Published by:

Financial System Stability Bureau

Directorate of Banking Research and Regulation
Bank Indonesia
Jl. MT Thamrin No.2, Jakarta 10010
Indonesia

This Financial Stability Review (FSR) is one the report Bank Indonesia provides
to public in order to achieve its mission ≈to achieve and maintain stability of the Indonesian
Rupiah through maintaining monetary stability and promotes on financial system stability for
safeguarding long-term and sustainable national development.∆

FSR issued biannually and has the following objectives:

- To foster public vision on financial system stability issues, both domestically and internationally;
- To analyze potential risks to financial system stability; and
- To recommend policies to relevant financial authorities for promoting a stable financial system

Information and Order:

This document was used data as of 30 June 2004, unless otherwise state.
This completed document is available at http//www.bi.go.id.

Any requests, comments and advises should be directed to :

Bank Indonesia
Directorate of Banking Research and Regulation
Financial System Stability Bureau
Jl. MT Thamrin No.2, Jakarta, Indonesia
Tel: (+62-21) 381 7990, 7353
Fax: (+62-21) 2311 672
Email: BSSK@bi.go.id
 fsr
Financial Stability Review
No. 1, June 2004
ii
Contents

Foreword v

Executive Summary ix

Chapter 5 Capital and Money Markets 55

Chapter 1 Overview 3
1. Stock Market 55
2. Development of Bond Market 57
Chapter 2 Development of International & Domestic
2.1. Corporate Bonds 57
Economies 7
2.2. Surat Utang Negara 58
1. Development of International Economy 7
3. Development of Mutual Funds 59
2. Development of Domestic Economy 9
4. Money Market 60
3. Development of the Real Sector 12
Box 5.1: Oversubscribed Foreign Currency Bonds:
Box 2.1: Potential Pressures on Several Industries due to
Momentum of Rising Foreign Confidence 62
Oil Price Hikes 16

Chapter 6 Payment System 65

Chapter 3 Indonesia»s Banking Industry 21
1. Structure of Banking Industry 21
2. General Picture of Banking Industry 21 APPENDIX
3. Credit Risk 22 1. Table 1. Balance of Payment 71
4. Liquidity Risk 29 2. Table 2. Macroeconomic Indicators 71
5. Market Risk 34 3. Table 3. State Budget 72
6. Operational Risk 37
7. Profitability 39 ARTICLES
8. Capital 41 1. Analysis of Foreign Bank»s Role in Enhancing
9. Directon of Banking Policies 43 Indonesia»s Real Sector Recover 75
9.1. Indonesian Banking Architecture 43 2. The Model To Predict Bankruptcy for Commercial
9.2. Rural Bank (BPR) 44 Banks in Indonesia 95
9.3. Sharia Banking 45 3. An Analysis in respect of the Behavior of Investment
Box 3.1: Financial Safety Net 46 Managers in Facing Uncertainties 115

Chapter 4 Non-Bank Financial Institutions 49

1. Condition of Insurance Industry 49
2. Development of Pension Fund Industry 50
Box 4.1: Cases of Bankruptcy Pronouncements of
Insurance Companies : PT. Prudential Indonesia
dan PT. Manulife Indonesia 51

iii
 List of Table and Chart
Table
2.1. Repayment Plan of Indonesian Offshore June - 3.7. Undisbursed Loan by Usage
December 2004 3.8. NPL Gross and Net
2.2. Simulation of Debt Equity Ratio of 3 Major Group of 3.9. NPL to Capital
Companies 3.10. NPL of ASEAN Countries
2.3. Outstanding and Growth of Loans to Small Scale 3.11. Stress Test of NPL - June 2004
Business 3.12. Loan by Sector
3.13. NPL by Sector - June 2004
3.1. NPL by Nominal 3.14. NPL by Agriculture, Mining and Manufacture
3.2. NPL By Bank Group 3.15. Foreign Loan by Group - June 2004 (%)
3.3. 25»s Top Debtors (25 TD) 3.16. Liquidity Ratio
3.4. Loan Restructuring 3.17. Deposits Ownership
3.5. Bank Funding & Placement Structure 3.18. Interbank Offering Rates QII-2004
3.6. Development of Deposits and Net Asset Value (NAV) 3.19. Composition of Deposits among Large Banks
3.7. Deposits and Core Deposit Ratios 3.20. Stress Testing of Exchange Rate
3.8. Interbank Money Market 3.21. Interest Rate Stress Testing
3.9. Interbank Rates 3.22. Net Open Position to capital of Large Banks
3.10. Deposits Permaturity Bucket 3.23. Composition of Interest Income of Large Banks
3.11. Exchange Offer 3.24. Composition of Interest Income of All Banks (2003-
3.12. Fraud Cases in Banks 2004)
3.25. Net Interest Income Trends (Excl. Interest Income from
Table Box 4.1 Fiancial Highlights of Prudential Life Assurance Securities)
(Indonesia) 3.26. Trend of ROA (Peer Group Comparison) - June 2004
3.27. Distribution of ROA - June 2004
5.1. Corporate Bonds 3.28. Efficiency and Overhead Cost Ratios - June 2004
5.2. Auctions of Government Bonds 3.29. Fee Based to Total Operating Income Ratios
Table Box 5.1 Long-term Foreign Currency Bonds of the 3.30. CAR - June 2004
Republic of Indonesia 3.31. Distribution of CAR
3.32. Tier 1 to Total Asset Ratio - June 2004

Chart
4.1. Government Bond Ownership
2.1. GDP of Major Trading Partners
2.2. GDP of Some Asian Countries
5.1. Equity Index and Market Capitalization
2.3. Export Performance of Some Major Industrial Countries
5.2. Volatility of Equity Index
2.4. Euro and Yen Exchange Rates Against USD S1-2004
5.3. Equity Index and Transaction of Foreign Investors
2.5. Exchange Rates of Asian Currencies Against USD
5.4. PER of World Stock Exchanges
Chart Box 2.1 Loan Classification of Airline Industry - July
5.5. Equity Index of Financial Corporations
2004
5.6. NAV per Type of Mutual Funds
5.7. Composition of NAV per Type of Mutual Funds
3.1. Earning Assets
5.8. Trend of Domestic Interest Rates
3.2. Loans by Group
5.9. Spread of Interest Rates
3.3. Loan to Deposit Ratio
3.4. NPL of Consumer Loan
6.1. Volume and Value of Real Time Gross Settlement
3.5. New Disbursed Loan 2002, 2003, 2004
6.2. Volume and Value of Clearing Settlements
3.6. Undisbursed Loan by Sector
6.3. Real Time Gross Settlement System Transactions

iv
 Foreword

One of the roles of Bank Indonesia is the maintainance and stability of the national currency. To meet the
objective, Bank Indonesia undertakes routine enhancement actions and continually monitors factors that influence
domestic financial stability. Results of our monitoring and assessment are presented in the bi-annual Financial
Stability Review.

During the first half of 2004, Indonesian financial system was stable and we expect continued stability
throughout 2004. Notwithstanding, potential internal and external challenges that could pose greater risks to
Indonesian financial system remain threatening. Several positive signs occurred during the first half of 2004,
rising international confidence as evidenced by oversubscriptions in Indonesian international bonds sales, Indonesia’s
improved ratings, and high foreign investors’ interest in buying Indonesian financial products. Within the country,
the legislative and presidential elections went smoothly helping maintain public confidence in the recovery of
the Indonesian economy.

There are still several national challenges, however, such as the real sector that has not fully revived, weak
enforcement of sound administrative practices and laws. Immediate measures have to be made to pull out Indonesia
from prolonged crisis and and therefore become a respected, prosperous country. Considering the broad scope of
efforts required to achieve financial system stability, the development and maintenance of financial stability requires
joint responsibility of the related authorities and stakeholders. This review is expected to provide useful information
to our various stakeholders in conducting their respective roles for more stable economy. We want to express our
highest appreciation to those whose contributions in completion of this review improved the quality of the review
along with sharper analyses.

In closing, we welcome any suggestions, comments or critiques from all stakeholders to enhance the quality
of this review in the coming periods.

Jakarta, June 2004

Maman H. Somantri

Deputy Governor

v
vi
 Executive Summary

Executive
Summary

vii
 Executive Summary

viii

Executive Summary
During the first half of 2004, the Indonesian financial
system was reasonably stable. However, at the end of the
semester, there was potential for rising risk exposures
largely prompted by a slight depreciation of the rupiah
and a modest inflation increase. The success of general
election on 5 April 2004 helped contribute to the
improvements in public confidence and business activities
in Indonesia.
The economies of Indonesian trading partners, such
as the US, Japan, and ASEAN countries, were stable during
semester I/2004. This is expected to continue into the
next period. However, there is an uptrend of the Federal
Funds rates, which could change global market conditions.
Also, competition with exports from China needs to be
closely watched in the coming periods.
The changes of economic indicators did not create
serious consequences on the financial sector, particularly
the banking sector. Financial and operational performances
of banks as the most dominant player of Indonesian
financial was reasonably stable and adequate, despite a
slight drop in CAR, stemming from increases in number of
loans granted.
Programs for implementation of the Indonesian
Banking Architecture, preparation for implementation of
international standards (best practices), including Basel 2,
as well as Bank Indonesia»s strong commitments to
implement sound risk management principles within the
banking industry have contributed to maintaining public
confidence on the Indonesian banking industry.
Loans grew quite rapidly by Rp51.5 trillion (10.8%),
or 93.8% of banks» business plan for semester I/2004
accompanied by a modest rising of NPLs. NPLs actually
Executive Summary
trended downward, however, this was more due to quite
large rise in loans. In the short-to-medium term, it is
predicted that credit risk would have a slight upward trend,
largely prompted by rising interest rates and the remaining
sluggish real economy.
In addition, market risk remained stable despite the
rupiah depreciation since April 2004. The measures of
Bank Indonesia to minimize the excess liquidity has
boosted the strength of the rupiah. In addition, results of
stress tests show that capital of the major banks stays
robust should the rupiah depreciates up to Rp2,500/USD.
As banks converted bonds and SBI, profitability of
banking industry started to rise in line with growth of loans.
Consequently, ROA and NII also improved from 2.5% and
Rp3.2 trillion in December 2003 to 2.7% and Rp5.4 trillion
as of June 2004. However, potentials for increases in
interest rates and credit risk must be carefully watched by
bank management in order to maintain and increase their
abilities to earn revenues and maintain adequate capitals.
Cases of fraud in the banking sector also need special
attention, considering that its frequency has relatively
increased, particularly in the period 2003/2004. As such,
there is a need for early detection approach and effective
law enforcement to prevent the recurrence of similar
incidents in the future.
Capital markets became relatively more sensitive as
reflected by the downward trend of the composite index
since April 2004 while it previously experienced a rise since
end-2003. This has boosted an upward shift in investment
to lower-risk portfolios such as mutual funds with
underlying government bonds and bank deposits that are
fully guaranteed by the government. This condition is
ix
 Executive Summary
reflected by rising net asset value (NAV) of Rp16 trillion
(23.2%) to Rp85 trillion.
In addition, the payment system, operating both
through the BI-RTGS system as well as the clearing system,
stayed robust. During the first semester, daily average
transaction value of BI-RTGS system has dropped by
Rp49.7 trillion (- 35.9%), while that of the clearing system
has increased by Rp4.6 trillion (92.3%). Nevertheless, the
role of the clearing system is relatively smaller than that of
the BI-RTGS, at only 0.02% of BI-RTGS daily average value.
x
Supervision of the BI-RTGS system continuously
strengthen, particularly for ensuring the operational safety
of the system, both on the operators as well as the
participant side. Supervision of the BI-RTGS system safety
on the participant side is also aimed at minimizing the risk
of fraud.
Going forward, Bank Indonesia will intensify
supervision over card-issuing institutions with the objective
to ensure a safe and efficient payment system and to
examine consumer protection aspects..
 Overview

Chapter 1
Overview

1
 Overview

2

Chapter 1
Overview
Risks to Indonesia»s financial system stability, and that
of several of its major trade partner countries and other
ASEAN countries, are moderating in the short-term.
However,a rising interest rate environment at a time of
relatively high levels of bank credit and domestic
government debt would have the potential to increase
market and liquidity risks.
In general, Indonesia»s financial institutions and
markets, particularly banks, remain sound and growing.
Problems, risks, and mitigation of risks will be discussed in
more detail in this financial stability review.
International economies have improved in the first
half of 2004 as evidenced by rising GDPs of the US,
countries in the Euro region, and Japan. However, this
opportunity has not been optimally seized by Indonesia as
reflected by the low rise in Indonesia»s non-oil/gas
international trade volume.
In addition, the domestic condition is susceptibile to
an increasing state budget deficit and pressures on several
of Indonesia»s largest foreign currency contributing
commodities, such as textiles and textile products, footwear
products, wood-based products, paper products, etc.
However, economic growth is predicted to continue with
the support from the consumption sector and productions
from micro, small, and medium businesses.
Major risks to Indonesia»s banking industry, such as
credit, liquidity, and market risks were relatively under
control. However, in the coming few periods, it is predicted
that credit and market risks would rise again due to high
uncertainty stemming from less supportive domestic
economic condition and pressures coming from
international factors, namely rising global interest rates
and oil price hikes.
Overview
Meanwhile, banking operational risk is still quite high.
This is evidenced by the few incidents of fraud that have
occurred at several banks. This high level of risk results
from weak internal controls and loosely applied good
corporate governance. Bank Indonesia has taken follow-
up actions on violations in the banking sector through
cooperation with related authorities and the issuance of
enforcement orders dealing with bank risk management
practices, including operational risk management.
Improvements in the Banking sector is evidenced by
rising profitability resulting from credit expansion that
began in the beginning of 2004. ROA rose from 2.5% to
2.7%, while NII rose from Rp3.2 trillion to Rp5.4 trillion.
However, there were still many national banks with ROA
far below 1.2% (28 banks) due to relatively low efficiency
levels, particularly in state banks.
Meanwhile, the downward trend of interest rates
during semester I has lowered the profits of non-bank
financial institutions, particularly insurance companies and
pension funds. However, the potential rise in interest
rate in the post-semester I period and expanded business
opportunities resulting from new financial product
offerings provides for potential improvement in
profitability.
The capital market as an alternative source of
financing has shown quite encouraging performance.
However, it is predicted that a weak performance of world
bourse, the potential for rising interest rates and payment
failures (defaults) on the part of several large companies
in the Asia Pulp and Paper group (PT Tjiwi Kimia, PT Indah
Kiat, PT Lontar Papyrus and PT Pindo Deli) and Mulia group
(PT Muliakeramik Indahraya and PT Muliaglass) could
deteriorate investors» confidence. Meanwhile, the surat
3
 Overview
utang negara/SUN (government bond) market condition
is still growing positively and liquid, despite having
experienced sales cancellations for two consecutive months
and the existence of high potential for refinancing risk in
a state budget condition that is more burdened.
Efforts to support financial system stability,
particularly regarding the realization of a safe and reliable
payment system , are continuously undertaken. Control
over risks within the payment system, both settlement and
operational risk, is implemented in line with international
standards (best practices). In addition, institutions that issue
credit cards, debit cards, and ATM cards will be supervised
to ensure that the payment system remains safe and
efficient and the customer is protected
A bankruptcy prediction model for individual
commercial banks and banking groups operating in
Indonesia, based on their financial reports has been
developed. Results of statistical analyses show that this
4
model is effective in predicting bankruptcy three months
ahead of the occurrence.
In addition, research has been conducted on the
role of foreign banks in the recovery of intermediation,
particularly in credit channeling. Results of this research
confirm that currently foreign banks» activities are more
focused on activities that earn fee based income, credit
channeling to the consumption sector, and placement of
funds in marketable securities. Data also show that foreign
banks give priority to non-credit incomes (42.1%) and that
their ROA (0.29%) has a negative correlation with credit
growth.
In relation to the realization of financial stability on
the capital market side, a review has been made on
investment manager»s behaviors through the
implementation of progressive incentives in order to increase
the financial industry»s competitiveness. However, this needs
to be undertaken cautiously in order to prevent fraud.
 Chapter 2 Development of International & Domestic Economies

Chapter 2
Development of International
& Domestic Economies

5
 Chapter 2 Development of International & Domestic Economies

6
 Chapter 2 Development of International & Domestic Economies

Chapter 2
Development of International & Domestic Economies

Opportunities that came with improving international performance occurred both on the external side as well as
economy in the first half of 2004 have not been optimally on the domestic side.
seized by Indonesia. This is evidenced by relatively low Economic growth of advanced and Asian countries
increase in Indonesia»s international (non oil/gas) trade has given positive influence on Indonesia»s exports as
volume, which stemmed from supply problem such as evidenced by Indonesia»s export performance that was still
structural problem and weak competitiveness of Indonesia»s rising, particularly oil and gas exports. However, it has to
industry sectors that produced prime export products. be realized also that Indonesia»s rising oil and gas export
performance was also much influenced by rising
1. DEVELOPMENT OF INTERNATIONAL ECONOMY international oil prices. Considering the volatile trend of
During semester I/2004, world economy still oil prices, Indonesia»s oil and gas industry sector should
experienced quite high growth (Chart 2.1) although it was increase efforts to raise production volume, which would
overshadowed for a while by a worry over rising uncertainty make institutions that finance this sector feel more secured
that has risen from several geopolitical problems such as because their debtors» revenue source would be more
heightening political condition in the Middle East. certain.
Economies of advanced countries such as the US and
Britain still showed quite high growth, largely supported % y-o-y
15.0
by rising domestic demand. Meanwhile, in the Euro region,
10.0
domestic economic performance was still moving slowly
5.0
and as such economic growth in that region was more
supported by external sector performance. In the particular 0.0

case of Japan, significant improvement in economic -5.0

Korea Malaysia Singapore China Thailand

-10.0
% y-o-y I II III IV I II III IV I II III IV I II III IV I II
6.0 2000 2001 2002 2003 2004
Source : Bloomberg
5.0
4.0
Chart 2.2
3.0
2.0
GDP of Some Asian Countries
1.0
0.0
-1.0 Indonesia»s major export destination countries in
-2.0
USA
-3.0
EU
semester I/2004 was still dominated by Japan with total
-4.0
Japan
-5.0 I II III IV I II III IV I II III IV I II III IV I II export value of USD3,796.9 million (15.82% of total non-
2000 2001 2002 2003 2004
Source : Bloomberg oil/gas exports), followed by the US with total value of
Chart 2.1 USD3,601.6 million (15.01%), Singapore with total value
GDP of Major Trading Partners
of USD2,467.6 million (10.28%), and China with total

7
 Chapter 2 Development of International & Domestic Economies

value of USD1,382.6 million (5.76%). On the other hand, other than the US, this situation poses a heavy challenge.
Indonesia»s largest non oil/gas imports came from Japan Financing institutions/banks also need to pay close
with total value of USD2,504 million (16.22% of total non attention to this phenomenon.
oil/gas imports), followed by the US with total value of Expanding global economic activities and rising oil
USD1,510.9 million (9.78%), China with total value of and gas and non-oil/gas commodity prices have prompted
USD1,421.4 million (9.21%), and Singapore with total expanding demand, which has accelerated the rise of
value of USD1,094.1 million (7.09%). inflation in several countries. Inflation rate in advance
In several Asian countries, the growth rates of their country group went up from 1.5% (yoy) in semester II/
trades with other countries were still rising, as reflected 2003 to 1.9% (yoy) in semester I/2004.
by indicators of export-import activities in several These expanding economic activities have been
countries (Chart 2.3). Meanwhile, China»s policy package followed by an uptrend of interest rates in the international
to solve the overheating of its economy has started to money market, which has been prompted by similar trend
show influence, particularly in the decline of its in advanced countries (except Japan). Meanwhile, offered
international (export-import) trade activities. For interest rates in Asian countries were relatively stable. In
Indonesia, China»s economic slowing policy has not the international stock market, shares recovered after
shown influence in semester I/2004. This is evidenced experiencing a drop for a while as uncertainty regarding
by non oil/gas exports that still rose by 8.4% relative to US economy lessened and optimism regarding improved
the same period in 2003, while non oil/gas imports rose profits for corporations in the US rose. In addition, in the
by 30.9%. However, adoption of above policy by China foreign currency market, the strengthening trend of the
would make it difficult for non oil/gas exports to that US dollar exchange rate, which was related to expectation
country to expand, which currently have only reached over acceleration of US economic growth followed by
5.76% of Indonesia»s total non-oil/gas exports (compared expectation over the rise of Fed Fund interest rate, was
to Japan, the US, and Singapore each with a share of only temporary. The US dollar weakened again because
15.82%, 15.01% and 10.28%). For certain industry market players considered that the US economy was still
sectors that are looking for alternative export markets in a big problem in the short-term, largely due to existing
twin deficits (US deficit in trade transactions and fiscal

% y-o-y deficit). In addition, crude oil price hikes also put pressure
40.00
on the US dollar exchange rate. Fundamentally, oil price
30.00
hikes occurred because the need for crude oil was larger
20.00
than its supply, which was quite disrupted by the crisis in
10.00
Iraq and problem in the world second largest oil company,
0.00
Yukos.
-10.00
USA Japan
UK Germany
From the sentiment side, these oil price hikes were
-20.00
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May
2002 2003 2004 related to speculative activities on oil amidst uncertainties
Source: Interntational Financial Statistics, (processed)
over the plan to reduce OPEC oil production quotas, oil
Chart 2.3
company labor strikes in Venezuela, political fighting in
Export Performance of Some Major Industrial Countries
Nigeria and Middle East, as well as information on low

8
 Chapter 2 Development of International & Domestic Economies

fuel reserves in several advanced countries, particularly the IDR,KRW/USD THB,PHP/USD

10,000 58
US and Europe.
9,000
This condition has had negative influence for 8,000 53

7,000
Indonesia, which currently is a net oil importer. It would 48
6,000
raise fuel subsidy cost and as a result would increase 5,000
43
4,000
state spending in the state budget. In the end, it would
3,000 38
have the potential to expand Indonesia»s state budget 2,000
1,000 33
deficit. Meanwhile, financial institutions need to give 1-Jan 21-Jan 10-Feb 1-Mar 19-Mar 8-Apr 28-Apr 18-May 7-Jun 25-Jun
KRW/USD THB/USD IDR/USD PHP/USD

close attention to potential interest rate increases due Source: Bloomberg

to quite large pressure on the rupiah as a result of this
condition. In addition, they also have to be cautious in
financing projects that are much influenced by oil prices.
Oil price hikes have the potential to raise production
cost, which in turn will have the potential to threaten
the sustainability of these projects. Financing of export-
oriented businesses with exports to countries that are
very much dependent on oil imports also need to be
closely watched. Oil price hikes could have an impact
in slowing down these countries» economic growth and
reducing their imports.
International capital flows to developing countries,
including Indonesia, experienced outflows for a while due
to the issue on Fed Fund interest rate rise. During the first
few weeks in semester I/2004, outflows that occurred in
developing countries reached USD124 million. However,
those capitals are predicted to have returned in line with
Chart 2. 5
Exchange Rates of Asian Currencies Against USD
lessening expectation over US economic recovery in the
short-term.
2. DEVELOPMENT OF DOMESTIC ECONOMY
On the side of balance of payments, current
transactions in semester I/2004 recorded a surplus of
USD659 million, lower than USD3.6 billion in the same
semester in 2003 (Table Indonesia»s Balance of Payments,
Appendix 2.1). This drop in surplus was prompted by
import rise (14.2%) being larger than export rise (1.1%),
particularly oil and gas import rise.
During semester I/2004, the rupiah exchange rate
experienced depreciation compared to the previous period,
along with rising volatility. Up to end of June 2004, the
average rupiah exchange rate has reached Rp8,733/USD,

USD/EUR JPY/USD
or slightly above the beginning estimated range of
1,3000 116
1,2800 114
Rp8,200/USD √ Rp8,700/USD.
1,2600 112 Meanwhile, in June the rupiah exchange rate reached
1,2400 110
1,2200 108
its lowest of Rp9,486/USD for a while. This depreciation
1,2000 106 in general was spurred by external and domestic factors.
1,1800 104
USD/EUR (left axis) JPY/USD (right axis)
1,1600 102
The external factors were the spill over impact of US dollar
1,1400 100
strengthening, which was related to expectation over Fed
1,1200 98
1-Jan 21-Jan 10-Feb 1-Mar 19-Mar 8-Apr 28-Apr 18-May 7-Jun 25-Jun
Fund interest rate rise and acceleration of US economic
2004
Source: Bloomberg
recovery, as well as regional sentiment over China»s
Chart 2. 4
Euro and Yen Exchange Rates Against USD S1-2004 economic slowing, all of which were overreacted by
domestic market players. This attitude has dampened the

9
 Chapter 2 Development of International & Domestic Economies
positive sentiment arising from improvement on Indonesia»s
foreign debt rating.
In May 2004, Standard and Poors has raised
Indonesia»s sovereign rating outlook from stable to positive
while Japan Credit Rating Agency (JCRA) has also raised
Indonesia»s ratings on long-term currency senior debt as
well as long-term local currency senior debt from B to B+.
Meanwhile, in June 2004, Japan»s rating institution Rating
& Investment raised Indonesia»s long-tem debt rating from
B- to B with stable outlook.
Domestic factor also contributed in putting pressure
on rupiah exchange rate through negative market
sentiment at the approach of the general election. In
addition, negative market sentiment was also influenced
by the bandwagon effect from the rupiah exchange rate
weakening, which was evidenced by rising foreign currency
demand by corporations for import financing, foreign
obligations, in addition to speculative motives.
In the framework of reducing pressures on the
rupiah, Bank Indonesia has issued an economic
stabilization policy package, which covers three aspects.
The first aspect covers controlling policy on the side of
rupiah liquidity by way of absorption of the banking
sector»s excess liquidity that has not been utilized by the
real sector. This is achieved through activation of 7-day
Bank Indonesia Deposit Facility and increase in minimum
reserve requirement for banks. The second aspect covers
enhancement of bank prudential requirement on foreign
currency net position. The third covers increased
monitoring on foreign currency demand.
During semester I-2004, CPI inflation reached 6.83%
(yoy), up from 6.62% (yoy) in the same period last year.
In general, the rise in inflation was prompted by the rise in
telephone tariffs, declining supplies of a number of
commodities that are classified as volatile food due to
seasonal factor, as well as influence of exchange rate
weakening. Combination of these three factors has
10
prompted the formation of public expectation over rising
inflation. If this inflationary pressure persists, it will have
an impact in raising interest rate. As a consequence,
interest rates of credits and domestic bank deposits would
rise. This would make credit channeling more difficult
and the real sector movement would become slower.
Weakening trend of rupiah exchange rate and rising
inflation expectation have prompted a slowing in the
acceleration of SBI interest rate decline, which made SBI
interest rates relatively stable in the last two months.
During semester I/2004, average interest rates of 1-month
and 3-month SBIs came to 7.57% and 7.49%, lower than
11.51% and 11.66% in semester I/2003. Fed Funds
interest rate increase of 25 bps in June 2004 does not
seem to have influenced domestic interest rate
development yet. However, it is predicted that in the
coming period it would influence domestic money market
condition, which would be reflected in the rise of interbank
money market interest rate. The prediction is even stronger
as US interest rate increase is predicted to continue in
several stages.
On the side of state budget realization in semester I/
2004, domestic currency decline against US dollar and
rising trend of crude oil prices in the international market
have influenced realization of state budget aggregates and
made several basic assumptions, used as references in the
calculation of state budget realization, become no longer
valid. This situation has the potential to raise state budget
deficit and as such revision on state budget cannot be
avoided.
State receipt in semester I/2004 came to Rp144,783.3
billion or 41.4% of state budget target. Meanwhile, tax
receipt for the same period reached Rp118,909.2 billion
or 43.7% of state budget target, with the main sources
being non oil/gas income tax and value-added tax.
On the side of state spending, in semester I/2004,
there has been a rise in government spending in relation
 Chapter 2 Development of International & Domestic Economies

to government policy to give 13th month salaries to civil million was for government foreign debt payments and
servants, members of the Arm Forces/Police, retired civil USD1,572 million was for private foreign debt payments.
servants, and government officials, which were paid in Of total private foreign debt payments, USD1,195 million
June 2004, foreign debt interest payments, and other was for financial institutions» foreign debt payments (for
routine spending related to the cost of holding the general banks amounting to USD1,184 and for non-banks
election. In addition, realization of fuel subsidy reached amounting to USD11 million). The remaining balance of
Rp8,773.2 billion or 60.4 % of its ceiling in the 2004 state USD377 million was for non-financial institution foreign
budget, which was primarily influenced by high realization debt payments. These foreign debt payments influenced
of crude oil prices. This realization of fuel subsidy in the weakening of rupiah exchange rate for a while due to
semester I/2004 was much higher compared to semester quite large demand for dollars for the need of these
I/2003 when it reached Rp3,852.9 billion. Development payments. However, weakening of rupiah exchange rate
spending also experienced a slight rise, particularly due to was not such that it has endangered Indonesia»s banking
rupiah financing. Realization of total state spending in financial condition.
this semester reached Rp163,337.3 billion or 43.6% of Planned 2004 payments on Indonesia»s foreign debts
2004 state budget target. (June up to December 2004) are projected to reach
With above developments, semester I/2004 brought USD16,523 million, comprising payments on principals and
a deficit of Rp18,553.9 billion (3.3% of GDP or 76.0% of interests in the amounts of USD13,102 million and
state budget target), which was primarily financed from USD3,421 million, respectively. Of the total, payments on
the balance of the government account at Bank Indonesia, government foreign debts are projected to reach USD6,005
particularly investment fund account, yields from million, comprising payments on principals and interests
government shares privatization, sales of assets under the in the amounts of USD3,969 million and USD2,036 million,
bank restructuring program, and net yields of issuance of respectively. This payment plan needs to be scheduled
surat utang negara/SUN. cautiously in order to avoid excessive demand for the dollar
Meanwhile, decline in oil production and increase in at the same time, which would bring pressure on the rupiah
domestic fuel consumption along with rising international exchange rate.
oil prices have the potential to raise deficit. Of course,
Table 2.1
rising state budget deficit would have negative influence
Repayment Plan of Indonesian Offshore
for Indonesia because it would lower investors» confidence June - December 2004
(USD million)
in Indonesian government capability to finance that deficit
Type Principal Interest Total
rise. Further impact would be negative sentiment, which
A. Government Debt 3,969 2,036 6,005
would bring pressure on the rupiah exchange rate and in B. Private Debt 7,965 1,385 9,350
b.1. Financial Institution 1,699 93 1,792
the long-run could also lower Indonesia»s foreign debt Bank 1,142 41 1,183
Non Bank 557 52 609
rating.
b.2. Non Financial Institution 6,266 1,292 7,558
Indonesia»s foreign debt payments up to May 2004
C. Securities *) 1,200 0 1,200
have reached USD2,142 million, comprising payments on
Total 13,134 3,421 16,555
principals and interests amounting to USD1,900 million
*) Marketable securities own by non resident
Source: Bank Indonesia
and USD241 million, respectively. Of the total, USD569

11
 Chapter 2 Development of International & Domestic Economies
3. DEVELOPMENT OF THE REAL SECTOR
Indonesia»s economy in semester I/2004 grew 4.66%
(yoy). This growth was still dominated by consumption
activities, while investment and export activities had yet
to gain larger roles. This situation was brought about by
rising public purchasing power as well as availability of
various easy financing facilities. Meanwhile, rupiah
exchange rate weakening has not lowered consumer
expectation of the economy.
Easing in financing by financial institutions was
evidenced by quite active offers for consumer credit
products, which in the end bolstered rapid consumption
credit growth during the reporting period. During semester
I/2004, investment activities (formation of gross domestic
fixed capital), which had occurred since quarter III/2003,
have not shown optimal performance. In the last few
periods, the real sector seemed to start reviving as an
impact of improving economic stability and rising market
confidence over Indonesia»s better economic prospects in
the coming periods. This is reflected by rising approvals
for domestic capital investments by 34.1% from January
√ July 2004 compared to the same period the year before
while foreign capital investment dropped by 33.6%.
However, several investment activity indicators have not
shown satisfactory performances, as reflected in the decline
in capitalization value of the corporate bond market during
semester I/2004 by 38.8% compared to the same period
the year before.
Export performance in semester I/2004 recorded a
growth of 3.14% relative to the same period in 20031 .
This growth originated in the increases of oil and gas
exports by 6.29% and non-oil/gas exports by 2.21%. Oil
and gas export rise was prompted by the increases in crude
oil and natural gas exports, while, in contrast, oil product
exports dropped. In addition, although daily level of oil
production dropped, the rise in oil and gas exports was
influenced by the rise in international oil price. However,
12
this oil price increase has the potential to raise state budget
deficit and companies» production cost, such as airline
companies (see box), with a possibility of threatening the
sustainability of these companies» businesses.
Meanwhile, import value in semester I/2004 rose by
27.2% compared to the same period in 2003. This rise
was brought about by the increases in oil and gas imports
by 36.47% and non-oil/gas imports by 24.5%. Import
growth, which was quite high and exceeded that of
exports, prompted the trade account to drop by 23.8% in
the months of January √ May 2004.
In addition, foreign currency reserve during the period
May √ June 2004 dropped by US$1.9 billion due to among
others payments on foreign debts and Bank Indonesia»s
foreign currency interventions. However, in the month of
June 2004, foreign currency reserve position was still quite
high, reaching US$34.9 billion or equivalent to around 6
months of imports and foreign debt payments. Such level
of foreign reserve was still considered to be safe by investors
as evidenced by the ability of Indonesia to obtain foreign
debts and the existence of foreign investment inflows to
Indonesia.
3.1 Impact of Changes in Exchange Rates On
Corporate Payment Capability
Results of a simulation of exchange rate changes on
debt to equity ratios (DERs) of three large groups show
that DERs of these groups have the potential to worsen
prompted by assumed exchange rate changes. The main
factor for this potential is the fact that each business group
debt structure is still dominated by foreign currency debts,
which are accompanied by relatively low export share in
total sales. Part of their foreign currency debts has been
obtained from national banks. The potential worsening
of these three group»s DERs indicates a potential danger
to the national banking industry and financial system
1
Source: BPS-Statistic Indonesia

stability that might come from these groups» lessening
repayment capability.
Under the assumption that the rupiah exchange
rate against USD would become Rp11,000, results of
the simulation show that the Sinar Mas group would
face the largest potential DER decline, from 2.7x to 3.3x
or a drop of 21.2%. This is largely due to the fact that
59% of the groups» debt composition as of December
2003 is dominated by foreign currency debts. Basically,
this group has the potential to adapt to exchange rate
fluctuations, considering that their export sales give
58.94% contribution to total sales. However, the
existing foreign currency debt structure would bring
heavy pressure on this group in its efforts to immediately
raise its income in the short-term to be used for settling
its obligations.
Table 2.2 Simulation of Debt Equity Ratio
of 3 Major Group of Companies
Assumption
of USD/IDR
8,465 9,000 9,500 10,000
Astra 1.2 1.2 1.2 1.3
Indofood 2.6 2.6 2.7 2.8
Sinar Mas 2.7 2.8 2.9 3.0
Source : The related company»s publicized financial report (processed)
The second potential DER decline would occur in the
Indofood group, from 2.6x to 3.0x or a decline of 15.4%.
However, this group would face heavier challenge because
its exports share of total sales is only reaching 17.46%. In
order to reach the ASEAN and International markets, this
group plans to build factories overseas (particularly ASEAN),
which will at the same time be the basis for competing in
overseas markets.
Meanwhile, results of simulation on the Astra group
show that the DER of this group would worsen, from 1.2x
to 1.3x or a drop of 12.4%. This would largely occur
because its foreign currency debt share to total debts
reaches 35%. Other heavy challenges that would face
this group would be among others yet high import-content
Chapter 2 Development of International & Domestic Economies
in their automotive products, which are the main engine
of the Astra group»s businesses.
The banking industry needs to well anticipate the
potential worsening of DERs as shown by results of this
simulation, which uses an assumption of weakening rupiah
exchange rate. Otherwise, this condition has the potential
to spur these groups» worsening repayment capability,
which in turn would raise banking industry»s non-
performing loans.
3.2 Textiles and Textile Products Industry
One of the industry subsectors that has experienced
quite serious problems is the textiles and textile products
(TTP) industry. Since 2003, credits extended to this industry
have been declining. There are banks that even have
classified the TTP industry into the negative list because
this industry is considered to be an industry that is going
down (sunset industry), with high risk (its debts are
10,500 11,000 susceptible to becoming non-performing) and not so good
1.3 1.3 prospects. There are several factors that have influenced
2.8 3.0
banks» evaluation. First, the TTP industry, which exports
3.1 3.3
have once been one of the largest foreign currency
contributors for Indonesia, is facing heavy threat because
it has to compete with cheaper TTP products from China
and it has to survive despite the revocation of export quotas
by the European Union, US, and Canada starting 1 January
2005 as part of WTO agreements. Second, the slow down
of the TTP industry also stems from unclear regulations
and labor problems. Third, banks consider the TTP industry
complicated and that it requires special skills to enter this
business due to its specific characteristics. In addition, its
competitiveness is diminishing against China or Vietnam,
who are more aggressive and able to produce cheaper
products.
The main factor that has made Indonesia»s TTP
industry loose in competition against neighboring
countries» products is the fact that the industry»s
13
 Chapter 2 Development of International & Domestic Economies

Table 2. 3
Outstanding and Growth of Loans to Small Scale Business
(Billion rupiah)

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

Total loans to Small Scale Business 75,047 87,199 16.2 119,749 37.3 161,814 35.1 213,291 31.8 243,791 14.30
Consumer 23,307 36,215 55.4 54,869 51.5 76,122 38.7 100,965 32.6 118,033 16.90
Investment 12,148 10,423 (14.2) 14,599 40.1 16,718 14.5 22,296 33.4 26,408 18.44
Working Capital 39,592 40,561 2.4 50,281 24.0 68,974 37.2 90,030 30.5 99,350 10.35

Source: Bank Indonesia

machineries are already out-of-date and almost reach
maximum utilization. Therefore, the most important step
that can be taken at this time is to revive the TTP industry
through revitalization. According to the Indonesian Textile
Association, there are 2 options in revitalization. Option
one involves replacement of machinery spare parts and
machineries. If replacement is done using own capital,
only machinery spare parts can be replaced. If bank credits
can be obtained, all machineries can be replaced. However,
in order to increase Indonesia»s TPT competitiveness against
other countries as well as raise production capacity, option
two has to be adopted. As is the case with other industry
sectors, development of several TPT industry sub sectors
still need to be supported. In addition to bringing in foreign
currency, the industry also absorbs high level of labors (it
provides jobs), which is currently a national problem. From
financial system stability side, there is a worry that a
collapsed TTP industry would raise banks» NPLs, both from
the industry sector itself as well as its laid-off workers.
3.3 Micro, Small, and Medium Scale Business
One of the business units that has quite large role in
moving the real sector is the micro, small, and medium
scale business (MSMB). Research has shown that MSMB
has proved to be able to withstand crises compared to
large businesses . In addition, MSMB has also proved to
be a source for economic growth and absorbs extremely
large number of workers. Therefore, various problems that
are facing the MSMB need to be immediately solved so
that MSMB can be developed into a strong part of the
Indonesian economic system and later on can also play a
role in maintaining financial system stability.
In semester I/2004, bank credits extended to MSMB
experienced a growth of Rp30.5 trillion or 14.3%
compared to its end-2003 position. This figure represents
84.7% of 13 large banks» plan for total credit channeling
to MSMB in 2004, which amounts to Rp36.02 trillion. This
growth reflected the banking industry»s commitment to
continue assistance in developing MSMB although it is
probably still far from optimal.
Several problems that face the banking industry in
channeling credits to MSMB are among others (i) limitation
on number of bank marketing staffs as well as bank outlets/
networks, which makes it difficult to reach remote areas
or centers of small business people, (ii) lack of information
on potential and bankable MSMB debtors, (iii) lack of
proper collaterals, while guarantees through PT Askrindo
and Perum Sarana Pengembangan Usaha will add costs
to potential MSMB debtors, (iv) higher overhead cost for
credit channeling to MSMB.
In order to solve all these various problems and to
raise credits channeled to MSMB in 2004, several efforts
have been made by banks, which cover among others : (i)
actively increase marketing efforts to MSMB centers, (ii)
increase human resource quality through various trainings,
(iii) increase linkage programs through partnership with
BPRs ad Small Business Credit Financing Institutions such
as state pawn company, (iv) develop credit scheme of core-
plasma partnership, and (v) undertake business mapping
of potential Rural Banks (BPRs).

14

Meanwhile, on the side of business people,
constraints coming from banks that face them in
developing their businesses are among others : (i) Banks
are considered to still be hesitant in extending credits to
MSMB. This is evidenced by difficult and lengthy credit
extension procedures, requirement for additional collaterals
along with legal proofs (certificates and licenses to build/
IMB), as well as high interest rates, (ii) The banking industry
does not yet have clear knowledge on MSMB condition,
(iii) Difficulty in communicating with banks» officers
because they are too rigid, (iv) Lack of information on
availability of cheap funds provided by state-owned
enterprises, that are managed by banks, and (v) There is
no sustainable supervision over MSMB debtors.
In the framework of increasing intermediary function
and in order to solve one of the constraints coming from
banks that are facing MSMB, the banking industry needs
to continue holding periodic meetings with business people
Chapter 2 Development of International & Domestic Economies
and the government. In addition, it is hoped that the
government and the banking sector can provide
information on funds coming from parts of state-owned
enterprises» profits that have been given to and are
managed by several banks for channeling to MSMB.
Micro credits have become segmentation target of
several commercial banks such as Bank Danamon, BNI,
and Bank Mega through the establishment of micro
business units so that this business segment can develop
rapidly in line with these banks» work plans. There is a
need for further monitoring and review, particularly as
regard the possibility of competition over the same target
market between commercial banks and BPRs.
This possible competition would create problems for
BPRs, although these will still be within the context of free
competition, considering that protection for common
people has become a sensitive issue, which if not handled
properly would trigger overall financial system instability.
15
 Chapter 2 Development of International & Domestic Economies
Box 2.1 Potential Pressures on Several Industries due to Oil Price Hikes
World oil price development that has been
trending upward and reached US$47.86 per barrel
on 23 August 2004 warrants cautious attention. In
addition to its potential to bring pressures on the state
budget, world oil price hikes also have the potential
to put pressures on the real sector performance,
particularly the airline industry. Although credits
extended to this industry has only reached 0.09% of
total credits extended by the banking industry as of
end of June 2004, the industry»s NPLs have reached
6.8%. If this situation is not well anticipated, this
trend would bring pressures on financial system
stability.
World crude oil price hike that reaches US$50/
barrel would trigger transportation cost hike, which
in turn has the potential to put pressures on
performance of businesses, which raw materials are
based on imports. The textile and plastic industries
have the potential to come under pressure due to
soaring world oil prices because almost 90% of their
raw materials still depend on imports. Although direct
impacts of oil price hikes have not materialized yet,
several companies in the plastic industry have already
slowed down their factory performance and
undertaken efficiency efforts in several areas. In
addition, companies in the plastic industry plan to raise
their selling prices by 25%.
The airline industry will be the first to feel the
impact of world oil price hikes because these hikes
would trigger avtur price hikes, where avtur price
constitutes one of the components that determine
tariffs (35% up to 40% of the cost of an airline
16
company comes from avtur cost). This condition has
the potential to prompt operational cost to rise, while
on the other hand airline companies are facing price
war, which in the end would influence revenue.
There is a worry that this upward trend in world
crude oil prices that is predicted to continue until end-
2004, prompted by among others rising world demand
as several developing countries such as China and India
are advancing, upcoming summer season on the other
hemisphere, as well as sensitivity towards news of
violence in Iraq, would disrupt world oil supply.
Data as of end of July 2004 show that non-
performing loans of credits that have been extended
to the airline industry have reached Rp29,985 million
or 6,8% of total credits that have been extended to
this industry. Of these NPLs, 83% is owned by Bank
Danamon and 11% is owned by Bank Mandiri.
Although credits channeled to the airline industry have
only reached 0.09% of total credits channeled by the
banking industry as of end of June 2004, this industry»s
relatively high NPLs need to be closely watched,
70 %
7% 0%
23 %
Current Special Mention Doubtful Loss
Source : Bank Indonesia,BPS
Chart Box 2.1
Loan Classification
of Airline Industry - July 2004

considering that the uptrend of oil prices would
probably continue until end of 2004 and heavy tariff
war is still on going among airline companies.
In view of above development, banks are
expected to continuously increase their monitoring of
their debtors that are directly impacted by world oil
Chapter 2 Development of International & Domestic Economies
price hikes such as the airline companies or related
companies. In addition, Bank Indonesia and the
government (fiscal authority) need to intensify
coordination, among others in maintaining
assumptions on inflation rate and SBI interest rates in
line with market needs.
17
 Chapter 2 Development of International & Domestic Economies

18
 Chapter 3 Indonesia’s Banking Industry

Chapter 3
Indonesia’s Banking Industry

19
 Chapter 3 Indonesia’s Banking Industry

20

Chapter 3
Indonesia’s Banking Industry
1. STRUCTURE OF BANKING INDUSTRY
Indonesia»s financial system was yet dominated by
the banking industry (representing 90% of the financial
system»s total assets). The condition of the banking industry
itself was very much marked by the conditions of 15 large
banks (major banks), considering these banks dominated
the banking industry»s total assets (72.5%). Ten of these
large banks were recap banks.
Up to June 2004, number of banks was lower than
in previous report»s period. Due to the closure of two
small banks, it came to 137 banks with total assets
amounting to Rp1,185.7 trillion.
Indonesia»s banking industry still relied on credit
channeling and accumulation of public deposits and as
such the largest potential for instability would come from
these two sources. However, in terms of earning assets,
the share of credit itself was only 47.5% and the rest
comprised marketable securities (recap bonds and SBIs),
which had zero risk. Meanwhile, deposits were yet
dominated by short-term and corporate deposits, which
were extremely sensitive to interest rates.
Ten banks among the above-mentioned 15 large
banks were recap banks that were yet undergoing
consolidation. Therefore, the operational risks faced by
those banks were yet quite significant, considering that
there have been additions of new owners and
management, which could result in rising operational risks.
2. GENERAL PICTURE OF BANKING INDUSTRY
Stability of the financial system during semester I/
2004 was quite maintained with the support of the banks
as major players in controlling risks being faced, coming
both from internal as well as from external factors.
Chapter 3 Indonesia’s Banking Industry
During the said period, the banking industry faced
heavier pressures relative to the previous year due to yet
inconducive economic condition, exchange rate
weakening, world oil price hikes, and the general election.
In addition, during the same period, two small banks have
been closed and incidents of fraud have occurred in several
banks.
These pressures did not disturb financial system
stability because the related institutions were able to handle
the situation well. Bank Indonesia consistently continued
its efforts in maintaining the banking industry»s stability
by issuance of new regulations to strengthen the banking
system, which included among others reformulation of
the minimum reserve requirement (MRR) and net foreign
currency position, as well as planned implementation of
the Indonesian Banking Architecture.
Credit risk was quite under control and there were
no risk fluctuations that could significantly affect the
financial system»s stability. This is reflected by improving
credit quality marked by decreasing NPL ratio. In addition,
at the end of semester one recorded a quite large jump in
new credits and a decline in the rise of undisbursed loan
relative to the previous month.
Banking sector»s excess liquidity that was quite large
was gradually reduced by a new formulation in the MRR,
which could reduce potential for speculations. In addition,
the plan for phasing out the blanket guarantee needs to
be approached carefully because of its potential in reducing
public confidence in the banking industry.
On the other hand, market risk was quite moderate
despite exchange rate weakening and interest rate rise
by The Fed. Banking industry»s profile, particularly that of
15 large banks, was not much differet that in the previous
21
 Chapter 3 Indonesia’s Banking Industry
report. It was yet at short position for the short-term
and as such was extremely susceptible to market risk as
well as liquidity risk. Meanwhile, opeational risk was yet
relatively high due to yet ineffective risk management
and good governance implementations, which have
allowed a few cases of fraud to occur. However, banking
industry profitability rose in line with rising credits. On
the other hand, capital declined due to a rise in risk-
weighted assets (RWA) resulting from rising credits.
However, this capital decline did not stir problems in the
banking sector because aggregate CAR was yet relatively
high, namely above 20%.
However, there were a few factors that needed close
attention, particularly credit risk and operational risk, which
had the potential for disturbing banking industry stability.
In the light of developments during the previous year
and economic prospects of semester II/2004, the banking
industry is projected to face heavier pressures. Stage 3 of
the general election is not expected to be a factor of
concern for businesses or the banking industry, considering
that stages 1 and 2 of the general election that has been
held during semester I/2004 has not caused fluctuations
in the banking sector. However, economic and banking
industry»s growths would be much influenced by
developments of world oil prices, rupiah stability, and
interest rates.
The rise in oil prices would raise production costs,
including transportation cost for businesses, which in the
end would raise prices. Should such a situation occurs in
a condition where there is no rise in public income,
business people would experience difficulty in paying off
their debts to banks, which in the end would rise banking
industry NPL.
3. CREDIT RISK
In the period of end December 2003 up to semester
I/2004, Indonesia»s bank credit risk was relatively under
22
control. This was marked by improving bank credit quality
as reflected by declining trend of NPL ratio. However,
starting semester II/2004 onwards, credit risk would again
rise due to high level of uncertainty coming from external
factor, namely yet inconducive domestic economic
condition, and pressures from international factor, namely
oil price hikes. In addition, the business and banking
sectors would be waiting for policy directions of the newly
elected government, which are expected to be announced
at the start of 2005.
In general, several main challenges, which would face
the banking industry in improving its credit quality in the
future, cover :
i. National economic condition that is not yet conducive
and rising world oil prices. In the long-run, these
would have an impact in raising production cost.
Currently, sea transportation tariffs for goods have
experienced a rise of 20%, both domestic as well as
international.
ii. Existence of a potential rising in credit interest rates
due to interest rate hikes by The Fed and several other
world central banks, which would indirectly influence
global economy, including Indonesia.
iii. Weakening of rupiah value, which would disturb the
performances of exports as well as domestic
businesses that use imported raw materials.
iv. Absorption capability of the real sector, particularly
the corporation sector, is still relatively low because
in general their restructuring process has not been
fully completed. Therefore, it is difficult to
significantly raise new credits. As an impact, new
credit channeling is dominated by small credits and
consumption credits, which cannot accelerate
growths of bank credit portfolio as well as the
economy.
v. There is a potential for a rise in NPLs in the future,
which would come from restructured credits.
 Chapter 3 Indonesia’s Banking Industry

In the short-term, the impact of oil price hikes would Percentage Percentage
90 25
not yet be realized by the business sector. However, the 80
20
size and duration of oil price hikes cannot be predicted 70
60
yet, including by APEC, because they are very much related 50
15

40
to issues of wars/terrorism and political instability in several 10
30
countries that are world largest oil suppliers. 20 5
1 2 10
On one hand, new credit rise and undisbursed loan
0 0
Des Dec Dec Dec Dec Dec Dec Jun Dec Jun
decline, which have occurred in the last months of semester 1996 1997 1998 1999 2000 2001 2002 2003 2003 2004
Loan (left) Interbank (right) Securities (left) SBI (left)
I/2004, are sufficient to prompt bank credit as well as
Chart 3.1
economic growths. On the other hand, these will also Earning Assets
raise credit risk, which could reduce capitals, if a prudential
approach is not adopted. It is hoped that this credit rise As of above position, credit rise reached Rp50.9
will not be temporary but will continue. trillion, which particularly came from public funds mobilized
However, improving economies of Indonesia»s major by the banking sector amounting to Rp24.2 trillion, a
trading partners, such as the US, on the one hand and decline in recap bonds (Rp19.6 trillion) and interbank
China»s overheating economy on the other hand give an placements (Rp12.0 trillion). This growth prompted a rise
opportunity for Indonesia to expand its exports, which in in the share of credit in produtive assets from 42.5% to
turn would raise demand for investment and working 46.1%. This share of credit is the largest compared to the
capital credits. shares of other types of earning assets in the post-crisis
period, which two months previously was yet dominated
3.1. Development of Credits by marketable securities (government bonds and SBIs).
Bank credit growth was yet influenced by sectors The rise in credits resulted from the banking sector»s
and types that did not prompt economic growth, which efforts to continuously promote its intermediary function,
in nominal terms did not dominate. New credit which prompted banking LDR to also rose to 46.4%.
withdrawals were smaller than in the pevious year although This is reflected by the credit growth (y-to-y) of foreign
the last two months showed quite encouraging bank group, which was recorded as being negative in the
development, which has prompted the share of credit to
surpass that of marketable securities and caused bank LDR Trillion Rp
300,000
State-owned Bank
to rise. Private Bank
250,000
Foreign and Joint Venture Bank
Indonesia»s bank post-crisis earning asset composition Regional Development Bank
200,000
is marked by quite large share of recap bonds that has
150,000
zero risk as a result of the recapitalization program in 1998.
100,000
As of June 2004, bank earning assets rose by Rp29.7 trillion
50,000

(2.7%) from December 2003 position, particularly credits

0
1996 1997 1998 1999 2000 2001 2002 2003 2004
and SBIs, which rose by 11.6% and 9.1%, respectively.

1
Chart 3.2
New credits are credits withdrawn by debtors in the same months as the dates of the
credit agreements. Loans by Group
2
Credit facilities made available by banks but not yet utilized by debtors.

23
 Chapter 3 Indonesia’s Banking Industry

previous report but started to show positive growth in

Trillion Rp.
2.0
this reporting period. However, bank credit growth during Substandard Doubtful Loss
1.8
this period was yet supported by the domestic bank group. 1.6
1.4
Therefore, it can still be stated that marketable 1.2
1.0
securities still provide a safe and quite large source of
0.8
income for the banking sector because their risk do not 0.6
0.4
weigh as much as that of credits. 0.2
0.0
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May
2000 2001 2002 2003 2004
Trillion Rp Percent
1,000,000 100 Chart 3.4
900,000 90
NPL of Consumer Loan
800,000 80
700,000 70
600,000 60
500,000 50
400,000 40 3.1.2 New Credits and Undisbursed Loans
300,000 30
200,000 20 Withdrawals of new credits were lower relative to
100,000 10
0
Loan (left axis) Deposits (left axis) LDR (right axis)
0
the previous year, however, the last two months showed
1996 1997 1998 1999 2000 2001 2002 2003 2004
quite a significant rise. In addition, undisbursed loans (Uls)
Chart 3.3
Loan to Deposit Ratio
was quite large relative to the previous year. However,
the large number of new credit withdrawals have caused
a decline in the rise of Uls. It is hoped that this positive
3.1.1 Consumption Credits development would continue in order to support economic
Despite its small share (9.7%), the quality of growth.
consumption credits need to get special attention, The rise in credit portfolio was prompted by a rise in
considering the growth of this type of credit has been withdrawals of new credits that have been approved and
recorded to be the highest with a trend of rising NPLs. withdrawn during 2004, which up to June have reached
Since the start of 2002 up to May 2004, consumption Rp31.9 trillion, smaller compared to the same position in
credit NPLs have been recorded as being on the rise 2003 of Rp41.8 trillion.
although it has started to experience a decline, where as
of June 2004 it came to 2.4% with similar nominal value Billion Rp
25,000
as its December 2003 position of Rp2.9 trillion. 2002
20,000
This high consumption credit growth relative to public
2003
15,000
income growth requires a close attention in a situation of
2004
yet inconducive economic condition. Economic condition 10,000

very much influences the performance of this type of credit, 5,000

particularly in a situation where there are occurrences of 0

Jan Feb Mar Apr May Jun
company closures and employee discharges, considering
that the payoff for this type of credit relies on individual Chart 3.5
New Disbursed Loan 2002, 2003, 2004
income.

24
 Chapter 3 Indonesia’s Banking Industry

3.3.1 Non Performing Loans

5%
15%
2% Improvement of non-performing loans (NPLs) has
1%
33% reached a saturation point where bank NPLs declined with
12%
a much lower magniture although credits continuously
3%
rose. In addition, there is a concern that NPLs that has
reached a saturation point might reverse.
24%
4% 1%
Credit quality is a reflection of bank credit risk. This
Agriculture Electricity Transportation Others
Mining Construction Business Services is indicated by developments of NPL ratios, both gross and
Manufacture Trading Social Services
net. Position of bank NPLs at the reporting period was
Chart 3.6 quite high. This was due to economic condition that has
Undisbursed Loan by Sector
not fully recovered, which was tackled by the banking
sector through quite cautious implementation of its
Based on type of use, the largest extension of new intermediary function as well as through formation of quite
credits occurred in working capital credit (amounting large reserve in anticipation of possible risk.
to 52.3%), while based on sector, it occurred in the During the period of December 2003 up to June
business services, trade, and industry sector. Meanwhile, 2004, Indonesia»s bank credit quality improved as reflected
46.5% of new credits extended during 2004 was by a decline in gross and net NPL ratios. Gross NPL ratio
channeled to small-to-medium size businesses. dropped from 8.21% to 7.54%, the smallest ratio since
However, the number of Uls for this type of credit and the 1997/1998 banking crisis. Net NPL ratio also dropped
this sector was also the highest. The percentage shares from 3.04% to 2.09% (Chart 3.8).
of Uls by type of use and by sector are presented in the
following two Charts.
Percent

Most (91.6%) of bank Uls belonged to 25 banks 60

NPLs Gross NPLs Net
50
(13 large banks, including 3 state banks, 7 foreign banks,
40
4 foreign joint venture banks, and 1 other private bank).
30

20

10

14.7% 0
Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun
73.3%
1997 1998 1999 2000 2001 2002 2003 2004
12.0%
Chart 3.8
NPL Gross & Net

However, in nominal terms, NPLs also rose as the

Working Capital Loan Investment Loan Consumer Loan
result of yet inconducive economy. However, this rise was
relatively small compared to the rise in total credits. Bank
Chart III.7
Undisbursed Loan by Usage credits rose by 10.8%, while the rise of NPLs was only
1.8% (Table 3.1).

25
 Chapter 3 Indonesia’s Banking Industry

Table 3.1
quite large number of restructured credits and IBRA»s
NPL by Nominal
Loan 2002 2003 2004 credits, which quality had yet to improve. Meanwhile,
Classifica- December June December June
tion Nom % Nom % Nom % Nom %
improvement on the credit quality of the foreign bank

Current 333.4 80.8% 342.2 78.8% 389.0 81.5% 441.0 83.4% group and foreign joint venture bank group was due to
Special
Mention 43.7 10.7% 57.2 13.2% 49.0 10.3% 47.7 9.0% their credit portfolios that have started to rise, where
Substandard 9.1 2.5% 11.2 2.6% 13.9 2.9% 12.5 2.4%
previously they had negative growths
Doubtful 7.9 1.9% 6.2 1.4% 5.1 1.1% 5.6 1.1%
Loss 16.1 4.0% 17.3 4.0% 20.1 4.2% 21.7 4.1%
Total Loan 410.2 434.1 477.1 528.6 Table 3.2
Total NPL 33.1 8.1% 34.7 8.0% 39.1 8.2% 39.9 7.5% NPL By Bank Group
2002 2003 2004
In the short-term, it is estimated that bank CAR Banks December June December June
Gross Net Gross Net Gross Net Gross Net
would not be influenced by the rise in credit risk,
State-owned Banks 6.83 1.47 9.04 3.11 9.77 5.27 10.02 3.13
considering that in general banks have formed reserves
Major Banks 6.80 1.56 7.05 0.55 8.53 3.31 8.09 1.97
that exceed requirements. A more conservative ratios are Medium Size Banks 5.16 3.46 3.27 1.86 3.9 2.73 3.94 2.59
Small Banks 3.79 1.44 4.34 2.91 3.00 1.71 3.46 1.86
NPLs to Equity and NPLs to Core Equity. As of June 2004,
Joint Venture Banks 18.62 6.48 16.52 5.28 11.95 3.32 9.16 2.92
these ratios came to 24.1% and 30.5%, which dropped Foreign Banks 16.14 2.12 13.74 1.67 11.47 1.14 9.03 1.97

from their positions at December 2003 of 26.6% and

35.8%, respectively.
NPLs in Other Countries
Indonesia»s bank NPLs were recorded to be relatively
Percent
40 better although the ratio has included a factor of credit

35
channeling. Malaysia, Thailand, and the Philippines each
had NPL ratios of 8.8%, 12.1% and 13.9% at May 2004
30

position. However, there has been an indication that

25
Indonesia»s bank NPLs were understated as proven by the
20
findings of bank auditors. In the future, this situation will
NPL to Total Capital NPL to Core Capital
15
Dec Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun be corrected in order to have NPL values that are closer to
2002 2003 2004
actual conditions.
Chart 3.9
NPL to Capital

Percent
60
The largest NPLs yet belonged to the state bank Thailand Philippines
50
Indonesia Malaysia
group, foreign bank group, foreign joint venture bank
40

group with ratios above that of the industry, a condition

30

that did not much change from the previous condition. 20

NPLs of the foreign bank group and foreign joint 10

venture bank group experienced a slight improvement 0

Dec Aug Apr Dec Aug Apr Dec Aug Apr
relative to December 2003 positions, while NPLs of the 1998 1999 2000 2000 2001 2002 2002 2003 2004

state bank group tended to continuously rise. Weakening Chart 3.10

NPL of ASEAN Countries
of state bank»s credit quality was particularly prompted by

26
 Chapter 3 Indonesia’s Banking Industry

3.1.4 Provision for Earning Assets Losses
The amount of provision for earning assets losses (PEAL)
was quite larger than required. On one hand this indicates
high credit risk being faced, while on the other hand in so
doing banks looses opportunities to maximize profits.
Value of the PEAL established by Indonesia»s banks
was in aggregate adequate and no bank has violated the
requirement. Compared to December 2003, PEAL ratio
established over required ratio experienced a decline, from
181.1% to 167.4%, however it still exceeded the
requirement. This condition differed between banks. It
was recorded that 23 banks (medium and small banks)
had ratios of 100%, while the rest had ratios of over 100%.
Meanwhile, special provision for credits established
by banks also rose, from Rp31.8 trillion to Rp36.2 trillion.
The rise in the value of PEAL influenced bank net NPL ratio,
which at June 2004 showed improvement.
Differences found between collectibility calculations
by banks and auditors as well as by banks and debtors
indicated that NPLs reported by banks were lower than
actual. This supported the reason why banks established
provisions that exceeded the required amounts. It showed
that banks were ready for worst probability.
large banks using a number of hypothetical scenarios (NPL
rise from 5% up to 50%) with June 2004 CAR position as
the base. Bank capital resilience was still adequate for
NPL rise up to 25%. Meanwhile at NPL rise of 30%, one
bank had its CAR come below 8%.
3.2. Credit Concentration
3.2.1 Large Debtors
Large credits had the potential to become problem
credits in several banks, considering NPLs at those large
debtors were above the banking industry»s NPLs.
Credits extended by 13 large banks to 25 largest
debtors on average has reached 22.5% of total credits
extended by those banks, where the largest NPL reached
28.9% of outstanding credits to that particular debtor.
Amongst those credits that concentrated on 25 large
debtors, the highest was extended by one private bank
with a value of around 43% of that bank»s total credits.
Meanwhile, the lowest credit was extended by a state bank
with a value of around 2.0% and NPLs amongst those
credits extended to 25 large debtors were in general high
as presented by the following table.
Table 3.3
25»s Top Debtors (25 TD)

Percent NPL
3.1.5 NPL Stress Test Bank
to Total Loan
25 TD to 25 TD to
Nominal Percent Capital Core Capital
In order to assess the impacts of lower credit quality
A 20.6% 1.885.4 11.7% 64.6% 171.7%
on capital (CAR), stress test has been conducted on 15 B 27.7% - 0.0% 70.5% 78.4%
C 13.4% 1.264.4 18.1% 57.6% 69.1%
D 2.5% 79.6 27.4% 21.3% 30.9%
CAR (%)
25 E 10.6% 1.414.2 24.3% 54.9% 64.7%
J N O 15 BB F 49.2% 418.0 17.1% 156.6% 307.7%
20 G 30.9% 561.0 15.1% 112.0% 173.1%
H 18.6% 418.8 18.7% 151.6% 166.0%
15 I 40.9% 532.1 12.8% 112.1% 134.5%
J 52.2% - 0.0% 727.3% 782.8%
10 K 14.1% - 0.0% 49.8% 56.0%
L 17.4% 353.3 12.5% 139.8% 184.4%
5 M 25.1% 211.6 12.4% 151.4% 174.6%
20.4% 7.138.4 11.2% 81.7% 119.1%
0
10% 15% 20% 25% 30% 35% 40% 45% 50%
NPL Incremental Scenario
In the short-term, debtor concentration with such
Chart 3.11 level of NPLs as presented in the above table would not
Stress Test of NPL - June 2004
bring too much influence on those banks» capital nor on

27
 Chapter 3 Indonesia’s Banking Industry

the overall banking industry, considering that in general sector, bank credits were yet dominated by the industry
those banks have set up PEAL in adequate amounts. sector (27.8%) and the trade sector (20.0%). Meanwhile,
the highest growths (y-to-y) in semester I/2004 were
3.2.2 Credits By Economic Sector dominated by the social services and mining sectors, which
The industry sector has wide inter-relations with other were recorded at 63.0% and 60.4%, respectively. High
sectors. Problems that occur in this sector would have a growth was also recorded by the construction and
wide impact, considering that this sector dominated bank transportation sectors. In the other hand, the industry and
credits and contributed quite a large share to bank NPLs agriculture sectors, which were the main pillars of the
and that it is extremely susceptible to economic condition. economy, recorded the lowest growths of 18.0% and
Problems occurring in this sector would also very much 12.4%, respectively.
influenced credit demand, particularly for investment and By economic sector, the industry sector still posed
working capital credits. the highest credit risk potential, considering that quite large
percentage of NPLs came from this sector. In addition,

Percent
credits to this sector are very much susceptible to domestic
30
Manufacture as well as international economic conditions.
Others
25
Compared to December 2003, the industry sector»s
Trading
20
NPLs rose, from 10.59% to 10.62% as of June 2004, or
15
equivalent to 47.4% of total bank NPLs (Chart 3.14).
Business Services
10
Therefore, the largest source for bank credit risks would
Transportation Agriculture
5 Construction Social Services
Mining Electricity
be credits extended to this sector.
0

Percent
Chart 3.12
70
Loan by Sector Agriculture
60
Mining
50
8.0% 1.3% Manufacture
1.3% 9.8%
7.8% 40
4.8%
30

20

10

15.6% 47.4% 0
1996 1997 1998 1999 2000 2001 2002 2003 2004
2.6% 1.2%

Chart 3.14
Agriculture Electricity Transportation Others
NPL by Agriculture, Mining and Manufacture
Mining Construction Services
Manufacture Trading Social Services

Chart 3.13 Amongst several economic sectors, credit quality of

NPL by Sector - June 2004 the construction sector experienced a slight improvement,
from 6.04% to 4.92%. This was in line with quite large
During 2003 and 2004 (up to June), there has been rise in the portfolio of this type of credit, which was due
practically no significant change in the distribution of to vigorous growth of property credits during post-crisis
credits by economic sector as well as by type of use. By period.

28
 Chapter 3 Indonesia’s Banking Industry

3.2.3 Credit Restructuring
In general, there has been quite meaningful
improvement in restructured credits at 15 large banks,
where 3 large banks that had previously owned quite large
portfolios of restructured credits, during the reporting
period recorded zero positions. However, restructured
credits, particularly at bank B, need close attention because
the amount of its restructured credits was quite large
(29.3% of its total credits), however these had better
development relative to the previous reporting period. Total
restructured credits at 15 large banks reached Rp 36.9
credits, considering that the share of this type of credits
was relatively small. By currency, credits were still
dominated by rupiah credits, reaching 76.5% of total
credits. However, this condition need to be closely watched
at the foreign and foreign joint venture bank groups
because the share of foreign currency credits was larger
than the share of rupiah credits, as reflected by the
following Chart.
120
Rupiah Foreign Exchange
100

trillion, which included credits purchased from IBRA 80

amounting to Rp 12.8 trillion. 60

40
Table 3.4
Loan Restructuring 20

Share to Industry % NPL 0

Bank to Total Loan State-owned Private Regional Joint Venture Foreign
Total NPL Restructuring Bank Bank Development Bank Bank Bank

A 9,355.3 1,579.8 17.9% 16.9% Chart 3.15

B 21,697.1 2,340.1 27.9% 10.8%
Foreign Loan by Group - June 2004 (%)
C 912.5 266.0 7.6% 29.2%
D 146.0 36.7 2.6% 25.1%
E 63.2 43.6 0.9% 69.0%
F 153.0 - 1.1% 0.0% Banks have been asked to map their debtors that
G 10.1 8.9 0.2% 88.1%
H 806.5 36.0 8.0% 4.5% have obtained foreign currency credits but had local
I 1,534.0 547.9 12.7% 35.7%
marketing targets. In addition, although foreign and
J 866.5 225.7 17.4% 26.0%
K 773.8 492.2 3.4% 63.6% foreign joint venture banks were not classified into large
L 3,455.9 1,318.7 6.3% 38.2%
M 18.1 - 0.1% 0.0% bank category, these banks were still reminded to monitor
N 239.2 89.1 2.1% 37.2%
O - - 0.0% 0.0% developments of their debtors that have obtained foreign
Total 40,031.2 6,984.7 11.7% 17.4%
currency credits.
Share to Industry : 8.1%

3.2.4 Foreign Currency Credits 4. LIQUIDITY RISK

There has been no potential risks arising from foreign
currency credits, considering the share and growth of this
type of credits were relatively small. Development of this
type of credits at foreign and foreign joint venture bank
groups needs close attention, considering that this type
of credits dominated their portfolios.
Weakening of the rupiah against the US dollar that
has occurred in the last few months has not raised potential
risk to banks, which would originate from foreign currency
The banking industry was in overliquid condition and
therefore faced relatively low liquidity risk and tended to
be stable during the first semester of 2004. This condition
was evident by relatively high ratios of liquid assets to short-
term liabilities and to total assets as well as relatively low
bank funds channelled in the form of credits. National
banking industry still had excess liquidity in large amount,
which in general was placed in SBIs and interbank
placements.

29
 Chapter 3 Indonesia’s Banking Industry

With relatively stable liquidity condition, the closure interbank placements. Although this overliquid condition
of two banks at beginning of April 2004 did not put tended to support bank liquidity resilience, a close watch
pressures on bank liquidity. Likewise with Bank Indonesia»s needs to be placed over its impact on bank profit
plan to raise the rupiah MRR effective July 2004. It is sustainability, considering the existence of a trend of
estimated to not disturb banking liquidity, considering that declining interest rates.
the additional need for reserve requirement can be supplied Table 3. 5
Bank Funding & Placement Structure
by SBIs/FASBIs and recap bonds. Rp. Trillion
Dec Jan Feb Mar Apr May Jun
Several matters that potentially can put pressures on 2003 2004

banking liquidity and need to always be anticipated by FUNDING

Third Party Fund 888.6 888.6 877.1 875.1 872.9 895.1 912.8
banks are : Borrowed Fund 7.5 7.5 9.7 9.1 8.6 10.3 9.8
Interbank Borrowings 68.6 65.1 65.3 68.0 66.1 69.2 65.6
(i) Third-party funds was still dominated short-term (less Securities 10.8 10.8 11.4 11.5 11.7 12.3 12.7
PLACEMENT
than 3 months) deposits. During the first semester
Credit 477.2 475.0 477.3 485.9 496.1 513.4 528.7
of 2004, the average ratio of short-term deposits to Equity Investment 5.9 6.0 6.0 6.1 6.8 6.90 7.1
SBI 101.4 130.4 136.8 133.2 120.3 106.7 110.6
total third-party funds reached around 93%. Securities and other investment 68.7 67.2 71.3 71.6 71.8 70.5 77.1
Intarbank Lending 112.2 103.2 102.8 100.2 91.8 108.7 100.2
(ii) Although deposits owned by corporations and loan/TPF (%) 53.7 53.6 54.4 55.5 58.8 57.4 57.9
Loan/Source of Funds (%) 48.9 49.0 49.5 50.4 51.7 52.0 52.8
institutions only reached around 14% of total
deposits, funds withdrawals by these depositors at Meanwhile, ratios of bank liquid assets4 to short-
relatively the same time are estimated to have the term liabilities and to total assets were yet adequate,
potential to influence the liquidity condition of large although in the middle of the semester for a while the
banks. ratios experienced quite large drop due to lower SBIs.
(iii) The plan to phase-out the coverage of the blanket However, the amount of SBIs rose again at the end of
guarantee is estimated to have the potential to lower the semester. SBIs together with FASBIs were used by
public confidence in the banking sector as indicated several large banks to fulfill the new MRR in July 2004.
by results of the confidence towards the banking With the occurrence of this conversion, fulfilment of the
3
sector index survey . new MRR is predicted to not put pressure on bank
liquidity.
4.1 Structure of Bank Funding and Placement
Bank overliquid condition was reflected by yet Percent
30
relatively low amount of funds, which came from third-
25
party funds mobilized by the banking industry, channeled
20
in the form of credits. During semester one of 2004, on
15
average, the comparison of bank credits against third-
10
party funds reached around 55% with a rising trend each Liquid Asset/Short-term Liabilities
5
month relative to the condition at end of 2003. Most of Liquid Asset/Total Asset
0
that excess liquidity was placed by banks in SBIs and Dec Jan Feb Mar Apr May Jun
2003 2004

Chart 3.16
3
Results of the 2003 confidence towards the banking sector index survey. Results of the Liquidity Ratio
same survey for 2004 are still in process.

30
 Chapter 3 Indonesia’s Banking Industry

Although there has been a rise in the MRR, banks

% to Deposits
12
yet had excess liquidity that could be placed again, State-owned enterprise (1) Private insurance company (2)
10
particularly in SBIs/FASBIs, as well as in other forms of short- Pension Fund (3)
8
term placements. This is in consideration that the amount
6
of excess liquidity that could be absorbed (locked-up) was
4
relatively small based on a simulation of Rp18.4 trillion5 .
2
With such condition, imposition of the new MRR will not
0
May Jun Jul Aug Sep Oct
have influence on the banking system liquidity, unless BI 2003

implements extremely tight monetary policy (tight-biased

Chart 3.17
policy). This condition is predicted to not influence banks» Deposits Ownership

capability to channel credits (recovery of bank

intermediation), as reflected by the credit rise that occurred Table 3. 6
Development of Deposits and Net Asset Value (NAV)
during semester one. Rp. Trillion
Development of third-party funds, particularly Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04

deposits, during semester one of 2004 was relatively in NAV 69.5 72.2 76.1 72.9 83.9 86.2 86.77
Deposits 888.6 886.5 877.1 875.1 872.9 895.1 912.8
line with the trend of development of deposit interest rates. - Current Account 219.1 216.1 223.9 226.1 216.9 235.6 243.9
Bank third-party funds trended to rise with a growth of - Saving Account 240.7 243.9 244.0 247.3 251.5 254.8 260.8
- Time Deposits 428.8 426.4 409.2 401.7 404.5 404.7 408.0
2.7% (December 2003 to June 2004), although it dropped Core Deposits* 622.0 620.5 614.0 612.6 611.0 626.0 639.0

Sources : BI and Capital Market Supervisory Body

for a while during the first quarter of 2004. The largest * Core Deposits : assumption 70% of Deposits

rise occured in current accounts, particularly those owned

by state-owned companies and private corporations, Mutual funds NAV growth that was relatively large
followed by saving accounts while deposits trended to during December 2003 √ June 2004 (24.8%) reflected a
decline. The relatively low deposit interest rates during condition where mutual funds as an investment alternative
this period have caused the public to choose more tended to get more public interest. The availability of more
attractive instruments, among others mutual funds and varied investment alternatives would enable investors to
capital market instruments. This was reflected by the rising undertake more optimal diversifications in order to
trend of net asset value (NAV) of mutual funds during the minimize risks. On the other hand, mutual funds growth
first semester of 2004. Meanwhile, current accounts and would prompt banks to increase competitiveness through
savings accounts yet had stable growths, considering they product development, innovation, and service.
were mostly used for transactional needs (transactional Meanwhile, with the assumption that core deposits
motives). reached 70% of total third-party funds, its ratio to total
This rise in third-party funds, particularly in May 2004, Table 3.7 Deposits and Core Deposit Ratios
is estimated to be the impact of the policy on realignment
Des-03 Jan-04 Feb-04 Mar-04 Apr-04 Mei-04 Jun-04
of guarantee interest rates.
- Demand to Total Deposits 24.7% 24.4% 25.5% 24.7% 24.7% 24.7% 24.7%
- Saving to Total Deposits 27.1% 27.5% 27.8% 28.3% 28.8% 28.5% 28.6%
- Time Deposits to
4
Liquid assets comprise cash, current accounts at BI, and SBIs.
5
Total Deposits 48.3% 48.1% 46.7% 45.9% 46.3% 45.2% 44.7%
Results of a simulation undertaken by the Directorate for Economic and Monetary Policy
Researches Core Deposit to Total Assets 52.0% 53.6% 53.3% 53.3% 53.4% 53.1% 53.9%

31
 Chapter 3 Indonesia’s Banking Industry

assets during semester one of 2004 on average reached dominated as 5 largest net lenders in these markets. The
53.4% and tended to be stable. overall interbank money market positions of each bank
group in semester I/2004 are presented in the following
4.2 Interbank Money Market Transactions table.
During semester one of 2004, the largest players in Table 3.8
the interbank money market were dominated by large Interbank Money Market
Interbank Money Market Peer Group
banks (state banks and national private banks) as well as
Interbank MM Rp On shore interbank USD Off shore interbank USD
(IDR) (Million) MM (Forex Currency) (Thousand) MM (Forex Currency) (Thousand)
foreign banks.
State-owned Banks 38,920,300 Private National Banks 3,369,237 Foreign Banks 43,444,335
In the rupiah interbank money market, the foreign Private National Banks 4,495,430 Regional Govt» Banks 19,400 State-owned Banks 27,267,8477
Regional Govt» Banks 4,482,000 State-owned Banks (1,621,383) Private National Banks 17,228,268
and foreign joint venture bank groups always became net
Foreign Banks (39,016,250) Joint Venture Banks (1,308,204) Joint Venture Banks 3,725,615
borrowers, where several foreign banks even dominated Joint Venture Banks (7,847,600) Foreign Banks (985,650)

as 5 largest net borrowers. Meanwhile, the state bank

group and Regional Government Banks (BPD) group took
the role of net lenders with net transaction volumes that
tended to rise at end semester, where several state banks
dominated as 5 largest net lenders. In the case of national
private bank group, from beginning to mid semester it
came as net lender while at end semester it»s role switched
to a net borrower with a relatively small change.
In domestic foreign currency interbank money
market, most bank groups played as net borrowers,
dominated by the foreign and state bank groups.
Meanwhile, in the case of the foreign joint venture bank
group, at the beginning of the semester it played as a net
Borrowing interest rates during semester I/2004
relatively did not experience significant fluctuations, where
borrowing interest rates in the foreign currency interbank
money market even stayed relatively the same during the
first 6 months of 2004. Borrowing interest rates in the
rupiah interbank money market in total, as well as in the
morning and afternoon interbank money markets tended
to decline. Meanwhile, interest rates of the overseas
foreign currency interbank money markets relatively
fluctuated each month.
Percent
8

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

6
a net borrower with transaction volumes that continously
rose until end semester. Meanwhile, the group that played 4

continous net lender role was the national private bank

2
group, particularly the large banks that dominated as 5
largest lenders. 0
April May June
2004
In overseas foreign currency interbank money Interbank IDR Interbank IDR (am) Interbank IDR (pm)
Interbank Foreign Exchange Currency (on shore) Interbank Foreign Exchange Currency (off shore)

markets, all bank groups played as net lenders with Chart 3.18
relatively similar transaction volume fluctuations, namely Interbank Offering Rates QII-2004

it tended to rise in March, declined in April, and then rose Several banks that obtained funds from borrowings
again at end semester. The group with relatively large in the interbank money markets with interest rates that
transaction volume rise compared to other bank groups exceeded those of the industry are presented in the
was the foreign bank group. These foreign banks following table. In relation to the closure of 2 banks at

32
 Chapter 3 Indonesia’s Banking Industry

beginning April 2004, the structure of the interbank money precautionary motive of bank customers. Domination of
markets relatively did not experience any changes. Several short-term funds in the national banking funding structure
banks that tended to be net borrowers were suspected to reflected yet low public confidence in the national banking
experience structural liquidity problems. industry.
Imbalance funding structure can bring the following
Table 3.9
Interbank Rates implications to the national banking industry :
Interbank Rates Q II-2004 (i) The financial system will be susceptible to systemic
IDR FX Currency on Shore FX Currency off Shore
liquidity problems, where problems occurring in a
Number Number Number
Rate Rate Rate
of Banks of Banks of Banks bank that has a systemic influence would arouse
Industry Average 6% - 1% - 2% - contagion effect and as a result severe liquidity crisis
Banks offering more than 7% 3 Joint Bank 2% 1 B.`non-SIBs 3% 2 Foreign Bank
industry average 1 Foreign Bank 4% 1 Joint Bank 1 Joint Bank could quickly occur;
17 B. non-SIBs 4% 1 Foreign Bank
(ii) Due to public dependence on the government
8% 4 B. non-SIBs 1 Joint Bank
9% 1 B. non-SIBs 6% 1 Joint Bank guarantee program (blanket guarantee), funds
migration to other banks or to overseas banks could
4.3 Third-Party Funds Diversification occur should the program be discontinued.
Despite relatively high liquidity, bank third-party Immediate follow-up actions need to be taken in
funds structure was yet not adequate, considering most anticipation of these potential problems, which cover
were short-term funds. The share of short-term funds (1 among others the enforcement of the Financial Sector
√ 3 months), particularly deposits, on average was around Safety Net Law.
85% of total deposits each month. If the components of On the other hand, the banking industry»s
savings and current accounts were included, the share concentration on large deposits (> Rp100 million) was also
exceeded that percentage (monthly average at 93.3% relatively high. Bank total large deposits at end semester
of total third-party funds), causing the banking sector one of 2004 (June) reached Rp329.6 trillion, or around
yet to be susceptible to rising liquidity risk. In this situation, 80.8% of total deposits with number of accounts totalling
liquidity risk exposure could rise should bank customers 23.7% of bank total number of deposit accounts. This
do not roll-over their deposits after falling due or should amount dropped from that at end 2003 (December) of
they even convert to other investment instruments. The Rp335.8 trillion (78.3% of total deposits). Likewise,
large share of short-term deposits also reflected yet high dependency of 15 large banks on large deposits was also
Table 3. 10 relatively high, on aggregate reaching 76.6% in June 2004.
Deposits Permaturity Bucket
Factors that have influenced high concentration on
Deposits Permaturity Bucket (Rp Trillion)
large deposits in 15 large banks were:
Dec-03 Jan-04 Feb-04 Mar-04 Apr-04 May-04 Jun-04

1-3 month 359.7 358.1 345.3 341.4 347.3 351.8 356.7 (i) Customer profile that relatively concentrated on
3-6 month 25.9 25.3 25.1 24.9 23.8 21.8 21.8
customers that were corporations, state-own
6-12 month 32.45 33.6 31.0 29.6 28.8 26.7 22.2
> 12 month 10.7 9.3 7.7 5.6 4.6 4.3 7.1 companies, foundations, pension funds, and
Ratio to Total Deposits (Percent)
1-3 month 83.9 84.0 84.4 85.0 85.9 86.9 87.4 insurance companies, which owned large deposits.
3-6 month 6.0 5.9 6.1 6.2 5.9 5.4 5.4
6-12 month 7.6 7.9 7.6 7.4 7.1 6.6 5.4 (ii) Widespread networks of bank branch offices.
> 12 month 2.5 2.2 1.9 1.4 1.1 1.1 1.8
(iii) Deposit minimum values imposed by large banks.

33
 Chapter 3 Indonesia’s Banking Industry

(iv) Interest rates and services that were relatively better swap transactions, buys and borrowings in the interbank
compared to banks of medium and small scales. money markets. The next payment obligations will fall
Anticipative actions need to be taken to tackle this due at end 2004.
condition, particularly in relation to the phasing out plan Table 3.11
of the government guarantee program and Exchange Offer
Exchange Offer Repayment Plan
implementation of a new guarantee scheme that plans (in Million USD)
Projection 2004 Projection 2005
for a maximum of Rp100 million per customer per bank.
NO PEER June December June
With the imposition of the new guarantee program, there GROUP Pokok Bunga Bunga Pokok Bunga

is a possibility that large depositors would break their funds. 1. Freezed/Bank

under liquidation 153.35 4.9 1.97 97.08 1.97
And as such, there is a potential of fund migrations from 2. Taken-over Bank 67.92 1.38 0.08 4 0.08

one bank to other banks or fund migrations outside the 3. State-owned Bank 623.94 19.6 7.7 378.92 7.7
4. Others 46.99 1.24 0.34 16.95 0.34
banking sector.
Total 892.2 27.12 10.09 496.95 10.09

Percent 5. MARKET RISK

120
During the first semester of 2004, Indonesia»s bank
100 N
E M
H
D
G
I L
O
Industry market risk was relatively low however at a rising trend in
80
J
A B

F
K 15 Large Banks semester two 2004 in line with potential rise of global
60 C

C
40 F
A
B J
K 15 Large Banks
20
D L
I
E
G H
0
> 100 Million < 100 Million
Chart 3.19
Composition of Deposits among Large Banks
Meanwhile, from ownership type, the shares of third-
party funds owned by state-owned companies, insurance
companies and pension funds trended downward during
semester one 2004, particularly those of state-owned
companies and pension funds. Most (>50%) funds owned
by state-owned companies and pension funds were placed
at 15 large banks. Deposit ownership of these three
depositors reached 14.4% of bank total deposits while
their ownership at 15 large banks reached 15.8% (June
2004 position).
As regards bank exchange offer obligations that
would fall due in 2004, banks have made pay-offs up to
end May or beginning June 2004, among others through
interest rates. This relatively low market risk was prompted
by stable macroeconomic condition, reducing rupiah
Industry
M N
O exchange rate volatility, stable domestic interest rates, as
well as low net foreign currency position. Results of the
stress test6 showed that bank capital stayed stable at above
8% against exchange rate depreciation and interest rate
change. On regulatory side, implementation of the new
requirement for net foreign currency position is considered
as being able to increase banks» capability to manage
exchange rate risk.
Along the same line, implementation of the new
capital requirement in order to accommodate market risk
will not have a negative impact on bank capital. Despite
all these, there are several factors that could influence the
rise of market risk exposure, which are among others
pressures on the payment account due to world oil price
hikes and global interest rate increases, which are spurred
by US interest rate rise. In addition, bank maturity profile
6
At moderate scenario of rupiah depreciation against the US dollar by 2,500 points (for
example USD/IDR = Rp9,000 to Rp11,500).

34
 Chapter 3 Indonesia’s Banking Industry

is in general short for the short-term. This position is very
sensitive to interest rate rise.
5.1 Exposures
Indonesia»s banks, particularly those having the form
of local legal entities (locally incorporated), in general do
not have relatively high market risk exposures, considering
that the their portfolios and transactions that are exposed
to market risk are limited. Banks in Indonesia in general
only have interest rate risk and foreign exchange risk.
Considering the regulatory factor and the relatively
less complex bank transactions compared to other banks
applied on a sample of 13 large banks, bank CARs remain
stable towards rupiah exchange rate depreciation against
USD. After rupiah depreciation, CAR drops by insignifican
percentage, 3 bps, or average CAR drops from 20.37% to
20.34%. Results of the stress test show that these banks»
CARs remain stable at above 10%. The main factor that
supports stability of bank capital is bank relatively low net
foreign exchage position, which raises bank capability to
accommodate unexpected losses attributable to rupiah
exchange rate depreciation.
35

30
abroad, other market risk components have not covered
25
equity position risk, commodity risk, and risk from option
20
price changes (option risk). The trading book position in 15

bank portfolio is in general still relatively small. Trading 10

5
book means all bank-owned trading positions (proprietary
0
positions) on financial instruments at on and off-balance A B C D E F G H I J K L M Ave-
rage
CAR Current (%) 18.61 17.69 25.29 14.98 30.62 29.94 10.74 11.65 18.18 21.74 16.24 21.62 27.47 20.3669
sheet positions, which are meant for resale in the short- CAR after Stress Test (%) 18.56 17.64 25.23 14.83 30.61 29.93 10.74 11.64 18.17 21.85 16.23 21.61 27.43 20.3438

term and owned for the purpose of obtaining short-term Chart 3.20
Stress Testing of Exchange Rate
profits.

5.2 Stress Testing 5.2.2 Interest Rate Stress Test

Stress test is a tool used to measure bank capital During semester I/2004, bank capital in general was

sensitivity to changes in exchange rates and interest rates. adequate for covering increases as well as decreases of

In this relation, stress test is always conducted regularly interest rates. With an assumption of 1% drop in 1-month

each month with a sample of large banks that have SBI interest rate, results of stress test applied on a sample

relatively larger market risk exposure compared to bank of 13 large banks show that these banks» CARs drop on

groups that are considered to be medium and small. average 68 bps (from 20.37% to 19.69%). In the case

Results of stress tests undertook during semester I/2004 where 1-month SBI interest rate rises by 1%, these banks»

show that on average bank capital was adequate for CARs rise by 82 bps (from 20.7% to 21.20%). These

tackling changes in exchange rates and interest rates. results show that banks are yet dependent on placements
in SBIs.

5.2.1 Exchange Rate Stress Test In this case, factors that have supported stability of

Under a scenario of rupiah depreciation of Rp2,500 bank capital are as follows :

per USD (from USD1 = Rp9,268 to USD1 = Rp11,7687 ) a. Spread between the interest rates of credits and third-

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

35
 Chapter 3 Indonesia’s Banking Industry

35

30
0.03
25
0.025
20
0.02
15
0.015
10
0.01
5
0.005
0
A B C D E F G H I J K L M Ave-
rage
CAR-Current (%) 18.61 17.69 25.29 14.98 30.62 29.94 10.74 11.65 18.18 21.74 16.24 21.62 27.47 20.367 0
CAR-SBI rate decreases 1% 18.01 17.44 25.05 14.14 29.96 29.29 9.67 11.12 17.53 21.13 15.64 20.88 26.08 19.688 January Quarter-I Quarter-II (current)
CAR-SBI rate increases 1% 19.21 17.94 25.53 15.82 31.28 30.59 11.81 12.18 20.83 22.34 16.84 22.23 28.86 21.189
2004
Note : CAR as of June 30, 2004

Chart 3.21 Chart 3.22

Interest Rate Stress Testing Net Open Position to capital of Large Banks

Up to end semester I/2004, credit interest rate was net foreign currency position above 6% due to an
yet relatively high. The weighted average spread exchange offer obligation that would fall due in June 2004.
between the interest rates of working capital credit Considering that all these banks had long USD positions,
and 1-month term deposit, for example, reached a depreciating trend of rupiah against USD would not have
8
7.67% . As such, there was yet room for banks to much influence on their profitability and capitals.
eliminate negative impacts attributable to rising cost However, Bank Indonesia realizes that low net foreign
of funds. currency positions would give sufficiently large room to
b. High fund placements in SBIs and SUNs. these banks to undertake speculations, should monitoring
Bank earning asset structure at this time influenced and regulating be inadequate. In this respect, effective 1
results of the stress test, where the share of fund July 2004, a new regulation on net foreign currency
placements in SBIs and SUNs was quite large, 22.79% position is enforced whereby net foreign currency position
of total earning assets9 . Considering banks» high that should be maintained by a bank should be at
dependence on marketable securities that had low maximum 20% of its capital for balance sheet position,
risk and sovereign, declines in interest rates would admistrative accounts, and overall. This new regulation
lower CAR and vice versa. would increase a bank»s capability to eliminate negative
impacts of exchange rate volatility so as not to disrupt it»s
5.3 Net Foreign Currency Position capital. The new regulation has a very positive impact on
Banks» net foreign currency positions were in general financial system stability.
relatively low, which reflected banks» prudent approach in
taking open positions in foreign currency. The average 5.4 Impact of Requirement on Market Risk
net foreign currency positions of 13 large banks, for Adjusted Capital Adequacy On Bank Capital
example, showed a downward trend since January 2004. Bank Indonesia has imposed an obligation on banks
Those banks»s net foreign currency positions were in the to provide adequate capital for accommodating market
range of 1%-8%, except one state bank with an average risk, effective January 2005. Implementation of this new
requirement would not have negative impacts on financial
8
As of 30 June 2004
9
As of 30 June 2004 system stability, considering that banks» CARs would yet

36

remain above 8%. Based on a simulation on June 2004
positions of 39 banks that would have to meet this market
risk requirement, there was a drop in CARs in the range of
10 √ 212 bps, except CAR of one foreign bank that
dropped by 812 bps (outlier) due to the large amount of
marketable securities in its trading book portfolio.
However, overall, these banks would yet have CARs at
above 8.0%.
5.5 Market Risk Outlook
Despite that fact that banks» capital would yet be
stable, market risk is estimated to have a slight rising trend
in semester II/2004, taking into consideration the following
factors :
- Indonesia»s balance of payment is predicted yet to
experience relatively heavy pressures due to oil price
hikes and overseas debt payments in semsester two
of 2004
2004. Continous oil price rise could put pressures
on rupiah exchange rate against USD, considering
that Indonesia»s position can be classified as net
importer. World oil price hikes would raise demand
for USD, which would not be met by equal supply.
- Gradual rise of US interest rate. Increases of Fed Funds
Rate (FFR) could be followed by increases of domestic
and international interest rates. Empirically,
Indonesia»s interest rate level has always been
influenced by US interest rate. As such, increases of
FFR could have impacts on banks» capability to
manage market risk exposures, considering the
following :
a. Overshooting of rupiah exchange rate would
continue in the short-term. With the increases
of FFR, investors would assess that investments
in Indonesia»s money and capital markets
become less attractive because its country risk is
yet high while its credit rating is not yet
∆investment grade∆;
Chapter 3 Indonesia’s Banking Industry
b. Increasing volatility of the rupiah due to capital
outflows undertaken by foreign investors, who
enters and exits Indonesia»s money market within
a short time. Indonesia»s characteristic is quite
unique whereby hedge funds and foreign
investors dominate domestic capital market.
During semester I/2004, large banks» maturity profiles
in general showed short position for the short-term (less
than 3 months). This position is relatively sensitive to
interest rate changes, especially if Bank Indonesia
accommodates increases in US interest rates by raising SBI
interest rates, which influence domestic interest rate rise.
Although banks» capitals would be relatively stable at above
8% as shown by stress test results, interest rate increases
could lower performance of banks with maturity profile
at short position and as such these banks are predicted to
raise interest rates in order to maintain their profitability.
6. OPERATIONAL RISK
Indonesia»s bank operational risk was quite high. This
was particularly evidenced by the occurrence of a few cases
of fraud at several banks. This quite high risk was due to
weak internal cotrol and weak implementation of good
corporate governance. Bank Indonesia has taken follow-
up actions on cases of violations in the banking sector
through cooperations with related authorities as well as
issuance of regulations on risk management, which also
cover principles of operational risk management.
Operational risk arises from human errors, defaults
in systems and procedures, as well as fraud. Amongst
cases that have created operational risks at Indonesia»s
banks, fraud remained to be the largest source of risk. In
2003, there were two banks that have experienced fraud
and consequently suffered losses amounting to Rp1.70
trillion (18.45% of capital) and Rp294 billion (4.25% of
capital). During semester I/2004, one case of fraud
occurred in one bank with a nominal value of Rp35 billion.
37
 Chapter 3 Indonesia’s Banking Industry

Operational risks stemming from defaults in systems and
procedures as well as unintentional mistakes made by bank
staffs (human errors) were in general relatively small yet
and banks have handled these cases well.
The impact of operational risks on banks» capital in
Indonesia cannot yet be quantified. This is due to the fact
that data recorded by banks in Indonesia on losses resulting
from fraud, human errors, or weak systems is not yet
available. However, based on a simulation of 25 banks in
2003, operational risks faced by banks in Indonesia are
yet relatively high. Calculations based on the basic indicator
method and extreme scenario with __(beta) 18%, the
capital charge for opeational risks that these banks would
have to provide is extremely high. The impact would
drastically lower these banks» CARs to a range of 1.14%
to 14.26%.
In terms of number of banks, in 1999 61 banks have
been lodged. This number was getting smaller until it
became 22 banks in 2003. The quite high number of
banks lodged in 1999 stemmed from the fact that most
banks, which were liquidated and had their businesses
freezed, had undertaken violations with fraudulent motive.
Factors that have led to incidents of fraud at banks
in Indonesia are among others :
- Weakness in bank internal control
Although in general banks already have good internal
control systems, there are yet weaknesses in the
systems that makes their implementation weak.
Investigations of several cases of fraud , whether by
BI or bank internal audit work unit, revealed that the
main reasons that have led to the occurrence of fraud
were yet weak implementation of internal control,

Table 3.12
lack of competency and independence in bank
Fraud Cases in Banks internal audit work unit, as well as weak monitoring
Total Write off
Value Fraud Value of corrective actions undertaken.
Year Loss Provision %
(Rp Billion) (Rp Billion) to Capital (Rp Billion) - Collusion and yet low bank staffs» integrity

Bank 1 2003 1700 1200 18.45% 941 78.42 Based on investigation results, in general, various
Bank 2 2003 294 294 4.25% 294 100.00
cases of bank fraud involved insiders, who undertook
Bank 3 2004 35 35 1.06% n.a. n.a.
the fraudulent acts alone or under collusions with
external parties. Involvement of bank staffs showed
Cases of violations in the banking sector in Indonesia
that at several banks there were yet staffs with low
were yet many, however the occurrence was declining.
integrity. Involvement of bank staffs confirmed the
Cummulatively, violations in the banking sector that have
statement that no matter how strong the internal
been reported to Bank Indonesia from 1999 up to 2003
control system is, it will not be useful when people
comprise 376 cases10 . However, not all cases have criminal
that execute bank operations undertake a collusion.
elements (fraud). In addition to fraud, these cases
- Weak law enforcement
concerned abuse of authority, fictitious reporting, and
Although Bank Indonesia has found and taken follow-
violations of banking regulations. Cases with element of
up actions on cases of fraud, law enforcement on
fraud were only 40% where all of these have been handed
banking criminals in Indonesia is yet weak. Imposition
over by UKIP (Special Unit for Bank Investigations) to the
of penalties and sanctions on doers of fraud is felt to
law enforcement authority.
be inadequate.
High operational risk could impact financial system
10
Data source : UKIP 2003. Banks» data comprises those of commercial banks and bank
perkreditan rakyat stability. If the situation is not well anticipated, it might

38
 Chapter 3 Indonesia’s Banking Industry

impact on lower banks» reputation, which in the end might Percent Percent
55 18
create distrust towards the banking sector. Taking this into
16

consideration, Bank Indonesia has taken follow-up actions, 50 14

12
both from the supervision side as well as regulatory side. 45
10

From the supervision side, Bank Indonesia has implemented 40

8

6
a risk-based approach to bank supervision. From the 4
35
regulatory side, Bank Indonesia has imposed the obligation 2

30 0
to implement risk management as incorporated in Bank May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun

Securities Loan Placement at BI Others

Indonesia regulation number 5/8/PBI/2003 dated 19 May
2003. In addition, banks are also put under the obligation
to implement effective bank internal control function.
7. PROFITABILITY
The banking industry»s profitability has shown
improvement in line with rising credits, which has started
since beginning 2004. ROA rose from 2.5% to 2.7% while
NII rose from Rp3.2 trillion to Rp5.4 trillion. However, there
were yet many national banks with ROA far below 1.2%
(28 banks). One of the reasons for this condition was yet
relatively low efficiency level, particularly at state banks.
During the next short-term, it is estimated that bank
profitability will be under pressure, mainly due to rising
trend of domestic and international interest rates. If this
risk is not well anticipated, it could have a negative impact
on profitability stemming from banks» maturity gap, which
tend to have more obligations that are sensitive to changes
in interest rates.
Chart 3.23
Composition of Interest Income of Large Banks
placements and marketable securities dropped from
15.3% and 30.8% to 9.5% and 26.3%, respectively.
The rise in the share of credit interest income has
prompted the rise of net interest income (NII) from Rp3.2
trillion in December 2003 to Rp5.4 trillion in June 2004.
As such, cummulatively bank interest income has risen from
Rp41.5 trillion (from July 2003 up to December 2003) to
Rp75.8 trillion (up to June 2004).
However, if interest income from marketable
securities are excluded from calculation of NII, up to
December 2003, the 15 large bank group, which mostly
comprise of recap banks, still experienced negative spread.
One of the largest state banks even only reached positive
spread at end of June 2004. This shows that although
credit exposure during 2004 has been quite large,
Percent Percent
60 17

7.1 General Condition 55

15
50
The banking industry»s profitability has started to 13
45
improve, particularly prompted by the rise in credits. 11
40
In line with rising bank credits since beginning 2004, 9
35

the share of interest income from credits has slowly exceed 30 7

those from interbank placements and marketable 25 5

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

securities. The share of interest income from credits has Securities Loan Placement at BI Others

increased from 46.6% in December 2003 to 56.4% in Chart 3.24 Composition of Interest Income
of All Banks (2003-2004)
June 2004, while interest income from interbank

39
 Chapter 3 Indonesia’s Banking Industry

8.0 15.0
6.0
7.0 10.0 Industry State-owned Bank Private bank
15 Large Banks (right axis) Joint Bank Foreign Bank
6.0 5.0 5.0
5.0 0.0

4.0 -5.0 4.0

3.0 -10.0
3.0
2.0 -15.0

1.0 -20.0 2.0

0.0 -25.0
Dec Dec Dec Mar Jun
1.0
2001 2002 2003 2004 Dec Apr Jun Aug Oct Dec Feb Apr Jun
Foreign Banks Joint Venture Banks
2002 2003 2004
Medium Banks Small Banks 15 Large Banks

Chart 3.25 Net Interest Income Trends Chart 3.26

(Excl. Interest Income from Securities) Trend of ROA (Peer Group Comparison) - June 2004

Indonesia»s banking industry has yet been very much 45

dependent on interest income from government bonds. 36

22
7.2 Return on Asset and Efficiency Level
16
12
National banks» profitability was far below that of
foreign bank group, stemming particularly from state
banks» being less efficient. <0 0.01 - 1.19 1.2 - 1.99 2.01 - 3.99 >4
Percent
The banking industry»s Return on Asset (ROA) also
Chart 3.27
rose from 2.5% (December 2003) to 2.7% (June 2004). Distribution of ROA - June 2004
This rise in ROA showed that the rise in banks» total assets
during semester I/2004 was particularly prompted by the inefficiency as evidenced by its high ratio of operational
rise in earning assets and as such could raise profitability. expense to operational income (OEOI).
However, although in aggregate banks» ROA was Low level of efficiency seems to be a basic problem
quite good, there were yet many banks with ROA at below at national banks, particularly state banks. For industry
1.2%11 . The highest ROA belonged in the foreign bank average, yet adequate efficiency ratio (OEOI) would be
group, namely 4.25%, while the smallest ROA belonged
Percent Percent
in the state bank group, namely 2.38%. 120 35

In addition to having stemmed from stable profit 100 30

25
growth and good efficiency level, this high ROA of the 6,0
20
foreign bank group stemmed from relatively small growth 60
15
of its assets. The low ROA of the state bank group 40
10

stemmped from among others : (i) yet relatively high 20 5

number of SBIs and government bonds (portfolios that 10 0

15 Large Banks

Industry
Foreign

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

Bank

are sensitive fo interest rate declines) owned by those

Bank

Efficiency Ratio (left axis) OHC (right axis)

banks; as well as (ii) this bank group»s operational Chart 3.28

Efficiency and Overhead Cost Ratios - June 2004
11
Limit of sound ROA from level of sound

40

90.24% or classified as Sound. Meanwhile, the state bank
group and the 15 large banks group each had OEOI ratio
of 102.86 and 97.11% (Both groups are classified as
Unsound). The best efficiency levels were achieved by the
foreign and foreign joint venture bank groups with ratios
of 79.8% (Sound) and 84.5% (Sound), respectively.
7.3 Fee-Based Income12
The foreign bank group was extremely dependent
on fee-based income.
The foreign bank group earned the highest fee-based
income compared to other bank groups. Relatively better
quality human resources and relatively better support of
experience, network, and information system technology
have prompted the share of fee-based income of the
foreign bank group reached 75% of its total operational
income. The next bank group that had high share of fee-
based income, namely 345, was the foreign joint venture
bank group. Meanwhile, the shares of the state bank
group and foreign currency bank group were only 19%
and 18%, respectively, far below the banking industry»s
average of 27%.
Dec Jun Sep Dec Mar
2001 2003
Industry State-owned Bank Private Bank Joint Bank
Chart 3.29
Fee Based to Total Operating Income Ratios
7.4 Impact of Possible Interest Rate Rise on Bank NII
Indonesia»s bank portfolio maturity pattern in general
has a gap that is called liability sensitive, where sensitive
Chapter 3 Indonesia’s Banking Industry
liabilities owned are larger than sensitive assets owned13 .
This condition will cause the interest expense side of the
banks to experience faster repricing compared to their
interest income side.
7.5 Future Risk and Prospect
In general, several matters that will threathen banks»
profitability are among others : (i) yet low level of efficiency
in national banks, particularly the state bank group and
15 large bank group, (ii) potential rise of interest rate that
in the short-term will influence banks» NII, as well as (iii)
yet relatively high banks» NPL ratio that is even suspected
to worsen, which is estimated to also pressurize banks»
profitability.
However, in the short-term, national banking
profitability is estimated to remain sufficiently stable
supported by yet rising credit channeling. Results of
simulation on the planned new minimum reserve
requirement effective July 2004 also show insignificant
impact in banks» profitability decline.
8. CAPITAL
The banking industry»s capital ratio during 2004 has
been quite adequate, on average above 20%, however
with a downward trend attributable to rapid credit growth.
However, up to end semester I/2004, there were two banks
with CARs below 8% and 7 banks with CARs between
8% - 10%.
In addition, several risk factors that have the potential
Jun to put the banking industry»s capital under pressure are
2004
Foreign Bank among others : (i) Banks» tendency to undertake less tight
assessment of NPLs and as such banks» credit quality might
be worse than reported, (ii) There have been several cases
of violation of maximum limit for credit extensions, (iii) yet
12
Dividends, commissions on credit extensions and derivative transactions, fees on man-
aged credits, and others
13
Sensitivity to interest rates is evidenced by the larger amount of short-term liabilities
owned by a bank over the amount of its short-term assets
41
 Chapter 3 Indonesia’s Banking Industry

relatively low national banks» recapitalization capability, Number of Banks

90 30
and (iv) RWA rise due to credit rise. > 20% 8 – 20% < 8%
25
80
However, this decline in capital ratio is estimated to
20
not have serious impact yet on financial system stability 70
15
and the banking industry in particular because the banking 60
10
industry»s capital is yet quite adequate.
50
5
< 8% (right axis)
Rapid growth of credits during 2004 was still ably
40 0
Sep Feb Jul Dec May Oct Mar Aug Jan Jun
covered by adequate capital. The banking industry»s CAR 2000 2001 2002 2003 2004

during 2004 averaged above 20% although with a Chart 3.31

Distribution of CAR
downward trend due to RWA growth resulting from rising
credits. As such, at June 2004 position the banking
industry»s CAR slipped a bit to 20.9%, its lowest in 2004. up to the end of the report period. Meanwhile, there
were 17 banks with CARs above 50%, which in general

55
Percent were the foreign joint venture banks. This condition
Industry
50
State-owned Bank
reflected the intermediary function that has not yet fully
45
40
Private Bank functioned in the related banks.
Joint Bank
35
Foreign Bank
30
25 8.2 Capital Ratio By Bank Group
20
Using a more conservative approach, the tier 1 to
15

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

DecDec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun
00 01 2002 2003 2004 those for the state bank group and 15 large bank groups
Chart 3.30
were less smaller, namely 7.92% and 8.0%, respectively.
CAR - June 2004
The highest ratio belonged to the foreign bank group at
9.14%.
8.1 Composition of Banks» Capital This condition showed that the foreign bank group»s
Although banks» capital ratio was yet relatively high, equity and capitalization capability were better than other
there were 10 banks with CARs of 8% - 10%, which were
quite susceptible to declines in earning asset quality and 15 40

CAR (right) T1 : TA (left) 35

or rising risks. This condition has relatively not changed 12
30
since December 2003, which reflected these banks» lack
9 25

of capability to undertake improvement. 20

6
15
Meanwhile, there were 2 small banks with CARs of
10
3
<8%. These two banks have actually fulfilled the 5
-
commitment for additional capitals, which have been 0
Industry
Foreign
15 Large Banks

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

Bank

placed in escrow accounts in May 2004. However, these

Bank

fund deposits could not be calculated as capital deposits Chart 3.32

Tier 1 to Total Asset Ratio - June 2004
because they were still undergoing formal legal process

42

bank groups». The banking industry»s CAR is estimated to
be overstated because of banks still applied too loose
assessment on credit collectibility (overstated). This was
an evidence of differences in collectibility assessment
between bank auditors and the banks.
8.3 Future Prospects
Although the banking industry»s capital was relatively
quite adequate, there are several aspects that put pressures
on bank capital, specifically on banks that have CARs
between 8% - 10%, namely : (i) A potential of decline in
earning asset quality and or rise in losses, (ii) a tendency
of banks to apply less tight assessment on NPLs, (iii) the
findings of several cases of violation of maximum limit for
credit extensions, and (iv) yet relatively low national banks
recapitalization capability compared to the foreign bank
group.
However, this decline in capital ratio is estimated to
not yet have serious impact on financial system stability,
nor on the banking industry in particular, due to banks»
capital ratio being yet quite adequate.
9. DIRECTIONS OF BANKING POLICIES
9.1 Indonesian Banking Architecture
Indonesian Banking Architecture (IBA) activity
program implemented from January up to June 2004 went
well. This is evidenced by implementation of several IBA
programs from several pillars, namely :
9.1.1 Program for Strengthening National Banking
Structure (Pillar I)
Strengthening of Bank Capital
As already determined, the structure of the
national banking industry will comprise International-
quality banks (international champions), national banks
(national champions), banks that are focused players,
banks with limited business activities, and Rural Banks
Chapter 3 Indonesia’s Banking Industry
(BPR). Programs concerning the strengthening of bank
capital comprise :
1. Program to increase minimum capital requirement for
commercial banks (including Regional Government
Banks) to Rp100 billion up to 2010; and
2. Program to retain capital requiremet of Rp3 trillion
for newly established banks up to 1 January 2011.
In order to realize these two programs, currently
formulation of scope concepts for each bank category is
undergoing in accordance with the categories determined
in IBA»s visions. More intensive studies and discussions
have been undertaken specifically for banks with limited
business activities category, which is commercial bank
group that will be downgraded to banks with limited
business activities, if their capitals come to below Rp100
billion in 2011.
9.1.2 Program for Enhancing Bank Regulatory
Quality
Expert Panel
Establishment of an expert panel , which is one
of the activities of the initiative for ∆formalization of
the syndication process in formulation of banking
policies∆, is for creating a forum for experts, both from
within the country and abroad, to give strategic inputs
on banking.
9.1.3 Program for Consolidation of Supervisory
Function (Pillar III)
For the five programs under Pillar III, namely program
for enhancement of bank auditor/supervisor competency,
program for development of risk-based supervision system,
program for enhancing coordination between supervisory
institutions, and program for enhancing enforcement
effectiveness, currently compilation of and review over
inputs are undergoing for inprovement of the preliminary
concept that has been developed.
43
 Chapter 3 Indonesia’s Banking Industry
9.1.4 Program for Minimum Standards of Good
Corporate Governance (Pillar IV)
Determination of minimum standards of good corporate
governance
Determination of minimum standards of good
corporate governance is one of the activities of the initiative
for ∆ enhancing bank good corporate governance∆. The
coverage of this activity is quite wide, and therefore its
discussions are undertaken in stages. At this stage,
discussion was focussed on bank directors and board of
commissioners. Internal discussions within BI that have
been conducted several times will be complemented with
discussions with representatives of the banking players.
Discussions with these external parties will be conducted
through a forum that will be established in the near future
through cooperation with the National Committee For
Good Governance Policies.
Requirement on Risk Manager Certification
Requirement on risk manager certification comprises
one of the activities of the initiative for ∆enhancing bank
risk management quality∆ (Pillar IV). Discussions under this
activity that have been undertaken with representatives of
the banks, namely the Indonesian Risk Professional
Association (IRPA), have reached an advance stage. In
cooperation with IRPA, blueprint for the risk management
certification program has been developed and formalized
in a kick-off meeting on 7 July 2004. The official formalization
was made by Bank Indonesia»s Governor and attended by
representatives of the banks and banking associations.
9.1.5 Program for Enhancement of Customer
Protection (Pillar VI)
Of the four programs under enhancement of
customer protection, namely development of mechanism
for customer complaints, establishment of independent
44
mediation institution, product information transparancy,
and customer education, two programs (development of
mechanism for customer complaints and product
information transparancy) have been completed and will
soon be enforced through Bank Indonesia new regulations
on Mechanism for Customer Complaints and Product
Information Transparancy. At the moment, specifically on
product information transparancy, there is a constraint that
is being solved that concerns implementation of standard
clauses in the banking industry.
As regards the two other programs, namely
establishment of independent mediation institution and
customer education, intensive discussions are made with
related parties, including banking law experts, and
recommendations have been put forward to raise the
status of the mediation institution to a banking arbitrage
body. Meanwhile, for the customer education program,
codification of materials and formulation of education
strategy for the short-term and long-term are also in
progress.
9.2 Rural Bank (BPR)
Rural Bank (BPR) have proven that their role is
becoming more important in promoting the growth of
small businesses. Although several BPRs have been closed,
there have been many more BPRs opened in order to
promote development of regional economy. In general,
performance and risk of BPRs have been relatively small
as evidenced by the rise of number of BPRs categorized
as being sound and adequately sound.
In the framework of creating sound BPR industry,
Bank Indonesia continues the implementation of
government guarantee program in order to maintain public
confidence as well as undertakes the policy to restructure
the BPR industry by making efforts in rehabilitation steps
through acquisitions, additions to paid-in capital, mergers

of problem BPRs that can still be salvaged, as well as
encourage the entry of new investors tht have capability
to strengthen BPR capital and management. When a BPR
cannot be salvaged, its business activity is freezed or its
business license revoked.
Enhancement of regulatory and supervisory system
that take into consideration BPR characteristics and
international best practices is implemented through
enhancement of several regulations concerning BPR
institution, utilization of BPR database as a facility for early
detection system, enhancement of law enforcement
effectiveness, selection of BPR new management
candidates through compliance and capability tests, and
enhancement of BPR prudential principles, including the
CAMEL requirement, BPR soundness level that include
CAMEL percentage, ratio of minimum capital, ratio of
earning assets, ratio of provision for earning assets losses,
maximum limit on credit extensions, changes in clasification
of credit collecibility, provision for earning assets losses, as
well as credit restructuring.
In addition, in order to strengthen BPR operations
and support real time supervision, there is a need to
develop adequate information technology in BPR
operations. Constraints faced in efforts to implement
information technology in BPR industry is the fact that
many BPRs still do not have computers (personal
computers), which causes delays in provision of information
on BPR nationally.
Bank Indonesia also promotes linkage program
between commercial banks and BPRs in relation to credit
channeling to small and micro businesses. This linkage
program is a development on the success of the Micro
Credit Project. This strategy is a form of mutual benefit
cooperation between commercial banks and BPRs as well
as with micro finance institutions in order to widen the
scope for channeling micro credits.
Chapter 3 Indonesia’s Banking Industry
9.3 Sharia Banking
The sharia banking indusry was in relatively stable
condition with a potential to rise as evidenced by quite
rapid asset growth, growths of business volume and
soundness level, which are bolstered by widening sharia
banking service provisions through the opening of several
branch offices in several provinces.
In line with Bank Indonesia»s efforts to control excess
liquidity in the banking sector, enhancement of the
minimum reserve requirement (MRR) for commercial banks
is also followed by imposition of MRR on sharia banks.
The new MRR is basically a monetary policy instrument,
which imposition will involve all banking institutions as
institutions that have the capability to transmit every
monetary policy to the economic system. One of the
reasons for the decision to raise MRR is to support rupiah
exchange rate stability through absorption of banking
institutions» excess liquidity while still paying attention to
undergoing economic recovery process.
Sharia banks are banking institutions, where each
of their operational activities is an integral part of the
economic system itself. Therefore, results of
macroeconomic analyses will also include the sharia
banking institutions as agents that also can transmit every
adopted monetary policy. However, sharia banking has a
different operational concept than that of conventional
banking, where every transaction made has to be ensured
to have followed the sharia principles.
It can be understood that the rise in MRR, which
gives an insentive (current account fee) of 5% for every
increase from the previous level of MRR, is one of the efforts
to improve money market structural liquidity condition.
Imposition of MRR with an insentive package on sharia
banks will be made after a review has been conducted on
types of transactions that are acceptable by the sharia
principles.
45
 Chapter 3 Indonesia’s Banking Industry
Box 3.1 Financial Safety Net
Financial system stability is built on five pillars, namely
: (i) stable macroeconomic condition; (ii) sound regulating
and supervision of financial institutions; (iii) sound and
efficient money markets and institutions; (iv) safe and reliable
financial infrastructures; and (v) effective financial safety
net. In general, there are two major instruments that can
be used in relation to financial safety net, namely lender of
last resort (LLR) and deposit insurance.
Financial Safety Net
In the framework of increasing financial system
stability, Ministry of Finance and Bank Indonesia have
developed the frame for Indonesia»s Financial Safety Net/
IFSN. The IFSN frame has been developed together by the
IFSN team comprising officials from Ministry of Finance and
Bank Indonesia.
IFSN is a policy frame that explicitly contains the tasks
and responsiblities of each related institution, namely
Ministry of Finance (MoF), Bank Indonesia (BI), and the
deposit insurance institution (DII), as the players in the
financial safety net. In principle, MoF is responsible for
developing legislations for the financial sector and provide
funds for tackling crises. BI, as the central bank, is
responsible for maintaining monetary stability and banking
industry»s soundness, as well as safety and smoothness of
the payment system. DII is responsible for guaranteeing
bank customers» deposits as well as resolutions of problem
banks. The IFSN frame will be incorporated in the IFSN law,
which is planned to be completed at end 2004. This
upcoming IFSN law will function as a strong foundation for
policies and regulations that will be determined by related
authorities in the framework of maintaining financial system
stability.
Contingency Financing Facility
A good lender of last resort (LLR) policy has proven
to be one of the effective tools in preventing and handling
crises. In this regards, BI has formulated more clearly the
policy on LLR, both for normal and crisis conditions, by
making reference to best practices. In priciple, in a normal
condition, LLR facility is only given to an illiquid but solvent
bank with liquid collateral of high value. Meanwhile, in a
crisis condition, the main considerant is the potential for
46
systemic impact. However, requirements on solvency and
collaterals, with several exceptions, are still applicable.
In handling liquidity problems that have systemic
impact, BI as lender of last resort can give emergency
financing facility (EFF) to commecial banks, where the
government then bears their funding. This is based on
Law 23 of 1999 regarding Bank Indonesia as amended by
Law 3 of 2004, which has been approved by the People»s
Representative on 15 January 2004. On 17 March 2004, a
Minute of Agreement between the Minister of Finance and
BI»s Governor has been signed regarding stipulations and
procedures on decision making in handling bank financial
problems that have systemic impact, awarding of the
emergency financing facility, and financing source from the
state budget. For implementing guidelines, MoF and BI
have completed the development of draft regulation
concerning EFF for commercial banks that will be
incorporated in Minister of Finance Decree and BI
regulation.
Deposit Insurance Institution
Experience shows that deposit insurance institution
(DII) is one of the important elements for maintaining
financial system stability. The government blanket
guarantee program, which came into effect because of the
crisis that started in 1998, has indeed been successful in
recovering public confidence in the banking sector.
However, research shows that the blanket guarantee has
spurred moral hazard that has the potential to create crises
in the long-run.
In this regards, the government and BI have been
successful in developing draft law on DII. This draft law is
currently undergoing discussions with the People»s
Representative together with the government and BI as
source persons. In this draft law, DII will have two main
responsibilities, namely : (i) to guarantee bank customer
deposits; and (ii) to handle (find resolutions) problem banks.
In order to prevent negative impact on financial stability,
the implementation of the DII scheme will be made in stages.
Up to March 2005, the whole liabilities of banks will still be
guaranteed by DII. After that time, starting March 2007,
guarantee on bank customer deposits will be limited up to
Rp 100 million per account.
 Chapter IV Non-Bank Financial Institutions

Chapter 4
Non-Bank
Financial Institutions

47
 Chapter IV Non-Bank Financial Institutions

48
 Chapter IV Non-Bank Financial Institutions

Chapter 4
Non-Bank Financial Institutions

1. CONDITION OF INSURANCE INDUSTRY which is a business unit of Manulife Financial Corp.

The insurance industry still has a potential for (Canada). On 13 June 2002, AJMI was pronounced

expanding in Indonesia. However, national insurance bankrupt by the commercial court because it was judged

companies face heavy challenges, especially if there are to be incapable of paying dividends for accounting year

no coordinated efforts to revive its image that has 1999 along with related interests to PT Dharmala Sakti

deteriorated due to unprofessional management and Sejahtera Tbk (DSS) in the amount of Rp32.7 billion.

weak regulation enforcement. If these problems are not These two incidents may have a negative impact

addressed then the insurance companies» credibility will on the investment climate in Indonesia. Foreign investors

continue to suffer, resulting in a negative influence on may become unwilling to make investments in solvent

financial system stability. companies are pronounced bankrupt by the Commercial

Gloomy prospects for the insurance industry Court.

business are influenced by several factors. First, the After a protest from parent companies, the court

macroeconomic condition such as low interest rates and decision was changed. This gave the impression that

fluctuating exchange rate have lowered investment yields. judiciary institutions in Indonesia can be improperly

This is due to the insurance industry»s investment portfolio influenced , which lowers the credibility of the Indonesian

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

stocks/bonds (25.48%). Although shifts in portfolio to The third factor, which also impacted insurance

bonds and stocks have risen, their investment yields do industry development, is the unbalanced structure of

not automatically rise, considering bond interest rates insurance companies, whereby small insurance companies

follow those of SBIs. have to compete with large insurance companies with the

The second factor concerns legal uncertainty and same market risks. This condition poses heavier challenges

unsupportive business environment. For example, the for small companies due to the active cooperation between

Central Jakarta Commercial Court decision to pronounce large insurance companies and banks through the

bankruptcy on PT. Prudential Life Assurance. Although in mechanism of bancassurance. Consequently, large

2003 this company»s capital reached Rp202.6 billion with companies become larger and small companies are pushed

a ratio of capital adequacy to risk born reached 225%, far back further. Data from Infobank Research Bureau reveals

above the Ministry of Finance»s requirement of 100%, and that 75.83% of the premium market is dominated by 10

its income from premiums rose to 114%, the court large life insurance companies, while the remaining share

approved PT Prudential bankruptcy. Such an incident is spread between 32 companies. Meanwhile, in the

negatively affects the insurance industry by lowering public general insurance market, the 10 largest companies

confidence and interest in placing their funds in insurance dominate 59.85% of the share, while the remaining share

products. A similar incident also happened to PT. AJMI, is spread between 80 companies.

49
 Chapter IV Non-Bank Financial Institutions

The fourth factor is low capability to raise capital,
which makes it difficult for companies to grow. Difficulty
in obtaining additional capital for expansion is
experienced by both state as well as private insurance
companies. In deciding to place additional capital,
investors do not only assess the insurance company
condition but also the industry climate. For state
insurance companies, additional capital through
additional paid-in capital by shareholders is difficult,
considering government inability to finance capital.
Meanwhile, privatization is also difficult, considering
investors» interest in the insurance industry is small. One
possible alternative might be increasing capital from
profits by reducing payment of dividends to the
government. Currently, based on the agreement between
the government and state insurance companies, 50% of
company profit is paid to the government. Judging the
current insurance industry»s condition, it is recommended
that government share should not be the same in all state
insurance companies but instead based on each
company»s condition. If the capital of a state insurance
company is not adequate, the government»s share of
the dividends should be reduced and profits be added
to capital. This recommendation has been put forward
by officers of state insurance companies in a hearing with
Commission V of the People»s Representative on
Wednesday, 9 June 2004.
Based on the above mentioned conditions, the
insurance industry needs to realign its capital and
reformulate its core business in addition to improving its
2. DEVELOPMENT OF PENSION FUND INDUSTRY
Performance of pension funds during semester I
declined. However, it is predicted to rebound in line with
rising deposit interest rate, investment shift to SUN and
mutual funds that give higher yields. Pension fund
investment in SUN has risen rapidly by 255.3%. Therefore,
it is predicted that condition of pension funds would be
relatively stable.
Current condition shows that although allowable
alternative pension fund placements are quite wide,
placements are still predominantly in deposits and bonds,
with average shares of 60% and 10%, respectively.
Therefore, with the occurrence of routine sales of SUN in
large amounts, there has been quite a sizable shift in
pension fund portfolio investment pattern to this
instrument. By placing in SUN, pension fund portfolio
face lower risk due to government guarantee of SUN
although it receives lower yield.
As of September 2003 position, managed funds were
recorded at Rp41.2 trillion or up 18% compared to 2002.
During semester I/2004, managed funds placed in SUN
rose rapidly by Rp10 trillion or 255.3% to Rp13.5 trillion
(Chart on Government Bond Ownership). However, the
share of pension funds ownership in SUN is still relatively
small at 3.42%. Nonetheless, pension funds» role in
supporting routine sales of SUN is becoming more
important because of their ability to absorb 10% of sales.
Billion Rp
30,000
Insurers
25,000
Banks

management and operations. Insurance practices that are 20,000

Pension Funds
15,000
not sound will eventually harm insurance industry. The
10,000
addition of a number of insurance companies to the list
5,000
of companies with frozen business is suspected to have
0
occurred because these companies are not managed with Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr
2002 2003 2004

the principles of good corporate governance and have Chart 4.1

Government Bond Ownership
weak capitals.

50
 Chapter IV Non-Bank Financial Institutions

In the framework of developing pension funds
business activities, in the near future, the supervisory
authority will issue a regulation that will widen the choice
of alternatives for pension fund portfolio placements in
various investment products. It is expected that pension
funds capability to earn profits would increase. However,
utilization of this wider opportunity also demands that
pension funds managers apply tighter prudential principles
in the framework of risk management. Furthermore, growth
of managed funds is predicted to make pension funds role
become more strategic as a driving force for the capital
market and in the maintenance of financial stability.

Box 4.1 Cases of Bankruptcy Pronouncements of Insurance Companies :

PT. Prudential Indonesia dan PT. Manulife Indonesia

Table Box 4.1 Fiancial Highlights

Bankruptcy pronouncements on several insurance
of Prudential Life Assurance (Indonesia)
companies, including PT Prudential Indonesia and PT (Billion Rp)

2002 2003
Manulife Indonesia, have been caused more by factor
Total assets 756.6 1,567.7
of legal weakness than problems with the companies»
Capital 125.2 202.6
financial conditions. If event of such bankruptcy Liabilities 631.4 1,365.1
Premium Income 476.8 1,018.8
pronouncements continues, it is predicted that such
Profits 18.6 78.1
situation could trigger reputation risk due to Liquidity Ratio 109% 110%
RBC 141% 255%
deteriorating public confidence in the insurance
Source: Bisnis Indonesia
industry. Therefore, in the future, there is a need for
efforts in enhance the law on bankruptcy or insurance, requirement of 100%. Meanwhile, its premium income
which is based on prudential principles in the insurance rose to 114% compared to the year before to Rp1.0
business and justice. trillion in 2003. Prudential»s office network in Indonesia
PT. Prudential Life Assurance is a business unit of is also quite wide, with six marketing offices in : Jakarta,
Prudential Plc., an international financial services Medan, Surabaya, Bandung, Denpasar, and Semarang,
company incorporated in 1848 in England with total 61 agency offices, and 14 financial consultation centers.
managed funds reaching US$300 billion all over the Based on decision number 13/PAILIT/2004/
world. In Indonesia, Prudential started to operate in PN.NIAGA.JKT.PST dated 23 April 2004, the Central
1995. The shareholders are The Prudential Assurance Jakarta Commercial Court pronounced bankruptcy on
Company LTD (94.6%) and PT Sasana Dwi Paramitra PT. Prudential Life Assurance. The bankruptcy suit was
(5.4%). Currently, Prudential has 230 employees and lodged by Lee Boon Siong (a malaysian citizen), an ex
more than 8,000 professional marketing staffs. insurance agent consultant of Prudential. The plaintiff
The financial performance of Prudential itself has considered Prudential (the accused) as having an
been quite good. In 2003, its capital reached Rp202.6 obligation under the Pioneering Agency Bonus
billion with a ratio of capital adequacy to risk born Agreement. The Central Jakarta Commercial Court
reaching 225%, far above Ministry of Finance»s then pronounced bankruptcy on this insurance

51
 Chapter IV Non-Bank Financial Institutions
company because it was considered to have defaulted
on the payment of its obligation, which amounted to
Rp1.43 billion.
In taking the decision to pronounce bankruptcy,
the council of judges at the commercial court
considered the decision has fulfilled the stipulation of
Law 4 of 1998 on Bankruptcy. Paragraph 1, item (1) of
the law states that when a debtor that has two or more
creditors do not pay at least one matured debt can be
pronounced bankrupt by court decision. In other words,
without the need to consider the accused company»s
solvency, if the company has indeed legitimate debts
(meaning, the number of debts that have fallen due
matches the stipulation of the law) and the company
does not make payment, the commercial court could
pronounce bankruptcy on the company.
This law is considered to be the weak point of
the insurance industry. Pronouncement of bankruptcy
on insurance companies becomes quite easy. When
a debtor does not pay its debt (whether because it is
not able to, disputes the debt or because of another
reason), it can be pronounced bankrupt. Although
insurance companies are also financial service
companies, they are not like banks for example, where
pronouncements of bankruptcy must have Bank
Indonesia»s approval.
A similar case also occurred previously to PT. AJMI,
which is a business unit of Manulife Financial Corp.
(Canada). On 13 June 2002, AJMI was pronounced
bankrupt by the commercial court because it was
52
judged to have not paid dividends for accounting year
1999 along with related interests to PT Dharmala Sakti
Sejahtera Tbk (DSS) in the amount of Rp32.7 billion.
At that time, Manulife was in a sound condition with
total assets of Rp1.8 trillion, total obligations of Rp1.6
trillion, and ratio of capital adequacy to risk born of
167.3%. This pronouncement was then protest by the
Canadian government and International Finance Corp.
Afterwards, AJMI itself lodged an appeal at the supreme
court and the supreme court then agreed to the appeal
and annulled the commercial court decision.
These two incidents could have brought negative
impact on the investment climate in Indonesia. Foreign
investors could have become unwilling to place their
funds due to the ease at which companies are
pronounced bankrupt. Meanwhile, after a protest by
the parent companies, diplomatic inquires and others,
the court decision was subsequently changed. This gave
the impression that Indonesia can be influenced, which
could lower the credibility of the Indonesian state and
government.
In the settlement process of these cases, it is
predicted that these two insurance companies would
be able to fulfill their obligations, including through
the support from their parent companies. The problem
then would be the reputation of the insurance
companies. These incidents could make potential
customers hesitant in placing their funds in the
insurance, which could hamper development of the
national insurance industry that has just started to grow.
 Chapter 5 Capital and Money Markets

Chapter 5
Capital and Money Markets

53
 Chapter 5 Capital and Money Markets

54

Chapter 5
Capital and Money Markets
Development of the capital market in semester I/2004
was quite encouraging, marked by rising bond and
composite indexes.They achieved their highest levels in
Indonesian capital market history during April 2004 before
trending downwardthrough theend of the semester. Index
weakening at end of semester I/2004 was largely related
to the weakened world bourse performance and the
heightened domestic political climate due to the general
election. It is predicted that a potential increase in interest
rates could lower the performance of the capital market ,
which has started to develop as an institution for public
fund provision (alternative financing) and investments.
1. STOCK MARKET
Rising activities in Indonesia»s stock markets
particularly during the first four months of 2004, marked
the attainment of the highest index of 783 in April.
Improved economic fundamentals and the smooth
election of members of the legislative body contributed to
this positive result. However, subsequent revelations related
to problems with the ballot counting process and protests
Billion Rp
900
Market Capitalization
800
Index
700
600
500
400
300
200
100
0 0
Jan-00 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04
Sourve: Bloomberg
Chart 5.1
Equity Index and Market Capitalization
Chapter 5 Capital and Money Markets
submitted by several election candidates have impacted
the political climate and given worry to investors.
Weakening in the global bourse resulting from oil price
hikes and Fed Funds interest rate hikes have also brought
pressures on regional and domestic bourse development.
These negative impacts have contributed to a downward
trend in the composite index during May and June 2004.
During semester I/2004, there have been 21
additional issuers that registered stocks with a total value
of Rp3.3 trillion (1.32%). In addition, market liquidity
rebounded to its pre-crisis level of average 0.30%, albeit
at far larger volume. Liquidity from transaction frequency
rose to an average of around 15,000 transactions per
month. This condition reflects a developing market, which
could become an alternative source for corporate financing
and investment and as such can be expected to contribute
in acceleration of the real sector recovery.
From risk indicator that is reflected by stock price
volatility, development of the stock market volatility was
relatively small and did not give a signal of significant
pressures of upcoming crisis. Currently, average volatility
during 6 months was recorded at 0.49 compared to 5.32
45 in the period approaching the crisis. This condition implies
40
that if there are no large crisis pressures, the stock market
35
30 is still safe and profitable.
25
However, the stock market is extremely sensitive to
20
15 market sentiment. In addition, potential interest rate rise
10
could again put pressures on the index and transaction
50
frequency. This is due to the fact that most investors still
make use of the stock market as a facility for undertaking
short-term investments and quick profits, particularly large
investors that could influence market movements.
55
 Chapter 5 Capital and Money Markets

Foreign Investors, Net (Million Rp) JCI

40 900 2,000,000 820
VJSX (LHS) JCI (RHS) Expon. (JCI (RHS))
35 800 800
1,500,000
30 700 780
600 760
25 1,000,000
500
20 740
400 500,000
15 720
300
10 700
200 0
5 680
100
Foreign Investors Net JCI
0 0 -500,000 600
1/2 1/8 1/14 1/20 1/25 2/1 2/7 2/13 2/19 2/25 3/2 3/8 3/143/20 3/26 4/1 4/7 4/13 4/19 4/25 5/1 5/7 5/13 5/19 5/25 5/31 6/6 6/12 6/18 6/24 6/30
97 98 99 00 01 02 03 04
- 0.0013x)) Source : Bloomberg, CEIC
Source: CEIC, processed y = 509.23e

Chart 5.2 Chart 5.3

Volatility of Equity Index Equity Index and Transaction of Foreign Investors

The condition of the stock market could be adversely in the history of the capital market, although afterwards it

impacted by the activities of foreign investors who are the dropped quite drastically in May 2004.

main players in the Indonesian stock market. These foreign In such condition, fluctuations in the stock market

investors could easily spur fluctuations in the market due cannot really be avoided. The important thing to do is to

to their ability to enter and exit the market with a maintain economic fundamentals and domestic stability

significant amount of funds and within short time.The in order to keep the situation under control. Actually, the

composite index movements during 2004, evidence how Indonesian stock market still has room for expansion. This

index movements have been greatly influenced by is particularly due to the fact that stock prices in Indonesia

transactions undertaken by foreign parties. A rise in buying are still considered cheap compared to those in the regional

transactions undertaken by foreign investors would be bourse. This is reflected by the relatively low price earning

followed by a rise in the composite index. On the other ratio (PER) of stocks in Indonesia, which as of end of June

hand, if foreign investors undertake selling actions, the 2004 was 12.06%, compared to several other Asian

composite index would decline. Therefore, there is countries, which PERs are above 13%.

probably a need to think about applying monitoring over

short-term capital flows, particularly those driven by foreign
30
speculators, as is adopted by several advanced countries. 28
STI
26
During each of the first four months of 2004, foreign
24

investors recorded net buy transactions in relatively large 22

HANG SENG
PCOMP
20
amounts that averaged Rp2.0 trillion. Only in May there 18
KLCI
16
were net selling transactions undertaken by foreign 14 SET
12
investors amounting to Rp0.3 trillion. Meanwhile, June IHSG
10
1/2 1/12 1/22 2/1 2/11 2/21 3/2 3/12 3/22 4/1 4/11 4/21 5/1 5/11 5/21 5/31 6/10 6/20 6/30
2004 again experienced net buying position, however at 2004
IHSG STI SET KLCI PCOMP HANG SENG
Source: Bloomberg
a relatively small amount of Rp0.1 trillion. All these
transactions are reflected in the composite index Chart 5.4
PER of World Stock Exchanges
movements, which in April 2004 reached its highest point

56
 Chapter 5 Capital and Money Markets

The financial sector»s stock price index showed an group (PT Muliakeramik Indahraya and PT Muliaglass),
increase of 10.8 points to 89.6, while market capitalization have issued bonds in large amounts that have been
also rose by Rp426 million to Rp6.8 billion. These increases restructured and areagain experiencing payment difficulty.
were largely boosted by the stocks of banks such as Bank This situation has lowered investors» confidence in
Mandiri and BRI, which were still considered to be corporate bond performance.
undervalued but sufficiently profitable due to satisfying Total trading transactions of corporate bonds during
profits. semester I/2004 amounted to Rp7.4 trillion, relatively did
The closure of Bank Asiatic and Bank Dagang Bali not change compared to total transactions during semester
did not bring large negative impact on banking sector»s II/2003. Although number of transactions remained
index performance. After these closures, the index relatively the same, the value of bond capitalization,
dropped by 1.02% but afterwards rose again in line with especially in rupiah, experienced quite significant increase,
the issuance of banks» financial reports and plans for from Rp45.4 trillion at end-semester II/2003 to Rp50.5
dividend distributions. trillion this semester. Meanwhile, the highest monthly total
transaction value occurred in April 2004 in the amount of
Billion Rp
140 16 Rp1.88 trillion, the highest during 2004. The same positive
Market Capitalization
120 14 conditions that boosted the stock market in early 2004s
Index
12
100
also had a positive impact on the bond market, particularly
10
80
8 in relation to the downtrend of SBI interest rates. In line
60
6
with the stock market development, in the months of May
40
4
20 2
and June 2004, corporate bonds experienced declining
0 0 activities due to uncertain political condition and Fed Funds
Jan-00 Jun-98 Mar-99 Dec-99 Sep-00 Jun-01 Mar-02 Dec-02 Sep-03 Jun-04
Source: Bloomberg interest rate hikes. This condition then forced issuers to
Chart 5.5 offer higher interest rates for bonds that were going to be
Equity Index of Financial Corporations
issued. The interest rates on Bonds III of PT Indofood Sukses
Makmur, originally offered at 12%, had to be raised to
2. DEVELOPMENT OF BOND MARKET 12.5% in order to meet investors» request.
2.1 Corporate Bonds
Table 5.1
The corporate bond market displayed fluctuating Corporate Bonds

performance during semester I/2004. Its high spread of Semester I Semester II Semester I
2003 2003 2004
around 4-5% above SBIs could still attract investors,
Registered Bonds
particularly pension funds and insurance companies. Rupiah 132 180 207
USD 0 2 2
However, the corporate bond market was not as active as Registered Bond Issuers
Rupiah 61 90 98
the SUN (government bond) market due to the relatively USD 0 2 2
small volume of outstanding corporate bonds and the high Trading Volume (Rp Billion) 6.071 7.440 7.449
Daily Average (Rp Billion) 50 62 62
risk potential for defaults. Several corporations such as Capitalization
Rupiah (Rp Billion) 28.434 45.390 50.487
the Asia Pulp and Paper group (PT Tjiwi Kimia, PT Indah USD ($ Billion) 0 105 105

Kiat, PT Lontar Papyrus and PT Pindo Deli) and the Mulia Source: Surabaya Stock Exchange

57
 Chapter 5 Capital and Money Markets

The successful development of the corporate bond
market requires that investors have explicit legal
protections relative to issuer defaults and other situations,
such as buy backs that are not openly undertaken, that
are disadvantageous to the investor. In addition, issuers
are expected to provide interest incentive of around 1,5%
√ 2% above SUN interest rates and expand number of
issues in order to attract wider investors» interests.
2.2 Surat Utang Negara (Government Bonds)
Surat Utang Negara (SUN) market has developed
with positive potential. Despite cancellation of auction
for two consecutive months, it is predicted that future
auction will remain oversubscribed and rise significantly.
This result is expected due to the market liquidity and
the higher safety of the instrument and investor interest
in the varied maturity periods of government bonds.
Year-to-date June 2004, the government has issued
domestic and international bonds amounting to Rp16.3
trillion of the total planned SUN issues amounting to
Rp32.5 during 2004. As such, the remaining balance
to be issued to cover 2004 state budget»s needs, is still
quite large.
Meanwhile, SUN prices were still fluctuating. The
price of FR0002 series, which was the most saleable, had
a peak range in April of 114.0-115.0 before experiencing
a downward trend. The SUN price decline was prompted
Table 5.2
Auctions of Government Bonds
by the announcement of a higher than estimated y-o-y
inflation rate in April of 5.92%, and the weakening of
rupiah exchange rate against the USD. This decline
continued in line with the expectation of rising the Fed
Funds target during the FOMC meeting in June, which is
expected to prompt a rising SBI discounted rate, and a
continued weakening of rupiah exchange rate.
Cancellations of the announcement of auction and
redemption of SUN VR005 series in the amount of Rp8.38
trillion have raised excess liquidity in the market, which
raised speculations that could trigger market risk, default
risk, and refinancing risk. The maturity positions of SUN
are actually relatively equal and balanced. However, the
values of bonds that would mature in the years 2008 √
2010 are quite large at an average of Rp34 trillion. The
large outstanding SUN that will mature in those periods
have the potential to trigger refinancing risk should SUN
sales be cancelled due to undersubscription, auction
announcement cancelled by the government, or market
condition and the economy worsen. Therefore, consistent
efforts are needed to increase market efficiency and
liquidity.
To mitigate the potential refinancing risk it is
recommended that new issuance be designed to maintain
balanced maturities by issuing SUN with longer longer
maturities either by adding 6 months to the maturity dates
of other SUN (for example 7 years and 6 months) or by
choosing a longer maturity period, for example more than
10 years. SUN of longer maturity periods can be used as

Auction Maturity Volume Yield Coupon Spread a benchmark and as investment alternative more suitable
Series (IDR Average Bid
Date Date (%) FRO2 (bp)
Trillion) (%) for pension funds and insurance companies.
FR21 20-Dec-02 15-Dec-10 2.0 14.70 14.50 1.0 20
FR22 8-Apr-03 15-Sep-11 2.7 12.21 12.00 3.0 -3 A good plan can guarantee smooth financing
FR23 11-Sep-03 15-Dec-12 3.3 11.60 11.00 1.4 15
FR24 6-Nov-03 15-oct-10 2.5 12.92 12.00 2.2 133
through SUN and reduce financing cost, which would
FR24 18-Dec-03 15-oct-10 3.2 13.05 12.00 2.0 85 lessen the burden of taxpayers in Indonesia.
FR23 24-Feb-04 15-Dec-12 2.5 11.86 11.00 2.2 -112
FR23 16-Mar-04 15-Dec-12 2.0 11.57 11.00 2.8 -34 Implementation of the buy back program is also very much
FR25 27-Apr-04 15-Oct-11 3.0 10.72 10.00 3.3 -68
FR25* 25-May-04 15-Oct-11 3.1 11.74 10.00 - 15 supportive of the creation of debt management efficiency
* Canceled so that refinancing risk can be reduced and debt crises

58
 Chapter 5 Capital and Money Markets

that have happened in Latin American countries can be Trillion Rp Trillion Rp

84 12
avoided. Fixed Income (left axis)
72
10
Based on development of SUN market and market
60
Money Market 8
trend discussed above, good cooperation between the 48
(right axis)

6
monetary and fiscal authorities needs to be maintained 36
Mixed (right axis)
4
and enhanced in order to maintain financial stability in a 24

12 2
financial market that is becoming more integrated. Stock (right axis)
0 0
Similarly, market efficiency and monitoring of market Dec
2001
Feb Apr Jun
2002
Aug Oct Dec Feb Apr Jun
2003
Aug Oct Dec Feb Apr
2004
Jun

Source : Capital Market Supervisory Body

players» liquidity, particularly that of non-banks, needs to
Chart 5.6
be enhanced so that more clear information on market NAV per Type of Mutual Funds

conditions can be obtained and effective and credible

policies can be implemented.
3. DEVELOPMENT OF MUTUAL FUNDS
After having experienced a contraction in the second
half of semester II/2003, since January 2004, mutual funds
gradually improved. In May 2004, mutual fund net asset
value (NAV) recorded a new high. Although the capital
market experienced fluctuations in the months of May and
June 2004, mutual funds seem to still experience positive
growth. As of June 2004, mutual funds NAV reached
Rp87.7 trillion, up significantly (11.7%) from its March
2004 position of Rp78.5 trillion. The capital market
fluctuations did not seem to have any significant influence
on the development of mutual funds, except for an
indication of funds transfer from fixed-income mutual
funds to money market mutual funds. The availability of
various types of mutual funds would enable investors to
adjust their mutual funds portfolios in order to get
optimum results.
The rise in maximum guaranteed interest rates on
third-party deposits, followed by the rise in bank deposit
interest rate, apparently was not followed by a decline in
mutual funds NAV. The availability of four types of mutual
funds, namely fixed-income mutual funds, stock mutual
funds, money market mutual funds, and mixed mutual
funds, has made mutual funds quite a flexible product.
Decrease in bond price and increase in interest rate did
not automatically lessen investors» interests in investing in
mutual funds because they can switch from one type to
another type of mutual funds.
Redemption of SUN VR0005 series, that matured
on 25 May 2004, has resulted in an extremely large
amount of idle funds in mutual funds because most of
this SUN series was owned by mutual funds, particularly
fixed-income mutual funds. Meanwhile, alternative fund
placement again in SUN, which was planned through the
purchase of SUN FR0025 series, did not materialize
because the government has cancelled that auction. This
situation has made it difficult for investment managers
to seek bonds that will be used as the underlying of the
fixed-income mutual funds. Alternatively, they had to
buy from the secondary market at higher price. This
condition prompted over liquid positions at investment
managers.
Due to various factors such as interest rate hikes by
The Fed, deposit interest rate hike following the rise in the
blanket guarantee interest rate, as well as anticipation over
possible rise in SBI interest rate, mutual funds investors
have started shifting their funds to the money market.
The shift from fixed-income mutual funds to other types
of mutual funds are reflected among others by the decline
in fixed-income mutual funds NAV in June 2004 amounting

59
 Chapter 5 Capital and Money Markets

Percent portfolio. This revision is very much expected considering

100
Equity Mixed Portfolio Money Market Fixed Income
the importance of determination of fair market values of
80
stocks that would be underlying mutual funds in order to
58.2

60 80.1
87.5 84.8 83.2 82.7 82.6 82.8 85.8 86.2 86.3 84.4 determine its NAV. The use of various values by an

40 investment manager for stocks that form the underlying

27.7
20
of the mutual funds could bring losses for the investors.
7.9 15.4 8.1 9.4 11.0 11.3 11.5 11.6

6.1
3.9 4.0 5.3 5.3 5.4 5.3 5.0
11.2
2.4
11.0
2.2
10.8
2.2
12.6
2.2
This condition would hamper development of mutual funds
0 0.6 0.3 0.5 0.5 0.6 0.6 0.7 0.6 0.6 0.7 0.8
Dec Dec Sep Oct Nov Dec Jan Feb Mar Apr May Jun
2001 2002 2003 2004 as has occurred at the end of 2003. With the availability
Source : Capital Market Supervisory Body (BAPEPAM)

Chart. 5.7 of price references, it is hoped that development of mutual

Composition of NAV per Type of Mutual Funds
funds would be stable and sustainable in the future. This
is related to increasing investors» interest in line with clearer
to Rp0.34 trillion, while NAV of money market mutual information on the development of their investment values.
funds experienced an increase of Rp1.78 trillion.
However, this condition is predicted to only be 4. MONEY MARKET
temporary. After the capital market condition returns to Money market conditions during semester I/2004
normal, mutual funds will also make adjustment. Fixed- were relatively stable despite the fact that SBI and deposit
income mutual funds are still believed to be one that is interest rates in real terms have been relatively low and
most attractive for investors, considering that they are even negative during the last few months. The largest risk
relatively safe and give adequate return. to the capital market would be withdrawals of funds on a
In anticipation of mutual funds development and to large scale, which would create systemic risk. Because
increase prudential principles in mutual funds transactions, deposits are currently guaranteed by the government a
Bapepam (capital market supervisory board) as the potential increase in deposit interest rates rise would not
supervisory authority for mutual funds have and will issue be expected to create fluctuations in the money markets.
various regulations that will assist the development of In general, the money market was relatively liquid as
mutual funds in Indonesia. At end of May 2004, Bapepam evidenced by the downward trend of interest rate in the
has issued regulation number IX.C.6 on Guidelines for money market in line with changes in SBI interest rates.
Prospectus Format and Contents for Initial Public Offering Deposit interest rate that in the period of January up to
of Mutual Funds. One of the items regulated in it concerns April dropped by 41 basis points to 5.86% have risen
the investment manager»s obligation to state the again to 6.23% in June 2004. This excess liquidity condition
calculation method for fair market values of stocks in was also evidenced in the banking sector and low level of
mutual funds portfolio. By this disclosure, it is hoped that its credit channeling. Therefore, funds mobilization in the
investors would clearly know the characteristics of mutual banking sector and payments on SUN interest coupons
funds that they buy, transparency would increase, and are estimated to have increased liquidity supply in the
investors would gain knowledge on portfolio valuation money market.
made by the investment manager. The rupiah money market fluctuated with a
In the near future, Bapepam will also issue revised downward trend during semester I and had an average
regulation on fair market values of stock in mutual funds spread of JIBOR and SBI of 0.26. However, in February

60
 Chapter 5 Capital and Money Markets

Percent Percentage
20 1.00
JIBOR and SBI
18 0.80
Foreign Currency Denominated Interbank and Fed Fund
16 0.60
14 0.40
12 0.20
10
-
8
(0.20)
6
(0.40)
4
SBI 1 month Saving
2 (0.60)
Time Deposit 1 month Blanket Guarantee Scheme
- (0.80)
Dec Mar Jun Sep Dec Mar Jun
Jan May Sep Jan May Sep Jan May
2002 2003 2004
2002 2003 2004
Source: CEIC, Bank Indonesia processed

Chart 5.8 Chart 5.9

Trend of Domestic Interest Rates Spread of Interest Rates

2004, the JIBOR and SBI spread rose to 0.83. Market
liquidity increase resulting from government account
expansion and the return of currency in circulation. This
situation has prompted the 1-month SBI interest rate to
drop quite sizably by 38 basis points. However, it is
predicted that in the coming few periods, the money
market would remain stable and liquid, due to relatively
small demand for transactional needs from the foreign
joint venture bank group and small bank group.
Meanwhile, the spread between interest rates of the
foreign currency interbank money market and Federal
Funds showed relatively stable condition despite
depreciative trend of the rupiah/USD exchange rate.
During semester I, foreign currency supply was relatively
stable except for a slight pressure at June position due to
high foreign currency demand for payments of interests
and debts that have fallen due.
In line with the rising trend of SBI and Fed Funds
interest rates, it is predicted that Indonesian money markets
would become tighter and as such there is a need for
monitoring market condition, market players» behaviors,
and money market liquidity trend, particularly the foreign
currency money market that has the potential to raise
market risk in the financial system.

61
 Chapter 5 Capital and Money Markets
Box 5.1 Oversubscribed Foreign Currency Bonds: Momentum of Rising
Foreign Confidence
Investors» high enthusiasm over foreign currency
bonds issued by the government of Indonesia as
evidenced by cases of oversubscriptions by several folds
(total subscription reached US$4.16 billion) has
prompted the government to raise the amount of
foreign currency bonds issues from original plan of
US$400 million to US$1 billion. 10-year tenor bonds
that will mature on 10 March 2014 based on results
of book building finally offers coupon interest of
6.75% and yield of 6.85%. With this yield, Indonesia
obtains a spread of 277 basis points over the yield of
US treasury bond, which currently is 4.08%.
Indonesia»s yield is lower compared to bonds issued
by several other countries for the same tenor but better
rating. For example, the Philippines, with BB/BB/Baa/
BB ratings its yield comes to 8.81%. Meanwhile, Turki,
with B+/B1/B+ ratings its yield comes to 7.20%
(Bloomberg data, 3 March 2004, 17.00 hours).
Table Box 5.1
Long-term Foreign Currency Bonds
of the Republic of Indonesia
International Previous Rating Current Rating
Rating Agency Date Rating Date
Standard & Poor»s 5 May 2003 B- 8 Oct 2003
Moody»s 20 March 1998 B3 30 Sept 2003
Fitch Ratings 1 Aug 2002 B 20 Nov 2003
Although Indonesia»s rating is still four levels
below the investment grade (BBB), relatively low
interest spread and the occurrence of ovesubscriptions
show rising foreign confidence in Indonesia, both in
62
terms of current economic performance/condition as
well as its future prospects. Economic indicators during
2003 have improved significantly compared to the time
of crisis, evidenced by low and stable inflation rate,
relatively stable exchange rate, strengthening foreign
currency reserve, improving economic growth, as well
as political stability and security that are becoming
more conducive. Performance of the banking sector,
which was the economy»s driving force, also
experienced improvement as evidenced by various
banking sector»s indicators such as CAR, NPLs, ROA,
etc. In addition, rising international confidence in
Indonesia is also supported by Indonesia»s rating
upgrading by 3 international rating institutions during
2003.
Improving economic, monetary, fiscal, and
banking industry»s indicators as well as rising
international confidence provide a momentum for
acceleration of the real sector»s development. Concrete
foreign investment inflows would boost the real sector,
which is expected to create jobs that are currently a
Note
national problem, as well as bolster economic growth.
Rating
The government needs to continuously make efforts
B Upgraded
B2 Upgraded to provide conducive business climate through
B+ Upgraded
economic stability and security, legal certainty for doing
business, as well as law enforcement. If these efforts
are successful, it is hoped that unemployment would
be solved, the real sector»s activities would rise, credit
rating would improve, and in turn all these would boost
economic growth.
 Chapter 6 Payment System

Chapter 6
Payment System

63
 Chapter 6 Payment System

64
 Chapter 6 Payment System

Chapter 6
Payment System

Efforts to support financial system stability through
continued implementation of Bank Indonesia»s supervision
functions ensure a safe and reliable payment system.
Control over risks within the payment system, both
settlement as well as operational risks, was applied through
Bank Indonesia»s supervision of operator of the payment
system, regulatory authority of the payment system,
oversight of the payment system, as well as facilitator in
the development of the payment system.
Control over settlement risk, which among others is
undertaken through implementation of the Bank
Indonesia Real Time Gross Settlement (BI-RTGS) system
In terms of the overall payment system, the shift in
the use of settlement system from the clearing system to
the BI-RTGS system is meant to reduce payment system
risk, particularly liquidity and credit risks. Efforts to
systematically minimize the rising of risk in payment system
operations also support the financial system stability. A
well managed payment system available to all banks, is
part of the infrastructure required to support the realization
of a stable financial system.
Volume RTGS Nominal RTGS
25,000 160,000,000

140,000,000
since November 2000, has significantly minimized 20,000
120,000,000
settlement risk in the payment system. Based on data for 100,000,000
15,000

the period from January up to June 2004, the daily average 80,000,000
10,000 60,000,000
total transaction value processed through the BI-RTGS
40,000,000
5,000
system amounted to Rp108.75 trillion, while that of the 20,000,000
- -
clearing system amounted to Rp5.87 trillion (94.87% I II III IV V VI VII VIII IX X XI XII Total I II III IV V VI
2002 2003 2004

versus 5.13 %). Volume - Daily Average Value - Daily Averagel (Rp Million)

Although current value of transactions settled
through the clearing system is very small, around 5% of
total value of transactions booked, Bank Indonesia is
making efforts to implement a mechanism for Failure to
Settle (FTS) in the clearing system due to the possibility of
payment failures on the part of participating banks. This
FTS mechanism, which is designed to prevent and address
clearing participants inability to settle obligations, is
expected to be implemented in stages starting July 2005.
This mechanism is the result of agreement between
participating banks, which was formulated through
intensive discussions between representatives from all bank
associations with Bank Indonesia.
Chart 6.1 Volume and Value
of Real Time Gross Settlement
Currently, the BI-RTGS system is safe and efficient
and this condition has to be maintained. Daily activities
of the BI-RTGS system, between January to June 2004,
transactions settled through this system came to an
average value of Rp108.75 trillion and an average
volume of 19.842 transactions per day. Hence, there
have been increases from an average daily value of
Rp86.12 trillion and an average daily volume of 17,125
in 2003. By value, most transactions concerned are for
the settlements of marketable securities transactions

65
 Chapter 6 Payment System

Nominal (Rp. Juta) Volume Percent

10,000,000 500,000 100.00
9,000,000 450,000 90.00
8,000,000 400,000 80.00 Percent
Unsettled RTGS Transactions
1.40
7,000,000 350,000 70.00 1.20
ACPT (T.Settle)
PSED (T.Settle)
HCNL (T.Settle)
QCNL (T.Settle)
1.00
RJTD(T.Settle)
6,000,000 300,000 60.00
0.80
0.60
0.40
5,000,000 250,000 50.00 0.20
-
4,000,000 200,000 40.00 Jan Feb Mar Apr May Jun
2003
Jul Aug Sep Oct Nov Dec Jan Feb Mar
2004
Apr May Jun

3,000,000 150,000 30.00

2,000,000 100,000 20.00
1,000,000 50,000 10.00
- - - Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
I II III IV V VI VIIVIII IX X XI XII I II III IV V VI VIIVIII IX X XI XII I II III IV V VI
2002 2003 2004 2003 2004
Volume Value (Rp Million) TRFC ACPT HCNL PSED QCNL RJTD
By Total Value of Transaction

Chart 6.2 Chart 6.3 Unsettled

Volume and Value of Clearing Settlements Real Time Gross Settlement System Transactions

administered by Bank Indonesia (SBIs and government Code Description

bonds). By volume, most transactions were bank ACPT Transaction cancelled - due to incomplete
customers» transactions (74.6%). transmission
From January to June 2004, banking liquidity in HCNL Transaction cancelled by Host
relation to settlement of payment transactions was PSED Settlement pending √ waiting for data
adequate. This is illustrated by the share of nominal values QCNL Queue Cancelled - transactions in queue
of transactions successfully settled, 99,993%. Meanwhile, cancelled by sender (bank) due to business
the share of nominal values of transactions cancelled at consideration (prioritization)
end of day due to insufficient balance in banks» current RJTD Transmission rejected by supervisor
accounts was only 0,007 % or Rp7.61 billion per day. As
for the monitoring of financial system stability, smooth a. Confirmation of the term ≈ real time ∆, which
processing of transactions by the BI-RTGS system is an stipulates on the time limits for participants sending
important factor that is expected to reduce liquidity risk transfer instructions and for forwarding of funds by
and systemic risk, minimizing bank liquidity problems that receiving banks to customers, as well as
could disrupt the overall banking system. compensations for customers in cases of delays on
In the framework of BI-RTGS system implementation, funds forwarded by banks.
in order to ensure legal certainty for participants and users b. Confirmation on the responsibilities of sending
of the BI-RTGS system, where its implementation has been participants and receiving participants, in order to
based on Bank Indonesia regulation number 2/24/PBI/2000 avoid disputes between banks on the event of transfer
concerning Current Account Relation Between Bank delays or errors.
Indonesia and External Parties, on 11 March 2004, Bank c. Implementation of supervision over participants of
Indonesia regulation number 6/8/PBI/2004 concerning BI-RTGS system by Bank Indonesia»s Payment System
Bank Indonesia Real Time Gross Settlement System was Supervisory Unit.
issued. Basic changes in the management of the BI-RTGS d. Announcements on status changes of participants to
system as a result of BI regulation 6/8/PBI/2004 are as all other participants (for example, when a participant
follows : is suspended).

66

e. Imposition of sanctions in stages, starting with written
reprimand up to the highest sanction, namely
suspension (participants can only receive transactions
but cannot send transactions through the BI-RTGS
system).
To ensure financial stability, implementation of
transaction settlements of significant values through a
payment system dependent upon information technology,
assurances have to be made that the BI-RTGS system is in
a safe, reliable and its operations are sustainable. In this
regard, Bank Indonesia as the operator of the BI-RTGS
system is equipped with policies, procedures, and backup
facility to ensure the system»s reliable operations. The
components of the BI-RTGS system, namely hardware,
software, as well as communication network, have
adequate backups. In addition, off-site back up center
(Disaster Recovery Center/DRC) has been built since the
early stage of implementation. This enables operations of
the BI-RTGS system at the DRC in the event of disruptions
at the production site (at on-site facility). In order to ensure
Chapter 6 Payment System
sustainable operations, periodically tests are conducted on
the DRC facility.
Supervision of the payment system is continuous ,
both on the large-value payment system (BI-RTGS), and
on the retail payment system (the clearing system).
Supervision on the BI-RTGS system is required to ensure
safe operations of the system for both the operators as
well as the participants. Security of the BI-RTGS system
for participants is an important issue in required to
minimize operational disruptions that might disadvantage
the participants. In addition, supervision on the security
of the BI-RTGS system on the participants» side also
minimizes the risk of fraud.
Moving forward, Bank Indonesia will also increase
supervision on institutions that have roles in payment
instruments using cards, such as credit cards, debit cards,
and ATM cards. This will ensure the realization of safe
and efficient payment system as well as protection of
consumers. Implementation of supervision on payment
systems that use cards is planned to start in 2005.
67
Appendix
 Appendix

70
 Appendix

Appendix
Table 1
Balance of Payment

2003 2004
Description
Q. I Q. II Q. III Q. IV Q. I Q. II

CURRENT ACCOUNT 1.286 2.325 2.363 1.467 -666 1.325

Export 16.075 15.484 16.298 15.397 15.047 16.843
Oil and Gas 4.074 3.402 3.951 3.807 3.957 4.307
Non Oil and Gas 12.001 12.082 12.347 11.590 11.090 12.536
Import -10.570 -9.244 -9.737 -9.993 -11.781 -10.840
Oil and Gas -1.922 -1.710 -2.164 -2.020 2.409 -2.619
Non Oil and Gas -8.648 -7.534 -7.573 -7.973 -9.372 -8.221
Services -4.219 -3.916 -4.198 -3.937 -3.932 -4.678
Oil and Gas -1.328 -1.280 -1.382 -1.180 -1.222 -1.018
Non Oil and Gas -2.891 -2.635 -2.816 -2.757 -2.710 -3.660

CAPITAL ACCOUNT -946 -203 -630 188 1.394 -2.466

Goverment (Net) -122 -401 -379 294 344 -368
Private (Net) -825 198 -251 -106 1.050 -2.098

TOTAL 340 2.122 1.733 1.655 1.073 62

Monetary Movement 1) -539 -1.479 -11 -2.228 -1.123 2.568
Memorandum Items
Reserves 32.578 34.057 34.068 36.296 37.419 34.851
(In months of imports & Official debt Repayment) 6,3 6,6 6,6 7 6,5 6

1 (-) Surplus, (+) defisit

Source : Bank Indonesia

Table 2
Macroeconomic Indicators

2003 2004
Leading Indicators
Q. I Q. II Q. III Q. IV Q. I Q. II

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

GDP (% . annual)
Demand Side: 4.45 3.65 3.97 4.35 4.46 4.32
Total Consumption 4.12 4.64 4.75 5.01 6.43
Total Investment 4.26 -5.39 -1.15 -6.71 4.24 9.25
Production Side:
Agriculture 5.54 1.18 3.06 -0.17 1.53 1.67
Mining -1.05 0.96 -1.27 3.19 -2.72 -7.22
Manufacturing 3.1 3.45 3.57 3.87 5.46 5.98

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

Interest Rate (%)

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

Exchange Rate (Rp/USD), 8,693 8,275 8,395 8,420 8,564 9,401

Average 8,902 8,488 8,431 8,468 8,580 9,392
* May 2003
Source : Bank Indonesia

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 Appendix

Table 3
State Budget
(billion rupiah)

Description State Budget Semester I % to State Budget

A. Revenues and Grant 349,933.9 144,783.3 41.4

I. Domestic 349,299.7 144,734.4 41.4
1. Taxation Revenues 272,175.1 118,909.2 43.7
a. Domestic Taxation 260,223.9 113,200.8 43.5
i. Income Tax 133,967.6 60,033.1 44.8
1. Oil and gas 13,132.6 9,997.2 76.1
2. Non Oil and gas 120,835.0 50,035.9 41.4
ii. Value Added Tax 86,272.7 34,644.9 40.2
iii. Land and Property Taxes 8,030.7 3,151.8 39.2
iv. Land and Property Usage Duties 2,667.9 1,384.1 51.9
v. Duties 27,671.0 13,107.8 47.4
vi. Other Taxes 1,614.0 879.1 54.5
b. International Trade taxation 11,951.2 5,708.4 47.8
i. Custom Duties 11,636.0 5,561.7 47.8
ii. Export Taxes 315.2 146.7 46.5
2. Non Taxation 77,124.6 25,825.2 33.5
a. Natural Resources 47,240.6 16,729.2 35.4
i. O i l 28,247.9 10,103.2 35.8
ii. G a s 15,754.4 5,322.7 33.8
iii. Mining 1,628.3 555.6 34.1
iv. Forestry 1,010.0 591.7 58.6
v. Fishery 600.0 156.0 26.0
b. Dividen from SOEs 11,454.2 1,450.3 12.7
c. Others 18,429.8 7,645.7 41.5
II. Grant 634.2 48.9 7.7
B. Expenditure 374,351.3 163,337.3 43.6
I. Central Government 255,309.0 101,331.5 39.7
1. Routines 184,437.8 84,899.7 46.0
a. Renumeration and Benefits 56,738.0 30,804.5 54.3
b. Goods Services 17,279.8 4,911.5 28.4
c. Debt Repayment 65,651.0 30,084.5 45.8
i. Domestic 41,275.9 18,851.3 45.7
ii. International 24,375.1 11,233.2 46.1
d. Subsidies 26,362.1 10,649.8 40.4
i. Fuel 14,527.1 8,773.2 60.4
ii. Non Fuel 10,995.0 1,813.0 16.5
iii. PSO and Governmental Assistance 840.0 63.6 7.6
e. Other Routines 18,406.9 8,449.4 45.9
2. Development Expenditure 70,871.2 16,431.8 23.2
a. Development Projects 50,500.0 9,776.6 19.4
b. Project Financing 20,371.2 6,655.2 32.7
II. Regional Expenditure 119,042.3 62,005.8 52.1
1. Balancing Funds 112,186.9 57,059.7 50.9
a. Profit Sharing Funds 26,927.9 8,873.8 33.0
b. General Allocation Funds 82,130.9 47,775.9 58.2
c. Special Allocation Funds 3,128.1 410.0 13.1
2. Special Autonomy and Adjustment Fund 6,855.4 4,946.1 72.1
C. Primary Balance 41,233.5 11,530.6 28.0
D. Surplus/Deficits -24,417.4 -18,554.0 76.0
E. Financing 24,417.6 6,423.2 26.3
I. Domestic Bank 19,198.6 8,000.0 41.7
II. Privatization 5,000.0 3,489.0 69.8
III. Asset Disposal-Banking Restructurisation 5,000.0 10,400.7 208.0
IV. Government Bond (net) 11,357.7 -91.1 -0.8
1. Issues 32,500.0 16,301.1 50.2
2. Principal Repayment andRepos -21,142.3 -16,392.2 77.5
V. International Financing (net) -16,138.7 -15,375.4 95.3
1. Debt withdrawal 28,237.0 6,627.8 23.5
a. Program Debt 8,500.0 0.0 0.0
b. Project Debt 19,737.0 6,627.8 33.6
2. Principal Installment -44,375.7 -22,003.2 49.6
Source: Ministry of Finance

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Articles

73
 Article I

74
 Article I

Article I

Analysis of Foreign Bank’s Role

in Enhancing Indonesia’s Real Sector Recover
1) 2)
Muliaman D. Hadad, Wimboh Santoso,
3)
Dwityapoetra S. Besar, Wini Purwanti, Ricky Satria dan Ita Rulina

Abstract

Loan growth is an essential indicator of banking sector’s contribution to the real economy of a country.
Hence, this paper focuses on the role of foreign-incorporated banks in reviving the real economy of Indonesia
via loan growth. Estimation model used in this paper is Montgomery model (2003) postulating that return on
asset, cost-to-income and problem loan ratios are the best indicators for assessing the comparative performance
of the foreign-incorporated over local banks. To support the framework of analysis, this paper also makes use of
the method developed by Berger and Young (1997) using NPLs, efficiency ratio, capital (with return proxy over
the equity or asset), and risk-weighted asset as primary indicators.
The model is employed to search for factors driving foreign banks to grant loans and to observe their
behavior in expanding loan portfolios. On the basis of previously released research, this paper will apply five
variables turning out to be primary rationales for banks in granting loans: return on asset, efficiency ratio, non
performing loans, spread between US and domestic rates, and industry production index. To some extent,
however, estimation data for this paper is limited. Therefore, cautious interpretation over estimation result must
be exercised.
The outcome of this paper suggests that foreign-incorporated banks have long been shifting their roles
toward more fee-based income earners. Consequently, their roles in boosting the country’s economy growth
through loan making and trade financing have been dwindling. Although their focus on efficiency and asset
quality is similar to those of the other group of banks in Indonesia, foreign banks are leaning toward fee-based
items as their preferential sources of income and therefore their loans have proportionally lessening. The
estimation results presented in this paper confirm this phenomenon.

1. Head of Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : muliaman@bi.go.id
2. Executive Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : muliaman@bi.go.id
3. Bank Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : dwityapoetra@bi.go.id ; wini@bi.go.id;
ricky-s@bi.go.id; rulina@bi.go.id.

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This empirical study also suggests that foreign banks are in general less sensitive to the signal of domestic
economy changes than their domestic peers. Their highly dependence on inter-branches and headquarter funds
have driven those banks to be less susceptible to the adverse changes of Indonesian macroeconomy. Besides,
their loan portfolios have high degree of volatility and tendencies to be more contractive post crisis.
To ensure accuracy of capital measurement, this paper recommends that treatment over inter-branches
and headquarter fund placements in branches of foreign-incorporated banks in Indonesia be immediately
improved. The current regulatory capital for foreign banks in Indonesia does not ensure the function of capital
as cushion for absorbing unexpected losses and therefore less effective as a tool for monitoring their asset
growth.

Classification JEL : G28

Keyword : Bank

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1. O V E R V I E W
1.1 Background
In Indonesia, banks with foreign ownership are classified into three groups, namely (i) those operating as branch
offices (called foreign banks); (ii) those operating as subsidiaries, whether through joint venture with domestic banks
(called foreign joint venture banks) or through mergers with and acquisitions of domestic banks, which occurred in the
post-1997 crisis period (divestment program); and (iii) those operating as representative offices. Through June 2004, the
number of foreign banks in Indonesia came to 11 banks, after only one addition with the reopening of Bank of China in
April 2003. Meanwhile, the number of foreign joint venture banks came to 20 banks, down from the number in pre-
crisis period (excluding banks with foreign ownership acquired through the divestment program). In general, as foreign
banks, their strategies on operational activity implementation and adopted policies tend to focus very much on the
interests of their foreign headquarters. Each future plan or operation will depend much on the decisions of their head
offices or regional offices.
The main difference between foreign banks and foreign joint venture banks lies in their legal entity forms. Foreign
banks» legal entities follow those of their foreign headquarters» and they constitute important parts of their headquarters»
organizations (in accordance with US Department of Commerce √ H. Montgomery). Consequently, all foreign banks»
financial policies very much depend on their headquarters, and in general credits are channeled to large corporations
(Pigott (1986)-H.Montgomery), such as have happened also with foreign banks in Indonesia where their credits tend to
be channeled to multinational companies that also receive financing from their headquarters. Meanwhile, foreign joint
venture banks have local legal entity form, which in Indonesia is Perseroan Terbatas/PT or limited company form, and
legally are separate entities from their headquarters.
Basically, Bank Indonesia»s policies and regulations are equally implemented on foreign banks and foreign joint
venture banks. All regulations, including those related to prudential principles, are uniformly imposed on all banks
operating in Indonesia, whether domestic, foreign joint venture or foreign banks. The difference between foreign banks
and foreign joint venture banks lies in capital regulations. Banks operating as Indonesian legal entities follow the PT law
where business capitals are recorded on banks» balance sheets as paid-in capitals. Meanwhile, as regard foreign banks
operating in the same legal entity forms as their headquarters, their business capitals are recorded on their balance sheet
in intercompany account as business funds. Limitation imposed on foreign banks concerns geographic location of their
offices where they can only have offices at provincial cities.
The backdrop for opportunity given to foreign banks and foreign joint venture banks to operate in Indonesia is the
need for foreign capitals. In addition, these banks» operations in Indonesia are expected to boost development of
national banking industry and economy. In general, benefits obtained from foreign banks» operations, including foreign
joint venture banks, are among others capital inflows for domestic economy, rising competitions between banks, and
introduction of more varied products. However, a negative side that has to be anticipated relates to the fact that
particularly during a crisis these banks can become the receivers of funds when capital flight occurs. In addition, foreign
funds are here temporarily and only seek profits for a time (capital inflow during good times and capital outflow during
bad times). Meanwhile, the complexity of products and technology brought in by foreign banks from advanced countries
cannot always be recognized and controlled by the supervisory authority of the host country, and as such instead of

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

From several studies on foreign banks, it is revealed that although they are more responsive towards domestic
economic fluctuations, credit channeling by banks with foreign ownership in the form of subsidiaries is relatively
more stable compared to credit channeling by foreign banks that are in the form of branch offices (H.Montgomery).
Meanwhile, stability of credits channeled by foreign banks (both in the forms of branch offices and subsidiaries)
during the banking crisis period depended on their forms (mode of entry), whether as branch office or subsidiary.
Studies reveal that foreign banks in the form of subsidiaries can provide wider financial business activities and more
stable credit channeling in a host country compared to foreign banks» branch offices (Clarke and Sanches (2001)),
Miller and Parkhe ((1998)-H.Montgomery). In broad outline, it can be concluded that the entry of foreign financial
institutions tends to bring benefits for the host country. However, in order to get full benefit, policy makers must
receive these institutions in the forms of fully owned subsidiary and joint ventures, and turn away from offshore
institution and branch office models.

1.2 Problems
The 1997 Asian crisis period has left several remaining problems in the banking industry in Indonesia. Up to the
present time, development of bank credit channeling is still relatively stagnant or its growth is slower than that in the pre-
crisis period. This problem becomes heavier with continuously fluctuating rupiah exchange rate against world hard
currencies, such as the US dollar, which has influenced Indonesia»s economic development. Recent continuous drop of
rupiah exchange rate is suspected to be the result of several foreign banks in Indonesia having undertaken speculative
transactions.
Foreign banks have several advantages, such as more varied products and credit lines with overseas banks, which
enable these foreign banks to undertake transactions more freely with overseas markets. Due to bank credit channeling
that is still relatively hampered, including in the case of foreign banks, while on the other hand these foreign banks have
excess liquidity, as commercial banks that tend to be profit-oriented, these foreign banks would undertake activities or
transactions in order to maintain or raise their profitability.
With the prediction that problems in bank intermediation would remain and foreign banks would continue to
undertake speculative activities that could influence domestic economic development, a study needs to be undertaken
regarding the role of foreign banks in Indonesia»s economic development. This study would discuss and compare the
performances of foreign banks, foreign joint venture banks, and domestic banks until a picture emerges of the role of
each bank group in the national economy. Recommendations would depend on results of the study : whether it is still
necessary to retain the form of foreign banks as branch office with certain limitations or to change it; or to change the
form of branch office to subsidiary for existing foreign bank branch offices and to use the form of subsidiary for subsequent
new foreign bank offices.
This paragraph describes the structure of the study. Chapter 2 will cover analysis of the development of performances
of foreign banks, foreign joint venture banks, and domestic banks for pre-crisis, crisis, and post-crisis periods as well as
comparison of the performances of these three bank groups. Chapter 3 will discuss the experience and performance of

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

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foreign banks in other countries while making comparison with Indonesian situation. Both chapter 2 and 3 will also
include descriptions of existing regulations in each country. Chapter 4 will discuss qualitative and quantitative analyses on
the roles of foreign banks, foreign joint venture banks, and domestic banks. Quantitative analysis will be undertaken
using simple econometric technique. The last chapter, Chapter 5, will cover conclusions on the analyses and discussions
covered by the previous chapters as well as resulting recommendations.

2. REGULATIONS ON AND PERFORMANCE DEVELOPMENT OF FOREIGN BANKS

2.1 Regulations on Foreign Banks
As described in the previous chapter, a foreign bank»s participation in Indonesia»s banking sector can be done
through the opening of a foreign bank branch office (called foreign bank), a joint venture of foreign bank and domestic
bank (called foreign joint venture bank), or a representative office. In addition, in the post-1997 crisis period, government»s
divestment program of domestic banks has widened the entry opportunity for foreign participation in the national banking
sector through mergers or acquisitions.
Foreign participation in the national banking was reactivated around 1968 in order to boost the national banking
system. Foreign participation in the form of newly opened foreign bank branch offices at that time still exist until this
present time. There was one additional foreign bank branch office opened in April 2003 with the reactivation of Bank of
China. The opening of foreign bank offices is regulated by Bank Indonesia» Director Decree number 32/37/KEP/DIR dated
12 May 1999 regarding Requirements and Procedures for The Opening of Branch Office, Sub Branch Office, and
Representative Office of Banks That Domicile Abroad.
In post-1988 Pact at the time of banking liberalization, foreign participation increased with the entry of foreign
banks through joint ventures with domestic banks and often called foreign joint venture banks. In accordance with
prevailing regulation, the ownerships of foreign banks in foreign joint venture banks are at maximum 99%, up from
previous 85%. The opening of foreign joint venture banks is regulated by Bank Indonesia»s regulation number 2/27/PBI/
2000 dated 15 December 2000 regarding Commercial Banks, which is also applicable on domestic banks.
Basically, the prevailing regulation regarding Commercial Banks does not differentiate between foreign joint venture
banks and domestic banks. Neither does it differentiate between these two bank groups and foreign bank branch
offices. The prudential principles and related regulations are imposed uniformly on all commercial banks, which include
domestic banks, foreign joint venture banks, as well as foreign bank branch offices. Limitations or obligations previously
imposed on foreign bank branch offices, such as export credit channeling and number of foreign bank offices, are no
longer in effect. The main differences between domestic banks and foreign joint venture banks with foreign bank branch
offices only concern capital and legal entity form.
Domestic banks and foreign joint venture banks have Indonesian legal entity form under the prevailing PT form and
their business capitals are recorded as paid-in capital on their balance sheets. Meanwhile, foreign bank branch offices
have their headquarters» legal entity forms and their business capitals are recorded as Business Fund in the intercompany
account on their balance sheets.
Based on prevailing regulation, the definition of foreign bank branch office»s Business Fund is ≈net fund at the bank
branch office from the bank»s headquarter after deduction of bank branch office»s placements at bank offices abroad,

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 Article I

which is treated as the branch office»s capital component that must always be recorded for as long as the branch office is
in operation∆. This business fund can be in rupiah or foreign currencies in rupiah equivalence.
With regards business fund that is in foreign currencies, the size of bank capital will be influenced by rupiah
exchange rate fluctuations. Aside from that, with the existence of the stipulation on declared business fund (declared
NIOF), where a bank is obliged to maintain at minimum 90% of its total declared business fund, the bank can utilize the
difference between declared and realized business funds for transacting purposes in order to optimize its income.
Meanwhile, the intercompany fund method applied in the calculation of business fund can also be utilized by the bank
for transacting purposes in order to optimize profits.

2.2 Development of Foreign Bank Market Share (in terms of assets)

Through end-2002, there were only 10 foreign banks operating in Indonesia. By May 2004, with the reactivation of
Bank of China, the number of foreign banks came to 11 banks with total assets of Rp103 trillion or 8.77% of banks» total
assets. Foreign banks» total assets experienced quite significant development compared to one year prior to crisis, from
Rp14.37 trillion in 1996 (2.85% of banks» total assets) or up Rp88.63 trillion (617%). This quite significant change was
brought about by sharp exchange rate change, from Rp2,383 in 1996 to Rp9,210 per 1 dollar in May 2004. This
condition has made foreign banks» total assets, of which foreign currency portfolio was quite large, rose significantly.
If the foreign joint venture banks are included as part of the foreign bank group, the share of the foreign bank
group»s total assets to banks» total assets reached 12.75% in May 2004, from 7.74% in 1996. This is mainly due to quite
significant development of foreign joint venture banks to banks» total assets.

(in terms of credits)

Compared to credit growth of different bank groups, the foreign bank group experienced the smallest negative
credit growth in 1999. Further on, this group also experienced the lowest credit growth acceleration in the period of
2002 up to 2004.
Meanwhile, from the side of undisbursed loans (ULs), the foreign bank group, which comprises of relatively small
number of banks, has quite large Uls. In fact, it contributes 25.0% to banks» total Uls during 2004 of Rp21.0 trillion (up

Percent Percent
100 80
90 60
80
40
70
20
60
50 0

40 -20
30
-40
20
-60
10
0 -80
1995 1996 1997 1998 1999 2000 2001 2002 2003 May-04 2000 2001 2002 2003 2004

Domestic Bank Foreign Bank Joint Venture Bank Domestic Bank Foreign Bank Joint Venture Bank

Chart 1 Chart 2
Development of Shares in Total Assets (%) Credit Growth (y-to-y)

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to April 2004). In the foreign bank group, these Uls comprise

27.7%
largely of working capital credits and are primarily for the
industry sector. Particularly in regard the industry sector, the
percentage share of Uls of foreign bank group is larger than
banks» percentage. This means that not only foreign banks 0.4%

in Indonesia do not focus on credit channeling, but also the 71.9%

real sector that has been given credit allocation is not able
Working Capital Loan Investment Loan Consumer Loan
to well absorb funds made available by this bank group.
Chart 3
Foreign Banks» Undisbursed Loans √ By Type of Use
2.3 Development of Foreign Banks» Performance
Due to past crisis, quality of earning assets, particularly
1.5% 1.4%
27.7%
credits, of the foreign bank group is worse that the banking 48.0%

industry»s total asset. This is reflected in this bank group»s 0.2%

gross NPLs that are considered quite high although with a

downward trend compared to other banks» or even the 12.2% 3.4% 4.0%
1.0% 0.7%
banking industry»s. The foreign bank group»s gross NPLs (April
2004) and net NPLs are recorded at 11.5% and 1.1%2 Agriculture Electricity Transportation Others
Mining Construction Business Services
Nonetheless, this bank group»s operational and non- Manufacture Trading Social Services

operational incomes are relatively high compared to other Chart 4

bank groups, both during 2003 as well as during the first Foreign Banks» Undisbursed Loans √ By Sector

three months in 2004. The main source of income is not

credits but foreign currency/derivative transactions. With quite good profitability, this bank group»s CAR is quite high
compared to other bank groups» and as such these foreign banks have large room to raise their credit channeling. This is
suspected to be the result of the overall foreign bank group»s better risk and operational management.

Percent Percent
80 40

70 35

60 30

50 25

40 20

30 15
20 10
10 5
0 0
1999 2000 2001 2002 2003 2004 May 2000 2002 2003 2004
State-owned Bank Private Bank Regional Government Bank Industry Foreign Bank Joint Venture Bank
Joint Venture Bank Foreign Bank

Chart 5 Chart 6
Gross NPLs Chart 6 CAR (%)

2 For information, as of that position, the share of foreign currency credits in foreign bank group»s total credits was 46.3% (banks» share was 24.0%)

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REGULATIONS ON AND PERFORMANCE DEVELOPMENT OF FOREIGN BANKS IN OTHER COUNTRIES

The 1997 crisis in Asia and the need to undertake recapitalization of the banking sector have brought changes in
regulations concerning foreign bank establishment (entry) in countries that have experienced crisis such as Korea, Thailand,
and Indonesia. Despite changes in regulations, foreign banks» penetration in Asia has remained low but it is predicted to
raise competition, efficiency, and stability in the financial sector.
In the crisis period, namely around 1996 √ 1998, foreign banks» credit growth in Asian countries was relatively
higher compared to that of domestic banks. Where as in

Percent
Thailand it trended upward, in Malaysia and Korea credit
15.0
channeling trended downward. Foreign banks» credit growth
10.0
5.0 in Malaysia reached 38%, while that of its domestic banks
0.0
-5.0
reached 38.2%. During the same period in Thailand, foreign
-10.0 banks» credit growth reached 20.6%, while that of its
-15.0
-20.0 domestic banks reached √8.5% (negative). In Korea, foreign
-25.0
Thailand Korea Malaysia banks» credit growth reached 13.6%, while that of its
-30.0
Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar
1998 1999 2000 2001 2002 2003 2004 domestic banks reached 2.9%.
Source: CEIC
To give an overall picture, the following will describe
Chart 7 Foreign Banks» Credit Growth in Thailand,
changes in regulations on foreign banks made by the bank
Korea, and Malaysia
supervisory authorities in Malaysia, Thailand, and Korea.

3.1 Malaysia
Regulations
Compared to other Asian countries, foreign banks» role in Malaysia is relatively larger. However, in the beginning,
the banking authority in Malaysia was quite cautious in the opening of the banking sector. One of the facilities given to
foreign banks was that they could extend credits through cooperation with local banks and joint venture banks. After
1983, there have been no more foreign banks established in Malaysia.
With the effectiveness of the Banking and Financial
Institution Act of 1989 (BAFIA), foreign banks having business
RM mn Percent
120000.00 20
activities in Malaysia are obliged to have public company
Loan Share of Foreign Banks Loans to Total 20
100000.00
Deposits 19 form with licenses issued by the Minister of Finance on BNW
80000.00 19
recommendations. Therefore, all foreign banks that wanted
18
60000.00
18 to operate in Malaysia were also obliged to convert their
40000.00 17
17
legal entities into subsidiaries (locally incorporated banks) at
20000.00
16 the latest 1 October 1994 and foreign banks are allowed to
0.00 16
Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec
1999 2000 2001 2002 2003
have 100% ownership.
Source: CEIC
Since 31 December 2001, all foreign banks are obliged
Chart 8 Foreign Banks» Total Credits
to raise minimum capital to MR300 million, after taking into
and Third-Party Funds in Malaysia
account their losses, while domestic banks are obliged to

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raise minimum capital to MR2 billion. However there are no separate policies or guidelines that limit the activities of
foreign banks.

Banks» Development
Although Malaysia adopts the foreign currency control regime, quite stable economic prospects have prompted
increased activities of foreign banks in that country. In the period of 1999 √ 2003, third-party funds mobilized by foreign
banks rose by 41.5% to MR103,396 million and their credits rose by 34% to MR92,693 million.

3.2 Thailand
Regulations
Establishment of foreign bank branch offices in Thailand has started since the start of commercial bank activities in
1888. In the beginning, foreign banks were the most active banks, however, the government then puts a limitation on
foreign banks» activities, including on issuance of licenses to new foreign banks. As it progressed, that limitation was
subsequently eased by allowing foreign banks to open one branch office in Bangkok and foreign banks could open banks
with domestic legal entity form by giving majority ownership to Thai»s citizens. As such, there were no foreign joint
venture banks or subsidiary banks wholly owned by foreign parties.
This situation changed in the post-1997 crisis period due to the need for foreign capitals in order to save problem
banks. In this regard, the Thai government changed the regulation on foreign ownership limitation by giving an opportunity
to foreign parties to wholly own shares in financial institutions in Thailand for a period of ten years. Because of this policy,
at the end of 2001, there were four foreign joint venture banks operating in Thailand and several foreign banks have
entered the banking sector by opening branch offices. However, none of these banks have become public companies
and sold their shares in the capital market.
Currently, there are two categories of foreign banks, namely banks operating as branch offices and regular banks.
In accordance with the Commercial Banking Act, foreign ownership in banks are limited to 25% with the exception that
by the Minister of Finance»s approval foreign parties can have 100% ownership for a period of 10 years (hybrid bank).
Bank supervision is performed based on the same regulations. In addition, the following apply on foreign banks :
1. Ownership Structure : There is no requirement on ownership structure, unlike parent banks that depend on the
assessment of the supervisory authorities in the foreign banks» countries of origin.
2. CAR for foreign bank branch offices is determined at 7.5% while commercial banks and hybrid banks are obliged to
maintain CAR of 8.5%.
The Bank of Thailand is currently undertaking enhancement of banking policies into what is called One Presence
Policy in the framework of Financial Master Plan as follows :
1. Foreign bank branch office or hybrid banks can become full branch offices under prevailing regulation (Commercial
Banking Act).
2. Foreign bank branch offices can become hybrid banks, with the exception of 10 foreign banks on which a grandfather
clause on foreign ownership is imposed.
3. Foreign bank branch offices or hybrid offices can become subsidiaries when foreign ownership has reached 95%

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Baht mn Percent and there is no grandfather clause imposed on foreign

1,400,000 25.0
Loan Deposits Share of Foreign Banks Loans to Total ownership. After its establishment, the number of additional
1,200,000
20.0
1,000,000
branch offices a subsidiary can open is limited to only four.
15.0
800,000

600,000 10.0 Banks» Development

400,000
5.0 Foreign banks» performance seems to be declining as
200,000

- 0.0
evidenced by a decline in credits by Baht 786,266 million or
Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec Mar
1997 1998 1999 2000 2001 2002 2003 2004 64.2% to Baht 439,170 million. Post-crisis economic
Source: CEIC
recovery process is also followed by a decline in credit
Chart 9 Foreign Banks» Total Credits
and Third-Party Funds in Thailand channeling (credit rationing), both by domestic as well as
foreign banks. Foreign banks» share in credit channeling
after the establishment of the Thai Asset Management
Company (TAMC) in 2001 also dropped by Baht 147,374 (25.1%).
In line with the bank restructuring program in Thailand and implementation of Thailand Financial Master Plan, Bank
of Thailand has reviewed the existence of foreign banks. It is expected that the conversion of foreign bank branch offices
into foreign joint venture banks or local banks can boost the revival of bank intermediation through the role of foreign
banks.

3.3 Korea
Regulations
In the beginning, foreign banks in Korea faced restriction in operational activities. However, since the beginning of
1990, Korea has moved towards the direction of national treatment policy on foreign banks and eased the restriction by
revocation of limitation on number of branch offices that can be opened and allowing foreign ownership through the
establishment of foreign joint venture banks and subsidiaries that are wholly owned by foreign parties.
In post-1997 crisis period, the government of Korea sought funds in order to save two banks, namely Korea First
Bank and Seoul Bank, by inviting foreign investors. The
process took two years before there was agreement on sales
Won bn Percent
10000.00 2.50
Loan Deposits of shares. Although there has been quite large purchase of
9000.00
Share of Foreign Banks Loans to Total
8000.00 2.00 shares by Newbridge Capital at Korea First Bank in 1999
7000.00
6000.00 1.50 and a possibility to establish foreign joint venture banks, most
5000.00
4000.00 1.00
foreign parties that have entered the banking sector are still
3000.00
in the form of branch offices.
2000.00 0.50
1000.00
0.00 0.00
Dec Jun
1997
Dec Jun
1998
Dec
1999
Jun Dec
2000
Jun Dec
2001
Jun Dec
2002
Jun Dec
2003
Banks» Development
Source: CEIC
In post-1997 crisis period, mobilization of third-party
Chart 10 Foreign Banks» Total Credits
funds by foreign banks has experienced rapid expansion. In
and Third-Party Funds in South Korea
the period 1997 √ 2003, third-party funds rose by Won 7,644

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billion (or 737%). This was largely due to quite high public confidence in foreign banks and quite competitive interest
rate level.
Although in post-crisis period credit channeling has increased, foreign banks» credit channeling has relatively fluctuated
as reflected by a decline in outstanding credits in quarter III (September) 2001 by Won 768.93 billion (10.9%) from the
previous quarter due to bank restructuring program, which has prompted foreign banks to restrain from credit channeling.

3.3 Regulations on Foreign Banks in Several Other Countries

China
One of the websites provides information that in the beginning China allowed foreign banks to provide renminbi
for foreign companies and individuals, including citizens of Hong Kong and Macao. However, the more open banking
industry in China shows China»s commitment to fulfill the WTO agreement and widens foreign participation in its banking
industry»s reformation. This activity becomes China»s milestone in giving opportunity to foreign parties to be involved in
domestic business activities, both in foreign currencies as well as in local currency. CBRC (China Banking Regulatory
Commission) has boosted foreign role by easing regulations on foreign parties, which are strategically qualified in
participating in financial reformation by raising foreign individual investor»s equity share from 15% to 20%. CBRC also
amended the requirement on operating capital for foreign-financed financial institutions by reducing the minimum
requirement from US$72 million (600 million yuan) to US$60 million (500 million yuan) for the highest level, and from
500 million yuan to 400 million yuan for second highest level.

Canada
Foreign banks play quite a significant role in Canada»s financial sector. Currently, almost 42 foreign bank subsidiaries
operate with total assets reaching 10% of Canada»s domestic banks» assets. Several foreign banks also operate through
non-bank financial institutions such as insurance companies, securities, and leasing companies.
To optimize competition, foreign banks are allowed to operate as branches as well as subsidiaries. However, OSFI
still imposes several limitations on foreign banks operating as branches in Canada, which among others include :
1. Foreign bank branch offices are not allowed to receive retail deposits. The definition of a retail deposit is a deposit
at a value of below US$150,000. Foreign banks in the form of branches are allowed to receive deposits each with
a value of below US$150,000 as long as the total value of such deposits is still lower than 1% of total deposits
owned by the related branch.
2. In addition, in a condition that can endanger the financial system, the supervisory authority has the right to request
a foreign bank branch to maintain its assets in domestic currency for a certain amount.
3. Foreign banks in the form of branch offices can have indirect access through direct participation in the Canadian
Clearing and Settlement System. If a foreign branch office wants to have direct access to the Canadian Clearing and
Settlement System, the Canadian authority will undertake assessment of the insolvency laws of the origin country in
order to avoid conflicting regulations that might endanger the Canadian Clearing and Settlement System when the
foreign bank defaults.
4. When a foreign bank experiences an insolvent condition, the foreign bank»s branch in Canada will be liquidated, as

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is the case regarding Canada»s legal treatment of its legal entities. Assets owned by that foreign bank, whether
owned by the branch office or its subsidiaries would be used for settling claims on the defaulted foreign bank. At
the same time, the right of depositors of the subsidiary branch office will be protected.

4. THE ROLE OF FOREIGN BANKS IN BOOSTING CREDIT CHANNELING

4.1 Model
In most Asian countries» economies, foreign bank penetration is still a new phenomenon and as such empirical
studies on performances of foreign and domestic banks are still very limited. Mathieson and Roldos (2001) show that in
developing countries in Eastern Europe and Latin America, foreign banks in general have higher return on equity and
lower cost-to-income ratio, as well as lower NPLs compared to domestic banks.
Montgomery (2003) shows that return on assets, cost-to-income ratio, and problem loan ratio are important indicators
in assessing performance of foreign banks against that of domestic banks, particularly in post-crisis period. Therefore, in
this paper, analysis of foreign banks» performance in Indonesia will use these three indicators, which have been widely
used by economists in assessing foreign banks» performances in certain countries.
These indicators have also been used many times in previous studies, among others in a study on bank efficiency by
Berger and De Young (1997), which used NPLs, efficiency, capital (with the proxy of return on equity or assets) and ATMR
as indicators.
This paper will analyze in particular the influence of these indicators on foreign banks» performance in credit channeling.
Credit channeling is considered as an important indicator of bank role in boosting economic activities in developing
countries. Return on Assets (ROA) is an indicator, which when rises shows that bank assets have been optimally utilized
in earning income for the bank, and as such it is estimated that ROA and credit growth have a positive correlation. In
relation to bank business activities that boost the economy, a high ROA ratio shows that the bank has channeled credits
and earned interest income.
Another ratio, namely the operational expense to operational income (OEOI) ratio, shows bank efficiency level in
undertaking operational activities. Therefore, in this analysis, high OEOI ratio reflects a bank»s inefficient condition, where
as a consequence when the bank continues to channel credits it will experience a negative interest rate spread. This
condition will prompt a bank to reduce credit channeling in order to avoid larger losses and the bank would tend to
transfer its investments into marketable securities or fee-based income.
Non-performing Loans (NPLs) are calculated based on the share of a bank»s problem credits (collectability statuses of
3, 4, and 5) in total credits. If a bank»s NPLs are high the bank tends to reduce or stop extending credits (credit rationing),
which influences the bank management»s decision-making behavior in credit channeling. In an economic condition that
is considered less conducive, for example where the real sector has not fully recovered, a bank would tend not to channel
credits in order to avoid credit risk that is still high.
In addition, interest rate variable is also utilized by using the difference in monthly interest between federal funds
interest rate (monthly) set by the Federal Open Market Committee (The Fed) and SBI interest rate set by Bank Indonesia.
A rising difference will boost the banking sector, including foreign banks, to transfer their funds from credits to financial

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products in foreign currencies, particularly US dollar. Therefore, interest rate difference will be a market signal on bank
behavioral sensitivity to credit channeling and they have a negative correlation.
Industrial Production Index (IPI) also constitutes a market signal used for measuring production output. Rising IPI
reflects a positive signal on improving (booming) industry condition and will boost the banking sector to provide funds
(credits) for business makers.
In a mathematical format, the correlation between each variable can be illustrated as follows :

l k
Li,t = α + Σ Σ βi,k+εi,t
i=l k=l

In order to give a clearer illustration, the five dependent variables, namely Income (Return on Assets/ROA), Efficiency
(Operational Expense over Operational Income/BOPO), Problem Credits (Non-Performing Loans/NPL), Difference between
Indonesia»s and US interest rates (Interest Rate Differential/INT) and Industry Growth (Industrial Production Index/IPI),
starting from the month of January 1999 through May 2004 can be formulated as follows :

Lit = const + β1 ROA − β 2 BOPO − β 3 NPL − β 4 INT + β 5 IPI + ε it

t = {January 1999,..., May 2004} and i = {1,..,5}

The main purposes of this estimation is to obtain a complete model of several variables and its influence on overall
credit growth as well as to compare the condition of a certain bank group relative to the conditions of other bank groups.
For this consideration, this analysis will focus on relative values
Table 1
of the estimation results on the constants β 1 , β 2 and β 3 . In
Hypothesis and Interpretation
principle, this parameter will give information on level of credit
No. Cases Interpretation
growth. Bank group that has the larger value of β shows a
1 β1 = β2 = β3 = β4 = β5 = 0 It is proven that foreign banks only play a
small role in boosting economic growth potential for undertaking larger credit channeling, while one
through credit channeling.
with smaller value of β shows a limitation in undertaking
2 β1 = β2 = β3 = β4 = β5 ? 0 It is proven that foreign banks only play a credit channeling. The following table shows problems that
small role in boosting economic growth
through credit channeling. will be further reviewed.

4.2 Estimation Results

Estimation is performed using the regression model on overall as well as partial bases based on bank group, namely
foreign bank group, foreign joint venture bank group, and domestic bank group. This method is adopted in order to
obtain sharper analysis results by comparing a bank group with its peers and as such more realistic regression results will
be obtained.
a) Analysis on overall bank groups using the OLS method produces estimation that on average bank groups, including
foreign bank groups, have shifted from credit channeling to activities that earn fees (fee-based income) and foreign
bank group has relatively similar behavior as domestic bank group.

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Credit channeling is declining as efforts to step up efficiency are more directed at efforts to reduce credit channeling,
which incurs relatively additional costs for administration and compensation for credit risk that is still considered
high.
NPLs also become an important consideration for banks in channeling credits. Based on estimation, it is proved that
in general rising NPLs have prompted all banks to reduce credit channeling. In a condition where the real sector has
not fully recovered, banks consider additional credit extensions have the potential to create risk, which could disrupt
banks» performance in the future.
In addition, income target that is measured by return on assets ratio constitutes the most influential factor on bank
credit channeling. In the case of domestic banks, particularly recapitalization (recap) banks, ROA or ROE targets
prompt bank management to put priority on high income by undertaking placements in marketable securities and
reducing credit channeling that has the potential to raise bank administrative costs. Meanwhile, in the case of
foreign banks, rising ROA is particularly achieved through a step up in fee-based income earning activities, such as
trade finance, credit cards, etc.
Foreign bank branch offices show similar behavior as domestic banks in viewing ROA, OEOI, and NPLs as points of
consideration in undertaking credit expansion. An increase in ROA of 1% will lower credit growth by 42.1%; an
increase in OEOI by 1% will also lower credit growth by 0.9%; and based on the last indicator, NPLs, an increase in
NPLs by 1% will have an impact in credit contraction by 5.2%.
With its NPL condition as the highest among the bank groups, foreign banks tend to contract credit channeling and
put more focus on fee-earning activities as well as activities related to consumption credit channeling, which credit
ceilings are not too high while the tenors are short such as credit cards.
In the case of foreign joint venture banks, changes of 1% in each of the indicators do not bring quite so large
influence on bank credit channeling activities. Compared with other bank groups, the change in credit growth
of the foreign joint venture banks is relatively small as reflected by 38.2% change - in response to the change
in ROA, 3.9% change - in response to the change in OEOI, and 1.5% change - in response to the change in
NPLs.
Credit channeling performance of the foreign joint venture banks proves to be not so sensitive as the foreign
banks», which is very much influenced by a small change in each indicator as well as in market signals, namely
interest rate and industry index. This proves that although foreign joint venture banks are still influenced by
funding contributions from bank owners, the banks still give sufficient contribution to credit channeling in
Indonesia»s economy.
This phenomenon of course can be taken up as a consideration in policy determination concerning a step up in
foreign banks» role in credit channeling by changing the requirement for their legal entity form to that of foreign
joint venture banks or banks with Indonesian legal entities. The benefits for Indonesia are that not only would it
strengthen the commitment of bank owners and management, it could also reduce systemic risk at a time when
foreign funds are needed to strengthen bank capital.

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b) Based on analysis using the OLS method, the following estimate results are obtained :

Table 2
Regresion Output by Ordinary Least Square

Bank Group Constant ROA OEOI NPL INT IPI

Foreign Banks 1.51 -0.29 -0.08 -0.02 -0.37 0.01

# of observations = 320 (0.04) (0.65) (0.33) (0.77) (0.00) (0.91)
Joint Venture Banks 0.68 0.42 -0.05 0.02 -0.48 0.00
# of observations = 320 (0.47) (0.62) (0.53) (0.75) (0.00) (0.96)
Domestic Banks 0.72 0.38 0.05 -0.17 -0.44 0.05
# of observations = 320 (0.02) (0.09) (0.14) (0.02) (0.00) (0.36)

Source : Bank Indonesia and CEIC, processed.

Estimation results show signals in line with expectations that are based on assumptions of economic and financial
theories. However, there are several interesting phenomena. One phenomenon concerns foreign banks» ROA
coefficient of -0.29 that is different than preliminary expectation. This explains why a rise of 1% in ROA has
prompted credits to drop on average by 29%. This condition is not too shocking because based on data it has been
shown that foreign banks» credit growth is relatively low because their focus is on fee earning activities and credits
for the consumption sector.
Another phenomenon concerns the existence of a conflicting signal for NPLs at foreign joint venture banks, where a
rise of 1% in NPLs prompts a rise of 2% in credits. This condition stems from the fact that foreign joint venture
banks keep extending credits given by parent companies to their subsidiary companies in Indonesia. In addition,
most credits extended are in foreign currencies that are relatively not volatile against rupiah fluctuations.
Domestic banks also have an interesting phenomenon, where a rise in OEOI is followed by a rise in credits. A rise in
OEOI by 1% prompts a rise in credit channeling by 5%. This stems from the fact that funds deposited by customers
are still high and there is a rise in other income coming from government bonds and a rise in consumption credits,
particularly home ownership credits and vehicle ownership credits.
Estimation also shows that foreign joint venture banks and domestic banks are more sensitive to changes in market
signals compared to foreign banks. This stems from the fact that foreign banks» funds come from their headquarters
and as such they are not sensitive to changes in Indonesia»s macroeconomic condition. Nonetheless, foreign banks
show high level of volatility in credit channeling and tend to be contractive in post-crisis period.

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4.3 Empirical analysis of Capital and Loan of Foreign Bank

The estimation of capital and loan of foreign bank using Least Square Method is presented as follows:

Table 3
Regresion Output by Ordinary Least Square

Dependent Variable: LN_MODAL

Method: Least Squares
Date: 09/16/04 Time: 19:24
Sample(adjusted): 2000:09 2004:07
Included observations: 47 after adjusting endpoints

Variable Coefficient Std. Error t-statistic Prob.

C -1,673962 0,914654 -1,830158 0,0742

LN_ATMR 0,842146 0,106874 7,879832 0,0000
LN_NPL(-1) 0,072976 0,033022 2,209926 0,0325
LN_LOAN_DITA 0,097721 0,022747 4,295912 0,0001
R-squared 0,675745 Mean dependent var 6,859306
Adjusted R-squared 0,653122 S.D. dependent var 0,101765
S.E. of regression 0,059936 Akaike info criterion -2,709816
Sum squared resid 0,154470 Schwarz criterion -2,552356
Log likelihood 67,68067 F-statistic 29,87052
Durbin-Watson stat 1,218106 Prob(F-statistic) 0,000000

The result will be used to estimate the required additional bank»s capital in the future for providing additional loan
to the economy. By using July 2004 data, inasmuch bank required to supply 1% loan increase or Rp 391,4 billion, the
bank needs additional capital approximately Rp 59,2 billion. Since, the aggregated CAR of foreign bank is quite high
(15,3%), the additional capital needed due to the increased of loan growth may not be necessary. The impact of increasing
1% of loan only reduce capital by 0,1% which is relatively low and it will not have negative impact to the banks» CAR
individually. By assuming CAR of foreign bank is adjusted to 12%, the economy will receive additional Rp 15,9 trillion
from the foreign banks

4.4 Analysis of Business Fund In The Calculation of Foreign Bank»s Capital

The entry of banks that domicile abroad into Indonesia through the opening of branch offices is the consequence of
the open economic system adopted by Indonesia. Naturally, their presence is expected to increase banking sector»s role
in advancing Indonesia»s economy. In order for that expected role to be realized, foreign bank branch offices operating in
Indonesia are not exempted from having to implement sound banking practices. One of the main quantitative indicators
for determining whether foreign banks are implementing sound practices is fulfillment of the minimum reserve requirement
ratio or what is commonly known as Capital Adequacy Ratio (CAR).
As such, it is obvious that a bank»s capital is an important component in the calculation of the minimum reserve
requirement. The operation of a bank, which domiciles abroad, in Indonesia basically does not constitute a permanent
business entity but is only a branch office. Naturally, in a branch office there is no capital component. The concept of
capital in a branch office is the capital of its headquarter.

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In view of this condition and in consideration of the importance of capital in the calculation of the minimum reserve
requirement, Bank Indonesia has issued several regulations on foreign bank branch office capital. The latest regulation is
Director»s Decree number 32/37/KEP/DIR dated 14 May 1999. The existence of a regulation, which requires that a foreign
bank branch office must have its own capital, does not mean that the problem with foreign bank branch office capital is
totally solved.
This stipulation still raises a deep question of whether this concept of capital that consists of several components
can accurately define capital and as such when used in the calculation of the minimum reserve requirement will give a
reliable figure for minimum reserve requirement. From evaluation results there are several weaknesses in this concept for
calculating foreign bank branch office capital.
The May Package states that the capital for a branch office of a bank that domiciles abroad consists of net funds of
the headquarter and branch offices outside Indonesia (net head office funds), which among others comprise reserve from
after-tax profit of the Indonesian branch office, provision for earning assets losses (PEAL), reserve for fixed asset revaluation,
retained earnings, last year profit, current year profit, and net interoffice fund (NIOF).
The foreign bank branch office capital regulation under the May Package was amended by Director»s Decree number
32/37/KEP/DIR dated 14 May 1999. This latest decree requires that a foreign bank branch office uses the concept of
business fund to replace NIOF. Other components of capital are not changed by this latest decree and therefore remain
valid. Business fund is fund received from the foreign bank branch office»s headquarter abroad, which is expected to be
recorded on the foreign bank branch office» balance sheet for as long as it is in operation. If the foreign bank branch
office subsequently places back this fund at its headquarter or other branch offices abroad, the part that is placed back
reduces the bank»s business fund. This concept of business fund does not regulate declared business fund.
Based on the evaluation of foreign branch office capital components, there are several issues that cause the estimation
does not reflect the true value of bank capital. These weaknesses are as follows :
Total business fund might not reflect the real situation because of possibility of window dressing
With reference to the definition of business fund, there is a possibility for a foreign bank to window-dress its branch
office»s business fund so that the foreign bank branch office»s CAR looks good. Window dressing can be applied as
follows :
- On report dates, bank headquarter transfers fund to its branch office in Indonesia to improve its business fund.
- Bank only makes record but the fund itself is never transferred. This is possible because bank headquarter and its
branch office have one accounting book or they can be called as one accounting entity. This situation gets worse
because the branch office is not required to declare business fund, which is influenced by this transfer, to Bank
Indonesia»s Foreign Directorate and as such bank supervisors cannot monitor the existence of such transfer.
The amount of business fund does not reflect actual situation because of high frequency of transfers between a
foreign bank branch office and other branch offices as well as its headquarter
The possibility exists for a foreign bank»s headquarter window dresses its business fund in order to ensure that its
CAR fulfills requirement. However, there is one possible extreme situation where a foreign bank does not care about the
performance of its CAR and as such places back fund at headquarter or other branches. In this situation, this placement
has to be calculated as a reduction to business fund, which in the end would worsen its CAR. This situation is possible

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because most foreign banks that have branch offices in Indonesia are multi-national corporations that consider all sides of
the world as places where they can seek profits. Another possible extreme situation is when all branches of a foreign
bank race to transfer funds into Indonesia through headquarter and then through the branch office in Indonesia because
they consider there is a big opportunity for them to seek profits in Indonesia. These two possible extreme situations give
a picture of how fluctuant business fund can be, which makes it difficult for business fund to be one of capital components
in Indonesian foreign bank branch office capital.

5. CONCLUSIONS
Based on results of an analysis on all bank groups using the OLS method, estimation is obtained that on average
bank groups, including foreign bank groups, have shifted role from banks that extend credits to banks that undertake
activities that earn fees (fee-based income).
Results of estimation on overall bank groups confirm a phenomenon that exists amongst foreign banks where
although in efficiency and problem credit aspects foreign banks have similar behavior with domestic or foreign joint
venture banks, but from the point of view of income, foreign banks put more focus on income coming from non-credit
sources (42.1%).
In addition, based on an empirical study of each bank group, foreign banks are less sensitive to changes in domestic
condition signals compared to foreign joint venture and domestic banks. This stems from the fact that foreign banks»
funds relatively depend on funds coming from their headquarters and as such they are less sensitive to changes in
Indonesia»s macroeconomic condition. In addition, foreign banks also show high level of volatility in credit channeling
and tend to be contractive in post-crisis period.
In relation to weaknesses in the presentation of business fund in foreign bank branch office capital, the following
can be concluded :
√ The concept of capital regulated under BI Director»s Decree number 32/37/KEP/DIR dated 14 May 1999 should be
improved in calculating capital. This stems from the fact that one of the components of capital, namely business
fund, has weaknesses in its presentation.
√ The inaccuracy of this capital concept could make the result of calculation of the minimum reserve requirement not
as it should be.
√ The inaccuracy of this capital concept could make it not possible for the capital to be used as a buffer in anticipating
potential losses at the foreign bank branch office and cannot be used as a tool for controlling the foreign bank
branch office»s asset development.
The above condition of course can be taken up as a consideration in policy determination concerning a step up in
foreign banks» role in credit channeling so that foreign banks can play a greater role in domestic economic development
and be the motivator for foreign investors to reinvest in Indonesia.

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References
Berger and Robert DeYoung (1997): ≈Problem Loans and Cost efficiency in Commercial Banks∆ Journal of Banking
and Finance, Vol. 21..
Cho, Y.J. (2002), ≈Towards Stronger Banking Sector: Lessons from Bank Restructuring in Korea after the Crisis∆,
mimeo., Asian Development Bank Institute
Clarke, G., R, Cull, M.S.M. Peria, and S. M.Sanchez
M.Sanchez: (2001) ∆Foreign Bank Entry: Experience, Implications for
Developing Countries, and Agenda for Further Research,∆ mimeo. World Bank, 2001.
Crystal, J.S., B.G. Dages and L. Goldberg (2001), ≈Does Foreign Ownership Contribute to Sounder Banks in Emerging
Markets?: The Latin American Experience,∆ in R.E. Litan. P. Mason, and M. Pomerleano (eds)., Open Doors: Foreign
Participation in Financial Systems in Developing Countries. Washington, D.C., Brookings Institution Press.
Goldberg, L. B.G. Dages and D. Kinney (2000),∆Foreign and Domestic Bank Participation in Emerging Markets:
Lessons from Mexico and Argentina,∆ NBER Working Paper 7714.
Mathieson, D.J.., and J. Roldos
Roldos: (2001) ≈The Role of Foreign Banks in Emerging Markets, ≈ in R.E. Litan, P. Masson,
and M.Pomerleano (eds), Open Doors: Foreign Participation in Financial Systems in Developing Countries. Washington,
D.C.: Brookings Institution Press, 2001.
Miller S. and A. Parkhe
Parkhe(1998)∆ Patterns in the Expansion of U.S. Banks» Foreign Operations,∆ Journal of International
Business Studies, 29(2), 359-390, 1998.
Montgomery, H
H. (2003)≈ Do Foreign Banks Provide More Stable Credit?∆, Journal of Asian Development Bank
Institute, Dec. 2003
_______________
_______________.(2003) ≈The Role of Foreign Banks in Post Crisis Asia: The Importance of Method of Entry∆, Asian
Development Bank Institute Research Paper No. 51, January 2003.
Peek, J.E. Rosengren, and F. Kasirye (1998): ≈The Poor Performance of Foreign Bank Subsidiaries: were the Problems
Acquired or Created,∆ Federal Reserve Bank of Boston Working Paper 98.
Reynoso, A.
A., (2002) ≈Can Subsidiaries of Foreign Banks Contribute to the Stability of the Forex Market in Emerging
Economies? A Look at Some Evidence from the Mexican Financial System≈National Bureau of Economic Research Working
Paper No. 8864, April 2002.
Santiprabhob,V. (2002):∆Lessons Learned from Thailand»s Experience with Financial Sector Restructuring,∆ mimeo.
Asian Development Bank Institute.

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 Article II

Article II

The Model To Predict Bankruptcy

for Commercial Banks in Indonesia
1) 2)
Muliaman D. Hadad, Wimboh Santoso,
Sarwedi, Hari Sukarno, Moh. Adenan 3)

Abstract

The objective of this research is to establish a model for the prediction of bankruptcy for commercial
banks both overall as well as for each group of commercial banks in Indonesia based on the financial statement.
The analysis used is the Factor Analysis and Logistic Regression. As independent variables are the capital
ratios’ factors, the financial risks and the dummy variable of time variation, while as dependent variables is the
bank bankruptcy. The result of the research shows that from the three prediction models, which succeeded in
being established, it turned out that only MP3 was adequately to be used as the prediction model for bankruptcy
for commercial banks in Indonesia. At the level of modeling, MP3 possesses a classification accuracy of
94,9% (default cut-off = 0,5) or 94,2% (specification cut-off = 0,939) while at the level of model validation it
owns a classification accuracy of 82,6% (default cut-off = 0,5) or 89,8% (specification cut-off = 0,939). The
prediction model for bankruptcy for each group of banks was also established with the MP3 Formula through
dummy substitution of the bank’s group.

Classification JEL: G.21

Keywords : Bankruptcies, logistic regression, factor analysis, financial risk.

1. Head of Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : muliaman@bi.go.id
2. Executive Researcher at Financial System Stability Bureau - Directorate of Banking Research and Regulation, Bank Indonesia; email addess : muliaman@bi.go.id
3. Lecturers, Department of Economics, State University of Jember

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1. INTRODUCTION
1.1 Background of the Problems
At present the business world is in a fast moving competitive environment. According to the Basel Committee on
Banking Supervision (1999), recently the world financial system has shown the presence of an economic turbulence. A
turbulence in a financial system may create explicitly several threats, which may weaken the competitive power of a bank.
It may probably even be eliminated from the banking industry. In order to maintain the life expectancy in a turbulent
financial system, a bank must be able to compete with competitor banks and their other financial intermediary units,
which also render financial services» service. A bank management, which is creative and innovative shall always endeavor
to create several profitable prospective bank services» products without neglecting the principle of asset liability management
(ALMA), i.e. adjusting itself between profitability and risk.
The economic crisis knocking down Indonesia since the middle of 1997 for example, has brought a less profitable
change almost to all aspects of the nation»s life. According to data from BPS for the years 1995 and 1996 in a row: the real
GDP growth was 8,21% and 7,82%; the GDP per capita was US$1, 023 and US$1,128; the inflation rate was 8,6% and
6,47%. In line with the occurrence of the economic crisis, all said achievements drastically decreased. Still according to
data from BPS, the real GDP growth was minus 13,7%; the GDP per capita was US$ 487; and the inflation rate soared to
become 77,6%. These facts gave the Indonesian a profuse feeling of optimism. In addition, it also showed that all former
achievements turned out not to be supported by a strong infrastructure, such as an irrational debt to service ratio
(DSR>30%) and the fragile banking sector, such as an inclination of the lowering of profit and the increasingly business
risk faced by the banks.
In order to anticipate the appearance of financial problems at banks, a system needed to be compiled, which could
give early warnings of a financial problematic threatening the bank»s operations. The capital factor and the financial risk
had an important role in explaining a bank»s bankruptcy phenomena. By detecting very early the banking condition, it
would be very probable for bank to take anticipative steps in order to avoid, such that the financial crisis could immediately
be taken care of. Referring to the explanation above, the problem forwarded through this research is whether bankruptcy
in commercial banks in Indonesia may be predicted through their financial reports? Specifically the problem to be thoroughly
investigated may be formulated whether bankruptcy of each bank group in Indonesia can be predicted?

1.2 The objective of the Research

Several objectives which intended to be achieved through this research was to establish a model to predict bankruptcy
in commercial banks as well as in each bank group in Indonesia based on the financial report of the respective bank.

2. BIBLIOGRAPHY REVIEW
2.1 Agency Theory and the Bank»s Failure
The Agency Theory, explains the contractual relationship between principals and agents. The party of the principals
is the party giving mandate to another party, i.e. the agent, to carry out all activities on behalf of the principal in his
capacity as decision maker (Sinkey, 1992:78; Jensen & Smith, 1984:7).

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According to Sinkey (1992:79), one of the most important relationships of principals-agents in the financial sector
and the financial services» industry is depositor-borrower (i.e. the bank).
Each party has a very potential rational importance to emerge problems. There are two types of problems in said
relationship of principals - agents (Arrow, 1985 in Sinkey, 1992:78), that is an unknown action (hidden action) and
unknown information (hidden information).
The findings of Pantalone & Platt (1987) and other researchers show that the main reason for a bank»s failure is poor
management of the bank, the result of being too daring to take risks, and the scarce supervision towards fraud acts and
embezzlement of funds. Sinkey (1992:196) said that the acts of such bankers such as fraud, authority misuse and banking
crime actions constitute examples of a hidden action, while evaluation of errors towards the on-and off balance-sheet
constitute examples from hidden information. At the moment the signal of bankruptcy arises, the depositor party (principal)
shall have the right to withdraw his savings from the bank (agent). Consequently the Agency Theory can be explained
relationally the depositor-borrower (e.g. bank) as well as the emergence of the phenomena of the bank»s failure.

2.2 The Analysis Profile and the Analysis Distress Prediction

Historically the study on business bankruptcy cannot be separated from the existence of the profile analysis and
prediction distress analysis study. The pioneer of the study on profile analysis is Fitz Patrick, 1932; Winakor & Smith, 1935:
and Merwin, 1942 (Beaver, 1966), while the pioneer of the prediction distress analysis is Beaver for the univariate model
and Altman (1968) for the multivariate model. At the profile analysis it is shown that there is a clear difference between
financial ratios of bankrupt companies and solvent ones. The Prediction distress analysis stresses more on the information
of prediction capacity of the financial report regarding one important matter, for example the business bankruptcy. The
result of the overall study is based on the value and average financial ratios of a company (for profile analysis) and in how
far its dispersion (for prediction distress analysis) for some time prior to bankruptcy.

2.3 The Empiric study on Bankruptcy prediction

The pioneer of the study on bankruptcy is Beaver (1966), and Altman (1968). Both used accountancy data from the
balance sheet and the profit-loss reports from manufacturing companies in the form of financial ratios as discriminator
variables and bankruptcy predictors.
Beaver (1966), used the single variable with the period 1954-1964. The sample proportion of bankrupt and non
bankrupt manufacturing and non-manufacturing was 79:79 (1 year prior to bankruptcy), 76:77 (2 years prior to bankruptcy),
75:75 (3 years prior to bankruptcy), 62:66 (4 years prior to bankruptcy), 54:63 (5 years prior to bankruptcy). As many as
30 financial ratios were classified in the group cash flow ratios, net income ratios, debt to total asset ratios, liquid asset to
total asset ratios, liquid asset to current debt ratios, and turnover ratios. 6 ratios were chosen as variables to be analyzed.
Its result was, all the six financial ratio variables in an univariate way could classify between bankrupt and non-bankrupt
companies for 1 up to 5 years prior to bankruptcy. The closer to the time of bankruptcy the lower the level of classification
errors.
The prediction for bankruptcy with the multivariate model was pioneered by Altman (1968). During the period
1946 √ 1966 samples of 33 bankrupt manufacturing companies were used in the USA and from 33 companies, which

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were not bankrupt. Through the multiple discriminant analysis and 5 of the most significant financial ratios measured the
profitability, liquidity and solvability, the popular Altman Formula called Z-score is :

Z = 0.012 X1 + 0.014 X2 + 0.033 X3 + 0.006 X4 + 0.999 X5

in which : X1 : Working Capital /Total Assets; X2 : Retained Earning/Total Assets; X3 : Earning before Interest and
Taxes/Total Assets; X4 : Market Value Equity/Book Value of Total Debt; X5 : Sales/Total Assets and Z : Overall Index
The closer to the time of bankruptcy the higher level of prediction accuracy.
Several researchers abroad have developed the bankruptcy prediction model for banks. Among others : Meyer &
Pifer (1970); Stuhr & Wicklen (1974); Sinkey (1975); Korobow, Stuhr & Martin (1977); Santomero & Vinso (1977); Martin
(1977); Shick & Sherman (1980); Pettway & Sinkey (1980); Peterson & Scott (1985); Short, O»Driscoll & Berger (1985);
Bovezi & Nejezchleb (1985); Sinkey, Terza & Dince (1987); Pantalone & Platt (1987); Whalen & Thompson (1988); Randal
(1989); Young (1999); Hermosillo (1999); and Estrella & Peristiani (2000).
Research in respect of bankruptcy in commercial banks in Indonesia has ever been conducted by Wimboh Santoso
(1996), Indira & Dadang Mulyawan (1998), Abdul Mongid (2000), Titik Aryati & Hekinus Manao (2000), Etty M Nasser &
Titik Aryati (2000), Tengku N. Qurriyani (2000) Wilopo (2001), and Sri Haryati (2001).

2.4 The Validation Model Experiment

According to Beaver, Kennelly & Voss (1968), if the objective of a research were to predict an event, then logically
speaking an empirical comparison should be conducted. Its relation with the study on bankruptcy prediction, the estimate
of the probability of failure constitutes a signal in classifying firm i to one of the bankrupt and non-bankrupt groups.
(Ohlson, 1980). Rencher (1995; 334) states that in order to evaluate the ability of the classification procedure in predicting
membership of a group, the misclassification probability was used, called error rate. The errors may be known through
the validation experiment, comprising comparison with their actual data so that error type I and II may be known. At
another part, Ohlson (1980) said that a good prediction model is a model possessing a minimum sum of percentage
errors.
According to Hair, et. al (1998 √ 194), the empirical validation approach is the most suitable to experiment the
regression model based on a new sample lowered from the population. The researchers divide the research sample to
become 2 groups: the design sub sample to make the regression model and the holdout/validation sub sample to be used
for experiment of the regression model. According to Sumarno (1994;50) generally for the model experiment in the
research of the failure prediction is making use of the classification accuracy method both at the design as well as at
validation samples.
The size sample ratio for n-design samples is larger than n-validation samples. Hair et. al (1998;254) said, there is
no certain reference in dividing samples to become analysis groups and validation groups. Researchers like the division
of 60-40 or 75-25. Besides, the sample size for each dichotomy characteristic (failed √ non-failed) of the dependent
variable is not always the same (in pairs) so that both the design samples as well as the validation samples may be pair
or non-pair samples.

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3. METHODOLOGY
3.1 The Research Planning
This research is included in predicting organizational outcomes. Therefore, this first phase research established a
dependent variable prediction model and at the same time conducting its validation experiment. Later, it continued to
experiment the model validation based on new data (holdout samples).

3.2 The object and Research Population

This research object was ≈Commercial Banks∆ in Indonesia. The argumentation of choosing said object was that (a)
all commercial banks activities influence the national economic system, and (b) at present they have become the target of
the banking recapitalization program, carried out by the Indonesian Government. The group Bank Perkreditan Rakyat
(BPR) was intentionally not included as its role was felt less significant compared to the group Commercial banks.
The population in this research was ≈ all commercial banks∆ in Indonesia. The scope ≈commercial banks∆, which
was investigated comprised the state-owned, private, regional government , joint venture, and foreign banks. The
time period of investigated population were the monthly data from the period January 1995 up to December 2003,
while the establishment phase of the prediction model and its validation was separated between population for modeling
and population for validation. According to Sumarno (1994:23), a model should actually be evaluated by testing its
prediction accuracy based on design and validation sample. As long as the data used for validation accuracy are
different from the data used to establish the classification function (or prediction), the error rate obtained was unbiased
(Rencher, 1995:337).

3.3 The Variable operations and Research Data

The variables used comprised dependent and independent variables. Capital ratios, financial risks and time variations
(XT) constitute independent variables, while the condition of the bank to be predicted, i.e. the status of the bank»s
bankruptcy constituted a dependent variable (Y).

Capital Ratios
The measurement showing the level of the existence of a certain capital amount to protect depositors, to cover
losses and to protect the going concern bank, to buy fixed assets for the smoothness of the bank»s services service, and
in order to comply with the provision of the regulator»s party for protecting incorrect asset expansion (BC. Leavitt, in
Hempel et al., 1994:266). The ratios were : X2 ≈ (CAP1): capital to deposits; X3 ≈ (CAP2): equity to deposit; X4 ≈ (CAP3):
loans to equity; X5 ≈ (CAP4): loans to capital; X6 ≈ (CAP5): fixed assets to equity; X7 ≈ (CAP6) : fixed assets to capital; X8
≈ (CAP7): equity capital to total assets; X9 ≈ (CAP8): net open position to capital: X10 ≈ (CAP9): return on equity; X11 ≈
(CAP10): return on capital.

Financial Risk Ratios

The measurement showing the relative level on the consequence of the management decision taking in several
financial dimensions in order to achieve the expected return. A high return was usually only possible by also taking high

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risks, and the other way around (Short et al., 1985; Fraser & Fraser, 1990;30 and Hempel et al., 1994:68 and 272). Said
ratios were: X12 ≈ (Risk1): Liquidity Risk = (liquid assets-Short term borrowing) to total deposits; X13 ≈ (Risk2): Capital Risk =
equity to risk assets (= assets √ cash √ clearing BI √ Government Negotiable Papers); X14 ≈ (Risk3): Credit Risk = productive
assets classified (APYD) to productive assets (AP); X15 ≈ (Risk4): Deposit Risk = equity to total deposit; X16 ≈ (Risk5): Off -
Balanced Sheet Risk = loan commitment to fee income; X17 ≈ (Risk6): SOB1 Risk = Loans to assets; X18 ≈ (Risk7): SOB2 Risk
= Treasury Securities to assets; X19 ≈ (Risk8): SOB3 Risk = Other Securities to assets; X20 ≈ (Risk9): SOB4 Risk = Capital to
assets; X21 ≈ (Risk10): SOB5 Risk = core deposits to total liabilities; X22 ≈ (Risk11): NPL Ratio = Non Performing Loans to Total
Loans.
The use of the capital ratio indicators and financial risks was because : (1) wishing to be more realistic representing
the quality of the bank»s management, (ii) at the previous empirical study, the capital ratios constituted indicators which
almost always became the reason for the failure of a bank, and (iii) every bank»s management decision could raise risks
combinations, which might have the role of deciding a bank»s failure. Consequently, said ratios were meant as a proxy
towards the quality of the bank»s management in managing capital and its risk portfolio.
The condition of a bank predicted was expressed by the status of a bank, bankrupt or not. A bank having the status
of being bankrupt was a bank in the situation of legal bankruptcy, where a company was legally declared bankrupt
based on the bankruptcy law (Altman: 1992, in Brigham & Gapenski, 1997; 1034-5).A bankrupt bank in this study
comprised a bank of the status of a liquidated bank (BDL), a bank which stopped its operations (BSO), a bank take over
(BTO), a bank which business operations were suspended (BBKU) and a bank merger.
The argumentation of the use of some definitions of said bankrupt banks, was that the phenomena of a bank»s
bankruptcy legally only started in Indonesia, since the Government liquidated 16 BUSN on 1 November 1997, followed
by the policy of bank suspension (4 April and 21 August 1998); i.e. the policies on BTO, BBO, BBKU and the Recapitalization
Program, while said happenings almost never happened in the previous years. In the period prior to the 1st of November
1997, such banks maintained to be operating as a depository institution. Theoretically, a liquidation condition, suspension
of operations and a bank merger cannot happen, but were always preceded by said bank to experience financial
problems. Therefore, prior to the implementation of said policies there were several banks, which experienced financial
problems.
The time variation of the independent variable (XT) and the variable on the bank»s bankruptcy status have the
character of dichotomy. If XT=0, stating a time prior to the crisis (prior July 1997), and, XT=1 stated the time prior to the
crisis (after July 1997). Then if Y=1, stated that a bank was bankrupt and Y=0, stated that a bank was not bankrupt.
Consequently, the variable (XT) and Y constituted dummy variables and possessed the measurement of nominal scale.
Other independent variables possessed the measurement of ratio scale
scale, i.e. the capital ratios» variables and the bank»s
financial risks obtained from the data arithmetic process in the balance sheet and the bank»s profit-loss report.
The type of data used was secondary data, in the form of a monthly Bank»s Financial Report compiled periodically
from January 1995 up to December 2003. According to Sumarno (1994:23), a model should actually be evaluated by its
prediction accuracy based on design and validation sample. As long as the data used to validation accuracy differed from
the data used to establish the classification function (or prediction) the error rate obtained is unbiased. (Rencher, 1995:337).
Data from the months of January 1995 up to December 2000 were used as population for a design model while the data

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of the months January 2001 up to December 2003 were used as population for a validation model. Said data was
obtained from Bank Indonesia (KBI).

3.4 Analysis Method

The prediction model was established based on the logistic regression model, with the formulation expressed by
following equation:
1
Pit = E Y = 1 Xi . t − k = J
−( β 0+ Σ βi X ij .t −k )
j =1
1+ e
J
1
or Pit = −Z ; and Zit = √0+ Σ √j Xij.t-k
1 + e it j =1

j = 1,2, J dan k = 3,6, 12

in which: Pit : opportunity of the first bank bankrupt(Y=1); 0≤Pi ≤1

Xij : predictor variable j for the first bank
Zi : linier function from predictor variable; -∞ ≤ Zi ≤ +∞
t : time when the bank is bankrupt
k : period (month) prior to the bank being bankrupt
e : natural logaritm; e = 2,71828
‘ : regression coefficient

Value Y depends on the coefficient ‘j and explanatory variables Xj (j = 1, 2, º, J). Because this research used the
panel data, the assumption stated that the parameter coefficient is all the time the same and for all units (bank) cross
sectional, will cause all estimators in said panel data to become inefficient. Therefore, it needs to be reviewed whether the
effect at every unit (bank) cross sectional (_) and the length of time of the time series(l) constitute fixed effects or random
effects. In the event said effects are fixed effects, then the problem of an estimator who is not efficient can be overcome
by using dummy variables for the estimator and it seems that its regression equation coefficient slope is not connected.
On the other hand, if said effects were random effects, then the problem of the estimator who is inefficient can be
overcome by Error Component Models for Intercept (Mundlak, 1978 in Wimboh, 1996).
To determine fixed or random effects at a model to be used depends on whether there is a correlation between
each unit (bank) cross sectional (_i) and independent variable (Xi). In the random effects a most efficient estimator will be
produced when there is a correlation between (_i) and (Xi) with a certain/known distribution assumption (_i) known.
Judge (1985, in Wimboh, 1996) states that said random effects may produce an inefficient estimator when the (_i)
distribution, which actually turned out to be different with the distribution _i assumed known. Judge also suggested that
whatever the existence of the correlation between _i and Xi the dummy variable estimator constitutes a sufficient
adequate estimator for a small N. Referring to the opinion of said Judge, the dummy variable estimator to be used in this

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research is proven to be valid, as he only used 6 groups of cross sectional banks (N=6, i.e. : Government Bank group,
Foreign Exchange BUSN, Non-Foreign Exchange BUSN, BPD, Mixed Banks, Foreign Banks) and distribution _i was not
exactly known. In other words, the logistic regression model by involving 6 bank groups used in this research means that
it has already taken into consideration the random effects.
Then, if the logistic regression model used has taken into consideration the fixed effects, its assumption is that
intercept and its coefficients» slope is not the same among the bank groups. However, individually at each bank group the
extent of the intercept and said coefficient slope are the same as long as the time series. Consequently, a treatment will
be conducted towards equation (1) by using independent variables XT (time variation) having the character of ≈biner∆ as
proxy, the importance to consider the time variation. If XT = 0, stating the time/month prior to the crisis (prior to July
1997), and XT =1, stating the time/month starting the crisis (July 1997) and further. As such, the logistic regression model
used in this research should have (with XT) considered the existence of fixed effects.
Then, prior to achieving the objective of the research, first of all a Factor Analysis should be conducted towards the
independent variable of the measurement ratio scale, (variable X2, º, X22) as predictor factors. According to Rencher
(1995:445); the goal of factor analysis is to characterize the redundancy among the variables by means of smaller
number of factors. The Factor Analysis process will result in a new variable (factor grouping is formed), which remains to
bring important information from the former variable (TN. Qurriyani, 2000). Every original variable constitutes a linier
combination at random a number of variables, called factor variables, i.e. common factor and unique factor.

X 1 = v1 (1) f1 + v1 ( 2) f2 + .......... + v1( m ) f m + e1

X 2 = v2 (1) f1 + v 2 ( 2) f2 + ......... + v 2 (m ) fm + e2

X p = v p (1 ) f1 + v p ( 2 ) f 2 + .......... + v p ( m ) fm + e p (2)

in which: there is a number of m (m < p) common factor with notation f, and p original variable (notation X). vj,I is the
weight factor i (i = 1, 2, º.,p) related to variable j (j = 1, 2, º.., m). and ej (j = 1, 2, º.,p) is the unique factor.
After the original variable, comprising independent variables of the measurement ratio scale are grouped to become
the m factor, hence equation (1) is adjusted to become:

1 m
Pit = ; and Zit = √0+ ∑ √ q fi(j) (3)
1 + e −Zit j =1

q= 1, 2, 3, ,r

in which:
fi(j) : factor i to-j
m : the number of factors

Further in order to overcome the impact of the influence of the random and fixed effects, equation (3) needs to be
adjusted with the existence of dummy variables in the bank group and to enter variable XT (time variation).

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By involving said bank group»s dummy variable and dummy variable time variation (XT), hence equation (3) becomes:

1
Pit = (4)
1 + e −Zit
while:
n m
Zi = β0 + β1 D + Σ Σ β p +1 + m( k −1) f p
k =1 p =1

information:
f : factor, as independent variabel
D = XT : dummy variable time variation
k : the number of bank groups, for k = 1, 2, º, n
p : the number of factors in a group, for p = 1, 2,º,m
b : regression coefficient

In order to achieve objective no. 1, the prediction model is established by using the equation logistic regression
model formulation (4). Later, as a verification step a goodness of fit test and a significant Wald statistic test need to be
conducted towards equation (4)
a. Goodness of fit test. In this research to use Chi-square Hosmer and Lemeshow. The test Chi-square Hosmer and
Lemeshow measures the difference between the observation result value and the dependent variable prediction
value. The smaller the difference between the two, the better/adequate model obtained (Hair et.al, 1998:318-319).
b. The Wald Statistic Significance. Wald Statistic tests the significance of the logistic regression coefficient of each
predictor, with the statistic hypothesis formulation as follows. As this research is conducted towards the population
data, therefore the logistic regression coefficient significance does not need the Wald Statistic test as conducted
towards the sample data.
Later to be continued with the test power of regressions to predict, the bank»s opportunity experiencing bankruptcy
or not. Said prediction model will result in a score between 0 (zero) and 1 (one) interpreted as the probability figure. With
a certain cut-off point said prediction model will result in 3 estimation categories, i.e. : a exact estimation, an error
estimation Type 1 and the error estimation Type II (Wimboh, 1996:15). A cut-off-point constitutes a value to determine
whether a bank is estimated as a bankrupt bank or not. As stated by Wimboh, this approach has been often used by
previous researchers in estimating the opportunity of a failure of a bank/company. For example with a 0,4 cut-off-point,
the prediction model will identify a bank with a probability more than 0,4 as a bankrupt bank. On the other hand, a bank
with a probability of less than 0,4 is estimated as a non bankrupt bank. The prediction model will result in an accurate
estimate, while a bankrupt bank shall be accurately estimated as a bankrupt bank. The error Type I may occur when the
prediction model estimates a bank not to be bankrupt as a bankrupt bank, or the model results in a probability of a bank
not bankrupt more than 0,4. And, the error Type II may occur when the prediction model results in a probability of a
bankrupt bank less than 0,4. The lower the cut-off-point used the more banks that are predicted as bankrupt banks and
only some banks are predicted not to be bankrupt.

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Therefore, the choice of cut-off-point plays an important role in the calculation of the level of errors. Hence a fair
cut-off-point decision is very much needed. According to Wimboh (1996), a sample proportion of a bankrupt bank and
a not bankrupt bank is convinced to constitute the best criteria to determine said cut-off-point. If a sample of a bankrupt
bank amounting to 50% for example, and a sample of a not bankrupt bank amounting to 50%, then a cut-off-point
amounting to 0,5 shall be chosen. And if a sample of a bankrupt bank amounts to 60%, while a not bankrupt bank
amounts to 40%, then a fair cut-off-point would be 0,4. The choice of a cut-off-point in this research uses a proportion
of a bankrupt and not bankrupt bank as stated by said Wimboh (1966).
Then, after the prediction model is established, then in order to achieve the second (two) objective a substitution
needs to be conducted towards equation (4) based on the bank»s group.

4. THE RESULT OF THE RESEARCH

The prediction model conditionally established towards capital ratios» indicators and financial risks of a bank for a
period of 3 moths, 6 moths and 12 months prior to a bank being declared bankrupt. The relative time period has been
chosen based on the uniqueness of the banking industry business character, which proposes confidence. If a bank looses
its confidence from the community, said bank will be left by its clients. Depositors will withdraw their deposits, creditors
will decrease/stop their loans, and investors will conduct divestment, so that the bank will be threatened to become
bankrupt. Said phenomena may happen anytime. It is possible, that on this day said bank would be sound, however due
to a rush triggered off by a negative sentiment, causing the loss of confidence of the market, the bank shall experience a
bankruptcy at the following day. Consequently tools are required, which may give early warning signals of the condition
of said bank leading towards bankruptcy. The result of the empirical study shows, that the nearer the time of bankruptcy
the lower the level of classification errors of bankrupt √ not bankrupt banks. The concerned empirical study was
conducted by: Beaver (1966), Altman (1968), Meyer & Pifer (1970), Pettwy & Sinkey (1980), Pantalone & Platt (1987),
Indira & Dadang (1998), Mongid (2000), and Wilopo (2000).
Therefore, a prediction model to be established is 1) The prediction model 3 months prior to bankruptcy, abbreviated
MP3; 2) the prediction model prior to 6 months, abbreviated MP6; 3) the prediction model 12 months prior to bankruptcy,
abbreviated MP12.
The modelling of each said prediction model through the following phases: a) Factor analysis, b) Establishment of
the bankruptcy prediction model, c) the test of Goodness of Fit, d) Specification of cut-off-point, e) Model Validation.

4.1 The model for bankruptcy prediction of commercial banks (K1-K6)

In order to achieve the first objective, data are needed of each bank group, having published before financial reports
of 3 moths, 6 months and 12 months. Then it is continued with the Factor Analysis towards capital ratios» variables and
financial risks.
From the result of the logistic regression computation of equation (4) and the measurement of the design population
9.166 bank data, MP3 possesses Chi-square 17,027 with a significance probability of 0,030 (attachment 1). Based on the
goodness of fit test of Hosmer & Lemeshow, it turns out that said value of 0,030 is larger than a (=1%), such that H0 is
accepted. The meaning is, that there is no differece between the classification of the observation result and the bank»s

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Table 2:
The Empirical Result of the Prediction Model for Commercial Banks in Indonesia (Cut-Off Point = 0,5)

Information MP3 MP6 MP12

Modeling :
Design Population (bank data) 9,166 8,456 7,828
Goodness of fit (a = 1%) Adequate Inadequate Inadequate
Correct Estimates (%) 94.9 94.5 93.5
Error I Type (%) 0.7 0.6 0.7
Error II Type (%) 74.7 79.1 83.2
Validation Test:
Validation Population (bank data) 4,129 3,640 2,730
Correct Estimates (%) 82.6 86.5 91.32
Error I Type (%) 15.7 11.7 7.97
Error II Type (%) 91.1 95.0 43.64
Source: Monthly Processed Financial Reports of Commercial Banks.

prediction of bankruptcy √ non bankruptcy. In other words, said Chi-square value of 17,027 does not differ from 0 (zero).
Its implication is, as mentioned in Table 2 that MP3 statistically is adequate to be used as prediction model for bankruptcy
for commercial banks in Indonesia for a period of 3 months prior to bankruptcy at the level of significance less than 3%.
With the same procedure, MP6 possesses a Chi-square of 25,672 with a significance probability of 0,001 (attachment
2) and MP12 possesses a Chi-square of 21,924 with a significance probability of 0,005 (Attachment 3). Based on the
goodness of fit test of Hosmer & Lemeshow, it turned out that both values of said Chi-square were smaller than a
(=1%), such that H0 was rejected. The meaning is, that there was a difference between the classification of the observation
result and the bank»s prediction of bankruptcy √ non-bankruptcy. In other words, both said Chi-square values differed
from 0 (zero). Its implication was, that both MP6 as well as MP12 statistically were inadequately (Table 2) used as prediction
model for bankruptcy of commercial banks at the level of significance 1%.
Therefore, from the three prediction models that which suceeded being established (MP3, MP6, and MP12), it
turned out that only MP3 possessed a satisfactory result of the test goodness of fit. MP3 was declared adequately to be
used as prediction model for bankruptcy of commercial banks in Indonesia at the level of significance less than 3%.
Further, at the modelling level, at one part based on the correct estimates, it was proven that the three prediction
models showed a high classification accuracy (Table 2). MP3 was more accurate than MP6 and MP12, because MP3
possessed higher correct estimates (94,9%) than the two other prediction models (94,5% and 93,5%). Besides, MP3 also
possessed a level of errors (error I and error II), which were relatively lower than the level of errors possessed by MP6 and
MP12.
The level of model validation based on the validation population (January 2001 up to December 2003) showed that
MP3 was not better than MP6 and MP12, because MP3 possessed a lower level of classification accuracy (=82,6%) than
the level of classification accuracy MP6 (=86,5%) as well as MP12 (=91,32%) However, the classification accuracy of MP3
could be declared as being sufficient good as its value was still relatively high, i.e. amounting to 82,6%. The same result
was also obtained if their error-type was compared, where the error type at MP3 turned out to be higher than that at MP6
and MP12.
On the basis of said level, although MP3 possessed a lower classification accuracy based on validation population
than MP6 and MP12, but because MP3 was more adequate than the two other models, MP3 was declared as a better

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prediction model than MP6 and MP12, so that MP3 was adequately used as the prediction model for bankruptcy in
commercial banks in Indonesia.

4.2 Cut-off point specification

The choice of the cut-off value in this research used the proxy of the bankrupt and not bankrupt bank proportion as
stated by Wimboh (1996). Based on the population data survey the Cut-off point obtained for MP3 was 0,939; for MP6
was 0,9366; and for MP12 was 0,9295.The extent of said three Cut-off points were relatively almost the same.

Table 3:
The empirical result on the Cut-off point specification.

Information MP3 MP6 MP12

Specification cut-off point 0.939 0.9366 0.9295

Modeling:
Design Population (data bank) 9,166 8,456 7,828
Correct Estimates (%) 94.2 94.9 93.2
Error I Type (%) 0.03 0.1 0.1
Error II Type (%) 96.2 95.0 95.3
Validation Test:
Validation Population (data bank) 4,129 3,640 2,730
Correct Estimates (%) 89.8 92.0 94.62
Error I Type (%) 8.3 6.0 4.6
Error II Type (%) 95.6 97.5 43.64
Source: Monthly Processed Financial Report on Commercial Banks.

At the modelling level (Table 3), the three prediction models based on the cut-off-point specification, each produced
a high correct estimates value. That is 94,2% for MP3, 94,9% for MP6 and 93,2% for MP12. These results indicated that
the prediction model established was able to correctly classify 94,2% (MP3), or 94,6 (MP6), or 93,2% (MP12) the design
population member. Although the classification accuracy of MP3 was somewhat lower than MP6, however it was still
more accurate than MP12, which possessed high correct estimates, so that it could be stated that MP3 could adequately
be used as a prediction model for bankruptcy of a bank.
Further, as a prediction test, obviously the three prediction models at the level of model validation (Table 3) possessed
also a high correct estimates value. That is 89,8% for MP3, 92,0% for MP6 and 94,62% for MP12. The meaning is, that
the prediction models established were able correctly to classify 89,8% (MP3), or 92,0% (MP5), or 94,62% (MP12) the
validation population member.
From said elucidation and remaining to refer to the result stated in Table 2, it seemed that MP3 was still declared
adequate as a prediction model for bankruptcy in commercial banks in Indonesia, considering that MP3 also possessed
high correct estimates both at the level of modeling and at the level of model validation based on default of cut-off point
0,5 as well as based on the cut-off point specification 0,939.

4.3 An analysis on the Prediction Model of Banks» Bankruptcy

If we were only referring to the rule of thumb, the prediction power of MP3 was indeed sufficiently good, as it
possessed a high classification accuracy (because > 50%). However, if paying close and accurate attention, there was one

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matter which needed to be paid attention to in said modeling, especially MP3. It turned out that said MP3 prediction
strength was still less accurate (<90%), considering that this research constituted a survey research (population data).
Although the sum of correct rate exceeded the rule of thumb of 50%, it was less accurate (<90%) said prediction ability
was caused by; a) population used in the survey population, not the target survey so that there were still objects (bank
data) not involved in the statistic calculation because said bank»s monthly publication of financial report was not available,
b) there were predictors other than capital ratios and financial risks, determining the opportunity of a bank»s bankruptcy,
and c) financial report data publications which were used not revealing the aspect of a management moral violation, such
as fraud, embezzlement and cheating (Wimboh, 1996; Pantalone & Platt, 1987).
Some studies in respect of banks» bankruptcies in Indonesia had the basis of logistic methods, conducted by Wimboh
Santoso (1996), Abdul Mongid (2000), Tengku Nuzulul Qurriyani (2000), and Sri Haryati (2001). From the aspect of
classification accuracy (Table 4), empirically this research had the superiority of relative classification accuracy on prior
studies of banks» bankruptcies. At the level of modeling, this research classification accuracy reached 94,9% for cut-off
amounting to 0,5 and 94,2% for cut-off amounting to 0,939 while the classification accuracy at previous researches
stretched between 63,60% up to 92,55%.
At the level of model validation, the classification accuracy was somewhat different. A large part of former empirical
studies on bankruptcy of banks on the other hand did not conduct measurement of model performance as requirement
for validation of prediction model. The model performance test was only conducted by Wilopo (2001) and this research.
The classification accuracy value at validation population for this research was of a slightly higher value (82,6% and
89,8%) compared to the research of Wilopo (2001), i.e. 81,4%. Overall, both with the estimate data as well as with the
validation data, the results of said research proved to support the statement of Pantalone & Platt (1987) and Ou &
Penman (1989). That is, that failure of a bank may be predicted accurately although information publications as basis of
limited prediction, and financial ratios may be used to predict the future happenings by connecting financial ratios with
economic phenomena.

Table 4
Comparison of Classification Accuracy of a Prediction Model of Bankruptcy of Banks outside Indonesia

Classification Accuracy (%)

Research M o d e l Characteristic
Estimate Data Validation Data

Martin (1977) estimate 91.3 -.-

Estrella & Peristiani (2000):
• Bankruptcy 1993 estimate 85.5 -.-
• Bankruptcy 1992 estimate 88.4 -.-
• Bankruptcy 1991 estimate 88.4 -.-
• Bankruptcy 1990 estimate 88.8 -.-
This Research (2004)
default cut-off = 0.5 prediction 94.90 82.60
specification cut-off = 0.939 94.20 89.80
Source: Various Articles

Outside Indonesia, the study on bankruptcy of banks on the basis of logistic methods had also been conducted by
Martin (1977) and Estrella & Peristiani (2000). According to Table 5, the percentage of the classification accuracy of the
result of this research at the level of model estimate was also better than the two prior researches, i.e. 94,9% and 88,4%

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- 88,8% for Estrella & Peristiani (2000) and 91,3% for Martin (1977). The difference was that other than producing the
bankruptcy prediction model, this research also assessed the performance of the prediction model established, while that
matter was not conducted in the research of Martin (1977) and Estrella & Peristiani (2000). While, the performance
assessment of the prediction model constituted a pre-requirement if the objective of the research were to predict an
event, i.e. by making empirical comparisons (Beaver, Kennelly and Voss, 1968).
Up to here, it may be stated that the prediction model established possessed a surplus, among others : (1) said
model constituted a prediction model not only for estimate (comparison with empirical study), (2) possessed a level of
relative high accuracy, i.e. 94,9% (cut-off=0,5) or 94,2% (cut-off=0,939) at the level of modeling and 82,6% (cut-off
=5%) or 89,8 (cut-off = 0,939) at the validation phase, and (3) did not use a conventional predictor (CAMEL based), but
used a capital factor predictor and a financial ratio factor.
Then, in order to achieve the second (2) research objective, the establishment for the prediction model for each
bank group was only implemented to predict the bank»s bankruptcy 3 (three) moths prior to bankruptcy.

4.4 The Prediction Model for Bankruptcy of each Bank group.

Bank Group 1 (K1)
The prediction model for bankruptcy established was MP3 for K1. By substituting the existence of a dummy bank
group, MP3 for K1 was established based on equation (4a) while its regression coefficient is served at Table 5.

1 (5)
MP 3 = Pi t =
1 + e − Zit
in which

m
Z i = β 0 + β1 D + Σ β p +1+ m f p
p =1

Table 5: Table 6: Logistic Regression Coefficient

Logistic Regression Coefficient MP3 for K1. for MP3 for K2.
Variable β Wald Significance Variable β Wald Significance

XT 3.068 139.537 0.000 XT 3.068 139.537 0.000

F1X3K1 0.000413 0.03 0.956 F1X3K2 0.108 3.508 0.061
F5X4K1 -0.637 0.236 0.627 F5X4K2 0.157 71.260 0.000
F4X7K1 -80.241 0.590 0.442 F4X7K2 -4.610 18.157 0.000
F6X11K1 -0.914 0.043 0.837 F6X11K2 5.355 134.499 0.000
F2X8K1 0.503 0.130 0.719 F2X8K2 0.963 23.130 0.000
F3X17K1 2.663 0.545 0.460 F3X17K2 1.654 24.126 0.000
F7X18K1 -1.059 0.012 0.911 F7X18K2 3.668 19.903 0.000
Constant -7.148 441.107 0.000 Constant -7.148 441.107 0.000

Source: Processed Attachment 1. Source: Processed Attachment 1.

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 Article II

Bank Group 2 (K2)

The prediction model on bankruptcy established was MP3 for K2. By substituting the existence of a dummy bank
group, MP3 for K2 was established based on equation (4b), while its regression coefficient value is printed at Table 6.

1
MP 3 = Pi t = (6)
1 + e − Zit
in which
m
Z i = β 0 + β1 D + Σ β p +1+ 2 m f p
p =1

Bank Group 3 (K3)

The bankruptcy prediction model established was MP3 for K3. By substituting the existence of a dummy bank
group, MP3 for K3 was established based on equation (4c), while its regression coefficient value is served at Table 8.
1
MP 3 = Pi t = (7)
1 + e − Zit
in which
m
Z i = β 0 + β1 D + Σ β p +1+ 2 m f p
p =1

Bank Group 4 (K4)

The bankruptcy prediction model established was MP3 for K4. By substituting the existence of a dummy bank
group, MP3 for K4 was established based on the equation (4d), while its regression coefficient value may be seen on
Table 8.
1
MP 3 = Pi t =
in which
1 + e − Zit (8)

m
Z i = β 0 + β 1 D + Σ β p +1 +4 m f p
p =1

Table 7: The Logistic Regression Coefficient Table 8: The Logistic Regression Coefficient
for MP3 for K3. for MP3 for K5.
Variable β Wald Significance Variable β Wald Significance

XT 3.068 139.537 0.000 XT 3.068 139.537 0.000

F1X3K3 -0.056 0.469 0.493 F1X3K4 0.001 0.059 0.808
F5X4K3 -0.406 3.712 0.054 F5X4K4 -0.104 4.832 0.028
F4X7K3 -6.541 4.961 0.026 F4X7K4 1.420 0.065 0.799
F6X11K3 5.178 32.487 0.000 F6X11K4 0.046 0.002 0.960
F2X8K3 -0.060 0.042 0.838 F2X8K4 0.501 2.164 0.141
F3X17K3 2.246 11.020 0.001 F3X17K4 0.771 5.673 0.017
F7X18K3 2.417 1.228 0.268 F7X18K4 24.136 27.162 0.000
Constant -7.148 441.107 0.000 Constant -7.148 441.107 0.000
Source: Processed Attachment 1. Source: Processed Attachment 1.

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 Article II

Bank Group 5 (K5)

The bankruptcy prediction model established was MP3 for K5. By substituting the existence of a dummy bank
group, MP3 for K5 was established based on the equation (4e), while its regression coefficient value may be seen on
Table 9.

1 (9)
MP3 = Pit =
1 + e −Zit
in which
m
Z i = β 0 + β 1 D + Σ β p +1 f p
p =1

Bank Group 6 (K6)

The bankruptcy prediction Model established was MP3 for K6. By substituting the existence of a dummy bank
group MP3 for K6 was established based on the equation (4f) while its regression coefficient value is served at Table 10.

1
MP 3 = Pi t =
1 + e − Zit (10)
in which

m
Z i = β 0 + β1 D + Σ β p +1+ 5m f p
p =1

Table 9: The logistic Regression Coefficient Table 10: The logistic Regression Coefficient
for MP3 for K5. for MP3 for K6.
Variabel β Wald Signifikan Variabel β Wald Signifikan

XT 3.068 139.537 0.000 XT 3.068 139.537 0.000

F1X3K5 0.0027908 0.000 0.993 F1X3K6 3.567 16.956 0.000
F5X4K5 -0.626 0.001 0.981 F5X4K6 0.346 19.301 0.000
F4X7K5 -119.778 0.002 0.966 F4X7K6 2.487 8.235 0.004
F6X11K5 -15.887 0.003 0.956 F6X11K6 -4.971 13.503 0.000
F2X8K5 -3.421 0.004 0.952 F2X8K6 -6.257 8.018 0.005
F3X17K5 -5.361 0.002 0.964 F3X17K6 3.228 17.853 0.000
F7X18K5 -19.906 0.000 0.996 F7X18K6 -414.625 29.790 0.000
Constant -7.148 441.107 0.000 Constant -7.148 441.107 0.000
Source: Processed Tables 4.12. Source: Processed Attachment 1.

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 Article II

5. CONCLUSION
a. To establish a prediction model for bankruptcy in commercial banks in Indonesia (K1 up to K6) based on the relevant
bank»s financial report. An adequate prediction model is a model predicted 3 months prior to bankruptcy (MP3). The
result of the complete establishment of the prediction model is served at Attachment 1 (for MP3).
b. To establish a prediction model for bankruptcy of each bank group based on the bank»s financial report. The prediction
model referred to is MP3 for every bank group. The result of the complete prediction model for every bank group can
be seen at sub chapter THE RESULT OF THE RESEARCH.

111
 Article II

References
Abdul Mongid, 2000, ≈Accounting Data and Bank Failure: A Model for Indonesia∆, Symposium National Accoutancy
III, September, IAI, pp.2-26.
Altman, Edward I, 1968, ≈Financial Ratios, Discriminative Analysis and The Prediction of Corporate Bankruptcy∆,
Journal of Finance, vol.XXIII No.4 September, pp.589-609.
Altman, EI; RG Haldeman & P Narayanan, 1977, ≈ZETA Analysis. A New Model to Identify Bankruptcy Risk of
Corporations∆, Journal of Banking and Finance 1 North Holland Publishing Company, pp.29-54.
Bank Indonesia, Annual Report edition 1997, 1998, 1999, 2000, 2001, 2002 and 2003, Bank Indonesia, Jakarta.
ººº, Quarterly Report, 4th Quarter 2000, Bank Indonesia, Jakarta.
Basel Committee on Banking Supervision, 1999, A New Capital Adequacy Framework, consultative paper issued by
Basel Committee on Banking Supervision usually meets at The Bank for international Settlements in Basel, June.
Beaver, William H, 1966, ≈Financial Ratios as Predictors of Failure∆, Empirical Research in Accounting, Selected
Studies and Discussions by Preston K Mears and By John Neter, pp.71-127.
Beaver, William H, JW. Kennelly, WM. Voss, 1968, ≈Predictive Ability as a Criterion for the Evaluation of Accounting
Data∆, The Accounting Review, October, pp.675-683.
Brigham EF & LC Gapenski, 1997, Financial Management, Theory and Practice, 8th edition, The Dryden Press,
Orlando Florida.
De Young, Robert, 1999, ≈Birth, Growth, and Life or Death of Newly Chartered Banks∆, Economic Perspectives,
pp.18-35.
Estrella, Arturo & Stavros Peristiani, 2000, ≈Capital Ratios as Predictors of Bank Failure∆, Federal Reserve Bank of
New York (FRBNY) Economic Policy Review, July, pp. 33-52.
Etty M. Nasser & Titik Aryati, 2000, ≈Model Analysis CAMEL To predict Financial Distress at the Public Banking
Sector.∆, Accountancy Journal & Auditing Indonesia (JAAI), vol.4 No.2, December, pp.111-131.
Fraser, DR & LM Fraser, 1990, Evaluating Commercial Bank Performance : A Guide to Financial Analysis, Banker»s
Publishing Company, Rolling Meadows, Illinois.
Fraser, LM, 1995, Understanding Financial Statements, 4th edition, Prentice Hall, Inc., Englewood Cliffs, New Jersey.
Hair, Joseph F, Jr, RE. Anderson, RL. Tatham, WC. Black, 1998, Multivariate Data Analysis (International Edition), 5th
edition, Prentice Hall, New Jersey.
Hempel, GH; DG Simonson & AB Coleman, 1994, Bank Management, Text and Cases, 4th edition, John Wiley &
Sons, Inc., Canada.
Indira, G Ayu & Dadang Mulyawan, 1998, ≈ To predict the Banking Condition Through Solvency Approach Dyamically∆,
Monetary Economic and Banking Bulletin, September, pp. 169-184.
Jensen, Michael C & CW Smith Jr, 1984, The Modern Theory of Corporate Finance, McGraw-Hill, Inc., USA.
Martin, Daniel, 1977, ≈Early Warning of Bank Failure. A Logic Regression Approach∆, Journal of Banking and
Finance, 1 North Holland Publishing Company, pp.249-276.

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Meyer, Paul A & HW Pifer, 1970, ≈Prediction of Bank Failures∆, Journal of Finance, September, pp.853-868.
Ohlson, James A, 1980, ≈Financial Ratios and the Probable Prediction of Bankruptcy∆, Journal of Accounting Research,
vol.18 No.1 Spring pp.109-131.
Ou, Jane A and Stephen H. Penman, 1989, ≈Financial Statement Analysis And The Prediction of Stock Returns∆,
Journal of Accounting and Economics, 11 pp.295-329.
Pettway, R & JF Sinkey Jr, 1980, ≈Establishing On Site Bank Examination Priorities: An Early Warning System Using
Accounting and Market Information∆, The Journal of Finance, vol.XXXV No.1 March, pp.137-150.
Rencher, Alvin C, 1995, Methods of Multivariate Analysis, John Wiley & Sons, Inc., Canada.
Santomero, AM & JD Vinso, 1977, ≈Estimating the Probability of Failure for Commercial Banks and The Banking
System∆, Journal of Banking and Finance, 1 North Holland Publishing Company, pp.185-205.
Sinkey, J; JV Terza and R Dince, 1987, ≈A Zeta Analysis of Failed Commercial Banks∆, Quarterly Journal of Business
& Economics, vol.28 Autumn, pp.35-49.
Sinkey, Joseph F Jr, 1975, ≈A Multivariate Statistical Analysis of the Characteristics of Problem Banks∆, Journal of
Finance, vol. XXX No.1 March, pp.21-36.
Sinkey, Joseph F, 1992, Commercial Bank Financial Management in Financial Services Industry, 3rd edition, Macmillan
Publishing Company, Englewood Cliffs, New York.
Sri Haryati, 2001, ≈Analysis of a Bank»s Bankruptcy∆, Economic Journal and Indonesian Bisnis Indonesia, vol.16,
No.4, pp.336-345.
Sumarno Zain, 1994, ≈Failure Prediction: An Artificial Intelligence Approach∆, Accountancy Development in Indonesia,
Publication No.21, Accountancy Development Coordination Team, Jakarta.
Tengku Nuzulul Qurriyani, 2000, ≈Potential Indication Towards Bank Survival through Financial Ratio Analysis
:Trichotomy Logistic Regression Model∆, National Symposium Accountancy III, September, IAI, pp.619-651.
Titik Aryati & Hekinus Manao, 2000, ≈Financial Ratio as Predictor for Problem Banks in Indonesia∆, National
Symposium Accountancy III, September, IAI, pp.27-44.
Wahjudi Prakarsa, 2000, ≈Turbulent Environment And Poleksos Organization Environment. A Paper Presented in
the First Program Lecture of the Magister Management, Jember University on 10 September 2000 at Jember.
Wilopo, 2001, ≈Prediction of Bankruptcy of a Bank∆, Research Journal Indonesian Accountancy, vol. 4, No. 2, May,
pp.184-198.
Wimboh Santoso, 1996, ≈The Determinants of Problem Banks in Indonesia∆, Banking Research and Regulation,
Bank Indonesia.
Law No.10 of 1998, on Banking Bank, Indonesia, Jakarta.

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114
 Article III

Article III

An Analysis in Respect of the Behavior

of Investment Managers in Facing Uncertainties

Dadang Muljawan 1)

Abstrac t

The application scheme of progressive incentive statistically has the potential to increase the performance
of investment managers in increasing return.
The concept of progressive incentive on the other hand has been widely applied in banking management
as one of the endeavors to upgrade the competitiveness in the financial industry which more and more is facing
a very sharp level of business competitiveness. Nevertheless, the application of progressive incentives must be
conducted prudentially taking into consideration that the application of said scheme may have the potential to
increase the level of aggressiveness of the agent and may decrease the attitude of prudence in carrying out a
transaction. Macro-wise this is not in line with the industrial expectation in achieving a more stable financial
stability system. The application of progressive incentives must always be followed by an increasing accurate
and effective supervisory system to suppress the probability of the occurrence of fraud as the result of the
increase of aggressiveness occurred of the investment behavior.

Classification JEL: C51, C53

Key Words: Risk, Risk Preference

1 Bank Researcher at Directorate of Sharia Banking , Bank Indonesia ; email address : dmuljawan@bi.go.id.

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 Article III

1. INTRODUCTION
The stability of a financial system constitutes one of the pre-requirements of achieving a sustainable economic
growth. The experience of the crisis, which occurred in several countries has shown how large the damage can be when
to an economic system as a result of instability in a financial system. In many countries, especially in industrialized countries,
the attention given in order to achieve stability in a financial system is significant . Even in those countries a special
institution was established bridging prudential issues both at micro as well as in macro level. In the macro level, attention
had been given in the form of implementation of financial and monetary policies, the strengthening of their supporting
institutions and the consistency in policy implementation taken from time to time in the endeavor to achieve a high level
of industrial efficiency. In the micro level, attention had been given in the form of a financial structure analysis and market
discipline, which may support the creation of efficient and prudential financial activities for the users of financial services.
In a condition, in which the banking system still has a dominant character, attention naturally must be given in order that
the banking system may operate efficiently without resulting in a potential of the occurrence of financial problems being
the result of less prudential operational activities.
One of the sufficient important aspects for discussion is the analysis on the behavior of banking agents in facing
risks/uncertainties. In a condition of an increasingly liquid and sophisticated financial system, investment activities involving
financial instruments in large volumes are very easy to be handled. Moving funds from one instrument to another form of
instrument may be rapidly implemented through a very simple form of procedure. The benefit from the development,
achieved in this sophisticated financial system may succeed if and only if the supporting system is ready to anticipate each
potential of an arising problem; if not, a financial crisis √ difficult to be avoided √ resulting in very large economic costs,
which naturally will become the burden of the community.
The second part of this article provides the analysis background, which shows the importance of risk behavior from
the market agents. The third part discusses the model to be used in order to conduct simulation on the potential of the
agent»s behavior in facing uncertainty. The fourth part discussed the result of the analysis obtained and the fifth part
contains the conclusion.

2. THE BACKGROUND OF THE ANALYSIS

The technological application in the financial industry nowadays constitutes a challenges, which can no longer be
avoided. For the future it may be said that the industrial/banking industry has become an industry possessing a solid
technological basis. Technological development and innovation in creating financial instruments, as have been discussed
in the introduction, have significantly increased the efficiency in investment activities and the company»s liquidity
management. Nonetheless, at the same time, said matter has also increased the risk in investment activities. Financial
transactions at present are conducted in a wider market scope and in an increasingly narrower transaction time interval.
In facing an increasingly sharp level of competition, the financial/banking institutions have employed investment managers
in order to be able to benefit from the increasingly liquid market condition with the expectation that they produce a high
return. To increase the performance of their investment managers, a large percentage of banking institutions have
applied incentives for every Rupiah profit obtained from the transaction activities.

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 Article III

However, although at one part the application of incentives may spur the performance of the transaction experts to
obtain return for the banks, this may have the potential to increase the aggressiveness of the transaction experts in
choosing their investment portfolios.1 The experience of the fall of Barrings has shown that a too aggressive behavior
from a dealer, possessing the authority of placing sufficient large funds without supplemented by sufficient adequate
internal control has a very large potential in arising sufficient deep financial problems. Barrings was considered to be a
sound banking institution prior to the occurrence of said internal financial crisis.2 Barrings proves that weak internal
controls can crush a sound institution in a relatively short time.
At the level of an institution, Dewatripont and Tirole (1994, 1996) discussed the optimal stopping time in the
endeavor to take over the bank operations if the performance shown is low. The principal idea from this matter is the
concept of separating the supervisory right between shareholder and depositor. Takeover authority shall be done if the
management of the bank produces the potential of losses, which may threaten the sustainability of its operations,
although the evaluated losses have not yet occurred.
In its reality, problems in the banking activities are very much related to prudential policies taken both in the micro
as well as in macro level. Macro policies , comprise fiscal, monetary aspects as well as de-regulation policies, which will
determine a feasible set, which may be used as basis for choosing investment portfolio»s. Micro-wise, prudential provisions
will influence the behavior of the bank risks in taking every investment decision. Both types of policies will very much
influence the occurrence of problems in the banking industry in future. A good understanding in respect of the potential
of the behavior of investment managers certainly will very much be beneficial for the application of every provision in the
banking industry (drawn in Exhibit 1).

Macro-prudential
economic policy

Investment
Feasible Set

Risk Portfolio Probability of having

Behaviour Selection banking problem

Micro - prudential
banking regulation

Exhibit 1
Macro and Micro Prudential and Risk Behavior

1 A typical condition of adverse selection in which a bank will not possess complete information in respect of the behavior of the agent. First investigations in respect of the adverse selection
problem and the risk concept may be seen in detail in Akerlof (1970) and Arrow (1970)
2 A complete discussion on the Barrings» case and its problems can be seen in Hall (19954a,b and c) and Hall (1996a,b)

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 Article III

This article tries to model analytically the behavior of an investment manager in facing uncertainties by making use
of the income assumption of a stochastic nature. This article is expected to be able to provide a better level of understanding
both regarding the potential of behavior from investment managers in facing uncertainties so that said matter may be
useful both for supervisory authorities as well as banking institutions themselves in order to always increase a better
supervisory quality. Consequently, we can expect that the financial crisis potential of a banking institution, resulted by the
application of improper set of incentives, may encourage minimize the less prudential banking activities.

3. THE MODELING PROCESS

3.1. Assumption
An investment manager will obtain a reward in the form of a salary E[pV] on placing activities conducted. Funds
placed at various investment instruments possess certain financial characteristics (_, _). Pursuant to placing of funds at the
chosen types of instruments, a bank will obtain cash inflow as follows:

dπ = µdt + σdz (1)

Detail-wise, the placing mechanism and reward are shown in Exhibit 2.

With the freedom to choose investments, a transaction expert is

Bank
assumed to have two types of investment preferences in facing two
different conditions, which are shown with two different variances for
E[rV]
each condition, in which σ 1 ,σ 2  [σ ,σ ] . Generally, the present value
of a continuous cash flow is shown as follows:
Manager
t

(?,?) PV (w, t ) = ∫ [ w + sπ ]e −rt dt (2)

t0
d? ? ? dt ? ? dz

Portfolio
Investments In which PV, w and s_ represent the present value from the reward
to be obtained, the constant salary component and the performance salary
Exhibit 2 at a certain time between t0 up to t. It is assumed that a manager possesses
Monetary reward and punishment
two types of future cash inflow based on performance in placing his funds:
limited contract, if the performance shown by the manager is under the
expectation of the bank, so that the process of severing the work relationship may happen at any time; unlimited contract,
at the time the performance of the manager is above the expectation of the bank, it is assumed to establish a contract for
a long time. The present value for the manager, which may expect a contract for a long time with the Bank may be
expressed as follows: ∞
w + sπ
PV (w,[0, ∞ ]) = ∫ [w + s π ]e −rt dt = (3)
0
r

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 Article III

On the other hand, the present value for a manager who works in a condition in which the termination process of
the work relationship may happen at any time can be formulated as follows:

0+

PV (w, [0, ∞]) = ∫ [w + sπ ]e − rt dt = 0 (4)

0

Exhibit 3 shows an income stream which will be obtained by each manager and bank and the present value from
investment activities by a manager. Exhibit 3 (a) shows the wage scheme from a manager towards his investment
performance. If the return yielded is above the minimum return threshold p0, the salary received amounting to w added
with _s as performance fee. If the return level produced is below the minimum expectation, it is assumed that a
manager will experience severance of the work relationship, as cost to be spent in order to maintain the existence of said
manager is higher compared to the level of return, which he may produce (Exhibit 3 (b)).

Sudden
termination
Income region
(a) flow for Infinite
managers W employment
region

π0 π1
Income
(b) flow for
the bank

π0 π1

PV w + sπ s
(c) for the r
managers
1 w +sπ'
α=
r π1 −π 0

π0 π1

Exhibit 3
Graphical Interpretation on the Income Stream

While, Exhibit 3 (c) shows the present value from the reward accumulation obtained by a manager from a bank. In
order to simplify the problem, it is assumed that the probability of the occurrence of contract relationship severance with
the manager is linear distributed. The slope established from a pessimistic scenario to an optimistic scenario is shown as
follows:

1  w + sπ ' 
α =   (5)
r π1 − π 0 

Through a mathematic manipulation from similarity (1) and (5) a second order differential similarity is obtained for
two different conditions.

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 Article III

( r + q )V [
Max α VM + 1 σ 2V MM
2
σ  [σ 1 ,σ 2 ]
]π <π 0

rV Max [
αV + 1 σ 2V MM ] π?π
σ  [σ 1 ,σ 2 ]
M 2 0

In which the homogenous solution for both similarities above in general may be expressed as follows:

V (π ) = Ae µ1π + Be µ 2π
with boundary conditions to comply with the requirement smoothing conditions as follows:
π = −× 0 = Ae − µ1 × + Be − µ2 ×
π = 0 0 = A+ B = A+ B
π = 0 0 = µ1 A + µ 2 B = µ1 A + µ2 B
µ1π * µ π*
π = π * V M (π *) = µ1 Ae + µ 2 Be 2 = s
2 µ π* 2 µ π*
π = π * V MM (π *) = µ1 Ae 1 + µ 2 Be 2 = 0

3.2 Simulation
The aggressive incentive scheme
In the model two incentive mechanisms are simulated with two different incentives» proportions. The dotted line
shows a lower prudential pattern at the time the performance is nearing the lowest point. Said matter shows that the
aggressiveness of an investment manager will increase. Said matter will certainly increase the potential of the occurrence of
the gamble condition for resurrection, which certainly have the potential to endanger the sustainable operations of a bank.

Absolute risk aversion (Vxx/Vx)

10
9 The incentive scheme with a lower ratio poisson.
8 In the model also two incentive conditions are simulated
7 with the probability of detecting a loss as a result of a transaction
6
by the bank management for further action. A broken line shows
5
a model with a lower poisson value, resulting in a lower value of
4
prudence.
3
2
4. EMPIRICAL RESEARCH
1
0 Based on a theoretical analysis executed at the prior part, a

-1 empirical research is conducted to see the general pattern which

-0.5 -0.3 -0.1 0.1 0.3 0.5 0.7 0.9
may occur at a Mutual Fund company from the performance
Cummulated Profit
aspect and the relationship between risk and return.3
Exhibit 4 Absolute risk aversion level
with different incentive schemes

3 Data Source is obtained from the column Stock Exchange and Finance; the financial performance of the mutual fund institution issued by the daily ≈Bisnis Indonesia∆ with a observation
duration during one month (15 December 2003 up to 15 January 2004). The observation activities of 109 active mutual fund companies in transaction and registered in the capital market.

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 Article III

Absolute risk aversion (Vxx/Vx)

The difference in performance between a foreign
10
mutual fund company and a local one.
8

Generally, a mixed mutual fund company has a level of

6 performance and an average higher increase deviation of the
Net Asset Value (NAV) compared to a local mutual fund company.
4
A mixed mutual fund company has an average NAV growth

2
amounting to 0,7279% per month with a deviation amounting
to 0,4166%, while a local mutual fund company has a average
0 NAV growth amounting to 0,6194% per month with a deviation
-0,5 -0,3 -0,1 0,1 0,3 0,5 0,7 0,9 amounting to 0,3339%. Nevertheless, individually, the financial
-2 performance produced cannot make the determining factor in
Cummulated Profit
the difference between a local mutual fund company and a mixed
Exhibit 5 Absolute risk aversion level
company significantly. This is shown by the low level significance
with different Poisson ratio
at the logistic regression implemented.

The behaviour on risk and return from the manager of the mutual fund company.
In one general concept , an investment decision taken by an investor very much depends on the budget constraint
of an investor and the investment feasible set faced. The investment optimum Point occurs at the time the budget
constraint is established is touching the feasible set with a positive point of contact gradient (Investing on more profitable
investments would bear higher level of risk). Said matter obviously did not happen at mutual fund companies. The
empirical investigation result proves that the level of NAV growth (assumed as gains for investors) owns a negative
relationship with risk (represented by the variation level of NAV produced by each institution) (See attachment 1). Said
matter shows that the Investment Manager (MI), which has the task to manage investment activities not having the same
preferences with that which actually should be owed by an investor. A MI in processing a mutual fund company acts as an
agent, having full freedom to determine the effort level (including in it is the profit level target and determining the risk
level in investment). An MI, in this case, owns two types of values, i.e. the value of an deterministic character and
stochastic, originating from an uncertainty. It is assumed that in the mutual fund industry in Indonesia, each MI owns an
equal relative value, so that ;

V MI : f (V Det ,V Stok )

ƒVMI ƒV MI
dV MI = dV Det + dV Stok
ƒV Det ƒV Stok

ƒVMI ƒVMI
if dVMI = 0 and, =Γ =Ω then ΓdVDet = −ΩdVStok
ƒV Det ƒV Stok

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 Article III

As previously discussed, the stochastic value of a MI will be comparable to the extent of the return variations
occurred and said matter will be maximize by the MI as a compensating factor or a lower deterministic gain.

5 MATTERS BENEFICIAL FROM THE GAIN OBTAINED.

Analyses conducted in order to reveal the preference dynamics of a investment manager in facing uncertain conditions
offer several benefits at least in 3 areas, among others:
a. To understand the nature of the types of incentives - Each financial/banking institution may possess a different
incentive scheme in its endeavour to increase the work performance, which at the end is expected to increase
income (profit) for the company. One of the forms of the incentives, which may be implemented is providing income
components to managers based on the achievement of profit, being the result of their transactions. Nonetheless,
the application of said incentives have the potential to raise problems taking into consideration that incentive
components may cause an investment manager to have a more aggressive attitude, which naturally directly may
threaten the sustainability of operations of a banking institution and provide a bad influence towards the overall
financial system.
b. Anticipatory action - If a banking institution intends to apply incentives to an investment manager, there are several
matters, which must become the attention in the endeavour to handle the lowering of the absolute risk aversion
level of said manager to become in a nothing to loose condition. In the endeavour to lower the probability of
occurring disruptions towards the financial system, a necessary regulator in order to understand the establishment
of the risk behaviour, especially established because of the application of a certain incentive.

6. CLOSING
The application of progressive incentives have become the trend in reward mechanism for the banking agents.
Many parties are convinced that the application of said incentives will be able to increase the performance of front-liners
in said industry in obtaining a higher level of return. Nevertheless, the application of progressive incentives must be
prudentially implemented, considering that said matter will have the potential to increase the level of aggressiveness of
an agent and will lower the absolute risk aversion in conducting transactions. This certainly is less in line with the macro
expectation to obtain a more stable level of stability in the financial system. In addition, the application of progressive
incentives must be followed by a increasingly accurate and effective supervision concept in order to press the probability
of the occurrence of fraud as a result of the formation of a level of aggressiveness.

122
 Article III

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 Financial Stability Review
No. 1, June 2004

Coordinator
NELSON TAMPUBOLON AND MULIAMAN D. HADAD

Editors in Chief
WIMBOH SANTOSO, SATRIO WIBOWO, AND DODU BLASYUS

Analyst/Contributors
BSSK
FG Banking : S. Batunanggar Ricky Satria Wini Purwanti
Endang Kurnia Saputra Fernando R.Butarbutar

FG International & Domestic Finance

: Indradjaja Yulianti Kusumastuti
Ita Rulina

FG Non Bank Financial Institutions and Markets

: Dwityapoetra S. Besar Noviati
Ferial Ahmad Dipa Pertiwi

FG Indonesia Banking Architecture

: Boyke W. Suadi

Directorate of Banking Supervision 1 : Tindomora Siregar Priyantina

Directorate of Banking Supervision 2 : Yusra Riza A. Ibrahim
Irwan Lubis Irisa Navyarini
Directorate of Banking Examination 1 : Agus Priyanto
Directorate of Banking Examination 2 : Julius Liston T.
Directorate of Sharia Bank : Dadang Muljawan
Directorate of Rural Bank : Ayahandayani
Directorate of Accounting and Payment System : Farida Perangin-angin Pipih Dewipurusitawati

Compilator, Layouter and Production

Dwityapoetra S. Besar, Fernando R.Butarbutar, and Ricky Satria

Partners
Directorate of Economic Research and Monetary Policy
Directorate of International Affairs
Directorate of Monetary Management
Directorate of Economic and Monetary Statistics
Directorate of Foreign Exchange Management
Bureau of Credit
Directorate of Banking Licency and Information

Data Analyst
Fernando R.Butarbutar Ricky Satria Suharso I Made Yogi

Supporting Team
Holil Hasanuddin Adek Achiriyadi Merlinda Pelawi