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By Dr Wimboh Santoso1
Abstract
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. Previous studies in this area have normally been concerned with the assessment of the probability of bank failure, although the assessment of bank condition prior to failure is more important for banking supervisors. Moreover, the number of bank failures recorded in these earlier studies was often very low, causing statistical problems for researchers. In these respects, this paper marks an improvement on previous empirical studies. The paper employs pool data of problem and nonproblem banks as dependent variables and financial ratios, which represent various risks in banks, as independent variables. Using an out of sample test, the results show that an appropriatelyspecified logit model can estimate 87.82% of observations correctly.
JEL classification: G21; G28 Keywords: Bank; Risk; Failure; Supervision; Regulation.
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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 riskbased capital adequacy requirements, as proposed by the Bank for International Settlements (BIS) and the European Commission (EC) (Hall, 1989). The aims of riskbased capital regulation are to ensure that banks provide cushions for losses against the various risks taken and to reduce competitive inequalities arising from capital adequacy regulation. The risk coverage of the capital regulation, however, plays an important role in determining the effectiveness of banking supervision, so it is important to accommodate 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 factor risk and market risk (McNew, 1997); but for data availability reasons, regulatory risk and human factor risk 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 or corporate failure (see, for example, Altman, 1968; Altman et al, 1977; Sinkey 1975; and Meyer and Pifer, 1970 ), most of the previous researchers were typically concerned with the probability of failure when the number of bank failures was very low compared with the number of solvent banks. This data problem may have caused inaccurate results. Additionally, identification of the determinants of problem banks (ie. the condition before a bank is deemed to have failed) is more useful for banking supervision than determining the probability of bank failure because regulatory authorities 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 the condition of Indonesian banks in the period prior to failure. Using quarterly panel data for 231 banks from March 1989 to September 1995, an empirical study is conducted to identify bank risks (which are represented by the explanatory variables used in regressions). Moreover, the paper shows how the results of this study can be used as an additional early warning signal in banking supervision. The paper is organised as follows: Section 2 discusses the banking industry in Indonesia; Section 3 provides a literature review of bank failure models; Section 4 outlines the models; Section 5 provides the theoretical background for the goodness of fit and specification of errors; Section 6 describes the dependent variables; Section 7 describes bank risk classification and the independent variables; Section 8 discusses the results of the empirical 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 to September 1995. The year of 1989 was the starting point of a new era for the banking industry in Indonesia. The central bank restructured banking regulation in October 1988 ( hereafter we call it “the reform”). The reform allowed for the establishment of new banks in Indonesia, including joint venture banks (Bank Indonesia. 1988). Many other bank regulations were also revised, involving the introduction of minimum riskbased capital adequacy requirements, the establishment of new banks and offices and new requirements for obtaining authorisation in foreign exchange operations. Therefore, the banking 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 last observation in sample is the third quarter of 1995 because the data was collected in 1996. At this point, it may be useful to outline, briefly, the development and structure of the banking industry in Indonesia. The number of banks and their offices increased significantly 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 banking business is very low. In November 1994, their share of total assets only amounted to 0.61 %. The rural banks will thus be excluded from this study as their contribution to the industry is insignificant. Commercial banks consist of: 7 state banks; 71 private foreign exchange banks (PFEB); 95 private nonforeign exchange banks (PNFEB); 31 joint venture banks (JVB); 10 foreign banks (FB); and 27 regional development banks (RDB). The differences between each group of banks depend on ownership structure and authorisation in foreign exchange operations. Based on ownership, banks may be distinguished as state banks, private banks, foreign banks, joint venture banks and regional development banks. Based on authorisation, banks may be categorised as foreign exchange banks and nonforeign exchange banks.
3. Literature Review Of Bank Failure Models
In general, there are two approaches which have been used in the prediction of bank or company failure; discriminant analysis and limited dependent variable regression models. 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 certain manner, such as “failed” and “sound”. This approach has been widely used in the
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prediction of bank failure (see Altman, 1968, Altman et al, 1977; Sinkey, 1975; and Martin, 1977). However, this approach employs some assumptions which violate realworld conditions. By simplifying reality, application of this approach in the economics, finance and business literature can only have limited usefulness. The key assumptions in discriminant analysis include the following (Hubert, 1994 and Eisenbeis, 1977): (1) The standard discriminant analysis procedures assume that variables used to describe or characterise the members of the groups being investigated are multivariate normally distributed. In fact, this is very rare in practice. Violations of the normality assumption may affect the validity of the significance parameters and estimated error rate tests. Employing the normality assumption and applying the standard procedures of discriminant analysis can, at best, produce only reasonable approximations to the truth. (2) The standard discriminant analysis also assumes that the group dispersion (variancecovariance) matrices are equal across groups. Violation of this assumption will affect the significance test for the differences in group means and classification rules. (3) Discriminant analysis procedures assume that the groups being investigated are discrete and identifiable. In fact, the definition of bank failure is based on arbitrary judgements. Haslem and Longbrake (1971) grouped banks based upon the distribution of their profitability. Sinkey (1975) distinguished between “problem” and “nonproblem” banks using guidelines which were used by the Federal Deposit Insurance Corporation (FDIC). Based on these guidelines, the FDIC keeps a list of problem banks and updates this constantly to keep its eyes on the banks which are most likely to need special attention from supervisors. Inconsistency in the application of the criteria used to identify “problem” and “nonproblem” (or “failed” and “nonfailed”) banks will lead to biased probability estimates. Additionally, discriminating factors in discriminant analysis are calculated just for the purposes of classifying groups, not for determining the causes of failure. Therefore, this approach is not suitable for determining the probability of bank failure. Realising the limitations of discriminant analysis, Mayer and Pifer (1970) adopted a limited dependent variable regression model in their study. This approach employs a binary choice of dependent variables which gives the symbol “1” for failed banks and failed (ie. sound) banks. Econometricians identify this model as a linear probability model (LPM). However, this approach does not guarantee that the estimates will fall in the range between 1 and 0 (Gujarati, 1995, p.554). To ensure that the estimates fall between 1 and 0 we have to impose a restriction on the regression estimates.
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The logistic approach can be applied to LPM (Aldric and Nelson, 1984, p.48 and Mandala, 1994, pp.236) as an alternative way to ensure that the estimates fall between 0 and 1. In mathematical terms, this can be explained in the following equation:
yi = β1 + ∑ ∑ βk xik + ei
i =1 k =1
N
K
(1)
where, yi = independent variable of observation i (symbol “1” for failed and “0” for nonfailed) β1 = intercept βk = coefficient of the k th independent variable x k = independent variable k ( k = 1,2,3............ k ) ei = error term for observation i The errors in the equation above are identically identified as following a normal distribution or i.i.d. N( 0,σ2 ). From equation 1, we can get the list of unconstrained probability estimates (zi ). Assuming Pi is the probability that a bank is classified as “failed” and P( = 1 − Pi ) is the probability that a bank is classified as “nonfailed”, the logistic function can be shown as follows: `
Ln
Pi = Zi (1 − Pi )
With algebraic manipulation , we can solve for Pi using the following equation:
ez Pi = (1 + e z )
(2)
The coefficients of independent variables can be derived using the maximum likelihood approach. With the logistic treatment, the probability will be bounded by 0 and 1 . The graph below shows the probability distribution using a logistic function.
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Graph 1 Probability Distribution of a Logistic Function
1 Distribution Range
Observations Source: Aldrich and Nelson (1984)
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Logit models have been widely used in the prediction of bank failure (Martin, 1977; Thomson, 1991, Espahdobi, 1991). They are preferable to discriminant analysis because of superior statistical properties which affect the ttest for significance parameters, the log likelihood ratio test for insignificant parameters and the PseudoR square for the goodness of fit, and because the discriminant analysis relies upon assumptions which do not exist in reality. This has lead a growing number of researchers to employ logit models in the prediction of bank or company failure. The standard logit model is normally applied to cross sectional data. If we apply a standard logit model to cross sectional and time series data (i.e. panel data), we must implicitly assume that the coefficients of the explanatory variables are the same over time and between cross sectional units. In mathematical form, this can be shown in the following equation:
yit = βi + ∑∑∑βk xkit + eit
k =1 i =1 t =1
K
N
T
(3)
where, yit = βi = xkit = βk = eit =
dependent variable of cross section i and time t intercept for all cross section i and time t k th independent variable for cross section i and time t coefficient of independent variable k for all cross section i and time t disturbance of cross section i and time t
Similarly to equation 1, equation 3 also assumes that eit is i.i.d. N( 0,σ2 ).
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The assumption that the coefficients of parameters are the same for all cross sectional units and over time may cause inefficient estimators. To accommodate the individual and time series effects, we can employ the following equation:
yit = βit + ∑ ∑ ∑ βkit xkit + eit
k =1 i =1 t =1
K
N
T
(4)
Since we have only a small number of cross sectional units and a short time series, applying this model (equation no. 4) will be very simple. It is similar to running regressions simultaneously on cross sectional units and time series. However, this model becomes more complicated for a large number of cross sectional units and a long time series. To simplify this problem, Chamberlain (1980,1982) proposed the use of the following alternatives: a fixedeffect model that maximises the joint likelihood function; or a fixedeffect model with a conditional likelihood function. The joint likelihood function fixedeffect model assumes that: (1) observations across groups are independent; (2) observations within a group are independent as well, but conditional on the group effects. The dependence of different observations within a group is assumed to be due to their common dependence on the group specific effect, β1 . In fact, a more general form of independence is possible, such as serial correlation. Therefore, the regression in this model is simply a multiple regression of y on x and a set of a group indicators which is represented by a dummy variable. Then, the likelihood function can be processed using the normal procedure. Chamberlain also suggests adopting a conditional likelihood function fixedeffect model. The key idea is to base the likelihood function on the conditional distribution of the data. Then, we can say that the statistic of the fixedeffect ( β1 ) is ∑ t yit . Chamberlain looks at the case of T = 2. If yi1 + yi 2 = 0 or 2 , then yi1 and yi2 can be determined using their sum. However, if yi 1 + yi 2 = 1 , two possibilities may occur for the order of yi1 and yi2 . The first event (wi = 0 ) arises if ( yi1 , yi 2 )=(0,1), and the second event ( wi = 1) arises if ( yi1 , yi 2 )=(1,0). The conditional density is given by the following:
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prob ( wi = 1 yi 1 + yi 2 = 1 ) =
[ prob (w
prob ( wi = 1) = 0) + prob ( w1 = 1)
i
]
(5)
e β'( xi2 − xi1) = F[ β '( xi 2 − xi1 ) = 1 + eβ'( xi 2 − xi1)
Then, the conditional loglikelihood function is:
L = ∑ i ∈I1 {wi ln F [β ' (xi 2 − xi1 )] + (1 − wi ) ln F[ − β ' (xi 2 − xi1 ]} ,
where,
I1 = {i yi1 + yi 2 = 1}
Heffernan (1995) adopts the conditional logit fixedeffect model to run panel data of bank failures from an international pool and a Scandinavian pool. However, the conditional logit fixedeffect model suffers from computational problems. According to Green (1995), the maximum of the series (T ) is 10. Computation in conditional logit fixedeffect models will become prohibitive when T>10 in the log likelihood function. The reason is that the larger the value of T in the log likelihood function the larger the space required, and computation is required at a geometric rate. Many variations on the standard logit model have been used in the prediction of bank failure. Thomson (1992) extends the standard logit model into a twostep logit model. Although, the model is similar to the standard logit model, the two step logit model employs an ordinary least square (OLS) regression to estimate one or more independent variables before running the logit regression. The drawback of this approach is that it requires the separation of the equation into at least two equations. This produces errors in each equation. Classification error analysis only appears in logit models (ignoring errors in other OLS equations). Error estimates do not represent the overall errors in the models, and the result will be misleading. For this reason, I believe a single equation model is preferable. Some researchers have employed probit models to predict bank or company failure (Bovenzi, et al, 1983; Casey, et al, 1986; Pastena and Ruland, 1986; and Dopuch, et al, 1987). The difference between probit and logit models lies in the treatment adopted to ensure that the probability estimates will fall in the range between 0 and 1. Unbounded results (i.e. unlimited range of probability) are useless in determining the probability estimates. Logit models adopt a logistic probability distribution function 8
while probit models adopt a normal probability distribution function. In mathematical terms, we can show the general form of a normal distribution for observations with mean µ and σ 2 in the following equation (Green, 1993, p.58):
f ( x µ,σ ) =
2 2 1 e− ( x− µ) /( 2σ ) 2πσ
(6)
Probit and logit models are alike because the normal and logistic distributions are similarly shaped. The difference lies just in the tails. Many studies have been done to compare these models (see, Aldrich and Nelson, 1984, Martin, 1977). The results show that probit and logit models yield similar probability estimates. However, the logit model is computationally simpler and more tractable than the probit model.
4. Models
The previous section reviews some quantitative models (e.g. Discriminant analysis, LPM, logit and probit) which have been widely used to determine the causes of company failure by taking the fact whether or not a firm goes bankrupt as the dependent variable and financial ratios as the independent variables. After reviewing those models, the main reason for choosing the logit model is the superior statistical properties of the model. However, a modified model is necessary to ensure that the coefficients of parameters are valid due to the existence of group effects in the panel data. The following part of this section develops the quantitative expression of the standard logit model for panel data. The logit models involve the calculation of the probability distributions for dependent variables based on the cumulative logistic distribution function, as shown below. Intercept and constant coefficients are calculated by using the maximum likelihood method (ML). This approach estimates intercept and constant coefficients in such a way that the probability of observing the value of the y ' s (dependent variables) is as high as possible up to the true values. This study employs a binary dependent variable ( y ) where y = 1 for problem banks and y = 0 for nonproblem banks. The value of y is assumed to depend on the constant β1 and the explanatory variables xi = (i = 1,2 , ........ i ) . The assumption that the coefficients of parameters are the same for cross sectional units and over time may create inefficient estimators in panel data. To provide evidence for this, we will employ 2 different models in this study. Model 1 assumes that the coefficients of parameters are the same for cross sectional units and over time while model 2 assumes that
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coefficients of parameters differ between groups and are the same over time. Detailed outline of econometric treatment for model 2 is discussed below. In mathematical terms, model 1 is the same as equation 3. Recall equation 3:
yit = βi + ∑ ∑ ∑ βk xkit + eit
k =1 i =1 t =1
K
N
T
(7)
where i = individual bank, t = time, k = the “ k th ” independent variable. The distribution of eit is assumed to be normal [i . i . d . N (0, σ 2 ) ]. The logistic treatment for this model has been discussed in section 2. Assuming we adopt the probability of Pi for Y = 1 given X i then the probability of
P = {( Y = 0)
given X i } = 1 − Pi , where Pi is the probability that a bank is classified as a
problem and P( = 1 − Pi ) is the probability that a bank is classified as a nonproblem bank. The probability of N values of sample Y given all N sets of values X i is calculated by multiplying the N probabilities: P (Y / X ) =
∏
n
i=1
Pi ( 1 − Pi )
ML estimation chooses the estimates of the intercept and the coefficients of parameters from a set of " K" independent variables (b ) which would make the ML
~
estimation produce estimates for Y as large as possible. The likelihood function is:
L (Y / X , b ) ≡ P (Y / X )
Each trial value b provides a value of L(Y / X i , b). ML estimation takes the value of
~ (b ) which yields the largest value of
L(Y / X i ,b ) or Max L( Y / X , b) .
b
Finally, we can derive the intercept and coefficients of the b' s by differentiating the probability equation with respect to a and b, setting the results to zero and solving for the intended coefficients.
Recall the following equation:
n
P (Y / X ) =
The likelihood function is:
∏ Pi (1 − Pi )
i=1
LP ( Y / X ) =
∏ Pi (1 − Pi )
i =1
n
10
To simplify the calculation, we transform the equation into logarithmic form and obtain the following equation:
n
LogL = ∑ [log Pi + log(1 − Pi )]
i =1 n ∂P / ∂β ∂ (log L ) ∂Pi / ∂β1 i 1 = ∑[ − ] ∂β1 Pi 1 − Pi i =1 n ∂P / ∂β ∂P / ∂βk ∂ (log L ) k = ∑[ i − i ] ∂βk Pi 1 − Pi i =1
Finally, we can solve for β1 and βk using the TSP software package to get efficient estimators. This study employs crosssectional and quarterly timeseries data of financial ratios of banks from March 1989 to June 1995. In this estimation, there may be a problem with behaviour over time for a given crosssectional unit and among the crosssectional units themselves to get efficient parameters in the estimation (Judge et al, 1985, pp.51560). According to Judge, we can classify the variation in behaviour over time and within crosssectional units into five alternatives, as given in the following outline. Recall the equation of a linear model in panel data:
yit = β1it + ∑ βkit xkit + eit
k =2
K
(8)
The first alternative assumes that all constants and slope coefficients are the same for crosssectional units and over time ( β it = β and β = β ). This treatment also assumes 1 1 kit k that the different behaviour between crosssectional units and over time will be captured in the disturbance term ( eit ). Therefore, eit will be heteroscedastic and autocorrelated. The second alternative assumes that the constant varies between crosssectional units only (i.e. is the same over time) and the slopes are the same both for crosssectional units and over time ( β1it = β1i = β1 + µi 1 and β = β ). The third alternative assumes that the kit k constant varies between crosssectional units and through time but the slope coefficients are the same ( β1it = β1 + µi + λt and β = β ). The fourth alternative assumes kit k that the slope coefficients and constants vary between individuals ( β1it = β1i = β1 + µi 1 and
βkit = βki = βk + µki ). The fifth alternative assumes that the slope coefficients and constants
vary between individuals and over time ( β1it = β + µi + λt and βkit = βk + µki + λkt ).
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However, it is still unclear whether the effects on the coefficients of variables of each crosssectional unit (µ) and over time (λ ) are fixed or random. If these effects are assumed to be fixed, we can use dummy variable models for the constant and the seemingly unrelated regression models for the slope coefficients. Alternatively, if the effects are assumed to be random, we can use Error Component Models for the intercept (Mundlak, 1978a) and Swamy Random Coefficient Models for the slope coefficients (Swamy, 1970). Another approach is recognised within the Hsio Random Coefficient Models, which assume that effects on the intercept and slope coefficients are random (Hsio, 1974, 1975). The choice of fixed or random effects for the model depends on whether the µi and X i are correlated. The random assumption results in a more efficient estimator when correlation between µi and X i exists by assuming a certain distribution of the µi . However, Judge (1985, p.527) suggests that the random assumption may produce inefficient estimators when the true distribution of µi is different from the assumption. Furthermore, Judge suggests that dummy variable estimators are appropriate for small N regardless of the correlation between µ and X i . Therefore, dummy variable i estimators are valid in this study for the following reasons: first, this study employs only 5 cross sectional units (i.e. N = 5 ); second, we are not sure of the distribution of µi . Model 2 assumes that the intercept and slope coefficients vary between groups using a fixed effects model, but that they are the same between individuals within groups and over time. The aim of model 2 is to test whether each group of banks has different significant coefficients of parameters. The results of model 2 may show different significant parameters for each group compared to that in Model 1. This information is useful for regulatory authorities as it enables them to focus on the particular risks to which the groups are sensitive in supervising banks. In mathematical terms, model 2 can be shown in the following equation:
y git = βg + ∑βgk xkgit + egit
k =1
k
(9)
where, g = groups of banks ( g = 1................. G); i = individual banks ( i =1…………..N); t = time series ( t = 1....................T ) k = the “ k ” independent variables ( k = 1.................. K ) . The disturbance term, eit , is also assumed to be normally distributed [ i . i . d . N (0, σ 2 ) ]. 12
This study adopts dummy variables of fixed effect models for the intercept and seemingly unrelated regression of fixed effect models for the slopes. According to Baltagi (1995, p.179), Mandala (1994), and McFadden (1984), the crosssection treatment applies for panel data of limited dependent variables since we assume there is no random effect for individuals. The treatment for the use of dummy variables for the intercepts is outlined in the following table: Table 1 Dummy Variables for Constants
D1 Group 1 Group 2 Group 3 Group 4 Group 5 1 0 0 0 0
D2 0 1 0 0 0
D3 0 0 1 0 0
D4 0 0 0 1 0
D5 0 0 0 0 1
To illustrate the treatment of fixed effects for slope coefficients using a seemingly unrelated regression model, we employ the following equation:
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y gi βg
* t
= β g1k 1 x *1 k1it + βg 2 k 1 x * 2 k1it + ..... β g n k 1 x * n k 1it + β g 1 k 2 x *1 k 2 it + g g g g
* x * 2 k 2 it +........ β g n k 2 x * n k 2 it + .... .... βG K x GKit + e g i t * g g
2k2
y * i t = y g 1it → if g = 1 a n d i = 1, ......... ... .... n1 g y g 2 it → if g = 2 a n d i = n1 + 1, ........... n 2 y g G it → if g = G a n d i = n g − 1 + 1, ......... ..... n g x *1 k1it = g x * 2 k 1it g
{ ={
x g1k 1it → if g = 1 a n d i = 1 , ...........................................n1 0→ O t h e r w i s e 0 → Otherwise x g 2 k1i t → ifg = 2 a n d i = n1 + 1, ..................................n 2
x * G k K it = g
e * i t = e1 it → if g = 1 and i = 1, ............ ... . n1 g e2 it → if g = 2 a n d n1 + 1, ........... n2 e g i t → if g = G a n di = n g −1 + 1.... .... .... .. n g
(10) Where: g = k = i = β = x = y = t = ng = the groups of banks ( g = 1,2,................ G) the “ k ” independent variables ( k = 1,2,............. K ) the individual bank (i = 1,2....................... N ) the coefficient of independent variables the independent variable the dependent variable the time series ( t = 1,2,..........................T ) the number of observations in group g and n1 + n2 +.......... ng = N
{
0→ Otherwise x g G k K it → ifg = G a n d i = n g − 1 + ............................. n g
If y belongs to g = 1 , this model will give a zero value to independent variables and a constant for g ≠ 1 .
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5. Goodness Of Fit And Specification Of Errors 5.1. GoodnessOfFit (Pseudo R²)
Traditional R² is not appropriate for the model with a limited dependent variable (Aldrich and Nelson, 1984, p.56) as the value of the dependent variable is 0 or 1. The criteria of success in the traditional R² estimation is the degree to which the error of variance is minimised while the logit model uses the criteria of maximum likelihood. Previous studies used several methods to measure pseudo R². Several surveys, such as those used by McFadden (1973, p121), Aldrich and Nelson (1984), and McKelvey and Zavoina (1975) different pseudo R²’s yield different values from the same model and data. To determine which one is the best is arbitrary. Zimmermann (1996, p.241259) suggests that the Mckelvey and Zovoina R²’s model (R²MZ) yields the best score. However, the R²MZ produces a score which is more sensitive to misspecification in the error term than the McFadden’s pseudo R², especially in binary probit and logit models. For the purpose of this study, we will therefore use McFadden’s pseudo R². The detail of the mathematical expression of the pseudo R² is shown in Appendix 2.
5.2. Test For Specification Of Errors
This study also examines the power of the regressions to predict the probability of problem banks emerging by using all observations. The result of this model is an array of probability numbers between 0 and 1. By employing a certain cutoff point, this model produces estimates in three categories: correct estimates, “error I type” estimates and “error II type” estimates. A cutoff point is the point to determine whether a bank is classified as a problem or nonproblem bank. This approach has been widely used by authors in estimating the probability of bank or company failure (Martin, 1977; Sinkey, 1975; Bovenzi, Marino and McFadden, 1983; Korobow and Stuhr, 1976, 1983; Espahbodi, 1991). For instance, a cutoff point of 0.4 means that the models identify estimated values of > 0.4 as problem banks and estimated values of < 0.4 as nonproblem banks. The models produce correct estimates when the observations of problem banks are estimated as problems or, with a cutoff point of 0.4, the estimated value is >0.4. Error I types occur when the models predict nonproblem banks as problems or, in this example, the models produces a probability >0.4 for a nonproblem bank. Error II types occur when the models produce a probability of < 0.4 for a problem bank. The lower the cut15
off point, the greater the number of banks predicted as problems is and the fewer the number of banks predicted as nonproblem is. The choice of a cutoffpoint plays an important role in the calculation of errors. Therefore, a fair cutoffpoint is important in error analysis. The sample proportion of failed and nonfailed banks is believed the best criterion to determine the cutoffpoint. For instance, samples with 50% of failed banks and 50% of nonfailed banks will use a cutoff point of 0.5, and samples with 60% of failed banks and 40% of nonfailed banks will use a cutoffpoint of 0.4. This study employs an out of sample test using the last observation (September 1995) which consist of 230 data points. The aim of this test is to examine the ability of the models to estimate the probability of banks being problems using data which are not employed to generate the models.
6. Dependent Variables
Logit models have been widely used in social science to determine the probability that a particular event occurs (see section 3 above) by using a range of independent variables. Some researchers use logit models to estimate the probability of bank failure. However, certain problems can cause inaccurate estimates. These problems include small sample size (related to bank failure) and lack of publication of true information. Additionally, the results would be biased if there was a substantial number of bank failures as a result of fraud. The argument is that the balance sheets and income statements could not handle fraud. Prediction of the probability of bank failure is not appropriate for this study because there were only a few banks which failed in Indonesia from 1970 to 1996 as a result of a “too big to fail” policy. However, there were some banks which were recognised as “problems”. To determine which banks might prove problematic, this study adopts criteria which have been used by the Bank of Indonesia. This study thus employs information on problem or nonproblem banks as dependent variables. A bank can be defined as “problem” if it satisfies one or both of the following criteria: first, the bank needs financial or/and management support from government to continue its operations; and second, its composite rating is either “poor” or “unsound” (Bank Indonesia, 1991b)2. The composite ratings are calculated monthly, based on financial reports and the judgement of supervisors. The central bank maintains a list of problem banks and updates it regularly. To insert the data into
2
The rating is defined based on the following credit points: 81100 is “sound”; 6680 is “fairly sound”; 5165 is “poor” ; 050 is “unsound”.
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models, this study assigns symbols to dependent variables of “1” for problem banks problem banks. By employing problem and nonproblem banks as dependent variables, the supervisory authorities have more lead time to introduce corrective action for banks estimated as problems than that of banks estimated as failures. If a bank has been categorised as a failure, the condition of the bank must be very serious and the authorities will find limited time to provide appropriate remedial treatment. Moreover, the internal consistency used in the identification of problem banks contributes significantly to the “goodness of fit” of the estimates in this study.
7. Bank Risk Classification And Independent Variables
Some economists classify risks according to the activities engaged in; market risk, economic environment changes (Flannery and Guttentag, 1979; Guttentag and Herring, 1988) and management and operations risks (Mullin, 1977; Graham and Horner, 1988) are often identified in this fashion. There are other kinds of risks, however, which may cause significant damage before their dimensions are well understood; these would include interest rate risk and sovereign risk (Stanton, 1994). The following section discusses most of the risks arising in practice. Gardener (1986) reported that bank risk comprises general risk, international risk and solvency risk. General risk is a fundamental risk faced by all banks, comprising liquidity risk, interest rate risk, and credit risk. Votja (1973) has yet another view of bank risk. Based on his approach, risk can be classified according to a bank’s operations or activities; credit risk, investment risk, liquidity risk, operating risk, fraud risk, and fiduciary risk all can be identified. Revel (1975), however, argues that Votja focuses on only some of the possible sources of risk; as a result, the limited risk classification system used could be very dangerous for both regulators and depositors. He mentions that the list does not identify foreign exchange rate risk as an important possible sources of bank loss, nor interest rate risk, apart from its effect on asset prices. In contrast, Maisel classifies the risk of banks to be interest rate risk, operating risk and fraud (Maisel, 1981, pp. 140). He argues interest rate risk contributes significantly to insolvency. Fraud is very common as one of the causes of bank failure. The fraud may come from either internal or external abuses. Owners and managers may alter the portfolio to enhance their personal investments or those of family or friends (Hall, 1992). There can also be defalcations made by members of staff, or the bank can be defrauded as a result of undue trust or inadequate investigation of borrowers (e.g. BCCI).
17
Although other authors suggest alternative risk classification systems, most of them provide almost the same descriptions and coverage as those of the authors mentioned above. Today, however, the most significant risk for banks is a failure to diversify. This risk may arise from a concentration of longterm maturities and, thus, an excessive interest rate risk. It may also emerge from a concentration of loans in a specific industry, or the location of small banks in single neighbourhoods or towns. A large bank may be faced with too many foreign risks, or too high a level of lending to a related group of investors or companies. A similar lack of diversification may arise from excessive shortterm borrowings or a concentration on other types of managed liabilities. Risk in a modern bank thus comprises more types of risk compared to that in traditional banks. McNew (1997) suggests a more comprehensive risk classification for a modern bank. She claims that financial risk in a modern bank comprises credit risk, market risk, liquidity risk, operational risk, regulatory risk and human factor risk. The detail of each risk is shown in the following figure:
Figure 1 Components of Financial Risk
Transaction risk Credit risk Portfolio concentration
risk
Issuer risk
Counterparty risk Trading risk Gap risk
Equity risk Financial Risks Market risk
Interest rate risk Currency risk Commodity risk
Liquidity risk Money transfer risk Operational risk Regulatory risk Human factor risk Valuation error risk System risk Clearance risk Model risk
18
From the discussions above, we can derive a number of conclusions. First, the risk components defined by the authors considered above are fairly closely related to each other; although they classify the risks in different ways, they seem to overlap with each other. Second, solvency risk covers major components of risk. It means we can hypothesize that insolvency has the most significant role to play in bank failure and other risks, such as credit risk, market risk (including exchange rate risk), interest rate risk and operating risk, are merely components of the solvency risk. Solvency risk can be defined as the risk which is associated with changes in the market value of equity in order to satisfy stakeholders that the bank is still solvent. If the value of equity is low, the regulator will require the bank to add more capital or to reduce risk by restructuring its risky assets to a level which increases the economic value of the equity. Third, there are also some risks which are not related directly to solvency risk. Banks may find difficulties in controlling these risks because the sources of the risks are mostly beyond the management boundary. These risks are normally associated with prudential operations with which the regulator needs to be concerned before a bank becomes insolvent, such as political risk and fraud. Financial ratios are the main explanatory variables used to estimate the probability of failure. The ratios normally represent liquidity, solvency, size, asset quality, and earnings. Most of the previous authors surveyed above believe that such variables can be used to represent the causes of bank failure. However, due to the development of risk analysis, the causes of bank failure can now be more closely identified as arising from such risk as credit risk, operational risk, foreign exchange risk, interest rate risk, credit risk, and fraud risk. These risks will affect the liquidity and solvency of banks. Some previous researchers did not include the ratios which represent foreign exchange and interest rate risk. Appendix 3 shows in detail the variables which have been used in previous studies. This study employs 14 independent variables which represent proxies for determinants of bank risks. As discussed in the previous outlines, the probabilities of banks suffering losses are measured by their risks. In general, bank risk consists of credit risk, interest rate risk, foreign exchange risk, liquidity risk, solvency risk and efficiency risk. There are other risks which are not covered in this study such as settlement risk, legal risk, fraud risk and exposure risk. The main reason is that there is little data to support analysis of these risks. The rationale for the relationship between risks and independent variables is discussed in the following section.
19
Sometimes, it is difficult to say precisely what the relationship (i.e. positive or negative) between dependent and independent variables is when one event occurs because of two or more coincidental conditions. For example, a short position in call money (negative gap in maturity) creates a benefit for banks when interest rates drop and causes a loss when interest rates increase. This study can only suggest the signs of independent variables under certain circumstances. The differences between the results and the suggestions will be discussed in the analysis of results. The following subsections discuss the financial ratios which are used as independent variables in this study.
7.1. Ratio Relating To Credit Risk
Credit risk is defined as the probability (ie. risk) of default by borrowers. Bank Indonesia assesses asset quality, used to form a proxy for losses due to default by borrowers, using the following procedure (Bank Indonesia, 1991a). First, bank supervisors classify the accounts of the borrowers into one of four categories, “good”, “substandard”, “doubtful” and “baddebts” (loss) by employing a rule agreed between the banking industry and the central bank 3. Second, bank supervisors calculate a proxy for the losses on each loan category based on an agreed rule 4. Third, bank supervisors estimate asset quality by summing the amount of proxy losses for all borrowers, and the result is then divided by total loans. Asset quality (AQ) represents credit risk in this regression. Theory suggests that the higher the AQ, the higher the probability of banks suffering problems
7.2. Ratios Relating To Liquidity Risk
Liquidity risk is the probability or risk of a bank being unable to meet its shortterm obligations, such as current account and time deposit withdrawals and shortterm money market liabilities, as they fall due. This study includes only the “banking book” items because only a few banks operate trading books (i.e. derivatives). The following financial ratios serve as proxies for liquidity risks:
3 4
The rule relies on variables such as the delay in expiration, and lack of security taken as collateral.
repayment, including interest and instalment,
A proxy for losses is calculated according to the following rules: a “good loan” is defined as zero loss; “substandard” is defined as a 50% loss; “doubtful” is defined as a 75% loss; and “bad” debt is defined as 100% loss.
20
a. Call Money To Total Assets Ratio (CMAR)
Call money is funds borrowed from the money markets with a maximum term of 90 days. Banks normally use these sources of funds to satisfy a minimum liquidity requirement imposed by the central bank at the end of the day after the clearing house has closed. The hypothesis is that the higher a bank’s funding on this basis, the higher the probability of it suffering problems (+ sign). This ratio also reflects the sensitivity of banks to interest rate risk as a result of the volatility of interest rates in money markets.
b. Discount Window Borrowing To Total Assets Ratio (DAR)
The discount window is a facility for banks which suffer illiquidity enabling them to borrow a certain amount of money from the central bank at market interest rates using money market certificates as collateral. Normally, banks use this facility when they are unable to borrow money from the markets or other banks. In this case, the central bank acts as the lender of the last resort. However, the use of this facility only is subject to tight requirements. Theory suggests that the higher this ratio, the higher the probability that a bank is suffering from liquidity problems (+ sign).
c. Loans To Deposits Ratio (LDR)
The loans to deposits ratio assesses the role of deposits in financing loans. A higher ratio means the lower the proportion of loans financed by deposits. Other funds are available to finance loans, such as call money, discount window borrowing and other market borrowings. (This study assumes that there is no paidup capital to finance loans). The interest rates on these other funds, however, are higher than for deposits and, especially for call money, the interest rates are volatile. Theory suggests that the higher this ratio, the higher the probability of a bank suffering liquidity problems (+ sign).
7.3. Ratios Relating To Solvency Risk
The solvency ratio represents the ability of banks to meet losses without being liquidated. This ratio normally measures net worth compared with total assets or borrowed funds. However, this study adopts the capital to total assets ratio (CAR) to proxy the solvency risk. The components of capital in this ratio consist of paid up capital, including capital stock, general reserves, retained earnings, and unpublished retained earnings. This study includes a delta earning of each quarter in the components of capital. The capital at problem banks must be higher than that of nonproblem banks as a result of the adoption of a risk based capital adequacy (Basle Accord of 1988) assessment regime since 1988. The rationale is that the problem banks have to maintain higher capital as reserves for settling the anticipated losses.
21
Thus, the higher this ratio, the lower the probability of a bank suffering solvency problems5.
7.4. Ratios Relating To Interest Rate Risk
Interest rate risk is the risk or probability of a bank suffering losses because of the volatility of interest rates (see section 2). Banks with long funding positions (i.e. positive maturity gaps) will benefit when interest rates decrease and the banks will lose money when interest rates increase. Banks with short positions (i.e. negative maturity gaps) will lose money when interest rates decrease and benefit when interest rates increase. To detect the sensitivity of banks to interest rates, this study uses three independent variables; CMAR, LDR and IRR. CMAR and LDR have been discussed in the liquidity risk section. Additionally, this model also uses interest rate risk (IRR) as an independent variable to detect, in general, the sensitivity of banks to interest rate movements. The interest rate data used in this model are daily money market rates at Jakarta interbank offered rates or JIBOR, and these are transformed into interest rates on a quarterly basis using delta weighted averages. To proxy for the interest rate risk, we multiply this delta interest rate by net call money positions. Finally, IRR is derived from the following equation:
IRR = (R − R−1)CMP t t
where, = the real interest rate in a given quarter R t − 1 = the real interest rate in the previous quarter CMP = the net call money positions
R
t
(11)
We expect a positive sign for IRR as evidence suggests that many banks suffer problems because of the volatility in interest rates.
7.5. Ratios Relating To Efficiency Risk
The ROA and ROE ratios are the main ratios to measure efficiency risk. The numerators of these ratios (ie. Returns) are derived from the retained earnings figures of income statements. However, these ratios are unable to show which components of profit and loss contribute significantly to the ratio. For this reason, this study examines efficiency risk using components or items in the profit and loss statements such as incomes, costs and expenses. Additionally, this section also examines the efficiency of funds allocated for fixed assets using a fixed assets to capital ratio.
5
The information on risk adjusted capital ratios (BIS approach) cannot be used in this study for secrecy reasons.
22
a. Return On Assets (Roa) Ratio
The ROA ratio measures the ability of banks to generate incomes from each unit of asset. Theory suggests that the higher the ROA, the lower the probability of banks suffering problems ( sign).
b. Return On Equities (Roe) Ratio
The ROE ratio measures the ability of banks to generate incomes from each unit of equity. This study also suggests that the higher the ROE, the lower the probability of banks suffering problems ( sign).
c. Operating Income Ratio (Oir)
The OIR is the ratio of noninterest operating incomes to total income. The operating income consists of incomes from trading activities and incomes from other services, including fees. This ratio measures the ability of banks to generate incomes from non loans or investments. A lower ratio indicates that a bank has problems earning revenues from nonloans and investment activities. This condition implies that banks’ operations are not efficient. Therefore, theory suggests that the lower this ratio, the higher the probability of a bank suffering problems ( sign).
d. Interest Income Ratio (Iir)
The IIR is the ratio of interest income to total incomes. This ratio measures the ability of banks to generate interest revenues from their investments. The purpose of including this variable in the regression is to examine whether interest incomes contribute significantly to (the causes of) the problems faced by banks. Since the banks concentrate on investment activities, theory suggests that the higher this ratio, the lower the probability of a bank suffering problems ( sign). However, this causation is not appropriate for banks which generate incomes mainly from foreign exchange trading, which will lower the resultant IIR.
e. Interest Cost Ratio (ICR)
The ICR is the ratio of interest costs to total costs. The objective of employing this ratio is to examine whether banks can manage interest costs effectively. A higher ratio implies that banks incurred higher interest costs (i.e. inefficient). A measure of the ability of banks to control interest costs is the interest rate margin. However, because of limited information, this study will not employ interest rate margins in the regressions. Theory suggests that the higher the ICR, the higher the probability of a bank suffering problems (+ sign).
f. Fixed Assets To Capital Ratio (FACR)
The FACR is the ratio of fixed assets to capital. The FACR measures the effectiveness of banks’ operations in allocating funds to investments which generate incomes. Because fixed assets are not earning assets, a high ratio is an indication of ineffectiveness in a bank’s operations. Theory thus suggests that the higher this ratio, the higher the probability of a bank suffering problems (+ sign).
g. Loan Provisions Ratio (LPR)
LPR is the ratio of loan provisions to total loans. The objective of employing this ratio is to examine the ability of banks to build reserves for both expected and unexpected losses. A high ratio shows that banks have enough funds to cover loan losses. Theory suggests that the higher
23
this ratio, the lower the probability of a bank suffering enough funds to back up its losses ( sign).
problems b ecause the bank will have
7.6. Exchange Rate Risk
To detect the sensitivity of banks to the volatility of exchange rates, this study employs the exchange rate of the US dollar against the domestic currency, the Indonesian Rupiah (IDR). This variable is represented by FXDER. The US dollar dominates the positions of Indonesian banks because most foreign exchange transactions are denominated in the US dollar6. Additionally, reports of foreign exchange positions made to Bank Indonesia are denominated in US$. Therefore, this study only employs data for the US$/IDR exchange rate. To calculate the FXDER, this study adopts continuous compounds (ie. log returns) of the quarterly average of exchange rate returns and multiplies the results by the foreign exchange positions. In mathematical terms, the FXDER can be expressed by the following equation: E FXDER = Ln t FX . E t −1
(12)
Theory suggests that the higher the foreign exchange volatility, the higher the probability of a bank suffering problems. This study assumes that the exchange rate US$/Rupiah is highly volatile and we therefore expect a positive sign for this variable.
8. Empirical Results
The discussion in this section begins with the signs of parameters and continues with testings of the coefficients. We discuss only the signs which are different from a priori expectation and attempt to explain why they occur. The discussion begins with an analysis of the results for model l and is followed by discussion of the results for model 2. Model 1 produces 3 signs (i.e. + for IIR, CAR and  for LDR) which differ from expectations (see Table2). Logically, one expects a negative sign for IIR whereas the result shows a positive sign. There are many possible explanations for this situation. The best possible explanation is that most of the problem banks try to make more money by charging higher interest rates on lending but they have to pay higher interest rates on borrowed funds. Therefore the IIR must be relatively high but the interest rate margin is relatively low. This policy is common for problem banks where operational
6 This condition may reflect the fact that the IDR was pegged to the USD
24
costs and expenses are relatively high. Alternative explanations are also possible, such as incurring losses on foreign exchange trading and fraud. The sign for CAR also differs from expectations. This condition shows that most problem banks post high CARs to comply with riskadjusted capital adequacy regulation. Another variable which gives a different sign from that expected is LDR. While a positive sign for LDR is expected, the model produces a negative sign. The negative sign means that the higher the LDR, the lower the probability of banks suffering problems. The higher LDR (LDR>1) means that banks finance loans from other sources of funds instead of using deposits. Other sources of funds may consist of borrowed funds from the money market or other banks. The negative sign shows that the banks which used borrowed funds gained a reduced probability of suffering problems. However, the coefficients of IIR and LDR are not significant using a tcritical value of 1.96 (a confidence interval of 95%). To examine whether the signs of those coefficients remain consistent across the groups, we will discuss the results of model 2 later in this section. Based on the tdistribution table, the results show that six variables (CMAR, FXDER, ICR, IRR, IIR, LDR) are insignificant even with a 0.10 confidence level. These variables represent interest rate risk (IRR, LDR and CMAR), foreign exchange risk (FXDER) and efficiency risk (IIR, ICR). To test whether these coefficients are still zero when they interact simultaneously, we use the log likelihood ratio test by excluding the insignificant variables from the model. The results show that the log likelihood ratio is 3.99 (L0 = 2012.69 and L 1 = 2104.68)7. Based on the chisquare distribution table with a degree of freedom (df) of 6, we accept the hypothesis that the coefficients of the omitted variables are zero at the 5% confidence level. Finally, we can conclude that only eight variables (i.e. AQ, CAR, FACR, DAR, LPR, OIR, ROA, and ROE) are significant. Based on the results in model 1, we can thus derive the conclusion that banks, individually, in Indonesia are not very sensitive to foreign exchange risk or interest rate risk, but that they are sensitive to credit risk, efficiency risk, solvency risk and liquidity risk.
7
Log likelihood ratio test=2(2103.362104.1)=1.48.
25
To compare the results for model 1 and model 2, this study employs the pseudoR2 proposed by McFadden (1973, p.121). The R2 is derived from the following calculation (see Appendix 2 for detail): R2= 1 − where, lm =
− 2 ,012.69 =0.38 − 3,253.75
2,012.69 and l o=3,253.75
This R2 is lower than the R2 in model 2 considered later in this discussion.
26
Table2 Regression Results
1 Variables Intercept 2 AQ + 3 4 5 6 7 8 ICR + 9 IIR 10 IRR + 11 LDR + 12 LPR 13 OIR 14 ROA 15 ROE Loglikelihood
CAR CMAR DAR FACR FXDER + + + +
Expected sign Model 1 Coefficients tstatistic Prob Test Coefficients tstatistic Prob Model 2 Group 1 Coefficients tstatistic Prob Group 2 Coefficients 0.95 1.56 0.57 0.57 0.84 3.77 0.00
0.23 27.22 0.00
0.01 8.92 0.00
0.001 0.067 0.003 0.45 0.65 7.45 0.067 0.003 2.85 0.00 2.78 0.01 2.81 0.01 2.67 0.01
0.000 1.12 0.26 Prob: 
0.003 0.000 0.000 0.007 0.13 0.014 1.16 0.008 1.24 0.22 0.28 0.13 5.72 0.00 0.01 1.18 0.009 0.13 0.89 0.41 0.68 0.59 0.55 5.61 0.00 2.15 20.30 3.47 0.03 0.00 0.00
1911.85
Log likelihood ratio: 0.61 6.66 0.00 0.23 27.51 0.00 0.014 9.28 0.00
1916.49
2.27 21.41 3.54 0.02 0.00 0.00 1680.24
1.47 3.51 0.00
0.06 0.56 0.58
0.08 1.37 0.006 0.71 1.15 0.48 0.25 1.56 0.12
0.000 0.79 0.43
0.24 3.25 0.00
1.56 0.57 0.57
0.000 0.91 0.36
1.81 1.86 0.06
1.46 2.84 0.00
0.04 0.44 0.66
6.55 0.004 3.16 0.00 0.30 0.76
0.25
0.01
0.01
0.03
0.01
0.00
0.00
0.00
0.00
0.02
0.15
0.05
4.98
0.00
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1 tstatistic Prob Group 3 Coefficients tstatistic Prob Group 4 Coefficients tstatistic Prob Group 5 Coefficients tstatistic Prob 6.58 5.27 0.00 0.33 0.10 0.92 0.10 0.38 0.71 0.90 0.37
2 8.76 0.00
3 0.87 0.38
4 0.41 0.68
5 0.50 0.62
6 1.44 0.15
7 0.37 0.71
8 0.19 0.85
9 0.33 0.74
10 0.42 0.67
11 0.40 0.69
12 1.35 0.18
13
14
15
2.29 10.78 0.01 0.02 0.00 0.99
0.24 17.00 0.00
0.01 7.01 0.00
0.01 1.41 0.16
0.28 4.18 0.00
0.00 0.36 0.72

0.00 1.47 0.14
0.01 2.44 0.01
0.00 0.79 0.43
0.03 1.88 0.06
0.04 1.26 0.21
0.01 0.85 0.40
1.43
0.00
15.92 0.39 0.00 0.69
0.13 3.82 0.00
0.00 0.31 0.76
0.00 0.23 0.82
0.08 0.21 0.83
0.05 1.39 0.16
0.00 0.86 0.39
0.03 2.04 0.04
0.00 0.01 0.99
0.00 0.73 0.47
0.01 0.37 0.71
0.01 0.06 0.95
0.01 0.22 0.83
2.34 0.27 3.10 2.33 0.00 0.02
0.39 11.65 0.00
0.01 0.62 0.54
0.02 0.99 0.32
0.04 0.49 0.63
0.01 0.98 0.33
0.00 0.20 0.84
0.00 0.36 0.72
0.01 0.87 0.39
0.00 1.65 0.10
0.91 1.78 0.08
0.03 0.37 0.71
0.07 1.47 0.14
0.03 0.01 0.15 0.67 0.88 0.50
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The results of model 1 are based on the assumption that the constant and slope coefficients are the same between individuals and over time. There is an argument that the results may be different if we employ more restrictive models, such as model 2. Therefore, this study also employs model 2, which assumes that the constant and slopes vary among groups but are the same between individuals and over time, in order to examine whether each group of banks faces different risks as represented by the financial ratios. The following table shows the groups of banks in Indonesia:
Table3 Groups of Banks in Indonesia
BANKS State Banks Private Foreign Exchange Banks Private Nonforeign Exchange Banks Joint Venture Banks Regional Development Banks Total GROUP I II III IV V NUMBER OF INDIVIDUALS 7 71 95 31 27 231
The results of model 2 show that the intercept and constant coefficients for each group differ from that in model 1 (see Table2). This shows that group effects are significant in this model. Based on a confidence level of 0.05, most of the groups are sensitive to credit risk (AQ), but none is sensitive to foreign exchange risk (FXDER) . All groups are also sensitive to efficiency risk but only group 3 is sensitive to solvency risk (CAR). The results for group 1 show that banks are sensitive to AQ, ICR, LPR, ROA at a 5% confidence level and to LDR at a 6% confidence level. Therefore, banks belonging to group 1 are very sensitive to credit risk (AQ), efficiency risk (ICR, LPR, ROA), and interest rate risk (LDR). The results for group 2 show that banks are sensitive to AQ, OIR, ROA at a 5% confidence level. Therefore, banks belonging to this group are very sensitive to credit risk (AQ) and efficiency risk (OIR and ROA). The results for group 3 show that the signs of AQ, CAR, DAR, IIR, and ROA are
29
significant at a 5% confidence level and LDR is very significant at a 6% confidence level. In other words, banks belonging to this group are sensitive to credit risk (AQ), solvency risk (CAR), liquidity risk (DAR and LDR), efficiency risk (ROA), and interest rate risk ( LDR). The results for group 4 show that the signs of AQ, ICR, ROA and ROE are significant at a 5% confidence level. These findings imply that banks belonging to this group are very sensitive to credit risk (AQ) and efficiency risk (ICR, ROA and ROE). The results for group 5 show that only AQ is significant at a 5% confidence level while IRR is significant at a 10% confidence level, and LDR is significant at a 8% confidence level. Therefore, banks belonging to this group are sensitive to credit risk (AQ), interest rate risk (IRR ), and liquidity risk (LDR). To measure the goodnessoffit, we employ the same method as that in model 1. The R2 is derived from the following (see Appendix 2 for details): R2 = 1 − where, lm = 1,700.74 and lo = 3,142.04 Based on these results, model 2 is more efficient than model 1 in estimating the probability of banks being problems. This study employs an out of sample test using the last observations (September 1995) which consist of 230 data points. The aim of this test is to examine the ability of the models to estimate the probability of banks being problems using data which are not employed to generate the models. The results of out of sample tests are shown in Table 4. The error classification in this study adopts cutoff points of 0.5 and 0.6. In general, model 2 produces fewer errors than model 1. We can thus conclude that model 2 is better than model 1. Model 1 classifies 28 observations of nonproblem banks as problem (i.e. error I type), or 12.17% of total observations (230), using a cutoffpoint of 0.5. Error I type occurs if the model produces P > 05 for Y = 0 (see Appendix 2). Model 1 classifies 16 . observations of problem banks as nonproblem (i.e. error II type), or 6.96%. Error II type occurs if the model produces P < 0 . 5 f o r Y = 1 . The total errors of estimates in model 1 is 19.13%, or 44 observations out of 230 observations, so that correct estimates account for 80.87%, or 196 observations. However, when we use a cutoffpoint of 0.6, the total errors decrease to 16.96% and the correct estimates increase to 83.04%.
− 1, 700 .74 = 0.46 − 3,142 .04
30
Model 2 produces more correct estimates than model 1. Using a 0.5 cutoffpoint, model 2 predicts total errors of 13.91% and estimates 86.09% of observations correctly. The total errors decrease to 12.18% when we use a cutoffpoint of 0.6, which we believe is the fair cutoff point because this study employs 1984 observations of problem banks (or 41.32%) and 2,817 observations of nonproblem banks (or 58.68%). The errors mostly occur in the transition period from banks being classified as problem to nonproblem or the other way round. Finally, we can conclude that model 2 produces better coefficients of estimates than those in model 1.
Table 4 Error Summary
CORRECT AND ERROR ESTIMATES CUT OFF POINT OF 0.5* Model1 obs Correct Estimates Error I Type Error II Type Total 196 28 16 230 % Model 2 obs % CUT OFF POINT OF 0.6 Model 1 Obs 291 20 19 230 % 83.04 8.70 8.26 100 Model 2 obs 202 14 14 230 % 87.82 6.69 6.69 100
80.87 198 86.09 12.17 6.96 100 24 8 230 10.43 3.48 100
9. Summary And Conclusions
Based on the coefficients of the regressions, model 1 produces significant coefficients for AQ, CAR, DAR, FACR, LPR, OIR ROA, and ROE at a 5% confidence level. These parameters represent credit risk (i.e. AQ), solvency risk (i.e. CAR), liquidity risk (i.e. DAR) and efficiency risk (i.e. FACR, LPR, OIR, ROA and ROE). However, the coefficients of parameters which represent exchange rate risk (FXDER) and interest rate risk (i.e. CMAR, IRR and LDR) are insignificant at the 5% confidence level. Considering the findings in model 1, we can conclude that banks in Indonesia are not sensitive to exchange rate or interest rate risks, but that they are sensitive to credit risk, liquidity risk, efficiency risk and solvency risk. Each group in model 2 produces different and significant coefficients of parameters from those in model 1. This finding provides evidence that the group effects are significant. The coefficients of parameters which represent credit risk (AQ) for all 31
groups are significant at a 5% confidence level. The parameter which represents solvency risk (CAR) is significant at a 5% confidence level only in group 3. The coefficient of the parameter which represents interest rate risk (IRR ) is significant at a 10% confidence level in group 5; and LDR is significant at a 6% confidence level in group 1 and group 3, and at an 8% confidence level in group 5. Therefore, only group 3, group 1 and group 5 are sensitive to interest rate risk. The coefficients of parameters which represent foreign exchange risk (FXDER) are insignificant for all groups. Therefore, banks in Indonesia, by group, are less sensitive to foreign exchange risk. The coefficients of parameters which represent liquidity risk are identical with the parameters which represent interest rate risk. The additional parameter for liquidity risk is DAR which is significant only for group 3. Therefore, group 1, group 3 and group 5 are the only groups sensitive to liquidity risk. The coefficients of parameters which represent efficiency risk are mostly significant at a 5 % confidence level, which is the case for group 1, group 2, group 3 and group 4. Only group 5 is not very sensitive to operational risk. Finally, we can conclude that banks belonging to group 1 are sensitive to credit risk, interest rate risk, liquidity risk, and efficiency risk; banks belonging to group 2 are sensitive to credit risk and efficiency risk; banks belonging to group 3 are sensitive to credit risk, solvency risk, interest rate risk, liquidity risk, efficiency risk; banks belonging to group 4 are sensitive to credit risk and efficiency risk; and banks belonging to group 5 are sensitive to credit risk, interest rate risk and liquidity risk. Based on the results in model 1, banks in Indonesia are not very sensitive to interest rate risk. However, the results in Model 2 suggest that group 3 and group 5 are very sensitive to interest rate risk. This information is obviously useful for bank supervisors as it indicates which risks banks are likely to be sensitive to. Based on the Pseudo R 2 , the results of the estimates in model 2 are more efficient than those in model 1. To test the accuracy of estimating the probability of problem banks, this study employs an outof sample test which comprises 230 observations. Using a fair cutoff point (0.6), model 2 produces 12.18% of total errors and 87.82 % of correct estimates while model 1 produces 13.91% of total errors and 86.09% of correct estimates. This shows that model 2 is more efficient that model 1. To provide a fair comparison of the “performance” of these models with those of other rersearchers, we have to consider the following criteria: (1) the proportion of problem and nonproblem (e.g. failed and nonfailed) banks in the sample; (2) the observations employed in the error classification (i.e. within sample or outof sample); (3) the data employed to generate the model. This paper can be characterised as follows: it employs 41.3 % of problem banks and 58.67% of non problem banks; it uses an outof
32
sample test for error classification; and it employs supervisory data to generate the models. Based on the literature survey, there is no other study which matches our models’ comprehensive characteristics. The best result on the error classification front in the determination of the probability of bank failure for a study which employed a similar proportion of problem (46%) and nonproblem banks was achieved by Sinkey (1975). Sinkey’s model estimates 82% of observations correctly while model 2 in this study estimates 87.82% correctly. Therefore, model 2 provides better estimates than Sinkey’s. Based on these results, this study suggests that model 2 can be used as an additional early warning system (tool) for bank supervisors in Bank Indonesia to help identify emergent problem banks. By employing new data of independent variables of banks, bank supervisors can obtain the probability estimates of problem bank for each bank. Since the probability estimate of a bank classified as problem is higher than the cutofpoint, the bank is classified as a problem bank. Therefore, bank supervisors can suggest further examination to ensure whether the bank is really suffering problem. In general, the insignificance of the ratio for foreign exchange risk (FXDER) may indicate that traditional operations still dominate within banks in Indonesia. However, this condition may not be valid for selected individual banks which engage actively in foreign exchange trading. This condition occurs because, within the sample, the number of problem banks which are authorised in foreign exchange transactions is smaller than the number of nonforeign exchange banks. However, many banks suffered problem because of foreign exchange trading. Bank Duta suffered illiquidity because of huge losses in foreign exchange trading in 1990 and the Indonesian government rescued Bank Exim in 1997 due to foreign exchange losses. Many other banks have failed since the IDR exchange rate has gradually dropped since 1997. These cases support the suggestion that there are some individual banks which are heavily exposed to foreign exchange rate risk. There is no doubt, however, that banks, by group, in Indonesia are sensitive to interest rate risk.
33
Appendix 1 Solving Pi in Logit Models
A logistic function is in the following form:
Ln
Pi = Zi ( 1 − Pi )
(1)
Taking the anti log of the equation above, we get the following equation:
Pi = ez (1 − P ) i We can solve Pi in the following way:
(2)
Pi = (1 − Pi ) e z Pi = e z − Pi e z Pi − Pi e z = e z
Pi ( 1 + e z ) = e z Pi = ez (1 + e z )
(3)
34
Appendix 2 PseudoR In Limited Dependent Variable Models
2
Aldrich & Nelson (1984, pp.5557): Pseudo R2= where,
c = the chisquare statistic for overall fit (log likelihood ratio) which can be derived from the following equation: c = − 2 ( l m − lo )
c ( N + c)
N lm lo
= the total sample size = the log likelihood value of the model = the log likelihood value if all slope coefficients are restricted to zero
McFadden (1973, p121): Pseudo R2= 1 − l l
m o
McKelvey and Zavoina (1975, pp103120):
∑ ( Y$i * − Y * ) 2
Pseudo R2=
i =1
N
$ ∑1 (Y$i * − Y * ) 2 + N σ 2 i=
= 1 N
N
=
ExSS $ ExSS + N σ 2
where,
Y
Y$ i ExSS
* ' i
*
∑
N
i = 1
Y$i *
σ$
$ = x β (ie. evaluated at maximum likelihood) = the explained sum of squares = the standard deviation of disturbance under the normal distribution assumption. In a logit model this standard deviation is 1.814 (variance=3.29).
35
Appendix 3 Independent Variables Used in the Prediction of Bank Failure
No. Altma n (1968) Meyer and Pifer (1970) Martin (1977) Korobow, Stuhur and Martin (1976) Stuhr and Wicklen (1974) Thomson (1991; 1992) Sinkey (1975) Avery and Hanweck (1984) TA=total assests Natural logarithm of total bank assets less loan loss reserve allowance to (TA) Heffernan (1995) Variables for US banks Earning assets (average)
1
Workin g capital/ total assets
Error in Net income predicting /total assets cash and securities /total assets
2.
3.
Retain ed earnin gs /total assets Earnin Time gs /demand before deposit ratio interes t and taxes/t otal assets
Book equity capital plus the reserve for loan and lease losses minus the sum of loans 90 days past due but still accruing and nonaccruing loans/total assets Coefficient of Gross Equity capital Capital to Net chargevariation in chargeoff/net to adjusted assets ratio offs/total rate of operating risk assets loans interest on income time deposits Expenses/op erating revenue Operating Operating expenses to income to operating assets ratio revenues Loan portfolio based on Herfindahl index
Loans and leases to total sources of funds
Asset quality (ratio of classified and special mentioned assets to bank capital)
Cash+US Treasury Securities /assets
Loans/assets
Ratio of net Net interest aftertax income income to TA /average earning assets Ratio of equity capital plus loan loss reserve allowances to TA Noninterest income /average assets
Provision for loan losses /operating expenses
36
No.
Altma n (1968)
Meyer and Pifer (1970)
Martin (1977)
Korobow, Stuhur and Martin (1976)
Stuhr and Wicklen (1974)
Thomson (1991; 1992)
4.
5.
Market value equity/ book value of total debt Sales/t otal assets
Operating revenue /operating costs
Loans assets
/total Gross Debt to equity chargeoffs to ratio net income plus provisions for loan losses Commercial Assets and industrial of bank loans to total loans size
Net loans and leases/total assets
Operating income/total assets
Commercial loans/total loans
Nondeposit liabilities/cash and investment securities
6.

Growth of consumer loans /total assets
Loss provision /loans securities
+
Net Overheads/to occupancy tal assets expenses to net income Loans to total assets Net income after taxes /total assets
7.

Growth of Net liquid cash and assets/total securities/tota assets l assets
Avery and Hanweck (1984) TA=total assests Loans/[capital Ratio of net + reserves] loans (total loans less loan loss reserve allowances) to TA Operating Ratio of net expenses loan charge/operating offs (gross income loan chargeoffs less recoveries) to net loans Loan revenue Ratio of /total revenue commercial and industrial loans to net loans US Treasury Ratio of US Securities government revenue/total and agency revenue securities plus cash items in process of collection, vault cash and reserves at Federal
Sinkey (1975)
Heffernan (1995) Variables for US banks Noninterest expenses /average assets
Equity/total assets
Dividends/net income
Average liquid assets /average assets
37
No.
Altma n (1968)
Meyer and Pifer (1970)
Martin (1977)
Korobow, Stuhur and Martin (1976)
Stuhr and Wicklen (1974)
8.

Coefficient of Gross variation of capital/risk total loans assets


9.

Real estate loans/total assets


10.

Fixed assets/total assets



Avery and Hanweck (1984) TA=total assests Reserve Banks to total assets Loans to State & local Percentage insiders/total obligation change in assets revenue /total total deposits revenue within each bank’s local banking market (an SMSA or nonSMSA county of the bank’s home office) Dummy Interest paid The variable for on deposits Herfindahl holding /total revenue index (the company sum of squares of market shares for banking organisations ) for each bank’s local banking market Natural Other logarithm of expenses/ total assets total revenue
Thomson (1991; 1992)
Sinkey (1975)
Heffernan (1995) Variables for US banks
Average loans /average assets
Average deposits /average assets
Nonperforming assets /total
38
No.
Altma n (1968)
Meyer and Pifer (1970)
Martin (1977)
Korobow, Stuhur and Martin (1976)
Stuhr and Wicklen (1974)
Thomson (1991; 1992)
Sinkey (1975)
Avery and Hanweck (1984) TA=total assests
Heffernan (1995) Variables for US banks loans & OREO Reserves /total loans
11.





12.





13.





14.





Natural logarithm of average deposits per banking office Output Herfindahl index constructed using state level gross domestic output by one digit SIC codes Unemployme nt rate in the county where the bank is headquartere d Percent change in statelevel personal income




Net chargeoffs /average loans


Recoveries /gross chargeoffs


USD assets /total USD assets
39
No.
Altma n (1968)
Meyer and Pifer (1970)
Martin (1977)
Korobow, Stuhur and Martin (1976)
Stuhr and Wicklen (1974)
Thomson (1991; 1992)
Sinkey (1975)
Avery and Hanweck (1984) TA=total assests 
Heffernan (1995) Variables for US banks USD assets
15.





16.





Dun and Bradstreet’s statelevel smallbusiness failure rate per 10,000 concerns 

17.








18.








19.








USD assets /US nominal GDP Log ASSGDP (log assests in USD/US nominal GDP) Average annual nominal (INT) or real (RINT) interest rate: annual average computed from monthly money market rate Annual inflation rate
40
No.
Altma n (1968)
Meyer and Pifer (1970)
Martin (1977)
Korobow, Stuhur and Martin (1976)
Stuhr and Wicklen (1974)
Thomson (1991; 1992)
Sinkey (1975)
Avery and Hanweck (1984) TA=total assests 
Heffernan (1995) Variables for US banks Annual consumer price index Annual real GDP growth rate IBCA rating for bank
20.







21.








22.








41
Appendix 4 (i) Mean of independent variables
Model 1
Variables
C
AQ CAR
CMAR
DAR FACR FXDER ICR IIR IRR
LDR
LPR OIR ROA ROE
Mean All Mean D=1 Mean D=0 1.00 1.00 1.00 7.95 14.84 3.17 26.39 28.63 24.84 4.89 4.20 5.37 0.44 0.78 0.20 23.93 22.62 4.83 (16,944.42) (15,810.12) (17,730.01) 62.33 65.41 60.20 78.47 79.30 77.90 (168.84) (183.46) (158.71) 1.95 1.98 1.93 1.53 1.79 1.36 7.39 6.26 8.18 1.34 0.86 1.67 14.91 8.75 19.17
42
Appendix 4 (ii) Mean of independent variables
Model 2 Variable
D1
D2 D3 D4 D5 AQ1 AQ2 AQ3 AQ4 AQ5 CAR1 CAR2 CAR3 CAR4 CAR5 CMAR1 CMAR2 CMAR3 CMAR4 CMAR5 DAR1 DAR2 DAR3 DAR4 DAR5
FACR1
FACR2 FACR3 FACR4 FACR5 FXDER1
Mean All Mean D=1 Mean D=0 0.04 0.04 0.04 0.2 0.15 0.24 0.55 0.61 0.5 0.11 0.05 0.16 0.1 0.15 0.07 0.49 0.84 0.24 0.92 1.15 0.76 4.05 7.91 1.37 0.35 0.57 0.2 2.15 4.38 0.6 0.16 0.2 0.13 3.23 2.18 3.96 18.58 22.41 15.93 2.61 1.01 3.72 1.81 2.84 1.1 0.09 0.08 0.09 1.1 1.07 1.12 2.97 2.76 3.12 0.66 0.12 1.03 0.07 0.16 0 0.02 0.01 0.03 0.07 0.06 0.07 0.27 0.56 0.08 0.01 0 0.01 0.07 0.15 0.02 2.56 2 2.95 4.87 3.36 5.91 12.82 13.48 12.36 1.13 0.13 1.82 2.54 3.6 1.81 2435.43 2991.88 2049.97
43
Variable FXDER2 FXDER4 FXDER5 ICR1 ICR2 ICR3 ICR4 ICR5 IIR1 IIR2 IIR3 IIR4 IIR5 IRR1 IRR2 IRR3 IRR4 IRR5 LDR1 LDR2 LDR3 LDR4 LDR5 LPR1 LPR2 LPR3 LPR4 LPR5 OIR1 OIR2 OIR3 OIR4 OIR5 ROA1
Mean All Mean D=1 Mean D=0 14059.4 12190.8 15353.9 459.51 635.51 337.58 0.66 0 1.12 2.67 2.74 2.62 14.13 11.13 16.21 35.48 42.09 30.9 5.54 3.03 7.28 4.53 6.42 3.23 2.58 2.75 2.46 13.81 10.45 16.13 45.04 50.07 41.56 8.93 4.14 12.25 8.13 11.88 5.52 94.49 15.83 148.98 63.37 132.32 15.62 4.09 22.46 8.63 8.62 14.58 4.5 1.71 1.67 1.73 0.09 0.1 0.08 0.27 0.18 0.33 0.89 1.19 0.68 0.61 0.38 0.76 0.1 0.13 0.08 0.11 0.18 0.06 0.26 0.22 0.28 0.72 0.98 0.54 0.27 0.15 0.35 0.18 0.26 0.12 0.48 0.39 0.53 1.64 1.19 1.94 2.56 2.79 2.41 1.91 0.66 2.77 0.81 1.23 0.53 0.05 0.04 0.06
44
Variable ROA2 ROA3 ROA4 ROA5 ROE1 ROE2 ROE3 ROE4 ROE5
Mean All Mean D=1 Mean D=0 0.21 0.06 0.31 0.7 0.45 0.88 0.17 0.03 0.27 0.21 0.29 0.15 3.02 1.45 4.11 3.07 0.71 4.71 5.9 4.1 7.14 1.2 0.17 1.91 1.71 2.3 1.31
45
Appendix 5 Colinearity Of Independent Variables
AQ
CAR
(0.08) 1.00 0.14 (0.06) (0.21) 0.07 (0.24) 0.23 0.02 (0.04) 0.07 (0.14) (0.06) (0.29)
CMAR
(0.15) 0.14 1.00 (0.05) (0.10) (0.02) (0.09) 0.05 (0.03) (0.20) 0.03 (0.01) (0.09) (0.12)
DAR
0.24 (0.06) (0.05) 1.00 0.03 0.06 (0.05) (0.01) 0.03 (0.01) (0.05) 0.18 0.08
FACR FXDER
0.02 (0.21) (0.10) 0.03 1.00 0.01 0.07 (0.17) 0.01 (0.07) (0.12) 0.11 0.14 0.47 0.03 0.07 (0.02) 0.01 1.00 (0.07) 0.08 (0.10) 0.01 (0.03) (0.03) 0.05 0.02
ICR
0.05 (0.24) (0.09) 0.06 0.07 (0.07) 1.00 0.23 (0.03) (0.03) (0.08) (0.05) (0.20) 
IIR
(0.03) 0.23 0.05 (0.05) (0.17) 0.08 0.23 1.00 0.02 0.06 0.09 (0.16) (0.07) (0.18)
IRR
0.02 (0.03) (0.01) 0.01 (0.10) (0.03) 0.02 1.00 0.01 (0.03) (0.02) 0.01 (0.02)
LDR
0.07 (0.04) (0.20) 0.03 (0.07) 0.01 (0.03) 0.06 0.01 1.00 0.16 0.11 (0.01) (0.01)
LPR
0.24 0.07 0.03 (0.01) (0.12) (0.03) (0.08) 0.09 (0.03) 0.16 1.00 0.05 0.01 (0.12)
OIR
(0.05) (0.14) (0.01) (0.05) 0.11 (0.03) (0.05) (0.16) (0.02) 0.11 0.05 1.00 0.08 0.18
ROA
0.17 (0.06) (0.09) 0.18 0.14 0.05 (0.20) (0.07) 0.01 (0.01) 0.01 0.08 1.00 0.47
ROE
0.07 (0.29) (0.12) 0.08 0.47 0.02 (0.18) (0.02) (0.01) (0.12) 0.18 0.47 1.00
AQ CAR CMAR DAR FACR FXDER ICR
IIR
1.00 (0.08) (0.15) 0.24 0.02 0.03 0.05 (0.03) 0.07 0.24 (0.05) 0.17 0.07
IRR LDR LPR OIR ROA ROE
46
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