Since 1988, many countries around the world have adopted minimum risk-based capital adequacyrequirements, as proposed by the Bank for International Settlements (BIS) and the EuropeanCommission (EC) (Hall, 1989). The aims of risk-based capital regulation are to ensure that banksprovide cushions for losses against the various risks taken and to reduce competitive inequalities arisingfrom capital adequacy regulation. The risk coverage of the capital regulation, however, plays animportant role in determining the effectiveness of banking supervision, so it is important toaccommodate as many risks as possible. Theoretically, bank risk may be subdivided into credit risk,liquidity risk, solvency risk, operational risk (ie. including efficiency risk), regulatory risk, human factorrisk and market risk (McNew, 1997); but for data availability reasons, regulatory risk and human factorrisk will be ignored in this study.
This paper identifies the risks faced by Indonesian banks using econometric models.Although many studies have already been done to assess the probability of bank orcorporate failure (see, for example, Altman, 1968; Altman
, 1977; Sinkey 1975; andMeyer and Pifer, 1970 ), most of the previous researchers were typically concernedwith the probability of failure when the number of bank failures was very low comparedwith the number of solvent banks. This data problem may have caused inaccurateresults. Additionally, identification of the determinants of problem banks (ie. thecondition before a bank is deemed to have failed) is more useful for bankingsupervision than determining the probability of bank failure because regulatoryauthorities may be able to utilise the information to rescue the banks before failure.The objective of this paper is to develop econometric models for the assessment of thecondition of Indonesian banks in the period prior to failure. Using quarterly panel datafor 231 banks from March 1989 to September 1995, an empirical study is conductedto identify bank risks (which are represented by the explanatory variables used inregressions). Moreover, the paper shows how the results of this study can be used asan additional early warning signal in banking supervision. The paper is organised asfollows: Section 2 discusses the banking industry in Indonesia; Section 3 provides aliterature review of bank failure models; Section 4 outlines the models; Section 5provides the theoretical background for the goodness of fit and specification of errors;Section 6 describes the dependent variables; Section 7 describes bank riskclassification and the independent variables; Section 8 discusses the results of theempirical study; Section 9 provides a summary and conclusions.