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ASEAN Economic Bulletin Vol. 27, No. 3 (2010), pp. 24562 DOI: 10.1355/ae27-3a

ISSN 0217-4472 print / ISSN 1793-2831 electronic

Assessing the Impact of Financial Crisis on Bank Performance

Empirical Evidence from Indonesia
Fadzlan Sufian and Muzafar Shah Habibullah

The paper seeks to examine the determinants of Indonesian banks profitability during the period 19902005. The empirical findings indicate that income diversification and capitalization are positively related to bank profitability, while size and overhead costs exert negative impacts. During the period under study, Indonesian banks seem to have been skimping on their resources, particularly during the pre-crisis and crisis periods. The impact of economic growth and banking sector concentration are positive during the pre-crisis and crisis periods. We find that the Asian financial crisis exerts negative and significant impact on the profitability of Indonesian banks, while Indonesian banks have been relatively more profitable during the pre-crisis compared to the post-crisis and crisis periods. Keywords: Banks, profitability, Indonesia.

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
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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

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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 sectors 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 19902005, which is characterized as a time of significant reform in the countrys 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. 2008; Kosmidou and Zopounidis 2008). In contrast, few studies have looked at bank performance in developing economies. Guru et al. (2002) investigate the determinants of bank profitability in Malaysia. They used a sample of seventeen commercial banks during the 1986 1995 period. The profitability determinants were divided in two main categories, namely the internal determinants (liquidity, capital adequacy, and expenses management) and the external determinants (ownership, firm size, and economic conditions). The findings revealed that efficient expenses management was one of the most significant in explaining high bank profitability. Among the macro indicators, high interest ratio was associated with low bank profitability and inflation was found to have a positive effect on bank performance. Chantapong (2005) investigates the performance of domestic and foreign banks in Thailand during the period 19952000. All banks were found to have reduced their credit exposure during the crisis years and have gradually improved their profitability during the post-crisis years. The results indicate that foreign banks profitability is higher than the average profitability of domestic banks although importantly, in the post-crisis period, the gap between foreign and domestic bank profitability has closed, suggesting that the financial restructuring programme has yielded some positive results. Ben Naceur and Goaied (2008) examine the impact of bank characteristics, financial structure,

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and macroeconomic conditions on Tunisian banks net-interest margin and profitability during the period 19802000. They suggest that banks with relatively high amount of capital and overhead expenses tend to exhibit higher net-interest margin and profitability levels, while size is negatively related to bank profitability. During the period under study, they find that stock market development has positive impact on banks profitability. The empirical findings suggest that private banks are relatively more profitable than their state-owned counterparts. The results suggest that macroeconomic conditions have no significant impact on Tunisian banks profitability. Ben Naceur and Omran (2008) examine the influence of bank regulations, concentration, financial and institutional development on Middle East and North Africa (MENA) countries commercial banks margin and profitability during the period 19892005. They find that bankspecific characteristics, in particular bank capitalization and credit risk, have positive and significant impact on banks net interest margin, cost efficiency, and profitability. On the other hand, macroeconomic and financial development indicators have no significant impact on bank performance. More recently, Sufian (2009) examines the determinants of Malaysian domestic and foreign commercial banks profitability during the period 20002004. The empirical findings suggest that Malaysian banks with higher credit risk and loan concentration exhibits lower profitability levels. On the other hand, banks that have a higher level of capitalization, higher proportion of income from non-interest sources, and high operational expenses tend to be relatively more profitable. The results suggest that economic growth has a negative effect on Malaysian banks profitability, while higher inflation rates have a positive impact on Malaysian banks profitability. Molyneux and Thornton (1992) were the first to explore thoroughly the determinants of bank profitability on a set of countries. They use a sample of eighteen European countries during the period 198689 and find a significant positive relationship between the return on equity and the

level of interest rates in each country, bank concentration, and government ownership. In another comprehensive study, Demirguc-Kunt and Huizinga (1999) examine the determinants of bank interest margins and profitability using bank level data for eighty countries from 1988 to 1995. They find that a larger ratio of bank assets to GDP and a lower market concentration ratio lead to lower margins and profits. The findings also suggest that foreign banks have higher margins and profits than domestic banks in developing countries, while the opposite prevails in developed countries. Demirguc-Kunt and Huizinga (2001) present evidence on the impact of financial development and structure on bank profitability using bank level data for a large number of developed and developing countries over the 19901997 period. The results indicate that financial development exerts significant impact on bank performance. They find that higher bank development is related to lower bank performance due to tougher competition. On the other hand, stock market development leads to higher profitability and margin for banks, particularly at lower levels of financial development suggesting complementariness between the banking sector and the stock market. More recently, Pasiouras and Kosmidou (2007) examined the performance of domestic and foreign commercial banks in fifteen EU countries during the period 19952001. They find that profitability of both domestic and foreign banks is affected not only by bank specific characteristics, but also by financial market structure and macroeconomic conditions. The results suggest that all variables have significant relationship with bank profitability, although their impacts and relation are not always uniform for domestic and foreign banks. III. Data and Methodology We collected our bank-specific variables from the financial statements of a sample of commercial banks operating in Indonesia over the period 19902005 available in the Bankscope database of Bureau van Dijks company. The macroeconomic

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variables are retrieved from IMF Financial Statistics (IFS) database. Due to the consolidation and exit of banks during the past decade, the total number of commercial banks in the sample varied from eleven banks in 1990 to thirty-two banks in 1997. This gives us a total of 404 bank year observations. III.1 Performance Measure In the literature, bank profitability, typically measured by the return on assets (ROA) and/or the return on equity (ROE), is usually expressed as a function of internal and external determinants. Internal determinants are factors that are mainly influenced by a banks management decisions and policy objectives. Such profitability determinants are the level of liquidity, provisioning policy, capital adequacy, expenses management, and bank size. On the other hand, the external determinants, both industry and macroeconomic related, are variables that reflect the economic and legal environments where the financial institution operates. Following Ben Naceur and Goaied (2008), Kosmidou (2008), and Abbasoglu et al. (2007) among others, the dependent variable used in this study is ROA. ROA shows the profit earned per dollar of assets and most importantly reflects the management ability to utilize the banks financial and real investment resources to generate profits (Hassan and Bashir 2003). For any bank, ROA depends on the banks policy decisions as well as uncontrollable factors relating to the economy and government regulations. Rivard and Thomas (1997) suggest that bank profitability is best measured by ROA given that ROA is not distorted by high equity multipliers and represents a better measure of the ability of the firm to generate returns on its portfolio of assets. ROE on the other hand, reflects how effectively a bank management is in utilizing its shareholders funds. Since ROA tends to be lower for financial intermediaries, most banks utilize financial leverage heavily to increase ROE to competitive levels (Hassan and Bashir 2003).

III.2 Internal Determinants The bank-specific variables included in the regressions are LNTA (log of total assets), LLP/TL (loans loss provisions divided by total loans), NII/ TA (non-interest income divided by total assets), NIE/TA (total overhead expenses divided by total assets), LNDEPO (log of total deposits), and EQASS (book value of stockholders equity as a fraction of total assets). The LNTA variable is included in the regression models as a proxy of size to capture the possible cost advantages associated with size (economies of scale). A positive relationship between size and bank profitability could be expected if there are significant economies of scale (Akhavein et al. 1997; Bourke 1989; Molyneux and Thornton 1992; Bikker and Hu 2002; Goddard et al. 2004). However, other researchers have found that only marginal cost savings can be achieved by increasing the size of the banking firm (Berger et al. 1987; Boyd and Runkle 1993; Miller and Noulas 1997; Athanasoglou et al. 2008). In essence, the impact of size on bank performance remains inconclusive. The ratio of loan loss provisions to total loans (LLP/TL) is incorporated as an independent variable in the regression analysis as a proxy of credit risk. The coefficient of the LLP/TL variable is expected to be negative because bad loans erode bank profitability. In this direction, Miller and Noulas (1997) suggest that the greater the exposure of the financial institutions to high risk loans, the higher would be the accumulation of unpaid loans and the lower profitability would be. Miller and Noulas (1997) suggest that decline in the loan loss provisions are in many instances the primary catalyst for increases in profit margins. Furthermore, Thakor (1987) also suggests that the level of loan loss provisions is an indication of the banks asset quality and signals changes in the future performance. To recognize that financial institutions in recent years have increasingly been generating income from off-balance sheet business and fee income generally, the ratio of non-interest income over

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total assets (NII/TA) is entered in the regression analysis as a proxy of non-traditional activities. Non-interest income consists of commission, service charges, and fees, guarantee fees, net profit from sale of investment securities, and foreign exchange profit. The ratio is also included in the regression model as a proxy measure of bank diversification into non-traditional activities. The variable is expected to exhibit a positive relationship with bank profitability. The ratio of overhead expenses to total assets, NIE/TA, is used to provide information on the variations of bank operating costs. The variable represents total amount of wages and salaries, as well as the costs of running branch office facilities. For the most part, the literature argues that reduced expenses improve efficiency and hence raise the profitability of a financial institution, implying a negative relationship between operating expenses ratio and profitability (Bourke 1989). However, Molyneux and Thornton (1992) observed a positive relationship, suggesting that high profits earned by firms may be appropriated in the form of higher payroll expenditures paid to more productive human capital.1 In any case, it should be appealing to identify the dominant effect, in a developing banking environment like Indonesia. The variable LNDEPO is included in the regression model as a proxy variable for branch networks. It would be reasonable to assume that banks with large branch networks are able to attract more deposits, which is a cheaper source of funds. Earlier studies by Chu and Lim (1998) point out that large banks may attract more deposits and loan transactions and in the process command larger interest rate spreads, while the smaller banking groups with smaller depositors base might have to resort to purchasing funds in the inter-bank market, which is costlier (Randhawa and Lim 2005). EQASS is included in the regression models to examine the relationship between profitability and bank capitalization. Even though leverage (capitalization) has been demonstrated to be important in explaining the performance of

financial institutions, its impact on bank profitability has been ambiguous at best. As lower capital ratios suggest a relatively risky position, one might expect a negative coefficient on this variable (Berger 1995). However, it could be the case that higher levels of equity would decrease the cost of capital, leading to a positive impact on bank profitability (Molyneux 1993). Moreover, an increase in capital may raise expected earnings by reducing the expected costs of financial distress, including bankruptcy (Berger, 1995). III.3 External Determinants Bank profitability is sensitive to macroeconomic conditions despite the trend in the industry towards greater geographic diversification and larger use of financial engineering techniques to manage risk associated with business cycle forecasting. Generally, higher economic growth encourages banks to lend more and permits them to charge higher margins, as well as improve the quality of their assets. Neely and Wheelock (1997) use per capita income and suggest that this variable exerts a strong positive effect on bank earnings. Demirguc-Kunt and Huizinga (2001) and Bikker and Hu (2002) identifies possible cyclical movements in bank profitability i.e. the extent to which bank profits are correlated with the business cycle. Their findings suggest that such correlation exists, although the variables used were not direct measures of the business cycle. To measure the relationship between economic and market conditions and bank profitability, LNGDP (natural log of GDP), CR3 (the three largest banks asset concentration ratio), DUMTRAN1 (dummy variable that takes a value of 1 for the first tranquil (pre-crisis) period, 0 otherwise), DUMCRIS (dummy variable that takes a value of 1 for the crisis period, 0 otherwise), and DUMTRAN2 (dummy variable that takes a value of 1 for the second tranquil (post-crisis) period, 0 otherwise) are used. Gross domestic product (GDP) is among the most commonly used macroeconomic indicator to measure total economic activity within an economy.

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The GDP is expected to influence numerous factors related to the supply and demand for loans and deposits. Favourable economic conditions will affect the demand and supply of banking services positively, but will have either positive or negative influence on bank profitability. The CR3 variable measured as the concentration ratio of the three largest banks in terms of assets is entered in the regression models as a proxy variable for the banking sector concentration. According to the industrial organization literature, a positive impact is expected under both the collusion and efficiency views (Goddard et al. 2001). In order to examine for the impact of the Asian financial crisis on the profitability of the Indonesian banking sector, DUMTRAN1, DUMCRIS, and DUMTRAN2 are introduced in regression models 3, 4, and 5 respectively. Formally, the three hypotheses to be tested by the analysis are as follows: H1: The Indonesian banking sector has been relatively more profitable during the pre-crisis compared to the crisis and post-crisis periods after controlling for other bank specific and macroeconomic conditions. H2: The Asian financial crisis exerts negative influence on the Indonesian banking sector after controlling for other bank specific and macroeconomic conditions. H3: The Indonesian banking sector has been relatively more profitable during the postcrisis compared to the pre and crisis periods after controlling for other bank specific and macroeconomic conditions. Table 1 lists the variables used to proxy profitability and its determinants. We also include the notation and the expected effect of the determinants according to the literature. Table 2 presents the summary statistics of the dependent and explanatory variables. III.4 Econometric Specification To test the relationship between bank profitability

and the bank-specific and macroeconomic determinants described earlier, we estimate a linear regression model in the following form: yit = t + jt Xijt + it Xejt + jt (1)

where j refers to an individual bank; t refers to year; yjt refers to the return on assets (ROA) and is the observation of bank j in a particular year t; Xi represents the internal factors (determinants) of a bank; Xe represents the external factors (determinants) of a bank; jt is a normally distributed random variable disturbance term. We apply the least square method of fixed effects (FE) model, where the standard errors are calculated by using Whites (1980) transformation to control for cross-section heteroscedasticity. The opportunity to use a fixed effects rather than a random effects model has been tested with the Hausman test. Extending equation (1) to reflect the variables, as described in Table 1, the baseline model is formulated as follows: yjt = t + jt (LOANS/TAjt + LNTAjt + LLP/TLjt + NII/TAjt + NIE/TAjt + LNDEPOjt + EQASSjt) + t (LNGDPt + CR3t + DUMTRAN1t + DUMCRISt + DUMTRAN2t) + jt (2) Table 3 provides information on the degree of correlation between the explanatory variables used in the multivariate regression analysis. The matrix shows that in general the correlation between the bank specific variables is not strong suggesting that multicollinearity problems are not severe or non-existent. Kennedy (2008) points out that multicollinearity is a problem when the correlation is above 0.80, which is not the case here. IV. Empirical Findings It is of public interest to know what banks can do to improve their profitability so that scarce resources are allocated to their best uses and not wasted during the production of services and goods (Isik and Hassan 2003). For this purpose, we investigate whether any aspects of the banks

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TABLE 1 Description of the Variables Used in the Regression Models Variable Dependent ROA Independent Description with Profitability The return on average total assets of bank j in year t. Internal Factors LNTA LLP/TL The natural logarithm of the accounting value of the total assets of bank j in year t. Loan loss provisions/ total loans. An indicator of credit risk, which shows how much a bank is provisioning in year t relative to its total loans. A measure of diversification and business mix, calculated as non-interest income/total assets of bank j in year t. Calculated as non-interest expense/total assets and provides information on the efficiency of the management regarding expenses relative to the assets in year t. Higher ratios imply a less efficient management. LNDEP is a proxy measure of branch networks, calculated as the log of total deposits of bank j in year t. A measure of bank js capital strength in year t, calculated as equity/total assets. High capital asset ratio is assumed to be an indicator of low leverage and therefore lower risk. A measure of loans intensity, calculated as total loans/ total assets. The ratio indicates what percentage of the assets of the bank is tied up in loans in year t. External Factors LNGDP CR3 DUMTRAN1 DUMCRIS DUMTRAN2 Natural logarithm of gross domestic products. The three largest banks asset concentration ratio Dummy variable that takes a value of 1 for the first tranquil (pre crisis) period, 0 otherwise. Dummy variable that takes a value of 1 for the crisis period, 0 otherwise. Dummy variable that takes a value of 1 for the second tranquil (post crisis) period, 0 otherwise. +/ +/ + + +/ Hypothesized Relationship

NA

NII/TA

NIE/TA

LNDEPO EQASS

+/ +/

LOANS/TA

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TABLE 2 Summary Statistic of Dependent and Explanatory Variables ROA Mean Min Max Std. Dev. 0.036 4.517 0.297 0.296 LNTA 14.979 5.548 19.389 1.954 LLP/TL 0.045 0.663 2.156 0.168 NII/TA 0.034 0.006 0.726 0.041 NIE/TA 0.012 0.612 0.154 0.034 LNDEPO 14.528 5.400 19.145 2.156 EQASS 0.052 4.267 0.579 0.335

NOTE: The table presents the summary statistics of the variables used in the regression analysis.

are related to their degree of profitability. In the following analysis, we will analyse the performance of the Indonesian banking sector based on the results derived from a series of parametric and non-parametric tests, before we embark on a discussion on the results derived from a multivariate regression setting. IV.1 The Performance of the Indonesian Banking Sector: A Univariate Setting To examine the difference in the relative performance of the Indonesian banking sector during the pre and post-crisis periods, we perform a series of parametric (t-test) and nonparametric (Mann-Whitney [Wilcoxon] and Kruskall-Wallis) tests. The results are presented in Table 4. It is observed that on average the Indonesian banking sector has incurred lower losses and credit risk and has been relatively better capitalized during the post-crisis compared to the pre-crisis period (statistically significant at the 10 per cent level in the nonparametric Mann-Whitney [Wilcoxon] and Kruskall-Wallis tests). It is also apparent that Indonesian banks have been larger (15.74599 > 14.31200) with wide branch networks (15.42588 > 13.74585) during the post-crisis period and is statistically significant at the 1 per cent level in the parametric t-test. The results from the parametric t-test are further confirmed by the non-parametric Mann-Whitney [Wilcoxon] and Kruskall-Wallis tests.

IV.2 Determinants of Bank Profitability: A Multivariate Analysis The regression results focusing on the relationship between bank profitability and the explanatory variables are presented in Table 5. To conserve space, the full regression results, which include both bank and time specific fixed effects are not reported in the paper. Several general comments regarding the test results are warranted. The model performs reasonably well with most variables remaining stable across the various regressions tested. The explanatory power of the models is also reasonably high, while the F-statistics for all models is significant at the 1 per cent level. The relationship between size (LNTA) and bank profitability is negative. The negative coefficient indicates that larger (smaller) banks tend to earn lower (higher) profits and provides support to the earlier studies by Pasiouras and Kosmidou (2007) and Staikouras et al. (2008). Eichengreen and Gibson (2001) suggest that the effect of a growing banks size on performance may be positive up to a certain limit. Beyond this point, the effect of size could be negative due to bureaucratic and other reasons. On a similar vein, the earlier studies by McAllister and McManus (1993) points out that a proportionate increase in inputs would only result in a smaller increase of outputs for the large banks, due to the fact that the large banks have in general been operating at diseconomies of scale (operating at decreasing returns to scale, due to being at more than the optimum size).

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The notation used in this table is defined as follows: LLP/TL is a measure of bank risk calculated as the ratio of total loan loss provisions divided by total loans; NII/TA is a measure of bank diversification towards non-interest income, calculated as total non-interest income divided by total assets; NIE/TA is a proxy measure for management quality, calculated as personnel expenses divided by total assets; LNTA is a proxy measure of size, calculated as a natural logarithm of total bank assets; LNDEPO is a proxy measure of branch networks, calculated as the log of total deposits; EQASS is a measure of capitalization, calculated as book value of shareholders equity as a fraction of total assets; LNGDP is natural log of gross domestic products; CR3 is a measure of banking sector concentration, calculated as the ratio of the three largest banks total assets; DUMTRAN1 is a dummy variable that takes a value of 1 for the first tranquil (pre crisis) period, 0 otherwise; DUMCRIS is a dummy variable that takes a value of 1 for the crisis period, 0 otherwise; DUMTRAN2 is a dummy variable that takes a value of 1 for the second tranquil (post crisis) period, 0 otherwise. NIE/TA LNDEPO EQASS LNGDP CR3 0.059 0.106* 0.089 0.015 0.095 0.035 0.162** 1.000 0.322** 0.112* 0.091 0.057 0.332** 0.011 1.000 0.475** 0.244** 0.162** 0.030 0.479** 1.000 0.792** 0.146** 0.420** 0.063 1.000 0.002 0.040 0.322** 1.000 DUMTRAN1 0.296** 0.189** 0.040 0.035 0.327** 0.158** 0.653** 0.227** 1.000 DUMCRIS 0.060 0.420** 0.074 0.033 0.089 0.100 0.040 0.452** 0.333** 1.000 DUMTRAN2 0.331** 0.117* 0.014 0.058 0.382** 0.082 0.607** 0.546** 0.736** 0.393** 1.000

Independent Variables

LNTA LLP/TL NII/TA NIE/TA LNDEPO EQASS LNGDP CR3 DUMTRAN1 DUMCRIS DUMTRAN2

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TABLE 3 Correlation Matrix for the Explanatory Variables

LNTA

LLP/TL

NII/TA

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1.000

0.157** 1.000

0.408** 0.242** 1.000

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**

NOTE: The table presents the results from Spearman r correlation coefficients. and * indicates significance at 1 per cent and 5 per cent levels.

TABLE 4 Summary of Parametric and Non-Parametric Tests Test Groups Parametric Test Individual Tests t-test Non-Parametric Test Mann-Whitney [Wilcoxon Rank-Sum] test t (Prb > t) Mean Rank Kruskall-Wallis Equality of Populations test

Test Statistics ROA Pre-Crisis Post-Crisis LNTA Pre-Crisis Post-Crisis LLP/TL Pre-Crisis Post-Crisis NII/TA Pre-Crisis Post-Crisis NIE/TA Pre-Crisis Post-Crisis LNDEPO Pre-Crisis Post-Crisis EQASS Pre-Crisis Post-Crisis

0.0564 0.0132

1.462

211.76 191.86

1.711*

2.927*

14.31200 15.74599

7.898***

166.46 243.91

6.650***

44.227***

0.05383 0.03456

1.147

215.24 187.86

2.352**

5.532**

0.01100 0.01351

0.733

204.04 200.73

0.285

0.081

0.03367 0.03401

0.082

196.24 209.69

1.155

1.335

13.74585 15.42588

8.469***

160.91 250.28

7.674***

58.885***

0.03788 0.06824

0.908

211.44 192.23

1.649*

2.720*

NOTE: Test methodology follows among others, Aly et al. (1990), Elyasiani and Mehdian (1992), and Isik and Hassan (2002). Parametric (t-test) and non-parametric (Mann-Whitney and Kruskall-Wallis) tests test the null hypothesis of equal mean between the two models. *** ** * , , indicates significant at the 1 per cent, 5 per cent, and 10 per cent levels respectively.

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TABLE 5 Multivariate Regressions Results ROAjt = 0 + 1LLP/TLjt + 2NII/TAjt + 3NIE/TAjt + 4LNTAjt + 5LNDEPOjt + 6EQASSjt + 7LNGDP + 8DUMTRAN1+ 9DUMCRIS+ 10DUMTRAN2 + jt The dependent variable is ROA calculated as net profit divided by total assets; LNTA is a proxy measure of size, calculated as a natural logarithm of total bank assets; LLP/TL is a measure of bank risk calculated as the ratio of total loan loss provisions divided by total loans; NII/TA is a measure of bank diversification towards non interest income, calculated as total non-interest income divided by total assets; NIE/TA is a proxy measure for management quality, calculated as personnel expenses divided by total assets; LNDEPO is a proxy measure of branch networks, calculated as the log of total deposits; EQASS is a measure of capitalization, calculated as book value of shareholders equity as a fraction of total assets; LNGDP is natural log of gross domestic products; DUMTRAN1 is a dummy variable that takes a value of 1 for the first tranquil (pre-crisis) period, 0 otherwise; DUMCRIS is a dummy variable that takes a value of 1 for the crisis period, 0 otherwise; DUMTRAN2 is a dummy variable that takes a value of 1 for the second tranquil (post-crisis) period, 0 otherwise. Values in parentheses are t-statistics.
*** **

, , and * indicates significance at 1, 5, and 10 per cent levels. (1) (2) 3.524 (1.752) 0.066* (1.828) 0.024 (0.677) 0.567** (2.266) 2.299*** (3.127) 0.030 (1.513) 0.642*** (4.939)
*

(3) 5.115 (2.213)

**

(4) 3.400 (2.314)

**

(5) 2.015 (1.300) 0.083** (2.400) 0.024 (0.769) 0.547** (2.352) 2.346*** (3.316) 0.033* (1.689) 0.643*** (5.116)

CONSTANT Bank Characteristics LNTA LLP/TL NII/TA NIE/TA LNDEPO EQASS

0.131 (1.103) 0.041* (1.655) 0.002 (0.041) 0.620** (2.075) 2.207*** (2.957) 0.033 (1.561) 0.641*** (4.705)

0.040 (1.589) 0.077** (2.122) 0.602** (2.411) 2.226*** (3.081) 0.017 (1.160) 0.645*** (4.957)

0.059** (1.977) 0.078** (2.163) 0.580** (2.552) 2.278*** (3.261) 0.020 (1.222) 0.647*** (5.177)

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TABLE 5 contd (1) Economic and Market Conditions LNGDP CR3 DUMTRAN1 DUMCRIS DUMTRAN2 (2) (3) (4) (5)

0.283* (1.744) 0.162** (1.981)

0.377** (2.150) 0.229** (2.391) 0.066*** (2.640)

0.279** (2.307) 0.100** (2.120)

0.193 (1.520) 0.044 (0.772)

0.067*** (2.838) 0.061*** (3.822) 0.952 0.945 1.787 135.479*** 404 0.956 0.949 1.823 142.388*** 404 0.958 0.952 1.954 148.984*** 404 0.960 0.954 2.019 156.547*** 404 0.957 0.951 1.859 145.297** 404

R2 Adjusted R2 Durbin-Watson stat F-statistic No. of Observations

It is also interesting to note that the coefficient of the LLP/TL variable entered regression models 3 and 4 with a positive sign (statistically significant at the 5 per cent level), which is in consonance with Berger and DeYoungs (1997) skimping hypothesis. To recap, Berger and DeYoung (1997) suggests that under the skimping hypothesis, a bank maximizing the long-run profits may rationally choose to have lower costs in the short run by skimping on the resources devoted to underwriting and monitoring loans, but bear the consequences of greater loan performance problems. In the case of the Indonesian banking sector, the empirical findings seem to suggest that Indonesian banks could have chosen to skimp on the resources devoted to monitor loans during the pre and crisis periods. Similarly, the relationship between NII/TA and ROA is positive and is statistically significant at the 5 per cent level in all regression models. The results imply that banks which derived a higher

proportion of its income from non-interest sources such as fee based services tend to report a higher level of profitability. The empirical findings provide support to the earlier study by Canals (1993), who suggests that revenues generated from new business units have significantly contributed to improve bank performance. Concerning the impact of overhead costs, NIE/ TA exhibits a negative and significant impact on bank profitability. The results imply that an increase (decrease) in these expenses reduces (increases) the profits of banks operating in Indonesia. Pasiouras and Kosmidou (2007) and Kosmidou (2008) have also found poor expenses management to be among the main contributors to poor bank profitability. Clearly, efficient cost management is a prerequisite for the improved profitability of the Indonesian banking sector i.e. the high elasticity of profitability to this variable denotes that banks have much to gain if they improve their managerial practices.

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Furthermore, the Indonesian banking sector has not reached the maturity level required to link quality effects from increased spending to higher bank profitability. Referring to the impact of branch networks on bank profitability, it can be observed from Table 5 that the coefficient of the LNDEPO variable is positive, supporting the earlier findings by Randhawa and Lim (2005) and Sufian (2007) which have found that banks with extensive branch networks tend to be relatively more managerially efficient. It could be argued that banks with extensive branch networks across the nation could have the advantage over their counterparts as they may attract more deposits and loan transactions and in the process command larger interest rate spreads and subsequently higher levels of profitability. However, it is worth noting that the coefficient of the variable is only statistically significant when we control for the post-crisis period. The level of capitalization (EQASS) is positively related to the profitability of Indonesian banks. The empirical finding is consistent with Berger (1995), Demirguc-Kunt and Huizinga (1999), Staikouras and Wood (2003), Goddard et al. (2004), Pasiouras and Kosmidou (2007), and Kosmidou (2008), providing support to the argument that well-capitalized banks face lower costs of going bankrupt, thus reduce their cost of funding. Strong capital structure is also essential for banks in developing economies, since it provides additional strength to withstand financial crises and increased safety for depositors during unstable macroeconomic conditions. The results for the impact of GDP growth on ROA is consistent with the results of Hassan and Bashir (2003), Pasiouras and Kosmidou (2007), and Kosmidou (2008) and provides support to the argument of positive association between economic growth and banking sector performance. It can be observed from Table 5 that the impact of the banking sectors concentration (CR3) is positive (statistically significant in the baseline regression model and when we control for the pre-crisis and crisis periods). The empirical findings clearly support the Structure-Conduct-

Performance (SCP) hypothesis, which states that banks in highly concentrated markets tend to collude and therefore earn monopoly profits (Short 1979; Gilbert 1984; Molyneux et al. 1996). As expected, DUMTRAN1 and DUMTRAN2 variables entered the regression models with a positive sign (statistically significant at the 1 per cent level), suggesting that the Indonesian banking sector has been relatively more profitable during the pre- and post-crisis periods compared to the crisis period. It can also be observed from Table 5 that the coefficient of DUMCRIS is negative and is statistically significant at the 1 per cent level supporting the notion that the Asian financial crisis exerts negative impact on the profitability of the Indonesian banking sector. IV.3 Robustness Checks: Examining the Channels of Transmission It is of interest to examine the channels through which the impact of the Asian financial crisis is more prevalent. To address this issue, we interact all the bank-specific variables against the respective years exchange rate (EXCR) and repeat equation 2. It is also worth mentioning that we introduce a new bank specific explanatory variable in the form of LOANS/TA (the ratio of total loans scaled by total asset) in the regression models to control for banks liquidity risk, arising from the possible inability of banks to accommodate decreases in liabilities, or to fund increases on the assets side of the balance sheet. The loans market, especially credit to households and firms is relatively risky compared to other bank assets, such as government securities. The results are presented in Table 6. It can be observed from Table 6 that, when we interact all the bank-specific explanatory variables against the exchange rate, the coefficients of the baseline variables stay mostly the same: they keep the same sign, the same order of magnitude, they remain significant as they were so in the baseline regression models (albeit sometimes at different levels), and with few exceptions, do not become significant if they were in the baseline regression models.

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TABLE 6 Multivariate Regressions Results ROAjt = 0 + 1LLP/TLjt * EXCR + 2NII/TAjt * EXCR + 3NIE/TAjt * EXCR + 4LNTAjt * EXCR + 5LNDEPOjt * EXCR + 6EQASSjt * EXCR + 7LOANS/TAjt * EXCR + 8LNGDP + 9DUMTRAN1 + 10DUMCRIS+ 11DUMTRAN2 + jt The dependent variable is ROA calculated as net profit divided by total assets; LNTA is a proxy measure of size, calculated as a natural logarithm of total bank assets; LLP/TL is a measure of bank risk calculated as the ratio of total loan loss provisions divided by total loans; NII/TA is a measure of bank diversification towards non interest income, calculated as total non-interest income divided by total assets; NIE/TA is a proxy measure for management quality, calculated as personnel expenses divided by total assets; LNDEPO is a proxy measure of branch networks, calculated as the log of total deposits; EQASS is a measure of capitalization, calculated as book value of shareholders equity as a fraction of total assets; LOANS/TA is a proxy of loans intensity calculated as total loans scaled by total assets; LNGDP is natural log of gross domestic products; DUMTRAN1 is a dummy variable that takes a value of 1 for the first tranquil (pre-crisis) period, 0 otherwise; DUMCRIS is a dummy variable that takes a value of 1 for the crisis period, 0 otherwise; DUMTRAN2 is a dummy variable that takes a value of 1 for the second tranquil (post-crisis) period, 0 otherwise. Values in parentheses are t-statistics.
*** **

, , and * indicates significance at 1, 5, and 10 per cent levels. (1) (2)

**

(3)
**

(4)
**

(5)
**

CONSTANT Bank Characteristics LNTA * EXCR LLP/TL * EXCR NII/TA * EXCR NIE/TA * EXCR LNDEPO * EXCR EQASS * EXCR LOANS/TA * EXCR

0.024 (2.420)

3.976 (2.319)

4.520 (2.442)

3.594 (2.462)

3.190* (1.750) 0.000 (0.222) 0.000 (1.436) 0.000*** (2.629) 0.000*** (2.721) 0.000 (0.075) 0.000*** (5.613) 0.000** (2.320)

0.000 (0.151) 0.000 (0.167) 0.000** (2.334) 0.000*** (2.591) 0.000 (0.186) 0.000*** (5.425) 0.000** (2.177)

0.000 (0.034) 0.000 (1.217) 0.000*** (2.621) 0.000*** (2.608) 0.000 (0.209) 0.000*** (5.605) 0.000*** (2.610)

0.000 (0.691) 0.000** (2.391) 0.000** (2.556) 0.000*** (2.593) 0.000 (0.741) 0.000*** (5.554) 0.000** (2.548)

0.000 (0.254) 0.000** (2.418) 0.000*** (2.739) 0.000*** (2.658) 0.000 (0.433) 0.000*** (5.739) 0.000** (2.493)

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Economic and Market Conditions LNGDP CR3 DUMTRAN1 DUMCRIS DUMTRAN2

0.281** (2.322) 0.151** (2.380)

0.314** (2.430) 0.169*** (2.668) 0.062* (1.785)

0.255** (2.471) 0.108** (2.013)

0.228* (1.781) 0.089 (1.219)

0.039** (2.327) 0.044 (1.362) 0.962 0.957 1.579 172.145*** 404 0.966 0.961 1.620 185.096*** 404 0.968 0.963 1.767 189.620*** 404 0.968 0.963 1.772 189.849*** 404 0.967 0.962 1.702 184.995*** 404

R2 Adjusted R2 Durbin-Watson stat F-statistic No. of Observations

Referring to the impact of bank size and branch networks, the empirical findings seem to suggest that the coefficients of the LNTA and LNDEPO variables loses its explanatory power when we interact the variable against the exchange rates. Concerning the impact of liquidity risk, it can be observed that the coefficient of the LOANS/TA variable has consistently exhibit a negative sign, indicating a positive relationship between bank profitability and the level of liquid assets held by the bank. As higher figures of the ratio denote lower liquidity, the results clearly suggest that the more (less) liquid banks tend to exhibit higher (lower) profitability levels. A plausible reason is the increased cost for screening and monitoring required by a higher proportion of loans in the banks assets portfolio since loans are the type of assets with the highest operational cost in a bank portfolio (Ben Naceur and Omran 2008). It could also be argued that banks operating in the Indonesian banking sector could have other policy objectives, which may not necessarily be profit oriented. These banks could be argued to

have been lending to related parties, for other development activities, etc., of which is relatively riskier, but may not necessarily generate higher returns. These developments could have restrained the banks resources from other revenue enhancing activities. The empirical findings presented in column 5 of Table 6 indicate that the coefficient of LNGDP has a statistically significant and positive impact on Indonesian banks profitability during the postcrisis period. On a similar vein, it can be observed from Table 6 that the coefficients of the DUMTRAN1, DUMCRIS, and DUMTRAN2 keeps its sign, but the coefficient of the DUMTRAN2 variable seems to lose its explanatory power when we interact the bank specific explanatory variables against the exchange rate. All in all, the empirical findings seem to indicate that the Indonesian banking sector has been relatively more profitable during the pre-crisis compared to the crisis and post-crisis periods when we interact the bank specific explanatory variables against the exchange rate.

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V. Concluding Remarks and Directions for Future Research The Asian financial crisis has had profound negative impact on the Indonesian banking sector. The sharp decline in the domestic currency had damaging effects on the leading banks balance sheets. Moreover, banks revenue shrank as banks could not pass on higher rates to distressed corporate borrowers, subsequently resulting in negative interest rate spreads, reducing banks net income, and damaging their capital adequacy. By using an unbalanced bank level panel data, this study seeks to examine the determinants of Indonesian banks profitability during the period 19902005. The empirical findings from this study suggest that income diversification and capitalization are positively related to bank profitability, while size and overhead costs have negative impacts. During the period under study, Indonesian banks seem to have been skimping on their resources, particularly during the pre-crisis and crisis periods. The impact of economic growth and banking sector is positive, particularly during the pre-crisis and crisis periods. We find that the Asian financial crisis exerts negative and significant impact on Indonesian banks profitability, while Indonesian banks have been relatively more profitable during both tranquil periods. The findings of this study offer considerable policy relevance. In view of the increasing com-

petition attributed to the more liberalized banking sector the continued success of the Indonesian banking sector depends on its competitiveness. Therefore, bank managements and other stakeholders will be more inclined to find ways to obtain the optimal utilization of capacities as well as making the best use of their resources, so that these resources are not wasted during the production of banking products and services. From the regulatory perspective, the policy direction going forward will be directed towards enhancing the resilience of the banking institutions with the aim of intensifying the robustness and stability of the financial sector. Moreover, the ability to maximize risk-adjusted returns on investment and sustaining stable and competitive returns is an important element in ensuring the competitiveness of the financial sector. Future research could include more variables such as taxation and regulation indicators, exchange rates as well as indicators of the quality of the offered services. Another possible extension could be the examination of differences in the determinants of profitability between small and large or high and low profitability banks. Another focal point which could be addressed by future study is the problem of currency mismatch between banks assets and liabilities. In terms of methodology, a statistical cost accounting and frontier techniques could also be used.

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Fadzlan Sufian is an Assistant Vice President in Khazanah Research and Investment Strategy, Khazanah Nasional Berhad, Kuala Lumpur.. Muzafar Shah Habibullah is a Professor in the Department of Economics, Faculty of Economics and Management, Universiti Putra Malaysia.

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