Bank Portfolio Model and Monetary Policy in

Indonesia1

Doddy Zulverdi2, Iman Gunadi3, and Bambang Pramono4

Draft: August 2006

Abstract
This paper analyzes the bank’s behavior in selecting its portfolio composition and its
impact on the effectiveness of monetary policy transmission process in Indonesia. We
employ an analytical model of the banking portfolio behavior based on microeconomic
theory to understand how banks’ portfolio behavior in maximizing its profit links to the
efficacy of monetary policy. This study finds that micro banking condition and prudential
regulation affects the effectiveness of monetary policy. This study also finds structural
changes in banks and borrowers have altered the smoothness and effectiveness of
monetary policy to encourage the economic growth and hindered the process of economic
recovery. As perception on risk has large impact in supporting the effectiveness of the
monetary policy, effort to reduce risk through the formation as credit bureau, credit
guarantee scheme, and rating agencies is critical as it will improve transparency and
availability of debtor information. The need for better coordination and harmonization
between macro and micro policies would be beneficial.

Keywords: Bank Portfolio Model, Monetary Policy

JEL: G21, E52

1
Presented in International Seminar “Financial System Reform and Monetary Policies in Asia”, Sep, 15-16
2006, Hitotsubashi University, Tokyo, Japan.
This paper is part of the research papers in the Directorate of Economic Research and Monetary Policy –
Bank Indonesia. The views expressed in this paper are those of the authors and do not represent the views
of Bank Indonesia.
2
Doddy Zulverdi, Senior Economist. Author’s, address: IMF, Washington DC, email :DZulverdi@imf.org,
dzulverdi@bi.go.id. Tel +1-202-623-9088 (O), Tel +1-703-685-0553 (R), Mobile: +1-202-3900-879
3
Iman Gunadi, Economist, Author’s address: Directorate of Economic Research and Monetary Policy,
Bank Indonesia, Jl. M.H. Thamrin no. 2, Jakarta, Indonesia, email: imangunadi@bi.go.id,
IXG025@bham.ac.uk.
4
Bambang Pramono, Economist. Author’s address: Directorate of Economic Research and Monetary
Policy, Bank Indonesia, Jl. M.H. Thamrin no. 2, Jakarta, Indonesia Tel. +62-21-381-8869, Fax. +62-21-
3502030 (F), email: bpramono@bi.go.id.
I. Background
It is widely known that banks plays determinant role in financing economic development.

This is so because banks are more superior compare to other financial institution in coping with

asymmetric information and high cost operation in financial intermediary activities (Stiglitz &

Greenwald 2003). By its nature, banks are capable to deal with different types of borrowers,

surpassing asymmetric information problems. This phenomenon is even more true for

underdeveloped countries, such as Indonesia, where the development of non-bank financial

institutions has been impeded by inadequate institutional infrastructures and weak investor basis.

During 2001 – 2004 the flows of credit from the banking sector contributed on average about

77% of total financing from major financial institutions (banks, bond market, and stock market).

As a result, the rise and fall of banks in Indonesia would have strong correlation with the

economic booms and busts in Indonesia.

Bank portfolio composition plays an important role in explaining the monetary policy

transmission (Silber 1969 & Beckhart 1940). Within banks’ portfolio, a special attention has been

given to banks’ credit. The growing awareness of the importance of credit in the monetary policy

transmission process is driven among others by concerns over the impact of financial sector

weaknesses, bank failures, non-performing loans (NPLs), and credit rationing on the effectiveness

of the transmission process (see e.g., Blinder [1987], Bernanke and Blinder [1988], Brunner and

Meltzer [1988]). In the past, monetary literature had paid little attention to the role of credit due

to the emergence of monetarist thinking and the overriding influence of Keynesian thought on

“Liquidity Preference” that stresses the importance of money rather than credit (Gertler [1988]).

Current stream of monetary policy paradigm has acknowledged the importance of supply and

demand of credits.

Within this context, this paper analyzes the bank’s behavior in selecting its portfolio

composition particularly as an intermediary agent and its impact on the effectiveness of monetary

1
policy transmission process in Indonesia. We begin with a historical overview of the development

of banking sector and monetary policy in Indonesia. We then proceed with a brief explanation of

the model being used in analyzing the banks’ behavior. Based on this framework, we conduct an

empirical simulation that will compare banks’ behavior and its impact on the effectiveness of

monetary policy before and during the post-crisis period. Lastly, we conclude how changes in

banks portfolio behavior could alter the efficacy of monetary policy and provide need for some

policy recommendations.

II. Banking Sector and Monetary Policy Development in Indonesia

Pre-crisis period: 1960s-mid 1997

Prior to a series of financial deregulation in 1980s, state-owned banks dominated banking

sectors, holding 80% of total bank assets. State-owned banks acted almost as a sole credit

provider to the real sector and played as agent of development by channeling significant amount

of government subsidized loans. These state-owned banks were heavily regulated as such that

interest rate determination was controlled by the government to an artificially low level, hence

discouraging efficient funds mobilization and stifling competition among banks.

In such condition, monetary policy was conducted by implementing the use of direct

control instruments. The Central Bank employed direct monetary instruments such as imposing

ceiling on lending rates and the volume of loans, injecting subsidized credits, and endorsing

selective foreign exchange control, whereas the exchange rate regime was relatively fixed.

Supported by windfall profit from oil boom, this was marked as the era of government-led growth

lasting in the 70s and 80s with an average growth rate of 7.5% per year.

Due to the world recession and the dramatic drop of oil price in early 1980’s, the

government had changed the development strategy. As the current account deficit widened thus

threatening the external position’s of the country and GDP growth dropped to 2.3% in 1982 from

2
an average of 7-8% from preceding years, the government took a sweeping adjustment measures.

As the first instance, the government devalued the Rupiah by 38% to correct the external

imbalance by stimulating non-oil exports. Furthermore, the government realized that it could no

longer act as the main engine of growth as fiscal sustainability was under pressure. Following this

situation, government postponed some large projects and gradually shifted its dominant role as

development agent to the private sector. Therefore, government had introduced a number of

deregulation policy packages in the financial sector to encourage the promotion of banking sector

and the financial sector in order to tap private saving and channeling it to private investments

efficiently and effectively.

The first financial deregulation was introduced in June 1983 (PAKJUN 83), involving three

aspects, i.e: (1) abolishing credit ceiling that had been used as a means of monetary control and

introducing indirect monetary instruments, (2) reducing the injection of liquidity credit provided

by Bank Indonesia, and (3) granting freedom to state-owned banks to set up their own interest

rates and allowing more opportunities to all banks to mobilize deposits from the public. ConseAS

aresult, the share of private banks in lending increased rapidly, funded by deposit mobilization,

inter-bank borrowing from state banks, and offshore borrowings.

Furthermore, another policy package was issued in October 1988, known as PAKTO 1988,

aimed at promoting non-oil exports and at enhancing banks and non-banks’ efficiency, improving

the efficacy of monetary policy, and creating conducive climate for the capital market

development. These measures effectively marked the new and liberalized financial environment

era, abandoning the financial repression regime. On the banking front, this deregulation package

facilitates easier openings of new banks and their branches. Within two years, licenses to open 73

new commercial banks and 301 branches were issued. Since then, banking activities increased

substantially in terms of assets (Figure 2.1). The other important aspect of this package including

the permission of state-owned and local government enterprises to deposit up to 50 percent of

3
their funds at private banks and the possibility for banks to merge along with efforts to reduce

credit risks.

180 $ bn

160
140
120
100
80
60
40
20
0
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Figure 2. 1. The Development of Banks’ Assets

As the deregulation measures have provided better foundation for banking development

along with improvement in banking competitions, it gave the opportunity for the Central Bank to

launch a more market based indirect monetary policy instruments. During 1983-84, minimum

reserve requirement was set down from 15% to 2% and the open market operations mechanism

was improved through the auctions of two monetary instruments, namely the central bank

certificate (SBI) and money market securities (SBPU). Unfortunately, the pace of banking sector

developments was far too fast, and capacity building in the area of supervision was lacking.

Consequently, the enforcement of prudential regulations was inadequate while intervention into

the Central Bank policy was pervasive. As a result, this environment has created widespread

moral hazard and adverse selection problems, leading banks to excessive credit expansion, largely

to their own interest groups (connected lending).

In order to prevent the economy from overheating, in January 1991 a tight monetary

policy was taken by ordering major state-owned enterprises to switch their deposits into SBI, the

central bank certificate, and banks’ access to offshore borrowings were constrained. As a result,

inflation rate was brought under control to 4.9% at the expense of soaring interest rate. In

4
addition, exchange rate band was also widened, hindering negative impact of short-term inflows

and lessened dependency of banks in foreign exchange transaction to Bank Indonesia. In addition,

in February 1991 more comprehensive prudential banking principles were imposed and banks

were suggested to merge or to consolidate. Unfortunately, the expected wide scale banking

consolidation never took place due to lack of commitment by bank owners. Banks kept on

pumping supply of credit to the economy excessively. Despite the improvements in prudential

regulations and banking supervision, businessmen still found loopholes in getting new credits.

Trilion
1200,00

1000,00

800,00

600,00

Excess Supply
Loan
Loan Capacity
400,00

200,00

0,00
Aug-83

Aug-84

Aug-85

Aug-86

Aug-87

Aug-88

Aug-89

Aug-90

Aug-91

Aug-92

Aug-93

Aug-94

Aug-95

Aug-96

Aug-97

Aug-98

Aug-99

Aug-00

Aug-01

Aug-02

Aug-03

Aug-04

Aug-05

Figure 2.2. Banks’ Loan, Loans Capacity and Excess Capacity.

The financial reforms in Indonesia since 1983 have encouraged intermediary functions of

the banking system. Banking system had succeeded in supporting strong economic development

for more than a decade prior to the 1997 Asian financial crisis. This was reflected in the numbers

of bank loans and banks’ loan capacity that had cosistently increased5 (figure 2.2). From 1983

5
Loan capacity is defined as total liabilities less reserve requirements, cash in vault, and capital.

5
until the crisis struck in July of 1997, banks’ loans and loan capacity increased from Rp12,83

trilllion and Rp16,61 trillion to Rp340 trillion and Rp383 trillion respectively.

2.2 Crisis Period (mid 1997-mid 1999)

Following a contagion effect from Thailand and South Korea the large depreciation in the

exchange rate led to an external debt crisis as most domestic firms could not service their

liabilities to international and domestic banks. As the same time, severe liquidity problems rising

from increased burdens of firms servicing external debts, coupled with the overall worsening of

international banking relations, were subsequently exacerbated by mass withdrawal of deposits as

public confidence eroded. The closures of 16 banks without a proper deposit guarantee scheme

further deteriorated public confidence that led to bank rush.

To prevent another cycle of bank rush, the government announced the blanket guarantee

scheme which effectively guaranteed the payment of all type of banks liabilities by the

Government. After the government introduced a blanket guarantee on deposits on January 27,

1998 in which all depositors and creditors of all domestic banks were to be completely protected,

the public responded positively, the exchange rate appreciate and deposits began flowing back

into the banking system.

Nevertheless, the currency crisis and external debt crisis managed to evolve into a full-

blown corporate crisis that led to a deterioration of banks’ asset quality and an increase non-

performing loans (NPLs). The amount of non performing loans increased from average Rp28

trillion in prior crisis period to Rp84 trillion afterwards. During the crisis, non performing loans

reached their highest figure, moving from Rp100 to Rp 300 trillion (figure 2.3). In this period, a

large increase in non performing loans indicated an increase in the probability of default.

Therefore banks tended to do hasten internal consolidation to improve their asset quality rather

than extending more loans.

6
 Trillio Rp
800

700
NPL's
600 Loan
500

400

300

200

100

0
Jan-94

Nov-94

Jul-96

May-97

Mar-98

Jan-99

Nov-99

Jul-01

May-02

Mar-03

Jan-04

Nov-04
Sep-95

Sep-00

Sep-05
Figure 2.3. Bank’s Loan and NPLs

The severe crisis put the banking performance at its nadir. The increase risk of

bankruptcy led to liquidity problems which further became insolvency problems, eroding banks’

capital and their ability to function the role of financial intermediary in the economy. As a result

the amount of loans has reduced, particularly since 1999. The lag between the time of the crisis

and the notable impact on loan issuances was partially due to the effect of a previous banks’ loan

commitments before the crisis period and the weakening rupiah that led the value of foreign

currency loans increased in terms of rupiah. Drops in loans issuances without a subsequent

reduction in loan capacity increased the excess loan capacity.

This situation interpreted as an indication of banks credit rationing behavior in which

banks ration their loans due to reduced net worth and a higher risk of bankruptcy. Agung et al

(2001), and Zulverdy et al (2004), found a strong indication that there was a credit crunch

phenomenon in Indonesia. Unwillingness of banks to issue loans could also be reflected in the

negative interest rate between deposit rates and loan rates (figure 3). During the period from

August 1997 to May 1999, banks did not permit their loan rates to exceed their deposit rates as

doing so would most likely have led default their borrowers.

7
 %
70

60 1 Month Deposit Rate

Working Capital Rate
50

40

30

20

10

0
Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06
Figure 2.4. Loan and Deposit Rates

In order to address the insolvency problem in the banking system, authorities in

cooperation with international support from international Agencies such as International

Monetary Funds (IMF), World Bank and Asian Development Banks (ADB) introduced a

recapitalization program for domestic banks in March 1999. Using a minimum capital adequacy

ratio (CAR) criteria of 4 percent and feasibility of banks’ business plans, efforts were aimed at

determining which banks were still viable and met the requirements for recapitalization program,

and which banks were be closed down.

To finance the costs for bank recapitalization program, the government issued bonds to

the central bank in exchange for funds needed by the government to inject additional capital into

banks, and at the same time the central bank resold the bonds to the recapitalized banks. Hence

the balance sheets of the recapitalized banks showed government bond holdings in their asset side

and government equity participation in their liability side. Specific measures were also

implemented for restructuring the non-performing loans of the banking sector. For the

recapitalized banks and banks taken over by the Indonesian Bank Restructuring Agency (IBRA),

8
non-performing loans were removed from their balance sheets and transferred to the IBRA as an

integral part of the bank rehabilitation program.

2.3 Post Crisis Period: mid 1999-present

The recapitalization program has changed banks’ balance sheets. On the asset side, the

main composition of bank funds shifted from loans to government bonds (figure 4). Prior to

crisis, around 70% of bank’s portfolio were in loans and only less then 10% in the form of liquid

assets (with SBI around 1% and other securities asset about 8,9%) and no government bonds.

After the recapitalization process in 2000, loans decreased to 33%, while banks’ holding of

government bonds accounted for 44%.

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1997 2000 2001 2002 2003 2004 2005
Loans SBI Govt. Bonds Interbank Securities and Others

Figure 2.5. Banks’ Balance Sheet Composition

The ability of the banking system to generate loans has to this date not fully recovered

from the impact of the crisis. Many problems, both internal and external, still remain such as the

high risk of the business sector and the relatively slow progress on firms’ restructuring, causing

9
banks to choose safe securities (government bonds and SBI) over extending loans. Such a

situation more closely resembles the activities of mutual funds than fully functioning commercial

banks.

A study by Pramono (2004) found that during period of 1999 to 2003 there has occurred

sustained excess demand in the loans market, showing the continuation of the existence credit

crunch in Indonesia6. Using Stiglitz and Greenwald’s model, this study also found that the

bankruptcy risk could explained the mechanism through which the credit crunch existing in

Indonesia.This study also found that the existence of the credit crunch has implication for

monetary policy. Due to the credit crunch, a tight monetary policy has more impact than

expected.

Despite the success to control inflation rate, tight monetary policy taken in the period of

crisis has also amplified banks’ unwillingness to extend loans and contributed to less supply of

loan. In contrast, a loose monetary policy taken in the aftermath of the crisis and recently has not

induced banks to extend loans. A decrease in the interest rate does not immediately affect

restructured firms and they remain unable to get loans for some time. Loose monetary policy does

not necessarily restore banks’ willingness to supply loans as long as banks remain concerned with

bankruptcy risk in their loan decision.

Further study by Zulverdi et. al, 2004a found the indication of a reversed situation from

credit crunch during crisis to a period of excess loan supply. The excess supply was particularly

pronounced among existing (good) borrowers. Considering that finding new good borrowers is a

difficult issue for banks particularly when have to meet many prudential regulations under the

banking restructuring program, banks compete to keep their good borrowers by increasing the

supply of loan commitment to them. However, due to unfavorable business prospects, the use of

6
The credit crunch defines as a credit rationing situation due to supply constraints caused by a sharp
decline in bank loan supply

10
new loans limited. This situation led to an increasing trend of undisbursed loans reflecting the

slow progress of corporate restructuring and the high-risk premium imposed by banks on their

loans.

The non-functioning of bank financial intermediation affects the relationship between

loans and economic output. The lack of loan availability has constrained monetary policy to

encourage the economic growth and hindered the process of economic recovery until recently.

The effectiveness of monetary policy transmission has not improved as reflected in the slow

response of loan rates to reduction in SBI and the widening spread between loan and deposit rates

(Graph 2.6). The effect of lose monetary policy after the crisis was over has not significantly

increased the loan supply as banks’ loan portfolios are still low as reflected from the Loan to

Deposit ratio that has slowly increase, recorded at 502% by end of 2004 far below pre crisis level

of 82%.

Due to credit rationing and the market’s collapse, lowering interest rates does not

immediately help restructured firms get new loans and does not necessary restore banks’

willingness to supply loans. Banks still could not predict about the bankruptcy risk and are

reluctant to bear the risk, therefore the unwillingness of banks to supply loans remains. Banks still

behave in risk averse manner and are reluctant to extend loans. They prefer to put their funds into

safe places such as SBIs and government bonds rather than to extend loans.

11
 %
80

70

60 1 Month Deposit Rate

Working Capital Rate
50
SBI Rate
40

30

20

10

0
Jan-94

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05
Figure 2. 6. Interest Rate Development

III. The Analytical Framework of Bank’s Portfolio Behavior

3.1 The Model

Based on work by Zulverdi et al (2004 b), we develop a static partial equilibrium model

as an analytical framework to understand how banks’ portfolio behavior in maximizing its profit

links to the efficacy of monetary policy. Simplifying the model, we assume that Indonesian

banking sector has the following balance sheet structure:

Table 3.1 Balance Sheet of Commercial Banks

Asset Liabilities
Excess Reserve (incl. cash in vault) Saving and Demand Deposits
Reserve Requirement
Time Deposits
Loans
Government Bonds Capital
SBI and FASBI (central bank certificates)
Net Inter-bank Money Market

As intermediary institutions, banks collect fund from surplus spending units with a

certain cost and distribute it to deficit spending units by imposing a certain interest rate as bank’s

earning. Aside of deposit interest cost, banks also face contemporaneous transaction costs that

12
assumed in the form of quadratic function in both asset and liabilities side. Imposing these costs

will lead to an interdependent relationship between asset and liabilities which means a change in

asset lead to a change in liabilities and vice versa (see Elyasiani, 1995). Banks objective function

is to maximize its profit, as follows:

I ∞
Max ∑∑β
i t=0
t +1
π ti+ 1 (3.1)

where, profit function is defined as

π ti+1 =
N O M

∑ (r in
Lint )(1 − η tin ) + rPti Pt i + ∑ rStio S tio + ∑ rBtim Btim + rFti Ft i
Interest revenues
Lt
n o m
Q
Interest Expenses
− ∑ rDtiq Dtiq − rTti Tt i
q

 N α Lin in 2 α Pi O
α io M
α im 
Marginal costs of holding assets &
∑ ( Lt ) + ( Pt i ) 2 + ∑ S ( S tio ) 2 + ∑ B ( Btim ) 2 
liabilities
 n 2 2 o 2 m 2 
− 
α i Q
α iq
α i
α i
+ F ( F i ) 2 +
 2
t ∑ 2
D
( D t
iq 2
) +
2
T
(Tt
i 2
) +
2
x
X t
i 2


( )
 q 

Note: List of variables is presented in the appendix

In maximizing their profits, banks are subject to the following constraints:

• Bank assets should be equal to its liabilities at all times (equation 3.2).

∑L in
t + Pt i + ∑ Stio + ∑ Btim + Ft i + X ti − ∑ Dtiq (1 − ρ D ) − Tt i (1 − ρT ) − K ti = 0 (3.2)

• Demand for loans is a linear function with negative relationship to loan interest rate

(equation 3.3).

Lint = et − f t rLtin (3.3)

• Supply of time deposit and saving deposit are both a linear function with positive relationship

to time deposit rates and saving deposit rates, respectively (equation 3.4 and 3.5).

Dtiq = at + bt rdtiq (3.4)

13
 Tt i = ct + d t rti (3.5)

• Banks always maintain a certain level of excess reserve (in cash and in accounts at the

Central Bank) as a proportion of deposits (equation 3.6).

X ti = ρ Xi (∑ D t
iq
+ Tt i ) (3.6)

• The capital adequacy ratio (CAR) imposed by Bank Indonesia limits banks behavior in

maximizing their profit. As a risk-averse investor, bank could calculate risk-weighted asset

(RWA) on loan higher than that imposed by the Central Bank. (equation 3.7)

(γ ∑ L
1
in
t )
+ γ 2 Pt i + γ 3 ∑ Stio + γ 4 ∑ Btim + γ 5 Ft i Ω it ≤ K ti (3.7)

• Interest rate on monetary instruments, SBI and FASBI are exogenous and set up by Bank

Indonesia. Interest rates of government bonds are also exogenous.

Solving this optimization problem will give some clues about how changes in monetary

policy affects banks’ portfolio, and furthermore, explain how the monetary policy is transmitted

via banks. The followings are some important findings that related to banks’ response to a change

in policy rate (SBI).

Impacts of a Change in Policy Rates on Loan Volume

∂L  f   1 − Ωγ 1 
= −     < 0 (3.8)
∂rS  (1 − η ) + α L f   1 − Ωγ 3 

As the theory predicts, the volume of loans ( L ) has a negative relationship with policy

rates ( rs ). A reduction of policy rates, for example, will shift allocation of funds from

central bank certificates (SBI) into loans. Equation 3.8 indicates that monetary policy

14
 transmission will be less effective (as reflected in lower sensitivity of loan volume to

changes in policy rates) if borrowers are less sensitive to interest rates ( f is lower), CAR

( Ω ) is high, banks’ perception on default risks is high (as reflected in high risk weighted

assets on loans ( γ 1 )7, marginal cost of managing loans ( α L ) are high, and non-

performing loans ratio (η ) is low.

As long as banks continue to perceive high loan risks in contrast to low risk on holding

SBIs ( γ 3 ), banks would consequently reluctant to expand loans, particularly to their

new debtors. Therefore, lowering loan risk perception would be expected to encourage

banks to expand lending and discourage them from dominant holding of SBIs.

Impacts of a Change in Policy Rates on Loan Rates

∂rL 1 1 − Ωγ 1
= > 0 (3.9)
∂rS 2(1 − η ) + α L f 1 − Ωγ 3

Loan rates ( rL ) have a positive relationship with policy rates (equation 3.9). Monetary

policy transmission will be less effective (as reflected in lower sensitivity of loan rates to

changes in policy rates) when banks’ perception on default risk is high, CAR is high, and

marginal costs of managing loan are high.

The negative impact of higher default risks on the effectiveness of monetary policy

transmission is consistent with the phenomenon of asymmetric effects of monetary

policy. In the recession (economic crisis) when default risk tends to be high, a loose

monetary policy would not be optimally followed by a decrease in loan rates (an increase

7
It should be noted that banks’ risk perception can be also endogenous with respect to changes in policy
rates. However, it is easy to present cases where banks may have formed its risk perception based on the
instability and uncertainty of social and political situation (eg. in a country like Indonesia), independently
on the changes in policy rates by the central bank.

15
 in loan volume). In contrast, during the expansion period in which default risk is

relatively lower, a tight monetary policy would be effectively followed by an increase in

loan rates (a decrease in loan volume). In this environment, a tight monetary policy may

be more effective than a laxer monetary policy. 8

Impacts of a Change in Policy Rates on Spread between Loan Rates and Time Deposit Rates

∂ (rL − rD ) η + (1 − η )( ρ D + ρ X ) − Ωγ 1
= (3.10)
∂rS (1 − η )(1 − Ωγ 3 )

• Equation 3.10 indicates that when banks’ perception on default risks ( γ 1 ) and CAR ratio

( Ω ) are substantially high relative to non performing loan ratio (η ), reserve requirement

ratio ( ρ D ), and excess reserve ratio ( ρ X ), policy rate will have a negative impact on the

spread between loan rates and deposit rates. Therefore, in an easing monetary condition,

for example, a decline in policy rates would widen the spread.

• This negative relationship reflect a situation when banks’ opportunity cost of extending

credit is larger than the opportunity cost of holding non productive fund (NPLs + reserve

requirement + excess reserve). In this situation, bank tends to move loan rates slower than

deposit rates.

3.2 Empirical Simulation

Based on the above analytical results, we have run an empirical simulation for

Indonesia’s case by calibration some of the parameters of the model. We divide the simulation

8
Kato et al (1999), for example, has proved empirically the existence of this phenomenon in Japan.

16
into three period: 1) pre-crisis (1996.01-1997.06), 2) Crisis (1997.07-1999.06), and post crisis

(1999.07-2004.3)9. The followings are some important findings (Table 3.2).

Table 3. 2 Simulation Results

Pre-Crisis Crisis Post-Crisis

A. Estimated Indicators of Effectiveness of

Monetary Transmission:
dL/drS -7725 -8332 -7635
drL/drS 0,423 0,396 0,410
d(rL - rD)/drS -0,005 -0,006 -0,005

B. Banks' Internal Conditions:

Default Risks ( γ1) - calibrated 1,45 17,80 1,85
CAR ( Ω) - actual figures 0,11 0,02 0,14
NPL ( η) - actual figures 0,11 0,30 0,19

C. Demand for Loan Conditions:

Constant (e) - calibrated 395000 630660 402116
Slope (f) - calibrated -10050 -11983 -10325

D. Supply of Time Deposit Conditions:

Constant (a) - calibrated -337500 -426342 -332003
Slope (b) - calibrated 30500 14077 31071

E. Monetary Policy Conditions:

Policy Rates (rS) - actual figures 0,13 0,38 0,13
Reserve Requirements ( ρD) - actual figures 0,03 0,05 0,05

Monetary Transmission via Banking Channel during the Peak of the Crisis Period

There are strong indications that the effectiveness of monetary policy transmission via

banking channel had been significantly lower during the peak of the crisis period. They

are evidences of smaller sensitivity of loan rates to changes in SBI rates ( ∂rL / ∂rS )

during the crisis as compared to pre-crisis period. Two major factors are responsible for

this condition. First, economic crisis and its impact on mounting NPLs had increased

banks’ perception on default risks very significantly. This factor had reduced banks’

willingness to increase loan rates as a respond to higher policy rate as it would worsen its

9
Considering that there is no structural changes in the banking sectors during the period of 2004 to 2005,
the use of this period as the representative of the post crisis period is valid.

17
 NPLs. Second, as most borrowers experienced huge solvability problems, they became

more sensitive to loan rate changes (the slope of loan demand, f , increased). This factor

reduced banks’ ability to increase loan rate without losing their good customers. Both

factors were so dominant that they overshadowed the incentive to increase loan interest

revenues to cover the losses from higher NPLs .

As borrowers were more sensitive to loan rate changes and banks suffered huge losses

from higher NPLs, the negative impact of higher policy rates on loans volume ( ∂L / ∂rS )

were larger during crisis.

As default risks were substantially high, the opportunity cost of extending credit was

higher than the opportunity cost of holding idle fund (fund “trapped” in bad debts,

reserve requirement, and excess reserves). These made loan rates less sensitive to policy

rates relative to deposit rates. Consequently, the increase in SBI rates increased deposit

 ∂ [rL − rD ] 
rates much faster than the increase in loan rates  < 0 , creating negative
 ∂rS 

interest margin.

Monetary Policy Transmission during the Post Crisis Period

The improvement of monetary policy transmission has been very slow during post-crisis

period. The sensitivity of loan rates to policy rates changes ( ∂rL / ∂rS ) increased only

slightly, and still smaller than the sensitivity during pre-crisis period. Although banks’

perception on default risk has improved significantly, banks are still very cautious as

evidenced by higher CAR ratio than the level required by regulation. The positive income

effect of smaller NPLs has also reduced the incentive for banks to fully respond any

18
 changes in policy rates. Both factors have resulted in slower decline of loan rates than the

decrease of SBI rates during the period. (See graph 2.6)

The sensitivity of loan volume to policy rate changes ( ∂L / ∂rS ) has been declining

during post-crisis period. It is even lower than the sensitivity during pre-crisis period.

Banks are still very cautious in extending credit as evidenced in higher CAR ratio. In

addition to that, smaller NPLs ratio has reduced banks’ loses significantly. This situation

has reduced the need from banks to increase loan supply to cover losses from NPLs. On

the other hand, as borrowers are not suffering from solvability problem so heavily as

during peak crisis, their demand for loans are less sensitive to interest rate changes.

Consequently, as monetary authority reduced the policy rates to boost aggregate demand,

the increase in loan volume is relatively slower than if the same policy were conducted

during pre-crisis period.

As banks are still maintaining higher CAR, the opportunity cost of extending credit is

still higher than the opportunity cost of holding idle fund (which is declining as NPLs are

smaller). This makes loan rates still less sensitive to policy rates relative to deposit rates.

Consequently, lower SBI rates reduce deposit rates faster than loan rates.

IV. Conclusion

Structural changes in banks and borrowers leads to changes in the monetary policy

transmission. Micro banking condition and regulation affects the effectiveness of monetary

policy. Since the source of financing of firms in Indonesia is largely tied to bank credit, the slow

growth of supply of banks’ loans has constrained monetary policy to encourage the economic

growth and hindered the process of economic recovery until recently.

19
 Banks’ willingness to extend loan is affected by external condition and the monetary

policy as well as the banking regulation. The monetary and banking policy could affect the

banking behavior not only through changes in interest rate but also through changes in constrain

and incentives (Stiglitz, 2003). For example, the contraction in monetary policy during crisis

period led to further increases in bankruptcy risk which in turn worsened the risk of default on the

existing loans and finally led to a further decrease in banks’ net worth and willingness to extend

loans. The imposition of CAR requirement has also contributed to a decrease in banks’

willingness to supply loans. This situation leads banks tend to put their excess liquidity in low

risk assets, especially in government bonds and SBIs.

From the analysis above, it has shown that one of the serious problems facing the banking

community in Indonesia is the asymmetric information. Risk perception, even though has been

declining, is still relatively high among bankers in Indonesia which may have led them to be

(overly) cautious. To overcome this problem, there is an apparent need to initiate efforts that can

provide more information regarding credit-worthiness of the borrowers while at the same time

trying to continue boosting the real side of the economy, if banks are willing to approve new

loans.

In order to overcome with the problem of asymmetric information in the banking sector,

we need to consider the following policy recommendations.

• As perception on risk has large impact in supporting the effectiveness of the monetary

policy, effort to reduce risk through the formation as credit bureau, credit guarantee

scheme, credit rating, as well as law enforcement need to be improved. These policies

will improve transparency and availability of debtor information, thus reducing

asymmetric information problem.

• The authorities could also provide more information regarding potential promising

economic sectors. Considering the pervasive asymmetric information in the credit market

20
 for small and medium enterprises, the introduction of credit guarantee scheme can also be

considered, with minimum moral hazard.

• To improve the knowledge in assessing risks, banks should be supported to invest more

in credit research and monitoring.

• The maintenance of macro stability needs to be continued in order to enhance public

confidence and reduce the perception of default risk. As stated by Stigltiz, 2003 we needs

a reformulation regulation policy in the banking/financial sectors based on portfolio

approach to regulation which includes:

– Understanding that banking regulation theory should be started from a model of

banking behavior;

– Understanding that the authority has a limitation in controlling banking behavior.

Therefore, the authority needs to take various steps that include incentive and

constrain

• As both monetary policy and banking regulations gain its positive impact on loan

performance, the need for better coordination and harmonization between macro and

micro policies would be beneficial.

• Increasing the role of non-bank financial markets and increased competition in financial

markets should be promoted to reduce over dependence on banks, thereby gradually

promoting a sound and efficient non bank financing and thus reducing downward rigidity

in bank lending rates.

21
Appendix:

π ti+1 = Profit for bank i at time t + 1,

β = Discount value
Lint = Loan outstanding of type n loan for bank i at time t
rLtin = Loan interest rate of type n loan for banks i at time t
Pt i = Oustanding of interbank market placement for bank i at time t
rPti = Interest rate of interbank placement for bank i at time t
S tio = Oustanding of o - month maturity of Bank Indonesia Certificate (SBI) for bank i at time t
rStio = Interest rate of o - month maturity of Bank Indonesia Certificate (SBI) for bank i at time t
Btim = Oustanding of m - year maturity of Government Bonds for bank i at time t
rBtim = Interest rate of m - year maturity m of Government Bonds for bank i at time t
Ft i = Oustanding of Bank Indonesia Facility (FASBI) for bank i at time t
rFti = Interest rate of Bank Indonesia Facility (FASBI) for bank i at time t
Dtiq = Outstanding of q - month maturity of time deposit for bank i at time t
rFti = Interest rate of q - month maturity of time deposit for bank i at time t
Tt i = Outstanding of saving deposit for bank i at time t
rFti = Interest rate of saving deposit for bank i at time t
K ti = Capital of bank i at time t
X ti = Excess reserves of bank i at time t
Ω it = Capital adequacy ratio of bank i at time t
ρ D = Reserve requirement of time deposit for bank i at time t
ρ T = Reserve requirement of saving deposit for bank i at time t
ρ X = Ratio of excess reserve to total deposits
α L , α P ,α S , α B ,α F ,α D , α T = Marginal cost of each items of balance sheets

22
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