Academic journal article Journal of Southeast Asian Economies

Assessing the Impact of Financial Crisis on Bank Performance: Empirical Evidence from Indonesia

Academic journal article Journal of Southeast Asian Economies

Assessing the Impact of Financial Crisis on Bank Performance: Empirical Evidence from Indonesia

Article excerpt

I. Introduction

Over the last few years, major structural changes have occurred in the Indonesian banking system. The major changes in the Indonesian banking system happened after 1997, when Indonesia suffered severe economic damage during the Asian financial crisis. The sharp decline in the domestic currency has resulted in damaging effects on the leading banks' balance sheets and their capital adequacy. In response to the depreciating exchange rate, Bank Indonesia (the central bank of Indonesia) lifted interest rates on deposits. This has resulted in bank revenues to decline, as banks could not pass on higher interest rates to distressed corporate borrowers, subsequently resulting in negative interest rate spreads and reducing banks' net income.

To mitigate the impact of the Asian financial crisis on the banking sector, the government unveiled a four-pronged banking sector restructuring programme which involves recapitalization, foreclosures, mergers and acquisitions, and the privatization of state-controlled banks (sale of government-owned shares to the private sector). Despite the wave of mergers and acquisitions and closures of banks, the concentration in the Indonesian banking sector continued to remain high with the top five banks representing 61 per cent of the total assets of the banking sector. The rate reaches 90 per cent when it comes to the top twenty-three banks (Indonesian Chamber of Commerce 2005).

It is reasonable to assume that these developments posed great challenges to financial institutions in Indonesia as the environment in which they operated changed rapidly, a fact that consequently had an impact on the determinants of the profitability of Indonesian banks. As Golin (2001) points out adequate earnings are required in order for banks to maintain solvency, survive, grow, and prosper in a competitive environment.

As the banking sector is the backbone of the Indonesian economy and plays an important financial intermediary role, their health is very critical to the health of the general economy at large. Given the relation between the well being of the banking sector and the growth of the economy (Rajan and Zingales 1998; Levine 1998; Levine and Zevros 1998; Cetorelli and Gambera 2001; Beck and Levine 2004), knowledge of the underlying factors that influence the financial sector's profitability is therefore essential not only for the managers of the banks, but for numerous stakeholders such as the central banks, bankers associations, governments, and other financial authorities. Knowledge of these factors would also be helpful to help the regulatory authorities and bank managers formulate going-forward policies for improved profitability of the Indonesian banking sector.

By using an unbalanced bank level panel data, this study seeks to examine the determinants of Indonesian banks profitability during the period 1990-2005, which is characterized as a time of significant reform in the country's financial sector. While there have been extensive literature examining the profitability of financial sectors in developed countries, empirical work on factors that influence the performance of financial institutions in developing economies is relatively scarce.

This paper is structured as follows: the next section reviews related studies in the literature, followed by a section that outlines the econometric framework. Section IV reports the empirical findings. Finally, section V concludes and offers avenues for future research.

II. Related Studies

The empirical literature on bank profitability have mainly focused on the U.S. banking system (Berger 1995; Angbazo 1997; DeYoung and Rice 2004; Stiroh and Rumble 2006; Hirtle and Stiroh 2007) and the banking systems in the Western and developed countries, e.g. New Zealand (To and Tripe 2002), Australia (Williams 2003), Greece (Pasiouras and Kosmidou 2007; Kosmidou et al. 2007; Athanasoglou et al. …

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