremely slow loan growth and wide interest spreads.
In addition, alternative fund placements that were safer
and more profitable (such as SBIs) reduced banks»
motivation in loan extension. On the other hand, the real
sector»s demand for bank financing seemed subdued with
high undisbursed loans (90% in 25 banks) and declining
extensions of new loans. In addition, alternative funding
sources (bond and share issuance) have proven popular
with large corporations, which are mainly potential debtors
of banks.
On the external side, the economies of Indonesia»s
major trading partners (such as the US and Japan) have
been sluggish, and only early signs of recovery appeared
during much of 2003. However, it will take time for the
recovery to have much influence on demand for goods
exported from Indonesia. Moreover, if the available
opportunities are not well utilized, low competitiveness of
Indonesian producers will cause their business to
deteriorate, which in turn will weaken demand for
During 2003, bank credits 1 rose by Rp53.4
trillion, from Rp410.3 trillion (at the end of 2002) to
Rp463.7 trillion (October 2003). During this period,
new loans amounted to Rp53.6 trillion. Compared to
funds accumulation, banks» loan to deposit ratio
(LDR) was only 42.4%, far below its pre-crisis position
that averaged 75% (Chart III.2). However, growth in
loans was higher than in third-party funds, due in
large part to declining SBI and deposit rates (Box III.2
: Interest Rate Rigidity). These lower rates prompted
fund owners to shift their money from deposits to
other, more profitable investments such as mutual
funds. Meanwhile, on the loans side, growth was
quite slow as reflected in declining new loan
extensions and rising undisbursed loans (Box III.3 :
Undisbursed Loans).
Growth of loans during 2003 was largely bolstered
by performance of the national private commercial banks
1
Including channelling.
Trillion Rp Percentage
1,000,000 100
900,000 90
800,000 80
700,000 70

investment and working capital loans for exports. 600,000 60

500,000 50
400,000 40
300,000 30
Development of Bank Loan 200,000 20
Loan (left axis)
Loan expansion was largely boosted by an increase 100,000
LDR (right axis) Deposits (left axis)
10
0 0
in consumer loans and performance by the national private 1996 1997 1998 1999 2000 2001 2002 2003

commercial banks and the Regional Government banks Chart III.2

Development of LDR
(RGB).

21
 Chapter 3 Development of The Banking Industry

Box III. 2 Rigidity of Loan Interest Rates

Interest rates on SBIs and the guarantee ceiling and consumer loans were on average quite high at
have fallen sharply in recent quarters. By November 15.77%, 16.27% and 19.0%. Quite significant
2003, they were down to 8.38% (3 months) and declines only occurred for certain consumer loans such
7.28% (3-month deposits), respectively, and they have as KPM (motor-vehicle loans) and KPR (housing loans).
continued to fall. The banks followed this development For example, interest rates on KPR and KPM at certain
with adjustments to interest rates paid on third party banks were lowered to around 13% and 6.5% (for
funds for all tenors. As of October, the average interest the first year).
rates on savings, 1-month deposit, and 3-month Credit interest rate rigidity was caused by several
deposit stood at 5.71%, 7.47% and 7.96%, factors:
respectively. a. Banks» perceptions that loan risk remained high.
By contrast, banks have been slow to lower their This was related to various constraints faced by
loan interest rates as shown by the accompanying banks in improving their loan quality, particularly
graph. Interest rates on working capital, investment, in lowering their NPLs.
b. Banks, particularly recapitalization banks, have
Percentage
20
profit targets (RoE) set in their recapitalization
18
16 agreements with the government. Declines in their
14
12 incomes from SBI and recapitalization bonds put
10
8
pressure on banks to maintain high loan rates in
6
Interest Rate on Guarantee (3 Month) order to maintain their incomes.
4
Deposit (3 Month)
2
BI Certificates (3 Month)
c. The operational efficiency of Indonesian banks,
0
2001 2002 2003
particularly recapitalization banks, was still
Chart Box 3.2.1 relatively low. In addition, these banks were still
Interest Rates of Guarantees, SBIs & Deposits
in recovery and thus did not want to significantly

Percentage accelerate loan rate declines.

22
20 d. Demand for loans, particularly from the corporate
18
16 sector, was low as reflected, among others, in
14
12 quite large unused loan facilities (undisbursed
10
8 loans) and limited growth of investment and
6
4
Working Capital Loan working capital loans.
Investment Loan
2
0
Consumer Loan Therefore, there is a need for stimulus coming
2001 2002 2003
from real sector policies, so that declines in loan rates
Chart Box 3.2.2
can bolster a rise in demand for loans.
Loan Interest Rates (Average)

22
 Chapter 3 Development of The Banking Industry

and the RGB (Chart III.3). By sector, the main sources of
growth were consumer loans, particularly KPR (housing
loan) and KPM (motor-vehicle loan), with the largest
demand coming from individual borrowers.
Another factor that contributed to slow growth in
bank credits was the business strategy of foreign and joint
venture banks that did not focus their expansion on credit
channeling.
(28.9%), other (24.1%), trade (19.5%) and business
services (9.8%). The business services and other sectors
experienced quite significant growth recently, resulting
from quite high growth in consumer credits (Chart III.8).
Meanwhile, the main «engines of economic growth»,
Percentage
80

60
By economic sector, there was potential for further
40

deterioration in credits to the industrial sector, brought 20

0
on by worsening conditions in the textile and wood-
-20
processing industries. Nearly half of banks» NPLs originate -40

in these sectors. -60

Deposits Loan
-80
During 2003, there was no significant change in the 1997 1998 1999 2000 2001 2002 Jun Jul Aug Sep Oct

2003
distribution of credit by economic sector. As of October
Chart III.5
2003, banks» credits were still dominated by industry Growth of Credits & Funds

Percentage Percentage
100 60

80
40
60
20
40

20 0

0 -20
-20
-40
-40
State Owned Bank Private Bank -60
-60
Foreign & Joint Venture Regional Gov’t Bank
Individual Private Corporate
-80 -80
1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
2003
2003

Chart III.3 Chart III.6

Loan Growth by Bank Group Credit Growth by Debtor Group

Percentage
100
300,000
State Bank Private National Bank 80
Foreign & Joint Venture Regional Gov’t Bank
250,000 60

40
200,000
20

150,000 0

-20
100,000
-40
50,000 -60
Industry Trading Services Others
-80
0 1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
1996 1997 1998 1999 2000 2001 2002 2003
2003

Chart III.4 Chart III. 7

Outstanding Credit by Bank Group Credit Growth by Certain Economic Sectors (%)

23
 Chapter 3 Development of The Banking Industry

Box III. 3 Undisbursed Loans

Banks» outstanding credits continued to rise, and

16.4%
so did undisbursed loans. By percentage, undisbursed
loans increased even faster than outstanding credits.
During 2003 (January √ October), undisbursed
loans rose by 28.6%, while credits increased by only 9.6%

73.9%
13.6%. Total undisbursed loans reached 47.8% of
Working Capital Loan
2003 total new credits. Total undisbursed loans for
Investment Loan Consumer Loan
2003 reached Rp25.6 trillion compared to Rp19.1
Chart Box III.3.3
trillion (Jan-Oct 2002). By usage, working capital credit
Banks» Outstanding Credits, Undisbursed Loans &
was the largest (73.9%). New Loans (Trillion)

Trillion Rp
12 The largest undisbursed loans were owned by
10
8 the national private commercial bank group (38.8%),
6
4
followed by the state banks (26.8%) and the foreign
2
banks (26.7%). For information, 90.25% of total
0
-2 undisbursed loans belonged to 25 banks. Meanwhile,
-4
-6 by economic sector, the largest undisbursed loans were
-8
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct for industry and trade. The large size of undisbursed
2002 2003
New Loan Loan loans for the industrial sector showed that the economy

Chart Box III.3.1 has not developed in a robust manner, especially

New Loan Growth and Undisbursed Loans considering that industry is the main engine for
economic growth and absorbs the largest number of
16.4% 4.9% 2.9%
0.7% workers.
10.4% 34.8%
Debtors» main reason for not utilizing more of
the available credit is that business or economic
3.1% conditions are not conducive. Other factors are high
23.5% 0.4%
2.9%
Agriculture Mining Industry
credit rates (see Box : Rigidity of Credit Interest Rates);
Electricity Construction Trading
Transportation Services Social Services Others issues of continuous declines of interest rates; and
cheaper alternative sources of funds (e.g. issuance of
Chart Box III.3.2
Undisbursed Loans √ By Usage corporate bonds).

24
 Chapter 3 Development of The Banking Industry

Trillion Rp Percentage
250.0 80
Industry
60
Trading
200.0
Services 40
Others 20
150.0
0
100.0 -20

-40
50.0
-60
Investment Capital Working Consumer
- -80
1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
1996 1997 1998 1999 2000 2001 2002 2003
2002

Chart III. 8 Chart III. 10

Credit Development by Economic Sector Loan Growth by Usage

namely industry and agriculture, recorded the smallest
expansions in credit.
Credit risk in the industrial sector was the highest
with 10.5% of its credits being NPLs (total NPLs were only
7.8% of total assets). NPLs in this sector constituted 44.8%
of the banking industry»s total NPLs. In the future, this
figure could rise and become the trigger for systemic risk,
particularly with potentially deteriorating conditions in the
textile and wood & forestry industries.
On the side of uses of credit, the rapid expansion of
consumer credit has the potential to raise banks» NPLs in
the future should the economy deteriorate. Meanwhile,
although working capital NPLs were quite small, its share
in banks» total NPLs was the largest (45%) among uses of
credit.
Through October 2003, the composition of credit
by uses has not changed much. Banks» credits were still
dominated by working capital (54.0%), followed by
consumer (23.8%) and investment loans (22.2%).
Consumer loan had the highest rate of expansion, at
33.5% (y-o-y).
The large share of working capital in total credit is a
matter of concern because a failure in this type of credit
would have a major impact on overall credit performance.
Although working capital NPLs were only 6.7% of total
working capital credits (total NPLs were 7.8%), by value
they were 54.4% of total NPLs.
Meanwhile, investment credit NPLs were highest, at
10.9% of total investment credit. By contrast, consumer
credits were only 2.7%.

Trillion Rp Trillion
450,000 1.4
Investment
400,000
Working Capital 1.2
350,000
Consumer
1.0
300,000
250,000 0.8

200,000
0.6
150,000
0.4
100,000
50,000 0.2
Sub standard Doubtfull Loss
0 0.0
1996 1997 1998 1999 2000 2001 2002 2003 12/01 2/02 4/02 6/02 8/02 10/02 12/02 2/03 4/03 6/03 8/03 10/03

Chart III. 9 Chart III. 11

Loan Development by Usage NPLs of Consumer Loans

25
 Chapter 3 Development of The Banking Industry

As credit growth illustrates, economic growth has
been concentrated in areas boosted by consumer credit.
On the other hand, investment and working capital credits,
which were supposed to support engines of economic
growth (investment and exports), have performed poorly.
The large share of consumer credits and the recent
downward trend in new credits suggest that the Indonesian
economy has not fully recovered to its pre-crisis condition.
New credit extensions during 2003 tended to decline
after mid-year. During 2003 (up to October 2003), new
credit extensions were Rp53.6 trillion with the shares of KI
(investment credits), KMK (working capital credits) and KK
(consumption credits) at 27.4%, 54.3% and 18.3%,
respectively. This total was considerably smaller than during
the comparable period in 2002 (Rp63.5 trillion). During
2004, the general election is expected to boost money-in-
circulation and consumption, which points towards
consumer credits as the continuing leader in banks» credit
growth.
As regards property credit, the relatively large increase
in housing credits warrants close monitoring. Based on
experience, the quality of housing credits is sensitive to
the cycle in economic growth.
Although housing credit NPLs averaged less than 5%
in 2003, the rising trend in housing credits needs to be
monitored carefully. Company shutdowns and factory
relocations to other countries are a few examples of events
that can result in significant employee layoffs. In such
circumstances, employees would have difficulty in making
on-time repayments on housing credits. As is the case for
consumer credits, deteriorating economic conditions could
raise housing credit NPLs.

Trillion Rp
Billion 90
900 Property
Agriculture Construction 80
800 Construction
Mining Transportation 70
700 Real Estate
60
600 Housing
50
500
40
400
30
300
20
200
10
100
0
0 1996 1997 1998 1999 2000 2001 2002 2003
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov

Chart III.12 Chart III.14

New Loans by Economic Sector Development of Property Loans

Billion Rp Percentage (y-oy)

7,000 40

Working Capital Loans

6,000 20
Investment Loans
5,000
0
Consumer Loans
4,000
-20
3,000
-40
2,000
-60
1,000 Property Real Estate
Construction Housing
0 -80
Jan Feb Mar Apr May Jun Jul Aug Sep Oct 1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
2003

Chart III.13 Chart III.15

2003 New Loans by Usage Growth (y to y) of Property Sector (%)

26
 Chapter 3 Development of The Banking Industry

Boks III. 4 Capital’s Resilience To Credit Expansion

On the assumption that total credits at 15 large This analysis indicates that when there is a 20%
banks will rise 20% (Rp92.6 trillion) from its position rise in credits, large banks» CARs will decline, but
as of October 2003 (Rp463.7 trillion), the average CAR remain at a safe level. This is supported by these 15
of these banks would drop by 2.8% (the highest being banks» fund placements in SBIs are quite large, i.e.
5.2%, the lowest 1.8%). However, no bank would Rp86.3 trillion; trade portfolio bonds amounting to
have a CAR below 8% (Chart). Rp65.1 trillion; and their excess provisioning in the
amount of Rp11.3 trillion (a total of Rp162.7 trillion).
Percentage All have the potential to be converted to credits
40
CAR New CAR
35 quickly.
30
From this illustration, there is no problem on the
25

20 supply side if banks channel significantly more credits.

15
However, on the demand side, there is a difficulty in
10
5
relation to uncertainty about potential debtors»
0 capacity to absorb more credit. In this regard, it should
A B C D E F G H I J K L M N O

be noted that new credit extensions were declining

Chart Box 3.4.1
CAR with 20% Credit Increase during 2003 while undisbursed loans were rising.

Judging from developments during 2003, the Non-Performing Loans (NPLs)

property industry grew rapidly, marked by vigorous
construction of malls, house-shop buildings and offices in
the Jabotabek area as well as in several provincial cities.
Nonetheless, the share of property credits remained
relatively small. Funds used by construction developers
mostly come from non-bank sources, such as own funds,
issuance of bonds or foreign loans.
However, property credits (construction, real estate,
and housing credits) expanded rapidly during 2003,
largely spurred by the high demand for housing. As of
October 2003, total property credit reached Rp43.9 trillion
or 9.5% of banks» total credits. Of total property credit,
the share of housing was 63.8%; construction and real-
estate credits accounted for 22.0% and 14.3%,
respectively.
Concerning the quality of credit, banks» NPLs declined
during 2003. However, 2004 could be quite different,
based upon the following considerations: (i) the quality of
credits could decline due to (restructured and
unrestructured) credits purchased from IBRA; (ii) the rising
trend of (gross and net) NPLs owned by state banks in the
last several months; and (iii) indications that NPLs are higher
than reported, as suggested by higher-than-required
Provisions for Earning Assets Losses (PEAL).
This NPL problem has the potential to generate
systemic risk, because CARs are sensitive to changes in
NPLs. In addition, pressures from credit concentration are
also quite high, considering that: (i) credit concentrated2
2
Credit concentration to 25 large debtors at large banks was 26.1%, with NPLs averaging
9.1% (industry-wide NPLs were 7.8%). Total credits extended to these debtors reached
98.9% of the capital of these banks.

27
 Chapter 3 Development of The Banking Industry

in the 25 largest debtors at large banks had NPLs higher
than banks» average for NPLs; and (ii) NPLs of the industrial
sector (which has the largest share of credits) were also
higher than banks» average for NPLs 3 .
NPLs were relatively high in 2003, as the economy
has not fully recovered from the crisis of 1997/98. The
banking industry adjusted to this situation with large
amounts of provisioning (PEAL). However, credit risk was
lower in 2003 (with a slight downward trend in the last
few months) compared to the previous year. Banks» NPLs
in gross and net terms averaged 8.1% and 1.1%,
respectively compared with 11.5% and 3.8%, respectively,
in 2002.
In 2004, NPLs are expected to be on an upward trend,
primarily due to a weakening trend in the quality of
restructured credits and an end to the grace period on
classification of credits purchased from IBRA. In addition,
structural problems (such as legal uncertainty, regulations
and their enforcement, and a disappointing economic
banks» and auditors» calculations of collectibility,
provisioning that exceeds requirements, and the
classification of ex-IBRA restructured credits as being
≈current∆. Analysis using more conservative ratios
presents a different picture. For example, the ratios of
NPLs to total capital and to core capital average of
33.0% and 42.0%, respectively. Although there are no
well-defined benchmarks for these ratios, Indonesian
banks» NPLs are clearly high compared to capital (Box
III.5 NPL Stress Test). However, in the short term, banks»
capital ratio (CAR) is not expected to be influenced much
by these NPLs, because banks have generally provisioned
(PEAL) in larger amounts than required (Box III.6
Provisions for Earning Asset Losses).
By bank group, the joint venture banks had the
highest NPL ratio of 13.4%. This was due to these banks»
Percentage
80
60

recovery to date) will continue to hinder banks from 40

20
improving their NPLs.
0

Currently, banks» NPLs are believed to be higher -20

-40
than reported. This is supported by the number of Current Special Mention Sub Standard
-60
occasions when discrepancies have arisen between -80
Doubtfull Loss
1997 1998 1999 2000 2001 2002 Jan Feb Mar Apr May Jun Jul Aug Sep Oct
2003

Chart III.17
Percentage Trillion Rp
Growth of Loans Classification
20 500
18 450
16 400 Trillion Trillion
14 350 500 160
Current (left axis)
12 300 Special Mention (right axis) 140
400
10 250 Sub Standard (right axis)
120
Doubtfull (right axis)
8 200 300
Loss (right axis) 100
6 150
4 100 200 80

2 50 60
100
0 0
Dec Jun Dec Jun Dec Jun Oct 40
2000 2001 2003 2003 0
20
NPLs Gross NPLs Net NPLs Nominal Loan
-100 0
1996 1997 1998 1999 2000 2001 2002 2003
Chart III. 16
Non Performing Loans
Chart III.18
3
Development of Outstanding NPLs
The industrial sector»s NPLs reached 10.5% (average NPLs were 7.8%); its credit share
was 28.9% (the largest).

28
 Chapter 3 Development of The Banking Industry

Box III. 5 Stress Test of NPLs Impact on Capital

CAR (%)
Results of stress tests indicate that two banks are 20

relatively sensitive to rising NPLs. Considering that these 15

two are large banks, rising NPLs would have quite an 10

influence on the financial system stability. 5

To access the impact of a decline in credit quality 0

on capital (CAR), a stress test was conducted on 15 B D H N 15 BB

-5
Start 10 15 20 25 30 35 40 45 50
large banks using a number of hypothetical scenarios NPL Decreasing Scenario (percentage)

(rises of NPLs from 5% up to 50%) from a base CAR Chart Box 3.5.1 Stress Test of NPLs Impact on CAR

as of October 2003. Results of the stress test using (1 state bank and 1 national private commercial bank)

rises in NPLs of 10% and 30% indicated that 2 banks would have CARs below 8%.

Box III. 6 Provisions for Earning Assets Losses (PEAL)

Although gross NPLs are relatively high, in the Trillion Rp

800
Loan NPL Provision
short-term this will not have a negative impact on 700

600
financial system stability, considering that reserves are
500
high enough to cover potential losses. 400

Overall provisions (PEAL) at Indonesian banks are 300

200
quite high, 127.8% of requirements, indicating that
100
banks are very conservative in anticipating credit risk. 0
1996 1997 1998 1999 2000 2001 2002 2003
However, this also reflects banks» lack of confidence
Chart Box III.6.1
in the quality and prospects of their credits, including Development of NPLs & PEAL
in Indonesia»s economic prospects. In addition, this Percentage
300
suggests that the credit performance of banks in
250
Indonesia is not yet optimal because excessive PEAL is
200
substituting for efforts to reduce NPLs (net). On the
150
other hand, this situation also shows the opportunities
100

for banks to channel more credits. 50

The high PEAL ratio is due to the provisioning at 0

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

15 large banks, where the average provisioning against Provision made by bank/ Provision for NPL/NPL
Required PEAL

credits reached 147.8%, with a very large range (the Chart Box III.6.2
lowest being 58.4%, the highest 269.5%). PEAL for Loans & Channeling

29
 Chapter 3 Development of The Banking Industry

Table III. 1 Table III. 2

NPLs by Bank Group Loans Concentration on 25 Largest Debtors (LD)
Percentage Percentage
2002 2003 NPLs Gross
25 largest
Group October December October Bank debtors to NPL of 25 LD to NPL of 25 LD to
Gross Net Gross Net Gross Net total loan (%) Bank total loans of total
25 LD Banks Loans
State Owned Bank 8.52 1.90 6.83 1.47 8.68 2.01 A 24.4 8.5 0.0 0.0
Recapitalization Bank 24.31 9.81 8.36 3.74 7.00 -0.47 B 32.8 2.2 4.7 1.5
Bank A Category 5.18 1.29 5.20 2.33 4.36 0.82 C 25.3 5.2 22.1 5.6
D 1.6 3.8 25.8 0.4
Taken Over Bank 4.87 0.10 6.53 0.79 6.08 -2.30 E 12.5 12.7 21.3 2.7
Regional Gov» Bank 6.38 4.72 5.24 4.14 4.67 3.72 F 48.6 11.9 19.1 9.3
Joint Venture Bank 22.91 10.191 8.62 6.481 3.45 3.92 G 32.8 3.7 0.0 0.0
H 24.2 16.4 27.0 6.5
Foreign Bank 19.8 12.76 16.14 2.12 11.89 1.07 I 41.7 17.1 34.7 14.5
J 86.0 6.1 0.0 0.0
K 11.9 1.0 0.0 0.0
NPLs having undergone credit restructuring by the banks L 22.2 4.5 5.5 1.2
M 24.4 4.4 5.4 1.3
themselves during the crisis period because their capital N 28.2 2.0 5.5 1.6
AVERAGE 26.1 7.6 9.1 2.4
was quite large. Low NPLs of other bank groups were
due to the transfer of these banks» NPLs to IBRA during Indonesia»s, as reflected in their stronger ratings and
recapitalization. lower sovereign risk.
NPLs at the state banks need to be monitored closely. Loan concentration in the 25 largest debtors is quite
In gross and net terms, their NPLs rose markedly from end- high and needs to be closely watched; when the quality
2002 through October 2003, from 6.83% and 1.47% to of their credit deteriorates, it will directly lower banks»
8.68% and 2.01%, respectively. Credits increased by capital.
10.5% and NPLs by 40.5%. Credit concentration in the 25 largest debtors at 14
In general, Indonesian banks» NPLs are lower than large banks was quite high, on average reaching 26.1%
those of several other Asian countries, such as Malaysia, of total credits with NPLs at an average of 9.1% of total
Thailand, and the Philippines (October 2003). However, credits extended to those debtors. In general, those 25
this further supports suspicions that NPLs in Indonesia largest debtors» NPLs were in the manufacturing sector
are under-reported, considering that economic (plastics, paper, shoes, wood, cement, gas, and textiles)
conditions of those countries are generally better than and plantations.

Asian Countries NPL Gross

Percentage New Zealand
45 South Korea
43 Hong Kong
41 Taiwan
39 Singapore
Japan
37
Indonesia
35
India
33
Malaysia
31 Thailand
29 Philippines
NPL/Capital
27 China
NPL/Tier I
25 0 5 10 15 20 25
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
Percentage
2002 2003
Source: ADB - personal website

Chart III. 19 Chart III. 20

2003 Ratio of NPLs to Capital Gross NPLs of Asian Countries

30

Percentage
300
25 Largest debtors to Capital
25 Largest debtors to Tier I
250
200
150
100
50
0
A B C D E F G H I K
Chart III. 21
Ratio of 25 Largest Debtors» to
Capital √ August 2003
Credits extended to these 25 large debtors averaged
98.9% of these banks» total capital with quite a wide range
between the lowest of 16.6% (bank D) and the highest of
1,304.7% (bank J). Compared to core capital, this ratio
was 137.7% (the lowest at 20.5% and the highest at
1,447.2%).
These high ratios indicate that bank credit risk is
still quite high. Should credits extended to these large
debtors become non-performing, the entire capital of
these banks will be consumed and could become
negative. Results of stress tests indicate that, if all credits
extended to large debtors at these 14 banks become non-
performing, only 3 banks would maintain a CAR above
8%. Among the others, 2 banks would have CARs
between 0-8% and 9 banks would have negative CARs.
These results warrant close attention, because the average
performance of the large debtors at these 14 banks is
less satisfactory than those of other debtors; NPLs of the
largest 25 debtors (9.1%) are higher than the banking
industry»s average NPLs (7.8%).
Quality of Restructured Loans
There is potential for a decline in the quality of
restructured credits, which would raise NPLs significantly
due to the large amounts involved.
Chapter 3 Development of The Banking Industry
As of August 2002, restructured credits held by
26 banks reached Rp14.5 trillion (12.0% of banks» total
credits), comprising performing loans of Rp10.3 trillion
and NPLs of Rp4.2 trillion. This total amount is quite
sizable and could have a significant impact on these
banks» condition should the quality of restructured
credits deteriorate again. This has been demonstrated
L M N
through a stress test under a worst-case scenario, where
all performing loans were changed to non-performing.
The result showed 2 banks would have CARs below 8%,
while 2 other banks would have negative CARs. This
result is worrisome because of the condition of the
restructured credits, particularly those coming from IBRA.
These credits are scheduled to have their quality re-
evaluated at the end of a 1-year grace period, because
they were originally automatically categorized as
performing loans.
3.1.2. Liquidity Risk
During 2003, bank liquidity condition was generally
adequate, as reflected in the upward trend in ratios of
liquid assets to short-term liabilities and to total assets.
Indeed, banks still experience excess liquidity, which has
largely been invested in interbank placements and
marketable securities, particularly SBIs. Several problems
could develop and put pressures on banks» liquidity,
including: a funding structure that concentrates on short-
term funds; large deposits and core depositors; banks»
medium-term payment obligations; and the development
of mutual funds. Meanwhile, banks need to anticipate
the possibility of funds migration as the blanket guarantee
program is removed, as it is planned to cover up to a
maximum of Rp100 million for each bank customer at
each bank.
With declining interest rates, there is potential for
the shifting of deposits from banks to the capital market.
This could endanger banks» liquidity considering that bank
31
 Chapter 3 Development of The Banking Industry

Trillion of Rp Percentage
Rp Trillion 500 60
1,000
Marketable Securities Interbank Liabilities
450 55
Borrowed funds Deposits 12
11
950 11 400 50
4 7 7 9
4 4 4 7
66
350 45
900 71
72 67 300 40
81 79 80 76
84 82 81 7
7 250 35
7 7
850 14 6 200 30
12 9 9 8 6
863 879 150 25
800 852
847 858 100 20
836 832 833 838 838 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
825
2002 2003
750
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Checking Accounts (IDR) Time Deposit (IDR) Saving Accounts (IDR)
2002 2003 Checking Accounts (%) Time Deposit (%) Saving Accounts (%)

Chart III. 22 Chart III. 23

Banks» Funding Structure Structure of Third Party Funds

assets are dominated by loans, which cannot be liquidated This development is also related to the rapid expansion of
quickly. mutual funds through September 2003. These attracted
In 2003, bank»s funding structure was still dominated large amounts of banks» third party funds, particularly
4
by third-party funds , particularly deposits. As of October deposits (Table III.3).
2003, third party funds reached 91.2% of total funding, Rapid development of mutual funds is reflected in
followed by interbank placements (6.8%), marketable their continuous, rapid rise in net asset value (NAV), which
securities (1.3%), and borrowed funds (0.7%). The shares has indirectly affected banks» deposits. With the downward
of third party funds and marketable securities have trend in SBI interest rates (which influences deposit interest
increased since end-2002 (Chart III.22). rates), customers have sought alternative placements with
Banks» third party funds, which are dominated by higher returns.
deposits, trended upwards during much of 2003, after The structure of banks» funding source is relatively
having dropped in the first month in the year. However, unbalanced, as reflected in: (i) banks» high dependence
since July 2003, the share of deposits has dropped on short-term deposits (up to 3 months); (ii) relatively large
continuously partly mirroring rising shares of current amount deposits owned by certain depositors; and (iii) a
accounts and savings in total third party funds (Chart III.23). high concentration in large depositors.
As of October 2003, 3-month deposits reached
4
Comprising current accounts, deposits, and savings accounts. 81.4% of total deposits or 40.5% of total third party funds

Table III.3
Development of Third Party Funds and NAV
Trillion Rp

1996 1997 1998 1999 2000 2001 2002 Jan»03 Feb»03 Mar»03 Apr»03 May»03 Jun»03 Jul»03 Aug»03 Sep»03 Oct»03

NAV 2.78 4.92 2.99 4.97 5.52 8.00 46.6 51.1 54.7 58.4 61.3 65.3 68.4 76.9 81.3 85.9 79.2
Deposits 303.21 400.35 625.33 617.64 699.11 797.36 835.8 824.6 832.0 833.4 837.8 838.1 846.8 852.2 858.0 863.5 879.4
- Checking
Account 59.49 86.40 99.78 111.83 161.47 186.15 197.0 186.2 188.3 189.9 191.9 194.8 202.0 203.8 208.0 217.6 222.8
- Saving
Account 61.57 67.99 68.69 122.98 152.94 171.30 192.6 188.7 189.1 189.4 192.9 196.9 201.6 204.0 209.7 213.2 219.3
- Time
Deposits 182.15 245.96 456.86 382.83 384.70 439.91 446.2 449.8 454.5 454.1 453.1 446.4 443.2 444.4 440.4 432.7 437.3

32
 Chapter 3 Development of The Banking Industry

Banks» dependence on certain depositorsƒnamely

Percentage
100 4.0 5.1 8.7 state-owned companies, insurance companies, and
90 7.5 7.6
7.1 6.7 9.9
80
8.5 pension fundsƒhas remained quite significant despite a
70
60 downward trend. As of October 2003, the share of these
50
40 81.4 80.6
72.9
depositors accounted for 10.3% of total third party funds
30
20
(Chart III.25). Similarly, the shares of State-owned
10
Comapnies, Insurance Companies and Pension Funds at
0
Industry 15 BigBanks State Banks
up to 3 month 3 to 6 month 6 to 12 month over 12 month
15 large banks and state banks was quite significant,
reaching 11.1% and 16.6%, respectively. At 5 banks,
Chart III. 24
Composition of Time Deposits by Tenor these depositors exceeded the average for the banking
industry; at 1 bank, they represented 40.5% of that bank»s

(Chart III.24). Most of these funds were denominated in third party funds (Chart III.26).

rupiah (65.6% of total deposits); those denominated in Concentration of banks» fund sources in large

foreign currencies amounted to 15.8% of total deposits. deposits is also relatively high. As of October 2003, total

Of total short-term deposits, 74.3% was placed at 15 large large deposits (with value above Rp100 million) accounted

banks. for 79.2% of total deposits, or 20.5% of total number of

Despite such conditions, banks are expected to accounts (Chart III.27). There were 9 large banks that had

stop their maturity profile structure gaps from becoming concentrations of large depositors exceeding that ratio.

too wide, which will give banks adequate time to Banks with relatively high concentrations of deposit

anticipate possible migration of deposits to the capital ownership are expected to take anticipatory steps to

market. implement liquidity risk mitigation techniques.

Large depositors and certain other depositors are Banks» heavy dependence on third party funds

generally market-sensitive. They tend to withdraw their (particularly short-term deposits) reflects in part depositors»

funds quickly when conditions are considered cautious attitudes. But it also indicates a situation where

unprofitable. banks face a risk of funds withdrawals in large amounts,

Billion Rp Percentage
% over Deposits
40,000 45
12 % over Deposits
35,000 40
State Company (1) Private Insurance Company (2)
10 Core Depositors 35
30,000
Pension Funds (3) 30
8 25,000 25
20,000 20
6
15,000 15
4 10
10,000
5
2 5,000 0
- -5
0 A B C D E F G H I J K L M N O
May Jun Jul Aug Sep Oct BANK
2003

Chart III. 25 Chart III. 26

Ownership of Third Party Funds by Core Depositors Third Party Funds Ownership
at 15 Big Banks

33
 Chapter 3 Development of The Banking Industry

Percentage
100 3
Percentage
5 6
8 30
90 18 17 14 17 16
21 24 22 24 21
26
80 35 25
47
70
60 20
50
92 95 97 94 15
40 82 83 86 83 84
79 76 78 76 79
74
30 65 10
53
20
10 5
Liquid Assets/Total assets Liquid Assets/short-term deposits
0 A B C D E F G H I J K L M N O 15 BB Industry 0
BANK Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
% nom > 100 Million % nom < 100 Million 2002 2003

Chart III. 27 Chart III.28

Composition of Time Deposits by Amount Liquid Asset Ratio

Percentage
100
Loan/Deposits Loan/Funding
if these funds are not rolled over upon maturity. This can Investment/Funding Investment/Deposits
88 87 88 88
90 85
87
83 85 85
put severe liquidity pressures on a bank. However, in the 79
82

80
light of current development of the bond market, which is 76 76 76
79 80 79 80 80

70 74 75
71
characterized by increasing numbers of banks issuing bonds,
60
52 52 53 53
50 51 51 51
banks» funding structure is expected to improve, which 49 49 49
50

would reduce their dependence on short-term funding. 40

44 44 44 45 46 46 46 47 47 48 48

Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
A high concentration in large depositors has similar 2002 2003

potential for disrupting banks» liquidity, especially in the Graph III.29

context of a continuous downward trend in deposit rates.
Another factor that needs to be considered is elimination
of the blanket deposit guarantee, which will be replaced
in part by a ceiling of Rp100 million per customer in each
bank. This might prompt customers to divide their funds
and place them in several banks and thereby cause fund
migration from bank to bank. Another implication is the
possible migration of these funds outside the banking
industry (Box III.7 : Implications of Implementation of The
New Guarantee Scheme).
Excess liquidity at banks will cause them to be
inefficient, considering that incomes from SBIs and the
interbank money market do not carry high margins.
Banks» liquidity during 2003 was adequate, indeed,
many were over-liquid. This was reflected in a rising liquid
asset ratio5 compared to its position at end-2002. Also,
banks» total liquid assets amount to nearly one fifth of
5
Cash, current accounts at BI, and SBIs.
Ratio of Funds Channelled over Funds Sources
their total assets (Chart III.28). In addition, a relatively
low percentage of third party funds and other fund
sources were channeled to credits (Chart III.29). Excess
funds were generally placed in marketable securities,
particularly SBIs, and interbank placements. The liquid
asset ratio in semester II/2003 was relatively slower after
having dropped at the beginning of quarter II/2003.
As of October 2003, the ratio of liquid assets to short-
term liabilities6 at 15 large banks was lower than the
banking industry»s average (Chart III.30). Also, it was down
slightly from semester I/2003, with most of these banks
recording a drop in the ratio. At 2 banks the ratio dropped
quite sizably due to a decline in SBI holdings.
A simple stress test conducted on banks» reserves
showed that the state bank group has considerable
6
Current accounts, savings, and deposits of up to 3 months» maturity

34
 Chapter 3 Development of The Banking Industry

Box III. 7 Implications of Implementation of The New Guarantee

Scheme

If not implemented effectively, the new guarantee
scheme, which limits deposit balances to a planned
maximum of Rp100 million per customer in each bank,
could trigger migration of deposits between banks or
outside the banking industry. This has the potential to
damage bank liquidity.
Results of a simple simulation on 15 large banks
shows that, in general, funds that will migrate between
banks could reach more than 30% of total third party
funds. This estimate is derived from the assumption
that the guarantee ceiling is Rp100 million and that
deposits in excess of this amount are transferred to other
banks or outside the banking industry (worst-case
scenario). Total estimated funds that could migrate
would still be fully covered by banks» liquid assets1 in
Trillion Rp
80
Outflow
70
aggregate and at the 15 large bank group (using
October 2003 data). Nevertheless, there would be 8
large banks whose liquid assets would not be adequate
to cover migrated funds.
A moderate-case scenario uses the assumption
that customers will split their funds, leaving 50% in
the same bank and transferring the rest of the funds
to another bank or outside the banking industry. In
this case, funds that might migrate from the 15 large
bank group and the banking industry are 18.6% and
19.7%, respectively. On an individual bank basis, there
would be 5 large banks with the potential for funds
migration of more than 30% of third party funds; only
2 banks have insufficient liquid assets to cover the
migrated funds.
Although possible funds migration can be
Liquid Assets covered by banks» liquid assets, in the long run such

60
migration has the potential to cause problems, because
50 of fund migration from perceived good banks to
40
perceived bad banks. Total funds that are estimated to
30

20
migrate from 15 large banks would be in the range of
10 8.1% to 61.7% of total third party funds (worst-case
-
A B C D E F G H I J K L M N O scenario), which would have a significant influence on
Chart Box 3.7.1 these banks.
Comparison of Deposit Outflows To Liquid Assets
at 15 Big Banks
1 Comprising primary and secondary reserves.

potential for experiencing liquidity pressures, if customers group. If NCD withdrawals are 50% of third party funds
were to make large withdrawals. (worst-case scenario), liquid assets cannot cover NCD
A simple stress tests indicates the potential for withdrawals (Chart III.31).
liquidity problems. If non-core deposits (NCD) are 30% of Result of this stress test illustrates that banks hold
third party funds7 (the moderate-case scenario), banks» relatively small amounts of liquid assets, particularly large
liquid assets8 can cover NCD withdrawals, for the whole
7
Current accounts, savings, and deposits
industry and the 15 large banks, but not for the state bank 8
Primary and secondary reserves.

35
 Chapter 3 Development of The Banking Industry

development of mutual funds. Meanwhile, liquidity risk

Percentage
60 will be moderate on a rising trend due to certain issues,
I
50 such as an unsound funding composition (which is heavily
K
40 concentrated in large depositors, certain other depositors,
F
30
G Industry and short-term deposits) and relatively large amounts of
A N
20 C
B M 15 Big Banks foreign currency liabilities that will fall due after 2003 at
E J L
10 D
H O several banks. The Government plan to implement a new
0
BANK guarantee program (with a ceiling on amounts covered)
Chart III.30 also has the potential to put pressure on banks» liquidity.
Ratio of Liquid Assets to Short-Term Liabilities
at 15 Big Banks Moreover, the over-liquid condition that has occurred in
2003 is estimated to continue in 2004, because banks are
banks. Shocks, such as a bank run, will put pressure on likely to continue facing difficulties in channeling their
banks» liquidity. Under a worst-case scenario, only 3 large funds in the form of credits.
banks would have liquid assets that exceed their NCDs. In relation to banks» relatively unsound funding
Under a moderate-case scenario, 10 large banks would composition and the expanding bond market, banks need
have liquid assets that exceed their NCDs. Taking all existing to improve their funding structure, among others through
9
reserves into account, 3 large banks have the potential issuance of long-term bonds, while still observing
for liquidity pressures because their total reserves are prudential principles. Concerning several issues that have
smaller than NCDs (under a worst-case scenario); 1 bank the potential to put pressures on liquidity, banks should
has the potential to not cover withdrawals of its NCDs be encouraged to improve their structure, especially with
(under a moderate-case scenario). the approach of the new guarantee scheme that will
Bank liquidity, which was quite adequate during replace the blanket guarantee program. In order for the
2003, is expected to remain stable in 2004. Similarly third new guarantee program to operate effectively and to
party funds would remain stable with an upward trend as reduce the potential for deposits to migrate outside the
in 2003. However, banks» deposits are expected to come banking industry, the government guarantee program
under pressure from declining SBI rates and the could be gradually eliminated, with consideration to the
public»s response.
Percentage
400
50% Deposits
350
30% Deposits 3.1.3. Profitability
300

250
In general, the banking industry»s profitability in 2003
200 improved as measured by indicators such as the net interest
150
margin (NIM) and the return on assets (ROA). The banking
100

50 industry»s NIM10 jumped from 0.4% in January 2003 to

0
3.8% in October 2003. Similarly, the banking industry»s
State banks
Industry

A B C D E F G H I J K L M N O 15
BB

ROA rose from 1.9% in December 2002 to 2.2% in January

Chart III. 31
Non-Core Deposits to Liquid Assets 9
Primary, secondary, and tertiary reserves.
10
Net Interest Margin (NIM) (%) : Net Interest Income/Earning Assets

36
 Chapter 3 Development of The Banking Industry

Trillion Rp Percentage
100
25.00

80
15.00
60

5.00
40

(5.00) 20

NII Interest Income Interest expense

0
(15.00) Jan Feb Mar Apr May Jun Jul Aug Sep Oct
Dec DecDec Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct
98 99 00 01 02 02 02 02 02 02 03 03 03 03 03 2003
BI Sertificate Securities Loan Other

Chart III. 32 Chart III.33

Development of Net Interest Income Composition of Interest Income at 15 Big Banks

Percentage
100
2003 and 2.4% as of September 2003, before slipping a
80
little in October 2003 to 2.3%.
60
There has been a pronounced downward trend in
40
interest income from SBIs and bonds during 2003. At the
same time, interest income from credits rose, albeit on a 20

relatively slow trend. 0

Jan Feb Mar Apr May Jun Jul Ags Sep Oct
2003
Since the beginning of 2003, banks» interest income BI Sertificate Securities Loan Other

and expense tended to decline in line with falling SBI rates.

Chart III.34
However, banks still managed to maintain their net interest Composition Interest Income - 2003

income (NII) during 2003 at between Rp3.8 trillion to Rp4.5

trillion per month (Chart III.32). This was due to the banks» As the decline in SBI rates moderates, the banking
ability to maintain quite a large spread between interest industry»s profitability in 2004 would be relatively stable.
rates on credits and rates on third party funds. The decline in interest income from SBIs and recapitalization
The composition of the banking industry»s interest bonds will continue, but at a slower pace than in 2003.
income was still dominated by interest income from SBIs Banks» operational efficiency has not shown any
and marketable securities, particularly recapitalization meaningful change as evidenced by their ratio of
bonds. For the whole banking industry, interest income operational income to operational expense (OIOE). As of
from SBIs and bonds remained in a range of 44% - 47% September 2003, banks» OIOE reached 90.29%, before
of total interest income; for the 15 large bank group, it slipping a bit to 89.92% in October 2003. The most
ranged from 42% √ 54%. inefficient bank group was the recapitalization bank group
However, as SBI rates declined, signs began to with an OIOE of 99.08%, followed by the state bank group
emerge of a gradual shift in interest income from SBIs and with an OIOE of 94.04%; the 15 large bank group had an
bonds to interest income from credits. This was the case OIOE of 87.66%. The joint venture and foreign bank
for both the 15 large banks (Chart III.33) and the entire groups remained to be the most efficient with OIOE of
banking industry (Chart III.34). 75.51% and 83.56%, respectively.

37
 Chapter 3 Development of The Banking Industry

Percentage
Percentage Percentage 50
120 30

100 0
25

80 20 -50

60 15
-100

40 10 Phillipines
-150
Malaysia Indonesia
20 5
Thailand South Korea
-200
0 0 1995 1996 1997 1998 1999 2000 2001 2002 2003

INDUSTRY
State-Owned
A B C D E F G H I J K L M N O

15 Big Bank
Operational Expense/Income (left axis) Source : ARIC - ADB
Interest Income : Over Head Cost (right axis)

bank
Chart III.35 Chart III.37
Efficiency Ratio Development of ROA in 5 Asian Countries

Another indicator, the cost efficiency ratio (CER11 ), 3.1.4. Capital

showed that state banks were less efficient than the The banking industry»s capital ratio was quite adequate
industry average (Chart III.35). Therefore, the operational as reflected in the aggregate CAR,12 which averaged 20.6%
efficiency enhancement program at state banks needs to as of October 2003. During the period from January to
be implemented more seriously. September 2003, banks» CAR averaged more than 20%.
The banking industry needs to step up its However, banks» aggregate CAR would decline if market
operational efficiency through, among others, and operational risks are included in the calculation.
improvement of work processes, reorganizations, and Banks» capital in 2004 is estimated to have declined
shedding less-productive activities. However, compared slightly due to a rise in risk-weighted assets (ATMR), in
with banks in several neighboring countries (Thailand, line with credit growth. Meanwhile, banks» internal
Malaysia, and South Korea), Indonesia»s banking industry capitalization capacity will remain relatively low due to
as measured by return on asset (ROA) was more inefficient operations, relatively high operational risks, and
profitable, as illustrated by Chart III.37. relatively low profitability.
11
Ratio of overhead cost (personnel, training, and rent expenses) to non-operational income. During 2003, the banking industry»s average CAR
12
Aggregate CAR = Banks» Total Capital/Banks» Total ATMR
was above 20%, with considerable variation by bank

Percentage group. The joint venture bank group»s average CAR was
96
State-Owned Bank Recapitalization Bank
the highest at 32.47%, followed by the national private
86
All Bank foreign-currency banks at 22.81%, the state banks at
76
18.96%, the BPDs at 18.57%, the foreign banks at
66
17.60%, and private non-foreign currency banks at
56
15.61%. Banks» CAR dropped a bit compared to previous
46
months due to a rise in risk-weighted assets (ATMR), in
36
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
2002 2003 line with higher earning assets, particularly credits, coupled
Graph III.36 with a decline in marketable securities (mainly SBIs and
CER Comparison
recapitalization bonds; Chart III.38).

38
 Chapter 3 Development of The Banking Industry

Percentage
580 420 140
Interbank (right axis)
560 2.40 410 130
BI Sertificates (right axis)
2.30 400 120
540
2.20 390 110
520
2.10 380 100
Loan (left axis)
500
2.00 370 90
480 360 80
1.90
460 1.80 350 70
RWA ROA (%) Marketable Securities (left axis)
440 1.70 340 60
Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
2002 2002 2002 2003

Chart III.39
Chart III.38
Development of Banks» Earning Assets
Risk-Weighted Asset and ROA

Looking further at the distribution of CARs, banks»
aggregate CAR during 2003 ranged between 20% - 26%.
There were 17 out of 138 banks with CARs between 8%
√ 10%. One of 15 largest banks had CAR of between
8% √ 10%, while 6 banks had CARs of between 10% √
15%. These CARs are quite sensitive to changes in the
quality of productive assets or to a change in the calculation
method, for example, by incorporating additional risk
components.
In the future, banks» capital (CAR) will remain
sufficiently high to accommodate credit expansion.
However, several large banks» whose CARs are below 15%
should raise their capital because operational risks could
cause their CAR to plunge below the required minimum
level of 8%.
This matter warrants serious attention because
banks» capital (CAR) is not yet able to cover all risks.
The current CAR calculation only includes credit risk and
is not taking into account market and operational risks.
Various efforts have been undertaken to enhance capital
requirements, covering among
implementation of a regulation on minimum capital
requirements starting in 2004, which takes into account
market risk; and (ii) a review on adjustments to the
regulation regarding credit risk and implementation of
operational risk in accordance to the proposed new Basel
Accord (Basel II).
Implementation of the regulation concerning market
risk will not significantly influence banks» capital to enhance
capital requirements. Result of a simulation on
implementation of market risk in 47 banks (based on their
31 July 2003 balance sheets) showed that their CARs only
declined between 1.60 up to 205.9 bps with no banks»
CAR falling below 8%. This small effect of implementation
of these new capital requirements was due to the banks»
high capital warrants serious attention and relatively low
net foreign-currency positions.
Similarly, a simulation of operational risks showed
only a moderate impact on 13 large banks» capital. Under
the assumption that 20% of operational profits were
allocated to cover operational risks, capital at these banks
slipped by an average of only 0.3%.
Furthermore, an assumption of zero interest income
from marketable securities (bonds, SBIs, and other
marketable securities) resulted in a quite significant drop
others: (i) in 13 large banks» capitals, to an average of 4%. However,
only one state bank had the potential for its CAR to slip to
below 8%.
Adopting a more conservative approach to capital
at the 15 largest banks, the analysis indicates that bank

39
 Chapter 3 Development of The Banking Industry

national banking industry»s CAR was higher than that of

18

15
several other Asian countries (Chart III.41).

12

9 3.1.5. Market Risk

6 Market risk facing the national banking industry
3 during 2003 was still at a controlled level. This condition
- is predicted to remain stable until the first semester of

15 Big Bank
Industry

Foreign Bank
State-Owned
A G B C D F E H I J K M L N O

2004, assuming that banks» capital and the exchange rate

Chart III.40
Ratio Tier 1 To Total Assets
capital is still not strong. The ratio of banks» core capital
to total assets was in the range of 4% - 10%, and only 4
banks had ratios above 8%. Application of a more
conservative approach to the capital of 16 large (core)
13
banks produced variable results,
banks having relatively limited capital. The ratio of core
capital to total assets at 15 of the banks came in between
2.73% to 15.76%, and only 5 banks had ratios of above
8% (see Chart III.40). Meanwhile, the ratio of liabilities
to total capital at 13 large banks was also on average 12
times.
Another problem is the relatively low capitalization
capacity of banks, particularly from internal sources. This
is reflected in the relatively low income from credits,
particularly at recapitalization banks. Nonetheless, the
bank
remain stable, and SBI rates hold around 8%. However,
pressures on the rupiah exchange rate should be
anticipated during the 2004 general election.
In general, banks have acted prudently as regards
their open positions in foreign currencies, which in quarter
III-2003 averaged 4.70% of capital. Meanwhile,
implementation of market risk in the calculation of capital
with most of these adequacy seems unlikely to have a negative impact on
banks» CAR. At the time of actual implementation of
market risk in January 2005, banks that will need to apply
the market risk requirements will be able to maintain CAR
at the minimum level of 8%.
Interest Rate Risk
Interest rate risk exposure faced by the national
banking industry in 2003 was still under control and it is
expected to be stable during 2004. Major factors
supporting this prediction include:
(i) Interest rates on credits are still high compared to

30
term deposits and other rate-sensitive liabilities. Since
25
the beginning of 2003, credit rates have been
20
15 extremely inelastic with respect to declines in SBI rates;
10
5 declines in SBI interest rates have not been followed
0
-5
by proportionate declines in credit rates;
-10
(ii) Inflation is estimated to come in below the inflation
-15
Malaysia Phillipines Thailand South Korea Indonesia
-20
Dec Dec Dec Jun Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct target predicted by the government and Bank
1999 2000 2001 2002 2003
Source : ARIC - ADB Indonesia;
Chart III.41
CARs of Several Asian Countries
13
Ratio of core capital to total assets.

40

(iii) Bank capital is quite high, which will enable the banks
to absorb unexpected losses due to interest rate
changes; and,
(iv) Bank liquidity is still relatively high.
However, several banks have maturity profile gaps
because their funding comes from short-term sources (less
than 3 months) while their placements are made in the
forms of credits and recapitalization bonds with more than
3 month maturity, with re-pricing of floating-rate bonds
every three months. In such conditions, these banks»
profits/losses are very sensitive to interest rate changes.
However, rupiah interest rates have been trending
downwards since early 2002 and this has generally had a
positive impact on banks in the short-term. A notable
exception are several recapitalization banks that have
significant amounts of floating-rate bonds; these banks
will experience a further decline in income from coupons
should SBI interest rates continue to drop. However, this
situation can be offset by banks reducing their interest
rates on funding sources, enough to leave their spreads
adequately wide.
Result of a stress test on interest rate declines showed
that several banks would experience declines in CARs, but
would still come above 8% (Chart III.42).
In 2004, SBI interest rates are expected to average
around 8%, as Bank Indonesia still has room to reduce SBI
Stress Test Interest Rate
18
16
14
12
10
8
6
4
2 -3.5
b d h k
0
Strart 1 2 3 4
Delta of Interest rate Decreasing (%)
Chart III.42
Stress Test on Interest Rates
Chapter 3 Development of The Banking Industry
rates. Banks would be able to mitigate interest rate risk
by setting interest rates at relatively high levels,
notwithstanding declines in SBI interest rates.
Exchange Rate Risk
With a stable rupiah exchange rate in 2003, the
national banking industry faced stable exchange rate risk.
In 2004, this risk is expected to remain stable, although
there is a need for a close watch during the general election.
Banks» prudent approach in carrying open foreign-
currency positions was the primary factor that limited
exchange rate exposure of the national banking industry
in 2003. As an illustration, in quarter III-2003, the net
foreign-currency positions of 50 foreign-currency banks
was only 4.70% of capital.
Other factors that limited risk exposure of the
national banking industry in 2003 include:
• Derivative transactions that were relatively simple
(such as swaps and forwards) and generally for
hedging purposes. More complicated derivative
transactions (such as forward rate agreements (FRA),
futures, and options) were seldom undertaken by the
banks.
• Trading book portfolios were generally small, except
at large banks that participated in the recapitalization
program.
-0.5
-1.0
-1.5
-2.0
-2.5
-3.0
n Scenario of Increasing of USD/IDR
-4.0
5
5000 1000 1500 2000 2500
Chart III.43
Stress Test on Exchange Rates at Bank ≈X∆
41
 Chapter 3 Development of The Banking Industry
Based on a stress test on the impact of exchange rate
changes on banks» CARs, only one bank would experience
a relatively significant drop in its CAR (by 3.54%), if the
USD/IDR exchange rate were to rise to Rp2,500/USD. While
this situation is unlikely to occur, this result indicates that
the particular bank»s short exposure in USD would be
relatively significant at 14.2% of capital. However, the bank»s
CAR would remain relatively high, because its capital base
is strong. Results of the stress test on this particular bank
are presented in the accompanying graph.
Impact of Requirement for Inclusion of Market
Risk in Minimum Capital
The requirement for incorporating market risk in the
calculation of minimum capital will be implemented
effective at beginning of 2005. Results of three simulations
undertaken in 2003 showed that implementation of this
requirement would not have a negative impact on capital
of banks that are required to adopt this approach. Results
of the simulations showed that these banks» CARs would
only drop by 4 to 206 bps. All banks tested would still
have CARs above 8%.
3.1.6. Operational Risk
If not well controlled, operational risks facing the
Indonesian banking industry could disrupt financial system
stability in the future. This is indicated by various incidents
of fraud stemming from weak internal controls.
Fraud at several banks has been widely reported
through the mass media in this post-crisis era. In terms of
risk management, fraud is part of operational risks. The
increasing number of fraud at several banks strongly
suggests that operational risks facing the Indonesian
banking industry will need more serious attention in the
future.
Operational risk is one of the loss risks originating
among others from human error, system default, and fraud.
42
This risk has the attention of the Basel Committee on
Banking Supervision of BIS, resulting in the inclusion of
this type of risk in the components of CAR calculation
specified in the proposed New Basel Accord (Basel II; last
updated in April 2003).
Operational risk is considered high in Indonesia. As
an example, total losses due to frauds at two large banks
recently amounted to 18.45% and 4.25% of their capital,
respectively, forcing these banks to provide additional
reserves for losses, in the amount of Rp941 billion
(78.42%) and Rp294 billion (100%). As an impact, these
two banks» CARs dropped from 16.35% and 13.82% to
15.08% and 12.63%, respectively. As regards the first
bank, it is estimated that it would not reach its profit
target for 2003.
Calculations based on the basic indicator method in
Basel II showed that the operational risks at 25 large banks
are relatively significant. These banks» CARs would drop
between 1.14% and 14.26%. Calculation using the basic
indicator approach on the two banks just mentioned,
yielded lower impact than actually occurred. Basic indicator
method calculates operational risks from average gross
income in the last 3 years multiplied by a factor b (beta)
that depends upon the bank»s line of business (up to at
maximum 18%).
Based on lessons learned from this experience, Bank
Indonesia, as the supervisory authority, stresses that
implementation of risk management has become very
important. The framework and approach used in risk
management require predictions of operational risks and
the provision of reserves that match actual risk exposure.
Assessment of operational risks can be conducted using
various approaches, from the most basic (such as the basic
indicator method in Basel II) up to very sophisticated
models. Requirements concerning operational risks (as
recommended by the BIS) have been incorporated in Bank
Indonesia regulation number 5/8/PBI/2003 dated 19 May

Box III. 8 Impact of IBRA’s Dissolution
In line with the government»s decision to
dissolve IBRA at end of February 2004, Bank
Indonesia needs to anticipate several issues related
to IBRA»s tasks being incomplete at the time of
dissolution. Pre-emptive steps are needed to achieve
IBRA»s final goals.
Government Guarantee Program (Blanket
Guarantee)
Uncertainty concerning continuation of the
government guarantee program, which so far has
been handled by IBRA, needs attention in order to
maintain public confidence in the banking industry
(which is already quite low, according to surveys).
Accordingly, there needs to be an effective transition
of the program from IBRA to the Government
Guarantee Program Implementing Unit, which will
take over IBRA»s tasks and responsibilities after
dissolution and prior to the formation of a deposit
insurance institution.
2003 and Circular Letter number 5/21/DPNP dated 29
September 2003 concerning implementation of risk
management at banks.
Models for operational risk are implemented by
taking into account the probability of events and impacts
on profit/loss should those events occur. Events can
include fraud, fires, booking errors, and other human
mistakes. Calculation of the probability of events and
the event»s impacts are based upon the probability
distribution of the occurrence of the events. However,
before adopting this model, a bank should first have
Chapter 3 Development of The Banking Industry
Bank Rehabilitation Program
Uncertainty concerning the bank rehabilitation
program (for recapitalization banks, taken-over banks,
and other banks under rehabilitation program) can
create negative perceptions of these banks» prospects.
In this regard, some institution or party needs to take
over IBRA»s responsibilities concerning the
rehabilitation process of these banks prior to handing
them over to BI. In addition, attention need to be
given to the possibility of changing exit requirements
concerning IBRA»s tasks.
Asset Management
Uncertainty concerning the management and
settlement of government assets at banks with frozen
operations/activities and taken-over banks, might
cause shortfalls in government revenue targets. This
could disrupt fiscal policy and create difficulties for
the government in servicing its debts. In turn, this
could lower the price of recapitalization bonds and
force losses on banks, due to marked to market
considerations.
sufficient time series data on loss events to be able to
predict the relevant probabilities.
Furthermore, to enhance the effectiveness of banks»
internal controls, BI has also issued a framework and
guidelines for effective internal bank control. Internally,
BI has also completed a framework for a risk-based
approach to supervision. This approach focuses on
measuring banks» inherent risks and risk control systems
or banks» compliance in implementing sound principles in
line with risk management. In parallel, enhancement of
the quality and skills of bank supervisors and audit
43
 Chapter 3 Development of The Banking Industry

personnel in implementing risk-based supervision are being
continuously undertaken.
3.2. DEVELOPMENT OF SHARIA BANKING
During 2003, the sharia banking industry experienced
quite rapid expansion of assets, around 60% (y-o-y),
reaching Rp7.1 trillion (Chart III.44). Asset expansion was
followed by capital expansion of around 17%, while third
party funds expanded by some 60%.
Despite financing extensions and fund channeling
that rose by 50% and 100%, respectively, the quality of
the industry»s earning assets were still sound. This was
reflected in non-performing financing of less than 5%
(Chart III.45).
In general, the sharia banking industry»s earnings
were quite good, although they dropped significantly in
2003 due to large business expansion undertaken by these
banks. Business expansion is expected to continue in the
near future, because market conditions are still very
favorable to growth.
Indonesian Moslem Leader Council»s Religious
Instruction on Proscribed Interest
In December 2003, the Religious Instruction
Committee of the Indonesian Moslem Leader Council
(IMLC) decided on religious instruction regarding interest,
based on the results of their national meeting. The Council
determined that interest is proscribed based on the sharia
principle that proscribes usury in all forms. However, there
are various perceptions among the public as to the meaning
of usury. Some parties outside the IMLC are of the opinion
that not all interest should be categorized as usury; other

Trillion Rp Percentage Trillion Rp Percentage

6 100 6 100

80 80

4 4
60 60

40 40
2 2
20 20
Total Deposits Growth Total Deposits Growth
0 0 0 0
Jan May Sep Jan May Sep Jan May Sep Jan May Sep
2002 2003 2002 2003

Chart III. 44 Graph III. 46

Total Assets Deposits

Trillion Rp Percentage Trillion Rp Percentage

1.5 40 6 140

120

100
1.0 4
80
20
60
0.5 2
40

20
Capital CAR of Industry FDR Total Financing Growth
0.0 0 0 0
Jan May Sep Jan May Sep Jan May Sep Jan May Sep
2002 2003 2002 2003

Chart III. 45 Chart III.47

C a p i t a l Financing

44
 Chapter 3 Development of The Banking Industry

Trillion Rp Percentage
operating under sharia principles. Between May 2001 and
200 15
December 2003, there were 92 applications to establish
150 new Rural Banks. This large number of applications shows
10
investors» interest in participating in the development of
100
small businesses, which is the Rural Banks» market. This
5
50 also shows the public»s growing confidence in the prospects
NPL Nominal NPL (%)
0
for Rural Banks.
0
Jan May Sep Jan May Sep
2002 2003 Expansion in Rural Banks» total assets came from
Chart III.48 higher credits, mainly funded by deposits. On the side of
Non Performing Loans
funds accumulation, Rural Bank performance still showed
ROA % ROE %
4 20 stable growth on a positive trend, again indicating growing
public confidence in Rural Banks.
3 15
In line with their rising accumulated funds, credits
2 10 extended by Rural Bank also expanded significantly. Rural
Bank credits at the end of June 2003 stood at Rp7,739
1 5
billion. This rise in credits boosted the LDR to 79%
ROA ROE
0 0
Jan May Sep Jan May Sep
compared to 77% at end-2002. Meanwhile, NPLs rose
2002 2003
from 8.7% at end-2002 to 9.1% by the end of quarter I-
Chart III.49
ROA & ROE 2003, before falling back to 8.6% by mid-2003.
In line with improving quality of credit, Rural Bank

parties consider all forms of interest to be usury. Several profits also trended upwards, as reflected in current year

matters for consideration in limiting the prohibition of usury profits of Rp210 billion in quarter II/2003.

include: Indonesia»s sharia banking network is not yet Looking ahead, prospects look good for the Rural

widely available; sharia banking products that can Bank industry. However, it will still face various constraints.

adequately facilitate more intensive international trades First, the quality of Rural Bank human resources is relatively

are not yet available; and interest is acceptable as long as limited. Second, the number of Rural Bank»s supervisors is

it is agreed to by both parties. The basis of the IMLC»s not adequate. Third, there is tough competition in this

decision are: religious instruction regarding interest has market, including BRI units, commercial bank micro service

been discussed for quite some time within the IMLC; and units (at, for example, Bank BNI), non-bank financial

every religious instruction issued by the National Sharia institutions and branches of commercial bank.

Board regarding sharia banking operational activities avoids In relation to the above, Bank Indonesia is

the application of interest. implementing several strategies concerning Rural Bank

industry rehabilitation, enhancement of supervision,

3.3. DEVELOPMENT OF RURAL BANK development of a blue print, and strengthening of Rural

At the end of quarter II-2003, the total number of Bank infrastructure. The first strategy. Rural Bank industry

active Rural Banks (that is, excluding Rural Banks with rehabilitation program, covers (i) restructuring of problem

frozen activities) stood at 2,123, of which 86 were Rural Banks through capital injections by owners, mergers,

45
 Chapter 3 Development of The Banking Industry

Table III.4
Rural Bank Major Indicators
(in billion Rp)

2002 2003 ∆ ∆
Dec Dec ∆ ∆
No Sectors Dec 02- Jun 02-
2001 2002 (00-01) (01-02)
Mar Jun Sep Dec Mar Jun Jun 03 Jun 03

1 Total Asset 4.731 6.474 36,8% 6.91 7.514 8.393 9.079 40,2% 9.723 10.185 12,2% 35,5%
2 Loans 3.619 4.86 34,3% 5.251 5.781 6.419 6.683 37,5% 7.088 7.469 11,8% 29,2%
3 Deposits 3.082 4.28 38,9% 4.666 5.066 5.597 6.126 43,1% 6.629 6.891 12,5% 36,0%
- Saving Account 1.19 1.574 32,3% 1.661 1.706 1.867 2.002 27,2% 2.026 2.075 3,6% 21,6%
- Time Deposito 1.892 2.706 43,0% 3.005 3.36 3.73 4.124 52,4% 4.603 4.816 16,8% 43,3%
4 Profit & Loss 116 223 92,2% 73 151 294 338 51,6% 113 174 -48,5% 15,2%
5 NPLs 16% 12% - 12% 10% 9% 8,7% - 9,1% 8,7% - -
6 LDR 85% 81% - 81% 81% 82% 77% - 78% 79% - -
7 ROA 2% 3,4% - 1,1% 2% 4% 3,72% - 1,2% 2% - -

acquisitions, and the promotion of new, quality investors;
(ii) technical assistance from USAID and the Asia
Foundation for problem Rural Banks within the Jabotabek
area. The second strategy is the enhancement of Rural
Bank regulation and supervision system. Third,
development of a Rural Bank blue print: (i) is one part of
the Indonesian Banking Architecture, which is adjusted to
the needs and characteristics of Rural Banks as commercial
micro banks; and (ii) concerns Rural Bank information
technology. The fourth strategy, strengthening capacity
and institutions, covers (i) Rural Bank certified training,
and (ii) cooperation between Rural Banks and commercial
banks/other institutions (the linkage program). Fifth,
development of supporting infrastructure, which covers
(i) formation of a deposit insurance institution; (ii)
empowerment of Rural Bank associations (e.g., Perbarindo,
Perbamida, Asbisindo); (iii) promotion of an Apex institution
for the Rural Bank industry, whose main role would be to
assist Rural Banks in solving liquidity mismatch problems;
and (iv) promotion of a rating agency for Rural Banks.
There are several important issues that need attention
for future development of the Rural Bank industry. First,
there have been complaints from several parties concerning
the relatively high credit rates charged by Rural Banks.
Second, the existence of a linkage program between Rural
Banks and commercial banks to boost bank intermediation
to small and micro enterprises. Third, concentrated Rural
Bank ownership; based on tentative data as of January
1999, 327 Rural Banks were owned by 29 groups. Fourth,
uneven geographical distribution of Rural Banks with
concentration in Java and Bali (83% of total Rural Banks).
3.4 LAW ENFORCEMENT
To assist the government in law enforcement in the
area of banking, in December 1998 Bank Indonesia
established the Team for Deviation Investigation in the
Banking Area (TIPPER), which was subsequently changed
to the Special Unit for Banking Investigation (UKIP). The
mission of UKIP is to undertake follow-on actions following
supervision and audit findings as well as public reports
that have underlying criminal aspects. This will be important
in achieving a sound banking system and in bolstering
financial system stability. It will also raise banks» compliance
with prevailing legislation and regulations in the banking
area. In achieving its mission, UKIP has determined strategic
goals that include disclosing in a clear manner each
problem or deviation and recommending legal action
against the alleged perpetrators.
The role of UKIP in stepping-up law enforcement is
also expected to have a preventive impact, such as an

46
 Chapter 3 Development of The Banking Industry

announcement effect on players in the banking field.
Thereby, banksƒwhich are institutions based on trust and
operating with varied business riskƒwill be owned and
managed by persons with a high degree of integrity,
competence, and professionalism. In addition, banking
system stability as a key part of overall financial system
stability, needs to be enhanced and its sustainability
maintained. In the framework of achieving these
objectives, Bank Indonesia has developed the Indonesian
Banking Architecture program, which is expected to
provide guidance in achieving a sound, strong, stable and
efficient banking system and boosting national economic
development. Efforts can include stepping up supervision
and enhancing enforcement effectiveness. This latter
activity entails a stronger investigation process of banking
criminal acts, enhancement of supervision transparency
and regulation enforcement, customer protection, and an
ombudsman for banking problems.
1. Development of Banking Cases Investigations
Since its establishment through 2003, UKIP has
received 376 banking cases at 193 banks, with the highest
number of banks in 1999, namely 61 banks. Since then,
the number has dropped to an average of 32 banks per
year. These banking cases often involved several banks
that are reported more than once due to different locus
delicti or tempus delicti. The high number of deviations in
1999 suggests a critical era in the banking sector when a

(Number of Bank) (Number of Bank)

70 61 25 25 22

60
20
50
37 36
40 32 15
11
27 10 10
30 10

20
5
10

0 0
1999 2000 2001 2002 2003 1999 2000 2001 2002 2003

Chart III.50 Chart III.52

Development of Banking Cases Received by UKIP (in Development of Banking Cases Transferred to Law
number of banks) Enforcement Body (in number of banks)

(Number of Bank)

50 42
in progress
Transfered to law
7%
40 40%
30

30
17
20
8
5
10 No further
process
0 53%
1999 2000 2001 2002 2003

Chart III.51 Chart III.53

Development of Banking Cases, Where Investigations Completion of Banking Cases (cumulative)
Have been Stopped (in number of banks)

47
 Chapter 3 Development of The Banking Industry
number of large banks were liquidated (or had their
business activities frozen) due to operational deviations
with criminal elements. Of the total cases received by UKIP,
78 banks (40%) were handed over to law enforcement
parties for follow-up; 102 banks (53%) cases could not
be investigated further; and 13 banks with 39 cases are
still under investigation. Cases that could not be
investigated further included cases that did not contain
criminal elements. On other occasions, these cases were
reported and handled by law enforcement parties, but
evidence could not be found (particularly at banks that
have been liquidated or their business activities frozen), or
banks» licenses have been revoked and banks» owners/
management have disappeared (particularly Bank
Perkreditan Rakyat).
2. Investigations of Suspected Banking Infringement
During 2003, UKIP conducted investigations at 61
banks. Out of these investigations, 86 cases could not be
continued because they were administrative in nature,
while 37 cases were strongly suspected to have criminal
elements. From the cases that have been investigated, types
of criminal deviations involve:
a. Fictitious changes to credits in order to avoid
regulations concerning the maximum limit for credit
extension, related to violations of both the limit as
well as of the reporting on fund provision.
b. Fictitious financial recording and reporting.
c. Financing of fictitious exports through L/C issuance.
d. Violations of commitments on CDO. And,
e. Abuse of authority by shareholders, commissioners,
directors, and bank officers
The modus operandi of recent banking criminal acts
include: fund withdrawals of other banks» on-call deposits;
illegal use of customers» negotiable certificates of deposit
(NCDs) for cash collatera ls or cash withdrawals on credits;
illegal liquidations of customers» deposits without the
48
Authorization delinquency Loans engineering to avoid
by shareholder, commissioner, legal lending limit
directors, and other bank executives regulation
32% 41%
Commitment violence
to CDO
5%
Counterfeit export
finance by usance L/C Window dressing
19%
3%
Chart III.54
Types of Banking Violation Cases Followed-Up During
2003 (by number of cases)
customers» knowledge; and credit extensions with fictitious
NCDs as collaterals.
3. Implementation of CFTRA Functions By UKIP
In accordance with Article 45, Paragraph (3) of Act
15 of 2002 dated 17 April 2002 concerning Criminal Acts
of Money Laundering, UKIP has certain interim
responsibilities before the Center for Financial Transaction
Reporting and Analysis (CFTRA) is operational. In this
regard, UKIP is tasked to collect, maintain, analyze, and
evaluate information on suspicious transactions and to
report results of analyses on transactions that are suspected
to be criminal acts of money laundering to the Police and
Attorney General.
In executing these tasks for CFTRA (up to 20 October
2003), UKIP has received 291 reports of suspicious
transactions from 31 banks. Furthermore, based on
analyses conducted on these reports, analyses of 189
reports have not been followed up; analyses of 82 reports
have been transferred to the Police because of strong
indications of money laundering criminal acts; and analyses
of 20 reports are still in progress.
Reports have not been followed up for several
reasons. These include: the value of the transactions were
below the threshold of Rp500 million; the transactions
were normal business operations; transactions were
rejected by banks; customers» accounts have been closed
 Chapter 3 Development of The Banking Industry

Table III. 5
√ Weak Internal Controls
STR Reported to Police
In executing their operations, banks are generally
Nominal
No Predicate Crime
(Rp Million) equipped with systems and procedures as well as
1 Banking Crime 1,954,261 limits on authority and responsibility at various levels
2 Fraud 158,264
of the organization. To ensure this system works
3 Corruption 60,001
4 Embezzlement 51,758 smoothly, a control mechanism is also established on
5 Terrorism 514
6 Counterfeit 253 each transaction, to ensure that it is in accordance
7 Others 198,117
with the systems, procedures, and authorities. In
Total 2,423,168
practice, this control mechanism often does not work
because the banks did not feel comfortable doing business as it should, particularly when transactions are
with the customers; or reports were related to cash, for executed by or under the order of parties related to
which reporting is not required. Meanwhile, 82 reports the banks. In a large recent case, the bank»s branch
that are suspected to involve criminal acts of money office internal control could not catch the deviation
laundering have been handed over to the Police. These because of dependency on higher-ranking officers at
have a total nominal value of Rp2.42 trillion equivalent the bank branch and regional office levels. The
covering banking crimes, fraud, corruption, embezzlement, existence of good systems, procedures, and authority
terrorism, counterfeiting, and others. limits do not guarantee that a bank will be free from
With the enactment of Act 15 of 2002 concerning criminal cases, if the internal control system does not
Criminal Acts of Money Laundering and its amendment, function properly as has happened in several well-
Act 25 of 2003, the CFTRA already has acquired adequate publicized cases. Currently, several large banks have
personnel and equipment, so it is ready to execute its monitoring systems over branch transactions through
function. Accordingly, UKIP handed over these functions the use of information technology (IT). This monitors
to CFTRA on 20 October 2003. limits of authority and the layering of authority in
implementing integrated control; it presents data and
4. Causal Factors in Banking Crimes information in a quicker and more accurate way for
From experience to date, banking crimes often occur decision-making by bank management; and it
due to the following factors: enhances the quality of service to customers.
√ Weak bank internal systems and procedures
Several cases of deviation have been caused by
Others Banking
Counterfeit
2%
13% Crime unclear systems, procedures, responsibilities, and
Terorist 33%
6% limits to authority. The lack of regulations on such
matters provides wide opportunities for deviations.
Embezzlement
9% W ith unclear (or no) systems, procedures,
Corruption Fraud
15% 22% responsibilities, and authority limits, the control
function will not be of much help because there
Grafik III.55 are many weaknesses that can be utilized for
STR reported to Police by Numbers of Reports
deviations.

49
 Chapter 3 Development of The Banking Industry
√ Low integrity and professionalism of human resources
People that own and operate banks, as institutions
trusted to manage public funds, must be professional
and of high integrity. In this context, integrity is the
main factor in deciding who sits in key positions, like
branch managers or division heads that have wide
authority. Such persons must not have fictitious
backgrounds or have violated banking practices, either
directly and indirectly. Meanwhile, the professionalism
and competence of bank management and executive
officers must have extensive knowledge and expertise
in banking and finance, as well as an ability to
strategically manage banks. Without integrity and
professionalism, people in authority are easily
controlled by parties operating in their own self-
interest. Such a situation would eventually cause
problems that could bankrupt their banks.
√ Sub-optimal Performance of Compliance Directors
and Compliance Units
In an effort to minimize the deviations in bank
operations, Bank Indonesia has determined that each
bank should establish a Compliance Unit and appoint
a Compliance Director, who is responsible for his
bank»s compliance with legislation and regulations in
the banking area. In practice, a Compliance Director
cannot work independently in executing his function
because he/she is still easily controlled by the people
who control the bank. The position of Compliance
Director is difficult. On the one hand, he/she has to
enforce bank»s internal and external regulations. On
the other hand he/she works for the interest of bank
owners and he/she is a member of the board of
directors and therefore cannot act independently. In
this context, the professionalism of a Compliance
Director is at stake. In many cases, Compliance
Directors function sub-optimally, which makes
continued violations possible.
50
√ Bank supervision and regulations still need to be
enhanced.
Rapid development of the number of banks and bank
offices in the past decade has not been matched by
an adequate supply of supervision and audit
personnel, in both quantity and quantity. In addition,
banking deregulation, which was launched through
PAKTO88, was not followed by adequate prudential
regulations, including on exit policy. Thus, many
violations occurred, including imprudent fund
channeling, particularly to related debtor groups, and
these eventually become non-performing credits.
√ Weak law enforcement regarding banking cases.
Another important problem is law enforcement, as
imposition of sanctions for violations is felt to be
inadequate. Administrative sanctions imposed by
Bank Indonesia are not potent enough to act as a
deterrent for wrongdoers. Therefore, many
banking cases that qualify as criminal cases entail
only light penalties, or are pronounced free from
legal prosecution, or are not even pursued by the
authorities. Consequently, banking crimes
continue.
5. Responsibilities of Banks» Directors
Under Bank Indonesia regulation number 1/6/PBI/1999
(concerning the appointment of compliance director and
standards of internal audit at commercial banks), the
Compliance Director is obliged to ensure that the bank
has fulfilled all Bank Indonesia»s regulations and prevailing
legislation. The Compliance Director must also monitor
and ensure that the bank»s business activities do not violate
prevailing regulations. In other words, a Compliance
Director is obliged to prevent deviations in bank operations
(including those with a criminal element) by setting the
steps required in the compliance procedure at each work
unit.

In addition, the bank»s board of directors have
responsibilities as follows:
1. Bank board of directors are responsible for good
supervision of all the bank»s business activities by
ensuring that the bank»s business activities are well
run.
2. Bank board of directors are not guarantors or insurers
of actions that are not proper or prohibited being
undertaken by bank executive officers. From the side
of criminal liability, board of directors are not
responsible for bank losses due to unlawful actions
undertaken by their subordinates, but still have to be
responsible from the point of view of management
accountability, as determined in Act 1 of 1995
concerning limited companies. Therefore, they must
supervise the actions of their executive personnel
thoroughly.
3. Bank board of directors must pay attention to the
implementation of prudential principles on every
business activity of the bank.
4. Bank board of directors must pay sufficient attention
to bank business activities even though all bank
business activities are running well. Board of directors
must know all pertinent facts of the business,
including ensuring that the compliance systems and
internal audit system are implemented in each work
unit.
5. Bank board of directors are not expected to monitor
bank routine business activities every day, but they
must have knowledge of the implementation of bank
business activities in general, and give general
directions for important matters in the bank»s
operational activities.
6. Bank board of directors are obliged to check the
implementation of prudential principles as part of their
general supervision and check the bank»s condition
sufficiently frequently.
Chapter 3 Development of The Banking Industry
6. Strategic Steps to Avoid the Occurrence of
Banking Crimes :
a. General awareness
All bank employees must be aware of the possibility
of the occurrence of banking crimes with their
implications.
b. Good understanding
Prevention of banking crimes must be stepped up in
the area of understanding the need for standard audit
guidelines and other types of security against the
possibility of crime in bank operations.
c. Risk assessment
The next step is to include the possibility of banking
crimes in business risks. Supervision guidelines must
be available for daily operations, up to formulating
action plans and operational strategies of each front-
line manager in the event that incidents deviate from
standard operating procedures.
d. Dynamic prevention
Dynamic prevention is risk-based supervision that
functions as a main tool in identifying constraints in
achieving the objective. If implementation of this
policy is quite strict, all levels of personnel will provide
supervision that will safeguard the bank»s resources
as part of their routine jobs.
e. Proactive detection
As a business entity susceptible to crime, bank
management and personnel must have an
understanding of banking crimes, risks that arise due to
banking crimes, and how those risks can be managed.
f. Investigation
As part of the overall audit policy, an ability to
investigate a banking crime must be part of a bank»s
organization. This can be done by an internal work
force/bank team or by experts external to the bank.
The bank crime audit policy must be based on
investigation standards.
51
 Chapter 3 Development of The Banking Industry
In relation to the implementation of bank crime
audits, the following matters need close attention:
1. Security, including:
a. To develop a proactive security strategy.
b. To make security a principal matter.
c. To know where everything is.
d. To limit access.
e. To safeguard company equipment.
f. To protect the IT system.
g. To monitor for internet fraud.
h. To safeguard important company information.
2. Segregation of authority/duties.
3. Financial and operational audits.
4. The appointment of a Compliance Director and a
Compliance Unit.
7. Banking Cases in 2003
Major cases in 2003 included:
1. Fictitious exports using a Letter of Credit (L/C)
A bank took over an issuance L/C (WEB) and a standby
L/C submitted by several current account customers
(not debtors), which formally did not come from one
group. The proceeds from the discounted L/C were
to be used for settling the issuance L/C that had fallen
due. This happened repeatedly until quite a huge
nominal value had accumulated. In taking over the
issuance L/C, bank»s personnel and officers made
deviations from internal stipulations (procedures and
authorities) and other legislation (Banking Act, Act
on Criminal Acts of Money Laundering, Eradication
of Corruption Criminal Act, Criminal Law (KUHP), and
Bank Indonesia regulations). The deviations in the
handling of the L/C were:
- The opening bank was not a correspondent
bank.
- Taking over of the export documents was done
before there was acceptance by the issuing bank
52
(originating in a high-risk country) and there was
only the guarantee of a Letter of Indemnity.
- The issuance L/C that had fallen due was
extended by the customer service manager
without approval by the branch manager.
- A standby L/C had to be used as a counter
guarantee on the goods purchasing contract
between the exporter and importer by the bank
that took over the issuance L/C.
- There were discrepancies in export documents
(fake PEB, fake B/L, and an unclear applicant»s
address).
- Total and type of commodity were not
reasonable (export of sand to Africa).
- Exports were not executed (fictitious exports).
- Discounting proceeds were partly withdrawn in
cash and partly transferred to another bank for
the benefit of the group of the current account
customers.
2. Misuse of Officer Authority
A bank received a transfer from another bank through
the RTGS in a large amount to be placed as deposit-
on-call (DOC). Prior to the transfer, the officer of the
bank that owned the funds would communicate with
the officer of the operational office or branch
manager of the bank that received funds, and agreed
on some funds placement. The funds went directly
to the account of the receiving bank. Without
checking or verification by the operational division or
treasury division, the funds were booked into the
account of the branch office of the receiving bank.
The bank branch manager did not book the funds as
DOC, but through an intermediary gave the funds as
credit to another party. Every month interest was paid
directly by the funds user and not by the bank that
received the funds transfer. The bank that owned
the funds never questioned why the interest was paid

by another party that had no legal relationship with
the bank that owned the funds. The problem arose
only when the DOC fell due and the fund user did
not fulfill his obligation to return the funds.
Meanwhile, the bank that received the funds still had
the obligation to return the funds by, among others,
making a reconciliation of the funds of fund owners.
3. Misuse of Authority by Bank Officer
A customer transfer through RTGS, which was meant
to be placed as a deposit under the customer»s name,
was deviated and moved to a current account under
another party»s name based on a letter whose
authenticity was suspect. The modus operandi was
conducted as follows:
- Bank received a fund transfer through RTGS for
the benefit of a customer to be placed as the
customer»s deposit.
- On the same day, the bank officer was suspected
of sending a letter by fax containing an
instruction from the customer to the bank to
transfer those funds to a current account of
another party.
- The change in the mandate of the fund
placement actually had to be done in accordance
with the RTGS regulation, namely the instruction
to change also had to come through the RTGS;
it could not be done through letter/fax/other
method.
- Based on investigation, the authenticity of the
customer letter was doubtful among others
because the letter head and number of the letter
looked like they have been tampered with; the
submission of the letter was by fax; and the
officer»s signature was not acknowledged by the
customer.
Chapter 3 Development of The Banking Industry
4. A Case of Credit with Cash Guarantee (cash collateral
loan)
A bank received a transfer from another bank for the
benefit of a customer»s current account, which was
subsequently transferred into a deposit account by
the customer. That deposit was used as a credit
collateral under the name of another person that had
not met legal and prudential principles. This deviation
involved:
- The credit agreement letter (CAL) was blank
(nominal value, time period of the credit, etc.
were not written yet) except for the debtor»s
signature.
- The debtor did not sign the CAL in the presence
of a bank officer. Instead the blank CAL was
taken by a third party (an intermediary) for
signing by the candidate debtor, so its
authenticity was doubtful.
- The CAL was made without being legalized by
a notary.
- The credit analyst officer did not meet and
conduct an interview with the candidate debtor.
- The type of business and objective of the credit
were not clear. Plus, the debtor was physically
disabled and thus his capacity to conduct
business was doubtful.
- At the time of credit withdrawal, the funds were
transferred directly to another person»s
(intermediary) account in another bank based
on a transfer instruction letter from the debtor,
whose authenticity was doubtful.
- Every month interest payments were made by
another person (intermediary) by debiting the
intermediary account based on an authorization
letter.
53
 Chapter 3 Development of The Banking Industry

54
 Chapter 4 Non-bank Financial Institutions

Chapter 4
Non-bank Financial
Institutions

55
 Chapter 4 Non-bank Financial Institutions

56
 Chapter 4 Non-bank Financial Institutions

Chapter 4
Non-bank Financial Institutions

In 2003, the condition of non-bank financial institutions heightened risks for investors and financial institutions.

(NBFIs) was quite stable. They continued to grow, but at a This has led the supervisory authority to issue new

slower pace than in 2002. The downward trend in SBI and regulations intended to safeguard public funds and the

deposit interest rates reduced returns on the investments stability of the industry itself. The regulations were mainly

of insurance companies and pension funds. To adjust, issued for the insurance industry concerning institutional,

insurance companies and pension funds shifted their operational and investment issues; new regulations

investments into other instruments such as bonds, applicable to the pension fund industry mainly concerned

marketable securities guaranteed/issued by the investment issues.

government and mutual funds. Looking ahead, with The role of NBFIs in financial system stability cannot

continuing low interest rates, NBFIs need to implement be ignored, despite total assets that constitute only 9% of

good risk management, or the industry will face increased the whole financial industry (Graphs IV.2 and IV.3). The

risk of deteriorating profitability. Meanwhile, the role of development of various innovative financial products has

the NBFI industry supervisory authority has become more tightened the linkages between banks and NBFIs.

important as regards the issuance of regulations for Consequently, instability arising in one institution might

prudential development of the industry. impact the other. Cooperation in product marketing, for

With improving economic and financial climates in example bancasurance (Box IV.1 Bancasurance:

2003, the financial condition of the industry was quite Advantageous for All Parties?), risks the reputation of banks

stable, albeit with uneven growth. The positive that market this financial instrument, despite it being an

development of the banking industry during 2003 was insurance companies» product.

not immediately followed by NBFIs. Expansion of total In line with the continuing trend of low interest rates,

assets, capital, and total investments of the insurance and the insurance and pension fund industries are expected to

pension fund industries -which have quite large shares in

the financial industry- did not result in higher profits. This Shares, Goverment bonds (Trillion Rp) Corporate bonds, Mutual funds(Trillion Rp)
450 100

was due to those industries» investment portfolios being 400 90

350 80
dependent upon bank deposits, which tended to decline. 300
70
60
The downward trend in deposit interests for more 250
50
200
40
than one year has shifted funds into the capital market. 150
30
100
This shift, which is indicated by the high level of the 20
50 Shares Goverment Bonds
10
Corporate Bonds Mutual Funds
composite stock price index and by rapid developments in 0
Dec Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
0

2001 2002 2003

the bond and mutual funds markets, reflected improving Source : CEIC, Bapepam

public confidence (Graph IV.1). Investment expansion, both Chart IV.1

Developments of Shares, Bonds, Mutual Funds
by the general public and investment institutions, has

57
 Chapter 4 Non-bank Financial Institutions

has become more important, especially as regards the

Banking
90% issuance of regulations to support development of NBFIs
and to ensure prudence in NBFIs» business.

4.1. The Insurance Industry

Insurance
Pawn-Shop Company The insurance industry tended to slowdown during
0% 3%
Securities Financing Pension Fund 2002. Comprising 174 companies with a total share of
Corporation Corporation 3%
3%
1% 3.4% of the financial industry»s total assets, the insurance

Chart IV. 2 companies (both life and general insurance companies)

Asset Composition of Financial Institutions
faced many challenges during that year. Interest rates that

Unit trended downward continued to put pressure on the

400
industry»s profitability, because most of the insurance
350

300 companies» investment portfolios was in deposits. In

Life Insurance General Insurance Pension Funds
250
Corporate Bonds Securities addition to lower interest rates, the insurance industry
200

150 faced other challenges such as competing premiums,

100
efficiency, fulfillment of risk-based capital (RBC), and many
50

-
2000 2001
Sources : DJLK, Ministry of Finance
Chart IV. 3 Total Non-Bank Financial
Institutions 2000 √ June 2003
grow in 2004, but at a slower pace. Although shifting of
the portfolio pattern to non-bank products has started,
bank deposits would still be the largest investment asset,
considering that safety would be a major consideration in
insurance and pension investments. Discontinuation of
the blanket guarantee program, in conjunction with the
establishment of a deposit insurance institution, would
be another consideration for the insurance and pension
fund industries. Both pose risks for the NBFI industry.
There are a few steps that could be taken by the
industry to address these various issues. As regards shifting
investments to non-bank products, there is a need to
increase financial management performance (ALMA) in
terms of investment fund management within an
environment of global competitiveness and low interest
rates. Also, the role of the supervisory authority for NBFIs
new regulations, such as that concerning fit & proper tests.
2002 Jun-2003 *
These factors have prompted several insurance companies
to consider a merger strategy. Prominent positive
developments were innovations in alliances and
modernization of insurance products (bancassurance and
unit-link), particularly at joint venture/multinational
companies (Manulife, AIG Lippo, and Prudential Banc).
Of a total of 174 insurance companies in 2002, 60
were life insurance companies with a share of 37.3% of
the insurance industry. Of this total, 15 companies (8 of
which were joint venture companies) dominated (85%)
the life insurance market share. Almost 30% of this large
group is related to banking groups whose policies influence
investment behaviors of the insurance companies. This
significant interrelation with the banking industry, indicates
a quite high systemic risk should instability arise in the
insurance industry.
Meanwhile, of a total of 105 general insurance
companies in 2002, 23 of them (9 of which comprised
joint venture companies) dominated (71.4%) the general
insurance market share. This condition reflected tighter

58
 Chapter 4 Non-bank Financial Institutions

Box IV. 1 Bancassurance - Advantageous for All Parties?

A critical point in handling bancassurance unique characteristic that 72% of bancassurance

development is the need to provide an explicit legal
basis for banks to undertake this kind of business. It
will also be important for customers to distinguish this
product from other banking products.
In addition to marketing mutual funds through
banks, another form of vigorous integration between
banks and non-bank financial institutions since the
beginning of 2000 is bancassurance.
Bancassurance (French terminology referring to
the sale of insurance through bank offices) can be
divided into four types:
1. Marketing Cooperation: This entails limited
cooperation where banks only distribute
insurance products, as either stand-alone
products or synergized with bank products. In
general, this type of cooperation does not incur
products is life insurance. This is largely due to the
fact that the general data required to close an
insurance policy is often already available in a bank»s
customer data. In Europe, more than 60% of life
insurance is sold through banks. By contrast, in Asia
only Hong Kong has achieved 25%.
What prompted rapid growth of
bancassurance ?
A downward trend in Net Interest income (NII),
owing to interest rate declines and the global recession
of recent years, are the main factors that have
prompted banks to aggressively seek non interest
income (fee-based income). Also, cooperation with
14 % 17 %

exchanges of customers» data and only involves

limited investments.
2. Strategic Alliances: A more complex form
cooperation, which involves efforts in product
69 %
development, provision of services, marketing Joint Venture Marketing Agency Group *)

management, recruitment of sales personnel, and

Chart Box 4.1.1
investment in information technology. Forms of Bancasurance in Asia

3. Joint Venture: This type of cooperation requires

long-term commitments and a pattern of more 12 %
16 %
intensive customer data information exchanges.
4. Financial Services Group: A form of operational
cooperation, which integrates various financial
service products and provides a one-stop 72 %
Non Life Insurance Life Insurance Mixed
financial service.
In Asia, the most dominant form of Chart Box 4.1.2
bancassurance is marketing cooperation (69%), with Products of Bancasurance in Asia - 2000

59
 Chapter 4 Non-bank Financial Institutions
Percentage
80
70
60
50
40
30
20
10
0 0
France Portgl Spain Blgm Irlnd Swedn
Source : LIMRA
Chart Box 4.1.3
% Sales of Life Insurance via Banks √ Europe 2000
an insurance institution of international reputation will
enhance the local bank»s brand image, while product
diversification adds to the bank»s trustworthiness to
its customers perseption.
For the insurance institution
bancassurance is one way to increase market
penetration by taking advantage of the bank»s
customer database and office network. For this reason,
general insurance institutions that aggressively
undertake cooperation with local banks, are usually
foreign companies that do not have a network in the
local market; to compensate, they chose a local bank
that already has a wide office network.
For the customers, bancassurance has an
additional benefit, namely the ease and generally
market conditions in general insurance as compared to
life insurance. Tough competition in the general insurance
market was prompted by rate wars among general
insurance companies. At the same time, in order to cover
potential risks, general insurance companies normally
undertake reinsurance, for which premiums are increasing.
This situation was aggravated by a decline in investment
income due to lower SBI and deposit rates. Consequently,
profits earned by general insurance companies during 2002
60
Percentage
30
25
20
15
10
5
Nthrld UK Hong Kong Singapore Malaysia Indonesia Thailand China
Source : AXA Life
Chart Box 4.1.4
% Sales of Life Insurance via Banks in Asia - 2003
lower premiums provided by a one-stop financial
service.
On this basis, bancassurance seems to be an
advantageous solution for all parties. However, there
itself, are several critical points that must be the concern in
developing this financial product. For example, an
explicit legal basis related to licensing for banks to
deal in bancassurance business would be very useful.
On the other hand, it will be very important to
enhance customer knowledge to enable them to
differentiate insurance products from banks» own
products. These will be critical points in ensuring an
advantageous solution to all parties and to prevent
bancassurance from becoming counter-productive to
the financial system stability.
were lower than the previous year; ROA, ROE, and ROI all
recorded declines (Graphs IV.3, IV.4, and IV.5).
Lower deposit rates prompted the general insurance
companies to adjust their investment portfolios. The
option taken by many insurance companies was to shift
from investments in banking products (deposits) to capital
market products (shares, bonds, SUN, and mutual funds)
with the realization that risks could be higher. There was
considerably more investor interest in government
 Chapter 4 Non-bank Financial Institutions

securities (Surat Utang Negara/SUN), mutual funds, and
bonds, all of which promised higher returns. Nevertheless,
investments in deposits remained a core component of
insurance companies» portfolios, due to liquidity and
safety considerations as well as growing alliances with
Percentage
20
15
10
the banking industry through bancassurance (Graphs IV.7
and IV.8).
At the end September 2003, the Ministry of Finance
(the insurance industry»s supervisory authority) issued
several new regulations concerning fit & proper tests,
business operations, audits, financial soundness, and
licensing. These regulations are considered a first step
towards a framework to improve the industry during the
post-crisis period, after the erosion of confidence due to

5 financial problems and limitations on business activities at

0 several insurance companies. As regards the regulation
-5
on fit & proper tests, issues concerned the objectiveness
-10
General Insurance Life Insurance of implementation as well as the possibility of reducing
-15
1997 1998 1999 2000 2001 2002
Sources : Industri Asuransi Indonesia, InforDev
the number of members of boards of commissioners or
directors because many could fail checks on background
Chart IV. 4
ROA Value - Life and General Insurance Companies or personal history. (Box IV.2: Implementation of
Regulations on Fit & Proper Tests in the Insurance Industry).
Percentage
40

20
Polis Loan
Morgages 2% Time
0 0% Other Investment Deposits
Building & Land 1% 38%
4%
-20
Equity
Participation
13%
-40

-60 Mutual Funds

General Insurance Life Insurance 6%
-80 Sertificate
1997 1998 1999 2000 2001 2002 Shares Deposit
Securities guaranted Bonds 5% 0%
Sources : Industri Asuransi Indonesia, InfoDev by goverment BI Sertificate
14%
16% 1%
Sources : DJLK, Ministry of Finance
Chart IV. 5
ROE - Life and General Insurance Companies
Chart IV. 7
Investment Composition of Insurance Industry √ 2002
Percentage
30
25
Polis Loan
20 Morgages 4% Time
0% Other Investment Deposit
15 Building & Land 1% 44%
4%
10
Equity
5 Participation
13%
0
-5
-10 Mutual Funds
4%
-15 Sertificate
General Insurance Life Insurance Shares Deposit
-20
Securities guaranted Bond 4% 0%
1997 1998 1999 2000 2001 2002 by goverment
BI Sertificate
13% 0%
Source : Industri Asuransi Indonesia, InforDev 13%
Sources : DJLK, Ministry of Finance

Chart IV. 6
Chart IV. 8 Investment Composition of
ROI Value √ Life and General Insurance Companies
Insurance Industry √ Quarter II/2003

61
 Chapter 4 Non-bank Financial Institutions
Box IV. 2 Implementation of the Regulation on Fit & Proper Tests in the
Insurance Industry
The insurance industry is facing tight new
regulations concerning institutional, financial, and
soundness matters as well as their human resources.
The regulation on fit & proper test on members of
boards of directors and commissioners is a positive step
towards the improvement of the insurance industry
climate in order to maintain public confidence.
Implementation of this regulation needs to consider
the impact on industry restructuring and the possibility
of a decline in confidence if the public does not have a
good understanding. There is also a need to monitor
potential mismanagement, which could put financial
pressure on the insurance and other financial industries.
As one of the industries that is very much based
on confidence, the insurance industry became more
tightly regulated in September 2003 with the issuance
of 6 new regulations. These complementing
regulations were issued in an effort to create a tough
insurance business climate and to increase human
resource competence and integrity. In broad outlines,
these regulations concern (1) Evaluation of Ability and
Compliance (Fit & Proper Test) of Insurance Companies»
Members of Boards of Directors and Commissioners
(Minister of Finance/MOF decree number 421); (2)
Implementation of Insurance and Reinsurance
Companies» Businesses; (3) Audit of Insurance
Companies; (4) Financial Soundness of Insurance and
Reinsurance Companies; (5) Licensing and Undertaking
of Business Activities of Insurance Support Companies;
and (6) Business Licenses for Insurance and Reinsurance
Companies. MOF decree number 421 is considered
by several insurance industry players as a first step
towards improvement of the insurance industry.
62
The Insurance Industry»s Problems
Currently, the insurance industry is facing
significant pressures, including: market competition,
even with banks and security companies; fulfillment
of the RBC regulation; regulations concerning premium
income; investment risk; and potential erosion of
confidence due to financial problems that have been
experienced by several insurance companies (on which
limitations on business activities have been imposed).
As regards the human resource quality of management,
there are indications of less-qualified parties that might
create a moral hazard problem and erode public interest
in insurance. Currently, fulfillment of the RBC regulation
and its relation to investment products is only a gradual
process through 2004. The last portion of this
regulation will strengthen processes related to the
liquidation of unsound insurance companies.
Meanwhile, the regulation on fit & proper test poses
several challenges concerning objectiveness and the
quality of implementation. It is also possible that many
members of top management will not pass, which has
the potential to raise doubts about the stability of the
industry, including the safety of liabilities that are not
covered by the government guarantee program.
Improved Performance Through Infrastructural
Support
Currently, it is estimated that there are 980
officers of insurance companies that will be required
to take a Fit & Proper Test. Of this total, some members
of boards of commissioners and directors are in their
current positions due to family relationships or they
are suspected to be incompetent in the insurance area

or they are related to DOT (black list in banking).
Issuance of the 6 regulations is a step towards
increasing public confidence in the Indonesian
insurance industry. In particular, they will strengthen
the capability of each individual in the insurance
industry; a higher, more uniform quality of the industry»s
human resources will facilitate more professional
techniques.
Table Box 4. 2.1 Composition of Members of
Boards of Commissioners and Directors
Company Commisioners Directors Total
Life Insurance 171 148 319
General Insurance 318 269 587
Social Insurance 24 23 47
Reinsurance 14 13 27
Total 527 453 980
Implementation of MOF decree number 421
along with other regulations will have various
implications, including the possibility of vacant positions
at the level of directors and commissioners. Other
impacts might involve delays in the continuation of
the internal rehabilitation programs of companies;
possible cases of frauds at some companies whose
officers do not pass the test; and consolidation in the
number of insurance companies. If this situation is
not properly understood by the public, it has the
potential to lead to a rush of redemptions, creating a
domino effect on companies or prompting a shift to
foreign insurance companies. Redemptions would
To date, the activities of insurance companies have
been very closely related to banks, mainly because most
of their funds are invested in banks. Also, interest rate
declines have put pressure on investment income.
Meanwhile, risks have increased due to the shift in
investments to the capital market. Furthermore, this
Chapter 4 Non-bank Financial Institutions
impact on companies» (and the industry»s) finances,
which would lead to liquidation of investments in the
capital market and banking industry. Better regulations
concerning company soundness and audits as well as
institutional matters is one way to strengthen regulation
of the industry. Implementation of MOF decree number
421 over 2 years takes into consideration its impact on
the insurance industry.
From the financial system side, implementation
of these 6 new regulations in the insurance industry is
part of series of steps to maintain stability of the
financial system. Reliable human resources for
managing the insurance financial, risk and marketing
functions is vital, supported by strong insurance
industry infrastructure. Issuance of MOF decree
number 421 makes it important to monitor for possible
fluctuations in public confidence in the short-term,
especially considering socio-political conditions during
the general election when the public is more sensitive
to negative issues. On the investment side, where the
investment market is still susceptible to foreign
developments, the insurance industry needs to take
pre-emptive steps regarding its capital market
investment portfolio. Furthermore, public socialization
will be important for the understanding of MOF decree
number 421 and other regulations. This is necessary
to avoid undermining public confidence in local
insurance companies, which could lead to a rush of
redemptions and accompanying financial pressures.
industry is very sensitive to various issues and competition,
which holds down premiums. Cooperation regarding the
marketing of bancassurance products in conjunction with
several banks introduces a new risk for the banks, i.e.
reputation risk, should problems arise related to the jointly
marketed insurance products.
63
 Chapter 4 Non-bank Financial Institutions
Market liberalization has encouraged many
international insurance companies to enter the Indonesian
market, usually with large capitalization and more
professional human resources. Their presence could
become a separate challenge by increasing competition
through product development/innovation, while domestic
insurance companies still tend to market insurance
products in the traditional way.
In the future, the insurance industry is not expected
to change much. In particular, any shift in investment
patterns cannot be undertaken abruptly. Instead, it has
to be undertaken gradually considering that this industry
is oriented towards long-term investments. At the
beginning of 2004, the introduction of risk-based capital
(RBC; a minimum of 100% for each insurance company)
will be effective. Meanwhile, by the end of 2004, the RBC
of insurance companies should reach 120%. As of
December 2002, 15 general insurance companies had not
fulfilled the 100% RBC requirement. The regulatory
necessity to raise capital, amidst limited capacity for
additional capital by domestic companies, limits their
capability for product development.
Shifts in investment patterns by insurance
companies need to be undertaken only after thorough
consideration. For this purpose, enhanced management
performance in investment fund management is vital.
Rising inflows into the capital market that are not backed
by good financial management could spur liquidity
problems if the investments experience default risk,
redemption risk, or a decline in the prices of marketable
securities. Pressures related to such liquidity problems in
the insurance industry could have a systemic feedback
into the banking industry. Meanwhile, in order to fulfill
the 100% RBC requirement, insurance companies can
undertake several steps, including raising additional
capital, undertaking mergers, or focusing on sectors with
better prospects.
64
4.2. The Pension Fund Industry
To date, development of investment aspects of the
pension fund industry has been more prominent than their
institutional and operational development. On the
institutional side, there are two types of pension funds,
namely employer pension funds (EPF; which are formed
by companies that provide jobs) and financial institution
pension funds (FIPF; which are formed by financial
institutions, like banks and insurance companies). Two
types of benefits are offered, namely Fixed Pension Benefits
(EPF) and Fixed Contributions (FIPF). In the last three years,
FIPF have grown quite significantly compared to EPF. The
total number of pension funds reached 342 (December
2002), where many EPFs and FIPFs were closely related to
banks (state bank, private banks, BPD, foreign banks), in
terms of both establishing the pension funds and program
implementation. Meanwhile, total assets of pension funds
have a 3.0% share in total assets of financial institutions.
This interrelationship suggests potential for systemic risk
to the overall financial system should the pension fund
industry not be managed prudentially.
Basically, pension funds are institutions that have
very tight regulations. To date, the investment regulations
have been extremely conservative and prudent; most
investments are in deposits, although a share in the
capital market is possible. As with the insurance industry,
declining deposit interest rates have contributed to a shift
in the pattern of pension funds» investments. During
2003, the share of deposits has started to decline in favor
of capital market instruments. However, deposits still
dominant, mainly because pension funds» policies follow
the lead of the parent companies (banks); non-bank
parent companies also tend to place their funds in
banking products due to historical relationships between
the parent company and specific banks. Without
efficiency improvements, this shift risks a continuous
decline in the industry»s income.
 Chapter 4 Non-bank Financial Institutions

Currently, the pension fund industry in Indonesia is

Percentage
30
still very much dependent on the banking industry as
25
reflected in its fund placements in deposits. However, the
20
industry»s rate of return is trending downward in line with
15
declining interest rates. But a deterioration in pension
10
funds» performance will also influence banks» performance,
5
ROA ROI for example, through a decline in third party funds or lower
0
1998 1999 2000 2001 2002
fees obtained through execution of pension fund activities.
Sources : DJLK, Ministry of Finance

In addition, failure on the part of pension funds that are

Chart IV. 9
ROA & ROI Values - Pension Funds established by banks would bring reputation risk to bear
on the banks.

Performance of pension funds (ROI and ROA) In 2004, pension funds are not expected to change

improved only very slightly in 2002 (0.8% and 0.9%), while much. Despite great potential, pensions funds will still

their total investments rose to 17.9% (Graph IV.9). This face constraints. Investment patterns that are overly

was due to declining interest rates on bank deposits. prudent prompt the majority of funds to be invested in

Meanwhile, this industry is going to face various new deposits, probably ensuring lower returns for the time

constraints, for example, stemming from the plan to reduce being.

the coverage of the guarantee program. Limits of deposit To boost pension funds» performance, efforts can

insurance (through the Deposit Insurance Institution) might be made to increase public interest in pension funds,

cause pension funds» investment in deposits (which is often particularly through FIPF. Also, it will be important to

huge) to exceed the guaranteed limit. As a result, credit strengthen their management of investment funds in

risk faced by the industry could rise and adequate levels an environment of global competition and lower interest

of capital will be very important. rates.

65
 Chapter 4 Non-bank Financial Institutions

66
 Chapter 5 Capital and Money Markets

Chapter 5
Capital and Money Markets

67
 Chapter 5 Capital and Money Markets

68
 Chapter 5 Capital and Money Markets

Chapter 5
Capital and Money Markets

Indonesia»s capital markets experienced extraordinary

Stock Market Capitalization Bank Loans
development during 2003. The stock market had the (21%) (31%)

second best performance in the world, while the bond

market expanded rapidly with a tendency towards
oversubscription with each new issuance. For their part,
Government Bonds
the interbank money markets did not fluctuate in any way Market Capitalization Corporate Bonds Market
(31%) Capitalization (17%)
that could endanger financial stability.

Corporate Bonds Market Bank Loans

5.1. Development of Indonesia»s Capital Market
During 2003, the capital market experienced
extraordinary expansion as indicated by rises in the
composite stock price and bond price indexes of 63%
and 66%, respectively. This is evidence of the recovery
of the capital market as an alternative source of
financing and investment. However, this growth needs
to be closely monitored due to continuing high credit
and bond refinancing risks. In addition, the valuation
of capital market products may not yet reflect
fundamental values. Such conditions pose a challenge
for the capital market developers to ensure that the
capital market does not become a source of instability
in the financial sector.
Bank Indonesia»s attention to development of the
capital market has become more intense as products and
transactions in the financial system √including the capital
market√ become more integrated. Consequently, problems
arising in the capital market could have a systemic effect
on the broader financial system.
In general, the capital market is becoming more
important to Indonesia»s financial system (Chart V.1). In
2003, the share of financing issued by the capital market
in total financing rose by 5 percentage points compared
Capitalization (23%) (26%)
Government Bonds Stock Market Capitalization
Market Capitalization (22%) (23%)
Sources: Statistic Bank, Bloomberg and CEIC
Chart V.1 A Shift in The Role of Bank Loans Versus
Capitalization of Stock and Bond Markets
to the previous year, indicating the growing importance
of the capital market as a source of business financing.
During 2003, investment conditions in Indonesia
were still considered to be relatively high-risk for
international investors and rating institutions. This was
reflected in the relatively high sovereign yield spread of
Indonesia»s issuances compared to other South East Asian
countries. Also, the yield spread for Argentina (which
again plunged into crisis) was only 400 bps more than
Indonesia»s. This high risk rating had a negative impact,
namely increasing the interest expense of Indonesia»s
issuers; they had to pay an additional risk premium of at
least 2.16%. This high risk perception was also reflected
in Indonesia»s low rating compared with other developing
countries (Chart V.2).

69
 Chapter 5 Capital and Money Markets
18
16
14
12
10
8 into cash or other financial instruments (a flight to safety).
6
4
2 stability, there is a need to step up the importance of good
0
94 95 96 97 98 99 00 01 02
Indonesia Thailand Malaysia
Chart V. 2
Ratings of Indonesia and Other Developing Countries
However, in line with improving macroeconomic
conditions during 2003, confidence in the Indonesian
economy strengthened, as indicated by Indonesia»s
improved ratings from several international rating
institutions. As a result, there was a rise in capital inflows
during 2003, particularly in the form of portfolio
investment into Indonesia»s capital market.
Improved capital markets have provided many
opportunities for banks and corporations to undertake
investments using alternative financing sources. For banks,
financing through issuance of bonds and shares has
become an alternative to accumulation of customers»
funds. Meanwhile, banks» investments in the capital
market remained limited to non-stock instruments.
Through these instruments, banks can diversify their risk.
At the same time, capital market-based products sold
through the banking industry and developed to maintain
customer bases need to be monitored carefully, considering
the potential risks to banks» reputations.
In line with GDP»s projected growth and conducive
macroeconomic conditions, capital markets look set to
perform even better in the coming years. This is expected
to give a boost to the corporate sector in terms of
alternatives to funding from the banks. However, capital
market analysts predict a possible decline in market activity
70
due to a wait-and-see attitude around the general election
to be held in April 2004. There is a worry that security
and socio-political disruptions could hurt the capital market
because investors would tend to sell their assets and shift
Within the framework of maintaining financial
03 corporate governance. This is particularly the case as
Argentina
regards transparency, supervision and enforcement of
regulations, considering that there are still many cases of
violations like insider trading, cornering, and window-
dressing. In addition, the government»s plan to issue an
international bond √to be used for refinancing and as
Indonesia»s international bond benchmark√ needs to be
executed with the right timing.
Stock Market
In general, development of the stock market
contributed to financial system stability by providing an
alternative instrument for investors, for risk diversification
and an alternative source of corporate financing, thereby
reducing dependence upon bank financing. With such
alternatives, the risk of an excessively deep and extended
crisis due to gridlock of financing flows can be minimized.
Development of the stock market was not only
marked by greater market liquidity, but also by investors
having deeper understanding of conditions in the stock
market. Indonesia»s stock market had the second best
gain in global performance, second only to Thailand. The
index, which began the year at 409.13, rose by almost
66% during the year, ending 2003 at 691.90. This rise
was not only dominated by blue chips companies (namely
Telkom, Indosat, Gudang Garam, HM Sampurna and Astra
Internasional) but also by non blue chips like Bumi
Resources, Bank BRI, PN Gas, etc.
Since 2000, stock price volatility has been relatively
low, without any fluctuations like those during the period

Box V. 1 Mutual Funds
Mutual funds, which have experienced extremely
rapid growth since 2002, have dropped off since
October 2003. This was due to quite large redemptions
at one of the mutual fund investment managers
towards the end of October 2003. Concerns over
potential systemic risk disappeared as the risk did not
materialize, because the investment manager was able
to fulfill its obligations to investors with the support of
loans from its parent company. To avoid reoccurrence
of such fluctuations in the mutual funds market, BI
will continue to make efforts to coordinate market
players and the relevant authorities.
After having experienced extremely rapid growth
in 2002 that continued through quarter III-2003,
mutual funds contracted beginning in October 2003.
In November, mutual funds NAV dropped by Rp13
trillion from its peak in September 2003, to Rp72.8
trillion. This was due to large redemptions, particularly
at one large investment manager. Redemptions were
heavy for two types of mutual funds, namely mutual
funds under cooperation with banks (constituting a
quasi-deposit product) and pure mutual funds, which
did not involve cooperation with banks.
Table : Performance of Mutual Funds
Description Sep 2003 Oct 2003 Nov 2003
1. Number of mutual fund 171 181
2. Share holders/investment unit: 179,360 184,934 174,892
- foreign 432 469
- domestic 178,928 184,465 174,429
3. Net Asset Value (Trillion Rp) 85,87 79,24
4. Outstanding Number of shares/
investment unit (million) 73,684 68,442
Source : Bapepam
Chapter 5 Capital and Money Markets
Redemptions of quasi deposit mutual funds were
executed in accordance with the bank»s action plan in
response to BI»s request for observation of prudential
principles in mutual fund activities, reinforced by BI»s
letter dated 3 October 2003 to all commercial banks.
Because that particular redemption was planned al-
ready, it did not spur great concern.
The other part of the redemption occurred in pure
mutual funds, as mentioned, those unrelated to banks.
The triggering factor for this rush of redemptions was
largely due to a change in the method of evaluating
net asset value (NAV) of mutual funds, from an ac-
crual basis to marked to market. This change prompted
redemptions because the new method caused NAVs
to decline.
Redemptions of mutual funds resulted in a decline
in the total amount of government bonds held by
mutual funds, because most mutual funds are «fixed
income», with the underlying investments being
government bonds. In September 2003, the total
amount of government bonds held by mutual funds
reached Rp59.4 trillion; as of November 2003, it had
dropped by 26.1% (Rp15.5 trillion).
Trillion Rp
100
Managed Fund NAV
90
80
70
181
60
50
40
463
30
20
10
72,83 0
12 12 12 12 12 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11
96 97 98 99 00 01 2002 2003
Source: Capital Market Supervisory Agency (Bapepam)
63,263
Chart Box V. 1.1
Developments of NAV and Managed Funds
71
 Chapter 5 Capital and Money Markets

Government Bonds Held

Total (Trillion Rp) by Mutual Funds & BTO (Trillion Rp) Trillion Rp
440 110
90
NAV Goverment Bonds
430 100 80
420 90 70
410 80
60
400 70
Total Government Bonds 50
390 Government Bonds held by BTO 60
380 Government Bonds held by Mutual Funds 50 40
370 40 30
360 30 20
350 20
10
340 10
330 0 0
12 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11
12 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11
00 01 2002 2003
00 01 02 2003 Source : Database BI, Capital Market Supervisory Agency (Bapepam)
Source : Database BI

Chart Box V. 1.2 Chart Box V. 1.3

Development of Government Bonds Development of NAV & Government Bonds

To avoid a reoccurrence of such fluctuations in through meetings and other communications.

mutual funds √which could disrupt the financial Bapepam has already undertaken steps to support

system√ cooperation among related parties is very sound development of mutual funds. During 2003,

important. In this regard, to enable early anticipation Bapepam dissolved 17 mutual funds products that were

of problems, BI continues coordination with market considered inefficient in their management and having

players (investment managers, banks, etc) and related total managed funds below the minimum limit as

authorities (Bapepam and the Ministry of Finance) regulated in the collective investment contracts.

1997-99. In 2003, stock price volatility tended to be quite implementation of tight supervision by the supervisory

limited (around 5%), indicating that the market has authority (Bapepam). Many violations still occur and these

developed well and become more efficient (Chart V.3). could undermine investor confidence, especially among

However, the stock prices may not reflect corporations» small investors.

fundamental conditions. As a result, the market was still The rising number of banks undertaking sales of stock

susceptible to issuers» business risk, shocks and negative to the public, particularly through initial public offerings

sentiment concerning non-economic conditions, such as

security. 35 800
Expon. (JCI (RHS)) VJSX (LHS) JCI (RHS)
30 700
In line with developments of the global and domestic
600
25
stock markets as well as implementation of government 500
20
400
programs stated in the white paper, stock prices are 15
300
expected to continue rising in 2004. However, a market 10
200
5 100
correction might occur during quarter I-2004 when stage
0 0
1 of the general election is underway. 97 98 99 00 01 02 03 04
(y = 509.23e-0.0013x))
Source : CEIC, (processed)
Within the framework of developing the stock
Chart V. 3
market, there is a need to ensure good corporate
Composite Stock Price Index and Volatility
governance, particularly in terms of transparency and

72
 Chapter 5 Capital and Money Markets

in Indonesian banking conditions, particularly as regards

800 90
profitability.
700 80

600 70 For the next 6 months, banking stock prices are

JCI 60
500 expected to be relatively stable. Further, based on business
50
400
JFI 40 performance, the prices of several major banking stocks
300
30
200 20 (BCA, BRI and Danamon), would rise.
100 10
JFI (RHS) JCI (LHS) In relation to the above, listed banks are expected to
0 0
1997 1998 1999 2000 2001
improve their corporate governance, particularly in relation
Source : CEIC

to transparency and risk management. This will increase

Chart V. 4
Trend of Jakarta Finacial Index (JFI)
(IPOs), has contributed to financial system stability. During
2003, two banks held IPOs, Bank Mandiri and BRI, and
each stock sale was oversubscribed. The robust stock
market has opened up a cheap, alternative source of
financing for corporations and offered an alternative
investment instrument to the public.
On the performance side, the banking sector»s stock
prices during 2003 contributed to the strengthening of
overall stock prices. For instance, the financial sector price
index had a positive correlation with the composite stock
price index (Chart V.4). Also, stock issuance by Bank Mandiri
in May 2003 and Bank BRI in October 2003 boosted
capitalization of the Jakarta Stock Exchange (Chart V.5)
Improved performance of banking stocks is expected
to assist with recovery of the investing public»s confidence
stability in the stock market and in the overall financial
system.
Bond Market
In line with stable stock market conditions, the SUN
(government bonds ) market became more liquid and
efficient. However, a close watch is still necessary due to
refinancing risk and undersubscriptions, which could erode
government credibility and the sustainability of state
budget financing. Government bonds (issued in the
domestic and international markets) represent an
alternative source of financing for the government; they
also provide useful benchmarks for corporate bonds.
Large issuances of SUN and their varied maturities
have helped make this market more liquid than the
corporate bond market (Chart V.6). However, the
upward trend of SUN yields could disrupt government

Percentage
YtM (%)
0.08 70
13
PER (RHS)
0.07 60
3 per. Mov. Avg. (PER (RHS))
0.06
Volatility (LHS) 50 12
0.05
40
0.04
11
30
0.03
20 Aug Oct
0.02
10
0.01 10
Sep Nov
0.00 0
9
2001 2002 2003
0 1 2 3 4 5 6 7 8 9 10 11
Source : CEIC
Maturity (Year)

Chart V. 5 Chart V.6

Price Earning Ratio»s of Listed Bank Yeld Curve of Indonesia Goverment Bond

73
 Chapter 5 Capital and Money Markets

markedly. This is evidenced by the rising value of new bond

Trillions of Rp
50
issuances and market capitalization, which were up 202%
FR VR HB
40 and 3.2%, respectively. However, such rapid development
30 necessitates close monitoring due to the potential for credit

20
and systemic risk.
A sharp rise (of 66%) in the corporate bond price
10
index during 2003 made an important contribution to the
0
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20
Indonesian capital market. Liquidity of the corporate bond
Years

Chart V.7
market (Chart V.8) has picked up in terms of both price
Maturity Profile of Goverment Bond and value of bonds issued. However, a number of 2003
issuers had questionable fundamentals. Debt to equity

financial conditions due to higher interest rates on new ratios remained high in several sectors (such as textiles,

issuances. property, and pulp & paper), suggesting continued

In addition, large amounts of SUN will mature in the vulnerability. The loss given default of 10 biggest

period of 2004 to 2013, which narrows the long-term corporations that potentially could go bankrupt is US$27.9

options for SUN refinancing (Chart V.7). This was one of million (approximately Rp237 billion based on the end-

the factors behind several cases of undersubscription of 2003 exchange rate). In addition, many investors are still

SUN issuance in 2003. unsophisticated and unfamiliar with transaction risks in

Despite the reprofiling of government bonds (which the capital market. Consequently, there is a need to

also added more maturities), the timing of SUN issuance improve monitoring of the corporate bond market to avoid

remains very important because of the government»s need rising systemic risk (Box V.3 Corporate Bonds).

to reduce its interest burden, especially in the light of Of the 10 largest corporations in Indonesia that have

continuing high yields. Undersubscriptions of government issued bonds (Table V.1), several companies have default

bonds and rising yields illustrate the potential for financial ratings (according to S&P). If adequate monitoring is not

difficulties if SUN issuances are not planned carefully. undertaken and proper education is not given to investors

Within the framework of providing benchmarks and in bonds, the realization of credit risk might trigger panic

diversifying budgetary financing, timing of the

government»s issuance of the next Yankee Bond needs be
0.008 1400
Liquidity (LHS) Index (RHS)
carefully considered. Considerations in this regard include 0.007 1200

global interest rates, which are relatively low at present, 0.006

1000
0.005
and improving investor confidence as reflected in stronger 800
0.004
600
international ratings for Indonesia. These factors are 0.003
400
0.002
expected to accelerate the next issuance of international
0.001 200
bonds (Box V.2 Prospects for Issuance of Indonesia»s 0 0
2001 2002 2003 Nov
International Letters of Indebtedness Yankee Bonds). Source: CEIC

In line with development of the government bond Chart V. 8

Market Liquidity of Corporate Bond
market, the corporate bond market also improved

74
 Chapter 5 Capital and Money Markets

Table V.1
Rating of Default Probability of Large Corporate Bonds

O/S Maturity
No Issuer Industrial Sector LGD*
(US$ eq.) Date

1. Pratama Datakom Asia BV Media & Publishing 260 7/15/05 27.9

2. PT Polysindo International Finance Co BV Textiles & Clothing 250 7/30/06 26.9
3. Sampoerna International Finance BV Tobacco 200 6/15/06 21.5
4. PT Telekomunikasi Selular Finance Ltd Telecoms/Communications 150 4/30/07 6.9
5. Indofood International Finance Ltd Food & Drink 280 6/18/07 4.9
6. DGS International Finance Co BV Agribusiness 225 6/1/07 4.3
7. DPSL Finance Co BV Financial corporate 150 12/30/10 2.6
8. PT Polysindo International Finance Co BV Textiles & Clothing 260 6/15/06 1.5
9. RAPP International Finance Co BV Forest products/Packaging 200 12/15/05 1.1
10. PT Bank Negara Indonesia (Persero) Banking & Financial services 150 11/15/12 0.5

*LGD = Loss Given Default

selling by domestic investors, who do not yet understand
the risks in holding bonds.
These conditions are related to the rapid
development of the bond market, which has allowed
several high-risk corporations and industries (for example,
timber and textiles) to act as free-riders in collecting public
funds through the bond market. This needs to be watched
closely to avoid disruption to bond market development
and a drop in general investor confidence. Also, problems
in the bond market could disrupt overall financial system
stability, particularly the banks, because most bond issuers
also finance their businesses through bank credits.
Consequently, to maintain capital market
development and overall financial stability, the bond market
authority needs to enforce good corporate governance √
particularly transparency√ and to maintain tight supervision
over the market. Many violations still occur and these
could undermine investor confidence, which could in turn
others, a relatively low amount of bank credits compared
to funds accumulated.
As just mentioned, interest rates in both morning
and afternoon interbank sessions trended downward
during 2003. As of December 2003, interest rates in the
morning interbank market were down 32.9% compared
to January 2003; interest rates in the afternoon session
dropped by 39.4% (Chart V.10). This reflected abundant
liquidity in the interbank market, which could be observed
from the ratio of credits to third party funds of only 53%
as well as the ratio of fund placements to funding of
80%. This condition of bank overliquidity spilled over
into an oversupply of funds in the money market because
banks consider the interbank money market as an
Percentage
13
IBCM (morning)
12
IBCM (afternoon)
11

erode the larger financial system. 10

8
5.2. Development of Indonesia»s Money Market Bank Indonesia Certificate (SBI)
7
1 Month Deposit
During 2003, the money market was characterized 6
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
by a downward trend in interest rates, in both the morning Source : Database BI
2003

and afternoon interbank money market, in line with lower Chart V. 9

SBI rates (Chart V.9). This was supported by a continuing Development of SBI, Deposit, Interbank
Money Market Interest Rates
over-liquid condition in the banks, as suggested by, among

75
 Chapter 5 Capital and Money Markets

Box V. 2 Prospects for Issuance of Government International Securities

(SUN) (the Yankee Bond)

Prospects for the issuance of a new global bonds Table : Projection of Government»s
Payments of Interest and Principal
(Yankee bonds) are quite encouraging, in line with
declining global interest rates and Indonesia»s 2003 2004 2005 2006

Domestic Interest 55.2 53 49.9 48.7

improved risk premium. Success in issuance of the
Foreign Interest 26.8 27.5 26.6 26
Yankee bond will provide an alternative source for Total 82 80.5 76.5 74.7
Domestic Principal 13.5 30.5 35 36.7
government financing and assist with fiscal Foreign Principal 16.7 46.4 48.9 47.9
Total 30.2 76.9 83.9 84.6
sustainability, thus supporting stability in the overall Total Interest and
Principal 112.2 157.4 160.4 159.3
financial system. However, there is a need to closely
Source : Ministry of Finance
monitor international interest rates, which could rise
again, adding to the government»s debt servicing amount, recapitalization bonds √which carry high

burden. interest rates√ amount to Rp412.4 trillion, which is a

In financing the 2004 state budget deficit (of risk for government budget sustainability.

1.2% of GDP), the government will mainly use Are prospects for issuance of the Yankee bond

government savings and issue a Yankee bond in the viable?

amount of Rp3.5 trillion (USD 400 million). According 1. In response to declining interest rates, global

to the government»s plan, the Yankee bond will only markets have recently been flooded with bond

be issued if state revenues come in below target. issuance, including by Asian markets to take

Prospects for the issuance of a Yankee bond are advantage of the relatively low cost of borrowing.

quite encouraging in line with declining global interest Issuance of bonds by banks in Asia (excluding

rates and Indonesia»s improved risk premium. Japan and Australia) went up 20%, from USD12.5

However, the international bond market is starting to billion in the first semester of 2002 to USD14.9

look overcrowded; Indonesia»s rating is still weak, billion in the first semester of 2003.

despite recent up-gradings; and Indonesia»s existing 2. Total government debt is already high, being

debt is quite large. Furthermore, the possibility of a equivalent to 81.8% of GDP, well above the safe

rise in interest rates needs to be anticipated in order limit of 60% (benchmark best practice). This

to enable the government to undertake refinancing situation is aggravated by high interest rates on

at the cheapest cost. domestic debt, which could create a financial

Success in the issuance of a Yankee bond would problem for the government. Furthermore,

reduce risk for both the government and corporations payments of interest and principal are bunched

(including banks) and thereby contribute to the main- in 2004 and 2005, which could dampen investor

tenance of Indonesia»s financial system stability. interest in buying the Yankee bond.

Total government debt is quite large, at 3. Indonesia»s rating is still below investment grade

Rp1,317.3 trillion or 81.8% (2002) of GDP. Of this (S&P B-; the current rating for the 1996 Yankee

76
 Chapter 5 Capital and Money Markets

bonds is BBB), which will cause the Yankee bond which has improved recently but remains relatively
to carry a high interest rate because of a large high. This indicates improving investor confidence.
risk premium. This was also reflected in the yield
spread of 198.7 basis points (at 21 August 2003), Impact on Financial System Stability
1. Bank Mandiri»s foreign currency debt issue was
350 over-subscribed, and the Yankee bond is expected
329.5 331.8 275.2
300
319.5 321.0 320.8 to attract similar interest.
250
230.0 2. Success in the issuance of a Yankee bond will
200

150 renew government access to international capi-

100 tal markets; it will help with fiscal sustainability;
50
and it will not disrupt financial system stability.
0
Feb Mar Apr May Jun Jul Aug
2003 However, it will be important to maintain a close
*) Yield spread Yankee Bond RI 7.75 (1 Ags 2006) dg US Treasury 3.5 (15 Nov 2006)
Source : Bloomberg
watch for a possible reversal of interest rate de-
Chart Box V. 2.1 clines, as this could become a burden for the
Development of Yield Spread* of Indonesia»s
Yankee Bond government.

alternative placement for funds, promising profits with for the interbank money market was calculated based on

quite low risks. This is amplified by perceptions of high the average interbank money market rate at JIBOR member

credit risk on the part of the banks, causing them to seek banks (11 banks). Since September 2003, the maximum

relatively safe placements, such as SBIs and the interbank guaranteed interest rate in the interbank money market

money market. has been higher than the guarantee ceiling for rupiah

Government policy on guaranteeing interbank deposits due to a change in the formula for calculation of

money market transactions supported this condition. the latter (a sizable positive margin in the calculation was

During most of 2003, the guarantee interest rate ceiling eliminated). Relatively high interest rates in the interbank
market caused banks to place their funds in the interbank

Percentage
market, which added to the oversupply of funds in that
Trillion Rp
60 14
market and pushed rates down.
12
50
Fund placements in the interbank money market
10
40
8 adversely affect bank intermediation. Relatively high rates
30
6 (which do not differ much from those on SBIs), along with
20
4
a government guarantee causes banks to prefer the
10 IBCM (morning) (Trillion Rp) IBCM (afternoon) (Trillion Rp) 2
Morning PUAB’s Interest rate (%) Afternoon PUAB’s Interest rate (%) interbank money market rather than relatively risky credits.
0 0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2003 Also, the guarantee on the interbank money market could
Source : Database BI

become an additional burden for the government.

Chart V. 10
Development of Interbank Money Market In 2004, these conditions are predicted to continue.
Interest Rates and Transaction Volumes
There would be high liquidity in the interbank money

77
 Chapter 5 Capital and Money Markets
Box V. 3 Corporate Bonds
The bond market experienced some euphoria in
2003. This was brought on by declining SBI interest
rates, which prompted investors to shift to profitable
investments; by the prospect of elimination of the guar-
antee program; and by strong purchases of mutual
funds backed by recapitalization bonds. Moreover, im-
proving market perceptions of Indonesian companies
and declining country risk boosted the bond market.
During 2003, there were 54 issuances of bonds
totaling more than Rp 25.4 trillion. Of these, 80% (43
issuers) were private corporations, including potential/
existing large bank borrowers in the amount of Rp 19.2
trillion or 35.8% of total bank credits extended up to
October 2003.
Impact on Banks
Funds raised from bonds issuance would be partly
used by debtors to repay bank credits (both directly or
indirectly, that is, after being used for business restruc-
turing). However, this would reduce the growth of
market; interest rates would continue on a downward
trend; and banks would continue to seek alternatives to
high-risk credit placements. The plan to reduce coverage
of the blanket guarantee program will eventually eliminate
the guarantee on the interbank money market, which will
reduce banks» interest in placing their funds in that market.
On the downside, several small banks that have often
78
credit. In addition, banks now face a new competitor
(the capital market) in credit channeling and this could
cause them to loose potential clients, as has already
happened at several banks.
Impact on the Financial System
There is little potential risk for the financial sys-
tem, particularly the banking sector. However, with-
out adequate regulation, it is possible for under-quali-
fied debtors to issue bonds, which could result in de-
faults, as happened with PT Sinar Mas and PT Riau
Andalan Pulp and Paper.
On one hand, the issuance of corporate bonds
could reduce banks» credit risk. On the other hand, an
alternative source of financing will further reduce the
growth of credit, which will hamper development of
intermediation and cause SBIs to remain a principal
source of revenue. Another impact is that the entry of
a new competitor will force the banks to operate more
efficiently and to lower interest rates on their credits.
been borrowers in that market could experience liquidity
problems.
To avoid such a negative impact, the guarantee
program should be eliminated carefully and in stages.
Banks should continue to be reminded to actively place
their funds in earning assets, such as credits, including to
boost the real sector, which would directly support
economic growth.
 Chapter 6 Payment System

Chapter 6
Payment System

79
 Chapter 6 Payment System

80
 Chapter 6 Payment System

Chapter 6
Payment System

In general, risks within the Indonesian payment system,

Trillion Rp
particularly liquidity risk and credit risk, can be minimized 3,000,000
Clearing RTGS (Netto)
2,750,000
Poly. (RTGS (Netto)) Poly. (Clearing)
2,500,000
by implementation of the Bank Indonesia Real Time Gross
2,250,000 R 2RTGS = 0,8121
2,000,000
Settlement system (BI-RTGS). Remaining liquidity and credit 1,750,000
1,500,000
risks still need to be continuously monitored and further 1,250,000 R 2KLIRING = 0,9695
1,000,000
reduced. 750,000
500,000
Further progress in this regard can be realized 250,000
0 10 1112 1 2 3 4 5 6 7 8 9 10 1112 1 2 3 4 5 6 7 8 9 10 1112 1 2 3 4 5 6 7 8 9 10 1112
through good management of technical risk and liquidity
2000 2001 2002 2003

monitoring of the BI-RTGS system. To avoid technical risk,

Chart VI. 1
BI will give utmost attention to the robustness of the Clearing Transaction

system. Robustness of the BI-RTGS system can be

improved, among others, by achieving a high level of
availability (for example 99%) and by the support of a
good communication network. BI also makes various
efforts to minimize operational risk in the BI-RTGS system.
In addition, there is on going monitoring of the
possibility of a shortage of market liquidity. This monitoring
is meant to detect the possibility of a liquidity shortage
that would endanger smooth operation of the payment
system and could even trigger systemic threats to financial
system stability.
Since implementation of the BI-RTGS system in
November 17, 2000, there has been a shift in the use of
the payment system from clearing system to BI-RTGS
system. The volume of transactions processed by the BI-
RTGS system in the reporting year rose 93.11% while total
value rose by 51.94% relative to 2002. Reflecting the shift
to BI-RTGS, the transaction volume of clearing activities
dropped by 24.63%; total value dropped by 25.39%. In
2003, the share of daily use of the BI-RTGS system came
to 94.79%, leaving the clearing system with 5.21%
(Rp85.6 trillion and Rp4.7 trillion, respectively). This
indicates that 94.79% of the payment system risk has
shifted from the clearing system to the BI-RTGS system.
The shift from the clearing system to the BI-RTGS
system has changed the nature of payment system risk.
Previously, risk cumulated during the course of the day,
because the clearing system operates based on multilateral
netting with settlement at the end of day. Now, the risk is
spread out during all operational hours of the BI-RTGS
system (06.30 up to 17.00 Western Indonesian Time).
Distributing risk in this way requires users of the BI-RTGS
(in this case banks) to manage their liquidity during the
entire day. By this means, the shift from the clearing system
to the BI-RTGS system supports financial system stability,
which is the objective of introducing the BI-RTGS system.
To ensure good management of payment system risk,
it is necessary to oversee the payment system. Payment
system oversight in Indonesia is implemented with
reference to standards contained in the Core Principles
for Systemically Important Payment Systems (CP SIPS) using
a self-assessment method. Efforts in this regard ensuring
good management of payment system risk are made both

81
 Chapter 6 Payment System

internally by BI and by external parties. Efforts by external
parties include establishment of the risk management
committee within the National Payment System
Communication Forum, comprising representatives from
five banking associations. This committee discusses joint
efforts related to good management of payment system
risk, which will be made by users of the payment system
(banks) and BI.
Currently, the BI-RTGS system is quite safe and
efficient. This condition has to be maintained. From the
side of daily activities, the BI-RTGS system processes an
average value of Rp85.6 trillion and an average volume of
17,055 transactions per day. By nominal amounts, most
transactions concern settlement of marketable securities
transactions administered by BI (SBIs and government
bonds). By volume, most transactions were bank
customers» transactions (74.6%).
Percentage
100
90
1.40
Percent
80 1.20
ACPT (T.Settle)
HCNL (T.Settle)
Transaksi RTGS yang Tidak Settle (Not Settle)
Currently, banking liquidity in relation to settlement
of payment transactions is sufficiently good. This is
illustrated by the share of the value of transactions
successfully settled, namely 99.99% (Rp85.6 trillion). This
leaves the share of nominal value of transactions cancelled
at end of day (status QCNL) at only 0.01% (Rp9.2 billion).
This is evidence that the payment system operates smoothly
and that liquidity in the payment system is quite adequate
for transaction settlement by participating banks.
As for monitoring financial system stability, smooth
processing of transactions by the BI-RTGS system is an
important factor that is expected to reduce liquidity failure
and systemic risk stemming from liquidity shortages in any
large bank, which could disrupt the overall system. Most
material transactions are made at the beginning and end
of the day. Therefore, the BI-RTGS by-laws adopt a
graduated payment schedule rule and BI has a policy of
differentiated pricing at different times for processing by
the BI-RTGS system. This is intended to encourage
transactions to be sent and settled during the morning,

70
1.00

0.80
PSED (T.Settle) and not to be concentrated in the afternoon.
QCNL (T.Settle)
60 0.60

50
0.40

0.20
RJTD (T.Settle)
Within the framework of financial system stability, in
-
40 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

relation to trades of marketable securities and bonds issued

30
20 by the government within the framework of financial system
10
0 stability, BI has implemented the Bank Indonesia Scriptless
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Settle Not Settle Securities Settlement System (BI-SSSS). Implementation of

Chart VI. 2 this system constitutes BI»s effort to adopt the Delivery Versus
Unsetled RTGS Transaction
Payment (DVP) mechanism aimed at minimizing payment
system risk arising from the settlement of marketable
Code Description
securities (SBIs and government bonds). With
ACPT Transaction cancelled √ due to incomplete
implementation of the BI-SSSS, fund settlement can be
transmission
executed simultaneously with marketable securities
HCNL Transaction cancelled by Host
settlement, thereby minimizing the risk of payment failure.
PSED Settlement pending √ waiting for data
QCN
QCNL Queue Cancelled √ transactions in queue In 2003, payment transactions through the clearing

cancelled by sender (bank) due to business system were on a downward trend. The daily average value

consideration (prioritization) of clearing transactions declined from Rp6.2 trillion to

RJTD Transmission rejected by supervisor Rp4.7 trillion, while the daily average volume declined from

82
 Chapter 6 Payment System

470,514 to 300,903 transactions. Despite these declines,
the BI clearing system (which is a multilateral netting
settlement system) still constitutes the country»s second
largest payment system (next to the BI-RTGS system).
Although the risk emerging from use of this system is very
small (5.21% of total value of settlements), this risk still
needs to be well managed.
Management of clearing risk is still necessary
although the potential for systemic risk is quite low. This
is done through improvement of operational aspects of
the clearing system, comprising enhancement of technical
and non-technical aspects as well as clearing schedule
arrangements. In the framework of reducing clearing risk,
CP-SIPS will be adopted. With the FtS scheme, BI as
settlement operator would not be responsible for
insufficient funding experienced by clearing participants
in settling their clearing results.
In conclusion, risks in the Indonesian payment system,
particularly liquidity risk, have been reduced through
implementation of the BI-RTGS system. However,
continued monitoring of risks in the payment system is
necessary in order to maintain an efficient, smooth, and
safe payment system.
Trillions of Rp
350,000 6

300,000
5
BI has also implemented other risk mitigation steps in the
250,000
4
clearing system. For instance, limiting the value of
200,000
3
interbank debit notes (to a maximum of Rp10 million per 150,000
2
transaction) and limiting the value of credit notes that can 100,000 Sheet
Nominal
50,000 1
be settled through the clearing system (to less than Rp100
0 0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
million per transaction). In addition, within the framework
2003
Source : Bank Indonesia
of tackling the possibility of settlement failure through the
Chart VI. 3
clearing system due to insufficient liquidity, the Failure to Average Clearing Cycle
Settle (FtS) scheme in line with guidelines contained in the

83
 Chapter 6 Payment System

84
 Article I

Articles

85
 Article I

86
 Article I

Article I

Study on the Cost of Intermediation At Several Large Banks in Indonesia:

Are Commercial Banks’ Interest Rates on Credits Overpriced?

Muliaman D Hadad1, Wimboh Santoso2 & Dwityapoetra S. Besar3

October 2003

Abstract

Interest rates on deposits and credit are very important in calculating banks’ cost of intermediation and
in giving preliminary indications of overall economic efficiency. This paper explains the structures of banks’
cost of funding and credit interest rates in order to explain factors that have influenced the high levels of
credit interest rates in the period from January 2002 to June 2003. The estimation method used is the Cole,
Santoso and Heffernan method, complemented by the Historical Average Cost Approach for calculating
contributions to bank costs (overhead costs) using quarterly financial data.
This model is used to answer two main questions: Is the calculation of bank interest rates quite
reasonable?; and, what are the determining factors? Data limitations in this paper require that the estimation
results be interpreted cautiously.
This research mainly shows that banks’ cost of funding has come down in line with falling SBI interest
rates. However, banks’ credit rates are unusually high (overpriced) compared to the average cost of funds at
several banks, according to these estimates. Therefore, the overall cost of intermediation is still high compared
to what would normally be expected. There are several important causal factors. One is banks’ tendency to
limit competition because their liquidity is still quite adequate and their income from SBIs and bonds is still
high. These factors cause banks to adopt a wait-and-see attitude in the short-run regarding developments in
the money market and real sector. In addition, there is also a possibility that implementation of bank risk
management, particularly as regards product pricing, is still not accurate and tends to burden debtors with
excessively high risk premiums, which boosts the level of credit rates.

Keywords: Cost Intermediation, Bank

JEL Classification : G21, G28

1 Head of Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; e-mail address: muliaman@bi.go.id
2 Bank Executive Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; email address: wimboh@bi.go.id
3 Bank Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; email address: dwityapoetra@bi.go.id

87
 Article I

1. BACKGROUND
Effectiveness of monetary policy and financial system stability depends in part upon several important parameters
that are not directly under the control of the central bank. These parameters include the supply elasticity, the demand for
real and financial assets and the relationship between deposit and credit interest rates. All of these are influenced heavily
by the structure of the financial system, especially money market conditions and the level of sophistication, competition,
and availability of alternative financing sources.
Rigidity of borrowing interest rates is often considered a factor that hampers smooth transmission between monetary
policy and the real economy. For example, Bank Indonesia lowered SBI interest rates by a total of 280 basis points in the
period of January 2003 to June 2003, but credit rates declined only 64 basis points during the same period. This small
decline in credit rates has limited the impact of easier monetary policy on the real sector.
Surveys indicate that this rigidity stems from factors
that are both internal and external to banks. The internal
Percent factors include the earning assets structure while some of
25
them are sensitive to SBI»s rate and this stimulate bank to
20
limit their credit rates in order to protect their profit margins.
15
This is worsen also by long-term funding sources which is
10
relatively high-cost. At the same time, banks have also been
5 slow to implement optimal risk management, making it
SBI (1m) COF Credit Interest Rate

0 difficult to determine accurate pricing for individual debtors.

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
2002 2003
Source : Data 8 bank besar diolah From the external side, a large number of customers

Chart 1 are still waiting for further declines in interest rates before
Trends of SBI, Cost of Funds and Credit Interest Rates
obtaining loans from banks, and many potential debtors»
projects are not bankable.
This paper is focused more on the supply side, which looks at bank interest rates (that is, pricing) based on data
from January 2002 up to June 2003. The objective is to know whether bank pricing (in terms of cost of funds and credit
rates) reflected reasonable intermediation costs during that
period. In addition, analysis of the cost of funds (COF) is
used to complement the analysis of credit interest rates,
Bank (ex-post) Estimasi which is more observable and readily available. Considering

Profit Margin data and methodological limitations, this study is expected

Loan Interest rate Risk Premium
Compononts
Overhead Cost
to be a reference point for further work on intermediation
Guarantee
Loan conditions in Indonesia.
Reserve Requirement
Cost of fund

Cost of funds
2.RESEARCH METHODOLOGY
This research is conducted in a simple, quantitative way,
Chart 2
by making comparisons between estimated cost of funds
Components of COF and Credit Interest Rates (Rp)
and credit rates on the one hand, and bank actual data (ex-

88
 Article I

post) on the other. This provides a picture of factors that influence pricing formation of this market. In general, the
research methodology entails a literature study, estimation and simulation.

3. LITERATURE REVIEW
Commercial banks offer various types of savings services with varying degrees of coverage. Each feature is aimed at
meeting the needs of corporate and individual customers for saving funds or making transactions. For simplicity, the
model in this paper is limited to savings in current accounts, savings accounts, and rupiah-denominated fixed-rate deposits.
Floating interest rates could also be accommodated using a cost of fund based upon certain benchmark interest rates, for
example LIBOR or JIBOR, for compensating risk. Basically, this model is built to be flexible enough for further research to
use variable interest rates.
Theoretically, important issues in intermediation are related to the cost to creditors of obtaining information to
access credible debtor and differences in liquidity preferences as between creditors and debtors. This information cost
also reflects banks» cost of funds and interest rates on credits.
This study use the model developed by Heffernan (1996), which calculates the cost of intermediation as the difference
between banks» cost of funding and their credit rates. A high cost of intermediation suggests an inefficient economy and
weak bank performance. For analysis of the structure of the cost of fund and credit rates, see Rose (2002), who explains
that there are several components to cost of funds, such as interest cost, minimum reserve requirements, overhead costs,
profit margins, and risk premium. Application to the Indonesian context uses rupiah minimum reserve requirements of
5%, a 0.25% guarantee premium, and certain risk premiums calculated based on average credit risk in Indonesia plus an
asset yield spread.
The calculation of risk premium is difficult, therefore several approaches were used to meet bank operations, as
Copeland (1983) uses a table of premium grades credit quality, for example a standard risk premium of 0.5% or in special
cases 1.5%. In addition, an asset-spread approach can be used by calculating the difference between the yield on risk-
free marketable securities and the yield of another marketable securities with similar characteristics (maturity, duration,
liquidity, etc.). For example, the yield on Indonesia»s Yankee bond (a US$ government) or Surat Utang Negara (government
securities in rupiah) and the average yield on Indonesian corporate bond.
One measure of a bank»s efficiency is the accounting value of net interest income against total earning assets.
Meanwhile, a measure of profitability is before-tax profit relative to average capital (equity). This study focuses on
measurements of income and profitability as used by Demirguc-Kunt (1998).

4. DATA
The model»s data used for the cost of funds are deposits, savings, and rupiah current accounts, on a quarterly
frequency for five large banks from January 2002 to June 2003. For reviewing bank»s efficiency, the analysis uses banks»
balance sheets and profit/loss data, starting from January 2002. The weighted average for each saving types are used as
benchmark in calculating saving interest rates.
Risk premium can be calculated using the yield spread on Indonesian government bonds against US government
bonds with similar characteristics in terms of duration to maturity, liquidity, and so forth. JP Morgan has issued two types

89
 Article I

of estimated spreads of developing countries» government bonds (Cunningham (1999)). However, a spread that is more
suitable for Indonesia is the Emerging Market Bond Index (EMBI) because of its wider coverage (which includes Indonesia)
and its long data series, starting from 1991.
Data used in this study have been collected from various sources, largely from banks» monthly reports (balance
sheet and profit/loss report), which are available in Bank Indonesia. The JP Morgan spread data is available at Bloomberg.
Data on SBI interest rates and weighted average savings, and other data are obtained from Recent Indicator Reports,
which are compiled for Bank Indonesia»s internal use.

5. MODEL
The model used is a simple one that explains component structures and bank behavior. As explained by Shaffer
(1989 and 1993), an assumption of profit maximization leads to a simple equation where market forces can be calculated
explicitly. This framework combines relationships between certain balance sheet accounts (particularly deposits and credits),
which can illustrate bank intermediation spreads explicitly.
Banking activities are assumed to be strictly traditional (that is, the calculation does not take into account other
bank debts, off balance sheet transactions, and fee-earning business). Banks only take deposits and place funds in the
form of credits. On the assumption that a rise in deposits is used to fund credits, to meet minimum reserve requirements,
and to fund other non-interest earning assets, then additional assets can be expressed mathematically as follows (Cole
1991, Santoso, 2000):

t0-t1 = d0-d1=(r0-r1) + (l0-l1) +(p0-p1), where

t = total assets l = credits

d = deposits (savings) p = non-interest earning assets
r = minimum reserve requirement

The interest margin, which also constitutes intermediary costs, comprises overhead costs, the cost of capital, and
risk premium in the calculation of credit interest rates.
Using delta (d) to represent the increment, the above equation may be written as follows:
δt = δd = δr + δl + δp
If we simulate minimum reserve requirements and overhead costs (dr and dp, respectively), we get the following
equation:
δd = α δd+δl+β δd
where:
α = minimum reserve requirement (in %)
β = proportion of overhead cost
To simplify the calculation, d can be moved into the following equation and after that incremental credit (l) becomes:
l = d(1-α -β)

90
 Article I

Defining il to be the credit interest rate and id the deposit interest rate, the income interest rate on savings (r) can be
expressed as follows:
r = (ill √ idd √ cd) / d
r = ild (1-α -β)+idd √ cd /d
r = il (1-α -β) √ id √ c
where c is the cost of intermediation. Calculation of the credit interest rate can then be completed by re-arranging to:
il = (r + id + c) / (1 -α -β).
At the end, cost of intermediation that constitutes the difference between credit and deposit interest rates can be
obtained (il √ id). Calculation of risk premium in credit interest rate is based on Indonesia»s country risk, which is a calculation
of the difference between USD-dominated securities issued by the government of Indonesia and those issued by the US
government with similar characteristics. This risk premium can be considered as a compensation for a company or a bank
that incurs cost for issuing a riskier product.

6. RESULTS OF STUDY AND TESTS

As SBI rates have declined since early 2002, banks have generally adjusted their cost of funds quickly. However,
based on estimation results, the estimated cost of intermediation in quarter II-2003 was 2.43% lower than what was
actually observed. This suggests that costs of intermediation and actual credit rates are much higher than would normally
be expected. And while credit rates are still on the decline, they are coming down only very slowly.
This analysis shows that banks still have room in their current intermediation spreads (that is, without reducing
deposit rates further) to lower credit rates. This can be done by, for example, reducing their profit targets (ROE) and by
more accurate debtor credit risk analysis through implementation of risk-based assessment. Several large banks have
adopted this approach but their overhead costs and operational risks are still high. They tend to pass on this burden to
their debtors, which limiting declines in credit rates.
A decline of 2.21% in credit interest rate so is the optimal probability which allow banks to reduce real credit rates.
In practice, banks have reduced credit rates for selected sectors are given for productive credits and based on results of
assessment of debtor conditions and bank»s experience/competency in line with the sectors being financed.

Percent
Cost of Funds
25
Overall, the cost of funds at the banks in this study has
20
been on a declining trend since quarter I-2002. This decline
15 is in line with declines in SBI rates, which turned down in
10 January 2002. However, some longer-term savings have been
Sk. Bunga Kredit-Bank
Sk. Bunga Kredit-Est
5
relatively stagnant.
COF-Bank
COF-Est Still, there is considerable variation among banks. For
0
Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 example, one large bank still has an actual cost of funds
Chart 3 COF and Bank Interest Rate (ex-post) that is still higher than estimated. This shows that although
and Estimation Results
the average cost of funds is already quite low, some banks

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 Article I

still have high credit rates because the cost of their funding is inflated by longer-term, high-interest deposits. Results also
show that other banks have lowered their cost of funds, but not significantly. This development needs to be monitored
in order for banks not to experience negative interest rate spread again.

Influence of Lower Minimum Reserve Requirements on COF

A simulation of relaxing minimum reserve requirements (which are included in COF), shows that the impact on the
COF and on credit rates is relatively small. This is because the minimum reserve requirement ratio is already low (5%) and
the opportunity loss from idle placements has been included the cost of funds, using the SBI interest rate as a cost proxy.
Reduction (or even elimination) of minimum reserve requirement and the guarantee have a relatively small effect,
equivalent to an average decline in credit rates of only 0.5%.
Table 1 Influence of Changes in Minimum Reserve
Requirements and Guarantee Interest Rates on COF This is roughly the same as a bank policy adjustment to lower
Reserve requirment its ROE target by 5.7% (from base target to 13.6%). This
COF Reserve requirment
decrease to
Standard and loan interest = 0%
shows that minimum reserve requirements are not a dominant
Q1-2002 13.97% -0.43% -0.70% -0.73% factor in banks» cost of funds and credit interest rates. A
Q2-2002 13.29% -0.41% -0.67% -0.70%
Q3-2002 12.38% -0.38% -0.62% -0.65% better solution is demonstrated by a simulation that shows
Q4-2002 11.54% -0.35% -0.58% -0.61%
Q1-2003 11.11% -0.34% -0.56% -0.58% banks could reduce credit rates further by adjusting their
Q2-2003 9.60% -0.29% -0.48% -0.50%
profit targets by reviewing bank»s business plan and reducing
Average -0.37% -0.60% -0.63%
its ROE targets.

Table 2
Influence of ROE Changes on Credit Interest Rates Credit Interest Rates
Reserve requirment Although credit rates are on a downward trend, most
COF Reserve requirment
decrease to
Standard and loan interest = 0% banks» actual interest rates are still much higher than

Q1-2002 19.05% -0.54% -0.73% estimated (that is, much higher than would normally be
Q2-2002 18.37% -0.63% -0.82%
Q3-2002 17.45% -0.59% -0.77%
expected). On average, this difference is at least 2 √ 3%,
Q4-2002 16.73% -0.83% -1.01% which is considered to be the room for banks to lower their
Q1-2003 15.79% -0.31% -0.49%
Q2-2003 14.29% -0.37% -0.56% interest rates.
Average -0.55% -0.73%
Continuing high credit rates could also imply that
* average 5 banks 22.9% (»02) and 19.3% (»03)
* average big banks
* average public bank overhead costs at the five banks are too high, particularly
when compared with other South East Asian countries», in
the range of 1 √ 2%. Many banks» operations are still very dependent on branch networks but do not yet use sophisticated
technology, such as telephone/pc banking. High operational risks are another factor that contributes to high bank
overheads.
An additional important factor concerns competition. If the credit market is quite competitive, different credit rates
should reflect different clusters of banks, whereas the response of banks within one cluster should be relatively similar. All
five of these banks tend to limit credit rate reductions, which indicates that competition between banks has not recovered.
Banks» liquidity is adequate and bank income from SBIs and bonds is still high. Therefore, in the short-term, banks are
adopting a wait-and-see attitude towards the money market and the real sector. Also, banks are still affected by the

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 Article I

trauma of delinquent credits during the crisis of 1997/98;

3.5
during this post-crisis period, and they have tended to
3.0

2.5
safeguard their capital as a cushion against potential losses.
2.0 One of the five banks shows quite an interesting
1.5
phenomenon where credit rates remain high, despite declines
1.0
Big Bank in its cost of fund. This shows that the bank is trying to use
0.5
5 Bigest Bank credit interest income to compensate for declines in its income
0.0
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
2002 2003
from marketable securities (which carry variable interest rates).
Considering that the difference between actual and estimated
Chart 4
Overhead Cost to Productive Asset interest rates is still quite large, that particular bank could
recalculate its profit target and start lowering credit interest
2003
Bank E
2002
rates.
2001
Bank D 2000 Currently, consumer credits rate are already on the

Bank C decline, including for credits channeled to the consumption

Bank B
sector, including to the property sector, which is on the
rebound. Considering that the estimation results based on
Bank A
optimum assumptions and difference between actual √
0% 1% 2% 3% 4% 5%
estimated credit interest rates is still quite large, further
Chart 5
Cost to Average Assets lowering of credit interest rates can still be undertaken by
banks.
Weak demand for credit and rising undisbursed credits
Percentage
8 (Chart 6) provide an impetus to lower credit interest rates,
7
which would raise the demand for credits. However, in the
6

5 short-term, high credit interest rates and credit rationing seem

4 to be a matter determined by banks» particular business
3
considerations. Therefore, a push from the supervisory
2
Bank
1
Estimation
authorities to reduce credit interest rates would be helpful
0
Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 as competition among the banks does not seem to be
working quickly enough.
Chart 6 Comparison of Cost of Intermediation Between
Actual (ex-post) and Estimation Results
Cost of Intermediation
High intermediation spreads can be costly to the
economy because they lead to high lending rates. At the same time, this spread is the key mechanism through which
banks obtain profits and protect themselves from credit risk. Therefore, an analysis of spreads is important in knowing
whether a bank with high spreads is covering inefficient operations or if it is obtaining profits to strengthen the bank and
create a solid banking system.

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Table 3 Gap between Actual

In Indonesia, the estimated cost of intermediation has
and Estimated Costs of Intermediation
increased since quarter II-2002, but it is considerably smaller
Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003
than actual, observed costs of intermediation. Consequently,
Bank A 0.82% 1.06% -0.09% 0.02% -0.37% -0.30%
the actual intermediation cost could still be reduced by 2 √
Bank B -5.22%- 4.01% -4.50% -4.65% -5.68% -5.86%
Bank C -2.82% -2.93% -2.58% -2.38% -2.73% -2.59% 2.5%, mainly by more efficient banking operations.
Bank D -1.60% -1.86% -0.78% -1.44% -2.54% -2.69%
Bank E 0.16% -0.03% 0.33% 0.27% -0.39% -0.69%
Average -1.73% -1.55% -1.52% -1.64% -2.34% -2.43% Conclusions and Policy Implications
This paper analyzes a simplified bank pricing
methodology and considers the implications for the cost of intermediation. The analysis confirms results of previous
study and surveys. Namely, banks» cost of funds has declined more or less in line with SBI interest rates, but credit rates
are unusually high, because banks» intermediation costs are high, due in part to inefficient operations.
Internal factors causing the high cost of intermediation include banks» unwillingness to compete aggressively;
adequate levels of liquidity; and high levels of income from SBIs and bonds. Consequently, banks still adopt a wait-and-
see attitude towards the money market and the real sector developments. Also, there is a possibility that implementation
of bank risk management, particularly in relation to product pricing, is not sufficiently well developed. This tends to
burden debtors with high risk premiums that translate into high credit rates.
In the framework of accelerating declines in the cost of intermediation, it would be useful to push banks to enhance
efficiency, to reduce lending rates and to increase lending.
The possibility of relaxing banking regulations to reduce lending rates needs to be approached very carefully. It
should only be implemented within a coordinated macro and micro policy framework in order to achieve conducive
financial stability.
Finally, further research is needed, including into the lessons learned from other countries» experiences, particularly
countries in South East Asia, or elsewhere, that have experienced similar problems.

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 Article I

Bibliography

Berger, Allen N., and Robert DeYoung, ∫Problems Loans and Cost Efficiency in Commercial Banksª Journal of
Banking and Finance, Vol. 21 (June).
Barajas, Adolfo, Roberto Steiner, and Natalia Salazar, 1999, ∫Interest Spreads in Banking in Colombiaª IMF
Staff Paper Vol. 46., No. 2 (June 1999)
Cole, D.C; and McLeod R.H., 1991, ≈Financial Policy and Banking Deregulation in Indonesia∆, Gajah Mada University
Press, pp. 257 - 271
Copeland, Timothy SS., 1983, ∫Aspects to Consider in Developing a Loan-Pricing Microcomputer Model. ª The
Magazine of Bank Administration, August 1983.
Cunningham Alastair
Alastair, 1999, Bank of England Financial Stability Review
Demirguc-Kunt, Asli dan Harry Huizinga
Huizinga,1998, ∫Determinants of Commercial Bank Interest Margins and Profitabilityª
World Bank Working Paper No. 1900, Maret 1998
Gilbert, R. Alton
Alton, 1984, Banking Market Structure and Competition, Journal of Money, Credit, and Banking
16,617-660
Hanson,James A., and Roberto de Rezende Rocha,1986,
Rocha High Interest Rates, Spreads, and the cost of
intermediation,two studies, Industry and Finance Series 18, World Bank.
Heffernan, Shelagh, 1996 ∫Modern Banking in Theory and Practiceª, John Wiley and Sons,
Rose, Peter SS., 2002, ∫Commercial Bank Managementª, McGraw-Hill Irwin, 2002.
Santoso, W., 2000, ≈Indonesian Financial and Corporate Sector Reform∆, Bank Indonesia Working Paper, pp. 9-12.
Shaffer, Sherril, 1993, ∫A Test of Competition in Canadian Banking,ª Journal of Money, Credit and Banking, Vol.
25 (February) 1993.
ƒƒƒƒ, Sherril
Sherril, 1993 ∫Competition in the U.S. Banking IndustryªEconomics Letters, Vol. 29 (No.4).
Vittas, Dimitri
Dimitri, 1991, Measuring commercial bank efficiency, use and misuse of bank operating ratios, Policy Research
Working Paper 806, World Bank.

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96
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Article II

Early Indicators of Banking Crises

Muliaman D. Hadad1, Wimboh Santoso2 & Bambang Arianto3

December 2003

Abstract

Indonesia»s banking crisis of 1997/1998 provided a valuable lesson because of the high public cost of
rescuing the banking industry, a cost that reached more than 50% of GDP at the time. The banking crisis also
caused a loss of public»s confidence in the local banking industry that has been very slow to return. Consider-
ing these significant impacts, monitoring and analysis of factors that contribute to banking crises need to be
undertaken and continued in the future. In this review, causal factors are considered from both the real and
banking sectors, as well as other sharply fluctuating factors, which from now on will be called shocks. U sing
a model presented by Hardy and Pazarbasioglu (1999), logit analysis looks at several indicators of shocks and
of conditions in the real and banking sectors. It concludes that these indicators are useful as early warning
signs of banking system instability, and they could be used as inputs into policy formulation to prevent the
reoccurrence of a banking crisis.

Keywords: Macroeconomy, Banking Crisis

JEL Classification : E44, G21

1 Head of Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; e-mail address: muliaman@bi.go.id
2 Bank Executive Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; email address: wimboh@bi.go.id
3 Bank Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank Indonesia; mail address:bambang_a@bi.go.id

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 Article II

I. INTRODUCTION
I.1. Background
Indonesia»s banking crisis of 1997/1998 provided a valuable lesson that, when serious problems in the banking
sector are not detectedƒand fixedƒat an early stage, they can lead to a collapse of public confidence in the banking
industry. In addition, efforts to rescue the national banking system and to revive public confidence in that system can
require major amounts of public financing. In Indonesia»s case, the government has spent more than Rp500 trillion to
rescue and rehabilitate the banking sector, including through the Bank Indonesia Liquidity Assistance facility and the Bank
Recapitalization program.
Banking sector crises is related, directly and indirectly, to various activities that are normally undertaken by the
banking industry. On the side of funds accumulation, the amounts and composition of public deposits in the banking
system have a powerful effect on banking industry stability. Withdrawals of public funds on a large scale and in a rush
can be a severe shock to bank liquidity. If this situation is not tackled immediately, it will further create problems, like
insolvency. Banks will be forced to offer extremely high interest rates on savings in order to retain public deposits, and
these high rates will soon become too costly for the banks, hitting their profitability, especially if revenues sources drop
off, too, as happened in 1997√98.
Meanwhile, on the side of funds channeling, the composition of earning assets contributes to a bank»s resilience in
dealing with problems originating from outside the bank. For example, credit performance is very much determined by
prospects for industries that receive credits, as well as general macroeconomic conditions, such as inflation and the
exchange rate. From another perspective, economic growth often influences bank credit allocation policies towards
certain sectors, creating credit concentrations in some. This happened in the period immediately before the 1997/98
banking crisis, when credit was concentrated in the property sector, which was experiencing extremely rapid growth at
the time.
As mentioned, problems in the banking industry can originate from both the internal and external sides of the
banking industry. On the internal side, such problems can be viewed from the development of an individual bank»s
performance (at least those large enough to have a systemic impact) or from the performance of the overall banking
industry. Meanwhile, macroeconomic conditions and developments in industries that are heavily financed by banks, can
indicate potential problems for bank performance from external factors.
Therefore, it is important to undertake an on-going effort to monitor certain factors that are directly or indirectly
related to banking activity. For example, it would be useful to monitor banks» internal indicators, macroeconomic indicators,
and other variables that might give early warnings of problems in the banking industry. In this regard, a review needs to
be conducted on macro indicators that can be used as early signals of potential banking problems, so that preventive
actions can be taken before existing problems erupt into crisis.

1.2. Research Objectives

This review on early indicators of banking crises is directed at obtaining an understanding of factors internal and
external to banks that have the potential to indicate the existence of problems in the banking industry that could lead to
crisis.

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 Article II

1.3. Research Methodology

This review generally adopts the model researched by Hardy & Pazarbasioglu (1999). In this regard, the independent
variables are divided into three large groups, namely:
1. Real sector variables, for the purpose of explaining inefficiency in the use of banking credit and changes in repayment
capacity;
2. Banking sector variables, for the purpose of explaining bank resilience to significant changes, in both assets and
liabilities, and;
3. Shock variables, which are used to explain other factors that directly or indirectly (through the real sector) influence
banking conditions.
Data for this review comes from Macroeconomic & Financial Data in International Financial Statistics, IMF (CD-ROM
version, April 2003), which includes annual economic and banking data for 40 countries. Of these, 31 countries have
experienced severe distresses and 9 other countries are used as control models. With the coverage of those 40 countries,
the data totals 417 observations.

1.4. Discussion
This paper is divided into four chapters. Chapter I contains research background, objectives, research methodology,
and discussion. Chapter II explains other research on this topic, the theory on logit methodology, and statistical tests
using Type I & Type II errors. Chapter III presents research results and interpretations as well as an application of this model
to Indonesia»s current economic situation. Finally, Chapter IV describes the conclusions.

II. Literature Review

II.1. Banking Crisis
Several economic experts believe that the banking industry requires special attention because of its susceptibility to
external influences and because it is an integral part of the payment system.4 As part of the payment system, problems
in the banking industry can spread quickly throughout the entire economy, with an impact that is well beyond the effect
on any single company. In this regard, concern arises about «snowball effects» stemming from the collapse of one bank
that may lead to the collapse of other banks and other companies that have business relations with the banks.
Several analysts present reasons to support the statement that the banking industry is an industry that requires
special attention. These reasons include observations that the banking industry has:
1. A low cash to asset ratio;
2. A low capital to asset ratio; and
3. A high short-term funding to total deposit ratio.
In these conditions, large-scale fund withdrawals in a rush would cause liquidity problems for the banking industry,
which would then prompt banks to use every means possible to allow withdrawals by the public, including efforts to sell
assets at cheap prices. This condition brings about distress for the entire banking system and may have a follow-on
impact on profitability, which could eventually lead to insolvency.
4
George F. Kaufman, ≈Preventing Banking Crises in the Future: Lessons from Past Mistakes∆, The Independent Review, v.II, n.1. Summer 1997, p.55.

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 Article II

Banking crises in various countries, particularly in the Asian region, have prompted researchers to undertake reviews
of indicators that can give early warnings of crisis or other pressures on the banking industry. Kunt & Detragiache (1998)
define a crisis as a situation where one of the following conditions are fulfilled:
1. The ratio of non-performing assets to total assets in the banking system exceeds 10%;
2. The cost of the rescue operation is at least 2% of GDP;
3. Large scale transfers of ownership of banks to the government (nationalization); or
4. Extensive bank runs or emergency measures been enacted by the government, such as freezes on public deposits,
prolonged closing of bank offices (bank holidays), or generalized deposit guarantees.
Hardy & Pazarbasioglu (1999) further state that problems in the banking industry can be categorized into two broad
groups, namely ≈severe distress∆ and ≈full-blown crisis∆. Severe distress occurs when banking problems have cumulated
to a certain point but have not reached one of the conditions defined by Kunt & Detragiache (1998) above. A full-blown
crisis occurs when one of those conditions is fulfilled. Hardy & Pazarbasioglu further state that a crisis or major problem
in the banking industry can originate from the real sector, from sources internal to the banking sector, and from drastic
changes in certain economic indicators. For example, a sharp drop in GDP, a jump in real interest rates, a decline in the
incremental capital output ratio (ICOR), a sudden depreciation of the exchange rate, a sharp rise in inflation, a burst in
credit expansion or a significant shift in capital flows. The same issue is also described by Kunt & Detragiache (1998), who
says that banking crises tend to occur when macroeconomic conditions deteriorate. In this regard, low GDP growth is
very closely related to rising risk in the banking industry. In addition, increased risk for the banking industry can also
originate in high inflation, including when efforts to reduce inflation entail a sharp rise in real interest rates.
In the case of banking crises in the Asian region, Hardy & Pazarbasioglu (1998) state that the causes included
exchange rate appreciation followed by an extremely sharp depreciation, and sharp increase in foreign debts followed by
frequent defaults. In addition, major problems (although not of crisis proportions) in the banking industry generally
originated in domestic factors, such as excessive credit expansions to the consumer sector and high real interest rates on
deposits. Banking problems that lead to a crisis are generally caused by excessive credit expansion, especially from foreign
debts and sharp fluctuations in the real effective exchange rate.

II.2. Statistical Method and Tests

Logit Model
In general, dependent variables in regressions are not limited to a certain range. However, in some cases the
dependent variable may, by definition, lie between 0 and 1 (for example a probability) or only take on the values 0 or 1
(that is, binary values, for example, «yes» or «no»). In such a case, the logit model is often used, as represented by the
following equation:

 P 
ln   = α + βX + u (1)
1 − P 

In the above equation, P is a dependent variable that lies between 0 and 1. Taking anti-logs (exponential adjust-
ment), the following equation is derived :

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 Article II

1
P= − (α + β X + u ) (2)
1+ e

If beta is larger than 0, the value of P will approach 0 when the value of X approaches minus infinity (-•); the value
of P will approach 1 when the value of X approaches plus infinity (•). Therefore, the value of P lies within the range of 0
to 1. Graphically, the logistic curve P is presented below:
The estimation procedure for the logit model is
Y
influenced by the nature of P, namely whether it has values 1

between 0 and 1, or its values are only 0 or 1. If the value of

P lies between 0 and 1, then the method undertaken is to
transform P and derive Y=ln[P/(1-P)]. The next procedure is
to regress Y on a constant and variable Xi. However, if the
value of P is binary (that is, 0 or 1), then the procedure is to Y

use the maximum likelihood method because the logarithmic 0

value of P/(1-P) is undefined. Several assumptions used in Chart 1

Logistic Curve
the logit method are as follows:

(i) Yi ∈ {0,1}, i = 1,......., N

exp(∑ bk X ik )
(ii) P(Yi = 1 X i ) =
1 + exp(∑ bk X ik )

(iii) Y1, Y2, ....., YN all are statistically independent

(iv) No linear relationship amongst the Xik

Estimation using Maximum Likelihood

Estimation using maximum likelihood has a different final objective than the ordinary least square (OLS) method, but
has the same process as the OLS method in reaching that final objective. The final objective of the maximum likelihood
method can be explained as follows. For example, Pi=P(Yi=1|Xi). Then, P(Yi=0|Xi)=1-Pi and probability of deriving observation
result Yi (0 or 1) is shown by P(Yi|Xi)=PiYi(1=Pi)1-Yi. In this regard, in general the equation can be represented by :

N
Y
P(Y X ) = ∏ Pi i (1 − Pi )1− Yi (3)
i= 1

The values of Pi and P(Y|X) in the above equation are determined by the value of b coefficient, whose estimation is
the final objective of the maximum likelihood method. Therefore, the function of b likelihood can be represented by:

L(Y X , b) ≡ P(Y X ) (4)

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 Article II

Yi 1− Yi
 exp(∑ bk X ik ) 
N  1 
L(Y X , b) = ∏     (5)
 1 + exp(∑ bk X ik ) 
i= 1   1 + exp(∑ bk X ik ) 

With the consideration that it is easier to apply a summation procedure than a multiplication procedure, the above
equation is converted to:

N
log L (Y X , b) = ∑ [Yi log Pi + (1 − Yi ) log(1 − Pi )] (6)
i= 1

Further, taking first derivatives of the above function, then the likelihood equation derived for the logit model is as
follows:
N  exp(∑ bk X ik ) 
∑ Y i −  X ij = 0
1 + exp(∑ bk X ik )  j=1, ......., k (7)
i =1 

or

∑ [Y i
− P (Y i = 1 X i , b) ]X ij = 0 j=1, ......., k (8)
i =1

In short, using this procedure to derive the estimated equation, entails obtaining an estimate for the parameter b
that provides the largest observation value of Y.

Type I & Type II Errors

The decision to reject or not to reject the null hypothesis, in this case that specific indicators cannot be used to
predict banking crises, entails two possible errors. First, there is a possibility of rejecting the null hypothesis when it
should be accepted. This type of error is called a «Type I» error. Second, there is a possibility of accepting the null
hypothesis when it should be rejected. This is called a «Type II»
error. This is summarized in the following table. Table 1
In ideal conditions, efforts can be made to minimize both Type I & Type II Errors
Condition
type I and type II errors, by choosing more «powerful» tests Decision
Null hypothesis fulfilled Null hypothesis not fulfilled
(see following paragraph). However, it is more generally
Reject Type I error No error
assumed that the occurrence of a type I error will have a higher
Do not reject No error Type II error
cost than a type II error.5 In this regard, the consequence is to
set the probability of a type I error at low level, for example
1% or 5%, and use an estimation technique that is as «powerful» as possible (also see following paragraph)
The probability of the occurrence of a Type I error is often represented by the notation a, and is known as the level
of significance of the test. The probability of a Type II error is represented by the notation b. The probability of not making

5
Damodar N. Gujarati, ≈Basic Econometrics∆, 4th.ed, p.908.

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a Type II error is known as power of the test. In other words, the power of a test is the ability to reject the null hypothesis
when that condition is not fulfilled.6 In general, applications of a and b in hypothesis testing are done by setting a at a
certain level (for example 1% or 5%), and then attempting to minimize b by maximizing the power of the test.

III ESTIMATIOM RESULTS AND INTERPRETATION

III.1. Estimation Results
This review of early indicators of a banking crisis generally adopts the model used by Hardy & Pazarbasioglu (1999).
The hypotheses used in this review are:

H0 = the real sector, banking sector, and shock indicators cannot be used as early indicators of a banking
crisis
H 1= the real sector, banking sector, and shock indicators can be used as early indicators of a banking crisis

Further, the model is estimate using a model specifications as follows :

CSD = f ( PDBR, KNSW , INVS , DPK , KRSW , REER, PDEF )
Where :
CSD = Crisis / severe distress PDBR = Real GDP
KNSW = Private Consumption INVS = Investment
DPK = Third party funds KRSW = Credit to private sector
REER = Real Effective Exchange Rate PDEF = Inflation

In this model specification, almost all independent variables are in logarithmic form and first differences. In this
regard, the use of logarithmic independent variables is aimed at explaining the changes in dependent variables, which are
not always proportional to the changes in independent variables. For its part, the dependent variable takes on binary
values (0 and 1), where 1 indicates crisis or severe distress and 0 indicates no crisis or severe distress.
In general, data for the real sector group cover real GDP growth (PDBR), private consumption growth (KNSW) and
investment growth (INVS). Data for the banking sector variables cover third party funds (DPK) and credit to the real sector
(KRSW), while those for the shock variables cover inflation (PDEF) and the real exchange rate (REER).
Estimation results indicate that (with 95% level of confidence) there is a relationship between the occurrence of a
crisis (or severe distress) in the banking industry and: real GDP growth; the real effective exchange rate; the growth of
credit to the private sector; the change in public deposits; and private consumption growth. Meanwhile, changes in
investment and the inflation rate are not significant. Estimation results conducted using the EViews program are presented
in the accompanying Table
Turning to the incidence of Type I and Type II errors (with a 10% cut-off point), there are 15 observations (3.62% of
the sample) where the model did not predict a banking crisis when a crisis actually occurred, thus causing a Type I error.

6 Ibid.

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 Article II

Table 1
Estimation Results

Variable Coeficient Std. Error z=Statistic Prob.

C -2.440598 0.248.169 -9.834.404 0.0000

DLPDBR -11.51757 4.079719 -2.823130 0.0048
DL RER -6.983.535 1.554.213 -4.493.294 0.0000
DLKRS(-2) 3.291.377 1.485.540 2.207.393 0.0273
DLDPK (-2) -3.377.351 1.478.805 -2.286.931 0.0222
DLKSW (-2) 1.390.082 0.652.175 2.131.457 0.0331
DLINVS (-1) -0.910.838 0.474.818 -1.918.286 0.0551
DLPDEF (-1) -0.208.565 0.131.684 -1.583.827 0.1132

Log likelihood -103.2181 akaike info criterion 0.537.286

Restr. log likelihood -124.6481 Schwarz criterion 0.615.080
LR statistic (7 df) 42.86002 Hannan - Quin likelihood -0.249.319
Probability (L stat) Mc Fadden R-squared 0.171.924

In addition, there are 59 observations (14.25%) where estimation leads to the conclusion of a crisis when no crisis actually
occurred, thus causing a Type II error. In other words, results of the tests on Type I and Type II errors show that for 82.13%
of the sample (340 observations), the model was a reliable indicator of a banking crisis.

Table 3
Results of Test on Type I & Type II Errors

Cut-off Point = 0,1

Observation %

Correct Estimates 340 82.13

Type I Error 15 3.62

Type II Error 59 14.25

Total 414 100.00

The capability of this model to predict a crisis (or severe distress) in the banking industry is depicted in the following
diagram.

0.5 1
0.45 0.9
0.4 0.8
0.35 0.7
0.3 0.6
0.25 0.5
0.2 0.4
0.15 0.3
0.1 0.2
0.05 0.1

0 0
122 122 128 128 132 134 134 138 138 138 142 144 146 146 146 156 158 172 172 176 181 181 182 182 186 186 186 193193 196 196 199 199 233 238
238 253 273 273 288 298 299 423 423 423 439 536 536 542 542 548 566 566 566 576 576 578 578 578 612 612 622 628 634 634 638 664 674 674 722

Code Country Code Country

Diagram 1
Probability of the Occurrences of Crises/Severe Distress in 40 Countries

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0.9
For Indonesia, the probability of a crisis was well
0.8 predicted as simulations indicate the probability of crisis at
0.7
0.6 more than 70% using this model.
0.5
0.4
0.3 III.2. Interpretation
0.2
Using the model specified earlier, crisis (or severe
0.1
0 distress) in the banking industry can be predicted by the use
1984 1985 1986 1987 1989 1990 1991 1992 1993 1994 1995 1996 1997

Years of six indicators, namely: real GDP growth; rising private

Diagram 2 Probability of the
consumption; declining investment; sharp exchange rate
Occurrence of 1997 Crisis in Indonesia
depreciation; heightening credit extensions to the private
sector; and continuous declines of total public deposits.
Rising private consumption, accompanied by declining investment and declining real GDP can be interpreted as a
fall in the capacity of the economy to produce goods and services. This situation will hurt companies» capacity to make
profits and repay their credit from the banking industry. Further, expanding credit by the banking industry will worsen
existing conditions because credit is no longer being extended based on business viability. Consequently, the ratio of the
banking industry»s non-performing loans will be rising, which in turn will harms banks» performance. With an accumulation
of problems in the banking industry that are caused by problems in the real sector, public confidence in the banking
industry will deteriorate, causing a drop in deposits.
Problems cumulate, as foreign investors take the view that Indonesia»s economic fundamentals are deteriorating as
reflected, among others, in declining real GDP and rising non-performing loans. Consequently, many foreign investors
will withdraw their funds. If this is done on a large scale and in a rush, the exchange rate will depreciate sharply. This
depreciation will further hurt companies» repayment capacity and banks that have high foreign-currency denominated
liabilities.
This combination of negative factors can put severe pressure on the banking industry, which may well lead to crisis.
Therefore, development of these indicators can be used as indicators of potential problems, which if not tackled immedi-
ately, can lead to a banking crisis.

IV. CONCLUSION
Analysis of annual data on 40 countries (of which 31 experienced crisis or severe distresses) shows that macroeco-
nomic and banking indicators together with shock variables can be good early indicators of crisis in the banking industry.
The macroeconomic indicators include slowing economic growth, declining volumes of investment, and rising private
consumption. Also, factors internal to the banking industry that can be early indicators of crisis include rising credit to the
private sector, and sharply declining total third party funds. Useful shock indicators are rising a inflation rate and a sharp
exchange rate depreciation.
In the case of Indonesia, current economic indicators suggest that there is no potential for a banking crisis in the
short-term. This can be seen from GDP growth, which is showing an upward trend, a relatively stable rupiah exchange
rate, investment that has tended to be stagnant since the crisis, slow expansion of credit to the real sector, a declining

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trend in inflation and stable public deposits. However, there is one indicator that requires attention, and that is rising of
private consumption. On one hand, a rise in private consumption can boost the economy by raising demand for goods
and services. However, if it is not matched by a rise in investment and domestic production, it could put pressures on the
prices of goods and services, causing rising inflation and higher interest rates, which could push up non-performing loans
due to debtors» declining repayment capacity.

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Bibliography
Aldrich, John H., and Forrest D. Nelson, 1984, ≈Linear Probability, Logit and Probit Models∆, Series: Quantitative
Applications in the Social Sciences, Sage University, California.
Damodar N. Gujarati, 2003, ≈Basic Econometrics∆, 4th Ed. McGraw-Hill, Singapore.
Dermiguc √ Kunt, Asli, and Enrica Detragiache, 1998, ≈The Determinants of Banking Crises in Developing and
Developed Countries∆, IMF Staff Papers Vol. 45 No. 1 (March), International Monetary Fund, Washington.
Goldstein, Morris, Graciela L. Kaminsky, and Carmen M. Reinhart, 2000, ≈Assessing Financial Vulnerability: An
Early Warning System for Emerging Markets∆, Institute for International Economics, Washington.
Hardy, Daniel C. & Ceyla Pazarbasioglu, 1999, ≈Determinants and Leading Indicators of Banking Crises: Further
Evidence∆, IMF Staff Papers Vol. 46 No. 3 September/December 1999, International Monetary Fund, Washington.
_________________________________, 1998, ≈Leading Indicators of Banking Crises: Was Asia Different?∆, IMF
Working Paper 98/91, International Monetary Fund, Washington.
Kaminsky, Graciela, Saul Lizondo, and Carmen M. Reinhart, 1998, ≈Leading Indicators of Currency Crises∆, IMF
Staff Papers Vol.45 No. 1 (March), International Monetary Fund, Washington.
Kaufman, George F., 1997, ≈Preventing Banking Crises in the Future: Lessons from Past Mistakes∆, The Indepen-
dent Review, v.II, n.1., p.55.
Ramanathan, Ramu, 1998, ≈Introduction to Econometrics with Applications∆, 4th Ed., The Dreyden Press, HBJ, New
York.

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Article III

Company Failure Indicators in Indonesia :

As An Additional Early Warning Tool On Financial System Stability

Muliaman D Hadad1, Wimboh Santoso2 & Ita Rulina3

December 2003

A b s t r a ct

The purpose of this study is to obtain empirical evidence on financial ratios that are able to discriminate
failed companies behavior from those that are not, as well as to compare the capability of two techniques that
are often used in predicting bankruptcy. Techniques used in this study are Discriminant Analysis and Logistic
Regression. Coefficients of the independent variables are estimated using the simultaneous approach for
Discriminant Analysis and maximum likelihood method for Logistic Regression. This study shows that liquidity
ratios are the best discriminators in differentiating failed companies from those that are not. Furthermore, this
study also shows that Logistic Repression is a better approach than Discriminant Analysis relatively. This is
reflected by the values of correct estimates of Logistic Regression that is on average higher than those of
Discriminant Analysis, where these average values were each 86.72% and 78.1% for 1 year before the event of
bankruptcy.

Keywords: Bankruptcies, logistic regression, and discriminant analysis.

JEL Classification: G33, C35

1
Head of Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank IndonesiaΩ; e-mail addressΩ: muliaman@bi.go.id
2
Bank Executive Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank IndonesiaΩ; email address: wimboh@bi.go.id
3
Bank Researcher at Financial System Stability Bureau √ Directorate for Banking Research and Regulation, Bank IndonesiaΩ; email address: rulina@bi.go.id

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I. INTRODUCTION
I.1. Background
1997 crisis that occurred in Indonesia incurred very expensive fiscal cost, reaching 51% of GDP. This crisis stimulated
a realization of the importance of financial market stability and financial institutions» soundness, which form the financial
system. Financial market stability and financial institutions» soundness are able to dampen a crisis, which actually are
interactions between several risks that need to be well managed constantly. One of the risks that must be managed well
to avoid disruption to financial system stability, is companies» failures to repay their borrowings. Companies» failures to
repay their borrowings can be called corporate failure.
A study by Beaver (1966) is often used as a main reference in corporate failure studies. Beaver looked at a company
as a reservoir of liquid assets, which was supplied by inflows and drained by outflows. Beaver used 30 ratios applied to
79 failed and non failed companies» pairs. Using the univariate discriminant analysis as the statistical tool, Beaver concluded
that working capital funds flow/total assets and net income/total assets were able to differentiate failed companies and
those that were not, each at 90% and 88% accuracy.
Altman (1968) conducted another study on the same topic as Beaver but he used the multivariate discriminant
analysis and produced a model using 7 financial ratios. In his study, Altman used a sample of 33 pairs failed and non
failed companies. The model could accurately predict 90% of failure cases at one year prior to bankruptcy.
Studies on this topic continue to be conducted and the latest one on the subject was focused on the statistical
testing tool. Ohlson (1980) was the first researcher that used the logit analysis to predict companies failures. On his
study, Ohlson used 105 failed companies and 2058 non failed companies and found 7 ratios as the best predictors of
failed companies with accuracy level closed to Altman»s study.
The importance of corporate failure was also supported by Krugman, who discussed global financial downturns
and included balance sheet fundamentals theory as a signal of a crisis (Krugman, 1999). Although many studies on
corporate failure have been conducted, it looks like they are going to be continued because the business world develops
so rapidly and the question always arises whether the factors that cause corporate failure remain the same.

I.2. Issues
It is necessary to identify factors that cause corporate failure that will give impact on financial system stability and
financial institutions» soundness. This will enable us to identify a crisis earlier and minimized the loss of a crisis. Based on
this condition, this study will focus on:
1. Which financial ratios are able to differentiate failed companies from those which are not.
2. Whether the Discriminant Analysis or the Logistic Function will be the best statistical tool to predict failed companies.

1.3. Objectives
The objectives of the study are :
1. To obtain empirical evidence on financial ratios which are able to discriminate the behaviors of failed companies
from those that are not.
2. To obtain the best statistical testing tool to be used in predicting companies» failure.

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1.4. Benefits
This study is expected to bring benefits to the following parties :
1. Creditors and Investors
Creditors have an interest to know whether companies are able to repay their borrowings. Investors have an
interest to know whether companies are sound and able to give optimal returns on their investments. Creditors and
investors can use this study to minimize potential losses of their placements.

2. Auditors
On the other hand, auditors are responsible for making evaluation on their clients going concern. Auditing Standards
Statement number 30, Indonesian Accounting Association 1993, states that when an auditor concludes that there is a
fundamental doubt on their client»s ability to continue going concern, the auditor is obliged to disclose this in his report.
An auditor»s inability to predict their client»s failure is called as audit failure (Taylor and Glezen 1994) and can entail quite
high legal claim cost. The growing number of legal claims on auditors, which will cause higher audit failure cost, will
prompt audit companies to enhance the failure prediction techniques used.

3. Bank Indonesia and Government

As already mentioned in the beginning, the main objective of this study is to identify factors that influence financial
system stability and financial institutions» soundness. From this point of view, this study will be useful for Bank Indonesia
and the government.
For Bank Indonesia, particularly the Banking Research and Regulation Directorate, Bank Supervision Directorate,
and Bank Examination Directorate are working units that are concerned with corporate failure. As regards the government,
the Capital Market Supervisory Board (Bappepam) will be the predominant user of this study. As regards Bank Indonesia,
one of the tasks of bank supervisors/examiners is to assure that banks operate in prudential manner to safe depositors»
interest. To improve bank supervisors/examiners» evaluation on Banks» loan quality, this study can be used as one of early
warning tools. It is expected that supervisors/examiners are able to detect bank that lend money to unsound companies
as early as possible. In the end, supervisors evaluate credit risks faced by banks, banks actions to undertake these risks,
and supervisory actions needs to be taken on this bank. After that, supervisors/examiners/policy makers can make
evaluations whether the risks are systemic because for example the debtor is a large company that is also being financed
by other banks.

1.5. Methodology
The paper is organized as follows :
Chapter I, contains background, issues formulation, objectives, benefits, and methodology.
Chapter II, present theoretical concepts of corporate failure technique, definition of failure, and uses of financial
reports.
Chapter III, describes the model used in this study, notations, variable definitions and measurement, data collection
technique, as well as characteristics of data obtained.

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Chapter IV, present data analysis, which are divided into two sections. The first section contains statistical data
descriptions, while the second contains discussion on statistical test results.
Chapter V, contains the conclusions, recommendations, and descriptions of limitation of the research.

II. LITERATURE STUDY

II.1. Development of Research Techniques on Corporate Failure
Beaver was a pioneer in corporate failure study and his research is often considered as a milestone in this area. The
approach adopted by Beaver was the univariat, where each ratio without being followed by other ratios is tested on its
capability to predict corporate failure. Altman (1968) tried to improve on Beaver»s study by adopting the multivariate
linear discriminant analysis (MDA), a method often proved to make limitations. The MDA technique used by Altman is a
regression technique of several uncorrelated time series variables that uses cut-off values to determine the classification
criteria for each group. The advantage of using the MDA technique is that all characteristics of the variables observed are
included, together with their interactions. Altman also concluded that the MDA reduces the measurement distance/
dimensionality from the researchers by the use of cut-off points. In general, because the MDA is easy to use and
interpreted, it is often the choice of researchers on corporate failure all this time.
However, in using financial ratios to predict corporate failure, the MDA technique uses the error method that
follows the characteristics of data used. With this condition, the important issues that have been discussed many times
in research literatures are that of the use of the proportional assumption and zero intercept of the financial ratios (Lev
and Sunder, 1979, Whittington, 1980; McDonald and Morris, 1984; Rees, 1990; Keasey and Watson, 1991). As such,
overall, the resulting empirical proofs become more uncertain and there is no formal statements confirming that more
sophisticated ratios are better than the basic ratios. For this reason, simple ratios are still used in most studies on
corporate failure.
Another problem related to the MDA on prediction of corporate failure is the problems of data normality, inequality
of dispersion matrix of all groups, and non-random-sampling of companies that fail and do do not fail. Each of this
problem makes the regression result becomes ordinary.
In general, researchers ignore these limitations and continued on Altman»s research with the hope of obtaining a
more accurate model. Several examples of researches conducted afterwards are :
1) Probability membership classes project conducted by Deakin, 1972;
2) The use of quadratic classifier (Altman, Haldeman and Narayanan, 1977);
3) The use of cashflow based model (Gentry, Newbold and Whitford, 1987);
4) The use of quarterly financial report information (Baldwin and Glezen, 1992);
5) Current cost information (Aly, Barlow and ones, 1992; Keasy and Watson, 1986).
But, none of these researches obtained better accuracy than Altman»s research. Furthermore, in many cases,
application of bankruptcy models faced difficulties because models used turned out to be more complex.
What ought to get attention regarding development of statistical testing techniques used to predict bankruptcy is
the statistic testing technique used by Ohlson (1980). In 1980, Ohlson used the logistic regression (logit analysis) to
predict bankruptcy, a method that avoids the limitations of the MDA technique. In the logit analysis, the assumption of

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multivariate normal distribution is ignored. With this assumption, the limitations in the statistical testing technique for
bankruptcy using the MDA can be overcome by logit. Logit, together with the probit analysis (a variation of logit), are
called as the conditional probability model because logit provides conditional probability of observations derived from
one group.
Another consideration in using logit is among others the logit model has a statistical advantage. However, this
model has to be modified to ensure the validity of the parameter coefficients with the group influence resulting from the
data panel.

II.2. Information Obtained From Financial Report

The research on corporate failure starts at financial ratio analysis. The main reason for the use of financial ratios
is that a financial report usually contains important information concerning the condition and future prospects of the
company (Fraser, 1995). A financial report is a report concerning a company»s past performance, which is often used
to predict the company»s performance in the future. Decisions made by the company»s management usually are related
to two main information. First, information stated in the revenue and expense group, while the second, the timing of
the occurrences of those revenue and expense transactions. In several cases, the management is motivated to act not
exactly honestly in reporting the revenues and tax expense it has to pay. A company»s management also often reports
higher profit only for the purpose to attract investors or to overcome financial pressures being experienced by the
company.
The use of financial ratios to make a statement on the going concern capability of a company is a technique that is
largely used. Financial ratios are replacement measurements in making an observation on the real characteristics of a
company.
Studies using financial ratios were started in 1930»s and several follow-on studies put more focus on business
bankruptcy. Most of those research results were convinced that a company that was bankrupt had different ratios than
one that is not. In general, ratios that measure profitability, liquidity, and solvency have been successful in being indicators
of business bankruptcy.
In conducting a research on bankruptcy, Beaver (1966) used the following financial ratios: cash flow/total debt,
current assets/current liabilities, net income/total assets, total debt/total asset, working capital/total assets.
Altman (1968), who has conducted a research on bankruptcy after Beaver, again used financial ratios as factors that
can be evaluated to indicate a company»s bankruptcy. The financial ratios used by (1968) were Current Assets/current
Liabilities, Market Value of Equity/Book Value of Debt, Net Sales/Total Asset, Operating Income/Total Asset, EBIT/Total
Interest Payments, Retained Earnings/Total Assets, Working Capital/Total Assets, Working Capital/total Assets, Retained
Earnings/Total Assets, Earnings Before Interest and Taxes/total assets, market value equity/book value of total debt, sales/
total sales.
With the Logistic Regression statistical test, Ohlson (1980) again conducted a research on financial ratios that can
be indicators to see a company»s bankruptcy. The financial ratios used by Ohlson in conducting his research are as follows:
total liabilities/total assets, working capital/total assets, current liabilities/current assets.

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II.3. Company Bankruptcy

II.3.1. Definition of Bankruptcy Commonly Used in International World
Standard & Poors (S&P) defines bankruptcy (default) as follows:
The first occurrence of a payment default on any financial obligation, rated or unrated, other than financial obligations
subject to a bona fide commercial dispute; an exception occurs when an interest payment missed on the due date is made
within the grace period.
While, the definition of bankruptcy by ISDA (International Swaps and Derivatives Association) is when one of the
following condition occurs :
1. A company that has issued indebtedness letters stopped operation (bankrupt)
2. A company that is not solvent or is not able to pay debts
3. A claim on bankruptcy has emerged
4. A bankruptcy process is occurring
5. The receivership has been appointed
6. All assets have been transferred to the custody of a third party
A financial theory assumes that a perfect bankruptcy system gives quite valuable benefit to the economy. In general,
two types of costs are known in a case of a company»s bankruptcy, namely direct cost and indirect cost. Direct cost is cost
that is directly incurred by the company to pay lawyers, accountants, and other professionals to restructure its finance and
then report it to the creditors. In addition, the interests that the company has to pay on further borrowings, which usually
are more expensive, are also direct cost of the bankruptcy. Meanwhile, indirect cost is the potential loss faced by the
company that is suffering from financial difficulties, such as loss of customers and suppliers, loss of new projects because
its management is concentrating on settlement of financial difficulties in the short term. The loss of the company»s value
when the Manager or Judge liquidates a company that still owns a positive net present value is also an indirect cost of the
bankruptcy. When looking at quite high direct and indirect costs of a company that is experiencing financial difficulties,
a modern bankruptcy court will attempt to keep the company as a going concern and tackle creditors» claims as quickly
as possible. An established bankruptcy law will give protections for the creditors as well as give a good mechanism for
solving the disputes between the parties quicker. By eliminating uncertainty, the established bankruptcy system will
prompt the businessman and large company to take larger risks. This can also reduce cost of capital by requesting a
finance expert to calculate/estimate how creditors will be paid when default occurs.

II.3.2. Bankruptcy in Indonesia

The definition of bankruptcy in Indonesia refers to government regulation as replacement of law number 1 of 1998
concerning Amendments to Bankruptcy Law, which states :
1. A debtor, who has two or more creditors and does not pay at least one debt after it has fallen due and that debt
cannot be claimed, is declared bankrupt by authorized court decision, whether at the debtor»s own request or at the
request of one or more of the debtors» creditors.
2. The request mentioned above can also be lodged by a public prosecutor for the sake of public interest.

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The bankruptcy law basically determines how disputes are settled when a company cannot fulfill its debt obligations
anymore and also how to settle disputes between individuals related to business conducted. There are several important
criteria :
1. The accounting has to be clear. Asset valuation has to be transparent and uses ways that are commonly acknowledged
(international standards);
2. Debt grading level based on priority of guarantee determines who should be first in the settlement of debt. For
example : In the case of a bankrupt company; who should have the first right to receive payment and should get the
next right;
3. The civil court regulates parties that have interests, parties that arrange the bankruptcy process, the competent
court, and the way/process to be undertaken in settling the case;
4. Determination of penalties by an authorized court if one of the parties does not fulfill a promise. The length of time
given to a company that considers itself able to settle its debts on its own;
5. Although it is pronounced bankrupt, of course a company can still operate for a while. In this case, the prerequisites
and the parties that should supervise the rehabilitation process are determined. A company that is pronounced
bankrupt does not need to immediately stop all its activities. They must be given opportunities to finalize financial
matters and other activities for the interest of the parties that claim repayments of debts;
6. Settlement of disputes can also be done through an outside the court arbitrage.
A company that is pronounced bankrupt if within a determined period cannot make payments on debt principals
and or interests. Bankruptcy can also be requested by a company»s owners or also by its creditors.
In addition to the terminology bankruptcy described above, in the business world the terminology delisting is also
know. The Jakarta Stock Exchange registration regulation number 1B of 2000 and 2001 state the following as regards
delisting rules :
1. Delisting can be undertaken at the request of an issuer or when determines by the Bourse. In the case of delisting
that is determined by the Bourse, the opinion of the Securities Registration Committee has to be heard first.
2. Delisting at the request of an issuer can only be undertaken when it has been decided by the shareholders» general
meeting and the related issuer has settled all its obligations to the Bourse.
3. Delisting at the request of an issuer is submitted two months before the date delisting becomes effective by stating
the reasons and attaching the minutes of the shareholders» general meeting mentioned above.
4. In the case the request for delisting is fulfilled, the Bourse is obliged to make an announcement on the delisting plan
at least 30 days before the date delisting becomes effective.
5. An issuer, which securities are listed at the Bourse, that experiences one of the following conditions will be considered
to be imposed with delisting :
a. For 3 consecutive years has suffered losses, or has a loss balance of 50% or more of paid-in capital in the
company»s balance sheet of the last year;
b. For 3 consecutive years has not paid cash dividends (for shares).Has not fulfilled its obligations for three times
(for bonds);
c. Its own total capital is less than Rp3,000,000,000,- (three billion rupiah);

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d. Total shareholders is less than 100 (people/entity) during 3 consecutive years based on the annual reports of the
issuer/Securities Administration Bureau;
e. There hasn»t been any transactions during 6 consecutive months;
f. The financial report developed is not in accordance with the generally accepted accounting principles and
regulations determined by Bapepam;
g. Violates the regulations of the Bourse in particular and the capital market in general;
h. Undertaking actions that violate public interests based on an authorized institution»s decision.
i. An issuer is liquidated because of merger, amalgamation, bankruptcy, dissolution (mutual funds) or other reasons;
j. The issuer is pronounced bankrupt by the court;
k. The issuer is facing claims/cases/incidents that materially influence the condition and going concern of the
company;
l. Specifically for mutual funds issuer, the net asset value declined less than 50% of the value of first offerings due
to operating loss.

III. METHODOLOGY
III.1. Model Specifications
Discriminant analysis and logistic regression are statistical techniques that are most suitable when the dependent
variables are non-metric or categoric (for example, male and female; bankrupt and not bankrupt). In most cases, dependent
variables consist of two groups, for example male group versus female group or bankrupt company group versus non-
bankrupt company group. There could also be three grouping, such as short group, medium group, and tall group.
Discriminant analysis is able to settle regressions with two or more dependent variable groups. If two dependent variable
groups are used, this technique is commonly known as two-group discriminant analysis. If three dependent variable
groups are used, it is commonly called the Multivariate Discriminant Analysis. The Logistic regression, commonly known
as the logit analysis, is limited to two groups, although a more complex alternative formula can handle more than two
groups of dependent variables.

Discriminant Analysis
Discriminant analysis attempts to produce the best linear combination of two or more independent variables, which
will discriminate the bankrupt group from the non-bankrupt group. This is achieved by the statistical decision rule of
maximizing the between-group variance relative to the within group variance. This relationship is expressed as the ratio of
between-group to within-group variance.
The equation in the discriminant function is a linear combination of the financial ratios of the company group that
will produce a new axis Z, which is a diagonal line with 45-degree angle of financial ratios used. The new axis, called Z,
gives a maximum capability to differentiate the two group companies. The new axis Z is called discriminant function and
a projection of one point in the discriminant function is called discriminant score. Z is a discriminant function determines
the values of w1 dan w2 of the above discriminant function in order to maximum the value of lambda (l).

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Between group sum of squares

λ =
Within group sum of squares

The discriminant function is derived by maximizing the value _ and is called Fisher»s linear discriminant function. The
evaluation of the significance of the discriminant variable can be seen from the average financial ratios, whether they
differ significantly between those of the bankrupt companies and those of the non-bankrupt companies.
The discriminant analysis derives the linear combinations from an equation that takes the following form:
Z = ω1 x1 + ω 2 x2 +º+ ω n xn
Where:
Z = discriminant score
ωi = discriminant weights
xi = independent variables (financial ratios)
Thus, each company in the sample receives a single composite discriminant score, which is then compared to a cut-
off value, which determines to which group each company belongs.
Discriminant analysis gives the best result provided that the variables in every group follow a multivariate normal
distribution and the covariance matrices for every group are equal. However, several past researches have shown that
especially bankrupt firms violate the normality assumption and the assumption of equal covariance matrices for every
group. Multicolinearity between independent variables even becomes a serious problem, particularly when the stepwise
procedure is used (Hair et al. 1992). However, empirical studies have proved that the problems connected with normality
assumptions were not weakening its classification capability (to differentiate the bankrupt group from the non-bankrupt
group), but its prediction ability.

Estimation with Discriminant Analysis

The most frequently used methods in estimating equations using discriminant analysis are the simultaneous and the
stepwise methods. The simultaneous method estimates the discriminant function by entering all the variables simultaneously
into the discriminant function, without considering first the discriminatory power of individual variables. This method
then chooses variables that have the most discriminatory power. For its part, the stepwise method starts with a selection
of independent variables that have the most discriminatory power. It then adds other independent variables as long as
the equation»s discriminatory power increases. The simultaneous method used in this research is included in the SPSS
program package used at Bank Indonesia.
In choosing the preferred estimate of a discriminant function, several issues require the researcher»s close attention,
namely:
1. Is there a significant difference between the two groups of companies? Statistical judgement is made in this regard
by calculating Wilk»s Lambda test statistic. To test the statistical significance of the calculated value for Wilk»s Lambda,
it can be converted into an F ratio.

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2. To test the statistical significance of the discriminant function, a multivariate test of significance is used. This test can
use the value of Wilk»s Lambda or an approximation using a Chi-Squared statistic.
3. Analyze the squared canonical correlation (Gujarati) to determine the ability of the independent variables to explain
the differences that occur between the two groups of companies.
4. The coefficients used in the discriminant equation are obtained from the Standardized Cannonical Discriminant
Function Coefficient table (Gujarati).
5. Meanwhile, to determine a cut-off point, it is necessary to check the value of the variables in the matrix structure
table.

Logistic Regression
Logistic Regression is used to analyze the probability of certain events occurring, as predicted by certain independent
variables. Mayer and Pifer (1970) adopted a limited dependent variable regression model in their research. This approach
uses the symbol ≈1∆ for bankrupt companies and ≈0∆ for non-bankrupt companies. Econometric experts identify this
model as the linear probability model (LPM). However, Gujarati is of the opinion that this approach does not guarantee
that the estimation results will lie in areas between 1 and 0; therefore, the regression equation has to be estimated
subject to certain limitations. The Logistic Regression approach can be adapted for the LPM (Aldric & Nelson. 1984) so
that there is a guarantee that the estimation results will lie between 0 and 1. The equation formed is:

N K
yi = β1 + Σi=1 Σk =1 β k xik + ei (1)

where:
yi = dependent variable of cross section i data and period of time t
b1 = Intercept for all cross section i data and period of time t
bk = coefficient of independent variable k for all cross section i data and period of time t
xik = the kth independent variable for cross section i data and period of time t
ei = disturbance (error) term for observation
The assumptions used here are that the average disturbance value is 0 or E(eiI xi) = 0; variance µi for each value of
x is the same or var (µi I xi) = (µi2 I xi) = s2; there is no autocorrelation between disturbances or cov (µI, µj I xi, xj) = 0.
From equation 1, unconstrained probability estimate (Zi) is derived. For example, Pi is the probability that a company
is categorized as being bankrupt and P=(1-Pi) is the probability that a company is categorized as being not bankrupt, then
the logit function will be as follows :

Pi
Ln = Zi
( 1 − Pi )

With some algebraic manipulation, Pi can be re-written as:

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ez
Pi =
(1 + e z )
Y

1
The constant ( b 1 ) and coefficients ( b k ) on the
independent variables of equation 1 can be estimated using
the maximum likelihood approach. This approach estimates
values for b 1 and b k such that the probability of the
observation value Y (dependent variable) is as close as possible
Y
to its actual value. The logarithmic value of Pi will be in the
0
range of 1 and 0, producing the following chart:

Logistic Regression Estimation Method

The estimation method for Logistic Regression is maximum likelihood. The objective of the maximum likelihood
method is to obtain parameter estimates that yield the closest values to observation value Y. In general, this equation is:

Σ [Y
i= 1
i
− P(Yi = 1 X i , b)]X ij = 0 j=1, ......., k

The difference between this model and Discriminant Analysis lies in the following statistics that the researcher»s
attention:
1. Goodness-Of-Fit (Pseudo R2)
The traditional R2 [Gujarati] is less suitable for a model with a limited dependent variable (Aldrich and Nelson, 1984)
because the value of the dependent variable is either 0 or 1. The success criteria using the traditional R2 is the level
at which the error variance is minimized, which is the same of the logit model using the maximum likelihood
approach.
Previous studies use several methods to measure the pseudo R2. Several studies, such as McFadden (1973), Aldrich
and Nelson (1984), and McKelvey and Zavoina (1975) showed that various pseudo R2s, calculated with different
techniques would produce different values despite using the same model and data. To determine the best pseudo
R2 is somewhat arbitrary. Zimmerman (1996) suggested that the pseudo R2 from the McKelvey and Zovoina (R2MZ)
model was the best choice. However, R2MZ gives a value that is more sensitive to error misspecification than McFadden»s
pseudo R2, particularly in the binary probit and logit models. This research uses McFadden»s pseudo R2.
2. Test For Specification Errors
This research also tests the regression»s ability to estimate the probability of companies going bankrupt by using all
observations. The result is a set of probability numbers between 0 and 1. By using a certain cut-off point, this model
will produce 3 category of estimates: correct estimates, ≈type I error∆ (see following paragraph) estimates and ≈type

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II error∆ (also see following paragraph) estimates. The cut-off point is the probability that determines whether a
company is categorized as a bankrupt or non-bankrupt company.
This approach has often been used by researchers in estimating the probability of a company going bankrupt (Martin,
1977; Sinkey, 1975; Bovenzi, Marino and McFadden, 1983; Korobow and Stuhr, 1976, 1983; Espahbodi, 1991). For
example, suppose the cut-off point value is determined to be 0.5. This means that if the estimated probability
produced by the model is > 0.5, that company is included in the bankrupt group; if the estimated value is < 0.5, that
sample is included in the non-bankrupt group. Type I errors occur when the model produces estimated values > 0.5
for companies that do not go bankrupt. Type II errors occur when the model produces estimated values of < 0.5 for
companies that do go bankrupt. The lower the cut-off point, the larger the number of companies that are estimated
to go bankrupt and the smaller the number of companies predicted not to go bankrupt.
The choice of the cut-off point plays an important role in discriminant analysis. As a general rule, best criterion for
determining the cut-off value is the ratio between actual bankrupt companies and actual non-bankrupt companies in the
sample. For example, a sample comprising 50% of bankrupt companies and 50% of non-bankrupt companies should
use a cut-off point of 0.5. Similarly, a sample comprising 60% bankrupt companies and 40% non-bankrupt will use a cut-
off point of 0.4.

III.2. Descriptions of Research Variables and Data

Variables used in this study are liquidity ratios, profitability ratios, and solvency ratios.
Liquidity:
The total cash funds required by a company to finance its disbursements depend very much upon the company»s
line of business. Consequently, company management does not like the use of benchmarks for critical liquidity ratios.
Nonetheless, companies generally suffered a severe lack of liquid assets immediately after bankruptcy episodes, and
usually these companies borrowed even larger amounts for managing their short-term liabilities. Past research shows
that useful liquidity ratios for bankruptcy prediction models include the short-term debt/revenue from operations ratio
and the cash/total asset ratio.

Profitability:
A company»s profitability, which is usually measured as a return on capital, is a key factor for monitoring the liquidity
and solvency aspects of its operations. In the long-term, a company must make sufficient profit from its business in order
to be able to pay its liabilities. Continuous losses will soon weaken the solvency of a company, and if the company wants
to expand its business, it needs retained earnings to contribute to this need. In the short-term losses can immediately
reduce the company»s liquidity. Furthermore, the company»s profitability will influence the company»s ability to obtain
financing from abroad.

Solvency:
If financial markets are not perfect, capital structure will be important in the contractual relationship between
shareholders and creditor. The larger the amount of shareholders» equity, the lower the company»s financial risk and the

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easier for the company to borrow from third parties. Furthermore, the ratio of equity to total assets provides information
on past performance and also acts as a buffer against losses in the future.

Liquidity variables used in this study are:

1. Cash to current liabilities ratio
2. Cash flow to current liabilities ratio
3. Cash flow to total assets ratio
4. Cash flow to total debt ratio
5. Cash to net sales ratio
6. Cash to total assets ratio
7. Current assets to current liabilities ratio
8. Current assets/net sales ratio
9. Current assets/total assets ratio
10. Current liabilities/equity ratio
11. Equity/fixed asset ratio
12. Equity/net sales ratio
13. Inventories/net sales ratio
14. Long-term debt/equity ratio
15. Total debt/equity ratio
16. Net Income/total assets ratio
17. Net sales/total assets ratio
18. Operating income/total assets ratio
19. Liquid assets/current liabilities ratio
20. Liquid assets/net sales ratio
21. Liquid assets/total assets ratio
22. Retained earnings/total assets ratio
23. Total debt/total assets ratio
24. Working capital/net sales ratio
25. Working capital/equity ratio
26. Working capital/total assets ratio

Research Data
Data used in this research are obtained from the quarterly financial reports of companies that are (or have been)
listed at the Jakarta Stock Exchange (JSE). Unfortunately, data on companies delisted from the JSE are limited and related
documents often do not give information as to the reasons for the companies being delisted. Due to the many reasons
that a company can become delisted from the JSE, it was necessary to simplify the collection of sample companies that
are categorized as bankrupt. Accordingly, the criteria for a delisted (bankrupt) company were limited as follows: a company

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that during 3 consecutive years suffered losses, or a company with a loss balance of 50% or more of paid-in capital in the
company»s previous year»s balance sheet.
On this basis, the sample consists of 32 companies, of which 16 companies are still active on the Bourse and 16
companies have been delisted from the JSE. Due to data limitations, the grouping of bankrupt versus non-bankrupt
companies does not take into consideration the industries and asset sizes of those companies. Because the timing of
companies becoming delisted was not always the same, the financial data used for those companies are for 3 years prior
to becoming delisted. Meanwhile, data for listed companies cover the period 1999 to 2002.

IV. EMPIRICAL RESULTS

Results of data processing using the SPSS statistical software for Discriminant Analysis and EViews software for
Logistic Regression, as well as the related discussion, are presented in the two sections of Chapter IV, namely Discriminant
Analysis and Logistic Regression.

IV.1. Discriminant Analysis

To choose one or more variables that have a good ability to differentiate bankrupt from non-bankrupt companies is
not an easy matter, because the average data on these company groupings do not differ much. One way to eliminate
variables that do not have discriminatory ability is to use the simultaneous estimation method (using this SPSS program).
Output in this regard is presented below.
Output of the discriminant analysis in this paper is divided into 3 sections: the best discriminatory variables simulated
at 3 years, 2 years, and 1 year prior to bankruptcy.
Simulation of companies at 3 years prior to bankruptcy produces a Wilks» Lambda value of 0.797 or a Chi Squared
value of 86.028 with a significance of 5%, which means that the discriminant function is statistically significant. This
shows that the average values for the two groups of companies differ significantly. The discriminant function for condition
at 3 years prior to bankruptcy comprises six variables, namely R2L, R3L, R6L, R12S, R17P and R20P. The analysis indicated
that 6 variables were important in predicting bankruptcy. The classification result for this equation is 74.5%, which means
that the model is accurate 74.5% of the time in classifying companies into the two groups, 3 years prior to bankruptcy.
Estimation at 2 years prior to bankruptcy produces a

Table 1 Comparison of Discriminators

Wilks» Lambda value of 0.731 and a Chi Squared value of
based on Discriminant Analysis 78.468 with a significance of 5%, which means that the
3 year before 2 year before 1 year before discriminant function is statistically significant. The
Failure Failure Failure
discriminant function for condition at 2 years prior
Standardized 0.593 R2L 0.662 R1L 0.919 R1L
Canonical -0.731 R3L -0.558 R5L 0.533 R7L
bankruptcy comprises 7 variables, R1L, R5L, R6L, R17P, R20P,
Discriminant 1.052 R6L 0.955 R6L -0.327 R16S R24L, and R28S. The analysis indicated that 7 variables were
Function 0.353 R12S 0.321 R17P 0.430 R17P
Coefficients 0.312 R17P -0.637 R20P -0.674 R20P important in predicting bankruptcy. The classification result
-0.698 R20P 0.614 R24L
for this equation is 77.3%, which means that the model is
-0.278 R28S
Classification accurate 77.3% of the time in classifying companies into
Results 74.5% 77.3% 78,1%
the two groups, 2 years prior to bankruptcy.

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Simulation of conditions 1 year prior to bankruptcy produces a Wilks» Lambda value of 0.654 or Chi Squared value
of 52.431 with a significance of 0.000, which means that the discriminant function is statistically significant. The discriminant
function for condition at 1 year prior to bankruptcy comprises the R1L, R7L, R16S, R17P, and R20P variables. The analysis
indicated that 5 variables were important in predicting bankruptcy. The classification result for this equation is 78.1%,
which means that the model is accurate 78.1% of the time in classifying companies into the two groups, 1 year prior to
bankruptcy.
Statistically, these results are somewhat difficult to interpret because the average value of Wilk»s Lambda is surprisingly
close to 1, which means that the difference between the groups is not large. Nonetheless, the chi-squared test produces
a statistically significant value, as mentioned. For 3 years prior to bankruptcy, the R6L (Cash/Total Assets) variables have
the largest parameter values of 1.052, indicative of its importance as determining variables in that equation. At simulation
of conditions at 2 years prior to bankruptcy, R6L (Cash/Total Assets) and R1L (Cash/Current Liabilities) variables have the
largest parameter values of each 0.955 and 0.662, suggesting that these two liquidity ratios are the key determinants. At
1 year prior to bankruptcy, variables R1L (Cash/Current Liabilities) and R20P (operating income/total asset) have the
largest parameter values of each 0.919 and √0.674.
This description shows that liquidity ratios do play an important role in discriminating between the bankrupt and
the non-bankrupt companies. In addition, when the three simulations are compared, simulation of conditions 1 year
prior to bankruptcy gives the best statistical results. This means that the closer the company is to bankruptcy, the greater
the accuracy of the analysis in predicting the bankruptcy.

IV.2. Logistic Regression

Estimation results of the logit model are similarly categorized into 3 sections, simulations at 3 years, 2 years, and 1
year prior to bankruptcy. The chosen cut-off point is 0.5, because the sample size for the bankrupt companies is the same
as for non-bankrupt companies, namely 16 companies in each group.
For simulation at 3 years prior to bankruptcy, the EViews output produces an equation with correct estimates of
80.99% for a model comprising the R5L, R13L, R20P, R31L, R7L, and R14S variables. This means that these variables,
taken together, can accurately explain the difference between the two groups in 80.99% of the cases.
The estimated equation for 2 years prior to bankruptcy (with the same cut-off point) produces 85.54% correct
estimates for a model comprising the R5L, R20P, R31L, and
Table 2 Comparison of Discriminators
R7L variables. This means that these variables together can
Based on Logistic Regression
3 year before 2 year before 1 year before accurately explain the difference between the two groups
Failure Failure Failure for 85.54% of the cases.
R5L R5L R5L For the simulation at 1 year prior to bankruptcy (with
R13L R20P R20P a cut-off point of 0.5), the estimated equation accurately
R20P R31L explains the difference between the two groups in 86.72%
R31L R7L
of the cases.
R7L
Comparing the Discriminant Analysis and Logistic
R14S
Regression approaches, both approaches produce the best

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results at simulations at 1 year prior to bankruptcy. Also, both techniques show that liquidity ratios play an important role
in discriminating companies that are bankrupt. Overall, the Logistic Regression appears more reliable than Discriminant
Analysis, as indicated by the former»s relatively high average

Table 3 Comparison of Correct Estimates between

correct estimates.
Outputs of Discriminant Analysis and Logistic Regression However, the combinations and types of discriminatory
(in percentage)
variables produced by the two techniques are different.
Correct Estimates Discriminant Logistic
Common discriminatory variables as between the two
3 years prior to bankruptcy 74.5 80.99
approaches and across the periods prior to bankruptcy (that
2 years prior to bankruptcy 77.3 85.54
1 year prior to bankruptcy 78.1 86.72 is, 3, 2 or 1 year) are ratios related to liquidity. This is in line
with Beaver»s hypothesis and results.
The estimated Logistic Regression model can be used as a tool to calculate the possibility that a company will
experience financial distress in the future, thereby detecting the possibility of rising credit risk in a bank at a relatively early
stage. This could help bank supervisors/auditors in ensuring that a bank is taking prudent actions to anticipate the
possibility of rising credit risk. It would also help anticipate pressures on the financial system.

RECOMMENDATIONS FOR FUTURE RESEARCH

This research has limitations that could be improved with further research, as follows.
First, data on delisted companies are not adequate at the JSE. Therefore alternative data sources need to be
considered.
Second, due to data limitation in this research, bankrupt and non-bankrupt companies are not categorized by
industry. Therefore, analysis of financial factors specific to certain industries could not be incorporated.
Third, this research does not differentiate companies according to the size of their assets. This is important because
the size of a company»s assets can make a difference in the company»s ability to generate liquidity when it comes under
financial pressure.

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