THE EFECTIVENES OF MACROPRUDENTIAL INSTRUMENTS AND BANKING MARKET STRUCTURE ON BANKS PERFORMANCE:

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1 THE EFECTIVENES OF MACROPRUDENTIAL INSTRUMENTS AND BANKING MARKET STRUCTURE ON BANKS PERFORMANCE: EMPIRICAL EVIDENCE ON EMERGING COUNTRIES Abstract: Yuli Teguh Hidayat, Tumpak Silalahi 1, and Prof. Dr. Rina Indiastuti 2 Recently, numerous Central Banks implement various macroprudential policies to complement monetary policy that have been established as a compulsory study at the Faculty of Economics and Business. However, macroprudential instruments are still relatively new. Its intended purpose is to achieve stability in the financial system while monetary policy is intended to achieve the objectives of macroeconomic stability. The structure of the banking industry affecting the effectiveness of macroprudential policy because the financial industry will respond to monetary policy and macroprudential policy would be well responded if the banking market structure can be identified in the early stage. Allegedly the differences that occur between the overly concentrated market structure as in the monopoly market and vice versa in a perfectly competitive market has a different effect when testing the effectiveness of monetary and macroprudential policies. This dissertation study aimed to explore the implications of macroprudential policy particularly the effect of banking market structure on the profitability of banks in Indonesia and how the interaction between macroprudential policy and market structure. Research methodology used is based on an econometric model with the model specification and the main purpose of research is to assess the performance of banks. There are two main models used in this study: firstly, using a longitudinal panel OLS regression analysis with a design that is analysis of longitudinal data modeling that consist of panel fixed effect model and random effect model is further equipped with a Hausman test. The second approach, complementary study was conducted with the model of Vector Auto Regression Model (VAR) to test cointegration, stationary test, Granger Causality Test, Impulse Response and Variance Decomposition. Key word: Macroprudential policy, Banking Structure, Commercial Bank Profitability. 1 Yuli Teguh Hidayat and Tumpak Silalahi, Student at the Faculty of Economics and Business, University of Padjdjaran, Bandung Indonesia, Working at Center for Central Banking Research and Education, Bank Indonesia, corresponding author: silalahi@bi.go.id or tumpak.bi@gmail.com 2 Co-author, lecture in Economics and Business Faculty, University of Padjdjaran, Bandung Indonesia, corresponding co- author: rina-ceha@yahoo.com. Call for Paper Page 1

2 MACROPRUDENTIAL INSTRUMENTS EFECTIVENES AND BANK MARKET CONCENTRATION ON BANKS PERFORMANCE: (EMPIRICAL EVIDENCE ON INDONESIAN BANKING FIRM PROFITABILITY) 1. INTRODUCTION Research on the banking industry became the topic of many resercher in depth at present, it is inseparable from the phenomenon of the global financial crisis of 2008, which makes a variety of changes to banking authority expects the model to corporate banking which is sustainable and beneficial for the economy. The emergence of bank failures due to the 2008 global crisis in the world banking industry, that indicated from a number of banks in developed countries (developed countries) to bail out, making the formulation of resilience in the banking industry is indispensable. The resilience of the financial system of the pressure his own crisis (financial resiliance) is influenced by various factors. One of the factors the durability depends on the structure of the market owned by a Contracting State on its financial system, are more oriented to financial or domination by capital markets (Capital market orientation). Indonesia's financial system is dominated by the banking sector which is reflected by the bank's market share is more dominant than the capital markets and non-bank financial institutions, therefore, highly relevant microeconomic deepening bank to do. Call for Paper Page 2

3 Emerging countries such as Indonesia have a very much interest on banking sector since bank interest margins as a measure of financial intermediation costs is particularly pertinent in the absence of developed capital markets and the small presence of non-bank financial institutions, households and firms largely depend on bank financing. The role of macro prudential instruments belief to stabilize the financial system, however on the individual banking institution those policy can affect the banking profitability. On the other side, the effectiveness of macroprudential policy depend on the bank market structure. According to Arreguy et all (IMF WP -13/167), implementing macro prudential will effect on the costs arise from an increase in the cost of intermediation and its effect on long-run output. Even though, the benefit is derived from the resilience of the economy from the policy measure a reduction in the probability of a crisis and output losses in the event of a crisis. 2. MOTIVATION OF THE STUDY Study about macro prudential instruments become a new policy trend particularly since the global financial crisis during 2008 s beside monetary policy that already long exist in the economic theory. However, it is still premature to know precisely how the interaction between monetary policy and macro prudential policy influence the business strategy of the banking industry. follows: Based on explanation above, this research is intended to study the things as Call for Paper Page 3

4 1. To review and analyze the impact on Indonesian macro prudential policies on performance of commercial banks in Indonesia. 2. To study the impact of market power or market concentration on commercial bank profitability. 3. To examine the relationship between economic cycle with commercial banks performance. 4. To review and analyze interaction between market power or market concentration and macro prudential policy in conjunction with the profitability of commercial banks in Indonesia. To achieve those objectives, research methodologies developed in this paper based on the econometric model as a primarily tool using quarterly commercial bank data since 2007 until recently as a compliment to descriptive and statistical analysis. 3. THEORETICAL BACGROUND Study of literature and research on micro-economic banking mostly refers to the contribution Brucker and Klein (1971) and Bernard Shull (1963). At the level of microeconomics, a production function of goods is relatively easy to explain but in the production function model in the banking services industry is not as simple as the production of goods. That's because the production on a bank deposit collection services and disbursements of public funds which of course is more complicated to measure. Several literature studies try to explain the level of productivity in the banking balance sheet by way of diagnosis (balance sheet) a simple bank among others: Xavier et al (2008), Mankiw, NG (1986) and Mishkin (2010), as follows: Call for Paper Page 4

5 Assets Reserves Loan Liabilities + Capital Deposits Equity On the assets side of the balance sheet there is a Reserve bank (R) is the difference between the volume of deposits received by banks as well as the volume of loans disbursed by the notation (D_it-L_ (it)). Reserve bank owned which symbol can be classified into two types, namely Statutory Reserves (usually not given interest) with the notation SR with i interest rate and t the period of bank portfolio position in the interbank market M(t) with the following model: +... (1.1) From the point of understanding or definition of a bank as a financial institution described as an example, by Xavier et al (1998, p.1) that defines the operations of the bank as a financial institution that guarantees loans and accept deposits from the public. While, Rose and Hudgins (2005) defines a more comprehensive bank: first, the economic functions it serves, both, the services it offers its customers and third, the legal basis for its existence. Monetary authorities generally require commercial banks keep a portion of the public funds in the bank as statutory reserves (reserve requirement) to be deposited in the central bank in the form of cash or securities in vault. The amount of the reserve requirement set each monetary authority and RR policies affect the ability of banks to lend that ultimately affect the performance of the bank. Why banks must keep some funds in Call for Paper Page 5

6 the banking industry has a RR for different legality of other non-bank industry is given the mandate / business license to collect public funds (Giro, deposits and savings). Because the banking industry is not controlled by a particular company, then the Monti- Klein models easily explain models of imperfect competition (Cournot) among a number of banks N is more a portrait of reality. To simplify the analysis, it is assumed there are N number of banks that have a similar cost function, and linear: ( ) 1.2 The link between market structure, conduct and performance is described by the company two paradigms is still a debate among academics. The first paradigm is Hyphotesis Structure Conduct Performance (SCP) and the second, Hyphotesis Relative Market Power (RMP). Traditional SCP Hyphotesis found the level of bank profitability is affected by the level of market domination which concentrated market structure (monopoly and oligopoly) with a market share effect on performance. While the RMP Hyphotesis found diversified banking products became the market power which in turn have an impact on improving the profitability of banks. Lubis (2012), examined the behavior of Indonesian banks in influencing the price that shows how much market power that empowered as an indicator of the level of competition in the market. The findings of the study was the level of competition in the Indonesian banking credit market is still quite high but can not be categorized as a perfectly competitive market. Parera (2010) (market concentration bank in Sri Lanka), concluded in his research on SCP, which is concentrated on bank structure impact on bank powers to set interest rates on loans and higher and lower interest rates on deposits. Call for Paper Page 6

7 4. RESEARCH METHODOLOGY There are many factors that affect the performance of the banks. The factor such as internal and external factors would be investigate for this research. Some research on the impact of external factor on Net Interest margin (NIM) for Indonesian Financial Sector had been done in a partial such as the effect of GDP and Inflation. Hoewever, the effect of macro prudential instruments on NIM still rarely since the data is unpublish by the Central Bank. Furthermore, the model developed in this research based on econometric as follows: Panel 1 Equation: Panel 2 Equation: = + + h Panel 3 Equation: Description: SRR DLTV GDP Infl MS CR Aset CAR CIR NPL NIM = Riil Reserve Requirement Ratio = Loan to Value Dummy = Growth Domestic Product = Inflation Rate = Market Share Power = Concentration Share Power = Bank Asset = Capital Adequacy Ratio = Cost to Income Ratio (Efficiency Perbankan = Rasio of Non Performing Loan = Net Interest Margin Call for Paper Page 7

8 Growth DPK = The Growth of Commercial Bank Funding. The analysis will be performed refers to two types namely panel data modeling residual Fixed Effects Model (Fixed Effect Model (FEM) and Random Effects Model Model (REM). Electoral most appropriate model among the models of Fixed Effects or Random Effects Model is based on the consideration that the model improper could cause bias. Therefore, using Hausman test will examine the best model which is FEM or REM. As a proxy for measuring the performance of the banking industry that bank profitability that need to be investigated whether macro prudential policy and the level of market share (market power) of a bank relative to the effect on the profitability of the banking industry. In academic circles, there is still debate whether the market share (level of competition) lead to market stability (stability Concentration hyphothesis) or market share actually cause market instability (Concentration fragility hyphothesis). If the level of mastery of a dominant market instability (fragility) and decreased levels of efficiency and profitability of the banking structure of the Indonesian Banking implications settings need to be cautious. Call for Paper Page 8

9 No Variables Description Source of Data Expected Sign. Riil Reserve 1 Requrement The change of Reserve Reserve Requirement Ratio. Bank Indonesia(BI) - 2 LTV'S Dummy Event Study, reguation of Loan to Value =1 for the period. Q-II 2012 since policy implementing and =0 other period. BI - 3 Market Power Level of market share compare to bank industries BI + 4 Concentration (CR4,CR11) Concentration of 4 firms to industry BI + 5 Bank Asset(Asset) Total Aset of Firm Bank Scope Bureau Vandijk +/- 6 Bank Capital Capital of bank proxy by Capital Adequacy Ratio(CAR) BI + 7 Bank Efficiency (Cost to Income Ratio), notation: CIR BI - 8 (Credit Risk) Non-Performing Loan to Total Loan, Notation: NPL BI - 9 Net Interest margin Net Interest margin, Notation: NIM BI + 10 Deposit Growth Growth of bank funding BI + 11 GDP Economic Growth IFS + 12 Inflation Inflation IFS + 5. DATA AND STATISTIC DESCRIPTION The data in this study will be obtained from a variety of sources of data that is owned by Bank Indonesia (Indonesian Banking Directory), the privately run Bank Scope Bureau Vandijk, Blomberg and data from the International Financial Statistics (IFS). By using longitudinal panel regression as a primarily tool based on quarterly commercial bank data since Q until Q-IV 2012, allows this research to avoid multicolinearity test. Call for Paper Page 9

10 6. STLYLIZED FACTS For region 5 Southeast Asian nations (ASEAN-5), the net interest margin is the highest Indonesian thus reflecting the relatively low efficiency of Indonesian banks in the ASEAN region. Indonesia's banking performance compared to the performance of banks in the Southeast Asia region and with other continents as depicted on the chart Africa Asia-Pacific Caribbean Central and Eastern Europe Central and South America Central Asia Europe Middle East North America GRAFIC: AVERAGE Return on Aset banking industry based on Regional Source: The Grafic: Average Net Interest margin To 10 Banks in ASEAN-5 Call for Paper Page 10

11 7. RESULTS AND SUMMARY The profitability of bank is influence by net interest rate margin, operational expenditure, policy rate and credit risk. The economic growth have significant effect statitistically on profitability on lag 3 that mean the commercial bank will respon to the economic cycle within 3 quarter. In addtion, this paper provides some conclusion and policy recommendation, firstly, as Bank Indonesia is a legal authority of monetary and banking suversion till now, so Bank Indonesia needs to understand the determinants of bank performance. Secondly, investigating the impact of macro prudential should aware with the market share of the each industry. Failure to understand the relationship the interaction between macro prudential instruments and market power will pose a risk to financial stability. These conclusion have policy implications both direcly and indericly on designing macro prudential instruments. Therefore, coordination and joint research between the monetary and fiscal policy will benefit to provide a finacial stability. Based on Panel 1 equation as describing on research methodology, the result of eviews-8 as follows: Call for Paper Page 11

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13 REFERENCE: 1. Arreguy et all (IMF WP -13/167), Implementing Macroprudential, IMF 2. Indranarin Ramlall (2009), Bank Specific, Industry Specific and Macroeconomic Determinants of Profitability in Taiwanese Banking System: Under Panel Data Estimation, International Research Journal of Finance and Economics, Euro Journals Publishing, Inc Beim dan Calomiries (2001), Emerging Financial market, 2nd edition, McGraw- Hill/Irwin. 4. Christobal M.Pagoso(2010), Money, Credit and Banking, Rex Book Store, Philipines. 5. Demircuc-Kunt, Asli and Enrica(1998), The Determinats of banking crises in develop and depeloping countries, IMF Working Paper, vol. 45 No.1, Washington DC. 6. Yener Altunbas, Lynne Evans, Philip Molyneux (2001), Bank Ownership and Efficiency, Journal of Money, Credit and Banking, Vol.33. No.4, The Ohio State University. 7. Thierno Amadou Barry, Santos Jose Dacanay III, Laetitia Lepeti, Amine Tarazi(2008), paper presented for the European Commision Asia Link project B7-3010/2005/ M.Anwar dan Aldrin Herwany (2006), The Determinants of Sucessful Bank Profitability in Indonesia: Empirical study for Provincial Governments Banks and Private Non- Foreign Banks. 9. Sujoko dan Ugy Soebiantoro (2007), Pengaruh struktur kepemilikan saham, leverage, factor Intern dan Faktor Ekstern terhadap nilai perusahaan,(studi empiric pada perusahaan manufaktur dan non manufaktur di Bursa Efek Jakarta). 10. Peter S. Rose and Sylvia C. Hudgins (2005), Bank Management and Financial Services, 6 th edition, McGraw Hill International Edition. 11. J. Soedradjad Djiwandono (2001), Bergulat denganj krisis dan Pemulihan Ekonomi Indonesia, Pustaka Sinar Harapan Indonesia. 12. Michael P. Todaro and Stephen C. Smith (2009), Economic Development, 10ed, Addison Wesley, Pearson Education. 13. Todaro dan Smith (2009), Economic Development, Harlow, London: Addison Wesley/Pearson Education. 14. Kaminsky dan Reinhart (2000), Bank Lending and Contagion:Evidence From the Crisis,Department of Economics, George Washington University,Washington DC Grigorian dan Manole (2002), Determinant of Commercial Bank Performance in Transtion Economies: An Application of Data Envelopment Analysisis, The World bank, WP Sabine Herman and Dubravko Mihaljek (2010), The Determinants of Cross-Border bank flows to emerging markets: new empirical evidence on the spread of financial crises, BIS Working Papaers No Harald Finger and Heiko Hesse(2009), Lebabon-Determinats of Commercial Bank Deposits in Regional Financial Center, IMF Working Paper WP/09/195. Call for Paper Page 13