Published by:

Bank Indonesia
Jl. MH Thamrin No.2, Jakarta
Indonesia

The Financial Stability Review (FSR) is one of the avenues through which
Bank Indonesia achieves its mission ≈to safeguard the stability of the Indonesian Rupiah by
maintaining monetary and financial system stability for sustainable national economic
developmentΔ

FSR is published biannually with the objectives:

to analyze potential risks confronting domestic financial system;
To recommend policies to relevant authorities for promoting a stable financial system; and
To foster market discipline and public knowlege on domestic and global financial system
stability issues.

This edition was launched in March 2007 and is based on data and inormation available by the end of 2006, except stated
otherwise. With the exception of those stated in graphs and tables, all data sources are from Bank Indonesia.

The pdf format is downloadable : http://www.bi.go.id

Any inquiries, comments and feedback please contact :

Bank Indonesia
Directorate of Banking Research and Regulation
Financial System Stability Bureau
Jl.MH Thamrin No.2, Jakarta, Indonesia
Phone : (+62-21) 381 7353, 381 8336
Fax : (+62-21) 2311672
Email : BSSK@bi.go.id
Financial Stability Review
II - 2006
( No. 8, March 2007 )
ii
Table of Contents

Foreword vi Chapter 3 Financial System Prospects 45

Economy Prospects and Risk Perception 45
Overview 3 Banking Industry Risk Profile: Level and Direction 46
Prospects of the Financial System 46
Chapter 1 Macroeconomic Condition 9 Potential Vulnerability Needs to be Anticipated 47
Global Economy 9 Banking Industry Prospects 47
Domestic Economic Performance 11
Chapter 4 Financial Infrastructure and Risk
Chapter 2 Financial Sector 19 Mitigation 51

Banking Industry 19 Payment System 51

Indonesian Financial Sector Structure 19 Financial Sector Safety Nets (FSSN) 53

Liquidity Risk and Funding 20 Risk Management and Basel II Implementation 54

Credit Performance and Risk 22

Market Risk 31 Box 4.1.Basel II and Financial System Stability 56

Profitability and Capital 33

Non bank Financial Institutions and Capital Markets 36 Articles
Finance Companies 36 Article 1 Financial Safety Nets: Review of Literature
Capital Markets 37 and Its Practices in Indonesia 61
Article 2 Macroeconomic Model to Measure
Box 2.1.Limited Deposit Insurance Scheme and Financial Stability Index: The Case of
Potential Impacts 22 Indonesia 79
Box 2.2.Impact of BI Rate On Bank Lending Rates 29
Box 2.3.Short term Capital Inflows through Box A1.1. Key Considerations of Emergency Lending 65
the Financial Market 42
Glossary 91

iii
 List of Graph and Table

Tables Graphs
1.1 World Economic Indicator (Volume) 9 1.1 World Trade 9
1.2 GDP Growth (y-o-y) Based on Constant Price 12 1.2 World Commodity Prices 10
1.3 Interest Rate Performance 10
2.1 Interest Rate and Exchange Rate 31 1.4 JPY & EUR Exchange Rate against USD 10
2.2 Risk Sensitive Assets and Liabilities - 1.5 Exchange Rate of Selected Currencies
Interest Rate 33 in the Asian Region 10
2.3 Banking Profitability Monthly Average 35 1.6 Private Capital Flows to Developing Countries 11
1.7 Composite Index 11
3.1 Concencus Forecast of Selected Economic 1.8 Inflation, BI Rate and SBI 12
Indicators 45 1.9 Rupiah Exchange Rate against USD 12
3.2 Indonesian Risk Perception 45 1.10 Non Oil and Gas Exports 13
1.11 Non Oil and Gas Imports 13
Table Box : 1.12 Credit and NPL of Consumption Credit 13
2.2.1 Increasing of SBI and BI Rate 30 1.13 Interest Rate and Inflation 13
2 2.2 Decreasing of SBI and BI Rate 30 1.14 Customer Confidence Index 13
2.2.3 Increasing of SBI and BI Rate 30 1.15 Unemployment Rate 14
2.2.4 Decreasing of SBI and BI Rate 30 1.16 ROA and ROE 14
1.17 Business Financial Indicators 14
4.1.1 Basel II Implementation Plan 57 1.18 Corporate Loss Ratio 14
1.19 DER and Debt/TA 15
1.20 Liabilities 15

2.1 Assets of Financial Institutions 19

2.2 Structure of Funding and Bank Placements 20
2.3 Bank Liquid Asset Ratio 20
2.4 Liquid Asset Ratio of 15 Largest Banks 20
2.5 IBMM Interest Rate Performance 21
2.6 Deposits Structure 21
2.7 Deposits and Credit Growth (y-t-d) 23
2.8 Earning Assets 23
2.9 Loan to Deposit Ratio 23
2.10 Interest Rate 23
2.11 Credit Growth by Economic Sector (y-t-d) 24
2.12 Credit Growth by Type (y-t-d) 24
2.13 MSM Credit 24

iv
2.14 Non Performing Loans 25 2.48 Global Index Performance 37
2.15 NPL Performance in 2006 25 2.49 Regional Index Performance 37
2.16 Gross NPL Ratio per Bank Group 25 2.50 SET Volatility 37
2.17 NPL Trends by Economic Sector 25 2.51 JCI Volatility 38
2.18 NPL Share by Economic Sector 26 2.52 Asset Performance 38
2.19 Gross NPL Ratio by Economic Sector 26 2.53 Stock Ownership 38
2.20 NPL Growth of Investment Credit 26 2.54 Sectoral Index Performance 38
2.21 NPL Growth of Working Capital Credit 26 2.55 Share of Sectoral Index Capitalization
2.22 NPL of Consumption Credit 27 (December 2006) 38
2.23 Growth in NPL Value 27 2.56 Price Performance of several Government
2.24 Gross MSM and Corporate Sector NPL 27 Bonds Series 39
2.25 Foreign Exchange Rate and NPL 27 2.57 Yield of 10-year Government Bonds of
2.26 Gross NPL Performance of Foreign Exchange 27 Selected Countries 39
2.27 Credit, NPL and APLL 28 2.58 Liquidity Distribution of Government Bonds 39
2.28 Interest Rate and Exchange Rate Performance 31 2.59 Government Bond Price Volatility in
2.29 Lending Rate by Bank Group 31 Selected Asian Countries 40
2.30 Rupiah Maturity Profile 31 2.60 Value and Volume of Corporate Bonds (2006) 40
2.31 Foreign Exchange Maturity Profile 31 2.61 Mutual Funds by Type (2006) 40
2.32 NOP Performance (Overall) 32 2.62 Time Deposits and NAV 41
2.33 NOP Performance (Balance Sheet) 32
2.34 Government Bonds in Bank Portfolio 32 3.1 Yield Curve 46
2.35 NII Growth 33 3.2 Risk Profile of Banking Industry and
2.36 Rupiah Spread (Weighted Average) 33 Its Direction 46
2.37 Structure of Bank Interest Income 34
2.38 Structure of Interest Income of 4.1 BI - RTGS Settlement Performance 52
the 15 Largest Banks 34 4.2 BI - RTGS Settlement Performance (by Agent) 52
2.39 ROA 34
2.40 Efficiency Ratio 34 Graph Box :
2.41 Capital Adequacy Ratio 35 2.1.1 Deposit Growth 22
2.42 Tier 1 Capital 35 2.2.1 Interest Rate Performance 29
2.43 CAR by Bank Group (December 2006) 35 2.2.2 Lending Rate and NPL 29
2.44 CAR Distribution (December 2006) 35 2.3.1 Foreign Net Transactions: Stocks, Government
2.45 Operational Activities of Finance Companies 36 Bonds and the Exchange Rate 42
2.46 Net Cash Flow of Finance Companies 36 2.3.2 Net of Foreign Shares Transaction - JCI 42
2.47 ROA, ROE and Ratio of Financing to Equity 37
Diagram 1 Basel II Structure 57

v
 Foreword

Since its inception in 2003, the format of the Financial System Stability Review (FSR) has
evolved despite maintaining an identical target, namely to present an analysis of financial
system development and resilience. We continually strive to make the FSR more focused and
future oriented. The material used in this edition is further emphasized by the evaluation of
significant risks on the financial system - be it externally or internally - and measures to mitigate
them.

Externalities are yet to relent, particularly due to global instability and sluggish global
economic growth, especially in the United States of America, and the potential of short-term
capital reversals. However, significant pressures on the domestic economy are yet to materialize.
Meanwhile, the domestic economy remains relatively stable despite lackluster growth and
such conditions support a sound banking industry.

Two fundamental challenges confronting banks are slow credit growth and high credit
risk. However, in general, banking risk remains moderate and controllable with support from
sufficient profitability and capital, as well as better risk management and corporate governance.
The performance of non-bank financial institutions as well as the capital and bond markets is
also relatively sound without significant risk exposure. In terms of infrastructure, the rise in
settlement value and volume, particularly through the BI-Real Time Gross Settlement (BI-RTGS)
system, is mitigated by the development of the settlement system coupled with effective
supervision. To this end, the reliability and security of the payment system can be maintained.

To further strengthening financial system resilience, the government and Bank Indonesia
continue to improve the Financial Sector Safety Net (FSSN). Banking supervision, on the one
hand, is more effective as a result of numerous post-crisis initiatives including Indonesian Banking
Architecture. On the other hand, the effectiveness of risk management and corporate
governance in the banking industry continues to improve in line with preparations for Basel II
implementation. Furthermore, the role of the Indonesian Deposit Insurance Corporation (IDIC)

vi
as an insurer and administrator of failed banks will become more strategic in the more dynamic
banking business environment, especially with the full implementation of a limited deposit
insurance scheme in March 2007. In addition, coordination between Bank Indonesia, IDIC
and the Ministry of Finance to prevent and overcome financial crises is more effective with the
function of the Financial System Stability Forum.

The stability and prospects of the financial system over the next six months will improve
due to monetary stability and economic growth. This is attributable to endeavours taken by
the government to meliorate the business climate and nurture corporate governance. Tighter
collaboration between the government and Bank Indonesia, including introducing the Financial
Sector Policy Package, will stimulate real sector development.

The current FSR provides a clearer picture to all parties regarding the performance, risks
and prospects of the financial system. Therefore, stakeholders can proactively perform their
roles in maintaining financial system stability.

Finally, on behalf of the Board of Governors, I extend our gratitude and appreciation to
the writers and all parties who have contributed to the latest FSR. May God guide the way
and bless us all so that we perform our tasks and responsibilities to the best of our abilities.

DEPUTY GOVERNOR

BANK INDONESIA

MULIAMAN D. HADAD

vii
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 Overview

Overview

1
 Overview

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2
 Overview

Overview

The resilience of the financial system was maintained in semester II 2006

with improving prospects. This was supported by monetary stability and the
buoyant domestic economy, as well as the release of pressures stemming
from the global economy coupled with a decline in interest rates and a rise in
asset value.
Stable conditions nurtured financial sector performance, particularly banks,
despite slower than expected growth for credit. Bank profitability rose and
capital remained adequate to cushion mounting risks. With improved
efficiency as well as better risk management and corporate governance, it is
projected that banks will accelerate the pace of credit growth to stimulate
the economy.
Notwithstanding, there remain sources of instability that must be well
mitigated to avoid disruptions to financial system stability.

1. SOURCES OF VULNERABILITY The External Environment

Nearly ten years on since the financial crisis, the
financial system - banks in particular - is becoming
healthier and more stable yet remains beset by multi-
faceted challenges. Analysis of Indonesian financial
system resilience focus on banks, especially the major
ones, the markets and financial infrastructure since
these sectors tend to have systemic effects.
Risk exposure generally stems from externalities
in the form of volatile short-term capital inflows.
Internally, risk emanates from the on going
restructuring of major debtors as well as inadequate
risk management and weak corporate governance.
The external environment remained
unfavourable primarily due to global imbalances and
sluggish global economic growth, especially in the
United States. However, pressures emanating from
the external sector were relatively low and did not
significantly affect the domestic economy.
Meanwhile, the domestic economy remained
relatively steady supported by monetary stability.
Unfortunately, such conditions were not fully utilised
to foster economic growth, primarily because of
inefficiency as well as an unfavourable business
climate and restricted real sector growth.

3
 Overview
Banking
The banking system remained relatively sound
with moderate risks. However, the slow pace of bank
credit requires attention, as do mounting credit risk
and operational risk that could threaten financial
system stability.
Slow credit growth
Bank credit continued to grow, however, at a
slower pace attributable to high credit risk and an
under-performing real sector, in particular
corporations, primarily due to the inauspicious
business climate. This encouraged banks to prefer
investing in SBI , ergo undermining financial
intermediation.
Unresolved credit restructuring
The restructuring of unhealthy corporations by
major banks remained unresolved, which could
exacerbate credit risk and erode bank profitability.
Challenges facing the limited deposit insur-
ance scheme
Implementation of the transitional limited
guarantee scheme - with a maximum of Rp100
million per customer per bank beginning March 2007
- has not triggered flight to safety. However, the high
concentration of bank deposits of over Rp100 million
could trigger liquidity risk for some banks. This needs
to be anticipated to avoid systemic effects.
Financial Market and Capital Market
Increasing short-term capital volatility
Macroeconomic improvements attracted short-
term foreign investment in the capital market. High
4
fluctuations in the exchange rate or interest rate could
impinge upon the domestic financial markets. Non-
transparent pricing and the shallow market made
the government bonds (SUN) market more attractive
for short-term investment, which is more volatile.
Increased financial market performance underpinned
primarily by sentiment rather than fundamentals lead
to a price bubble.
2. RISK MITIGATION
To minimize the risks outlined, a series of
measures were required for both the financial sector
and related authorities as follows:
Financial Sector Policy Package (FSPP)
The government and Bank Indonesia continued
financial sector reform to bolster the role of financial
institutions and markets in financing the economy.
The FSPP strives to buttress the structure of the
financial sector, enhance market and institutional
infrastructure as well as broaden the access of
business players to financing. Hence, macroeconomic
stability and financial system stability will foster real
sector development.
Strengthening the Risk Management of Banks
Basel II will be implemented in 2008 along with
advancements in the practice and methodology of
risk management and international standards,
commencing with the simplest approach to calculate
capital adequacy. The implementation of Basel II will
not only boost the quality of banking risk
management, therefore, leading to healthier
operations but will also bolster financial system
stability, especially in the banking sector.

Reinforcing Financial Infrastructure
Payment system
Bank Indonesia continuously develops a reliable
and secure payment system. Risk management - in
the Systemically Important Payment System (SIPS) and
Systemically Wide Important Payment System (SWIPS)
- has been conducted from the outset including the
system design phase, operational procedures and
participants» rules. In addition, oversight continues
to be strengthened. Other policies instituted include
the management of money remittances.
Furthermore, operational risk is mitigated by a
contingency plan and business continuity
management.
Strengthening the Financial Sector Safety Net
(FSSN) including Crisis Management
Through four key elements the government
and Bank Indonesia continue efforts to develop
FSSN, namely: (i) effective bank regulation and
supervision; (ii) lender of last resort for normal
conditions and systemic crises; (iii) a limited and
explicit deposit insurance scheme; and (iv) clear crisis
resolution policy. These key elements were
encompassed in the draft FSSN Act, which clearly
defines the tasks and responsibilities as well as a
coordination mechanism between related
authorities to prevent and cope with crises. This,
among others, is instituted through the Financial
System Stability Forum comprising of board
members, senior executives and officials from the
Ministry of Finance, Bank Indonesia and IDIC as
members.
Overview
Enhancing the Effectiveness of Financial
System Surveillance
The effectiveness of financial system surveillance
in terms of performance and vulnerability is
continuously improved through the development and
implementation of numerous methodologies
including stress tests. This is a crucial front guard
action to identify and anticipate potential instability.
3. FINANCIAL SYSTEM RESILLIENCE AND
PROSPECTS
Overall, risks in the financial system in semester
II 2006 was less pronounced and steadier in line with
monetary stability and the betterment of economic
conditions.
External factors had the potential to affect
Indonesian financial system resilience, including a
slight dip in the global oil price, sluggish global
economic growth and short-term capital inflows.
Internally, expanding credit allocation and
reducing persistent credit risk, which are highly
correlated, represent two primary challenges
confronting banks. Another challenge is to improve
the effectiveness of internal controls and corporate
governance as well as formulate a contingency plan
to curb operational risk.
Measuring financial system stability represents
a particularly challenging task and requires improved
methodologies and tools. However, a simple stress
test conducted to measure credit risk, liquidity risk
and market risk, demonstrated that banks have
adequate resilience to absorb shocks as a result of
changes in macroeconomic variables.
5
 Overview

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6
 Chapter 1 Macroeconomic Condition

Chapter 1
Macroeconomic Condition

7
 Chapter 1 Macroeconomic Condition

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8
 Chapter 1 Macroeconomic Condition

Chapter 1 Macroeconomic Conditions

Volatility in the external sector, due to surging globalization, did not

significantly affect economic stability. The shock from external sector may
emerge from global oil price hikes, continuing investor concerns regarding
the propagation of the foreign exchange control taken by Thailand and other
Asian countries, and outbreaks of avian influenza.
In addition, domestic economic conditions remained steady despite the
absence of sound economic growth. However, rigidity in the economy
brought inefficiency, which impinged upon real sector growth.

1.1 GLOBAL ECONOMY other countries, particularly Asian and oil exporting
External sector pressures stemming from countries. Global economic imbalances have
burgeoning capital inflows attributable to benefited some countries, particularly oil exporters,
globalization are projected to intensify. as reflected by high savings and current account
The global economy remains confronted by the surpluses. Such countries have become the primary
downside risk of global imbalance issue emanating contributors of excess global liquidity and propagate
from the large current account deficit in the US to the low long-term interest rate.
Against this backdrop, global economic growth,
Table 1.1 particularly in developing countries can prosper.
World Economic Indicator (Volume)
Furthermore, global economic expansion befalls
%
Projection some regions in a more balanced manner, allowing
Category 2004 2005
2006 2007
Graph 1.1
World Output 5.3 4.9 5.1 4.9
World Trade
Advanced Economies 3.2 2.6 3.1 2.7 %
Emerging & Developing Countries 7.7 7.4 7.3 7.2 14
12
Consumer Price
10
Advanced Economies 2.0 2.3 2.6 2.3
8
Emerging & Developing Countries 5.6 5.3 5.2 5.0
6
LIBOR 4
US Dollar Deposit 1.8 3.8 5.4 5.5 2
Euro Deposit 2.1 2.2 3.1 3.7 0
Yen Deposit 0.1 0.1 0.5 1.1 -2 World Trade Volume
Trend 1970-2005
Oil Price ($) - Average 30.7 41.3 29.7 9.1 -4
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006
Source: World Economic Outlook - September 2006 Source: IMF

9
 Chapter 1 Macroeconomic Condition

them to exceed initial projections. In addition, global property investment in the US. To restore US
trade volume has also surpassed its long-term economic growth amidst the looming threat of high
average. inflation rates, the Fed did not raise its interest rate
Entering semester II 2006, the global economy during semester II 2006. A level of 5.75% was
was adjusting to the imbalances, aiming for a soft- maintained to the end of 2006, which is expected to
landing scenario, including improvements in Asian drop in semester I 2007.
exchange rate flexibility, boosting expenditure from High capital inflows were prevalent to emerging
oil-producing countries, structural reform in the Euro countries, particularly in Asia, including Indonesia.
zone and Japan as well as fiscal consolidation in the These flows were attributable to a US dollar slump
US. Adjustments to global imbalances were coupled with a more flexible exchange rate system
accompanied by a drop in the global oil price, which in Asia together with the adoption of monetary policy
fostered economic growth in developing countries, anchored to inflation targets and the high investment
while the US economy tended to cool off. yield in some emerging markets.
In semester II 2006, financial markets in the
Graph 1.2
World Commodity Prices Southeast Asian region experienced a steep bullish
$
500
rally compared to the previous semester. Surpluses
Oil
450
Aluminum in some countries encouraged the further
400 Copper
350 Tin
Gold
300
Graph 1.4
250
JPY & EUR Exchange Rate against USD
200
JPY/$ $/EUR
150
125 1.4
100
50 120 1.35

0 115 1.3
2000 2001 2002 2003 2004 2005 2006
110 1.25

US economic growth is projected to decelerate 105 1.2

to 2.9% in 2007 from 3.4%, in 2006 following 100 1.15

95 1.1
tendencies of falling property asset value. This JPY/$ $/EUR (right axis)
90 1.05
precipitates a decline in household consumption and 2003 2004 2005 2006

Graph 1.3 Graph 1.5

Interest Rate Performance Exchange Rate of Selected Currencies in the Asian Region

% THB/$, PHP/$ SGD/$

7 60 1.75
SIBOR LIBOR Fed Fund Rate
6 55 1.7

5 1.65
50

4 1.6
45
3 1.55
40
2 1.5
35
1.45
1 THB/$ PHP/$ SGD/$ (right axis)
30 1.4
-
2003 2004 2005 2006
2000 2001 2002 2003 2004 2005 2006

10
 Chapter 1 Macroeconomic Condition

development of hedge fund activities with greater Market risk pressures are projected to intensify
volume. due to resurgent short-term capital inflows. These
Such investment is generally short term, flows are driven by expectations of improving
sparking high volatility in financial markets. economic growth in emerging markets.
The capital control policy in Thailand in mid Therefore, caution and domestic economic
December 2006, despite affecting the performance resilience are necessary to avoid a sudden capital
of financial markets in other Asian countries, did not reversal. The shock may stem from global oil price
trigger persistent bearish conditions. The JSX hikes, continuing investor concerns regarding the
Composite continued to climb and approached 1800 propagation of the foreign exchange control taken
from the middle of 2006 but tumbled by 2.9% to by Thailand and other Asian countries, outbreaks of
1737 on 19th December; coinciding with Thailands avian influenza and potential politic instability
Capital Control Policy. However, relatively steady domestically and regionally.
Indonesian macroeconomic conditions enabled
continuing capital flows into Indonesia. 1.2. DOMESTIC ECONOMIC PERFORMANCE
Consequently, the Jakarta Composite Index (JCI) Amidst ongoing adjustments to global
regained momentum and reached its new highest imbalances, economic activities, which slumped at
level of 1805 at the end of 2006. the beginning of 2006 due to weaker public
purchasing power post the fuel price hikes in October
Graph 1.6
Private Capital Flows to Developing Countries 2005, gradually regained momentum. Government
Billions of $ consistency not to push for another hike in fuel prices
550
500 and the basic electricity tariff in 2006 was responded
450 Estimation
400
to positively, reflected by a drop in inflation to 6.6%
350
300
in December 2006. The dip in inflation provided
250
200
sufficient manoeuvrability for steady BI Rate cuts,
150
100
which restored the expectations of investors
50
0
concerning economic prospects. Consequently, this
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Source: World Bank
fostered a surge in capital inflows to Indonesia, which
contributed to rupiah appreciation. Nevertheless,
Graph 1.7
Composite Index caution is still necessary considering that the majority
2,000
of the inflows are short term.
1,800
1,600
1,736.67 Through semester II 2006 the rupiah exchange
1,400
1,200 rate strengthened with low volatility (0.24%)
1,000
800 compared to the previous semester (0.46%) driven
600
400 by domestic macroeconomic improvements.
200
-
Furthermore, rupiah appreciation was also
Jun Jul Aug Sep Oct Nov Dec
2006 attributable to strong Asian exchange rates and

11
 Chapter 1 Macroeconomic Condition

Graph 1.8 Graph 1.9

Inflation, BI Rate and SBI Rupiah Exchange Rate against USD
% Rp/$
20 7,000
18 7,500
16 8,000 FFR 5% (May 10, 2006)
BI Rate 12.50% (May 9, 2006)
14 8,500
12 9,000
10 9,500
8 10,000
6 10,500
- Katrina Hurricane in New Orleans (Aug 29, 2005
4 11,000 - World Oil Price $69.81/barrel The implementation of
11,500 (Aug 30, 2005) New Fuel Price &
2 Inflation SBI BI Rate nd
2 Bali Bomb (Oct 1, 2005)
- 12,000
2002 2003 2004 2005 2006 Jan Feb Apr Jun Jul Sep Nov Dec Feb Apr Jun Jul Sep Nov Dec Feb Apr Jun Jul Sep Nov Dec Feb Apr Jun Jul Sep Nov Dec
2003 2004 2005 2006

bullish capital markets in Asia following investor
pessimism surrounding the US economy.
Along with the fall in inflation and rupiah
appreciation, the economy in semester II 2006 also
grew positively, primarily underpinned by the surplus
balance of payments supported by rising exports.
Notwithstanding, macroeconomic performance in
2006 was below expectations due to a persistently
low growth.
Internally, demand remains reliant on
consumption. Meanwhile, private investment has
not significantly improved with the exception of
construction projects that have tended to
increase.
Externally, the balance of payments is
projected to maintain its surplus due to the rise in
exports and a surge in capital inflows. Against this
backdrop, Indonesian forex reserves are adequate
at a level of USD42.4 billion as of year end 2006.
Consequently, Indonesia succeeded in servicing its
external debt to the International Monetary Fund
(IMF). Notwithstanding, the rise in exports was not

Table 1.2
GDP Growth (y-o-y) Based on Constant Price (Billions of Rp)

2005** 2006**

BI»s Projection BI»s Projection

QI Q II Q III Q IV Total QI Q II Q III
Q IV* Total*
1. Consumption ( 2 + 3 ) 2.03 2.63 5.52 6.71 4.25 3.75 5.57 2.84 3.53 3.91
2. Household 3.42 3.78 4.42 4.18 3.95 2.94 2.99 2.99 3.76 3.17
3. Government -9.60 -6.67 14.69 24.91 6.64 11.51 28.77 1.72 2.18 9.61
4. Investment ( 5 + 6 ) 18.40 18.44 11.22 -11.52 8.39 -3.24 -2.94 -0.55 14.15 1.43
5. Formation of Fixed Gross Domestic Capital 14.88 16.71 10.30 2.46 10.80 1.14 1.09 1.29 8.18 2.91
6. Stock Changes 108.88 39.46 24.89 -165.61 -25.69 -65.17 -43.74 -24.60 88.57 -29.79
Statistic Discrepancy1) -16.76 30.18 11.90 -30.19 -50.67 -25.76 -10.06 3.246.19 31.52 456.41
Domestic Demand ( 1 + 4 ) 5.89 6.54 7.00 1.93 5.29 1.91 3.23 1.92 5.95 3.27
Net Export ( 7 - 8 ) 21.73 -6.28 -5.06 47.05 13.56 54.65 30.99 0.09 -4.56 15.60
7. Goods and Services Export 21.97 17.44 11.97 15.16 16.36 11.56 11.30 8.17 6.08 9.16
8. Substracted by Goods and Services Import 22.02 23.52 17.04 7.23 17.07 2.76 7.47 10.12 9.70 7.57
9. GROSS DOMESTIC PRODUCT 6.06 5.87 5.81 5.00 5.68 4.98 4.96 5.87 6.11 5.48
10. Net Income to Foreign Production Factor 4.97 -48.84 -41.17 -46.84 -33.45 -23.64 -9.72 0.49 -3.51 -7.52
11. GROSS NATIONAL PRODUCT 6.62 3.76 4.00 2.77 4.27 4.15 4.62 6.31 6.30 5.35
12. Substracted by Indirect Tax 10.10 -110.96 -62.16 230.15 -24.89 3.49 1,360.45 107.51 -127.71 60.27
13. Substracted by Amortization 6.06 5.87 5.81 5.00 5.68 4.98 4.96 5.87 6.11 5.48
14. NATIONAL INCOME 6.43 8.68 6.54 -0.78 5.11 4.14 -1.45 4.90 8.90 4.09
Source: BPS-Statistics Indonesia (calculated)
1) Gap between GDP based on sectoral and GDP based on usage

12
 Chapter 1 Macroeconomic Condition

Graph 1.10 Graph 1.12

Non Oil and Gas Exports Credit and NPL of Consumption Credit

Millions of $ Trillions of Rp %
90 250 8
Manufacturing
80 Mining and Quarrying 7
70 Agriculture, Hunting, & Fishing 200
6
Total
60
150 5
50
4
40
100 3
30
20 2
50
10 1
Nominal NPL (right axis)
0 0 0
2000 2001 2002 2003 2004 2005 2006 Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec
2003 2004 2005 2006

triggered by improvements in efficiency or product private investment. This was attributable to weak
competitiveness, but more substantially by strong purchasing power and the second-round effects of
global demand and price hikes on some fuel price hikes at the end of 2005; exacerbated by a
commodities. Conversely, imports grew at a slower tirade of natural disasters throughout 2006. Such a
pace than exports tainted by controversy phenomenon was clearly evidenced by the tendency
surrounding smuggled goods. of rising non performing loans (NPL) for consumption
Weak product competitiveness and an credit.
unfavourable business climate triggered capital
Graph 1.13
inflows from exports to short-term investment in the
Interest Rate and Inflation
capital market. If this continues, it could adversely %
25
affect exchange rate stability and, coupled with
20
negative sentiment, trigger a capital reversal. Also,
more liquidity in the market, not followed by a rise 15

in production, could aggravate inflation. 10

Relatively slow real sector growth was evidenced 5 1 Month Time Deposits
Interest Rate of Working Capital Loan Interest Rate of Investment Loan
Interest Rate of Consumer Loan BI Rate
by low household consumption and uninspiring Inflation 1 Month SBI
0
2002 2003 2004 2005 2006

Graph 1.11
Non Oil and Gas Imports Graph 1.14
Customer Confidence Index
Millions of $
90 160
Manufacturing
80 140
Mining and Quarrying
70 Agriculture, Hunting, & Fishing 120
Total
60
100
50
80
40
60
30
40 Recent Economy Condition
20
20 Consumer Expectation
10 Consumer Confidence Index
0 0
2000 2001 2002 2003 2004 2005 2006 Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec
2003 2004 2005 2006

13
 Chapter 1 Macroeconomic Condition

Graph 1.15 Graph 1.17

Unemployment Rate Business Financial Indicators
%
12
Current Ratio
450
10
350
DER 250 ROA
8
150
50
6
-50

4
Collection Period ROE
2
Q3:2005
Q3:2006
0 Inventory Turn Over Ratio
2001 2002 2003 2004 2005 Feb-06 Aug-06 Base Year 2001 = 100

Various sweeteners offered through an
investment and infrastructure policy package at the
beginning of 2006, a financial sector policy package
at the beginning of semester II 2006 as well as
improved macroeconomic conditions, including a
drop in the inflation and interest rates, were unable
to stimulate real sector growth. This is primarily due
to unresolved real sector issues, particularly labour
issues, inadequate infrastructure and the high cost
economy. Amendments to the Labour Act designed
to improve the labour sector were postponed due
to massive labour rallies. Furthermore, the
infrastructure policy package, which requires tight
coordination among institutions, has not progressed
adequately. Meanwhile, government commitment
to support investment has not been realized as
expected. In addition, the BI Rate cut of 300 basis
points (12.75%) in 2006 to 9.75% has had, until
recently, only limited influence on banks reducing
their lending rates.
Therefore, despite an increase in producer
optimism regarding economic prospects, pervasive
rigidity in the economy created inefficiency that
triggered reluctance among business players to
expand. If this persists, it has the potential to raise
redundancies and consequently push up
unemployment, which in turn would impinge upon
economic growth and disrupt financial system
stability.
An apathetic real sector was reflected by the
poor financial performance of public listed companies
until the third quarter of 2006. This was further

Graph 1.16 Graph 1.18

ROA and ROE Corporate Loss Ratio
% %
700 350 0.70

600 ROA 300 0.60

ROE (right axis) 250
500 0.50
200
400
0.40
150
300
100 0.30
200
50
0.20
100
0
0.10
0 -50
-100 -100 0.00
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

2003 2004 2005 2006 2004 2005 2006

Property Consumption Agriculture Misc. Industry

Mining Infrastructure Basic Industry Trading

14
 Chapter 1 Macroeconomic Condition

Graph 1.19 Graph 1.20

DER and Debt/TA Liabilities
1.80 Billions of Rp Trillions of Rp
1.60 DER 3,000 600
Debt/Total Assets
1.40
2,500 500
1.20
1.00 2,000 400

0.80
1,500 300
0.60
0.40 1,000 200

0.20
500 Total of Corporate Liabilities 100
0.00
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Total of Working Capital + Investment Loan (Industry) (right axis)
0 -
2003 2004 2005 2006 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
2003 2004 2005 2006

evidenced by the drop in business profitability in terms
of ROA and ROE.
The performance shortfall primarily occurred in
other sectors including the textile industry and textile
products, shoes and the automotive industry, which
witnessed more defaults than any other sectors. This
was marked by a high number of redundancies in
these industries throughout the reporting period. On
the other hand, the mining and agricultural sectors
grew positively.
Corporate leverage reflected by the debt-to-
equity ratio (DER) tended to remain steady despite
an ongoing downturn since early 2004.
To restore purchasing power and foster
economic growth, collaboration between related
authorities must focus on resolving prevailing
constraints to improve real sector performance in
order to maintain macroeconomic stability.

15
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 Chapter 2 Financial Sector

Chapter 2
Financial Sector

17
 Chapter 2 Financial Sector

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18
 Chapter 2 Financial Sector

Chapter 2 Financial Sector

Financial sector resilience was maintained. The financial sector, which

remained dominated by banks, continued to improve amidst slow credit
growth. Bank liquidity was adequate but concentrated on short-term deposits.
Despite lower NPL, high credit risk remained a salient feature of the banking
industry. To mitigate the credit risk, banks maintained adequate capital and
reserves. On the other hand, market risk stayed relatively controllable in line
with the drop in the interest rate.
Meanwhile, bullish sentiment triggered by improving macroeconomic
conditions fostered rapid growth in the financial market and bonds market.
Nevertheless, this required caution considering the lack of fundamentals,
which could trigger high price volatility.

2.1. BANKING INDUSTRY Graph 2.1

2.1.1. Indonesian Financial Sector Structure Assets of Financial Institutions

The Indonesian financial sector is dominated by Share of Total Asset of Financial Institution
100
banks, especially large banks. Pawn Shop

80 Securities
The Indonesian financial sector comprises of Company
Commercial Bank
commercial banks, rural banks and non bank financial 60 Leasing
Company
institutions, namely insurance, superannuation, 40
87.9%
Pension Fund 80.6%
Insurance
finance companies, securities and pawn shops. The 20
Rural Bank
market share of the banking sector represents about
0
80% of the total assets of the financial system. Thus, 2001 2005
Sources: BI and Others

banking sector vulnerability, particularly in the major

banks with a market share of 69.6% of banking
assets, highly affects financial system stability.
Since 2001, non bank financial institution
activity has escalated, particularly insurance, finance
companies and securities companies, eroding the
market share of banks slightly, however, bank total
assets continue to accrue.
Total funds managed by the financial sector
have reached Rp1,824.2 trillion or approximately
65.50% of GDP 1 . Total assets of the financial

19
 Chapter 2 Financial Sector

sector have grown on average by 10% annually 147.3% at the end of semester II. This was triggered
since 2001. In addition, the past year of 2006 by an increase in the number of liquid assets
witnessed 16.6% growth, which exceeds annual (29.73%), which surpassed the increase in short-term
GDP growth at 5% compared to the previous three liabilities (10.39%).
years. The liquid asset ratio of the 15 largest banks
was relatively lower than other banks. At the end of
2.1.2. Liquidity Risk and Funding semester II, the liquid asset ratio of the 15 largest
Deposits remain the largest source of funds. banks had only reached 118.8%, whereas other
Deposit growth remained steady amidst a diminishing banks had reached 199.4%. The difference is due to
savings rate. Deposits still dominate bank funds with slower deposit growth of other banks compared to
share of 89%, most of which is short term. This the 15 largest banks.
reflects inadequacy of banks to narrow the gap in
the maturity profile through, among others, Graph 2.3
Bank Liquid Asset Ratio
subordinate loans with longer terms. Trillions of Rp %

Liquid Asset NCD Liquid Asset/NCD (right axis)

320
140
Graph 2.2
Structure of Funding and Bank Placements 240

% 120
100 1.0 0.4
Securities 7.7 10.1 160
Inter Bank 0.9 Inter Bank Equity
Participation
Borrowing 22.9 100
Securities
75 80
13.1 Placement to
Bank
Indonesia
50 0 80
Deposits 90.4
Dec Dec Jun Dec
2002 2005 2006
53.5
25 Credit

Graph 2.4
0 Liquid Asset Ratio of 15 Largest Banks
Funding Placement Trillions of Rp %
250
Liquid Asset NCD Liquid Asset/NCD (right axis)
120
Liquidity Adequacy 200

Bank liquidity remained sufficient while liquidity 150

105

risk relatively moderate through semester II 20062 . 100

90

This is evidenced by the ratio of liquid assets above 50 75

3
100% at the end of the reporting period . In addition
0 60
Dec Dec Jun Dec
to liquid assets4 , the inter-bank money market also 2002 2005 2006

performed steadily.
The liquid asset ratio of banks continued to
Inter-Bank Money Market (IBMM)
improve; from 129.0% at the end of semester I to
Generally, rupiah IBMM performance through
1 Nominal GDP of current price semester II 2006 remained steady and liquid with an
2 To the end of November 2006
3 Liquid asset ratio is a comparison between the number of liquid assets owned by banks average interest rate of 5% - 7%. The IBMM
and the amount of non-core deposits (NCD)
4 A liquid asset comprises of cash and placements at BI (BI checking account, SBI, and
FASBI)
transaction interest rate touched its highest level of

20
 Chapter 2 Financial Sector

30% as a result of huge liquidity requirements to short term and of large value, is susceptible to
settle Indonesian Retail Bonds (IRB) and to satisfy the sudden withdrawals, particularly by the larger
large public demand for currency for a long weekend customers.
holiday. To provide additional liquidity, some banks A bank strategy to overcome the gap in maturity
sold SBI Repo. profile was by adding liquid assets, particularly SBI/
Fasbi that increased by Rp46.6 trillion (63.8%) over
Graph 2.5
IBMM Interest Rate Performance semester II 2006. With the overnight period for Fasbi
%
12 and 1 to 3 months for SBI, placements in SBI/Fasbi
were more profitable, due to far lower risk, and more
9
liquid.
6

Implementation of the Limited Deposit

3
Morning FX-Onshore Insurance Scheme
Afternoon FX-Offshore
0 In line with the phased schedule, the deposit
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2006 insurance scheme will be limited to a maximum of
Rp100 million per customer per bank as of 22nd March
Unbalanced Deposits Structure
2007. Although the majority of customer accounts
At the end of semester II 2006, deposits
total less than Rp100 million, deposits are still
totalled Rp1,287 trillion or 76.0% of total banking
concentrated on accounts of over Rp100 million. This
assets. Furthermore, the structure of deposits
has the potential to intensify bank liquidity risk if one
remained highly concentrated on short-term (up
or a combination of three aspects occurs: (i) flight to
to 3 months) deposits (91.9%) and a deposit value
safety; (ii) a breakdown of customer deposits into
of over Rp100 million (75.0%). Deposits of Rp100
smaller amounts; and (iii) switching of deposits to
million represented just 2.3% of total customer
other investment forms.
accounts. The deposit structure, which is mostly
To mitigate liquidity risk Bank Indonesia, the
Graph 2.6 Deposit Insurance Corporation (IDIC) and banks
Deposits Structure
continued socialization programs through mass

> 100 million < 100 million

media and more directly through customer service
Nominal (75.0%) (25.0%)
officers and bank statements sent to customers. In

< 3 month > 3 month

addition, Bank Indonesia also mandated banks to
Maturity (91.9%) (8.1%)
prepare a contingency plan. In addition, some banks

Ownership Individual others maintained their liquidity through liquid placements,

(57.7%) (42.3%)

such as SBI/Fasbi.

21
 Chapter 2 Financial Sector

Box 2.1 Limited Deposit Insurance Scheme and Potential Impacts

As scheduled, the limited insurance deposit First, there has been no flight to safety. Second,
scheme will be limited to a maximum of Rp100 million deposits have not been broken down into a number
nd
per customer per bank from 22 March 2007. This of smaller accounts, evidenced by the lack of a surge
replaces the government blanket guarantee scheme in the number of customer accounts, which actually
adopted since 1998 to minimize moral hazard and even declined. Third, no symptoms of significant
boost public confidence in banking industry after the deposit switching to other investments were apparent.
Asian financial crisis. Furthermore deposits grew steadily from September
Since the reduction in the value of deposits 2005 to the end of 2006.
insured no serious impacts on bank liquidity and Bank Indonesia coordinated with IDIC to
financial system stability have been evident. This has anticipate the potential effects of a limited deposit
been corroborated by at least three specific conditions. insurance scheme, primarily by intensifying the
socialization program to the public through banks and
the mass media. As bank supervisor, Bank Indonesia
Graph 2.1.1
mandated that banks assess and mitigate their risks,
Deposits Growth
including a contingency plan. To this end, several banks
Trillions of Rp
444.6 increased their liquid assets.
Big Private Banks 411.6
388.4
84.9
396.9
Customer comprehension of the limited deposit
Middle Private Banks 78.2
72.8
20.0
71.8 insurance scheme and financial system stability,
Small Private Banks 17.4
15.6
16.1
35.9 particularly the soundness of the banking system, is
Joint Venture Banks 34.3
34.3 Dec '05 Sep '06
33.4
92.0 Mar '06 Dec '06 crucial to maintain public confidence in banking. In
Foreign Banks 91.2
89.7
92.1
129.1 addition, efforts to uphold the reputation of banks
Regional Dev. Banks 125.5
96.4
85.3
480.4 and foster customer loyalty represent the first line of
State-owned Banks 447.2
426.8
431.4
defense against risk pressures.

2.1.3. Credit Performance and Risk Credit Performance

Credit growth in semester II 2006 remained Credit growth reported poor performance

below expectations despite recording higher unparalleled in the last four years. Credit growth5 in

growth than the previous semester. This was 2006 was 14.1%, well below the target contained

primarily attributable to real sector issues and in the bank business plan of 18%. This affected

an inauspicious investment climate investment structure and bank income. Bank

compounded by weak purchasing power. investment shifted from credit disbursement to SBI,

Furthermore, bank credit risk was deemed although credit remained dominant with a share of

moderate, marked by persistently high NPL. 5 Including channeling

22
 Chapter 2 Financial Sector

Graph 2.7 Credit extension is affected by developments

Deposits and Credit Growth (y-t-d)
% % in the BI/SBI rate and the magnitude of the gap
30 30
between the BI/SBI rate and the lending rate. One of
25 22.70 25
Credit
24.70 the reasons for an increase in bank placements in
20 20
16.31 14.07 SBI was the relatively narrow gap between the BI/SBI
15 17.11 15
rate and the lending rate, thus not covering the risk
14.10
10 10
6.32
8.38 premium. Furthermore, deposit rate adjustments to
5 Deposits 5
the cuts in the BI Rate outpaced lending rate
0 0
2003 2004 2005 2006
adjustments. Therefore, the falling trend of the BI
Graph 2.8 Rate is projected to widen the gap between the BI
Earning Assets
Rate and lending rates, which will further improve
%
100 0.5 0.4 credit extension. This phenomenon is presented in
11.8 10.1

22.9
Box 2.2.
75 25.9

7.9 13.1

50
Graph 2.10
Equity Participation
Inter-Bank Interest Rate
Securities % %
54.0 53.5
25 20 20
Placement on BI
Credit Consumer
18 18
0 Working Capital
2005 2006
15 Investment 15

13 BI Rate 13
53.5%. Bank income from placements at BI increased
10 10
1 Month Time Deposits
significantly despite the falling BI Rate (300 bps in
8 8
2006). Nevertheless, the share of income from credit
5 5
Dec Jun Dec
remained relatively constant. 2005 2006

LDR changed little due to relatively low credit

growth, namely 64.7%. The narrow gap between Working capital credit experienced the highest
the BI/SBI rate and lending rate affected the growth, whereas consumption credit is already
investment behavior of banks. considered optimal. High working capital credit
growth (16.97%) in 2006 was in line with various
Graph 2.9
Loan to Deposit Ratio improvements made to encourage credit growth;
% Trillions of Rp
80 1,400
however, it remained below the previous year
70 1,200 (22.40%). Conversely, consumption credit recorded
60 LDR (left axis)
1,000 the most impressive expansion during the preceding
50 Deposits (right axis)
800
40 year (36.81%). This reflects improvements in
600
30
Credit (right axis) economic growth.
400
20

10 200 Investment credit growth was slow (12.51%)

- - primarily due to various constraints in infrastructure,
2002 2003 2004 2005 2006

23
 Chapter 2 Financial Sector

Graph 2.11
Micro, Small and Medium (MSM) credit
Credit Growth by Economic Sector (y-t-d)
remained prominent. The share of MSM credit was
Electricity 34.5

Mining approximately 52% of total credit at the end of 2006.

73.4
Services 20.2
8.0
However, its growth plunged from 25.60% (2005)
Business Services
Agribusiness 21.5 to 12.4% (2006). Notwithstanding, the portion of
Construction 22.6

Transportation 36.4 commercial MSM credit represented just 26% of total

Manufacturing 7.4
2006
9.3
credit.
Others Jun 06
Trading 2005 24.7

-20 -10 0 10 20 30 40 50 60 70 80 %
Credit Risk
Graph 2.12 In addition to uninspiring credit growth, credit
Credit Growth by Type (y-t-d)
risk re-emerged as a central issue of the banking

9.49
industry. Bank NPL tailed off at the end of the
Consumer
36.81 reporting period subsequent to a significant
12.51 surge in the third quarter of 2006. Meanwhile,
Investment
13.22 stress tests on the 15 largest banks evidenced
16.97 2006 their resilience in tackling credit risk assuming
Working Capital June»06
22.40 2005 a 20%-rise-in-NPL scenario.
- 5 10 15 20 25 30 35 40
Credit growth was surpassed by growth of
%

investment in SBI. Albeit slow, credit grew steadily

legal wrangling, an unfavorable investment climate and reached 53.5% of total earning assets. Bank
and high costs. However, the outlook for investment placements in SBI also witnessed strong growth
credit is still bright because of falling interest rates (41.5%), which pushed its share in total banking
for investment credit. However, undisbursed loans earning assets up to 14.0%.
6
(UL) for investment credit remained high at 28.0% Banks perceived risk to remain high, reflected
through 2006. by the tendency of banks to invest in risk-free liquid
assets rather than in credit. Banks with a better fund
Graph 2.13 management strategy and excess liquidity actively
MSM Credit
% invested in SBI and government bonds. The same
100

25.8 26.0 applies to mid-sized banks, particularly regional

80
government banks, as a result of abundant project
60 25.3 26.0
funds from the central government. This
40
phenomenon, on one side, slightly eased credit risk
49.0 48.0
20 Non-productive
Productive
pressures but, on the other hand, impinged on both
Non-MSME
0 credit and economic growth.
2005 2006
The quality of bank credit improved along with
6 Indicates credit approval yet to be withdrawn more conducive economic conditions in semester II

24
 Chapter 2 Financial Sector

2006. Brighter economic prospects supported credit that gross NPL of this group decreased from 10.6%
restructuring, which is clear from the drop in NPL to 8.4%. Gross NPL of other banks was in the range
(12.4% or Rp8.2 trillion) compared to the previous of 3% - 4% on average. The fall in NPL of the largest
period (9.0% or Rp5.7 trillion). As a result NPL fell banks was supported by the restructuring process of
to Rp58.1 trillion. Although credit extension was two state-owned banks, which positively impacted
unimpressive, growth was reasonably buoyant profitability and capital to buffer risk exposure. Hence,
compared to the previous period. Consequently, the the lower risk emanating from large banks helped
ratio of gross NPL in the banking industry tumbled reduce instability.
from 8.7% to 7.0%.
Graph 2.16
However, banks have sufficient provisions and Gross NPL Ratio per Bank Group
adequate capital to absorb risks and, therefore, avoid
14
Large Bank
instability. The decline in NPL mentioned largely 12 Joint Venture

depended on the success of the restructuring 10

Small
program. 8

6
Foreign
Graph 2.14
4
Non Performing Loans
2 Middle
% Trillions of Rp
12 80
0
11 2003 2004 2005 2006
70
10
9 NPL Gross 60
8
7
50 Loan restructuring of corporate debtors in the
6 40
5
industrial sector was relatively successful, which
NPL Nominal (right axis) NPL Net 30
4
3 20
precipitated a decline in the gross NPL ratio from
2
1
10 15.3% to 10.5% in the manufacturing sub-sector.
- 0
2002 2003 2004 2005 2006 As a result, the NPL of this sector contracted from

Graph 2.15
43.8% to 40.3% of total NPL; however, any
NPL Performance in 2006 downturn in this sector could potentially raise
50
Sub-standard
vulnerabilities.
45
Doubtful
40 Loss
35
Graph 2.17
30
NPL Trends by Economic Sector
25
20 Trillions of Rp
15
Services Semester II
10
Semester I
5 Business Service

0 Transportation
Jan Feb Mar Apr Jun Jul Aug Sep Oct Nov
2005 2006 Trading
Construction
Electricity
The decline in NPL from large banks also
Manufacturing
contributed to relieve credit risk pressure. The NPL Mining
Agribusiness
of the 15 largest banks dropped by Rp7.7 trillion so
-8.0 -6.0 -4.0 -2.0 0.0 2.0 4.0

25
 Chapter 2 Financial Sector

Graph 2.18 Graph 2.20

NPL Share by Economic Sector NPL Growth of Investment Credit
% Trillions of Rp
% 20 25
100
Other Sectors 18
16 20
80 Business Service
14
NPL (rigth axis)
12 15
60 Trading Interest Rate
10

40 8 10

Manufacturing 6

20 4 5
2
Agribusiness
0 - -
2000 2001 2002 2003 2004 2005 2006 Dec 2000 2001 2002 2003 2004 2005 2006

Other Manuacturings = Mining, Electricity, Service, Construction, Transportation

Graph 2.21
NPL Growth of Working Capital Credit
The quality of trade sector credit improved % Trillions of Rp
25 45
indicated by the slight decline in gross NPL from 7.5% NPL (right axis) Interest Rate
40
20
to 6.2% mainly due to credit growth. However, the 35
30
value of non-performing loans in this sector rose by 15
25
20
37.2% compared to year end 2005. 10
15
The risks in trade sector credit were more 5 10
5
controllable compared to the industrial sector due
- 0
2000 2001 2002 2003 2004 2005 2006
to a relatively small outstanding credit and negligible
corporate debtors which diluted the risks.
The quality of household sector credit a rise in the value of consumption credit NPL - of
deteriorated as a result of the decline in purchasing which nearly all debtors are households - by 42.8%
power; however, stability was unaffected due to its in semester I 2006. However, improving economic
relatively small share. conditions in semester II 2006 encouraged a slight
High lending rates in 2006 coupled with weaker decline in gross consumption credit NPL (3.4%).
purchasing power due to higher inflation severely Therefore, the gross NPL ratio for consumption credit
affected the household sector. This was reflected by contracted from 3.2% in the previous report to 2.9%.
The plan to raise the salary of civil servants and the
Graph 2.19
Gross NPL Ratio by Economic Sector minimum regional wage in 2007 is expected to boost
the repayment capacity of households, which will
Services Semester I
Business Service Semester II consequently improve the quality of consumption
Transportation
credit.
Trading
Construction The quality improvement of corporate credit
Electricity
contributed significantly to the amelioration of bank
Manufacturing
Mining credit quality. The decline in corporate NPL by 25.9%
Agribusiness
0.0 5.0 10.0 15.0 20.0
triggered a drop in the gross NPL ratio from 12.2%

26
 Chapter 2 Financial Sector

Graph 2.25
Graph 2.22 Foreign Exchange Rate and NPL
NPL of Consumption Credit Rp/$ Trillions of Rp
% Trillions of Rp 14,000 50
25 8 NPL of Foreign Exchange
45
NPL (right axis) Interest Rate 12,000 Exchange Rate (left axis)
7 40
20 10,000
6 35

8,000 30
15 5
25
4 6,000 20
10
3 4,000 15
2 10
5 2,000
5
1
0 -
- 0 2000 2001 2002 2003 2004 2005 2006
2000 2001 2002 2003 2004 2005 2006

Graph 2.26
Gross NPL Performance of Foreign Exchange
to 8.1%. This is primarily the result of loan %
45
restructuring in the major banks. Meanwhile,
40
vulnerabilities stemming from foreign exchange credit 35
30
risk remained relatively low due to a steady exchange
25
NPL of
rate. 20
Foreign Exchange
15
The value of non performing foreign exchange 10 Total of NPL

loans dropped quite substantially (34.0%) mainly due 5 NPL of Rp

0
to the restructuring program. Consequently, the gross 1999 2000 2002 2003 2004 2005 2006

NPL ratio of foreign exchange credit contracted

Graph 2.23
Growth in NPL Value significantly; from 18.0% to 9.9%. In addition, this
Trillions of Rp
50 type of credit also showed robust growth (19.4%)7 .
40 Conversely, the drop in NPL of credit denominated
Corporation
in rupiah was only 10.0%.
30

20

MSME
Credit Risk Mitigation
10
To mitigate credit risk several steps are required,
-
2002 2003 2004 2005
` 2006 including raising the effectiveness of credit risk
management, improving infrastructure and human
Graph 2.24
Gross MSM and Corporate Sector NPL resources, restructuring credit, allocating sufficient
14.0 6.0 provisions and adequate capital.
12.0
MSME (right axis) 5.0 Improving credit risk management function
function.
10.0
4.0 Since the introduction of risk management for
8.0
Corporation
6.0
3.0
banks in 2000 and its subsequent ratification in
2.0
4.0 2003, significant progress has been achieved in
2.0 1.0

- -
2002 2003 2004
` 2005 2006 7 Without channeling

27
 Chapter 2 Financial Sector

risk management. The major banks generally
have their own risk management unit and
implement four eyes principles to improve the
quality of credit extension. Furthermore, the
management of banks has to adhere to and
complete risk management certification to
embed risk management practices in daily
operations.
Utilization of credit information to reduce
asymmetric information and mitigate credit risk
risk.
To support banking infrastructure, Bank
Indonesia established the Credit Information
period, mainly in two state-owned banks, which
is in line with the development of large debtors.
The government also renewed Government
Regulation No 14/2005 regarding procedures of
write off state receivables with Government
Regulation No 33/2006 to harmonize the
restructuring process in state - owned and private
banks.
Graph 2.27
Credit, NPL and APLL
Trillions of Rp
100 900

th 90 Credit (right axis) 800

Bureau (CIB) on 29 June 2006. CIB collates, 80 700
NPL
70
stores and disseminates credit data from all 600
60
500
financial institutions such as commercial banks, 50
400
40
rural banks and finance companies, including 30 Provision
300

20 200
non-bank credit card providers. Such credit 10 100

information is valuable in supporting decision- 0

1999 2000 2001 2002 2003 2004 2005 Dec
0

making for consumption credit and reducing

credit risk.
Improving proficiency and infrastructure to
support MSM credit expansion
expansion. Large banks
continue to strive to augment the capabilities of
their personnel, including through the
recruitment of experts from rural banks and
establishing an MSM special unit to assess the
quality of MSM credit. The efficiency of the credit
approval process has also been streamlined
through a computerized credit scoring system.
Restructuring and write offs to stall the onslaught
of non performing loans
loans. The restructuring
process will be continued into the next reporting
Allocating Provisions for Loan Losses (PLL).
Throughout semester II 2006, banks established
PLL of Rp0.6 trillion representing an increase of
1.6%. However, several banks are yet to allocate
sufficient PLL as was indicated by a NPL ratio of
over 5%.
Maintain adequate capital.
capital In addition to
allocating adequate PLL, banks must also
maintain sufficient capital to mitigate risk. In
2006 the capital adequacy ratio (CAR) increased
slightly from 19.5% to 20.5%, whereas for large
banks it reached 19.4%.

28
 Chapter 2 Financial Sector

Box 2.2 Impact of BI Rate on Bank Lending Rates

The BI Rate tended to decline subsequent to occurred as follows: for time deposits the lag was 6.24
significant hikes in 2005. In response, banks were days, for savings 14.05 days and checking accounts
expected to cut their lending rates. 38 days. On the other hand, lending rates were
A preliminary survey was conducted incorporating adjusted as follows: working capital credit 31.7 days,
the 15 largest banks, which represent 69.6% of total investment credit 38.46 days and consumption credit
banking assets, to identify bank response to BI Rate 48.26 days.
changes by adjusting their lending rates. A rise in SBI and the BI Rate significantly affects
Generally, the survey results showed that the BI adjustments to the basic lending rate over a shorter
Rate strongly influences bank lending rates, as does period than the rise in the cost of loanable funds
the deposit insurance interest rate cap; lending rates (COLF). This demonstrates that the lending rate is more
of other banks; deposit rates and economic factors such responsive than COLF to rises in the BI Rate but,
as economic growth, inflation and the exchange rate. oppositely, COLF is more responsive than the lending
If the BI Rate is cut, banks immediately adjust their rate when the BI Rate is cut.
deposit rate; no later than 1 month. However, response A rise in the BI Rate would trigger a surge in NPL
through lending rates is slower, as banks enjoy within a 3 month period. This is possibly due to weaker
temporary profit taking considering that customers are debtor ability to make repayments because of the
still able to repay their liabilities at prevailing lending soaring oil price. A rise in NPL generally tends to be
rates. followed by higher interest rates, primarily to cover
The results of a further survey of 56 banks losses. The data presented below shows lending rate
returned similar results. Adjustments to deposit rates performance, in particular following COLF.

Graph 2.2.1 Graph 2.2.2

Interest Rate Performance Lending Rate and NPL

20 30
Interest Rate of Loan
25 NPL Gross
15

20
10
15
5
10

0
Cost of Loanable Funds SBI and BI Rate 5
Base Lending Rate Credit Growth
-5 0
Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May
2000 2001 2002 2003 2004 2005 2006 2000 2001 2002 2003 2004 2005 2006

29
 Chapter 2 Financial Sector

Table 2.2.1
Increasing of SBI and BI Rate

State-owned Joint Venture Regional Dev.

Period Private Banks Foreign Banks 15 Big Banks
Banks Banks Banks
Increasing of Cost of Loanable Funds
September 2000 to 0.94 Month 0.92 Month 1.2 Month 1.04 Month 0.98 Month 0.89 Month
June 2006 Increasing of Base Lending Rate
0.58 Month 0.46 Month 0.64 Month 0.66 Month 0.59 Month 0.52 Month

Table 2.2.2
Decreasing of SBI and BI Rate

State-owned Joint Venture Regional Dev.

Period Private Banks Foreign Banks 15 Big Banks
Banks Banks Banks
Decreasing of Cost of Loanable Funds
September 2000 to 0.52 Month 0.45 Month 0.66 Month 0.72 Month 0.98 Month 0.47 Month
June 2006 Decreasing of Base Lending Rate
0.98 Month 0.89 Month 1.4 Month 1.8 Month 1.63 Month 1.45 Month

Table 2.2.3
Increasing of SBI and BI Rate

State-owned Joint Venture Regional Dev.

Period Private Banks Foreign Banks 15 Big Banks
Banks Banks Banks
Elasticity of Cost of Loanable Funds
September 2000 to 0.087 0.055 0.084 0.065 0.044 0.061
June 2006 Elasticity of Base Lending Rate
0.028 0.026 0.014 0.038 0.018 0.027

Table 2.2.4
Decreasing of SBI and BI Rate

State-owned Joint Venture Regional Dev.

Period Private Banks Foreign Banks 15 Big Banks
Banks Banks Banks
Elasticity of Cost of Loanable Funds
September 2000 to -0.022 -0.026 0.034 0.055 0.004 0.044
June 2006 Elasticity of Base Lending Rate
-0.014 -0.015 0.008 0.0023 -0.024 0.009

30
 Chapter 2 Financial Sector

2.1.4 Market Risk Table 2.1

Interest Rate and Exchange Rate
Bank exposure to market risk was relatively small
Dec 2006 Growth
and nevertheless bank capital was adequate to cover
2005 Jun Dec Semester I Semester II
such risks. Bank market risk was manageable owing BI Rate 12.75 12.50 9.75 -0.25 -2.75
Exchange Rate 9830 9300 9020 -530 -280
to more favorable economic conditions and a falling 1-month
Time Deposit 11.98 11.55 8.96 -0.43 -2.59
interest rate
rate. Semester II 2006 was marked by a drop
in interest rates triggered by a decline in the BI Rate. Loan:
Working Capital 16.23 16.15 15.07 -0.08 -1.08
As of December 2006, the BI Rate had plummeted Investment 15.66 15.94 15.10 0.28 -0.84
Consumer 16.83 17.82 17.58 0.99 -0.24
275 bps on the previous semester. This was also
followed by a cut in bank interest rates for both time interest rate rebounds, which could potentially lessen
deposits and credit. Although such a decline was bank capital. Based on simulation results, a 1% rise
considered relatively low, the interest rate of all credit in interest rates would lead to an average CAR
types declined compared to the previous semester. decrease of 54 bps.
With a short maturity profile comprised The prevailing interest rate slump has triggered
principally of short term funds, banks enjoy profits public expectations of a continuation of the interest
when interest rates decrease. Risks emerge if the rate trend. The banking maturity profile, particularly

Graph 2.28 Graph 2.30

Interest Rate and Exchange Rate Performance Rupiah Maturity Profile
% Rp/$ Trillions of Rp
22 11500 450

Consumer Loan 300

19
10500
16 150
Investment Loan

13 Working Capital 9500 0

Loan

10 -150
8500 Dec»05 Jun»06
7 -300 Sep»06 Oct»06
Exchange Rate (right axis) Nov»06 Dec»06
1 Month Time Deposits
4 7500 -450
up to 1 month 1 - 3 months 3 - 6 months 6 - 12 months > 12 months
2002 2003 2004 2005 2006

Graph 2.29 Graph 2.31

Lending Rate by Bank Group Foreign Exchange Maturity Profile
% Trillions of Rp
40 10
Dec 05 WC = Working
Capital
Nov 06 I = Investment
C = consumer
30 Dec 06 5

20 0

10 -5 Dec»05 Jun»06
Sep»06 Oct»06
Nov»06 Dec»06
0 -10
WC I C WC I C WC I C WC I C WC I C up to 1 month 1 - 3 months 3 - 6 months 6 - 12 months > 12 months
State-Owned Regional Dev. Private Banks Foreign & Total
Banks Banks Joint Venture

31
 Chapter 2 Financial Sector

Graph 2.32 Government bonds in the trading portfolio of

NOP Performance (Overall)
seven previously recapitalized banks reached 47.1%.
%
24
Domestic Private Banks All Banks State-Owned Banks
The expanding share of government bonds in the
Foreign Bank Regional Banks
20
Joint Venture Bank Thehighest of NOP trading portfolio, which has been prominent since
19.8
18.9
16
16.9 17.1
15.6
August 2006, coupled with the declining BI Rate
14.7
12
intensified market risk. Simulation results
8
demonstrate that bank CAR would drop below 8%
4
only if the government bonds price fell by 10% or
0
Dec Jun Sep Oct Nov Dec
2005 2006 more.

Graph 2.33
NOP Performance (Balance Sheet) Graph 2.34
Government Bonds in Bank Portfolio
%
20 Trillions of Rp %
Private Banks State-Owned Banks
Joint Venture Banks Foreign Banks 300 21
16
Regional Dev. Banks All Banks
250 19
12
17
200
8 15
150
13
4
100
11
0 50
Dec Jun Sep Oct Nov Dec
9
2005 2006
0 7
Dec Feb Apr Jun Aug Oct Dec
2005 2006

rupiah, has shifted slightly since October 2006 from Trading % Government Bond - Trading to Total Assets (right axis)
% Government Bond to Total Assets (right axis) Investment
short term liabilities (under 1 month) to a longer
tenure (1 to 3 months). As for foreign exchange,
banks only have a short position for periods under 1 Bank market risk was manageable, supported
month. Periods of more than 1 month are dominated by maintaining their maturity profile and NOP,
by foreign exchange assets rather than liabilities. relatively high bank capital and improved economic
The rupiah exchange rate remained relatively conditions compounded by the falling interest rate.
stable (appreciating just Rp280/USD, on average, However, banks have had to anticipate a rise in the
compared to the end of semester I), which will not interest rate which would spark interest rate risks.
heap pressure on bank market risk. This is in line In addition, the potential of a short-term
with banks» ability to better mitigate exchange rate capital reversal could intensify market risk, especially
risk and maintain an overall average net open position if the rupiah depreciates significantly while banks
of only 5%. Therefore, the ability of banks to mitigate have significant foreign exchange liabilities.
exchange rate risks is relatively strong. This was Therefore, a bank»s ability to manage its assets and
reflected by bank CAR remaining above 8% under liabilities by maintaining NOP below 20% will help
stressed rupiah depreciation conditions. mitigate risk.

32
 Chapter 2 Financial Sector

2.1.5. Profitability and Capital Graph 2.36

Bank profitability is improving primarily Rupiah Spread (Weighted Average)
%
supported by credit growth and the declining SBI 18
16
interest rate
rate. However, bank efficiency has 14

deteriorated due to large provisions following the 12

10
rise in NPL. Meanwhile, the bank CAR remained 8
6
steady mainly due to sufficient capitalization,
4
despite significant credit growth through semester 2 Deposits Credit Spread
8 0
II 2006 . Dec Jun Dec Jun Dec Jun Dec
2003 2004 2005 2006

Profitability The interest rate spread is widening attributable

The decline in the BI Rate precipitated a rise in
income because the decline in the lending rate was
less pronounced than the drop in the deposit rate.
Consequently, bank net interest income (NII)
increased slightly from Rp7.6 trillion to Rp7.7 trillion.
The small rise in NII stemmed from credit growth
three-fold that of the previous semester and the
to the declining BI Rate and SBI rate, which are used
as a reference to determine deposit and lending rates.
The spread (weighted average) for banks grew from
9.76% in semester I 2006 to 10.17% at the end of
December 2006.
Table 2.2
Risk Sensitive Assets and Liabilities - Interest Rate

falling SBI rate since early 2006. Item Dec'05 Jun'06 Dec'06

Assets (Billions of Rp)

Graph 2.35 SBI/FASBI 106.898 153.768 217.589
NII Growth Securities *) 203.793 182.057 99.053
Credit **) 113.123 117.264 127.685
Trillions of Rp
8.0 Interbank Placement 44.780 45.669 64.205
Total 468.594 498.758 508.531
7.0
Liabilities (Billions of Rp)
1 month Time Deposit 324.464 322.001 317.362
6.0
Saving 281.266 279.062 333.864
5.0
Interbank Borrowing 50.370 53.092 70.386
Total 656.100 654.154 721.613
4.0 G a p (Billions of Rp)
Nominal (187.506) (155.396) (213.081)
3.0 % (40) (31) (42)
Dec Jun Dec Jun Dec Jun Dec Jun Dec Jun Dec
2001 2002 2003 2004 2005 2006 *) Government Bond - variable rate
**) Assumption: 20% of credit

The dip in the interest rate drove the NII rise
because the bank balance generally has a negative
net gap where total sensitive liabilities outweigh total
sensitive assets.
8 Comparison between June 2006 - December 2006, unless stated otherwise
Income sourced from interest on credit, which
still dominates bank interest income, increased in line
with credit growth. In addition, income from interest
on SBI also accrued mainly due to asset switching
from securities to SBI.

33
 Chapter 2 Financial Sector

The switching of securities to SBI was triggered Graph 2.39

ROA
by a securities price hike, which was perceived as %
3.5
optimal and consequently sold. Additionally, it was
3.0
also driven by the need to maintain liquidity. In order 2.5

to mitigate the knock on effects of the limited 2.0

deposits insurance scheme. 1.5

1.0

0.5
Graph 2.37
Structure of Bank Interest Income 0.0
Dec Dec Dec Dec Jun Dec
2002 2003 2004 2005 2006
%
100 Big Banks Other Banks Industry
7.0 6.9 8.9 9.2 8.2

75
49.8
namely 89%, whereas other banks recorded 81.3%.
59.7 59.2 60.1
63.1
50
The weakening efficiency ratio was attributable to a
rise in provisions along with the increase in NPL.
25 32.5
25.1 22.9 21.4
22.0

10.8 8.3 8.7 10.4

0
6.0 Graph 2.40
Dec Dec Jun Dec
2003 2004 2005 2006
Efficiency Ratio
%
BI Securities Credit Other
100.0 Big Banks Other Banks Industry

Graph 2.38 90.0

Structure of Interest Income of the 15 Largest Banks

80.0

%
100 4.7 5.0 6.4 6.5 6.5
70.0

60.0
75 45.8
56.8 58.4 58.4
61.5 50.0
Dec Dec Dec Dec Jun Dec
50 2002 2003 2004 2005 2006

40.1
25 31.4 29.0 27.3
27.8
Capital
9.4 6.8 4.3 6.2 7.8
0

2003
Dec
2004
Dec
2005
Jun
2006
Dec
Capital remained adequate and stable at 20.5%
BI Securities Credit Other despite a rise in risk weighted assets, in particular
those sourced from credit. However, this was
In line with the rise in net interest income ROA
followed by an accruement of capital, principally
increased slightly from 2.5% to 2.6%.
originating from profit accumulation.
Efficiency deteriorated evidenced by the rise in
Banks were able to absorb risk due to their
the efficiency ratio9 from 83.2% to 86.4%. The 15
capital adequacy, which alleviated instability. Capital
largest banks recorded the highest efficiency ratio,
adequacy also provided maneuverability for banks
9 The ratio of operational costs to operational income to expand credit.

34
 Chapter 2 Financial Sector

Graph 2.41 Graph 2.43

Capital Adequacy Ratio CAR by Bank Group (December 2006)
% %
1,100 24 30.0
Capital Risk Weighted Asset CAR (right axis) CAR
1,000
22 25.0 Tier 1 to Risk Weighted Assets
900
800 20
20.0
700
600 18
15.0
500
16
400 10.0

Joint Venture Banks

300 14

Foreign Banks
15 Big Banks
200 5.0

All Banks
12

Others
100
- 10 0.0
Dec Dec Dec Dec Jun Dec Jun Dec Jun Dec A B C D E F G H I J K L M N O
2000 2001 2002 2003 2004 2005 2006 Bank

Graph 2.42 Graph 2.44

Tier 1 Capital CAR Distribution (December 2006)
% %
22
> 26
21
19-25.9
20

19 13 - 18.9

18
8 - 12.9
17
<8
16 15 Big Banks Others

15 0 5 10 15 20 25 30 35 40
Dec Dec Dec Dec Jun Dec
2002 2003 2004 2005 2006

Big Banks Other Banks Industry

However, several medium and small banks with the institution of Indonesian Banking
persisted with a relatively small CAR ranging from Architecture to strengthen the structure of the
9% to 12%, leaving them susceptible to more risk. banking industry. Implementation is phased,
Banks will be obliged to maintain minimum therefore, by the end of 2007 the level will be Rp80
capital of Rp100 billion by the end of 2010 in line billion.

Table 2.3
Banking Profitability Monthly Average

Gap (Semester I -
Profit and Loss Items Semester I 2005 Semester II 2005 Semester I 2006 Semester II 2006
Semester II)
I Operational Income 13.0 16.6 17.5 21.5 3.9
Interest Income 10.2 12.1 14.6 17.4 2.9
Other Income 2.8 4.5 3.0 4.0 1.0
II Operational Expense 11.3 14.8 15.6 18.3 2.7
Interest Expense 4.4 6.0 7.8 8.9 1.1
Other Expense 2.8 5.3 3.1 3.8 0.7
Provision 2.4 1.5 2.6 2.8 0.3
III Operational Profit/Loss 1.7 1.8 2.0 3.2 1.2
IV Non Operational Profit/Loss 1.0 1.2 1.2 1.2 (0.0)
V Profit/Loss after Tax 2.0 2.1 2.3 2.9 0.6

35
 Chapter 2 Financial Sector
2.2. NON BANK FINANCIAL INSTITUTIONS AND
CAPITAL MARKETS
2.2.1. Finance Companies
Persistently high lending rates aggravated the
performance of finance companies
companies. The high
dependency on funds sourced from banks intensified
risks for finance companies. The knock on effects of
this also spurred risks for banks that extend credit to
finance companies.
Risks emerging from the operational activities
of finance companies remained high in 2006.
However, high bank lending rates undermined the
funding of finance companies, primarily sourced from
banks. In addition, finance companies had difficulty
in raising alternative sources of funding as the yield
of corporate bonds remained high.
Graph 2.45
Operational Activities of Finance Companies
Trillions of Rp
120
2003
100 2004
80
60
40
20
0
Assets Financing Source of Funds
Soaring interest rates hampered the ability of
debtors to service their loans, while finance
companies also struggled with their liabilities to
banks. To this end, finance companies issued bonds,
however, this was insufficient to offset the deficit to
finance their operations.
Several factors propagated business risk for
finance companies as follows:
Operational activities concentrated on customer
financing (63%), primarily to finance vehicles as
36
Graph 2.46
Net Cash Flow of Finance Companies
Billions of Rp
6,000
Net cash flow of operation activities
Net cash flow of funding activities
Net cash flow of Investment activities
4,000
2,000
0
-2,000
-4,000
Mar Jun Sep Oct
2006
a result of aggressive automotive financing,
especially by joint financing companies.
Tight competition in terms of business expansion
led finance companies to become less cautious
when extending loans. For example, loans were
distributed without a down payment.
High dependency on short-term loans from
banks, consequently the quality of loans
deteriorated, which had the potential to intensify
2005 bank credit risk.
Oct 06
Previous expansive financing by finance
companies began to adversely affect the performance
of the 10 largest finance companies. In addition to
poorer credit quality, this was compounded by
inadequate capital. Finance companies with a ratio
Capital
of financing to equity greater than 5 tended to have
a lower ROA and ROE compared to those with a ratio
below 5. Finance companies tended to suffer losses
if the ratio of financing to equity reached 10.
Joint venture finance companies additionally
seek financing from overseas loans rather than solely
domestic. Rupiah financing sourced from overseas
loans has higher exchange rate risk. Such conditions
are susceptible to high fluctuations in the exchange
rate, which will also encroach on the servicing of
their overseas loans.
 Chapter 2 Financial Sector

Graph 2.47 Graph 2.49

ROA, ROE and Ratio of Financing to Equity Regional Index Performance

% 1.60
1 12 JCI SET STI PCOMP KLCI
1.50
10 1.40
0.5

8 1.30
0
1.20
6
-0.5 1.10
4
1.00
-1 ROA ROE 2 0.90
Financing/Equity (right axis)
0.80
-1.5 0 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Jan Feb Mar Apr Mei Jun Jul Aug Sep Oct Jan Feb Mar Apr Mei Jun Jul Aug Sep Oct
2006
2006 2006
Non Joint Venture Finance Company Joint Venture Finance Company

security concerns. The Jakarta Stock Exchange (JSX)

2.2.2. Capital Markets experienced vast growth and recorded its highest ever
Stock Market level of 1805.52; becoming the highest performing
The buoyant stock market, which was to a large stock exchange after China.
extent supported by bullish sentiment, sparked a price The bullish JSX brought with it high volatility,
bubble
bubble. Weak fundamentals left the stock market exceeding the Thai and Philippine stock exchanges,
prone to corrections and high volatility, therefore, which were under pressure numerous times in 2006
the market only appealed to speculative investors. due to the political and security concerns in the
In 2006, foreign capital inflows to emerging countries themselves. Weak economic and corporate
markets were the primary catalyst to development fundamentals led to non-transparent pricing that
of the stock market. Nearly all global stock exchanges impinged on any potential rebound.
experienced immense growth. Consequently, Vast interest from foreign investors in the JSX
sentiment that influences the performance of global was clear from the growing asset share of foreign
stock exchanges mainly stemmed from the global investors in 2006; reaching 52.62%. However,
interest rate, particularly the Fed Fund Rate, investor strategy was more attributable to bullish
fluctuations in the global oil price and other short-term market sentiment, which had the potential
commodities as well as from domestic political and to spark a sudden capital flow reversal should any

Graph 2.48 Graph 2.50

Global Index Performance SET Volatility

2.40 7.00 850

JCI Hang Seng Nikkei FTSE DJIA VSET (LHS)
2.20 6.00 SET(RHS) 800
KOSPI SHCOMP Index SZCOMP Index SENSEX Index
Expon. (SET(RHS))
2.00 5.00 750
1.80
4.00 700
1.60
3.00 650
1.40 (y = 509,23e-0,0013x))
2.00 600
1.20

1.00 1.00 550

0.80 0.00 500

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2004 2005 2006
2006 Source : Bloomberg

37
 Chapter 2 Financial Sector

Graph 2.51 Graph 2.53

JCI Volatility Stock Ownership
Billions of Rp
1.60 2000
VJSX (LHS) JCI (RHS) Expon. (JCI (RHS))
600,000
1.40 1800 Domestic Foreign
500,000
1.20 1600

1.00 (y = 509,23e-0,0013x)) 1400 400,000

0.80 1200
300,000
0.60 1000

800 200,000
0.40

0.20 600 100,000

0.00 400
2004 2005 2006 -
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Source : Bloomberg
2006

bearish sentiment arise. This eventually transpired in Stocks in the banking sector will become more
Indonesia in May-June 2006. attractive to investors. Divestment issues and the
Several indices that demonstrated dogged performance of the NPL settlement process strongly
growth include the agricultural sector, property, affect banking stock price fluctuations. Stocks
infrastructure as well as the mining and financial sensitive to commodity prices are expected to have
sectors. Sentiment surrounding the domestic interest the potential to strengthen with more limited
rate decline, soaring mining commodity prices and fluctuations. Furthermore, stocks of prominent state-
high demand for alternative energy sources strongly
affected fluctuations in the sectoral indices. Graph 2.54
Sectoral Index Performance
Brighter prospects for the domestic economy
1,250 400
in 2007 and projections of a steady global interest Agribusiness
Mining
340
1,050 (left axis)
rate will positively shape the performance of the JSX. (left axis)
QI 280
850 Miscellaneous
However, more conducive market fundamentals (right axis)
220

will still only leave the JSX attractive to speculative 650 Q IV

160
Q II

foreign investors. Movements in the Fed Fund Rate 450 Infrastructure

Q III 100
Property
as well as the global oil price and other commodity 250
(right axis)
40
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
price fluctuations will continue to drive the market. Source : Bloomberg
2006

Graph 2.52 Graph 2.55

Asset Performance Share of Sectoral Index Capitalization (December 2006)
Billions of Rp
600
Domestic Foreign
500 Trading & Services Mining
Agriculture
5.60% 7.88%
2.74%
Financial Basic Industry
400 6.06%
26.63%
Miscellaneous
300 6.38%

200

100 Consumer
14.27%
Infrastructure Property
0 27.12% 3.34%
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2006

38
 Chapter 2 Financial Sector

owned banks that dominate stock market Graph 2.57

Yield of 10-year Government Bonds of
capitalization could still potentially strengthen as the Selected Countries
%
issuing companies generally service the needs of the 12

public. 10

Bonds Market 6

The decline in the domestic interest rate acted 4

as a catalyst to rapid growth in the government bonds 2

Indonesia India Philippines Thailand USA
market. Non transparent pricing and the shallow 0
15 17 19 21 23 25 27 29 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Nov Dec
market led to the government bonds market 2006

becoming more attractive for short-term investment,

which intensified price volatility
volatility. Generally, foreign will continue primarily due to the following two
investors were financial institutions interested in factors:
short-term government bonds to optimize income - The domination of government bonds in the
from the hedge funds they managed. bank trading portfolio coupled with a Primary
Dealers System.
Graph 2.56 - Low liquidity due to a lack of supply, leading to
Price Performance of several Government Bonds Series
non-transparent pricing, coupled with a shallow
130 market makes short term investment more
120 profitable.
110
The government bonds market suffered from
100
persistent high volatility preventing it from acting as
90

80 FR0002 FR0026 the reference for the corporate bonds market. For
FR0010 FR0031
70 FR0017 FR0034 example, a drop in government bonds yield would
FR0020
60 not trigger a subsequent decline in the yield of
Jan Feb Apr May Jun Jul Aug Sep Oct Nov Dec
2006 corporate bonds. However, the soaring yield of

The fall in yield did not discourage foreign Graph 2.58

Liquidity Distribution of Government Bonds
investors, reflected by government bonds in the
Trillions of Rp
portfolio of foreign investors jumping from Rp31 40
Fixed Rate Variable Rate
trillion to Rp54.5 trillion. Attractive government 35

30
bonds were primarily due to higher yields compared 25

to other Asian countries. 20

15
In 2007 the government bonds market will
10
remain active primarily due to the persistent interest 5

rate decline. Investor interest in government bonds 0

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

39
 Chapter 2 Financial Sector

corporate bonds discouraged issuing companies from recovery in the mutual funds market. However,
issuing bonds. Consequently, only 3 new issuing mutual funds remained high risk, particularly because
companies emerged in 2006 and the volume and mutual funds are concentrated on fixed income
value of stock issued rose by just Rp2.11 million and securities that are sensitive to interest rate fluctuations
Rp11.5 trillion respectively. and non-transparent pricing. Such conditions can
potentially trigger reputation risk for banks involved
Graph 2.59
Government Bond Price Volatility in in selling mutual funds
funds. The impressive growth
Selected Asian Countries witnessed in the stock market and government bonds
market facilitated recovery in the mutual funds
Indonesia
100 India
Philippines market as evidenced by the burgeoning NAV of
Thailand
50 mutual funds in 2006, approximately 76%.
Noteworthy NAV growth was not only the result of
30
higher underlying asset prices but also due to the
10 reemergence of investors in mutual funds. This was
0,0 1,5 3,0 4,5 6,0 7,5 9,0 10,5 12 13,5 15 % indicated by the rise in participation units by about
70%.
If the decline in lending rates tapers off it will Risks associated with mutual funds remained
undermine the issuance of corporate bonds in the high, especially due to the concentration of fixed
domestic market. The lower interest rate in the global income securities with a market share of about 39%.
market will encourage corporate investors to issue Furthermore, protected mutual funds, which grew
global bonds as a source of funds for business rapidly in 2006, achieved a market share of 22%
expansion. mainly based on underlying government bonds. High
risk principally stemmed from interest rate
Graph 2.60
Value and Volume of Corporate Bonds (2006) fluctuations to underlying assets.
Trillions of Rp Millions of Rp The prospects of a falling interest rate in 2007,
69 16
68 Value Volume (right axis) which will perpetuate the bullishness of the stock
15.5
67
66 15
65 Graph 2.61
14.5
64 Mutual Funds by Type (2006)
63 14
Trillions of Rp
62 13.5 25
61 Fixed Income Stocks Mixed Money Market Protected
13
60 20
59 12.5
Dec Mar Jun Sep Dec
15
2005 2006

10

Mutual Funds
5
Vast growth in the stock market and
0
government bonds market successfully underpinned Dec
2005
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
2006
Dec

40
 Chapter 2 Financial Sector

Graph 2.62
market and government bonds market, will raise the
Time Deposits and NAV
net asset value of mutual funds. Investor interest in
Trillions of Rp %
mutual funds will also heat up amidst tighter 700
Time Deposits Interest Rate of 3 months Time Dep. (right axis)
14

600 NAV Mutual Funds 12

competition from offshore products that use
500 10
underlying assets in the form of domestic capital
400 8
market instruments, especially government bonds. 300 6

The high risk nature of mutual funds could lead 200 4

to mounting reputation risk for banks acting as selling 100 2

agents. Higher risk mutual funds instruments are
mainly due to:
The lack of understanding by investors of mutual
funds characteristics triggered higher risks while
investors switched their deposits to mutual funds
due to low expected inflation. Furthermore, if
market corrections are levied on financial asset
prices leading to a drop in NAV, ill-informed
investors would panic triggering mass
redemptions. That actually occurred in Indonesia
in 2004.
Investor switching from fixed-income mutual
funds and protected mutual funds to mutual
0 0
Oct
2003 2004 2005 2006
funds based stock, such as indexed mutual funds
and Exchange Traded Funds (ETF), will disrupt
fixed-income mutual funds and increase risk due
to a highly volatile stock market.
Non-transparent investment valuation for
investors is reflected by the absence of mark to
market valuation by investment managers.
To mitigate such risk, Bank Indonesia instituted
regulations to ensure that banks implement and
monitor risk in their subsidiary companies on a
consolidated basis.

41
 Chapter 2 Financial Sector

Box 2.3 Short-term Capital Inflows through the Financial Market

The Indonesian financial market has attracted Graph 2.3.2

Net of Foreign Shares Transaction - JCI
the interest of foreign investors. However, the lack
Trillions of Rp %
of fundamentals caused more investment in short 5 15.00
term instruments. As a result, the risks in the 10.00
financial market remain high; therefore, the
5.00
market cannot function as a long term source of
0 0.00
funds.
-5.00
The increasing trend of the global interest
-10.00
rate in 2005 triggered short term capital inflows Net Foreign Growth of JCI
-5 -15.00
to emerging markets in Asia. The interest of Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2005 2006
foreign investors will remain high even if interest
rates in developing countries subside due to the taking. This was demonstrated by the
high investment yields possible in such countries,
strength of foreign investor stock
including Indonesia.
transactions, which tended to affect
Graph 2.3.1
fluctuations in the JCI.
Foreign Net Transactions: Stocks, Government Bonds
and the Exchange Rate Investment in government bonds by foreign
Trillions of Rp Rp/$
10.00 10000 investors (primarily financial institutions), to
Stocks Government Bond Exchange Rate
9800
8.00 optimize profit from hedge funds, triggered
9600
6.00
9400 high price volatility.
4.00 9200
Upbeat economic prospects in 2007 will
2.00 9000
8800 further push the interest rate down. However,
0.00

-2.00
8600
high short-term capital inflows will persist as the
8400
-4.00 8200
result of two factors. First, speculative capital
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2006 inflows will emerge from previous investments
in other emerging markets, particularly Thailand.
Factors affecting foreign short-term
Second, bullish sentiment regarding the global
investments are as follows:
bond market and the falling interest rate, will
Stock market development lacking
encourage foreign investors to invest more
fundamentals and non transparent pricing actively. This will mitigate the effects of changes
provides a lucrative opportunity for investors in interest rate spread on the income generated
to influence pricing for short term profit from hedge funds.

42
 Chapter 3 Financial System Prospects

Chapter 3
Financial System Prospects

43
 Chapter 3 Financial System Prospects

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44
 Chapter 3 Financial System Prospects

Chapter 3 Financial System Prospects

The Indonesian financial system was relatively stable in Semester II 2006.

Large banks maintained moderate profit and adequate capital. Furthermore,
favorable macroeconomic indicators and positive risk perception will help
preserve financial stability over the forthcoming six months. However, certain
risks could still intensify, including credit risk, market risk and operational
risk in the financial system, especially banks, which need to be well managed
to avoid instability.

3.1. ECONOMIC PROSPECTS AND RISK Table 3.1

Concencus Forecast of Selected Economic Indicators
PERCEPTION
Prospects for economic growth remain high 2006 2007 2008

with lower risk

risk. Market consensus remains positive Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2

in terms of the economic outlook. Accelerated GDP 4.8 5.1 5.5 6.1 5.9 5.7 5.9 5.7 5.9 5.9
Inflation 16.9 15.5 14.9 6.1 5.5 6.1 6.2 6.1 5.8 5.8
economic growth will be supported by stable inflation Balance of Trade 8.7 8.7 6.9 7.7 8.5 8.2 7.1 9 8.7 8.5
and increasing trade transactions. Such conditions Source: Asia Pacific Concensus Forecast

are expected to favorably reduce risks, especially

market risk. Improved macroeconomic conditions
have attracted foreign investment in the capital
market. However, such investment is primarily short
term and has lead to high price volatility and
vulnerability to shocks.
The perception of risk in Indonesia is improving
as was evidenced by the narrowing spread of global
alternative sources of funding overseas. In addition,
market players will remain optimistic concerning
economic outlook and the financial sector prospects,
which is reflected by the improving yield curve as
well as higher expectations of economic growth.
Table 3.2
Indonesian Risk Perception

bonds issued by the Indonesian Government against Yield to Spread (bp)

Bonds Rating
the US Treasury. Maturity (%) June December

The improvement in bond spread - which also Indo 14 BB- 5.93 140 89
Indo 35 BB- 6.61 216 137
serves as a benchmark for the issuance of bonds and
Indo 17 BB- 5.99 162 90
credit - will reduce domestic business costs by seeking Source: Bloomberg

45
 Chapter 3 Financial System Prospects

Graph 3.1 its direction improved slightly predominantly

Yield Curve
% attributable to a potential short-term capital inflow
140

120
reversal.
100 Credit risk remained moderate amidst an
80 inauspicious business climate and sub-optimal
60
financial intermediation. However, credit risk is
40 Jun 2006
Feb 2007 expected to improve if the restructuring process for
20 Log. (Feb 2007)
Log. (Jun 2006)
0
major debtors can be concluded and real sector
0.5 3 4 5 6 7 8 9 10 15 20

Source: Bloomberg
Years conditions recover in line with support from the
government to realize infrastructure projects, which
3.2. BANKING INDUSTRY RISK PROFILE: LEVEL will drive performance in related sub-sectors.
AND DIRECTION Additionally, relatively high operational risks persist
Banking resilience was relatively well that require attention. A high number of banking
maintained. Despite low credit growth and excess crimes are committed due to ineffective internal
liquidity, profits remained high, particularly those control and weak corporate governance. The
stemming from interest payments on government promulgation of effective regulations, law
bonds (SUN) and SBI. Against this backdrop, banks enforcement, risk-management improvement and
maintained capital at a solid level of 20.5%, technological infrastructure development, all
supported by profit accumulation and fewer high- adhering to international best practices, will allow
risk bank assets. Nonetheless, credit risk and banks to operate in a sound and efficient manner,
operational risk require special attention to prevent hence dissipating operational risks.
disruptions to financial stability.
Market risk was reasonably low supported by 3.3. PROSPECTS OF THE FINANCIAL SYSTEM
modest market risk exposure as well as stability in Stress tests on banking demonstrated banking
the macro-economy and the markets. Nevertheless, resilience against fluctuations in the exchange rate

Graph 3.2
Risk Profile of Banking Industry and Its Direction

Market Risk Credit Risk Operational Risk

Semester II 2006 Semester II 2006 Semester II 2006

High

Outlook Outlook Outlook

Inherent Risk
Moderate
Low

Strong Acceptable Weak Strong Acceptable Weak Strong Acceptable Weak

Risk Control Risk Control Risk Control

46

and interest rate
rate. The banking industry is relatively
resilient to changes in macroeconomic variables;
especially the exchange rate and interest rate based
on assessments for the upcoming six months using
stress testing.
Capital adequacy, as the primary indicator of
resilience, remained steady despite slight depreciation
of the rupiah against USD in the range of Rp500-
2500 as well as interest rate hikes of up to 5%. With
projected GDP growth and stable inflation in 2007,
banking conditions, non-bank financial institutions
and the financial markets are expected to be sound.
Banking industry soundness will also improve in
concurrence with better risk management.
3.4. POTENTIAL VULNERABILITY NEEDS TO BE
ANTICIPATED
Risk taking behavior in the future is not certain
certain.
Indonesian financial system stability is strongly
influenced by the behavior of financial institutions
and investors. Price hikes (JCI) and lagged volatility
in the financial markets has increased the concern
of market players for potential mounting risk. Such
conditions could easily be compounded by natural
disasters - for example floods and earthquakes that
have struck several regions - and adverse effects of
globalization. This will therefore require
sophisticated assessments of risks. However, the
necessary tools for market players are unavailable
but optimism surrounding conditions in 2007
remains upbeat.
A combination of various volatility levels can be
significant
significant. In assessing the future financial system
resilience it is crucial to consider extreme scenarios
despite their small probability of occurrence.
Chapter 3 Financial System Prospects
However, an amalgamation of various pressures can
affect financial system stability. Based on data from
the previous six months, two scenarios with dominant
effects on stability emerged as follows: (i) a resurgent
global oil price due to mounting geopolitical pressures
in the Middle East could affect business activities and
purchasing power; and (ii) soaring financial asset
prices, including shares, would bring price
adjustments and could lead to a foreign capital
reversal.
Numerous measures have been taken to bolster
the future stability of the financial system including
the development of bio-energy to reduce
dependency on oil supply and ease pressure on the
domestic oil price to avoid disruptions in production.
Also, an array of efforts has been taken, including
the improvement of risk management by market
participants and diversifying instruments in the capital
market. This is expected to dissipate potential risks
stemming from severe asset price adjustments and
portfolio switching by foreign investors.
3.5. BANKING INDUSRTY PROSPECTS
The scale of business has the potential to expand
in 2007
2007. Business prospects will improve primarily
supported by the low interest rate, stable exchange
rate as well as growing domestic and global demand.
Meanwhile, several sectors are projected to achieve
higher growth including the construction sector
(9.4%), transportation and communications (8.9%),
utilities (electricity, gas and water) (7.6%), as well as
manufacturing (7.1%).
Banking credit is projected to expand to an
average of 20%, supported by growth in deposits
by an average of 10%. Sources of additional funds
47
 Chapter 3 Financial System Prospects
for large banks will originate from interest payments
on government bonds (SUN). Credit growth will
originate predominantly from business expansion,
particularly for working capital in the trade (75%)
and industrial (20%) sectors. The growth is expected
to precipitate development in other sectors, which
will support financial sector stability.
48
To this end, amendments and refinements are
required to the legal framework, particularly business
and investment. Furthermore, law enforcement and
good corporate governance are required to ensure
market participants act optimally and responsibly.
Such conditions are prerequisite to financial
intermediation and a stable financial system.
 Chapter 4 Financial Infrastructure and Risk Mitigation

Chapter 4
Financial Infrastructure
and Risk Mitigation

49
 Chapter 4 Financial Infrastructure and Risk Mitigation

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50
 Chapter 4 Financial Infrastructure and Risk Mitigation

Chapter 4 Financial Infrastructure and Risk Mitigation

The panoply of initiatives including significant improvements in the payment

system, the introduction of a financial safety net, risk management practices
and corporate governance have ensured adequate financial infrastructure to
mitigate risk. Bank risk management improved reflected by the adequacy of
risk control systems and better corporate governance. Furthermore, the
financial safety net has been bolstered by the adoption of lender of last
resort for systemic risk and limited deposit insurance scheme. The payment
system was safe and robust due to well mitigated settlement risk and
operational risk.

4.1. PAYMENT SYSTEM Settlement Development

The Indonesian payment system remained
sound with negligible risks that could disrupt financial
system stability
stability. The BI-RTGS (Real Time Gross
Settlement) system was also robust and effective in
settling transactions, which totaled Rp131 trillion per
day in 2006. To mitigate payment system risks, Bank
Indonesia instituted a full array of policies. The failure-
to-settle mechanism (FtS) was implemented, which
requires a pre-fund from participants of the Bank
Indonesia National Clearing System (BI-NCS). FtS will
reduce settlement risk and credit risk stemming from
debit clearing. In addition, new regulations were
enacted regarding the administration of a nationally
integrated Black List of bad cheque and postal order
users to preserve confidence. Bank Indonesia also
reinforced oversight of the payment system and
regulated money remittances.
Through semester II 2006, settlement value and
volume continued to rise
rise. Settlements through BI-
RTGS increased with an average daily transaction
value in semester II 2006 of Rp131 trillion; up 21.4%
(y-o-y). Notwithstanding, transaction settlements
through the clearing system totaled Rp5.14 trillion,
on average, daily in semester II 2006, representing
an increase of 11.35% (y-o-y). Despite the impressive
rise in transactions processed, no significant
operational risk emerged in BI-RTGS or clearing that
could disrupt the payment system. As much as 96%
of settlements in the payment system are now
performed through BI-RTGS. This evidences the
importance of BI-RTGS in the payment system.
Furthermore, BI-RTGS is essentially aimed at reducing
settlement risk in order to maintain financial system
stability.

51
 Chapter 4 Financial Infrastructure and Risk Mitigation

Graph 4.1 Systemically Wide Important Payment System

BI - RTGS Settlement Performance
(SWIPS), were well managed
managed. As the regulator,
Thousands of Transactions Trillions of Rp Transactions
35 180
Daily Nominal Average (Trillions of Rp) overseer and administrator of the payment system,
Poly. (Daily Nominal Average (Trillions of Rp)) 160
30
Daily Volume Average
Poly. (Daily Volume Average)
140 Bank Indonesia is mandated to ensure that the
25
120
20 100
payment system runs safely, smoothly and efficiently.
15 80 To this end, Bank Indonesia manages risks in SIPS
60
10
40 and SWIPS. Risk management was conducted
5
20
comprehensively including system design,
- -
11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11
2000 2001 2002 2003 2004 2005 2006
operations as well as rules for SIPS and SWIPS
participants. Furthermore, risk control in SIPS,
Graph 4.2
BI - RTGS Settlement Performance (by Agent) particularly for BI-RTGS, took into account various
50
44.17
47.26 aspects that influence its smooth operation and
45 Nominal Share
Volume Share
40 performance. As a result, the reliability of BI-RTGS
35
30 was evidenced by the availability of the system,
24.46
25
20
20.01 which reached 99.9%. Risk control in SWIPS was
15.21
15
9.49
12.51
9.40
performed through expanding BI-NCS and FtS to
10
4.56 5.65
5 3.52 3.52
0,03
0.21 mitigate settlement risk stemming from the clearing
0
Joint Venture
Foreign Banks Banks State-Owned
Central
Bank Regional Dev.
Private Banks
Non Bank
system.
Banks Banks Fin. Institutions
Operational risk was mitigated by a thorough
The use of payment cards grew rapidly. The contingency plan
plan. To maintain operational reliability,
use of card based payments was prolific, dominated Bank Indonesia routinely tests the readiness of the
by ATM cards (59.4%) followed by debit cards Disaster Recovery System (DRC). The test results have
(31.26%) and credit cards (9.34%). Based on value, shown that the reliability of the back-up system as
debit cards represented the largest transaction share well as operational procedures executed by the
of 61.42%, followed by ATM cards (34.39%) and administrator (BI) and participants (banks) are
credit cards (4.19%). The extensive use of payment adequate. Bank Indonesia also consistently advocates
cards indicated a shift in the use of payment and develops Business Continuity Management
instruments such as currency towards non-cash (BCM). BCM is a comprehensive risk-management
means instead, therefore leading to a less-cash process that involves identifying potential emergency
society. To limit the risk exposure of credit cards to conditions that could disrupt the payment system.
banks, Bank Indonesia imposed a minimum payment It includes details regarding organizations,
of 10% of the monthly invoice. responsibilities and procedures to prevent disruptions
and also restore the payment system when
Mitigating Payment System Risks disruptions, both internal and external, occur. BCM
Risks in the payment system, both the development is part of the efforts to support financial
Systemically Important Payment System (SIPS) and system stability.

52

System development is necessary to improve the
reliability of the payment system. Realizing the
importance of the payment system as vital financial
infrastructure, Bank Indonesia continuously strives to
improve payment system reliability through various
endeavors as follows:
Improving the quality of payment system
application by enhancing Bank Indonesia
National Clearing System (BI-NCS) in December
2006. BI-NCS is equipped with new, simpler
features that help smooth clearing operations
in participating banks. Thus, the public can enjoy
the services of the payment system through fast,
efficient and secure clearing.
Improving the integrity of the payment system
th
by enacting BI Regulation No 8/29/PBI/2006, 20
December 2006. With this policy the
administration of blacklisted cheques and postal
orders will be performed nationally (National
Blacklist). Customers who bounce cheques or
postal orders three times or more within 6
months on the same account can be blacklisted.
This regulation is expected to encourage the user
accountability.
Improving the security and transparency of
remittances. Bank Indonesia issued BI
Regulation No 8/28/PBI/2006 regarding money
th
transfers on 5 December 2006 regarding
remittances by non bank administrators. The
new regulation is expected to foster
transparent fund transfers through non-banks,
maintaining the integrity of the payment
system. This regulation is also designed to
safeguard security, transparency as well as
legal and customer protection. Thus, criminal
money transfers such as for money laundering,
Chapter 4 Financial Infrastructure and Risk Mitigation
terrorist financing and other illegal activities
can be minimized and easier to detect.
4.2. FINANCIAL SECTOR SAFETY NET (FSSN)
Enhancing FSSN to buttress financial system
stability
stability. FSSN strengthening was continued to
improve financial system stability. Under the FSSN
framework the roles, responsibilities and
mechanisms of coordination between Bank
Indonesia, the Ministry of Finance and the
Indonesian Deposit Insurance Corporation (IDIC)
are clearly outlined to prevent and overcome
financial crises.
The framework was formulated in draft acts
that will become the clear legal foundation for
Bank Indonesia, the Ministry of Finance and IDIC
in performing their roles and collaborating to
maintain financial system stability. In the draft acts
four primary elements of FSSN are stipulated: (a)
effective bank regulation and supervision; (b)
lender of last resort; (c) a limited and explicit deposit
insurance scheme; and (d) effective crisis resolution
policy. To ensure effective coordination, the
Coordination Committee was established,
comprising of the Minister of Finance, the Governor
of Bank Indonesia and the Chief of IDIC Board of
Commissioners.
As part of the efforts to reinforce FSSN, IDIC
was established on 22nd September 2005 mandated
by Law No 24, 2004. IDIC has two roles, namely to
insure customer deposits at banks and administrate
failing banks. In March 2007, the limited deposit
insurance scheme was fully implemented to a
maximum of Rp100 million per customer per bank.
The scheme replaced the government blanket
guarantee program, which has been phased out
53
 Chapter 4 Financial Infrastructure and Risk Mitigation
periodically since 22nd September 2005 to minimize
moral hazard.
Effective coordination among authorities
through the establishment of the Financial System
Stability Forum (FSSF). On 30th December 2005, a
Joint Decree between the Minister of Finance,
Governor of Bank Indonesia, and Chief of IDIC Board
of Commissioners was signed regarding the
establishment of the Financial System Stability Forum
(FSSF). FSSF has four primary functions:
1. To support the Coordination Committee in
making decisions regarding problematic banks
considered systemic. The Coordination
Committee comprises of the Minister of Finance,
the Governor of Bank Indonesia, and the Chief
of IDIC Board of Commissioners and is regulated
by the Deposit Insurance Corporation (IDIC).
Meanwhile, the decision to provide liquidity
assistance to banks with systemic risk is made
by the Minister of Finance and the Governor of
Bank Indonesia.
2. To coordinate and exchange information in order
to harmonize laws and regulations in the
banking sector, non bank financial institutions
and the capital market;
3. To discuss problems in the financial system with
systemic effects based on information from the
relevant supervisory authority.
4. To coordinate the implementation and
preparation of certain initiatives, including the
development of Indonesian Financial Sector
Architecture and the preparation of the Financial
Sector Assessment Program (FSAP);
FSSF will enhance effective coordination
between related authorities to maintain financial
system stability. This is prerequisite to confront
54
systemic risk and necessitates collective actions as
well as timely and accurate decision making.
4.3. RISK MANAGEMENT AND BASEL II
IMPLEMENTATION
Banks» improving ability to implement risk
management helped bolster financial system
stability
stability. Financial system stability, particularly in the
banking sector, was supported by better bank risk
management. Since the implementation of Bank
Indonesia Regulation No. 5/8/PBI/2003 regarding the
implementation of risk management, banks have
established risk-management units and committees.
In essence, banks are becoming more competent in
identifying and mitigating various risks, especially
credit risk, liquidity risk and market risk. Banks also
have in place risk management information systems
tailored to the complexity of the bank risk profile.
In addition, the risk-management certification
program was instituted to raise the competence of
bank managers. To the end of December 2006, more
than 8,289 bankers had passed the certification
program.
More effective risk management is reflected by
improvements in the risk profile and the adoption of
risk control systems. In general, banks and especially
large banks use their own risk control systems. The
risk-management systems include internal controls,
management information systems (MIS) and
corporate governance. The challenges confronting
banks in developing effective risk management
include limited data and basic measurement
methods.
Improving risk management effectiveness is
congruent to the implementation of Basel II. As
planned, Basel II will be implemented in 2008 with

the simplest approach. The Basel II framework
provides incentives for banks to ameliorate their
risk-management quality. The better the risk
management, the more accurate the capital
calculation in anticipation of unexpected losses.
Adequate bank capital will cushion against any
shocks that may arise. Bank Indonesia regularly
reviews bank capital adequacy to ensure that risks
Chapter 4 Financial Infrastructure and Risk Mitigation
are well mitigated and supported by sufficient
capital. In addition, market discipline will be
fostered by bank transparency on one side and
public awareness of bank conditions as well as
responsible bank customers on the other. Synergy
between capital adequacy, effective bank
supervision and market discipline will further
reinforce the resilience of the financial system.
55
 Chapter 4 Financial Infrastructure and Risk Mitigation
Box 4.1 Basel II and Financial System Stability
Banks, for the most part, are the dominant
financial system component in the economy. Banks have
numerous risks inherent with the business, and thus
need to be regulated, supervised and managed soundly.
Bank failure - especially with systemic risk - can
endanger financial system stability and the economy.
Therefore, banks must maintain adequate capital to
cover the risks that may arise. To this end, augmenting
the quality of risk management is crucial to mitigate
fluctuations in the financial market and real sector. As
a refinement of the Basel Accord 1988, Basel II provides
incentives for banks to improve the quality of their risk
management.
In addition, Basel II will strengthen financial system
stability by maintaining the capital adequacy of banks
1
with systemic effects (Kupiec, 2006) . An adequate
solvency level of a bank has been proven to be a
precondition to a stable financial sector (Haldane et al,
2
2005) . Parity between regulatory capital and economic
capital would enable banks to overcome risks and
therefore become more resilient to instability.
The comprehensive Basel II framework, in
essence, stipulates three pillars that mutually reinforce
one another, namely: (i) minimum capital requirement;
(ii) supervisory review process; and (iii) market
discipline.
Pillar I: Minimum capital requirement details the
framework for calculating minimum bank capital
to cover credit risk, market risk and operational risk.
Pillar I provides several approaches to each risk type
in line with the complexity and quality of risk
management. The higher the bank»s quality of risk
management a more advanced and accurate
1 Kupiec, Paul H. (2006), ≈Financial Stability and Basel IIΔ
2 Haldane et al, (2005), ≈Financial Stability and Bank SolvencyΔ
3 Economic capital is real capital required by a bank to maintain its business.
56
approach can be taken. Therefore, banks have the
opportunity to gain incentives as the minimum
regulatory capital nears the economic capital3 of
a bank. Pillar 1 also expands the acknowledgement
of risk mitigation techniques, including collateral,
guarantees, netting agreements and credit
derivatives.
Pillar II: Supervisory review process emphasizes the
importance of the supervisory authority»s role in
continually assessing capital adequacy where:
1. Banks have to comprehensively assess capital
adequacy according to their risk profile,
including a strategy to maintain capital
adequacy;
2. Supervisors have to review and observe: (i)
strategy and capital adequacy calculations
performed by banks internally; and (ii) a bank»s
ability to monitor and comply with the
regulatory capital adequacy ratio;
3. Supervisors can request banks to operate above
the capital adequacy ratio and provide capital
greater than the minimum standard; and
4. Supervisors can intervene preemptively to
prevent a bank»s capital adequacy falling below
the minimum level and ensure that the bank
has conducted its contingency plan to maintain
or recover capital to its initial level.
Pillar III: Market discipline
discipline. Pillar I and pillar II are
more effective if market discipline is successfully
nurtured. Basel II set the minimum information limit
that must be published by banks, such as prevailing
risks, capital, risk exposure, risk measurement and
capital adequacy. Basel II minimizes the problem
of asymmetric information by encouraging
transparency that empowers the public to assess
risk profiles and a bank»s condition.
 Chapter 4 Financial Infrastructure and Risk Mitigation

Synergy between the three pillars will foster
financial system stability. First, banks are continuously
impelled to improve their risk management quality.
Second, less variance between capital and risks will
bolster bank resilience against potential crises. Third,
transparency will encourage banks to run their
businesses in a healthier way and also advocate the
responsibility of bank customers.
To this end, Bank Indonesia will initiate
implementation of Basel II for Indonesian banks in 2008
to be completed in 2010. Capital calculations will begin
using the simplest approach, namely a standard
approach for credit risk and market risk, and a basic
indicator approach for operational risk. However, banks
will have the opportunity to use more advance
approaches upon satisfaction of relevant criteria and
approval from the supervisor. Bank Indonesia has
published consultative papers regarding capital
calculations whilst banks themselves are also preparing
for Basel II implementation.

Table 4.1.1
Basel II Implementation Plan

PILLAR 1 PILLAR 2 PILLAR 3

Implementation of Parallel Run Completing

(Standardized) Effective Monthly Other Risks Transparency
Risks Assesment Issue of BI
Approach or CAR Accounting Report
Regulation
Validation Process Calculation Issue of BI Effective CAR Issue of BI
(Internal Model) On line System Regulation Calculation Regulation

Market Risk
Standardized Q3 2007 Q1 2008 - Q4 2008 Q1 2009 Q4 2008 Q1 2009
Internal Model Q3 2007 Started in Q3 2007 Q2 2008 Q2 2008 Q1 2009
Credit Risk
Q3 2007

Q1 2009
Standardized Q3 2007 Q1 2008 - Q1 2009 Q1 2009 Q4 2008 Q1 2009
IRBA Q4 2009 Started in Q1 2010 Q4 2010 Q4 2010 Q2 2011
Operational Risk
Basic Indicator Q3 2007 Q1 2008 - Q1 2009 Q1 2009 Q4 2008 Q1 2009
Standardized Q4 2009 Started in Q1 2010 Q4 2010 Q4 2010 Q2 2011
AMA Q4 2009 Started in Q2 2010 Q2 2011 Q4 2010 Q2 2011

57
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58
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

Articles

59
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

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60
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

Financial Safety Nets:

Review of Literature and Its Practices in Indonesia

Sukarela Batunanggar1

Abstract

In addition to effective regulation and supervision, a comprehensive financial safey nets policy is essential
to foster financial system stability, predominantly in banking sector. Financial system stability and monetary
stability are mutually dependent and, therefore, must be preserved for sustainable economic growth. To
safeguard financial stability - particularly banking system - a financial safety nets is key pilar in addition to
effective supervisory and regulatory frameworks. As a chief conduit to sustainable economy growth, financial
system and monetary stability - both intertwined - must be well-preserved. A well-designed and comprehensive
financial safety nets mitigates risks to financial system and as a tool of crisis management to eliminate adverse
impacts of crisis when they occur. Albeit its scheme varies, FSN fundamentally consists of four elements : (i)
independent as well as effective regulation and supervision; (ii) effective lender of last resort; (iii) explicit
deposit insurance scheme; and (iv) clear crisis management. The Government and Bank Indonesia have drafted
a comprehensive framework for a Financial Safety Nets (FSN). The FSN framework clearly defines objectives
and elements of FSN, roles and responsibilities of relevant authorities, and coordination mechanism among
the authorities involved in the FSN: Ministry of Finance, Bank Indonesia, and the Deposit Insurance Corporation.
Equipped with a lucid legal framework for FSN and integrated implementation, effective preventive measures
and crisis resolution are possible.

1. INTRODUCTION contraction. Crises showed us that deposit insurance

Financial Safety Nets (FSN) is a key building block
of financial system stability. It prevents bank run,
limits probability of financial instability, as well as
minimizes frequency and adverse impact of economy
1 Executive Bank Researcher at Bank Indonesia. The views expressed in this paper are
those of the author and do not necessarily reflect the views of Bank Indonesia. E-mail
address: batunanggar@bi.go.id
scheme, discount facilities, emergency liquidity
assistance of central banks offer security and liquidity
to banks. Notwithstanding, FSN has negative
consequences unless it is well-designed. It may trigger
distortion in price signal used for resource allocation,
provoke risk taking and moral hazard that ultimately
call for for effective supervision and regulation.

61
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
Graph 1:
Financial Safety Nets
Stable and Sound
Financial System
Regulation Lender of Deposit
and
Supervision
Last Resort
Policy
Insurance
System
System
Central Bank Central Bank DIC
(as Bank
(as LoLR)
Supervisor)
Solid legal framework, clear division of roles and responsibilities
and effective coordination mechanism
Until recently, there is no universal definition of
FSN. In general, FSN is public policy provided by
government to foster economy growth and financial
stability. Albeit its scheme varies, FSN fundamentally
consists of four elements : (i) independent as well as
effective regulation and supervision; (ii) effective
lender of last resort; (iii) explicit deposit insurance
scheme; and (iv) effective bank resolution and crisis
management. Typically, FSN has been succinctly
associated with lender of last resort and deposit
insurance. In this paper, on the other hand, the term
FSN refers to a broader definition.
2. REGULATION AND SUPERVISION
The ultimate objective of regulation and
supervision is to foster security and soundness of
financial institutions via evaluation and continous
surveillance. These include assessment on quality of
risk management, financial conditions, and
compliance with laws and regulations. Effective
regulation and supervision is the first safety nets
aiming at creating and promoting sound financial,
predominantly banking system.
Lack of supervisory capability is often cited as
one of the reasons for financial system weaknesses
62
(Mayes, Halme dan Liuksila, 2001). As Mishkin (2001)
argued, asymmetric information leads to adverse
selection and moral hazard problems that have an
important impact on financial systems and justifies
the need for prudential supervision.
Crisis
Management
Policy
The main focus of determining condition of a
bank pre-crisis is to rapidly help supervisor
MoF, differentiate banks having probability to survive from
Central Bank,
and DIC
those having probability to fail in a crisis. The main
characteristic of systemic crisis is that financial
condition of a bank will rapidly deteriorate as a result
of adverse economy and or widespread bank run.
Along with the rapid advancement, increasing
complexity, and greater risks confronting finance
industry, some multilateral agencies have developed
internationally accepted standards and supervisory
principles. The reference of standards and regulation
for banking industry is The 25 Basel Core Principle
for Effective Banking Supervision which is published
by the Basel Committee of Banking Supevision
(BCBS). For insurance industry, the standard refers
to The Principles of Insurance Supervision.
Some scholars including Goodhart (1998) and
Llewellyn (1999) have set up guiding principles of
banking regulation. Aside from the Basel Core
Principles, they set up principles of the importance
of incentives for bank management, effective
financial safety net which fosters prudential behavior
of bank management and stakeholders, market
discipline, and good corporate governance.
Financial system stability will exist should there
is power balance among various stakeholders,
shareholders, depositors, debtors, creditors, and
supervisors. Therefore, good corporate governance
is the key element in a supervisory framework (Mayes
et al., 2001). With respect to good corporate
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
governance, it is important to adopt regulatory
regime that is more market-based. Within this
context, transparency improvement through
enhanced disclosure must be the top agenda. New
Zealand is the country more adopting market-based
regime.
Drawbacks in governance and supervision have
been cited by experts as one of factors exacerbating
the Asian financial crises in 1997-1998, particularly
in Indonesia (Halim (2000), Nasution (2000),
Batunanggar (2002)). Hence, Bank Indonesia has
been strongly committed to enhance effectiveness
bank supervision comprehensively along with the
post-crisis bank restructuring program. Despite the
progress that has been made, challenges remain to
be seriously dealt with. From the supervision side, it
is essential to continuously enhance quality and
quantity of bank supervisors as well as enhance
quality of supervision information system in
proportion to the increasing complexity of business
and risks banks are confronting. From the banking
industry side, it is essential that banks exercise good
corporate governance, robust risk management, as
well as consistent and effective internal control.
Beside, to bolster the structure of banking industry,
banking consolidation initiative via merger is
indispensable.
The other important issue us the plan to unite
supervisory function of central bank and various
authorities into an independent mega regulator as
in the case of the United Kingdom, Australia, Japan,
and Korea in the last decade. In general, two
rationales for unification are to enhance supervision
efficiency and to effectively supervise financial
conglomerates. However, no empirical evidence has
been found concerning benefits of the unification
particularly from both micro-prudential and financial
system stability. In fact, Abram and Taylor (2000) and
Goodhart (2001) provide excellent discussions on the
issues in the unification of financial sector supervision.
Goodhart argues that banking supervision in less
developed countries is better to be kept within the
central bank because it will be better funded, more
independent and more expert and reliable. Hence, it
is important to rigorously consider the unification to
prevent potential problems from occurring, which
may deteriorate financial stability.
3. LENDER OF THE LAST RESORT (LLR)
LLR is discretionary provision of liquidity to a
financial institution (or the market as a whole) by
the central bank in reaction to an adverse shock
which causes an abnormal increase in demand for
liquidity which cannot be met from an alternative
source (Freixas et al., 1999).
The LLR concept was born in the19th century
by Henry Thornton (1802) who explicated the
fundamental elements of good central banking
practice in the light of emergency lending. Then,
Walter Bagehot (1873), more widely known as the
founding father of modern LLR, developed the
concept of Thornton (even though he did not
mention his name). Bagehot stated three principles
of LLR: (i) provide the lending against sufficient
collaterals (for solvent bank only); (ii) provide the
lending with penalty rate (for liquid banks only); (iii)
announce commitment to lend witout limit (to ensure
credibility).
Historical experience suggests that successful
lender of last resort actions have prevented panics
on numerous occasions (Bordo, 2002). Similarly,
Mishkin (2201) argues that central bank can
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
encourage the recovery of financial crisis by providing
loan in as lender of the last resort. Although there
may well be good reasons to maintain ambiguity over
the criteria for providing liquidity assistance, He
(2000) argues that properly designed lending
procedures, clearly laid-out authority and
accountability, as well as disclosures rules, will
promote financial stability, reduce moral hazard, and
protect the lender of last resort from undue political
pressure. There are important advantages for
developing and transitional economies to follow a
rule-based approach by setting out ex ante the
necessary conditions for support, while maintaining
such conditions is not sufficient for receiving support.
In the same vein, Nakaso (2001) suggests that Japan»s
LLR approach has shifted from ≈constructive
ambiguityΔ towards increasing policy transparency
and accountability.
As argued by Sinclair (2000) and Goodhart
(2002), within the time scale allowed, it is often
difficult, if not impossible, for central banks to
distinguish between a solvency and a liquidity
problem. Similarly, Enoch (2001) argued that there
should be restrictions against protracted use of such
lending, since this is likely to be an indicator of
solvency difficulties.
LLR activities by a central bank in a emerging
market countries with substantial foreign-
denominated debt, may not be as successful as in
an industrialised countries. Therefore, the use of the
LLR by a central bank in countries with a large amount
of foreign-denominated debt is trickier because
central bank lending is now a two edged sword
(Mishkin, 2001).
While individual frameworks differ from country
to country, there is a broad consensus on the key
64
considerations for emergency lending during normal
and crisis periods (see Box A1.1).
Lender of Last Resort in Normal Times
In normal times, LLR assistance should be
based on clearly defined rules. Transparent LLR
policies and rules can reduce the probability of self-
fulfilling crises, and provide incentives for fostering
market discipline. It may also reduce political
intervention and prevent any bias towards
forbearance. LLR in normal times should only be
provided for solvent institutions with sufficient
acceptable collateral, while for insolvent banks
stricter resolution measures should be applied such
as closure. Therefore, there should be a clear and
consistent adoption of a bank exit policy. Once a
deposit insurance scheme has been established, the
central bank role in LLR in normal time can be
reduced to a minimum since the deposit insurance
company will provide bridging finance in the case
where there is a delay in closure process of a failed
institution2 .
LLR in Exceptional Circumstances
In systemic crises, LLR should be an integral part
of a well-designed crisis management strategy. There
should be a systemic risk exception in providing LLR
to the banking system. Repayment terms may be
relaxed to support the implementation of a systemic
bank restructuring programme. In systemic crises the
disclosure of the operation of LLR may become an
important tool of crisis management. The criteria of
a systemic crisis will depend on the particular
circumstances, thus, it is difficult to clearly state this
2 See Nakaso (2001) for a discussion on the Japanese LLR model.
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
beforehand in a law. However, the regulations on
the LLR facility should clearly set the guiding principles
and specific criteria of a systemic crisis and or a
potential bank failure leading to systemic crisis. To
ensure an effective decision making process and
accountability, there should be a clear institutional
framework and LLR procedures. Bank Indonesia
should be responsible for analysing the systemic
threats to financial stability while the final decision
on systemic crises resolution should be made jointly
by Bank Indonesia and the Ministry of Finance. To
ensure accountability, an appropriate documentation
audit trail should be maintained.
Box A1.1 Key Considerations of Emergency Lending
1. Have in place clearly laid out lending procedures,
authority, and accountability.
2. Maintain close cooperation and exchange of
information between the central bank, the
supervisory authority (if it is separate from the
central bank), the deposit insurance fund (if exist),
and the ministry of finance.
3. Decision to lend to systemically important
institutions at the risk of insolvency or without
sufficient, acceptable collateral should be made
jointly by monetary, supervisory, and the fiscal
authority.
4. Lending to non-systemically institutions, if any,
should be only to those institutions that are deemed
to be solvent and with sufficient acceptable
collateral.
5. Lend speedily.
6. Lend in domestic currency.
7. Lend at the above average market rates.
8. Maintain monetary control by engaging effective
sterilization.
Criticism on LLR
Experts criticized the classic doctrine of LLR.
Goodhart (1999) argued the impossibility to make a
clear distinction between the illiquid and insolvent
banks. Given the modern inter-bank money markets
are generally available, the solvent banks will be able
to obtain money market borrowings. Solow (1982),
stated that a central bank is also responsible for
financial system stability. In the light with financial
stability maintenance, he added, in most cases a
central bank must rescue insolvent banks to prevent
a financial system from systemic crisis. In addition,
Kauffman (1991), criticized LLR practice in which the
9. Subject borrowing banks to enhanced supervisory
surveillance and restrictions on activities.
10.Lend only for short-term, preferably not exceeding
three to six months.
11.Have a clear exit strategy.
Additional Requirements for Systemic Crisis
12.Decision to lend should be an integral part of crisis
management strategy and should be made jointly
by monetary, supervisory, and the fiscal authority.
13.Emergency support operations should be disclosed
when such disclosure will not be disruptive to
financial stability.
14.Repayment terms may be relaxed to accommodate
the implementation of a systemic bank
restructuring strategy.
15.Emergency support operation should be disclosed
when such disclosure will not be disruptive to
financial stability.
Source: Dong He (2000), «Emergency Liquidity Support Facilities», IMF Working Paper
No. 00/79.
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
government intervention will lead to a potential
political pressure and deteriorate regulation. Discount
window is obscurely granted to rescue insolvent
banks. Goodhart and Huang (1999) also argued a
dilemma between systemic risk avoidance and moral
hazard by bank management predominatly in the
rescue of large insolvent banks (too big to fail).
The other means to prevent moral hazard as
recommended by Bagehot more than a century ago
is via penalty rates. Yet, according to Freixas et al.
(1999) this may: (i) aggravate problem confronting
banks; (ii) indicate erroneous signal to market that
exacerbate bank run; and (iii) provide incorrect
incentives to bank managers to adopt higher risk-
reward strategy to pay higher interst rates. Hence,
to prevent the moral hazard from occurring, Freixas
et al. (1999) recommended that intervention be made
conditionally on the lending that is not fully
collateralized. The constructive ambiguity is expected
to thwart moral hazard, providing that it is furnished
by strong law enforcement on managers and
management of banks which are lacking of
prudential attitude when operating bank.
LLR Policy in Indonesia
3
As stipulated in the Law , Bank Indonesia may
provide LLR facility both for normal conditions and
for preventing systemic crisis. According to article 11
verse 1 and 2 of the Law, in a normal condition, Bank
Indonesia may provide LLR to a bank for resolving
short term liquidity problem in the form of
conventional lending or Syariah based principle
financing for maximum of 90 days. These facilities
are guaranteed by high quality and liquid collaterals,
3 The Act of the Republic of Indonesia number 23 1999 concerning Bank Indonesia as
amended by The Act of Republic of Indonesia number 3 2004
66
at least of the similar value against the received
facilities.
Furthermore, according to the above mentioned
article, stipulated ≈in case of a bank confronts
financial difficulties deemed to be systemic and may
trigger a crisis threatening financial system, Bank
Indonesia may provide emergency liquidity lending
whose source of funds will come from the
governmentΔ. Regulations of decision making to
determine whether a crisis systemic, provision of
Emergency Liquidity Assistance (ELA), and source of
funds from the state budget are stipulated in a
separate law.
Prior to the enactment of the ELA regulations,
temporarily the ELA provision was stipulated in the
Memorandum of Understanding between the
Minister of Finance and the Governor of Bank
Indonesia dated March 17, 2005. As stipulated in
the MoU, Bank Indonesia is responsible for analysing
systemic risk that will threat financial system stability,
whereas decision to provide the ELA will be made
by both the Governor of Bank Indonesia and
Minister of Finance. The procedure of ELA provision
will be technically stipulated in the Regulation of
Bank Indonesia and Regulation of the Minister of
Finance.
Learning from the case of Bank Indonesia
Liquidity Support, at least two basic issues need to
be clearly made in a regulation to ensure
accountability in providing the ELA. First, collateral
issue, it is essential to determine whether the ELA is
secured or unsecured lending. Refer to best practices,
in general ELA is seen as unsecured lending from a
central bank and, therefore, some exceptions may
be applied. Second, the decision making needs to
be anticipated and clearly defined in the law should
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
disagreement between the Minister of Finance and
the Governor of Bank Indonesia occurs.
4. DEPOSIT INSURANCE
In general, deposit insurance have three
interlinked objectives: (i) to guarantee less
sophisticated depositors; (ii) to preserve public
confidence on the financial system, particularly
banking system; and (iii) to safeguard financial
stability. Fundamentally, deposit insurance system is
aimed at preventing bank runs. Refer to the model
of Diamond-Dybvig (1983), bank runs has a feature
≈self-fulfilling prophecyΔ, in which the erosion of
depositors may trigger banking crisis. This is due to
two factors: (I) information assimetry between
depositors and bank management; and (ii) in general,
depositors are lacking capacity to assess financial
soundness of a bank. Besides, banks are also
susceptible to liquidity risk as their liquid assets are
far less than their liquid assets.
In more detail, Thompson (2004) explained five
arguments to implement deposit insurance: (i) to
foster banking system stability that is susceptible to
bank runs during a crisis that would pose contagion
effect to sound and solvent banks (Diamond and
Dybvig, 1983); (ii) protected deposits provide
options to small depositors and, consequently, help
raise savings for investment purpose; (iii) if a
supervisory authority is under political pressure to
bail-out depositors (when an implicit deposit
insurance scheme exists), explicit deposit insurance
will be able to limit guranteed liabilities by
determining ex-ante what is or what is not
guaranteed; (iv) a deposit insurance scheme
empowers small banks to compete against large
banks; (v) explicit deposit insurance help supervisory
authority to exercise more rigorous supervision on
banks.
Before the 1997 crisis, none of the East Asian
crisis countries except the Philippines, which was least
affected by the crisis, had an explicit deposit insurance
scheme. Bank Indonesia provided both liquidity and
capital support to problem banks on an ad-hoc basis
and in non transparent ways4. The support was also
not based on any pre-existing formal guarantee
mechanism but rather on a belief that some of the
banks that needed support were too big to fail or
the failure of a bank could cause contagion.
A limited deposit guarantee in Indonesia was
first applied when the authorities closed down Bank
Summa at the beginning of the 1990s which was
considered unsuccessful5 . After then, there were no
bank closures until the authorities closed down 16
banks in November 1997 and introduced a limited
guarantee. However, this failed to prevent systemic
bank runs.
To restore domestic and international
confidence in the economy and the financial system,
the government signed the second agreement with
the IMF on 15 January 1998. However, market
perceptions and reactions to the government
commitment and capacity to resolve the crisis were
still negative. There was a huge amount of capital
flight of around $600 million to $700 million per
day. On 22 January, the rupiah plummeted to a record
low of Rp16.500.
To prevent a further slide and to maintain public
confidence in the banking system on 27 January, the
government issued a blanket guarantee. It covered
4 However, this was done primarily for domestic rather than foreign banks.
5 The plan for establishing a deposit insurance scheme has been discussed quite intensively
since the early 1990s. However, the authorities declined the proposal because they
considered that it would create moral hazard.
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia

all commercial banks liabilities (rupiah and foreign the likelihood of future banking crises. Therefore, he
currency), including both depositors and creditors. It suggested that Indonesian should develop an
was an interim measure pending the establishment incentive-compatible deposit insurance system -
6
of the Deposit Insurance Agency . Initially, the along the lines of FDICIA in the United States - which
administration of the blanket guarantee was a joint should be a permanent part of the financial
task between Bank Indonesia and IBRA. From June infrastructure.
2000 it has been the responsibility of IBRA alone7 . However, systemic bank runs in Indonesia at the
The Indonesian case suggests that a very limited outset of the 1997 crisis cannot be attributed solely
deposit insurance scheme was not effective in to the absence of a blanket guarantee. The
preventing bank runs during the 1997 crisis. Deposits inconsistent and non transparent bank liquidation
denominated of more than Rp20 millions - the policies applied by the authorities and some political
uninsured component - accounted for about 80% uncertainties during the end of Suharto»s regime also
of total deposits. Therefore, if a blanket guarantee played their part, as Lindgren et al. (1999) and Scott
had been introduced earlier at the outset of the crisis, (2002) document. The introduction of the blanket
the systemic runs might have been reduced. guarantee programme at the outset of the crisis
There was a controversy over the adoption of a might be necessary in order to prevent larger potential
blanket guarantee. Some commentators such as economic and social costs of the systemic crisis
Furman and Stiglitz (1998), Stiglitz (1999,2002), (Lindgren et al. 1999). However, the scheme should
Radelet and Sachs (1998) argue that the if the blanket be replaced as soon as possible with one that is more
guarantee had been introduced earlier, before some appropriate to normal conditions and does not create
banks had been liquidated, the damage and costs of moral hazard.
the crisis would have been much less.
In contrast, others criticised the blanket Best Practices
guarantee for being too broad. Goldstein (2000) Garcia (1999, 2000), based on surveys in 68
argued that had all bad (insolvent) banks been closed countries, identified the best practices of explicit
at the beginning of the crisis then even with the systems of deposit insurance principally should have
limited deposit guarantee scheme in place there good infrastructure, avoid moral hazard, avoid
would not have been widespread deposit adverse selection, reduce agency problems and
withdrawals because the remaining banks would ensure financial integrity and credibility. Based on a
have been «good» ones. He believed that with a study of deposit insurance systems in Asian countries,
blanket guarantee, the government ended-up Choi (2001) argues that it is reasonable in Asia to
providing ex-post deposit insurance at a higher fiscal establish and maintain an explicit and limited deposit
cost and with adverse moral hazard effects increasing insurance system in order to prevent further possible
financial crisis. Pangestu and Habir (2002) suggest
6 Initially it was to be retained for a minimum of two years, with a provision for an automatic
six months extension in the absence of an announcement of termination of the scheme.
that Indonesia»s deposit insurance scheme should be
7 BI retains the role of administering the guarantee scheme to trade finance, inter-bank
debt exchange and rural banks. designed on two key aspects. First, it should provide

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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
incentive to better performing banks by linking the
annual premium payment to their risk profile. Second,
it should be self-funded in order to foster market
discipline and reduce the fiscal burden.
In order to avoid a disruption to the banking
system, Garcia (2000) suggests that a partial
guarantee should not be introduced ideally until: (1)
the domestic and international crisis has passed; (2)
the economy has begun to recover; (3) the macro-
economic environment is supportive of bank
soundness; (4) the banking system has been
restructured successfully; (5) the authorities possess,
and are ready to use, strong remedial and exit policies
for bank that in the future are perceived by the public
to be unsound; (6) appropriate accounting,
disclosure, and legal systems are in place; (7) a strong
prudential regulatory framework is in operation; and
(8) public confidence has been restored. It seems that
currently Indonesia does not meet all these
requirements.
Demirguc-Kunt and Kane (2001) suggest that
countries should first assess and remedy the
weaknesses of their international and supervisory
environments before adopting an explicit deposit
insurance system. In line with this, Wesaratchakit
(2002) reported that Thailand decided to adopt a
gradual transition from a blanket guarantee to a
limited explicit deposit insurance scheme. It was
considered that there are some preconditions that
should be met - particularly the stability of banking
system and the economy as a whole, effectiveness
of regulation and supervision as well as public
understanding - before shifting to an explicit limited
deposit insurance system.
There is an issue of how depositors will react to
the introduction of the limited scheme. In January
2001, Korea replaced its blanket guarantee with a
limited deposit insurance system with an insurance
limit of 50 million won per depositor per institution.
There was a noticeable migration of funds from lower
rated to sounder banks. Also, large depositors actively
split their deposits to several accounts in banks and
non-bank financial institutions. But there has been
no bank run on the Korean financial system as a
whole.
It is important to prepare a contingency plan
before removing the blanket guarantee in order to
anticipate the worst-case scenarios such as a loss of
public confidence. If such conditions occur, the central
bank may have to extend liquidity support to illiquid
but solvent banks. In addition, there should be a clear
legal framework for the deposit insurance scheme.
To reduce moral hazard and to induce market
discipline, the authorities should set a tough sanctions
to the financial institutions and players which are
violate the rules and cause problems into banks and
ensure that law enforcement are in place.
Criticism on Deposit Insurance
Arguments in favor of explicit deposit insurance
scheme for financial deepening and financial stability
has been widely accepted by policy makers, even IMF
has recommended it to many countries (Folkerts-
Landau and Lindgren, 1997; Garcia, 1999).
Notwithstanding, some experts remain skeptical. Cull
(1998) is unconvinced about the argument that
deposit insurance fosters financial deepening by its
ability to expand deposit base as well as it lay solid
ground for more advanced banking system. Cull et
al. (2000) also argued that explicit deposit insurance
does not have strong effect on sectoral concentration
- that is likely to promote keener competition. Kane
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
(2000) concluded that based on study in 40 countries
in deposit insurance scheme, the weaker information
condition, ethics, and governance of a country, the
more detrimental effect of explicit deposit insurance
scheme on banking system stability. Corresponding
to the study, in a more comprehensive study, Kane
and Demirguc-Kunt (2001) concluded that whenever
law enforcement is feeble and creditors» rights are
not well-protected,explicit deposit insurance will likely
to spur financial instability.
Honohan and Klingebiel (2000), based on
sample of 40 developed and emerging market crises,
found that unlimited deposit guarantees, open-
ended liquidity support, repeated recapitalisation,
debtors bail-out and regulatory forbearance
significantly and sizeably increase the resolution costs.
Moreover, based on evidence from 61 countries in
1980-97, Demirguc-Kunt and Detragiache (1999),
find that that explicit deposit insurance tends to be
detrimental to bank stability, the more so where bank
interest rates are deregulated and the institutional
environment is weak. Similarly, Cull et al. (1999)
based on a sample of 58 countries also find that
generous deposit insurance leads to financial
instability in the presence of a weak regulatory
environment.
Greenspan (2002) explained two contradictory
implications of deposit insurance. On one side,
deposit insurance prevents bank runs disturbing
short-term financial structure. On the other hand, it
may erode market discipline and incite moral hazard
that is most likely trigger future systemic risks. A
deposit insurance scheme helps banks raise fund
more efficiently and take greater risks without
worrying of losing customers. In other words,
deposit insurance foster resources misallocation by
70
cutting correlation of risk and reward in particular
markets. Hence, it is imperative to have effective
supervision to protect tax payers and avoid cost of
crisis resolution.
Deposit Insurance Practice in Indonesia
To restore public confidence on banking sector
following the financial meltdown in 1997, the
Indonesian government was compelled to issue
blanket guarantee program. Under this program, all
deposits at banks are insured. The program
successfully restore public confidence on domestic
banking industry. Nonetheless, the all-inclusive
created burden on the state budget and triggered
moral hazard by management and bank customers.
Bankers were lacking of incentives to conduct
business prudently, whereas customers overlooked
financial conditions of bank when making
transaction. Beside, in general, blanket guarantee is
a temporary measure to restore public confidence
during a crisis.
Finally, Indonesia has a Deposit Insurance
Instition (Lembaga Penjamin Simpanan or LPS)
following a long and painstaking debates in the
Parliament. The Parliament enacted Deposit Insurance
Law number 24 year 2004 on September 22, 2004.
As stipulated by the law, the Deposit Insurance
Institution has two core functions: (1) provide
guarantee on customer deposits and (2) implement
resolution over failing bank. The law also stipulates
legal status, governance, asset and liabilities
management, reporting system and accountability
of the Deposit Insurance Institution as well as lay legal
basis for cooperation with other authorities. This is
important to ensure that the Deposit Insurance
Institutions is independent, transparent, and
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
accountable in performing its roles and
responsibilities.
The Deposit Insurance Institution carries out a
limited and explicit deposit insurance scheme. The
rationales behind the selection of this scheme are to
purge the burden of crisis resolution on the state
budget and to prevent moral hazard. This scheme is
mandatory for all banks operating in Indonesia, both
commercial and rural banks. The insured items are
saving accounts, demand deposits, certificate of
deposits, time deposits, and other similar type of
deposits.
For effective implementation, a two year
transition period was introduced prior to a full fledge
deposit guarantee scheme:
September, 22 2005 - March, 21 2006 : all
deposits
March 22, 2006 - September 21, 2006 : all
deposits up to Rp 5 billion
September, 22 2006 - March 21, 2007 : all
deposits up to Rp 1 billion
March 22, 2007 - onwards : all deposits up to
Rp 100 million
Some challenges remain. First, coordination
system between the Deposit Insurance Institution and
other authorities, in particular Bank Indonesia needs
to be clearly defined. The foremost challenging effort
is to foster coordination in handling and
implementing resolution on a failing bank. The
procedure of coordination can be set up by referring
to the best practices in other countries, including
using a Memorandum of Understanding.
Nonetheless, the practice is not so simple, as gaining
agreement between the respective authorities is
frequently a lengthy process. Notwihstanding,
interlocking structure of the Board of Commisioner
involving ex-officio member from Bank Indonesia and
the Ministry of Finance should help resolve the
coordination issue. Also, to cultivate more effective
coordination in the operational layer, some staff
members of the Deposit Insurance Institution are
seconded from central bank and ministry of finance.
This option is adopted by the Indonesian Deposit
Insurance Institution. Second, capital adequancy of
the Deposit Insurance Institution must be well-
mainted to ensure public confidence. Considering
the capital base of the Deposit Insurance Institution
is reasonably modest, it is essential to anticipate the
probability of bank failure demanding a substantial
amount of resolution cost in the short-term that will
substantially erode the capacity of the Deposit
Insurance Institution to perform effective resolution.
Third, it is essential to anticipate the probability of
flight to quality from the perceived less sound banks
to the perceived sounder banks. This is a sensitive
issue considering the concentrated structure of
banking deposits, in which around 50% of bank
depositors are those having balance exceeding Rp100
million. Hence, it is recommended that the flight to
quality issue be empirically studied or surveyed to
formulate accurate policy response. Fourth,
considering the lack of public awareness, the Deposit
Insurance Institution and Bank Indonesia need to
intensively make public the Deposit Insurance
Institution and its scheme.
5. CRISIS MANAGEMENT
In the last decade, the vast majority of countries
hit by systemic banking crises demanded expensive
and unavoidable cost of crisis to restore their banking
system. Shareholders of the shut down banks were
indeed reluctant to bear the crisis cost and, therefore,
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 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
how to solve the problem? In many countries, all
costs were borne by taxpayers. For instance, fiscal
cost of Indonesian banking resolution in 1997 and
1998 was Rp654 trillion or about 51% of GDP, the
highest in Asia. Indonesia ranked second after
Argentina which booked cost or 55.1% of GDP when
a crisis hit the country in 1980-1982.
Empirical study by Honohan and Klingebiel
(2000, 2002) revealed findings that unlimited deposit
insurance, open-ended liquidity support, repetitive
bank recapitalization, bail out, and regulatory
forbearance, augment fiscal cost of crisis substantially.
The case of Indonesia revealed five factors behind
high cost of crisis: (i) long delay of crisis resolution,
particularly bank closure and recapitalization
program; (ii) lack of understanding about the root
and the magnitude of crisis resulting in incorrect
strategy of crisis resolution (for instance partial
approach in bank closure); (iii) sub-effective
coordination and lack of consensus among
authorities with regard to crisis management; (iv) lack
of commitment to make prompt decision to solve
the crisis, for instance to close down insolvent banks
in the eve of the crisis and to avoid political
intervention; and (v) sub-optimal law enforcement
and drawbacks in legal and supervisory frameworks,
which in turn, incite moral hazard. Indonesia would
have been better should prompt corrective actions
were taken; however, it was extremely difficult as
due to rampant political intervention.
Along with the increasingly integrated global
financial system, responsive supervision and crisis
management policies are vital. The ultimate objective
of supervision is obvious; yet, challenges in crisis
management differ significantly. For instance,
resolution for globally operating large banks needs
72
a clear crisis management policy, cost sharing, as well
as effective inter government coordination (Gulde
and Wolf, 2005).
Considering the substantial cost of crisis and its
serious magnitude, robust crisis management is vital.
Crisis management should be supported by legal
framework and clear crisis resolution policies that
clearly define roles and responsibilities as well as
effective coordination of respective authorities. Also,
it is critical to have effective organization and
leadership and, hence, strategies and corrective
measures can be promptly made.
To bolster financial system stability, the
Government and Bank Indonesia have prepared a
comprehensive framework of Financial Safety Net
(FSN). The FSN framework clearly defines objectives
and elements of FSN, roles and responsibilities of
relevant authorities, and coordination mechanism
among the authorities. The FSN has four elements:
effective supervision and regulation; (ii) lender of last
resort; (iii) deposit insurance; and (iv) effective crisis
management. Currently, a task force composed of
staff members of Ministry of Finance, Bank Indonesia,
and Deposit Insurance Corporation, is drafting the
FSN Law. The law will be a solid legal basis for
respective authorities to preserve financial stability,
particularly for crisis management.
6. CONCLUSION
To enhance the Indonesian financial safet net,
two principal policies are recommended. First,
gradually replace blanket guarantee with a limited
explicit deposit insurance scheme. Second, formulate
and implement a transparent lender of last resort
policy both for normal and crisis times. Nevertheless,
both policies must be implemented comprehensively
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
and linked with banking prudential supervision and
market discipline to prevent a banking crisis.
For effective coordination, Coordination
Committee consisting of Minister of Finance, Bank
Indonesia and the Deposit Insurance Corporation was
established. In addition, Financial System Stability
Forum (FSSF) as a venue of coordination and
information sharing to discuss financial stability issues
among fiancial safety nets player was created.
Learning from the 1997 crisis, some crisis
management issues remain challenging. First, it is
imperative to: (i) lay a clear legal basis clearly defining
effective coordination means; (ii) clearly define
responsibilities of respective authorities, and (iii) foster
trust and cooperative culture among respective
authorities. This needs strong leadership and political
support from the parliament. Third, it is vital to
enhance operational capacity of resources from
respective authorities. Crisis management should be
promptly and accurately made. In some countries,
authorities set up «crisis management team» which
regularly meet to discuss financial stability issues and
exercise crisis management simulation as a part of
efforts to enhance organizational capacity.
Crisis episodes in some countries in the last two
centuries remind us two important lessons: first,
financial crisis repeatedly occurs; and two, a financial
crisis is difficult to predict and, therefore, difficult to
avoid. Hence, it is easier to prevent than to cure.
Referring to the principles, it is imperative to enhance
financial system stability via implemention of effective
supervision and regulation, robust risk management,
effective internal control - the first line of defense in
banking industry.
73
 Article I - Financial Safety Nets: Review of Literature and Its Practices in Indonesia
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 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Macroeconomic Model to Measure Financial Stability Index:

The Case of Indonesia

Muliaman D. Hadad1, Wimboh Santoso2, Sugiharso Safuan3,

Dwityapoetra S. Besar4, and Ita Rulina5

Abstract

The 1997 economic crisis that undermined economies in the region taught valuable lessons on the
importance of clear crisis management and monitoring potential crises. Therefore, this paper aims to build a
model to formulate the financial stability index based on three business activity blocks, namely the equity
market, bonds market and banking that influence financial stability. Based on various statistical tests such as
data trends of forecast results against actual data and measurements of model accuracy, the mean absolute
percentage error (MAPE) is expected to be relatively low indicating a fair and accurate prediction model. This
will enable the calculation of the financial stability index (Financial Soundness Indicator/FSI), which can be used
to explain phenomena in the banking and financial sectors. The simulation results for 2007 used to simulate
financial system stability show that in mid 2005 FSI was relatively higher than during other study periods. With
economic growth targeted at 6%, the decline in FSI up to the end of 2007 reflects improved stability.

1. INTRODUCTION High instability can trigger many crises including

The tendency of growing instability in
industrialized and emerging countries, particularly
since the banking crisis in 1997, has encouraged
several countries to pay greater attention to the
soundness of their banking sector and in financial
system policy.
economic crises. When a crisis occurs, a country often
not only suffers great financial loss but also struggles
to recover economic conditions.
The Indonesian banking industry still dominates
(80%) the share of total assets in the financial sector;
therefore, to stimulate economic activity requires a

1 Director, Directorate of Banking Research and Regulation, Bank Indonesia,
mhadad@bi.go.id
2 Head of Financial System Stability Bureau, Directorate of Banking Research and Regulation,
Bank Indonesia, wimboh@bi.go.id
3 Lecturer Department of Economic, University of Indonesia, sugiharso@fe.ui.ac.id
4 Senior Researcher, Financial System Stability Bureau, Directorate of Banking Research
and Regulation, Bank Indonesia, dwityapoetra@bi.go.id
5 Researcher, Financial System Stability Bureau, Directorate of Banking Research and
Regulation, Bank Indonesia, rulina@bi.go.id

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 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia
robust banking sector that functions well. The stability
and health of the banking sector as part of financial
sector stability is closely tied with economic
performance (Andrew Crocket, 1997). This
relationship is reflected by the intermediary function
of the banking system. Disruptions in the
intermediation function will constrain bank fund
allocation for investment in productive sectors of the
economy.
Looking at the strategic role of the financial
system in an economy, various instruments need to
be reviewed to supervise and assess financial sector
stability. One of the instruments is the financial
stability index, an indicator to monitor developments
and identify influential factors on financial stability.
In this study, financial sector sources will be discussed,
as well as the factors chosen to calculate the financial
stability index. In addition, this paper will discuss
the results of econometric simulation modeling to
assess the effect of microeconomic and
macroeconomic factors on financial sector stability.
2. LITERATURE STUDY
Some experts define financial instability as
something that can disrupt the implementation of
financial system functions. More precisely, financial
instability is the inability of a bank to function well,
particularly in extending credit and performing its
intermediation function (Mishkin, 2000; Bergman
and Hansen, 2002; Hawkesby, 2000). In this context,
financial stability can be defined as a situation where
the possibility of banking crisis is absent or negligible.
However, looking from a broader viewpoint,
financial risk also depends on financial system
structure. The financial system is highly integrated,
which means the disruptions to stability that may
80
arise from one component will immediately affect
other parts of the system. Therefore, the term
financial instability may also represent several aspects
that can agitate the financial markets including falling
asset prices, non-bank financial institution defaults,
for example in the bonds market, company
bankruptcies of non-financial institutions, or a
combination of the above.
The current paper defines financial instability
as various levels of financial pressure. The degree of
financial instability is estimated between 0 and 1.
Banking Sector: NPL and Financial Instability
One of the proxies that can be used to illustrate
banking sector stability is the amount of non-
performing loans (NPL) at a given time. The higher
the number of NPL, the greater the possibility for banks
to perform optimally as financial intermediaries, thus
the higher their instability becomes.
Equity Market: Stock Prices and Financial
Instability
Equity market fluctuations have an enormous
effect on the economy, which can be seen from four
sides (Mishkin, 2001). First, the effects of the equity
market on investment. Second, the effect of company
balance sheets. Third, the effect of household wealth.
And fourth, the effect of household liquidity.
Bonds Market: Corporate Bond Spread and
Financial Instability
The variable normally used to illustrate financial
instability in the bonds market is corporate bond
spread, which is a combination of credit risk, market
risk and liquidity risk (Duca, 1999). Credit risk is a
function of expected losses, whereas market risk and
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia
liquidity risk are functions of risk and uncertainty.
Therefore, a rise in risk premiums is an indication of
growing pressure on the company»s financial
conditions, which eventually impinge upon financial
stability. Sources of credit risk include default risk, credit
migration risk, uncertainty risk and recovery risk.
3. METHODOLOGY
This study adopted model developed by
Sterken (1991). The models constructed from
simultaneous equation comprising of 4 blocks:
banking sector, equity market, bonds market and the
real sector. Each block is represented by a set of
structural and behavioral equations, whereas
relationships between blocks are illustrated by an
identity equation.
Banking Sector: Credit Risk
NPL is defined as the following function:
NPL = f(REER, Y, M, BCRPB)
The banking sector block involves the following
structural equations:
BCRCOR = f(SHCOR-1, ML-1, LTD-1, BCRCOR-1,
LIQCOR-1, RSH, DV)
BCRHOU = f(BCRHOU-1, YD-1, RBCR, P)
ΔRCB = f(RCB-RSUSA-1, ((KUS/KEUS)-1))
ΔKUS = f(ΔKEUS, KUS-1, KEUS-1)
Meanwhile, the identity equation in the banking
sector block is defined as
BCRDNB = BCRCOR + BCRHOU - BCRPB
Equity Markets
IHSG = f(SHCOR, P, RBCR)
There are two structural equations in the equity
market block:
SHFOR = f(SHFOR-1, BONFOR-1, ERLFOR)
SHHOU = f(SHHOU-1, BONHOU-1, ERNFA)
The equity market block also uses the following
three identity equations:
ERLFOR = RLUSA + 0.2 ((KEUS / KUS) - 1)
ERNFA = RSUSA + 0.2 ((KEUS / KUS) - 1)
SHCOR = SHHOU + SHFOR
Real Sectors
The consumption function the real sector block
is formulated as:
KONS = f(SHHOU-1, BONHOU-1, BCRHOU-1,
KONS-1, YD, RCB)
Meanwhile, the investment function (I) in this
block is formulated as:
I = f(BONCOR-1, LIQCOR-1, RBON, DV, RCB)
The estimation process begins with the
identification of variables in all equations. The
specification process include determining the
specification of the model and the estimation
technique employed. Based on specification test we
found that the equation system over-identifies so
two stage leas squared method (TSLS) was applied.
Econometric tests on the classic assumptions are
performed to produce Best Linier Unbiased Estimation
(BLUE). Model testing prior to the estimation process
is performed to exclude specification errors in the
model and set the error variant at normal distribution.
The tests predominantly used include the Jarque Bera
(JB) test for normality and Ramsey»s Regression
Specification Error Test (RESET). The econometric tests
conducted include multicolinearity tests,
heteroscedastisity and autocorrelation. Significance
testing is undertaken to investigate the degree of
significance between endogenous and exogenous
variables. The significance tests used are the t test
and Goodness of Fit test (F test and adjusted R2).
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 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Sensitivity tests are conducted to reveal changes in
the model due to shocks from exogenous variables
which produce significant models. Tests conducted
include: Root of Mean Square Error (RMSE); Mean
Absolute Error (MAE); Mean Absolute Percent Error
(MAPE); and Theil Inequality Coefficient (TIC) including
its decomposition. The weighting techniques used to
combine variables into an index are: factor analysis,
credit aggregate weights and variance equal weights
(illing and Liu, 2003) and (Bordo et al. 2000).
4. ESTIMATION RESULTS
Banking Sector: Credit Risk
The banking sector block is specified by the non-
performing loan (NPL) variable, which is a function
of the real effective exchange rate (REER); gross
domestic product (Y); M2 money supply (M); and
the supply of short-term bank credit by private banks
(BCRPB). Estimation results using the TSLS method
for the banking sector block (credit risk) are as follows:
Among all variables in the NPL equation, two
variables are statistically significant in the regression:
real effective exchange rate (REER) and money supply
(M). The coefficient of determination (adjusted-R2)
shows that the variations of independent variables
in this equation are able to explain 92.5% of
variations in the NPL. As the parameter of REER is
negative, it can be concluded that real exchange rate
depreciation will reduce NPL. Meanwhile, the money
supply parameter (M), which was negative, shows
that the contraction of money supply will reduce
the NPL.
Equity Market
This block is specified by the Jakarta Composite
Index (IHSG), which is a function of stock supply by
corporations (SHCOR); inflation rate (P) and interest
rate on short-term bank credit (RBCR).
Estimation results using the TSLS method on
the stock market block are as follows:

NPL = 42.937 - 0.172 REER + 2.57e-05 Y √ 2.88e-05 M √ 9.14e-06 BCRPB IHSG = 1474.12 + 0.02 SHCOR - 22.267 P √ 63.848 RBCR
(t-stat) (2.953) (-9.723) (0.944) (-2.275) (-0.412)
(t-stat) (16.39) (10.166) (-1.636) (-13.93)
Adj.R2 = 0.925 Durbin Watson = 0.627
2
Adj.R = 0.948; Durbin Watson = 1.543
BCRCOR = - 10355.19 √ 0.109741 SHCOR(-1) + 1.062 ML(-1) + 0.026 LTD(-1)
SHFOR = 1327.58 + 0.79 SHFOR(-1) - 0.106 BONFOR(-1) - 90.55 ERLFOR
(t-stat) (-0.412) (-0.598) (2.548) (0.615)
(t-stat) (1.869) (9.127) (-1.154) (-0.54)
+ 0.812 BCRCOR(-1) - 15.859 LIQCOR(-1) √ 152.94 RSH - 0.12 DV 2
Adj.R = 0.624; Durbin Watson = 2.494
(8.944) (-1.18) (-0.809) (-1.16) SHHOU = 3271.253 + 0.47 SHHOU(-1) - 0.027 BONHOU(-1) - 66.285 ERNFA
Adj.R2 = 0.991Ω; Durbin Watson = 2.37
(t-stat) (3.084) (3.688) (1.875) (-0.4904)
BCRHOU = -14315304 + 0.997 BCRHOU(-1) + 48.994 YD - 81398.89 RBCR
2
Adj.R = 0.344 ; Durbin Watson = 2.20
(t-stat) (-1.16) (42.25) (1.565) (-0.299)
+ 111883.6 P
(0.636)
2
Adj.R = 0.998Ω; Durbin Watson = 2.18
The coefficient of determination value for the
D(RCB) = 0.27 √ 1.417 D(RSUSA) √ 0.06 (RCB - RSUSA) - 4.85 ((KUS/KEUS)-1) IHSG equation is high (0.948). From the three
(t-stat) (0.64) (-1.89) (-1.155) (-0.812)
explanatory variables, only one variable is not
Adj.R2 = 0.006; Durbin Watson = 2.66
D(KUS) = 0.928 D(KEUS) - 0.367 (KUS(-1) - KEUS(-1)) significant, namely the inflation rate (P) variable.
(t-stat) (7.14) (-2.51) Meanwhile, SHCOR and RBCR variables are
2
Adj.R = 0.52; Durbin Watson = 2.454
statistically significant.

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 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Bonds Market BONPB-1 has a statistically significant relation. The

The bonds market block is specified by the structural equation BONHOU has a coefficient of
interest rate (RBON), as a function of the official determination of 0.99. From the six independent
discount rate (RCB); M2 money supply (M), and variables in the equation, two are statistically
supply of bonds by corporations in the previous significant: BONHOU-1 and YD (disposable income).
period (BONCOR). Both parameters of those two variables have positive
Estimation results using the TSLS method on signs.
the bonds market block are as follows: Meanwhile, coefficient of determination in the
structural equation BONFOR is 0.605. Interestingly,
RBON = - 6.0648 √ 0.135 RCB + 4.47E-06 M + 0.000173 BONCOR(-1) + [AR(1) = 0.786] there is only one variable that is statistically significant
(t-stat) (-1.402) (-1.604) (1.083) (1.858) (9.306)
in the equation, namely BONFOR-1.
Adj.R2 = 0.913; Durbin Watson = 2.567
BONPB = 33720.66 - 0.0007 CASH(-1) + 1.96e-05 NFA(-1) + 0.94 BONPB(-1) - 0.034 W
(t-stat) (0.708) (-1.532) (1.002) (11.21) (-0.354) Real Sector
- 117.93 ERNFA + [AR(1) = 0.12] The real sector block comprises of the
(-0.684) (0.85)
consumption function and the investment function.
Adj.R2 = 0.92; Durbin Watson = 2.6
The consumption function is further specified as a

BONHOU = - 62437.47 + 0.859 BONHOU(-1) + 0.092 ML(-1) + 0.232 LIQHOU(-1) function of stock demand by households (SHHOU),
(t-stat) (-0.027) (6.03) (0.224) (0.331) bonds demand by households (BONHOU) in the
+ 0.1706 YD + 58.786 RBON + 8.698 ERNFA + [AR(1) = 0.240]
(2.155) (0.086) (0.068) (1.27)
previous period, short-term bank credit demand by
2
Adj.R = 0.993; Durbin Watson = 1.901 households (BCRHOU) in the following period,
BONFOR = 1356.201 + 0.772 BONFOR(-1) √ 41.861 RBON √ 153.03 ERLFOR
(t-stat) (1.913) (8.676) (-0.374) (-0.902)
consumption in the previous period (KONS -1),
2
Adj.R = 0.605; Durbin Watson = 2.102 disposable income (YD), and an official discount rate
BONCOR = 1338.037 + 0.113 SHCOR(-1) + 0.1907 BONCOR(-1) + 0.013 BCRCOR(-1)
(t-stat) (0.823) (3.203) (1.435) (1.164)
(RCB).
- 3.386 LIQCOR(-1) - 93.162 RBON - 131.337 RLIQ Results of the estimation using TSLS for the real
(-2.07) (-0.753) (-2.328)
sector block are as follows:
Adj.R2 = 0.48; Durbin Watson = 1.84
BONCG = 1.02 BONCG(-1) + 1.128 BD
(t-stat) (102.92) (1.92) KONS = -11673.25 - 0.001 SHHOU(-1) + 0.0079 BONHOU(-1) √ 2.62E-05 BCRHOU(-1)
Adj.R2 = 0.90; Durbin Watson = 2.36
(t-stat) (-0.768) (-0.037) (0.37) (-0.946)
+ 1.012 KONS (-1) + 0.03 YD + 12.44 RCB
Regression of the RBON equation in the (16.18) (2.14) (0.176)
Adj.R2 = 0.99; Durbin Watson = 0.634
simultaneous model produces a high coefficient of
I = 65706.73 √ 0.625 BONCOR(-1) + 27.885 LIQCOR(-1) - 104.04 RBON √ 0.354 DV - 379.83 RCB
determination (0.93). However, in this regression,
(16.669) (-0.91) (8.868) (-0.21) (-2.58) (-1.44)
there is only one variable significant at 10 percent 2
Adj.R = 0.836; Durbin Watson = 0.37

significance level, i.e. the BONCOR-1.

Furthermore, regression of the BONPB equation The consumption equation in the real sector
in the model also shows good results. The coefficient block has a high coefficient of determination
of determination is high (0.92) and in this equation, (adjusted R2), 0.99. Variables that are statistically

83
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Table A2.1
significant in the equation are consumption in past
Accuracy of the Simultaneous Model
period (KONS-1) and disposable income (YD). The two
Structural Equation RMSE MAE MAPE Theil
variables have positive relationships with
Banking (Credit Risk)
consumption.
NPL 0,962 0,803 8,558 0,044
The investment equation in the real sector block BCRCOR 4585,164 3740,251 3,255 0,017
BCRHOU 2251698 1864571 2,014 0,011
has 0.836 as its value of adjusted R2. In the equation, D(RCB) 2,226 1,763 19,868 0,087
D(KUS) 257,708 160,732 1,705 0,014
two independent variables are statistically significant,
Stock Market
more specifically liquidity demand by corporations IHSG 52,426 42,103 7,626 0,041
(LIQCOR-1) and change in GDP (DV). SHFOR 2031,948 1779,489 1191,246 0,327
SHHOU 3585,084 2614,779 38,572 0,199
Bond Market
Model Prediction: in the sample period RBON 0,588 0,483 15,307 0,073
BONPB 7487,752 6180,553 1,698 0,01
The simultaneous equation model in this study BONHOU 5444,276 4564,28 17,686 0,044
is used as a projection tool for various indicators. BONFOR 2103,221 1601,784 28,08 0,18
BONCOR 601,786 405,277 50,96 0,25
This section presents projections of the main variables BONCG 6,868 5,578 3,353 0,021

in each block involved in the simultaneous equation. Real Sector

KONS 1655,005 1492,961 0,637 0,003
The performance of a model can be evaluated in two I 7689,442 7014,681 8,751 0,048
ways: by measuring the accuracy of the prediction
and through graphical methods. The accuracy with ≈normalΔ behavior extolled in economic theory.
measurement is used to verify the power of prediction Nonetheless, inaccuracy in the estimations is often
and the validity of prediction results. Furthermore, found in empirical studies, especially among those
accuracy measurement is evaluated from several involving simultaneous equation models.
aspects: Root Mean Squared Error (RMSE), Mean In the next stage of the evaluation the following
Absolute Error (MAE), Mean Absolute Percentage variables obtained from the projections will be used
Error (MAPE), and the Theil Inequality Coefficient. to formulate the financial stability index (FSI):
Table A2.1 presents the accuracy measurements 1. Banking sector (credit risk), using predictions
of the model used in this paper. from the non-performing loan variable (NPL).
For prediction purposes, the performance of this 2. Equity market, using predictions from the JCI
model is considered «fair». For instance, the MAPE of variable (IHSG).
the model (as one measurement of accuracy) has a 3. Bonds market, using predictions from the interest
high average error value. There are several reasons rate on bonds variable (RBON).
for the «fair» evaluation of this model. First, the design
of the simultaneous equation model does not fully Banking Sector: Credit Risk
reflect general equilibrium for each sector within the In the following graph it can be seen that during
economy. Second, is related to the lack of available the research period projected NPL and actual NPL
data. Finally, is the behavior of several economic followed a similar trend. This graphically
agents in each sector block that is not compatible demonstrates the goodness of fit of the model.

84
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Graph A2.1
Financial Stability Index (FSI)
Projected NPL against Actual NPL
20 The financial stability index (FSI) formulated in
NPL Actual NPL Forecast
18
this study is a composite index based on the behavior
16

14
of the three markets. The composite index is based
12 on the study of Bordo, et.al. (2000). It is assumed
10
that the median is used as stability points throughout
8

6 the observation period. Here, the selection of the

4
2002 2003 2004
observation period is crucial.

Equity Market Graph A2.4

FSI Performance based on the Change in Standard
Throughout the research period, projected IHSG Deviation and Median
performance follows a similar trend to actual IHSG. 4.5
4 FSI
This also graphically demonstrates the strengths of 3.5
3
the model used.
2.5
Graph A2.2 2
Projected JCI against Actual JCI 1.5
1200 1
1100 JCI Actual JCI Forecast
0.5
1000 0
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May
900
2001 2002 2003 2004 2005
800
700
600 Graph A2.4 illustrates FSI performance during
500
400
2001 - 2005. At the initial point, FSI values during
300
2001 2002 2003 2004
2003 are assumed as the «stability points» for financial
stability. Extreme departure from the values of FSI in
Bonds Market 2003 is considered a symptom of financial system
Graph A2.3 illustrates that during the research instability. The movement of FSI, as depicted in Graph
period, projected RBON and actual RBON followed a A2.4, marks symptoms of instability.
similar trend. Again this graphically proves the
goodness of fit of the model used. Model Simulation
Graph A2.3 This section presents simulation results of the
Projected RBON against Actual RBON
simultaneous equations model. The period is
-1

-2 extended up to the end of 2007. The Indonesian

-3 economy is assumed to grow by 6% in 2007.
-4
Graph A2.5 shows the influence of economic
-5

-6 growth on the banking sector block through the NPL

-7
ratio. Simulation results indicate a rise in NPL in line
-8
RBON Actual RBON Forecast
-9
with economic growth.
2002 2003 2004

85
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Graph A2.5 yield (RBON) until early 2002. Simulation results show
NPL Simulation Results against Baseline NPL
that in 2006 the average rate of risk in the bonds
20

18 NPL NPL (Baseline) market is -1.87, while in 2007 it is -1.92.

16

14
Analysis of Financial Stability Index Simulation
12

10 The results of simulations up to the end of 2007

8
are used further to estimate the stability of the
6

4
2002 2003 2004 2005
In terms of the equity market, the simulation
returns under-predicted results in 2004, with IHSG
predicted to reach 1,000 by the end of 2004. The
simulation shows that IHSG will grow gradually with
the assumption of 6% economic growth. Furthermore,
the simulation projects that IHSG drops to 937 in 2006
but rebounds to around 944.52 in 2007.
In terms of the bonds market, Graph A2.7
demonstrates that the simulation over-predicts bond
financial system. Graph A2.8 shows that FSI in mid
2006 2007
2005 is relatively higher compared to other periods.
Using the assumption of 6% economic growth, FSI
is expected to decline up to the end of 2007.
Through the results of the simulations, it is
expected that with the assumption of 6% economic
growth financial system stability can be maintained.
Graph A2.8
Projected FSI Performance based on Fluctuating Standard
Deviation According to Position x from the Median
4
FSI Simulation
3.5

Graph A2.6 2.5

Projected IHSG against Baseline IHSG 2

1.5
1200
1
1100
0.5
1000
0
900 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep
800 2001 2002 2003 2004 2005 2006 2007

700
600 5. CONCLUSION
500
Regression of the simultaneous equation model
400
JCI JCI (Baseline)
300 in this study produced good results. Furthermore, the
2001 2002 2003 2004 2005 2006 2007
F-test is statistically significant. The adjusted
Graph A2.7 coefficient of determination (adjusted R2) for each
Projected RBON against Baseline RBON
-1 structural equation with direct impact on the
-2 composition of FSI is large (above 90%). However,
-3

-4
structural equations with indirect impact on the
-5 composition of FSI produced poor results. In this case,
-6
several parameters were insignificant, while the
-7

-8 coefficient of determination (R2) was small. Generally,

RBON RBON (Baseline)
-9 poor parameter performance can undermine the
2002 2003 2004 2005 2006 2007

86
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia
ability of a model to explain the phenomenon under
analysis and, therefore, cannot provide an accurate
forecast.
However, the in-sample-period prediction of this
model produced good results. In brief, the strength
of the simultaneous equation model used in this study
can be used to formulate a financial stability index
for Indonesia.
Although the results of the model used generally
returned satisfying results, several weaknesses were
found. One of the primary weaknesses was the
unavailability of data. Furthermore, in Indonesia some
sectors remain underdeveloped, such as the bonds
market. Notwithstanding, there are sectors that have
developed but unfortunately the data is as yet
unavailable.
Another constraint was found in the activities
(market) block of the structural equation, which was
unable to fully illustrate Indonesian economic activity.
To illustrate an economic system using simultaneous
equations, the study employed three market blocks
namely the credit market, equity market and bonds
market. The use of only three market blocks limited
the analysis scope.
To improve the study in the future, it is essential
to refine the model»s structure to make it more
suitable to Indonesia»s characteristics as a developing
country. In addition, more complete data is required.
Also, short-term corrections to the long-term balance
through an error correction mechanism (ECM) should
be included. Through such improvements it is
expected that a future Macroeconomic Model FSI can
be formulated to project a number of periods into
the future. The model will also be a reliable
forecasting tool, as part of efforts to support
policymaking in the banking and financial sectors.
87
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia
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89
 Article II - Macroeconomic Model to Measure Financial Stability Index: The Case of Indonesia

Appendix

Notations, Indicators, Units, and Data Sources

No. Variable Indicator Unit Source

1 BCRCOR demand of short-term bank credit by corporation Billion BI

(value of working capital loans and investment loans)
2 BCRHOU demand of short-term bank credit by household Billion BI
(value of consumer loans)
3 BCRDNB supply of short term bank credit by central bank Billion BI
4 BCRPB demand of short-term bank credit by private banks Billion BI
5 BD central government budget deficit Percent APBN
6 BONCG supply of bonds by the central government Billion BI
7 BONCOR supply of bonds by corporations Billion BI
8 BONFOR net demand for bonds by foreigners Billion BI
9 BONHOU demand for bonds by households Billion BI
10 BONPB demand for bonds by private banks Billion BI
11 CASH net demand for interbank money by private banks or J02
(total cash) Billion BI
12 DV GDP change (DV = Y - Y-1) Billion BPS, with further calculation
13 ERLFOR expected interest rate on short-term net foreign assets Billion Bloomberg
14 ERNFA expected foreign long-term interest rate Billion Bloomberg
15 I investment, gross fixed capital formation Billion BPS
16 IHSG stock market composite price index Rupiah Bloomberg
17 KEUS expected exchange rate (Rp per USD) Rupiah Bloomberg
18 KONS household consumption (constant price, 2000) Billion BPS
19 KUS nominal exchange rate (Rp per USD) Rupiah IFS
20 LIQCOR demand for liquidity by corporations Billion BI
21 LIQHOU demand for liquidity by households Billion BI
22 LTD long-term time and savings deposits (DPK) Billion BI
23 M money supply (M2) Billion BI
24 ML mortgage loan (KPR+KPA) Billion BI
25 NFA net foreign assets or V21 (foreign currency assets) Billion BI
26 NPL non performing loan Percent BI
27 P inflation rate Percent BI
28 RBCR interest rate on short term bank credit Percent BI
29 RBON interest rate on bonds Percent Bloomberg
30 RCB official discount rate Percent BI
31 REER real effective exchange rate Percent Bloomberg
32 RLIQ interest on liquidity Percent BI
33 RLUSA interest rate on US capital market Percent Bloomberg
34 RSH yield on domestic shares Percent Bloomberg
35 RSUSA interest rate on US money market Percent Bloomberg
36 SHCOR supply of shares by corporations Billion Bloomberg
37 SHFOR net demand shares by foreigners Billion BAPEPAM
(stock purchases-BAPEPAM)
38 SHHOU demand for shares by households Billion CEIC
39 W financial wealth Billion CEIC
40 Y gross domestic product (constant price, 2000) Billion BPS
41 YD disposable income Billion BI

90
 Glossary

Glossary

91
 Glossary

This page is intentionally blank

92

Glossary
Cost of loanable funds: includes interest on funds,
overhead costs, the deposit insurance premium and
minimum reserve requirement.
Bank Indonesia Real Time Gross Settlement (BI-RTGS):
Electronic transaction settlement in real time where
accounts are debited and credited multiple times per day.
Business continuity management: Risk management to
ensure critical functions during disruptions as well as having
an effective recovery process.
Downside Risk: The likelihood that a security or other
investment will decline in price, or the amount of loss that
could result from that potential decline.
Failure to settle: a mechanism which obliges participants
of the clearing system to provide a pre-fund to anticipate
liabilities emerging at the end of the day.
Discount Window: credit extended to banks by the central
bank to overcome liquidity problems caused by a temporary
mismatch in liquidity management.
Financial Sector Assessment Program: a joint program by
the IMF and World Bank to assess the resilience of a
country»s financial system and its adherence to international
standards.
Flight to safety: switching funds from banks considered
less safe to safer banks.
Four-eyes principle: credit approval considering business
prospects and risk management.
Financial Safety Net: framework to strengthen financial
system stability through four key elements: i) bank
regulation and supervision; ii) lender of last resort; iii)
deposit insurance; and iv) crisis management.
Capital Adequacy Ratio (CAR): The ratio of a bank»s total
regulatory capital to its risk-weighted assets.
Glossary
Non-performing loans (NPL): a loan that is in default or
close to being in default categorised as sub-standard (SS),
doubtful (D) and loss (L)
Lender of last resort: the function of a central bank in
extending credit to banks to overcome liquidity problems
caused by a mismatch in funds and to prevent systemic
crisis.
Crisis management: a comprehensive framework to
identify, mitigate and resolve crises.
Mark to market: Evaluating the price or value of a security,
portfolio, or account on a daily basis, to calculate profits
and losses or to confirm that margin requirements are being
met.
Risk mitigation: efforts to reduce the possibility and effects
of risk.
Economic capital: is the amount of real capital required
to cover accumulative excess or unexpected losses over a
fixed time period with a set confidence level.
Moral Hazard: behaviour of business players (bank owners,
managers and customers) that triggers financial losses for
the bank.
Crisis prevention: efforts to prevent crises through policies
for micro prudential regulation and supervision of financial
institutions and financial markets as well as macro
prudential surveillance of the financial system.
Crisis resolution: efforts to overcome crises including
restructuring and recapitalising banks with systemic effects.
Profit taking: the selling of assets or securities by investors
at a high price to receive profit.
Regulatory capital: the minimum capital required applied
to banks set by the regulator.
93
 Glossary
Restructuring: the act of improving loan conditions by
applying several options: i) adjusting the covenants to
provide additional financing; ii) converting all or partial
interest as new loans; iii) converting all or part of the loan
as equity for the bank in the company with or without
rescheduling or reconditioning.
Credit risk: the risk of loss due to a debtor»s possibility of
default, or non-payment of a loan.
Liquidity Risk: risk that an institution will not be able to
execute a transaction at the prevailing market price because
there is, temporarily, no appetite for the deal on the other
side of the market.
Operational risk: the risk of loss resulting from inadequate
or failed internal processes, people and systems, or from
external events.
Market risk: the risk that the value of an investment will
decrease due to the movements in market factors.
Systemic risk: describes the likelihood of the collapse of a
financial system, such as a general stock market crash or a
joint breakdown of the banking system.
Risk-free assets: an asset whose future return is known
with certainty. However, such assets remain subject to
inflation risk.
Systemically Important Payment Systems: are those that,
in terms of the size or nature of the payments processed
via them, represent a channel in which shocks could
threaten the stability of the entire financial system.
Risk-control system: is a system to control risk implemented
through bank policy and procedure in line with sound risk
management principles.
Credit scoring systems: provide a consistent, mathematical
system to evaluate potential debtors. A credit score is a
numerical expression based on a statistical analysis of a
potential debtor»s credit files, to assess the creditworthiness
of that debtor, which is the likelihood the debtor will pay
his or her debts.
94
Financial system stability: refers to a state in which a
financial system, consisting of financial institutions and
markets, functions properly. In addition, the participants,
such as firms and individuals, have confidence in the
system.Ω
Stress testing: is a simulation technique used on asset
and liability portfolios to determine their sensitivities to
different financial situations. Stress-testing is a useful
method of determining how a portfolio will fare during a
period of financial crisis.
Undisbursed Loans: are loans that have been agreed but
are yet to be withdrawn.
Unexpected losses: are defined as the difference between
expected loss and worst case loss. Expected losses are
≈smallΔ losses, unexpected losses are ≈low probability high
impactΔ losses and worst case losses are losses of such
magnitude that they would render most institutions
bankrupt.
Volatility: is the relative rate at which the price of a security
moves up and down. Volatility is found by calculating the
annualized standard deviation of daily change in price. If
the prices of securities move up and down rapidly over
short time periods, it has high volatility. If the price almost
never changes, it has low volatility.
Yield: The rate of income generated from a stock in the
form of dividends, or the effective rate of interest paid on
a bond, calculated by the coupon rate divided by the bond»s
market price. Furthermore, for any investment, yield is the
annual rate of return expressed as a percentage.
Financial Stability Review
No. 8, March 2007

DIRECTOR

Muliaman D. Hadad SWD. Murniastuti Wimboh Santoso

COORDINATOR & EDITOR

Sukarela Batunanggar

WRITER

Satrio Wibowo, Tirta Segara, Linda Maulidina, Herawanto, Ronald L. Toruan,

Dwityapoetra S. Besar, Pungki P. Wibowo, Pipih Dewi Purusitawati, Wini Purwanti,
Endang Kurnia Saputra, Ferial Ahmad, Ita Rulina, Ricky Satria, Fernando R. B,
Noviati, Sagita Rachmanira, Reska Prasetya, Leanita Indah P.

COMPILATOR, LAYOUT & PRODUCTION

Ita Rulina Ricky Satria Primitiva Febriarti

CONTRIBUTOR
Directorate of Bank Licensing and Banking Information
Directorate of Bank Supervision 1
Directorate of Bank Supervision 2
Directorate of Bank Supervision 3
Directorate of Economic Reserach and Monetary Policy
Directorate of Monetary Management
Directorate of Accounting and Payment System

DATA SUPPORT

Suharso I Made Yogi