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Santoso, The Determinants of Problem Banks in Indonesia

Santoso, The Determinants of Problem Banks in Indonesia

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The main aim of this paper is to provide general information about emerging risk in Indonesian banks using econometric models. However, it also demonstrates how the models employed can be used to produce “probability scores” for banks thought likely to suffer problems, which can be used as an early warning system in banking supervision.
The main aim of this paper is to provide general information about emerging risk in Indonesian banks using econometric models. However, it also demonstrates how the models employed can be used to produce “probability scores” for banks thought likely to suffer problems, which can be used as an early warning system in banking supervision.

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Published by: Muhammad Arief Billah on Jul 21, 2008
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10/15/2011

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The Determinants of Problem Banks in Indonesia(An Empirical Study)
By Dr Wimboh Santoso 
1
 
Abstract
The main aim of this paper is to provide general information about emerging risk in Indonesian banks usingeconometric models. However, it also demonstrates how the models employed can be used to produce“probability scores” for banks thought likely to suffer problems, which can be used as an early warningsystem in banking supervision. Previous studies in this area have normally been concerned with theassessment of the probability of bank failure, although the assessment of bank condition prior to failure ismore important for banking supervisors. Moreover, the number of bank failures recorded in these earlierstudies was often very low, causing statistical problems for researchers. In these respects, this paper marksan improvement on previous empirical studies. The paper employs pool data of problem and non-problembanks as dependent variables and financial ratios, which represent various risks in banks, as independentvariables. Using an out of sample test, the results show that an appropriately-specified logit model canestimate 87.82% of observations correctly.
JEL classification 
: G21; G28
Keywords 
: Bank; Risk; Failure; Supervision; Regulation.
1 The author is a senior researcher at Directorate of Banking Research and Regulations, Bank Indonesia,Jl. MH. Thamrin No. 2, Jakarta Indonesia, email: wimboh@bi.go.id.
 
 
 
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1. Introduction
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
et al 
, 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.
 
 
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2. The Banking Industry In Indonesia
This study employs quarterly data for banks’ financial ratios from March 1989 toSeptember 1995. The year of 1989 was the starting point of a new era for the bankingindustry in Indonesia. The central bank restructured banking regulation in October 1988( hereafter we call it “the reform”). The reform allowed for the establishment of newbanks in Indonesia, including joint venture banks (Bank Indonesia. 1988). Many otherbank regulations were also revised, involving the introduction of minimum risk-basedcapital adequacy requirements, the establishment of new banks and offices and newrequirements for obtaining authorisation in foreign exchange operations. Therefore, thebanking industry after the reform is totally different from that which existed before 1988.Because of this, this study employs quarterly data from March 1989. The lastobservation in sample is the third quarter of 1995 because the data was collected in1996.At this point, it may be useful to outline, briefly, the development and structure of thebanking industry in Indonesia. The number of banks and their offices increasedsignificantly after the reforms. In September 1995, there were 241 commercial banks,excluding rural banks which accounted for around 9072 banks (Bank Indonesia, 1995).Although, the number of rural banks is very high. However, their share of bankingbusiness is very low. In November 1994, their share of total assets only amounted to0.61 %. The rural banks will thus be excluded from this study as their contribution to theindustry is insignificant. Commercial banks consist of: 7 state banks; 71 private foreignexchange banks (PFEB); 95 private non-foreign exchange banks (PNFEB); 31 jointventure banks (JVB); 10 foreign banks (FB); and 27 regional development banks(RDB). The differences between each group of banks depend on ownership structureand authorisation in foreign exchange operations. Based on ownership, banks may bedistinguished as state banks, private banks, foreign banks, joint venture banks andregional development banks. Based on authorisation, banks may be categorised asforeign exchange banks and non-foreign exchange banks.
3. Literature Review Of Bank Failure Models
 
In general, there are two approaches which have been used in the prediction of bank orcompany failure; discriminant analysis and limited dependent variable regressionmodels. This section discusses in more detail the pros and cons of these models.Discriminant analysis is an approach used to classify banks or companies in a certainmanner, such as “failed” and “sound”. This approach has been widely used in the

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